2019 CFA® Program Exam Prep IFT Study Notes · The CFA Program curriculum is important and all IFT...
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© IFT. All rights reserved
2019 CFA® Program Exam Prep
IFT Study Notes
Volume 1
Ethical and Professional Standards
Quantitative Methods
This document should be read in conjunction with the corresponding reading in the 2019 Level I CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2018, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute.
Visit: www.ift.world
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Ethical and Professional Standards and Quantitative Methods 2019 Level I Notes
© IFT. All rights reserved 1
Copyright © 2018 IFT.
All rights reserved. This book or any portion thereof may not be reproduced or used in any manner
whatsoever without the express written permission of the publisher except for the use of brief
quotations in a book review.
Published in 2018 by IFT
Errata information can be found at: https://ift.world/errata
ISBN
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Ethical and Professional Standards and Quantitative Methods 2019 Level I Notes
© IFT. All rights reserved 2
Preface
IFThashelpedthousandsofcandidatessuccessfullyprepareforallthreelevelsoftheCFA®Programexamsince2011.IFTprovidesacompletelearningsystemandpreparationstrategy.AllIFTmaterialsremainclosetotheCFA®Programcurriculum.Wehelpstudentsdevelopathoroughunderstandingoffundamentalconceptsviaactivelearningandexampractice.IFTStudyNotesandDetailedLectureVideoshelpyouunderstandandretaincurriculumconcepts.PracticeusingIFTQuizzesandQuestionBankisessentialtotestyourgraspofthematerials.Closetotheexamdate,IFTHigh‐YieldVideos,High‐YieldNotesandHigh‐YieldQuestionBankalongwithmockexamswillhelpyouachievesuccess.
RecommendedExamPreparationStrategy
TheCFAProgramcurriculumisimportantandallIFTproductsfocusonitscoreconcepts.Startyourpreparationasearlyaspossible.Giveyourselfatleast6monthsforathoroughpreparationandbeginbymakingaschedule.Foreachreadinginthecurriculum,youshoulddothefollowing:
1. ReadIFTStudyNotesforeachreading.IFTrecommendsstartingwithQuantitativeMethods.Dothequestionsattheendofeachreadingtohelpreinforceandretaintheconcepts.
2. Ifyouneedadditionalhelp,watchIFTDetailedVideoLectures.Pause,rewind,andreviewwhereyouneedmoretimetounderstand.Printouttheslidesandtakeyourownnotesasyouarewatching.
3. Readtheexamplesinthecurriculum(alsoknownasblue‐boxexamples)anddothemonyourown.WatchIFTexamplevideostofurthergraspconceptsandpracticethem.
4. Dothepracticeproblemsfromthecurriculumattheendofeachreading.
5. DotheIFTQuestionBankforthatreading.
6. Afterdoingallthereadingsinatopic,taketheIFTTopicExam.
7. Twomonthspriortotheexamorwhenyouhavedonetheabovestepsforeveryreading,youshouldstartyourrevisionusingtheIFTHigh‐YieldCourse.
8. OnemonthbeforetheexamyoushouldattempttheCFAInstituteandIFTmockexams.Theseshouldbedoneinamannertoreplicateyourrealexamexperience.
BelowaresomefurtherdetailsaboutIFTresourcesforLevelIexampreparation.
IFTDetailedLectureVideos:Thesevideoscloselyfollowthecurriculumandcoverallsectionsandlearningoutcomesofareading.LecturesslidesareavailableinPDFformat.Youcanprinttheseslidesandmakenotesonthemasyoufollowthevideolecture.Thispracticeispartofactivelearningwherebyyoumakenotesandcarefullyfollowexamples.Thetotaldurationofthevideosisover70hours.
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Ethical and Professional Standards and Quantitative Methods 2019 Level I Notes
© IFT. All rights reserved 3
IFTStudyNotes:IFTStudyNotesarecloselyalignedwiththeDetailedLectureVideosandpresentinformationinaneasilyunderstandablemanner.Themostimportantpoints,formulas,andexamplesarehighlightedandexplained.Readingthenoteshelpsreinforceyourunderstandingandgraspofconcepts.Bothnotesandvideosareorganizedtomatchthecurriculum(readingnumber/sectionnumber)soyoucanstayclosetoit.
IFTExampleVideos:Thesevideospresentexamplesandtheirworkedsolutions.Theyaresimilarbutnotexactlythesameastheblue‐boxexamplesfromthecurriculum.Theunderlyingconceptsarethesame,butthenumbersmightbedifferent.Thetotaldurationofthesevideosisapproximately30hours.
IFTQuestionBank:Practicinglotsofexam‐likequestions(andsolvingthemcorrectly!)isthekeytoyourexamsuccess.TheIFTQuestionBankhasover3,000questionswithdetailedexplanations.Questionsareavailableforeverylearningoutcome,reading,andtopic.Thequestionsarearrangedintestsof20‐25questionseach.
IFTTopicExams:Thesewilltestyourpreparationatthetopiclevel.Atopicexamshouldbetakenafteryouhavestudiedallreadingsofagiventopicandhavecompletedpracticequestionsforeachreading.Thisisanessentialstepinpreparingfortheexam.
IFTMockExams:IFThasfulllengthmockexamstogetyouexam‐ready.Answersanddetailedexplanationsareprovidedforself‐grading.
IFTHigh‐YieldNotes:IFTHigh‐YieldNotesarebasedonPareto’s80‐20ruleaccordingtowhich80%oftheexamquestionsarelikelytobebasedon20%ofthecurriculum.Hencethesenotesfocusonthe20%materialwhichismosttestable.Theysummarizethemostimportantconceptsfromeachreadingintwotofivepages.
IFTHigh‐YieldVideos:ThesearevideolecturesbasedontheHigh‐YieldNotes.Eachreadingiscoveredin10to20minutes.Totaldurationisapproximately15hours.
IFTHigh‐YieldQ‐Bank:TheIFTHigh‐YieldQ‐Bankhasbetween600and700questionscoveringconceptswhicharemostlikelytoshowupontheexam.Alllearningoutcomesarecoveredandthereisminimumoverlapofthequestions.
Q&AwithIFT:Whenareyouarestuckonaconcept,example,orquestion,thenthe‘Q&AwithIFT’serviceiswheretoturnto.Submityourquery,andanIFTinstructorwillprovideanindividualizedresponse.
Finally,besuretofollowIFTonsocialmediaandvisitwww.ift.worldformylatestblogsandstudyadvice.DoreachouttotheIFTteamifyouneedanyhelporhavequestions.Iwishyouallthebestinyourstudies.
Warmregards,
ArifIrfanullah,CFA
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Ethical and Professional Standards and Quantitative Methods 2019 Level I Notes
© IFT. All rights reserved 4
TableofContentsR01EthicsandTrustintheInvestmentProfession..........................................................................8
1.Introduction .............................................................................................................................. 8 2.Ethics .......................................................................................................................................... 8 3.EthicsandProfessionalism ...................................................................................................... 9 4.ChallengestoEthicalConduct .................................................................................................. 9 5.TheImportanceofEthicalConductintheInvestmentIndustry ........................................ 10 6.Ethicalvs.LegalStandards ..................................................................................................... 11 7.EthicalDecision‐MakingFramework .................................................................................... 12 Summary ...................................................................................................................................... 14 PracticeQuestions ...................................................................................................................... 16
R02CodeofEthicsandStandardsofProfessionalConduct.......................................................19
Introduction ................................................................................................................................ 19 CFAInstituteProfessionalConductProgram ........................................................................... 19 CodeofEthics .............................................................................................................................. 20 StandardsofProfessionalConduct ........................................................................................... 20 Summary ...................................................................................................................................... 25
R03GuidanceforStandardsI‐VII...............................................................................................................26
Introduction ................................................................................................................................ 26 StandardI:Professionalism ....................................................................................................... 26 StandardII:IntegrityofCapitalMarkets .................................................................................. 32 StandardIII:DutiestoClients .................................................................................................... 34 StandardIV:DutiestoEmployers ............................................................................................. 40 StandardV:InvestmentAnalysis,Recommendations,andActions ....................................... 44 StandardVI:ConflictsofInterest............................................................................................... 48 StandardVII:ResponsibilitiesasaCFAInstituteMemberorCFACandidate ....................... 52 Summary ...................................................................................................................................... 55 PracticeQuestions ...................................................................................................................... 57
R04IntroductiontoGIPS................................................................................................................................66
Introduction ................................................................................................................................ 66 1.WhyWeretheGIPSStandardsCreated? ............................................................................... 66 2.WhoCanClaimCompliance? .................................................................................................. 66 3.WhoBenefitsfromCompliance? ........................................................................................... 67 4.Composites .............................................................................................................................. 67 5.Verification .............................................................................................................................. 68 6.TheStructureoftheGIPSStandards ..................................................................................... 68
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Ethical and Professional Standards and Quantitative Methods 2019 Level I Notes
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Summary ...................................................................................................................................... 69 PracticeQuestions ...................................................................................................................... 70
R05TheGIPSStandard....................................................................................................................................72
Introduction ................................................................................................................................ 72 GoalsoftheGIPSExecutiveCommittee .................................................................................... 72 KeyFeaturesoftheGIPSStandards .......................................................................................... 72 HistoricalPerformanceRecord ................................................................................................. 73 Compliance .................................................................................................................................. 73 ImplementingaGlobalStandard ............................................................................................... 74 NineMajorSectionsoftheGIPSStandards .............................................................................. 74 SamplePresentation ................................................................................................................... 78 Summary ...................................................................................................................................... 81 PracticeQuestions ...................................................................................................................... 82
R06TimeValueofMoney..............................................................................................................................84
IntroductoryNote ....................................................................................................................... 84 1.Introduction ............................................................................................................................ 84 2.InterestRates:Interpretation ................................................................................................ 85 3.TheFutureValueofaSingleCashFlow ................................................................................ 87 4.TheFutureValueofaSeriesofCashFlows .......................................................................... 92 5.ThePresentValueofaSingleCashFlow .............................................................................. 94 6.ThePresentValueofaSeriesofCashFlows ......................................................................... 97 7.SolvingforRates,NumberofPeriods,orSizeofAnnuityPayments ................................ 103 Summary .................................................................................................................................... 106 PracticeQuestions .................................................................................................................... 109
R07DiscountedCashFlowApplications.............................................................................................113
1.Introduction .......................................................................................................................... 113 2.NetPresentValueandInternalRateofReturn .................................................................. 113 3.PortfolioReturnMeasurement ............................................................................................ 117 4.MoneyMarketYields ............................................................................................................ 120 Summary .................................................................................................................................... 125 PracticeQuestions .................................................................................................................... 127
R08StatisticalConceptsandMarketReturn....................................................................................131
1.Introduction .......................................................................................................................... 131 2.SomeFundamentalConcepts ............................................................................................... 131 3.SummarizingDataUsingFrequencyDistributions ............................................................ 132 4.TheGraphicPresentationofData ........................................................................................ 133 5.MeasuresofCentralTendency............................................................................................. 135
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Ethical and Professional Standards and Quantitative Methods 2019 Level I Notes
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6.OtherMeasuresofLocation:Quantiles ............................................................................... 138 7.MeasuresofDispersion ........................................................................................................ 139 8.SymmetryandSkewnessinReturnDistributions ............................................................. 143 9.KurtosisinReturnDistributions ......................................................................................... 144 10.UsingGeometricandArithmeticMeans ........................................................................... 145 Summary .................................................................................................................................... 146 PracticeQuestions .................................................................................................................... 150
R09ProbabilityConcepts............................................................................................................................157
1.Introduction .......................................................................................................................... 157 2.Probability,ExpectedValue,andVariance ......................................................................... 157 3.PortfolioExpectedReturnandVarianceofReturn ............................................................ 163 4.TopicsinProbability ............................................................................................................. 165 Summary .................................................................................................................................... 170 PracticeQuestions .................................................................................................................... 174
R10CommonProbabilityDistributions..............................................................................................179
1.Introduction .......................................................................................................................... 179 2.DiscreteRandomVariables .................................................................................................. 179 3.ContinuousRandomVariables ............................................................................................ 183 4.MonteCarloSimulation ........................................................................................................ 188 Summary .................................................................................................................................... 189 PracticeQuestions .................................................................................................................... 193
R11SamplingandEstimation...................................................................................................................198
1.Introduction .......................................................................................................................... 198 2.Sampling ................................................................................................................................ 198 3.DistributionoftheSampleMean ......................................................................................... 200 4.PointandIntervalEstimatesofthePopulationMean ....................................................... 201 5.MoreonSampling ................................................................................................................. 206 Summary .................................................................................................................................... 208 PracticeQuestions .................................................................................................................... 211
R12HypothesisTesting................................................................................................................................216
1.Introduction .......................................................................................................................... 216 2.HypothesisTesting ............................................................................................................... 216 3.HypothesisTestsConcerningtheMean .............................................................................. 221 4.HypothesisTestsConcerningVariance ............................................................................... 225 5.OtherIssues:NonparametricInference .............................................................................. 229 Summary .................................................................................................................................... 230 PracticeQuestions .................................................................................................................... 234
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Ethical and Professional Standards and Quantitative Methods 2019 Level I Notes
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R13TechnicalAnalysis..................................................................................................................................238
1.Introduction .......................................................................................................................... 238 2.TechnicalAnalysis:DefinitionandScope ........................................................................... 238 3.TechnicalAnalysisTools ...................................................................................................... 239 4.ElliotWaveTheory ............................................................................................................... 252 5.Inter‐marketAnalysis ........................................................................................................... 253 Summary .................................................................................................................................... 254 PracticeQuestions .................................................................................................................... 258
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R01 Ethics and Trust in the Investment Profession 2019 Level I Notes
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R01EthicsandTrustintheInvestmentProfession
1.Introduction
Toillustratetheimportanceofethicalbehavior,thecurriculumcitestheexampleofananalyst’sactionatafinancialservicesfirm.Theresearchdepartmentatthefirmisresponsibleformakinginvestmentrecommendationstoclientsaftersoundanalysisandvaluationofcompanies.Oneoftheanalystsatthefirmmisrepresentsfactsinhisreportwiththeobjectiveofpleasingthemanagementofthesubjectcompany.Hehopedthiswouldleadtofinancialbenefitsforhisemployerandhimself.Clientswhoactedontherecommendationincurheavylossesandspreadanegativewordonseveralonlineforumsaboutthefirm.Thiseventuallyaffectsthereputationofthefirm,forcingittodownsizeandmanyemployeeslosetheirjob.Thisexampleillustrateshowonemember’sunethicalactionshaveaspiralingeffectonthefirmandotheremployeesfornofaultoftheirs.
Thefoundationoftheinvestmentmanagementindustryistrust.Thetopthreeattributesofaninvestmentmanagementfirmareasfollows:
Hastransparentandopenbusinesspractices. Takesresponsibleactionstoaddressanissueorcrisis. Hasethicalbusinesspractices.
Ethicalbehaviorisnotjustaboutadheringtothelaw,rules,andregulations.Itisaboutidentifyingpotentialconflictsandactingrighteouslyinsituationswheretherearenostatedrules.
2.Ethics
ThewordethicscomesfromtheGreekword“ethos”meaningcharacter,guidingbeliefs,orideals.Thereareseveraldefinitionsofethicsallofwhichessentiallyconveythesamemeaning.
Ethicscanbedescribedasasetofmoralprinciplesandrulesofconductthatprovideguidanceforourbehavior.Ethicalprinciplesdefinewhatisgood,acceptablebehaviorandwhatisforbiddenorunacceptablebehavior.Examplesofethicalprinciplesincludehonesty,diligence,justice,beingopenaboutthecostsinvolvedinaninvestment,fairness,andrespectfortherightsofothers.
Anotherdefinitionofethicalconductisbehaviorthatbalancesone’sowninterestwiththedirectandindirectconsequencesofthebehavioronothers.
Instructor’sNote:The‘others’areoftenreferredtoasstakeholders,i.e.groupsofpeopleorindividualswhoaredirectlyorindirectlyimpactedbyourdecisions.
Specificcommunitiesformallydefinetherulesforacceptableandforbiddenbehaviorintoawrittensetofprinciplescalledthecodeofconduct.Professionalassociations,universities
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R01 Ethics and Trust in the Investment Profession 2019 Level I Notes
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andcompaniesoftenadoptacodeofethicsandexpecttheirmemberstoadheretothoserules,attheveryleast.Themembersmaychoosetodisplayhigherstandardsofbehaviorthanwhatisstipulatedinthecodeofethics.
Somecommunitiesmayalsoexpandontheircodeofethicsandadoptexplicitrulesorstandardsthatidentifyspecificbehaviorsrequiredofcommunitymembers.Thesestandardsofconductserveasabenchmarkoftheminimallyacceptablebehaviorexpectedfrommembersofacommunity.
CFAInstituteisanexampleofacommunitythathaslaiddownacodeofethicsandstandardsofconductforitsmembersandcandidatestofollow.ThesetofprinciplescomprisingtheCodeofEthicsandStandardsofProfessionalConductisclearlydocumentedintheCFAInstituteStandardsofPracticeHandbook.
MembersandcandidatesarerequiredtopledgetheircommitmenttoabidebytheCodeandStandardseachyear.TheyarealsorequiredtodiscloseanyviolationsoftheCodeandStandardsintheirProfessionalConductStatementeachyear.MemberswhoviolatetheCodeandStandardsfacedisciplinaryaction.
3.EthicsandProfessionalism
Anoccupationcanbedividedinto:job,vocation,andprofession.Ajobisworkonedoestoearnalivelihood,orearnmoney.Avocationisajobthatoneispassionateaboutdoing;onederivesasenseofsatisfactionormeaningfromit,asitishis/hercalling.Aprofessionistheultimateevolutionofoccupation.It:
1) requiresspecializedtrainingandskills,2) isbasedonservicetoothers,and3) ispracticedbymemberswhoshareandadheretoacommoncodeofethics.
Professionalsusetheiracquiredskillstoservetheirclients.Clientsdifferfromcustomers.Acustomerisonewhoengagesinasingleoraseriesoftransactionstobuyagoodorservice.Thisrelationshipistransactionalinnature.Aclient,ontheotherhand,usestheservicesofaprofessionalonanongoingbasis,forafee.Thebasisofthisrelationshipistrustandtheclient’sintereststakepriorityoverpersonaloremployer’sinterests.
Inanygivenprofession,thecodeofethicsopenlycommunicatestheestablishedprinciplesoftheprofessionandhowitsmembersareexpectedtobehave.Ithelpsinbuildingpublicconfidencethatmembersoftheprofessionwillusetheirskillsandknowledgeforthebenefitoftheirclients.
4.ChallengestoEthicalConduct
Someofthechallengestoethicalconductincludethefollowing:
Overestimatingone’smorality:Peoplebelievetheyaremoreethicalthantheyactuallyare.Thisoverconfidenceinthemselvescansometimesleadtofaultydecision‐making.Itisoften
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R01 Ethics and Trust in the Investment Profession 2019 Level I Notes
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seenthatemotionscloudrationalthinking,promptingonetomakedecisionsthatmaynotbethemostethicalchoice.
Situationalinfluences:Theseareexternalfactorssuchascultural,social,andenvironmentalfactorsthatinfluenceone’sthinking,behavior,anddecision‐making.Someofthecommonsituationalinfluencesare: Moneyandprestige:Bothmoneyandprestigepushpeopletoactintheirownself‐
interestsandtakeactionsthatarelessethical.Thepromiseofalargefinancialbonusorapromotion,canimpactpeople’sthinkingabilityandcausethemtoactintheirownshort‐terminterestsandignorethelong‐termconsequencesoftheiractions.
Loyaltytoemployer,employee,andcolleagues:Loyaltycanhavebothpositiveandnegativeeffects.Forinstance,somecolleaguesmayencourageyoutobehavemoreethicallyandenrollintheCFAProgramtoadvanceyourcareer.Ontheotherhand,colleagueswhodonotadheretotheCodeandStandardsmayencourageyoutosimplyactinaccordancewiththelocallaw,eventhoughitmayfallshortofethicalconduct.
Complianceculture:Astrongcompliancepolicyisimportantforethicaldecision‐making;however,processesfocusedsolelyoncomplianceoversimplifydecision‐makinganddonothelpthelargercause.ThecurriculumcitestheexampleofEnron,whichengagedintransactionswiththird‐partyentitieswhereEnron’sCFO,AndrewFastow,hadapersonalinterest.Inkeepingwiththespiritofcompliance,FastowsoughtapprovalsfromtheboardofdirectorsforalltheproposedtransactionswithEnron.TheboardfailedtoseebeyondthecompliancerequirementsanddidnotquestionFastow’svestedintereststhatwerenotalignedwiththatofEnron’sshareholders.
5.TheImportanceofEthicalConductintheInvestmentIndustry
Theinvestmentindustryconnectstwoparties:investorsandborrowers.Borrowersarethosewhoareinneedofcapitaltofundtheirlong‐termgoalsortheirregularoperations.Long‐termgoalsmayincludebuildingschools,factories,bridges,etc.Investorsarethosewhosupplycapitalandseekareturn.Theinvestmentindustrybridgesthegapbetweenthosewhoareinneedofcapitalandthosewhoarewillingtoprovidecapital.
Thefoundationoftheinvestmentindustryisbuiltontrust.Alltheparticipantsinthesystemmustactethicallytobuildanenvironmentoftrust.Forinstance,ifinvestorstrusttheirfinancialadvisersandfinancialmarkets,ingeneral,thentheywillbewillingtolendcapital,takerisks,andnotpanicoverpricefluctuationsintheshortterm.Thiswillencouragemoreparticipationinthefinancialmarketsandensurecapitalflowtofundthegrowthofseveralprojectsthatwilllargelybenefitsociety.Similarly,organizationsinneedofcapitalwillbemorewillingtoexpandtheirbusinessesiftheyarereasonablyassuredofattractingfunds.
Whiletrustisimportantinanybusiness,itisparticularlyimportantintheinvestmentprofessionbecauseofthefollowingreasons:
Natureoftheclientrelationship:Investorsparktheirassetswithfinancialinstitutionsbecausetheytrustthefirmstosafeguardtheirassets.Ifthefirmandits
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R01 Ethics and Trust in the Investment Profession 2019 Level I Notes
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employeesbreachthistrustandfailtoprotecttheirclient’sassets,theywilleventuallylosebusinessasclientswillnolongerentrustthefirmwiththeirassets.
Differenceinknowledgeandaccesstoinformation:Investmentmanagershavemoreaccesstoinformationandmorespecializedknowledgethantheirclients.Clientstrustthattheprofessionalswillusetheinformationandknowledgeforthebenefitoftheclient’sinterestsandwillinnowayacttotheirdisadvantage.
Natureofinvestmentproductsandservices:Unlikeotherindustries,theproductsandservicesintheinvestmentindustryareintangible.Theycannotbetouchedorphysicallyfelttojudgetheirquality.Intheinvestmentindustry,assetsareoftennotionalwithvaluesmeasuredintheformofnumbers.Forinstance,thevalueoftheinvestmentsaspresentedbyone’sfinancialadviserismerenumbersprintedelectronically.Investorstrustthattheinformationpresentedtothemiscomplete,accurate,andpresentsafairpicture.
6.Ethicalvs.LegalStandards
Thereisagreyareabetweenwhatislegallyacceptedandwhatisethical.Actinginaccordancewiththelawandactingethicallyarenotnecessarilythesame.Therearefourpossibleoutcomesforanyactionfromalegalandethicalperspective:
Notlegalbutethical:Forexample,civildisobedienceorprotestingpeacefullyagainstanissuemaynotbelegal,butitisethical.Anotherexampleofanillegalbutethicalactisthatofwhistleblowing.Whistleblowingisraisingthecurtainoffanillegalorcorruptactivity.
Notlegalandnotethical. Legalandethical. Legalbutnotnecessarilyethical:Somecountriesdonothavelawsthatprohibit
tradingwhileinpossessionofmaterialnonpublicinformation.Whilethisactoftradingislegalfromthelocalcountry’sperspective,itisconsideredunethicalbytheCFAInstituteandotherinvestmentprofessionals.
Thereareseveralreasonswhylawsarenotsufficienttoensureethicalconductamongmarketparticipants,asdiscussedbelow:
Lawsandregulationsareoftencreatedinresponsetoexistingmarketpractices.Anewlawmightaddressanexistingethicalproblembutcreateanopportunityforotherunethicalbehaviorinfuture.
Lawscanbeinterpreteddifferently.Marketparticipantsmaychoosetointerpretthelawtotheiradvantageordelaycompliancewherethereisnopunitiveaction.
Lawscanvaryacrossjurisdictions.Thismayencouragequestionablepracticetomovetoplacesthatarelessrestrictiveinnature.
Ethicalconductencouragesusto: Gobeyondwhatislegallyrequired. Considertheimpactonallstakeholders.
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R01 Ethics and Trust in the Investment Profession 2019 Level I Notes
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Makegoodchoices,evenintheabsenceofclearlawsandregulations.
7.EthicalDecision‐MakingFramework
Firmsmuststrivetodevelopastrongethicalcultureandencourageinvestmentprofessionalstoapplyethicaldecision‐makingskillseveryday;somuchsothatitbecomessecondnature.Workingandoperatinginanenvironmentthatfostersintegrityandmotivatesitsemployeestodotherightthingwillgoalongwayinpreventingunethicalactions.
Settingupanethicalframeworkreinforcesinvestmentprofessionalstodotherightthing.Theethicalframework:
Helpsinevaluatingasituationfrommultipleperspectivesafterconsideringthelargerpictureinsuchawaythatitbenefitsstakeholdersinthelongterm.Often,theimpactofadecisionorallaspectsofasituationisnotclearintheshorttermanddecisionstakeninhastemayharmstakeholdersunintentionally.
Helpsdecisionmakersjustifyactionstoabroadergroupofstakeholders.
Thefollowingethicaldecision‐makingframeworkispresentedinthecurriculum.
Identificationphase:Identifyalltherelevantfacts.Thisincludesinformationonehasandwhatonewouldliketohave.o Identifyrelevantfactssuchasdetailsoftheemployer,informationonanIPOora
deal,rulesandregulationsoftheindustry,etc.o Identifythestakeholderssuchasemployer,marketparticipants,clients,
supervisor,investors,family,etc.o Identifyrelevantethicalprinciplesforthesituation.Thismayincludeloyaltyto
employer,clients’intereststakingprecedencebeforeeverythingelse,andmaintainingtheconfidentialityofinformation.
o Identifyanypotentialconflictsofinterest,orconflictsinyourdutiestoemployers/clients.Examplesofpotentialconflictofinterestincludedutiestooneclientversusotherclientsofthefirm,financialrewardslinkedtothesuccessofadealversusdutytoemployer,anddutytosupervisorversustheneedtoimpress.
Considerationphase:Seekguidancetonavigatethroughsituationalinfluencesandpersonalbiasesthatmayaffectdecision‐making.o Examplesofsituationalinfluencesincludehowmuchfeesthefirmwillearnfrom
adeal,howmuchbonusorcompensationoneexpectstoreceivebecauseofworkingonanIPO/deal,orassociatingone’sself‐worthtoworkingonaprestigiousaccount/deal.
o Examplesofwhereonecouldseekguidanceincludethefirm’scompliancedepartment,peers,theCFAInstituteCodeandStandards,orasupervisor.
Decideandact:Makeadecisionandact. Reflect:Oncethedecisionismade,assessthedecisiontoseeifithadthedesired
outcome.Ifnot,thenanalyzethereasons:werethestakeholdersidentified,wasthere
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R01 Ethics and Trust in the Investment Profession 2019 Level I Notes
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anyconflictofinterest,weretheethicalprinciplesidentified,didyouseekguidanceonhowtodealwithsituationalinfluencesandpersonalbehavioralbiases?
Sometimestheinformationisnotsufficienttomakeadecisioninwhichcasetheprocessbecomesiterativeasyouseekguidancetogathermorerelevantinformation.
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R01 Ethics and Trust in the Investment Profession 2019 Level I Notes
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Summary
LO.a:Explainethics.
ThewordethicsisderivedfromtheGreekword‘ethos,’whichmeanscharacter.Ethicsmeansmakinggoodchoices. Ethicsincludesasetofmoralprinciplesandrulesofconductthathelpusinourbehavior.
LO.b:Describetheroleofacodeofethicsindefiningaprofession.
Professionisthefinaldevelopmentofanoccupation.Professionis:
basedonspecializedknowledgeandskills. basedonservicetoothers. practicedbymemberswhoshareandagreetoadheretoacommoncodeofethics.
Inanygivenprofession,thecodeofethicsopenlycommunicatestheestablishedprinciplesoftheprofessionandhowitsmembersareexpectedtobehave.
Ithelpsinbuildingpublicconfidencethatmembersoftheprofessionwillusetheirskillsandknowledgeforthebenefitoftheirclients.
LO.c:Identifychallengestoethicalbehavior.
Onechallengeisthatpeopletendtobelievethattheirethicalstandardsareaboveaverage.Thisleadstooverconfidencebiasandthereforepeopleplacetoomuchimportanceontheirinternaltraits.However,studiesshowthatexternalfactors(situationalinfluence)arethemaindeterminantofethicalbehavior.Theyshiftourfocustotheimmediateratherthanlong‐termimpactsofadecision.Thethreemaintypesofsituationalinfluencesare:
Money&Prestige. Loyaltytoemployerand/orcolleagues. Strongcomplianceculture.
LO.d:Describetheneedforhighethicalstandardsintheinvestmentindustry.
Highethicalstandardsarealwaysimportant.However,theyareofparticularimportanceintheinvestmentindustry,becausethisindustryisbasedalmostentirelyontrust.Alsotheproductsandservicesofthisindustryareintangibleinnature.
Clientstrustinvestmentprofessionalstousetheirskillsandknowledgefortheirbenefitandtoprotecttheirassets.
Ifinvestmentprofessionalsadheretohighethicalstandards,allstakeholdersgainlong‐termbenefits.
LO.e:Distinguishbetweenethicalandlegalstandards.
Legalandethicalconductisnotalwaysthesame.
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R01 Ethics and Trust in the Investment Profession 2019 Level I Notes
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Lawsarenotalwaysthebestmechanismtoreduceunethicalbehaviorbecause: Legalstandardsareoftencreatedtoaddresspastethicalfailings.Theydonotprovide
directionforaneverchangingandincreasinglycomplexworld. Lawsareoftenrule‐based. Lawswillvaryacrosscountries.
Ethicalconductgoesbeyondlegalstandards.
LO.f:Describeandapplyaframeworkforethicaldecision‐making.
Aframeworkforethicaldecision‐makingcanhelppeoplelookatandassessadecisionfromdifferentperspectives.Thisenablesthemtomakegooddecisions,andtolimitunplannedconsequences.
Ageneralethicaldecision‐makingframeworkhasthefollowingfoursteps.1. Identify:Relevantfacts,stakeholdersanddutiesowed,ethicalprinciples,conflictsof
interest.2. Consider:Situationalinfluences,additionalguidance,alternativeactions.3. Decideandact.4. Reflect:Wastheoutcomeasanticipated?Whyorwhynot?
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R01 Ethics and Trust in the Investment Profession 2019 Level I Notes
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PracticeQuestions
1. Whichofthefollowingstatementsismostlikelycorrect?A. Ethicscanbedescribedasasetofmoralprinciplesthatprovideguidanceforour
behavior.B. Ethicalconductisbehaviorthatbalancesone’sowninterestwithonlythedirect
consequencesofthebehavioronothers.C. Professionalassociationsadoptacodeofethicstoprotecttheirownprofessional
community.2. Whichoneofthefollowingisleastlikelyareasonforaprofessiontoestablishacodeof
ethics?A. Acodeofethicsservesasanaidindecision‐making.B. Acodeofethicshelpsinstillconfidenceamongclientsandprospectiveclients.C. Acodeofethicshelpsensurethatmembersoftheprofessionwillfollowthelaw.
3. Whichofthefollowingisleastlikelyachallengefacedbyprofessionalstodisplayethical
behavior?A. Peopletendtobelievetheyaremoreethicalthantheyactuallyare.B. Peopletendtounderestimatetheirownmorality.C. Peopletendtounderestimatetheimpactofsituationalinfluences.
4. Whichofthefollowingstatementsisleastlikelyaccurate?Trustisparticularlyimportant
intheinvestmentprofessionbecause:A. investmentprofessionalshavespecializedknowledgeandaccesstoinformationis
asymmetrical.B. productsandservicesintheinvestmentindustrytendtobeintangible.C. returnscannotbeguaranteedformosttypesofinvestments.
5. Whichofthefollowingisleastlikelyareasonforlawsbeinginsufficienttoensureethical
conductamongmarketparticipants?A. Lawscanbeinterpreteddifferently.B. Lawsarelargelythesameacrossjurisdictions.C. Passingalawtakessignificanttime.
6. Whichofthefollowingstatementsaboutethicaldecisionframeworkis/aremostlikely
accurate? Statement1:Anethicaldecisionframeworkhelpsdecisionmakersjustifyactions
tostakeholders. Statement2:Toomanychoicescanatbestleadtoinaction.
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R01 Ethics and Trust in the Investment Profession 2019 Level I Notes
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Statement3:Anethicaldecisionframeworkservesasatoolforinvestmentprofessionalstochoosethebestpossiblealternative.
A. Statement1and3.B. Statement3only.C. Statement1,2,and3.
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R01 Ethics and Trust in the Investment Profession 2019 Level I Notes
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Solutions1. Aiscorrect.StatementBisincorrectbecauseethicalconductisbehaviorthatbalances
one’sowninterestwiththedirectandindirectconsequencesofthebehavioronothers.StatementCisincorrect.
2. Ciscorrect.Thecodeofethicscannotensurethatmembersoftheprofessionwillfollow
thelaw.StatementsAandBaretrue.3. Biscorrect.Challengesfacedbyprofessionalstodisplayethicalbehaviorinclude:1)
overestimatingone’smoralityand2)underestimatingtheeffectofsituationalinfluences.4. Ciscorrect.StatementAandBarevalidreasonsfortrustbeingimportantinthe
investmentprofession.Cdoesnotrepresentareasonforwhytrustisparticularlyimportantintheinvestmentindustry.
5. Biscorrect.Lawscanvaryacrossjurisdictions.Thismayencouragequestionable
practicetomovetoplacesthatarelessrestrictiveinnature.StatementsAandCarevalidreasonsforwhythelawalonemightbeinsufficienttoensureethicalbehavior.
6. Ciscorrect.Allthreestatementsregardingethicaldecisionframeworksarecorrect.
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R02 Code of Ethics and Standards of Professional Conduct 2019 Level I Notes
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R02CodeofEthicsandStandardsofProfessionalConduct
Introduction
TheCodeofEthicsandStandardsofProfessionalConduct(CodeandStandards)stipulaterulesandguidelinesforCFAInstitutemembersandcandidatesonhowtoconductthemselvesinaprofessionalandethicalmanner,withintegrity,underallcircumstancesforthebenefitofsociety.
CFAInstituteProfessionalConductProgram
AllCFAInstitutemembersandcandidatesenrolledintheCFAprogramarerequiredtocomplywiththeCodeandStandards.TheProfessionalConductProgram(PCP),inconjunctionwiththeDisciplinaryReviewCommittee(DRC),isresponsibleforenforcementoftheCodeandStandards.
TheDRCisavolunteercommitteeofCFAcharterholderswhoserveonpanelstoreviewconductandpartnerwithprofessionalconductstafftoestablishandreviewprofessionalconductpolicies.
TheCFAInstituteBylawsandRulesofProcedureforProfessionalConductformthebasicstructureforenforcingtheCodeandStandards.
ProfessionalConductinquiriescanbepromptedbyseveralreasons: Self‐disclosure:OntheannualProfessionalConductStatement,membersdiscloseif
theyhavebeenasubjectofcivillitigationorcriminalinvestigation. Writtencomplaints:ThePCPstaffmayreceivewrittencomplaints. Evidenceofmisconduct:ThePCPstaffmaycomeacrossviolationsthroughmediaor
anypublicsource. ReportbyaCFAexamproctor:Ifacandidateviolatedanyrulesonexamdayandis
reportedbytheproctor. CFAInstitutemayconductanalysisofscoresandexammaterialsaftertheexam,as
wellasmonitoronlineandsocialmediatodetectdisclosureofconfidentialexaminformation.Forinstance,ifafriendsitsfortheexaminAustraliaanddiscussesspecificquestionsonlineaftertheexamwhileyouareintheUnitedStateswheretheexamhasn’tstarted,itcanbeconsideredaviolationoftheCodeandStandards.
Afteraninquiryisinitiated,theprofessionalconductteamconductsaninvestigation.IftheprofessionalconductstaffbelievesaviolationoftheCodeandStandardshasoccurred,theyproposesanctionswhichcaninclude:publiccensure,suspensionofmembershipanduseoftheCFAdesignation,andrevocationoftheCFAcharter.CandidatesmaybesuspendedorprohibitedfromfurtherparticipationintheCFAprogram.
Thememberorcandidatehastheopportunitytoacceptorrejectanychargesandtheproposedsanctions.Ifthemember/candidateacceptstheviolation,thenthesanctionswillbeimposed.Ifthemember/candidatedoesnotacceptthechargesortheproposedsanctions,
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R02 Code of Ethics and Standards of Professional Conduct 2019 Level I Notes
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thematterisreferredtotheDRC,whichreviewsmaterialsandpresentationsfromprofessionalconductstaffandfromthememberorcandidate.Thepanel’staskistodeterminewhetheraviolationoftheCodeandStandardsortestingpolicieshasoccurredand,ifso,whatsanctionshouldbeimposed.
CodeofEthics
MembersoftheCFAInstitute(includingCFAcharterholders)andcandidatesfortheCFAdesignation(“Membersandcandidates”)must:
1. Actwithintegrity,competence,diligence,andrespectandinanethicalmannerwiththepublic,clients,prospectiveclients,employers,employees,colleaguesintheinvestmentprofession,andotherparticipantsintheglobalcapitalmarkets.
2. Placetheintegrityoftheinvestmentprofessionandinterestsofclientsabovetheirownpersonalinterests.
3. Usereasonablecareandexerciseindependentprofessionaljudgmentwhenconductinginvestmentanalysis,makinginvestmentrecommendations,takinginvestmentactions,andengaginginotherprofessionalactivities.
4. Practiceandencourageotherstopracticeinaprofessionalandethicalmannerthatwillreflectcreditonthemselvesandtheprofession.
5. Promotetheintegrityandviabilityoftheglobalcapitalmarketsfortheultimatebenefitofsociety.
6. Maintainandimprovetheirprofessionalcompetenceandstrivetomaintainandimprovethecompetenceofotherinvestmentprofessionals.
Instructor’sNote:ThesixcomponentsofCodeofEthics,outlinedabove,areimportantandshouldbememorized.
StandardsofProfessionalConduct
TherearesevenStandardsofProfessionalConduct.Eachstandardhassub‐sections.Thestandardsarecoveredindetailinthenextreading.
I. ProfessionalismII. IntegrityofCapitalMarketsIII. DutiestoClientsIV. DutiestoEmployersV. Investmentanalysis,Recommendations,andActionsVI. ConflictsofInterestVII. ResponsibilitiesasaCFAInstituteMember,orCFACandidate
I. Professionalism
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R02 Code of Ethics and Standards of Professional Conduct 2019 Level I Notes
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A. KnowledgeoftheLawMembersandCandidatesmustunderstandandcomplywithallapplicablelaws,rules,andregulations(includingtheCFAInstituteCodeofEthicsandStandardsofProfessionalConduct)ofanygovernment,regulatoryorganization,licensingagency,orprofessionalassociationgoverningtheirprofessionalactivities.Intheeventofconflict,MembersandCandidatesmustcomplywiththemorestrictlaw,rule,orregulation.MembersandCandidatesmustnotknowinglyparticipateorassistinandmustdissociatefromanyviolationofsuchlaws,rules,orregulations.
B. IndependenceandObjectivityMembersandCandidatesmustusereasonablecareandjudgmenttoachieveandmaintainindependenceandobjectivityintheirprofessionalactivities.MembersandCandidatesmustnotoffer,solicit,oracceptanygift,benefit,compensation,orconsiderationthatreasonablycouldbeexpectedtocompromisetheirownoranother’sindependenceandobjectivity.
C. MisrepresentationMembersandCandidatesmustnotknowinglymakeanymisrepresentationsrelatingtoinvestmentanalysis,recommendations,actions,orotherprofessionalactivities.
D. MisconductMembersandCandidatesmustnotengageinanyprofessionalconductinvolvingdishonesty,fraud,ordeceitorcommitanyactthatreflectsadverselyontheirprofessionalreputation,integrity,orcompetence.
II. IntegrityofCapitalMarkets
A. MaterialNonpublicInformationMembersandCandidateswhopossessmaterialnonpublicinformationthatcouldaffectthevalueofaninvestmentmustnotactorcauseotherstoactontheinformation.
B. MarketManipulationMembersandCandidatesmustnotengageinpracticesthatdistortpricesorartifciallyinflatetradingvolumewiththeintenttomisleadmarketparticipants.
III. DutiestoClients
A. Loyalty,prudence,andcareMembersandCandidateshaveadutyofloyaltytotheirclientsandmustactwithreasonablecareandexerciseprudentjudgment.MembersandCandidatesmustactforthebenefitoftheirclientsandplacetheirclients’interestsbeforetheiremployer’sortheirowninterests.
B. FairDealingMembersandCandidatesmustdealfairlyandobjectivelywithallclientswhenprovidinginvestmentanalysis,makinginvestmentrecommendations,takinginvestmentaction,orengaginginotherprofessionalactivities.
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R02 Code of Ethics and Standards of Professional Conduct 2019 Level I Notes
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C. Suitability1. WhenMembersandCandidatesareinanadvisoryrelationshipwithaclient,they
must:a. Makeareasonableinquiryintoaclient’sorprospectiveclient’sinvestment
experience,riskandreturnobjectives,andfinancialconstraintspriortomakinganyinvestmentrecommendationortakinginvestmentactionandmustreassessandupdatethisinformationregularly.
b. Determinethataninvestmentissuitabletotheclient’sfinancialsituationandconsistentwiththeclient’swrittenobjectives,mandates,andconstraintsbeforemakinganinvestmentrecommendationortakinginvestmentaction.
c. Judgethesuitabilityofinvestmentsinthecontextoftheclient’stotalportfolio.
2. WhenMembersandCandidatesareresponsibleformanagingaportfoliotoaspecificmandate,strategy,orstyle,theymustmakeonlyinvestmentrecommendationsortakeonlyinvestmentactionsthatareconsistentwiththestatedobjectivesandconstraintsoftheportfolio.
D. PerformancePresentationWhencommunicatinginvestmentperformanceinformation,MembersandCandidatesmustmakereasonableeffortstoensurethatitisfair,accurate,andcomplete.
E. PreservationofConfidentialityMembersandCandidatesmustkeepinformationaboutcurrent,former,andprospectiveclientsconfidentialunless:
1. Theinformationconcernsillegalactivitiesonthepartoftheclientorprospectiveclient,
2. Disclosureisrequiredbylaw,or
3. Theclientorprospectiveclientpermitsdisclosureoftheinformation.
IV. DutiestoEmployers
A. LoyaltyInmattersrelatedtotheiremployment,MembersandCandidatesmustactforthebenefitoftheiremployerandnotdeprivetheiremployeroftheadvantageoftheirskillsandabilities,divulgeconfidentialinformation,orotherwisecauseharmtotheiremployer.
B. AdditionalCompensationArrangementsMembersandCandidatesmustnotacceptgifts,benefits,compensation,orconsiderationthatcompeteswithormightreasonablybeexpectedtocreateaconflictofinterestwiththeiremployer’sinterestunlesstheyobtainwrittenconsentfromallpartiesinvolved.
C. ResponsibilitiesofSupervisors
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R02 Code of Ethics and Standards of Professional Conduct 2019 Level I Notes
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MembersandCandidatesmustmakereasonableeffortstoensurethatanyonesubjecttotheirsupervisionorauthoritycomplieswithapplicablelaws,rules,regulations,andtheCodeandStandards.
V. InvestmentAnalysis,Recommendations,andActions
A. DiligenceandReasonableBasisMembersandCandidatesmust:
1. Exercisediligence,independence,andthoroughnessinanalyzinginvestments,makinginvestmentrecommendations,andtakinginvestmentactions.
2. Haveareasonableandadequatebasis,supportedbyappropriateresearchandinvestigation,foranyinvestmentanalysis,recommendation,oraction.
B. CommunicationwithClientsandProspectiveClientsMembersandCandidatesmust:
1. Disclosetoclientsandprospectiveclientsthebasicformatandgeneralprinciplesoftheinvestmentprocessestheyusetoanalyzeinvestments,selectsecurities,andconstructportfoliosandmustpromptlydiscloseanychangesthatmightmateriallyaffectthoseprocesses.
2. Disclosetoclientsandprospectiveclientssignificantlimitationsandrisksassociatedwiththeinvestmentprocess.
3. Usereasonablejudgmentinidentifyingwhichfactorsareimportanttotheirinvestmentanalyses,recommendations,oractionsandincludethosefactorsincommunicationswithclientsandprospectiveclients.
4. Distinguishbetweenfactandopinioninthepresentationofinvestmentanalysisandrecommendations.
C. RecordRetentionMembersandCandidatesmustdevelopandmaintainappropriaterecordstosupporttheirinvestmentanalyses,recommendations,actions,andotherinvestment‐relatedcommunicationswithclientsandprospectiveclients.
VI. ConflictsofInterest
A. DisclosureofConflictsMembersandCandidatesmustmakefullandfairdisclosureofallmattersthatcouldreasonablybeexpectedtoimpairtheirindependenceandobjectivityorinterferewithrespectivedutiestotheirclients,prospectiveclients,andemployer.MembersandCandidatesmustensurethatsuchdisclosuresareprominent,aredeliveredinplainlanguage,andcommunicatetherelevantinformationeffectively.
B. PriorityofTransactions
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R02 Code of Ethics and Standards of Professional Conduct 2019 Level I Notes
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InvestmenttransactionsforclientsandemployersmusthavepriorityoverinvestmenttransactionsinwhichaMemberorCandidateisthebeneficialowner.
C. ReferralFeesMembersandCandidatesmustdisclosetotheiremployer,clients,andprospectiveclients,asappropriate,anycompensation,consideration,orbenefitreceivedfromorpaidtoothersfortherecommendationofproductsorservices.
VII. ResponsibilitiesasaCFAInstituteMemberorCFACandidate
A. ConductasparticipantsinCFAInstituteProgramsMembersandCandidatesmustnotengageinanyconductthatcompromisesthereputationorintegrityofCFAInstituteortheCFAdesignationortheintegrity,validity,orsecurityofCFAInstituteprograms.
B. ReferencetoCFAInstitute,theCFAdesignation,andtheCFAprogramWhenreferringtoCFAInstitute,CFAInstitutemembership,theCFAdesignation,orcandidacyintheCFAProgram,MembersandCandidatesmustnotmisrepresentorexaggeratethemeaningorimplicationsofmembershipinCFAInstitute,holdingtheCFAdesignation,orcandidacyintheCFAProgram.
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R02 Code of Ethics and Standards of Professional Conduct 2019 Level I Notes
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Summary
LO.a:DescribethestructureoftheCFAInstituteProfessionalConductProgramandtheprocessfortheenforcementoftheCodeandStandards.
TheProfessionalConductProgram(PCP),inconjunctionwiththeDisciplinaryReviewCommittee(DRC),isresponsibleforenforcementoftheCodeandStandards.TheCFAInstituteBylawsandRulesofProcedureforProfessionalConductformthebasicstructureforenforcingtheCodeandStandards.ProfessionalConductinquiriescanbepromptedby:self‐disclosure,writtencomplaintsandevidenceofmisconduct,andreportbyaCFAexamproctor.
IftheprofessionalconductstaffbelievesaviolationoftheCodeandStandardshasoccurred,sanctionsareproposed.Ifthemember/candidatedoesnotacceptthechargesorthesanctions,thematterisreferredtotheDRC,whichreviewsmaterialsandpresentationsfromprofessionalconductstaffandfromthememberorcandidate.TheDRCmakesafinaldecisiononwhethertherewasaviolationandifsowhatsanctionsmustbeimposed.
LO.b:StatethesixcomponentsoftheCodeofEthicsandthesevenStandardsofProfessionalConduct.
MembersoftheCFAInstitute(includingCFAcharterholders)andcandidatesfortheCFAdesignation(“Membersandcandidates”)must:
1. Actwithintegrity,competence,diligence,andrespectandinanethicalmannerwiththepublic,clients,prospectiveclients,employers,employees,colleaguesintheinvestmentprofession,andotherparticipantsintheglobalcapitalmarkets.
2. Placetheintegrityoftheinvestmentprofessionandinterestsofclientsabovetheirownpersonalinterests.
3. Usereasonablecareandexerciseindependentprofessionaljudgmentwhenconductinginvestmentanalysis,makinginvestmentrecommendations,takinginvestmentactions,andengaginginotherprofessionalactivities.
4. Practiceandencourageotherstopracticeinaprofessionalandethicalmannerthatwillreflectcreditonthemselvesandtheprofession.
5. Promotetheintegrityandviabilityoftheglobalcapitalmarketsfortheultimatebenefitofsociety.
6. Maintainandimprovetheirprofessionalcompetenceandstrivetomaintainandimprovethecompetenceofotherinvestmentprofessionals.
LO.c:ExplaintheethicalresponsibilitiesrequiredbytheCodeandStandards,includingthesub‐sectionsofeachStandard.
Coveredinthenextreading.
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R03 Guidance for Standards I-VII 2019 Level I Notes
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R03GuidanceforStandardsI‐VII
Introduction
Thisisalongreading,whichprovidesguidanceandrecommendedcomplianceproceduresforeachstandard.Severalexamplesarealsogivenonhowthestandardsshouldbeapplied.IFTNotesfocusontheguidanceandrecommendedcomplianceprocedures.Readtheexamples(applicationsofthestandards)fromthecurriculum.
StandardI:Professionalism
Standard1(A)KnowledgeoftheLaw
MembersandCandidatesmustunderstandandcomplywithallapplicablelaws,rules,andregulationsofanygovernment,regulatoryorganization,licensingagency,orprofessionalassociationgoverningtheirprofessionalactivities.Intheeventofconflict,MembersandCandidatesmustcomplywiththemorestrictlaw,rule,orregulation.MembersandCandidatesmustnotknowinglyparticipateorassistinandmustdissociatefromanyviolationofsuchlaws,rules,orregulations.
Interpretation:
You,asamemberorcandidate,mustbeawareofalllawswhereyouconductbusiness.Statingthatyouarenotawareofthelawsandhenceaviolationoccurred,willnotbeacceptable.
Guidance: RelationshipbetweentheCodeandStandardsandApplicableLaw:Assumeyouarean
investmentadviserbasedinMalaysia.YouareaMalaysiancitizenandyourclientsarealsobasedinMalaysia.HeretheMalaysianlawisthe‘applicablelaw’.AsaLevelIcandidate,theCodeandStandardsmustalsobeconsidered.Let’sassumethatMalaysianlawsprohibitparticipationofinvestmentadvisersinIPOsbuttheCodeandStandardsallowparticipationunderspecifiedcircumstances,thenyouhavetofollowthestricterlaw–theMalaysianlawinthiscase.Ifthereisnoapplicablelaworregulation,thenMembersandCandidatesmustfollowtheCodeandStandards.
Investmentproductsandapplicablelaws:Followthemorestrictlaw. Participationinorassociationwithviolationsbyothers:Youareresponsiblefor
violationsinwhichyouknowinglyparticipateorassist.Knowinglyisthekeywordhere.Assumeyouarepartofagroupandyouhavereasonablegroundstobelieveaviolationistakingplace.Undersuchcircumstances:o First,makeanattempttostopthebehaviorbybringingittothenoticeofyour
supervisor/compliancedepartment.o Seektheadviceofindependentlegalcounselifthecompliancedepartmentwasnot
helpful.
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R03 Guidance for Standards I-VII 2019 Level I Notes
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o Dissociateyourselfwiththatactivity.Dissociationvariesbasedonyourroleintheorganization;itcouldbe: Removingyournamefromtheinvestmentreportsandrecommendations. Askingforadifferentassignment. Refusingtoacceptanewclientorcontinuingtoadvisethecurrentclient.
o Inextremecases,leavetheorganization. Nottakinganactionafterreportingaviolation(andcontinuingassociationwiththe
illegalactivity),canbeconsideredasparticipatingintheillegalorunethicalconduct. Ifyouarenotsurethataviolationistakingplace,thentheappropriateactionwouldbe
toseektheadviceoflegal/compliancecounsel. CFAInstitutedoesnotcompelyoutoreportviolationstothegovernmentorregulatory
organizationunlessrequiredbylaw.
Recommendedproceduresforcompliance: Stayinformed:Haveaprocedureorregulartrainingtokeepemployeesinformedofthe
changesinapplicablelaws,rules,regulationsetc. Reviewprocedures:Periodicallyreviewfirm’swrittencomplianceprocedurestoensure
itconformstotheapplicablelaw. Maintaincurrentfiles:Latestcopiesofapplicablerulesandregulationsshouldbe
availableforreference. Legalcounsel:Ifindoubthowtorespondtoapossibleviolation,seektheadviceof
legal/compliancepersonnel. Dissociation:Documenttheviolationifyouaredissociatingfromanillegalactivity;urge
thefirmtotakestepstoceasetheactivity,andresigninextremecases. Advise/encourageyourfirmto:
o Developand/oradoptacodeofethics.o Provideinformationonapplicablelaws:makealltheinformationregardinglaws
andrulesavailableinacentrallocation.o Establishproceduresforreportingviolations:makeiteasytoreportviolations.
Standard1(B)IndependenceandObjectivity
MembersandCandidatesmustusereasonablecareandjudgmenttoachieveandmaintainindependenceandobjectivityintheirprofessionalactivities.MembersandCandidatesmustnotoffer,solicit,oracceptanygift,benefit,compensation,orconsiderationthatreasonablycouldbeexpectedtocompromisetheirownoranother’sindependenceandobjectivity.
Interpretation:
Maintainindependenceandobjectivity.Donotcompromiseyourindependenceandobjectivityunderanycircumstanceasitcanhurtnotjustyourfirm,butthewholeindustry.Forinstance,assumeyouarewritingaresearchreportandthefirmyouarecoveringgives
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R03 Guidance for Standards I-VII 2019 Level I Notes
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youanexpensivegift.Acceptingthegiftmayshroudyourjudgmenttobeimpartialandgiveanobjectivereport.
Guidance: Buy‐sideclients:Assumeyouworkintheresearchdepartmentofalargebrokerage(buy‐
side)firmandyoucoverpharmaceuticalfirms.Yourresearchreportsaredisseminatedtoinstitutionalclients(buy‐sideclients)suchasmutualfunds.Mutualfundswithlargepositionsinpharmastocksmighttrytoinfluenceyoutowritepositivereports.However,itisimportantforyou,nottosuccumbtopressure.Independenceandobjectivitymustbemaintained.
Investmentbankingrelationships:Nowassumeyourfirmalsohasaninvestmentbanking(IB)division.Pfizerisaclientofthefirm,andtheIBdivisionisworkingcloselyonPfizer’ssecondaryoffering.TheIBdivisionmayinfluenceresearchanalyststoissuefavorableresearchreports.But,asananalyst,youmustmaintainyourobjectivity.
Publiccompanies:Publiccompaniesmaytrytoinfluenceanalyststowritepositiveresearchreports.
Issuer‐paidresearch:Assumeacompanyisnotbeingwidelyfollowed.Ifthiscompanyapproachesyoutowritearesearchreportforthem,andcompensatesyou,thenthereisapotentialconflictofinterest.Thebestpracticeforindependentanalystsistonegotiateaflatfeeforthereport.Thefeeshouldbeindependentoftheeventualrecommendation.Disclosureofthetypeofcompensationisalsoimportant.
Travelfunding:Itisbestforcandidatestousecommercialtransportationpaidforbytheirfirm,andnottheclient.Ifcommercialtransportationisunavailable,membersandcandidatesmayacceptmodestlyarrangedtravel,toparticipateinappropriateinformation‐gatheringevents,suchasapropertytour.
Creditratingagencyopinions:Creditratingagenciesprovideratingsforfixed‐incomeproducts.Ifyouareworkingataratingagency,youmaybeofferedincentivesandcompensationbythesponsoringcompany(companiesissuingbonds)toissueafavorablerating.However,youshouldbeobjectiveabouttheanalysisandensuretheprocessesatyouragencydonotresultinaconflictofinterest.
Influenceduringthemanagerselection/procurementprocess:Assumealargepensionfundisintheprocessofselectinganassetmanagementcompany(AMC)tomanagetheirassets.Inordertogetthisbusiness,AMCsmaytrytoinfluencethehiringmanageratthepensionfundbygivinggifts,etc.Irrespectiveofwhichsideyouareintheprocess(pensionfundorAMCwhichisseekingbusiness),donotsolicitgiftsorcontributionseitherdirectlyorindirectlythatmayaffectyourindependence.
Brokeragehouses:Membersandcandidateshiresecondaryfundmanagerstomanagespecificassets,fortradingandreporting.Theremaybeattemptstoinfluencethemwithgiftsorcompensation.Itisimportantformemberstonotacceptsuchgiftsandstayobjectiveaboutthehiringdecision.
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RecommendedProceduresforCompliance: Protecttheintegrityofopinions. Createarestrictedlistforcompanieswhereafirmwantstodisseminateonlyfactual
information,andnonegativeorpositiveopinion. Restrictspecialcostarrangements:usecorporateaircraftonlyifcommercial
transportationisnotavailable. Limitgifts:astrictlimitfortokengiftsthatcanbeacceptedmustbeestablished. Restrictinvestments:Enforcepriorapprovalforemployeespurchasingequityorequity‐
relatedIPOs. Reviewprocedures. Establishanindependencepolicy. Appointedofficer:appointaseniorofficertoensurecompliancewiththefirm’scodeof
ethics.
Standard1(C)Misrepresentation
MembersandCandidatesmustnotknowinglymakeanymisrepresentationsrelatingtoinvestmentanalysis,recommendations,actions,orotherprofessionalactivities.
Amisrepresentationisanyuntruestatement,oromissionoffact,oranystatementthatisotherwisefalseormisleading.
Interpretation:
Thefoundationofanyclient‐customerrelationshipistrust.Iftrustislostbecauseofmisrepresentingfacts,itnotonlyhurtsyou,butalsohurtsconfidenceintheentireprofessionandintegrityofcapitalmarketsaswell.
Guidance: Impactoninvestmentpractice:Assumeyourfirmhasbeenmanagingalargecapequity
fundforseveralyearsandhasaddedasmallcapfundlastyear.Ifthefirmclaimsithasyearsofexperiencemanagingsmallcapfunds/stocks,thenitwouldbemisrepresentingfacts.o Membersandcandidatesmustnotmisrepresentfactsincludingtheirqualifications,
orcredentials.Forinstance,ifyouhaveclearedonlytwolevelsoftheCFAprogram,youcannotclaimtobeaCFAcharterholder.
o Whenissuingaresearchreport,youmaybeusingthird‐partyinformation.Youmustexercisecareanddiligencewhenusingthird‐partyinformationsuchascreditratings,research,ormarketingmaterials,toensurethereisnomisrepresentation.
o Ifyouareusingexternalmanagerstomanagespecificareas,youmustnotrepresenttheirinvestmentpracticesasyourown.
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Performancereporting:o Ifyouhavechosenabenchmarkforyourportfolio,arethestrategiesofboth
comparable?Areyouchoosingabenchmarkbecauseitmakestheportfolio’sperformancelookbetter?
o Youmustensuretheperformanceevaluationofyourportfoliohasareasonablebasis.
o Providepricinginformationofsecuritiestoclientsonaconsistentbasis.Donotchangepricingproviderssolelyonthebasisofhighervalueofasecurity.Thisisespeciallytrueofilliquidsecurities.Thiswillbemisrepresentinginformationasinvestorsmakethedecisionofwhetherornottoholdanilliquidsecuritybasedontheinformationprovided.
Socialmedia:ThelanguageusedonsocialmediaplatformssuchasFacebookandTwitterisofteninformal.However,membersandcandidatesmustensuretheinformationprovidedisthesameasintraditionalmodesofcommunication.TheformatmustadheretotheCodeandStandards,eventhoughthereisagreatdealofanonymity.
Omissions:Factsoroutcomesmustnotbeomitted,especiallywhenitcomestoperformancemeasurementandattribution.Forexample,assumeamanagerhadexceptionalperformanceinthepastthreeyears,butnegativereturnsinthethreeyearsprecedingit.Hemustpresenttheperformancefortheentireperiodandnotomityearsofbadperformance;thatiscalledcherrypicking(orselectivepresentation).
Plagiarism:Plagiarismisusingtheworkofotherswithoutacknowledgingorattributingthesourceofinformation.Examplesinclude:o Usingtheresearchreportofanotherfirm,andthenredistributingitbychangingthe
names.o Aresearchreportbasedonmultiplesourcesofinformationwithoutnamingthe
sources.o Excerptsfromarticleswithlittleornochangeinwording.o Notnamingspecificreferences,butinsteadattributingto“leadinginvestment
analysts”.o Usingchartsandgraphswithoutnamingtheirsources.
MembersandCandidatesmustdisclosethesourceofinformationusedintheirreports.Ifitispaidfor,thenitmustbedisclosed.Sentencesreproducedmustbewithinquotesandtheauthornamedspecifically.
Workcompletedforemployer:Work(models/reports/research)donewithinafirmmaybeusedbyothersinthefirmwithoutattribution.Ifthepersonwhodevelopedamodelhasleftthefirm,thefirmcancontinueusingitasitisapropertyofthefirmwithoutnamingtheperson.However,noonecanclaimthattheworkdonebythepersonwhohasquitthefirmhasbeendonebytheonewhoisnowusingit.
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RecommendedProceduresforCompliance: Factualpresentations:Eachmemberandcandidatemustbeawareofthefirm’sandthe
individual’scapabilitiesandlimitations.Awrittenlistofthefirm’savailableservicesshouldguidetheemployeeswhopresenttoclients.
Qualificationsummary:Eachmemberandcandidateshouldprepareasummaryofhis/herqualificationsandexperiencetopresenttoclients.Thesemustbeperiodicallyreviewed.
Verifyoutsideinformation:Ensurematerialfromathird‐partyisaccuratebeforepresentingittoclients.
Maintainwebpages:Anyinformationpublishedonawebpagemustbecurrent,andaccurate.
Plagiarismpolicy:Maintaincopiesofresearchreports/articlesusedinmakingyourresearchreport,attributequotationstotheirsource,andattributesummariestotheirsources.
Standard1(D)Misconduct
MembersandCandidatesmustnotengageinanyprofessionalconductinvolvingdishonesty,fraud,ordeceitorcommitanyactthatreflectsadverselyontheirprofessionalreputation,integrity,orcompetence.
Guidance:
Anyactthatinvolveslying,cheating,stealing,orotherdishonestconductisaviolationofthisstandardiftheoffensereflectsadverselyonamember’sorcandidate’sprofessionalactivities.AlthoughCFAInstitutediscouragesanysortofunethicalbehaviorbymembersandcandidates,theCodeandStandardsareprimarilyaimedatconductandactionsrelatedtoamember’sorcandidate’sprofessionallife.Someimportantpointsbasedonexamplesseenoften: Usingalcoholduringbusinesshours,thoughnotillegalimpairsaperson’sabilitytothink
objectively. Ifamemberorcandidatedeclarespersonalbankruptcy,itisnotmisconduct.But,ifthe
circumstancesthatledtobankruptcyincludedeceitorfraud,thenitwouldbeaviolationanddeemedasmisconduct.
RecommendedProceduresforCompliance: Codeofethics:Adoptacodeofethicsthateverymembermustadhereto. Listofviolations:Communicatetoallemployeesalistofpotentialviolationsandthe
associatedsanctions. Employeereferences:Dobackground(reference)checksofemployeestoensurethey
havenothadabrushwiththelawinthepastandareeligibletoworkintheinvestmentprofession.
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StandardII:IntegrityofCapitalMarkets
StandardII(A)MaterialNonpublicInformation
MembersandCandidateswhopossessmaterialnonpublicinformationthatcouldaffectthevalueofaninvestmentmustnotactorcauseotherstoactontheinformation.
Guidance: Whatismaterialinformation?:Thisisinformationthat,ifdisclosed,canhaveanimpact
onthepriceofasecurity,orinformationthatinvestorswouldwanttoknowbeforemakinganinvestmentdecision.Forexample,informationthattheCEOofacompanywasinvolvedinascandaltomanipulatefinancialstatementsandisgoingtobearrested,ismaterialinformation.Othercommonexamplesincludemergersandacquisitions,newproductlicenses,changesinmanagement,bankruptcies,legaldisputes,etc.
Whatconstitutes“nonpublic”information?:Asthenameimplies,informationthathasnotbeenmadepubliciscallednonpublicinformation.Forinstance,ifapharmaceuticalcompanyhasjustreceivednewsthataparticulardrughasbeenapprovedbyFDAanditisnotmadepublicyet,thenitconstitutesnonpublicinformation.Thisisalsomaterialinformationasitissomethinginvestorswouldliketoknowbeforeinvestinginthecompany.
Mosaictheory:AspertheMosaictheory,analystsarefreetoactonpublicandnonmaterialnonpublicinformationwithoutriskingviolation.Let’stakeanexamplefromthecurriculum.Ananalystisresearchingacompanyinthefurnitureindustry.Heanalyzesthepublicdisclosures,andspeakswithmanyfurnitureretailersonwhichhebaseshisrecommendationreport.Theinformationgatheredfromfurnitureretailersisanexampleofnonmaterialnonpublicinformationbecausetheinformationisnotpublic,andnotmaterialbyitselftoinfluencethestockpricesinanyway.
Socialmedia:Membersandcandidatesmustensurethatinformationobtainedfromclosedgroupsonsocialmedia(Facebook,LinkedIn)isaccessibletothepublicthroughothersources.
Usingindustryexperts:Usingexpertsisappropriateaslongasmembersarenotrequestingoractingonmaterialnonpublicinformation.
Investmentresearchreports:Assumeyouareawell‐knownanalystandyourrecommendationreportsmightimpactstockprices.Sinceyouarenotaninsideranddidnotbaseyourreportoninsiderinformation,StandardII(A)doesnotapply.Inthiscase,youarenotrequiredtomakethereportpublic.Ifthepublicwantsaccesstothereport,theycanbeaskedtopayforyourservices.
RecommendedProceduresforCompliance: Achievepublicdissemination:Takestepstopubliclydisseminatematerialnonpublic
information.Ensurenoinvestmentactionistakenbasedontheinformation.
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Adoptcomplianceprocedures:Adoptcomplianceprocedurestopreventthemisuseofmaterialnonpublicinformation.Ex:reviewemployeetrading,investmentrecommendations,andinterdepartmentalrecommendations.
Adoptdisclosureprocedures:Sameinformationshouldbecommunicatedtothemarketinanequitablemanner.Theinformationreceivedbybuy‐sideclientsshouldbethesameassell‐sideclients,andthesamegoesforlargefirmsandsmallfirms.
Issuepressreleases:Pressreleasesmustbemadebeforeconferencecallsandanalystmeetingssothatnewinformationisdisclosedatsuchgatherings.
Firewallelements:Afirewallisaninformationbarriercreatedtopreventtheflowofmaterialnonpublicinformationwithinafirm;forinstance,betweenthebrokerageandinvestmentbankingdepartmentsofafirm.Listedbelowareafewwaysafirewallisimplemented:o Reviewofemployeetrading.o Routeinterdepartmentalcommunicationsthroughthecomplianceorlegal
department.o Documenthowtoenforceprocedurestolimitinformationflowwithinthefirm.o Review/restrictproprietarytradingwhenafirmisinpossessionofmaterial
nonpublicinformation. Appropriateinterdepartmentalcommunications:Documentproceduresforhow
interdepartmentalcommunicationsmustoccur,reviewtradingactivity,andwhatactionstotakeifviolationsoccur.
Physicalseparationofdepartments:Topreventsensitiveinformationflowingfromonedepartmenttoanother.Ex:IB/corporatefinancetobephysicallyseparatedfromsalesandresearchofabrokeragefirm.
Preventionofpersonneloverlap:Anemployeeshouldbeononlyonesideofthefirewall.Forinstance,anemployeeworkinginthecommerciallendingdepartmentofabankmustnotbeassociatedwithitstrust/researchdepartments.
Areportingsystem:Haveareportingsysteminwhichauthorizedpeoplecanreviewandapprovecommunicationsbetweendepartments.Ifsharingofcertaininformationisnecessaryacrossthefirewall,thenadesignatedofficermustascertainwhethersharingisessentialandmustmonitortheprocess.
Personaltradinglimitations:Enforcerestrictionsonpersonaltradingbyemployees.Monitorbothproprietaryandpersonaltrading.
Recordmaintenance:Maintainrecordsofinterdepartmentalcommunication. Proprietarytradingprocedures:Outlineproceduresforunderwhatsituationsthere
shouldberestrictionsonproprietarytrading:o Marketmaking:Restrictionsontradingifthefirmisamarketmakercanbe
counterproductiveasitmaybeasignaltotradersthatthefirmisinpossessionofsomematerialnonpublicinformation.Thefirmmusttakethecontrasideofunsolicitedcustomertrades.
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o Arbitragetrading:Mustnotengageinproprietarytradingifitisinpossessionofsensitiveinformation.
Communicatetoallemployees:Educateemployeesthroughtrainingsonhowtoidentifymaterialnonpublicinformationandhowtoact(consultasupervisor/complianceofficer)iftheypossesssuchinformation.Circulatewrittencompliancepoliciesandprocedurestoallemployees.
StandardII(B)MarketManipulation
MembersandCandidatesmustnotengageinpracticesthatdistortpricesorartificiallyinflatetradingvolumewiththeintenttomisleadmarketparticipants.
Whatitincludes: Disseminatingfalseinformationintothemarket. Misleadingmarketparticipantsbydistortingprices.
Guidance: Information‐basedmanipulation:Spreadingfalserumorstoinducetradingbyothers.For
example,ananalystmaypumpfalseinformationintothemarketthroughblogsorsomeothermediatoartificiallyinflatestockprices.
Transaction‐basedmanipulation:Transactionsthatartificiallyaffectthepricesorvolumeofasecurity.Forexample,iftransactionsshowasecuritytobemoreliquid,thenmarketparticipantsperceiveitfavorablyandmaybuy.Forexample,alargefirmmayhaveofficesinTokyoandChicago.Oneofficemaysellalargenumberofsharesandtheotherofficemaybuy.Whileitmayappearasiftheliquidity/tradingvolumeofthesecurityisup.But,inreality,thetradingwaswithinthefirm.
StandardIII:DutiestoClients
StandardIII(A)Loyalty,Prudence,andCare
MembersandCandidateshaveadutyofloyaltytotheirclientsandmustactwithreasonablecareandexerciseprudentjudgment.MembersandCandidatesmustactforthebenefitoftheirclientsandplacetheirclients’interestsbeforetheiremployer’sortheirowninterests.
Interpretation:
Clientinterestscomefirst,followedbytheemployerand,then.personalinterestsofthememberorcandidate.Theonlyexceptionisthattheintegrityofcapitalmarketsmusttakeprecedenceovertheclient’sinterestsifthereisaconflict.Prudencerequirescautionanddiscretion.Whenhandlingfundsofaclient,prudencerequiresthatyoutreatthemwiththesameskill,care,anddiligenceasyouwouldtreatyourownfunds.
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Guidance: Understandingtheapplicationofloyalty,prudence,andcare:Investmentadvisershave
differentjobroles;somehavefiduciaryresponsibilitiesthatareimposedbylawandrequireahigherleveloftrustthanotherbusinessroles.Irrespectiveofwhetherornottheyareinafiduciaryrole,membersandcandidatesareexpectedtoworkintheclient’sbestinterest,andbeloyal,prudent,andexercisecareinmanagingtheclient’sportfolio.
Identifyingtheactualinvestmentclient:Identifywhoistheactualclient.It’softeneasytodefineaclientbutthereareinstanceswhenitmaynotbeclear.Forexample,ifapensionplanhiresaninvestmentmanager,thentheclientisnotthepensionplanbutthebeneficiariesoftheplan.Inthiscasethehiringentityisnotyourclient.Insomecases,theremaynotbeanydirectclientsorbeneficiaries.Ex:afundmanagermanagingthefundtoanindex.Insuchcases,fundmanagersshouldinvestaccordingtothestatedmandate.
Developingtheclient’sportfolio:Caremustbetakenindevelopingportfolios,whichareconsistentwiththeclients’objectives,circumstances,constraints,andrisks.Investmentdecisionsshouldbebasedontheoverallportfolio,ratherthanthecharacteristicsofanindividualinvestment.
Softcommission(dollar)policies:Assumeaclienthashiredyoutomanagehisfunds.Youhavediscretionovertheselectionofbrokerstoexecutetransactions.Conflictsmayariseifyouuseclientbrokerage(moneypaidbytheclientfortradeexecution)topurchaseresearchservicesfromthebroker.Thispracticeiscalled“softdollars”or“softcommissions.”Ifyoupayahigherbrokeragecommissionthanyouwouldnormallypay,toallowforthepurchaseofgoodsorservices,withoutacorrespondingbenefittotheclient,youhaveviolatedthedutyofloyaltytoyourclient.
Proxyvotingpolicies:Assumeyouareaninvestmentmanagerandyouhavepurchased1millionsharesofGeneralElectriconbehalfofyourclient.Sinceyouaremanagingyourclient’sportfolio,youcanvoteonbehalfoftheclient.Youshouldperformasimplecost‐benefitanalysistodecidewhetherornottovote.Whenyouvoteitshouldbeinthebestinterestoftheclient(shareholder),notthecompanymanagement.Yourfirm’sproxyvotingpoliciesshouldbedisclosedtoclients.
RecommendedProceduresforCompliance: Regularaccountinformation:Submitaquarterlystatementtotheclientthatincludes
credits,debits,securitiesholdings,andtransactionsduringtheperiod.Indicatewhethertheclientmustholdorsellassets.Andifsold,wheretheproceedsshouldbeinvestedinandwhen.
Clientapproval:Ifunsureofwhatcourseofactiontotakewithrespecttoaclient,membersandcandidatesmustdiscusswiththeclientinwritingandtakeapproval.
Firmpolicies:Encouragefirmstoadoptthesepolicies:o Followallapplicablerulesandlaws.
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o Establishtheinvestmentobjectivesoftheclient:returnrequirements,riskprofile,experiences,andconstraints.
o Consideralltheinformationwhentakingactions:theclient’sneedsandcircumstances,theclient’sportfolio,andaninvestment’sindividualcharacteristics.
o Carryoutregularreviews:Ifaclient’scircumstanceshavechanged(suddenneedforlargesumsofmoney,oranunexpectedinflowofmoney),thentheymustbeaddressed.
o Dealfairlywithallclientswithrespecttoinvestmentactions.o Discloseconflictsofinterest.o Disclosecompensationarrangements:Ifamanageriscompensatedbasedonthe
returnsgeneratedforaclient,thenitmustbedisclosedtotheclient.o Maintainconfidentiality.
StandardIII(B)FairDealing
MembersandCandidatesmustdealfairlyandobjectivelywithallclientswhenprovidinginvestmentanalysis,makinginvestmentrecommendations,takinginvestmentaction,orengaginginotherprofessionalactivities.
Interpretation:Thestandardfocusesondealingfairlyandobjectivelywithallclients.Itdoesnotmeanequallybecausethecircumstancesofeveryclientwillbedifferent.Also,afirmmayofferdifferentlevelsofservices.Aclientpayingahigherfeeforapersonalizedservicecannotbetreatedinanequitablemannerwithonewhoisnot.Moreover,itisalsonotpossibletocommunicateinformationtoallclientsatthesametimeasthemodesofcommunicationmayvary(e‐mail,phone,andfax).
Guidance: Investmentrecommendationisanyopiniontobuy,sell,orholdasecurity/investment.
Guidelinesonhowrecommendationsmustbedisseminatedtoclients:o Allyourclientsmusthaveafairopportunitytoactontheinvestment
recommendation.o Thereshouldnotbeselectivedisclosuresuchthatyourlargeclientsreceivea
reportfirstandthesmallerclientslater.Theremaybepracticaldifficultiesinreachingallclientsattheexactsametimebecauseoftimedifferencesandmodesofcommunication,butaneffortmustbemadetocommunicateinanequitablemanner.
o Theremaybeinstanceswhenyoumaychangeyourrecommendation.Let’sassumeyouissuedabuyrecommendationforastockerroneously.Youchangeditlatertosellandifthereareclientswhohaveactedonthebuyorderbutarenotawareofthechangetosell,youmustadvisethemofthechangebeforeacceptingtheorder.
Guidelinesformembersandcandidateswhoseprimaryroleistotakeactionsbasedoninvestmentrecommendationsreceivedeitherfromwithinthefirmorexternalsources:
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o Takecaretotreatallclientsfairly.o IPOandsecondaryofferings:Distributetoallclientsforwhomtheinvestmentsare
appropriate.Allocationofthestockshouldbeconsistentwiththepoliciesofthefirm.
o Oversubscribedissues:Distributeonaprorataandround‐lotbasis.Refrainfrombuyingforindividualandfamilyaccounts.But,ifafamily‐memberisafee‐payingclient,thenthefamilymembermustbetreatedonanequalbasisasanyotherclient.
o Blocktrade:Allaccountsofclientsinablocktrademustbegiventhesameexecutionpriceandchargedthesamecommissionfee.
o Ordersmustbetimestamped.o Ordersaretobeexecutedonafirst‐inandfirst‐outbasis.o Disclosetotheclienttheallocationproceduresthatthefirmfollows.o MembersandcandidatesmustnotwithholdsecuritiesofIPOs,tradingatapremium
inthesecondarymarket,fortheirbenefit.
Recommendedproceduresforcompliance: Developfirmpolicies.
o Limitthenumberofpeoplewhoknowthatarecommendationisgoingtobedisseminated.
o Shortenthetimeframebetweenthedecisiontomakeaninvestmentrecommendationandactualdissemination.
o Publishguidelinesforpre‐disseminationbehavior:Firmsmustbeencouragedtohaveguidelinesthatprohibitpersonnel,whoknowabouttherecommendation,fromtakingactionordiscussing.
o Simultaneousdissemination:Oncedisseminationtoallclientshashappened,membersandcandidatesmayfollowupwithindividualclients.
o Maintainalistofclientsandtheirholdings.o Developanddocumenttradeallocationprocedures(discussedabove).
Disclosetradeallocationprocedures. Establishsystematicaccountreview:Conductperiodicreviewtoensurenoclientis
receivingpreferentialtreatmentandtradesarebasedontheaccount’sobjectives.Ifthemanagerissellingfromoneaccountandbuyingitforanotheraccount,hemustdocumentthereasonsforboththetransactions.
Disclosethelevelsofserviceandtheassociatedfeestoallclients.
StandardIII(C)Suitability
1. Whenmembersandcandidatesareinanadvisoryrelationshipwithaclient,theymust:a. Makeareasonableinquiryintoaclient’sorprospectiveclient’sinvestment
experience,riskandreturnobjectives,andfinancialconstraintspriortomakinganyinvestmentrecommendationortakinginvestmentaction,andmustreassessandupdatethisinformationregularly.
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b. Determinethataninvestmentissuitabletotheclient’sfinancialsituationandconsistentwiththeclient’swrittenobjectives,mandates,andconstraintsbeforemakinganinvestmentrecommendationortakinginvestmentaction.
c. Judgethesuitabilityofinvestmentsinthecontextoftheclient’stotalportfolio.
2. Whenmembersandcandidatesareresponsibleformanagingaportfoliotoaspecificmandate,strategy,orstyle,theymustmakeonlyinvestmentrecommendationsortakeonlyinvestmentactionsthatareconsistentwiththestatedobjectivesandconstraintsoftheportfolio.
Interpretation:
Determinethesuitabilityofaninvestmentbeforetakingactionbasedontheclients’circumstancesandotherfactors.Itistheresponsibilityofmembersandcandidateswhoprovideinvestmentadvicetoaclienttodeterminethesuitabilityofaninvestment.Sell‐sideanalystsandothermemberswhoexecuteinstructionsarenotresponsibleforsuitabilityanalysis.
Guidance: Developinganinvestmentpolicy:Gatherclientinformation(personaldata,objectives,
risk,andcircumstances)atthestartoftherelationship.DevelopanIPSthatoutlinesreturnrequirements,risktolerance,andallinvestmentconstraints.IPSalsooutlinestherolesandresponsibilitiesofthepartiesintheadvisoryrelationship,whenperiodicreviewswillbeconductedandtheIPSreevaluated.
Updatinganinvestmentpolicy:IPSistobeupdatedatleastannuallytoreflectchangesinmarketexpectationsandcircumstancesoftheclient.Needsandcircumstancesoftheclientscanchangeatanytimeandtheinvestmentrecommendations/decisionsmusttakenoteofthis.Examplesofchangesinanindividual’scircumstances:taxstatus,numberofdependents,liquidityneeds,lossofjob/changeincurrentincome,etc.
Theneedfordiversification:Combiningdifferentinvestmentsreducestheriskofaportfoliohavingallassetsinasingleinvestment.Aninvestmentthatisrelativelyriskyonitsownmaybesuitableinthecontextoftheentireportfolio.
Addressingunsolicitedtradingrequestso Requestsfromclientsfortradesthatdonotalignwiththeriskandreturnobjectives
ofaclient’sIPS:Membersandcandidatesmusttakeeffortstobalancetheclient’srequestwhilenotdeviatingfromtheIPS.
o Unsolicitedrequeststhatarenotsuitableinvestments:IfyourclientsaskyoutomakeatradethatisnotinaccordancewiththeIPS,thenrefrainfrommakingthetradeuntilyoudiscussitwiththeclient.EducatetheclientaboutthedeviationfromthecurrentIPS.
o Iftheclientinsistsonmakingthetradeandifyouthinkitwillhaveamaterialimpactontheportfolio,updatetheIPS.IftheclientrefusestohavetheIPSmodified,thendeterminethefutureoftheadvisoryrelationship.
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Managingtoanindexormandate:Investaccordingtothemandate.Forexample,assumeyouareaportfoliomanagerforasmallcapfundandyourmandateistoincludestocksbelowacertainmarketcapitalization.Youwouldbedeviatingfromthemandateifyoubuylargecapstocksevenifyouexpectlargecapstoperformexceptionallywell.
RecommendedProceduresforCompliance: Investmentpolicystatement:Bothindividualandinstitutionalinvestorsmusthavean
IPS.TheIPSshouldoutlinethefollowing:clientidentification,investorobjectives,investorconstraints,andperformancemeasurementbenchmarks.
Regularupdates:IPSistobeupdatedonaregularbasis(atleastannually)toreflectchangingcircumstancesandcapitalmarketexpectations.
Suitabilitytestpolicies:Firmsmustbeencouragedtohavetestprocedurestodeterminethesuitabilityofinvestmentsfordifferenttypesofclients.
StandardIII(D)PerformancePresentation
Whencommunicatinginvestmentperformanceinformation,membersandcandidatesmustmakereasonableeffortstoensurethatitisfair,accurate,andcomplete.
Guidance: Providecredibleperformanceinformationtoclientsandprospectiveclients.Shouldnot
statethatpastperformancecanbeobtainedagain. Avoidmisstatingperformanceormisleadingclients. Ifthepresentationisbrief,makedetailedsupportinginformationavailabletoclientsand
prospectsonrequest.
RecommendedProceduresforCompliance:ApplyingtheGIPSstandardsisrecommended,butnotrequired.FirmsthatclaimcompliancewithoutapplyingGIPSstandardsmustdothefollowing: Considertheknowledgeandsophisticationoftheaudience. Presenttheperformanceoftheweightedcompositeofsimilarportfoliosratherthan
usingasinglerepresentativeaccount.Assumetherearethreeportfolioswithsimilarmandatesworth2million,10million,and8million.Iftheygeneratedreturnsof9%,2%,and2%,respectively,thentakeaweightedaverageofreturns.
Includeterminatedaccountsaspartofperformancehistory.Alsostatewhenthoseaccountswereterminated.
Includedisclosuresthatfullyexplaintheperformanceresultsbeingreported. Maintainthedataandrecordsusedtocalculatetheperformancebeingpresented.
StandardIII(E)PreservationofConfidentiality
MembersandCandidatesmustkeepinformationaboutcurrent,former,andprospectiveclientsconfidentialunless:
1. Theinformationconcernsillegalactivitiesonthepartoftheclient.
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2. Disclosureisrequiredbythelaw.
3. Theclientorprospectiveclientpermitsdisclosureoftheinformation.
Guidance: Statusofclient:Evenifanentityisnolongeraclient,membersandcandidatesmust
maintaintheconfidentialityofclientrecords. Compliancewithlaws:Complywithapplicablelaw.Ifaclientisinvolvedinillegal
activitiesandtheapplicablelawrequiresmembersandcandidatestomaintainconfidentiality,thentheinformationmustnotbedisclosed.
Electronicinformationandsecurity:Membersandcandidatesneedtobeawareofpossibleaccidentaldisclosures.Theyshouldtakecarewhencommunicatingsensitiveclientinformation.Forinstance,assumetwoclientsaninvestmentmanagerisdealingwith,havesimilarnames.Whensendingane‐mailwithupdatedIPS,theinvestmentmanagertypesinthenameoftheintendedrecipientanddoesn’trealizethatitgoestotheotherclientinsteadoftheintendedrecipient.Suchmistakescanhavedireconsequences.
ProfessionalconductinvestigationsbyCFAInstitute:Ifpermissibleunderlaw,membersandcandidatesmustcooperatewithPCPandprovideinformationaboutaclientinsupportofaninvestigation.AnyinformationgiventoPCPstaysconfidential.
RecommendedProceduresforCompliance: Thesimplest,mostconservative,andmosteffectivewaytocomplywithStandardIII(E)
istoavoiddisclosinganyinformationreceivedfromaclient,excepttoauthorizedfellowemployeeswhoarealsoworkingfortheclient.
Communicatingwithclients:Followfirm‐supportedcommunicationmethodsandcomplianceprocedureswhencommunicatingconfidentialinformation.
StandardIV:DutiestoEmployers
StandardIV(A)Loyalty
Inmattersrelatedtotheiremployment,MembersandCandidatesmustactforthebenefitoftheiremployerandnotdeprivetheiremployeroftheadvantageoftheirskillsandabilities,divulgeconfidentialinformation,orotherwisecauseharmtotheiremployer.
Interpretation: Assumeyouworkforaninvestmentmanagementfirmandhavecommittedtowork45
hoursaweek.Duringthistime,you’llnotindulgeinanyactivitythatwilldepriveyouremployerofyourskillsandabilities.
Now,assumeyouareabouttoplacealargebuyorderforastockforaclient.Youaretemptedtoplaceanorderforyourownaccountbeforebuyingfortheclient.Thisis
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calledfrontrunninganditmustbeavoided,asyoumustplaceyourclientandemployer’sinterestsbeforeyourowninterests.
Everythingelsetakesprecedencebeforedutytoyourownself.Ofcourse,it’snotablanketstatementthatrequiresmembersandcandidatestoalwaysputworkaheadofpersonalcommitmentsandimportantfamilyobligations.Thestandardrecommendsmemberstoenterintoadialoguewithemployerstostrikeabalancebetweenworkandpersonallife.
Guidance: Theemployermustnothaverules/writtenpoliciesthatconflictwithresponsibilitiesof
membersandcandidates.Ifthereareany,thenyoumustencourageyouremployertochangethosepolicies.
Independentpractice:Independentpracticeisengaginginabusinessactivitywhereyougetpaid,andtheworkisnotrelatedtotheemployer.Assumeyouarethinkingofstartinganindependentpracticetoworkovertheweekendsorafter‐workhours.Therearecertainrulesthatgovernthis:o Youmustnotstartapracticethatconflictswiththeinterestsofyouremployer.o Obtainconsentfromyouremployerbeforestartingthepractice.Disclosethetypes
ofservicesyouwillrender,theexpecteddurationoftheservices,andthecompensation.
Leavinganemployer:Assumeyouhavesubmittedyourresignationanddecidedtoleaveyouremployer.Thereisaonemonthnoticeperiod.Duringthisperiod:o Youmustcontinuetoactinthebestinterestsofyourcurrentemployer.o Youmustnotrevealtradesecretstoyournewemployer.o Youmustnotmisuseclientlists.o Youmustnotsolicitexistingclientstoshifttheirbusinesstothenewemployer.o Onceyouhaveleftyourcurrentemployerandarebeingpaidbythenewemployer,
youmayseekbusinessfromoldclientsifyouhavenotsignedanon‐competeagreementwiththepreviousemployer.
Guidelinesforwhatisacceptableafterstartingworkatanewfirm:o Itisokaytouseskillsandexperiencegainedatthepreviousemployerastheyare
notconsideredconfidential.Knowledgeofthenamesofformerclientsisnotconsideredconfidential.
o Onemustnotuseanything(records/work)storedinpaperorelectronicformatfromthepreviousfirm.Ex:Excelmodelforthepharmaceuticalindustrydevelopedatthepreviousemployer.
Useofsocialmedia:o Followfirmpolicieswithrespecttosocialmediaforinteractingwithclientsand
prospectiveclients.Ex:whenemployeesareleavinganorganization,itmaynotbeappropriatetoannounceitonsocialmediaasfirmsmayhaverulesonhowandwhentoannouncethistoclients.
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o Therecommendedpracticeistohaveseparateaccountsforpersonalandprofessionalsocialmediaactivities.
o Iftherearenofirmrules,it’sbesttoactinthespiritoftheStandardandnotengageinanyactivitythatwouldharmtheemployer.
Whistle‐blowing:Bringinginsiderknowledgeofillegal/unethicalactivitiesinanorganizationtotheattentionoflawenforcementactivitiesiscalledwhistle‐blowing.Whistle‐blowingisnotacceptableiftheintentisforpersonalgain.
Natureofemployment:Understandthenatureofemployment(full‐timeemployeeoracontractor).Youneedtobeawareofthetermsoftherelationship:numberofhours,compensation,benefits,worklocation,clientexpectations,etc.
Recommendedproceduresforcompliance: Competitionpolicy:Relatestotheindependentpractice,wesawintheguidelinessection.
Youmustunderstandtherules/proceduresofyourfirmwithrespecttopursuinganindependentpractice.
Terminationpolicy:Understandtheterminationpoliciesofyouremployer. Incident‐reportingprocedures:Beawareofincident‐reportingproceduresatyourfirm.
Ifthereisnone,encourageyourfirmtoadoptone. Employeeclassification:Understandyourstatuswithinthefirm:part‐time,full‐time,or
contractor.Beawareofthepoliciesthatapplytoyourclass.
StandardIV(B)AdditionalCompensationArrangements
MembersandCandidatesmustnotacceptgifts,benefits,compensation,orconsiderationthatcompeteswithormightreasonablybeexpectedtocreateaconflictofinterestwiththeiremployer’sinterest,unlesstheyobtainwrittenconsentfromallpartiesinvolved.
Interpretation: Assumeyouareaportfoliomanagerworkingforaninvestmentmanagementfirm.
Assumeaclienthasbenefitedimmenselyfromyourwork,andwouldliketogiftanexpensivecruiseforyouandyourfamilyasatokenofappreciation.Thisisanexampleofadditionalcompensation.
Assumeyouuseabrokeragefirmtoexecuteordersforyourclients.Ifthebrokeragewantstosendagiftsothatyoucontinuetodirectbusinesstotheminthefuture,itisanexampleofadditionalcompensation.
Guidance: Obtainpermissionbeforeacceptingcompensationthatmightcreateaconflict.Youmust
firstdisclosetoyouremployerandobtainwrittenconsentforanycompensationthatmaycreateaconflict.
“Writtenconsent”includesanyformofcommunicationthatcanbedocumented.
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Notallgiftsneedtobereported.Forexample,ifabrokeragefirmsendsyouadesktopcalendar,orifaclientsendsyouapenasatokengift(notofsignificantvalue),thenitneednotbereported.
Discusspossiblelimitationstotheirabilitiestoprovideservicesthatmaybecompetingwithyouremployer’sduringthenegotiationandhiringprocess.
Recommendedproceduresforcompliance: Makeanimmediatewrittenreporttoyoursupervisorandcomplianceofficerspecifying
anycompensationyouproposetoreceive. Thedetailsofthereportshouldbeconfirmedbythepartyofferingtheadditional
compensation,includingperformanceincentivesofferedbyclients.Inourearlierexample,wheretheclientofferedanexpensivevacation,whenyoudisclosethesametoyouremployer,itmustbevalidatedbytheclient.Thiswrittenreportshouldstatethetermsofanyagreement.
StandardIV(C)ResponsibilitiesofSupervisors
MembersandCandidatesmustmakereasonableeffortstoensurethatanyonesubjecttotheirsupervisionorauthoritycomplieswithapplicablelaws,rules,regulations,andtheCodeandStandards.
Interpretation: Thisstandardappliestoanyonewhohassupervisoryresponsibilities,irrespectiveof
whetherornottheemployeesundertheirsupervisionareCFAInstitutemembers,CFAcharterholders,orcandidates.
Ifthenumberofemployeesundersupervisionislarge,thensupervisorsmaydelegateresponsibilitiestosubordinates,butthatdoesnotabsolvethemofresponsibilityincaseaviolationhappens.Supervisorsmustensuretheirsubordinatesareawareoftherules,applicablelaws,firmpolicies,CodeandStandards,etc.
Theymusthaveregulartrainingprogramsoncompliancepoliciesforemployeesundertheirsupervision.
Ifthecomplianceproceduresatafirmareinadequate,theymustbringittotheattentionofthefirm’sseniormanagers.
Ifthecomplianceproceduresareinadequateornon‐existent,thenmembersandcandidatesshoulddeclinesupervisoryresponsibility.
Guidance: Systemforsupervision
o Understandthecomplianceproceduresofthefirm.o Ensureadequatecomplianceproceduresareinplacethatcoverallpossible
violations.Itisnotpossibletocovereverypotentialviolationthatmayoccur.
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o Onceaviolationisdetected,asupervisormustimmediatelyreportthemisconductandinitiateanassessmenttodeterminetheextentofwrongdoing.Itisnotsufficienttowarntheemployeeorrelyonhis/herstatementsthatitwillnotrecur.
o Hemustalsoensurethattheactisnotrepeateduntiltheinvestigationiscomplete. Supervisionincludesdetection
o Supervisorsareresponsiblefordetectingviolations.o Supervisorsareresponsibleforensuringcomplianceproceduresareimplemented
andthattheyarefollowedthroughperiodicreview.o Assumeyouasasupervisorhavetakenadequatestepstoensurecompliance
proceduresareinplace.Despitethis,aviolationoccurs.Sinceadequatestepsweretaken,youasamembermaynotbeinviolationofthestandardunderthesecircumstances.However,itisanindicationthattheexistingcomplianceproceduresarenotsufficient.
RecommendedProceduresforCompliance: Encouragefirmstoadoptacodeofethicsforstrongethicalfoundation. HaveadequatecomplianceprocedurestoensurethepoliciesintheCodeandStandards,
andsecuritieslawsareimplementedatthefirm,andadheredto,onadailybasis. Distinguishbetweenthecodeofethicsandcomplianceprocedures.Keepingthem
separatehelpsservetheirindividualpurpose.o Complianceproceduresmustbewritteninplainlanguagesuchthatanyaverage
personcanunderstandandassimilatethemeasily.o Assignacomplianceofficerwhohastheauthoritytoimplementthefirm’s
complianceprocedures.o Establishthehierarchyofsupervisionandassigndutiesamongsupervisors.o Oncethecompliancesystemisinplace,supervisorsmustperiodicallymonitorto
detectviolationsand,ifdiscovered,musttakethenecessaryactions. Implementationofcomplianceeducationandtraining. Establishanappropriateincentivestructure.
o Supervisorsandfirmsmustanalyzethecompensationstructuretoseeifitencouragesprofitsattheexpenseofethicalbehavior.
o Is“how”profitsaregeneratedgivenlessimportancethan“howmuch”profitsaremadeforthefirm?
StandardV:InvestmentAnalysis,Recommendations,andActions
StandardV(A)DiligenceandReasonableBasis
MembersandCandidatesmust:
1. Exercisediligence,independence,andthoroughnessinanalyzinginvestments,makinginvestmentrecommendations,andtakinginvestmentactions.
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2. Haveareasonableandadequatebasis,supportedbyappropriateresearchandinvestigation,foranyinvestmentanalysis,recommendation,oraction.
Interpretation:
Thelevelofdiligenceandthoroughnessofresearchdependsontheinvestmentphilosophythemember/firmisfollowingandtheroleofthememberintheinvestmentdecision‐makingprocess.
Guidance: Definediligenceandreasonablebasis. Whenusingsecondaryorthird‐partyresearch(researchconductedbysomeoneoutside
themember’sfirm)makereasonableeffortstoensurethird‐partyresearchissound. Ensurethefirmhasapolicyaboutperiodicreviewofapprovedthird‐partyresearch
providers.Ifnot,youmustencouragethefirmtoadoptaformalreviewpractice. Youmayrelyonthejudgmentofothers(seniormanagers)inyourfirmifyoubelievethe
duediligencedonebythemwasadequate. Whenusingquantitativelyorientedresearch,ensurethesoundnessofmodels.Youare
notexpectedtobecomeanexpertineverytechnicalaspectofthemodels,butyoumustunderstandthedata,parameters,assumptions,andlimitationsofthesemodels.Testtheoutputofthesemodelsundervariousscenariosbeforedistributingtheproduct.Ensurethatthemodelincludesabroadrangeofscenarios–evenhigh‐riskandpotentiallynegativeoutcomesthatarenotcommonlyencountered.
Developingquantitativelyorientedtechniques:Ifyouareinvolvedindevelopingnewmodels/algorithms,thenyoumustexercisehigherdiligenceinreviewingnewproductsthanindividualswhowouldusethesemodels.Includedataforbothpositiveandnegativeeconomiccycles.Testmodelsusingadversevolatilityandperformanceexpectations.Testthemodelforawiderangeofinputexpectations.
Selectingexternaladvisersandsub‐advisers:Ifyouareusingexternaladviserstomanageaspecificmandate,thenyoumustdiligentlyreviewthemjustasyouwouldanindividualfund/security.Reviewifthepublishedreturninformationisaccurate.Understandtheadviser’scomplianceprocedures,investmentprocess,andifhe/sheadherestothestatedstrategy.
Groupresearchanddecisionmaking:Often,membersandcandidatesarepartofagroupthatcollectivelyproducesaninvestmentanalysisorresearch.Thegrouparrivesataconsensusandgivesarecommendation.Thenamesofthemembersareincludedinthereport.Ifyoudonotagreetothefinalrecommendation,butbelievethatconsensusopinionhasareasonableandadequatebasis,andisindependentandobjective,thenyouneednotdissociateyourselforaskthatyournameberemovedfromthereport.
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RecommendedProceduresforCompliance: Establishapolicythatresearchreportsmusthaveareasonableandadequatebasis.
Eitheranindividualorareviewcommitteeconsistingofagroupofemployeesmustbeappointedtoreviewthereportbeforeitiscirculatedtotheoutsideworld.
Developwrittenguidanceforanalysts,supervisoryanalysts,andreviewcommitteethatoutlineduediligenceproceduresifarecommendationhasareasonableandadequatebasis.
Developcriteriaforassessingthequalityofresearch. Developwrittenguidancefortestingofallcomputer‐basedmodels. Developmeasurablecriteriaforassessingoutsideproviders.Thisrelatestothe
guidelinesforusingexternal/thirdpartyresearch(wesawthisintheprevioussection).
StandardV(B)CommunicationwithClientsandProspectiveClients
MembersandCandidatesmust:
1. Disclose to clients and prospective clients the basic format and general principles of theinvestment processes they use to analyze investments, select securities, and constructportfolios, and must promptly disclose any changes that might materially affect thoseprocesses.
2. Disclosetoclientsandprospectiveclientssignificantlimitationsandrisksassociatedwiththeinvestmentprocess.
3. Use reasonable judgment in identifying which factors are important to their investmentanalyses, recommendations, or actions, and include those factors in communicationwithclientsandprospectiveclients.
4. Distinguish between fact and opinion in the presentation of investment analyses andrecommendations.
Interpretation:
Thisstandardemphasizestheneedforcommunicatingclearlyandfrequentlywithclients.Itisimportanttocommunicatetoclientswhatfactorstheyconsideredwhilemakingtherecommendation.Ifthereisachangeintheriskcharacteristicsofasecurityorasset,thenthismustalsobecommunicated.
Guidance: Informingclientsoftheinvestmentprocess:Describeyour/firm’sinvestmentdecision‐
makingprocesstotheclient.Thismustincludetheprosandcons,risksandlimitationsoftheprocess.o Justcommunicatingthefinalrecommendation(forinstance,buy/sellasecurity)to
theclientisnotsufficient.Youmustexplaininsimplelanguagetheinvestmentprocess.
o Ifthereisanychangeintheprocess,informtheclient.o Communicatetotheclientifanyexternaladvisersarebeingusedfortheirexpertise
tomanageaspecificstrategy.
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Differentformsofcommunication:Communicationisnotrestrictedtotraditionalwrittenreport.Itcouldbein‐personmeetings,e‐mail,telephoneconversation,etc.o Careshouldbetakenwhencommunicatingthroughsocialmedia.o Iftherecommendationisconcise(stock‐list),thenyoumustnotifyclientsthat
additionalinformationwillsoonbemadeavailable. Identifyingriskandlimitations:Disclosetoclientstherisksandlimitationsofthe
investmentprocess/product. Reportpresentation:Inthereportincludethoseelementsthatwereimportantfor
analysisandconclusion. Distinctionbetweenfactsandopinionsinreports:Assumeyouarerecommendinga
sugarstockbecauseyoubelievethatthegovernmentwillraisetheexportquotalimit.But,thishasnotbeendoneyet;so,itisjustyouropinion.Youmustdistinguishbetweenfactsandopinionbystatingthisisanopinion.However,forinstance,ifyouwerepresentingtheperformanceofthepastthreequarters,thenthiswouldbeafact.
RecommendedProceduresforCompliance:
Theinformationincluded/excludedinresearchreportsvariesgiventhediversenatureofclientsandinvestmentassets.Thereisnospecificchecklistforwhatmustbeincluded.But,firmsmusthavearigorousmethodologytoreviewresearchmeantfordisseminationtoclients.
StandardV(C)RecordRetention
MembersandCandidatesmustdevelopandmaintainappropriaterecordstosupporttheirinvestmentanalyses,recommendations,actions,andotherinvestment‐relatedcommunicationswithclientsandprospectiveclients.
Interpretation:
Membersandcandidatesmustretainrecordsthatsupporttheirresearch,analysis,andconclusion.Whatrecordstomaintaindependsonthememberinvolvedinthedecision‐makingprocess.Recordscanbemaintainedeitherinhardcopyorelectronicformat.
Guidance: Newmediarecords:Itisthemember’s/candidate’sresponsibilitytomaintainarecordof
informationposted/discussedinsocialmediaevenifthefirmdoesnothavearecordretentionpolicyyet.Examplesincludetwitter/blogposts,Facebookupdates,etc.
Recordscreatedaspartofanyprofessionalactivityarethepropertyofthefirm;ifamemberdecidestoleavethefirm,he/shecannottaketherecordsorsupportingdocumentswithouttheconsentofthepreviousemployer.
Memberscannotreusehistoricalresearchreportsifthesupportingdocumentationisnotavailable.
Everycountry/jurisdictionwhereyouoperatemayhavecertainrulesforhowmuchdatatoretain.Forinstance,acountry’sregulatormaycallforretainingdataforthepastfive
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years.Similarly,firmsmayalsohavepoliciesforretainingresearch/communicationrecords.CFAInstituterecommendsretainingrecordsforatleastsevenyears.
RecommendedProceduresforCompliance: Theresponsibilitytomaintainrecordsthatsupportinvestmentactiongenerallyfalls
withthefirmratherthanindividuals. Youshouldarchiveresearchnotesandotherdocumentsthatsupportinvestment‐related
communications. Ifthefirmhaspoliciesandprocedurestofacilitaterecordretention,thenyoumustfollow
them.Ifnot,youmustencourageyourfirmtoadoptpoliciesforpreservingrecords.
StandardVI:ConflictsofInterest
StandardVI(A)DisclosureofConflicts
MembersandCandidatesmustmakefullandfairdisclosureofallmattersthatcouldreasonablybeexpectedtoimpairtheirindependenceandobjectivityorinterferewithrespectivedutiestotheirclients,prospectiveclients,oremployer.MembersandCandidatesmustensurethatsuchdisclosuresareprominent,aredeliveredinplainlanguage,andcommunicatetherelevantinformationeffectively.
Interpretation:
Conflictsoccuroftenintheinvestmentprofession.Theyoccurbetweentheinterestsofclients,interestsofemployers,ortheycouldbeyourownpersonalinterests.Disclosetheconflictofinterestinplainlanguagetoemployer,clients,orprospectiveclients.
Guidance: Disclosureofconflictstoemployers.Someexamples:
o Assumeyouareworkinginaninvestmentmanagementfirm.Youmanageaclient’sportfoliothathasperformedextremelywell.Theclientishappyandwishestocompensateyouforthisperformance.Thisisaconflictofinterestwithotherclientsandyoumustdisclosethistoyouremployer.
o Assumeyouvolunteeratacharityorganizationthatisinnowayrelatedtoyourwork,andyouarenotpaidforit.However,youarepassionateabouttheworkyoudoatthischaritywhichkeepsyoubusyonweekendsandmentallyoccupiedduringtheweek,andisdeprivingyouremployerofyourskills.Youmustdisclosethispotentialconflictofinteresttoyouremployer.
o Assumeyouholdstocksinyourpersonalaccountforwhichyourfirmhasabuyrecommendationandissuitableformanyclients.Thismaycreateaconflictofinterest.
Firmscreatepoliciestopreventactionsthatmayappearasaconflictofinterest.Policiesincluderestrictionsonpersonaltrading,outsideboardmembership,etc.
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Disclosuretoclients:Therearenumerousinstanceswhereaconflictofinterestexists;theseshouldbedisclosedtoclientssothattheyunderstandthecostoftheirinvestmentsandthebenefitsreceivedbythefirm.Afewinstancesarehighlightedbelow:o AssumeyouholdstocksofGeneralElectric(GE).Youareaskingyourclienttobuy
sharesofGE;itmaycreateapotentialconflictofinterestas,ifyourclientbuysandthestockpriceincreases,youwillbenefitfromthemovement.
o Youreceivecompensation(1%commission)fromyouremployerwhenyourecommendcertainmutualfunds.Youmustdisclosethistotheclientastheclientmaybelievethisrecommendationiskeepingtheclient’sbestinterestsinmind.Followingthedisclosure,theclientmaydecidewhetherthemutualfundissuitableornot.
o AssumeyouissueabuyrecommendationonGeneralElectricandrecommendyourclienttobuythestock.Ifyourfirmalsohasaninvestmentbankingrelationship,forinstance,thenitmustbedisclosedtotheclient.Theclientcanthendecideifitisinhisbestinterest,ortheinterestofthefirmandGE.
Cross‐departmentalconflicts:Assumeyouarearesearchanalyst(sell‐sideanalyst)workingatabrokeragefirm.Yourfirmhasaninvestmentbankingdepartment,andmaypressurizeyoutowritefavorablereportsforcompanieswithwhomtheyhaveanexistingrelationshiporaretryingtoforgeone.Ideally,existingcompaniesshouldbeonarestrictedlist.But,ifthatisnotpossible,thenyoumustmakeadisclosureoftheinvestmentbankingrelationshipintherecommendationreport.Anotherexamplewheresuchconflictsmayariseisbuy‐sideanalyst/bankswithunderwritingpowers.
Conflictswithstockownership:Membersandcandidatesmustdiscloseanymaterialownershipinastock/investmentthattheyarerecommendingtoclients.
Conflictsasadirector:Therearethreepossibleconflictsofinterestifyouareaninvestmentprofessionalandservingasadirectorofacompany:o Dutiesowedtoclientsanddutiesowedtoshareholdersofthecompany.o Asadirector,youmayreceivesecurities/optionstopurchasesecuritiesofthe
companyascompensation.Aconflictmayariseiftradinginthesesecuritiesincreasesthevalueofthesecurity.
o Asadirector,youmaybeprivytomaterialnonpublicinformationaboutthecompany.Theremaybeaperceptionthatthedirectorcommunicatesthisinformationtohisfirmandinvestmentrecommendationsarebasedonthatinformation.
Recommendedproceduresforcompliance: Disclosespecialcompensationarrangementswiththeemployerthatmightconflictwith
clientinterests,suchasbonusesbasedonshort‐termperformancecriteria,commissions,incentivefees,performancefees,andreferralfees.
Ifthefirmdoesnotpermitsuchdisclosure,youshoulddocumenttherequestandconsiderdissociatingfromtheactivity.Forexample,ifyoureceivea1%bonusfromyour
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firmforsellingcertainmutualfundsandyourfirmdoesnotpermitdisclosingthiscompensation,thenyoushouldconsiderdissociatingfromtheactivity.
StandardVI(B)PriorityofTransactions
InvestmenttransactionsforclientsandemployersmusthavepriorityoverinvestmenttransactionsinwhichaMemberorCandidateisthebeneficialowner.
Interpretation:
Ifyouaretradingforyourownaccount,thenyouarethebeneficialowner.But,assumethetransactionhappensinyourchildren’sorspouse’saccount.Eventhoughthoseaccountsarenotinyourname,youbenefitfromthemandyouarethebeneficialowner.Theaccounthereappliestoanyaccountwithwhomyouhaveadirectrelationship.
Guidance: Avoidingpotentialconflicts:Conflictsbetweenclient’sinterestandinvestment
professional’sinterestmayoccur.Thereisnothingunethicalaboutmanagers,advisers,ormutualfundemployeesmakingmoneyfrompersonalinvestmentsaslongastheyfollowthesethreerules:o Theclientisnotdisadvantagedbythetrade.Forexample,ifyouareexecutingasell
trade,thenitshouldnotaffectyourclientsinanyway.o Theinvestmentprofessionaldoesnotbenefitpersonallyfromtradesundertaken
forclients.o Theinvestmentprofessionalcomplieswithapplicableregulatoryrequirements.
Personaltradingsecondarytotradingforclients:Theorderofexecutingtradesis:clients,employers,andthenyourpersonalaccount,oroneinwhichyouarethebeneficialowner.Therationaleistopreventpersonaltransactionsfromadverselyaffectingtheinterestsofclientsoremployers.
Impactonallaccountswithbeneficialownership:MembersandCandidatesmayundertaketransactionsinaccountsforwhichtheyareabeneficialowner,onlyaftertheirclientsandemployershavehadanadequateopportunitytoactonarecommendation.Forexample,assumeyouareworkingasaninvestmentmanagerandyourgroupmadeabuyrecommendationonastock.Theclientmustgetthefirstopportunitytoactontherecommendation,thentheemployer,andthenyou.
Howshouldfamilyaccountsbetreated?:Assumeaclosefamilymemberisaclient.He/sheshouldreceivethesamelevelofserviceasanyotherclient.Ifyouhaveabeneficialrelationshipinthefee‐payingaccount,thenyoumaybesubjecttopreclearanceorreportingrequirementsoftheemployer.
RecommendedProceduresforCompliance: LimitedparticipationinequityIPOs:SomeIPO(initialpublicofferings)issuesarehighly
soughtafterandthesharepricerisesinvaluesignificantlyaftertheissueisbroughttothemarket.Usually,itisahotIPOifthesupplyislimitedandthedemandishigh.
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PurchaseoftheIPObyinvestmentprofessionalscreatesaconflictofinterestintwoways:o Itmayappearasifinvestmentpersonnelaretakingtheopportunityawayfrom
clientsforpersonalgain.Forexample,assumebothyouandyourclientareallotted200sharesinanIPO.Theclienthadappliedfor400butonlygot200.Allotmenttoyouraccountwillmakeitseemasifsomeopportunitywastakenawayfromtheclientforyourgain.
o ThepartythatisgivingtheinvestmentprofessionalthisopportunitytoparticipateintheIPOispossiblytryingtoinfluencehim/herinthefutureinvestmentdecisions.
Itisrecommendedthatmembersandcandidatesshouldpre‐clearparticipationinIPOsevenwherethereisnoappearanceofconflictofinterest,andstayawayfromequityIPOs.Fromafirm’sperspective,itmaynotberighttofollowablanketpolicythatbansemployeesfromIPOs.Instead,itwouldbeappropriatetohavereliableandsystematicproceduresinplacetoidentifyanyconflictofinterest,anddealtwithbysupervisors.
Restrictionsonprivateplacements:Privateplacementsaretransactionswhereyougetsharesofacompanythroughaprivateoffering,andnotthroughapublicoffering.TheconflictofinteresthereissimilartothatofIPOsasitmayseemthatthisparticipationinprivateplacementisafavorforfuturebusinessdeals.Assumeyouhaveparticipatedinaprivateplacement.Whentheinvestmentgoespublic,itmayseemasifyouhaveavestedinterestifyourecommendtheinvestmenttoclientsregardlessofitssuitability.
Establishblackout/restrictedperiods:Topreventfrontrunning(thepracticeoftradingforone’spersonalaccountbeforeclientaccounts),firmshaveblackoutperiodsduringwhichinvestmentpersonnelcannottradefortheirpersonalaccounts.Thisistosafeguardtheinterestsoftheclients.Thepolicyonblackoutandrestrictedperiodsvariesfromfirmtofirmdependingontheirsize.Itcanrangefromatotalbanontradingtopreventingtheinvestmentmanagerfromfrontrunning.
Supervisorsmustestablishreportingproceduresforinvestmentpersonnel.Forexample:o Disclosureofholdingsinwhichtheemployeehasabeneficialinterest:Thisshould
bedoneatthebeginningofemploymentandatleastannuallythereafter.o Providingduplicateconfirmationsoftransactions:Investmentpersonnelmust
directtheirbrokerstoprovideduplicatecopiesofallthesecuritiestransactionsdonewiththem.Itservestwopurposes:a)discouragesunethicalbehaviorbecausethereisanindependentverificationb)acleartransactionhistoryandflowofmoneyisavailable,andnotjusttheholdings.
o Preclearanceprocedures:Obtainingclearanceforplannedtradeshelpsreduceconflictofinterest.
Membersandcandidatesmustdisclosetoinvestorstheirfirm’spoliciesaboutpersonalinvesting/trading.Itshouldbeinsimplelanguagethatinvestorscanunderstand.
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StandardVI(C)ReferralFees
MembersandCandidatesmustdisclosetotheiremployer,clients,andprospectiveclients,asappropriate,anycompensation,consideration,orbenefitreceivedfromorpaidtoothersfortherecommendationofproductsorservices.
Interpretation: Assumeyouprovideequityinvestmentadvisoryservicetoaclient.Theclientisnow
interestedinmakingfixedincomeinvestmentsaswell.So,yourefersomeoneprovidingthisservicetotheclient.Youreceiveafeeforthisfromtheperson/firmgivingfixedincomeadvice.Asperthisstandard,youmustdisclosethefeeyougetforthereferral.
Anotherexampleiswhereyourecommendyourclienttopurchaseamutualfund,andthefundpaysyouacommission.Youmustdisclosethisarrangementtotheclientsothathe/shecanunderstandthefullcostoftheinvestmentandthebenefityouarereceiving.
Sayyoureceiveareferencefromsomeone/firm,andyoupayareferralfeetothepartyintroducingtheclient.Youmustdisclosetotheclientthefeepaidforthisreferral.
Guidance: Advisetheclientorprospectiveclientaboutanyreferralfeesbeforeenteringintoany
formalagreement. Disclosethenatureoftheconsiderationorbenefit.Forexample,flatfeeorpercentage
basis,one‐timefee,orcontinuingbenefitbasedonperformancemustbedisclosed.
RecommendedProceduresforCompliance: Encourageyouremployertodevelopproceduresrelatedtoreferralfees.Thefirmmay
completelyrestrictsuchfees. Provideclientsnotificationofapprovedreferralfeeprogramsandprovidetheemployer
regular(atleastquarterly)updatesontheamountandnatureofcompensationreceived.
StandardVII:ResponsibilitiesasaCFAInstituteMemberorCFACandidate
StandardVII(A)ConductasParticipantsinCFAInstitutePrograms
MembersandCandidatesmustnotengageinanyconductthatcompromisesthereputationorintegrityofCFAInstituteortheCFAdesignationortheintegrity,validity,orsecurityofCFAInstituteprograms.
Interpretation: ThisstandardcoverstheconductofCFAInstituteandMembersinvolvedwiththeCFA
Program. CFAInstituteprogramsincludetheCFAprogram,certificateininvestmentperformance
measurement(CIPM),andtheClaritas®InvestmentCertificate.
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ThestandardcoversmanyaspectssuchascheatingonanyCFAInstituteexaminations,violatingthetestingpolicies,disclosingconfidentialexaminformationtothepublic,andimproperlyusinganyassociationwiththeCFAInstitutetofurtherpersonalorprofessionalgoals.
Guidance: Confidentialprograminformation:Candidatesmaydiscussnon‐confidentialinformation
andcurriculummaterialwithotherswhilepreparingfortheexam.Examplesofinformationthatcannotbedisclosedinclude:o Specificdetailsofquestionsappearingintheexam.o Discussingwhatareasorformulasweretestedontheexam.
AdditionalCFAprogramrestrictions:o Thereareadditionalpoliciesthatdefineallowedanddisallowedactionsduringthe
exam.Testingpoliciesincludecalculatorpolicy(onlytwocalculatorsareallowed)andthepersonalbelongingspolicy.
o MembersmayparticipateasvolunteersinvariousaspectsoftheCFAprogramsuchasgrading,administering,ordevelopingtheexam.Buttheyarenotallowedto: Discloseanymaterialappearingontheexam. Howquestionsarescored. Anyinformationontheexamprocess.
Expressinganopinion:MembersarefreetoexpresstheiropinionordiscontentwithCFAInstituteregardingitspoliciesandprocedures.Forexample,ifyousaytheexamwasnotagoodrepresentationofthecurriculum,thenitisnotaviolationofthestandard.However,ifyoudiscussspecifictopicsorquestions,thenitisaviolation.
StandardVII(B)ReferencetoCFAInstitute,CFADesignation,andCFAProgram
WhenreferringtoCFAInstitute,CFAInstitutemembership,theCFAdesignation,orcandidacyintheCFAprogram,MembersandCandidatesmustnotmisrepresentorexaggeratethemeaningoforimplicationsofmembershipinCFAInstitute,holdingtheCFAdesignation,orcandidacyintheCFAprogram.
Interpretation: ItisnotintendedtoprohibitfactualstatementsrelatedtothebenefitsofearningtheCFA
designation. However,themeritsofCFAInstitute,theCFAProgram,andtheCodeandStandardsmust
beexpressedastheopinionofthespeaker. Thisstandardappliestoallformsofcommunication. ItisnotallowedtostatethatsomeonewithaCFAdesignationwillexhibitsuperior
performance.
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Guidance: CFAInstitutemembership:CFAInstitutememberreferstoregular/affiliatemembersof
theCFAInstitutewhohavefulfilledthefollowingmembershiprequirements:o RemitannuallytoCFAInstituteacompletedProfessionalConductStatement.o AnnuallypayCFAInstitutemembershipdues.
UsingtheCFAdesignation:OnceyouhaveearnedtherighttousetheCFAdesignation,youmustfollowtherulesassociatedwiththeusageofthedesignation.CFAcharterholdersareindividualswhohaveearnedthisrightbycompletingtheCFAprogramandhavetherequiredyearsofworkexperience.Theymustalsosatisfythemembershiprequirementsinordertousethedesignation.
ReferringtocandidacyintheCFAprogram:CandidatesmayrefertotheirparticipationintheCFAprogram.Apersonisacandidateifthepersonappearsforaspecifiedexaminationaftercompletingtheregistrationprocessorthepersonhasappearedforaspecifiedexamination,buttheresultsareyettobeannounced.
MembersandcandidatesmustencouragetheirfirmstocreatetemplatesconsistentwithstandardVII(B).
Instructor’sNote:ThisisthemostimportantreadinginEthicsandwillrepresentamajorpercentageoftheEthicsquestionsontheExam.Todowellonthistopicyoushouldcarefullystudyalltheexamples(ApplicationsoftheStandard)inthecurriculumandalsodoasmanypracticequestionsaspossible.
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Summary
LO.a:DemonstratetheapplicationoftheCodeofEthicsandStandardsofProfessionalConducttosituationsinvolvingissuesofprofessionalintegrity.
Readthe“ApplicationoftheStandard”segmentforeachstandardinthecurriculum.
LO.b:DistinguishbetweenconductthatconformstotheCodeandStandardsandconductthatviolatestheCodeandStandards.
LO.c:RecommendpracticesandproceduresdesignedtopreventviolationsoftheCodeofEthicsandStandardsofProfessionalConduct.
1.A.Knowledgeofthelaw
Understandapplicablelawandrules.Complywiththemorestrictlaw.Donotknowinglyparticipate/disassociatefromsuchactivity.
1.B.Independenceandobjectivity
Usereasonablecareandjudgment.Maintainindependenceandobjectivity.Donotoffer/solicitgifts.
1.C.Misrepresentation Donotmisrepresentfacts/performancereports.Avoidplagiarism.Donotomitfacts.
1.D.Misconduct Aimedatprofessionallife;actslikelying,cheating,andstealingaffectprofessionalreputation/integrity.
2.A.MaterialNonpublicInformation
Donotactorcauseotherstoactonmaterialnonpublicinformation.Achievepublicdissemination.Notaviolation:MosaicTheory=materialpublicinformation+nonmaterialnonpublicinformation.
2.B.MarketManipulation
Information‐basedmanipulation:Blogs,othermediatoinflatestockprices.Transaction‐basedmanipulation:Makeasecuritytoappearmoreliquid.
3.A.Loyalty,PrudenceandCare
Usereasonablecareandexerciseprudentjudgment.Placeclient’sinterestsbeforeyouremployeroryourinterests.Softdollarsshouldbenefittheclient.Striveforbestexecution.
3.B.FairDealing Dealfairlyandobjectivelywithallclients.Note:itdoesnotstateequallybecauseofdifferentlevelsofservice.Fee‐payingfamilymembershouldbetreatednodifferentthananyotherclient.Disseminatereportswithoutbeingpartial.Sametimeisnotpossiblebecauseofdifferentmodesofcommunication.
3.C.Suitability DevelopIPS.Understandclient’sriskprofile.UpdateIPSperiodically.
3.D.PerformancePresentation
Donotmisstateperformance.Ensureperformanceinformationisfair,accurateandcomplete.
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3.E.PreservationofConfidentiality
Maintainconfidentialityofcurrent,formerandprospectiveclientsunless:a)lawmandatesdisclosureb)illegalactivitiesbyclientc)clientpermitsdisclosure.
4.A.Loyalty Avoidfrontrunning.Getwrittenconsentfromemployerbeforestartinganindependentpractice.Youcannottakeproprietaryinformation,clientlistsofthepreviousemployer.
4.B.AdditionalCompensationArrangements
Donotacceptgifts,benefits,orcompensationthatwillcreateaconflictofinterest.
4.C.ResponsibilitiesofSupervisors
Ensureanyoneunderyoursupervisioncomplieswithapplicablelaws,rules,regulations,andCodeandStandards.
5.A.DiligenceandReasonableBasis
Exercisediligence,independence,andthoroughnessinanalyzinginvestmentsandmakingrecommendations.Bediligentandhaveareasonablebasis,evenwhenusingsecondaryorthird‐partyresearch.
5.B.CommunicationwithClientsandProspectiveClients
Disclosetoclientstheinvestmentprocess.Identifyrisksandlimitations.Distinguishbetweenfactandopinion.
5.C.RecordRetention Maintainrecordsthatsupportyouranalysisandresearch.CodeandStandardsrecommendstoringrecordsforatleastsevenyears.
6.A.DisclosureofConflicts
Makefullandfairdisclosureofmattersthatmayimpairindependenceandobjectivity.Disclosuretobemadeinplainlanguage.Exofconflicts:stockownership,director,crossdepartmental(IB/research)conflicts.
6.B.PriorityofTransactions
Anyaccountfromwhichyoubenefitmakesyouthebeneficialowner.Personaltradingsecondarytotradingforclients.Establishblackoutperiodstopreventfrontrunning.LimitparticipationinIPO.
6.C.ReferralFees Disclosereferralfeetoclients,prospectiveclients,andemployers.
7.A.ConductasparticipantsinCFAInstitutePrograms
Keepquestions,examinformationconfidential.Complywithprogramrestriction.Youmayexpressanopiniononthedifficultyofexam,curriculumetc.
7.B.ReferencetoCFAInstitute,theCFAdesignation,andtheCFAprogram
Payannualduesandfillprofessionalconductstatementtoclaimmembership.Referencestopartialdesignationnotallowed(CFA,Level1).CFAmarkcanbeusedifyou’veclearedallthreelevelsandfulfilledthemembershiprequirements.
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PracticeQuestions
1. NargisDilawez,CFA,worksasanindependentresearchanalystandusesvariousonlinesocialmedia sites tomake announcements, recommendations, and analyses of varioussecurities.SheisaresidentofCountrySwherethereisnolawagainstpostingofcommentsandopinions, but since her views are read globally she isworried about regulators incertaincountrieswhoimposerestrictionsandrequirementsononlinecommunications.AccordingtotheStandards,Dilawezshould:A. continue to post her comments since her resident country does not impose any
regulatoryrestrictions.B. discontinue immediately and wait for the restrictions to ease in the nonresident
countries.C. seek guidance from appropriate, knowledgeable, and reliable sources to diligently
followlegalandregulatorytrendsaffectingherprofessionalresponsibilities.2. WynonaFritzworksforBradyBrokerageasafixedincomeanalyst.Sheisalsoregistered
to take the Level III examination.After analyzing both the qualitative andquantitativeaspectsofSaberInc.,Fritzconcludesthatthecompanyisnotcorrectlyratedbythecreditratingagencyandshouldbedowngradeddue to the leverage in itscapital structure.AseniormanagerfromtheinvestmentbankingdepartmentinformsherthatSaberInc.haschosenBradyBrokerageasoneof the firms tounderwriteandmarket theirnewbondissue. Fritz is concerned that her report will cause the company to terminate theirrelationshipwith Brady and affect her employment. According to the Standards, Fritzshould:A. dissociatefromthereport,theunderwriting,andtheclient.B. be independent and objective in her analysis based solely on the company’s
fundamentals.C. changeherrecommendationaboutthecreditratingtoremovetheconflict.
3. JulieGrosky,CFA,worksforHarvestMutualFundwhereshemanagesafixed‐incomefund.
Inahastilycompiledperformancereview,Groskyreportstoherclientsthatherfundhasexceededthebenchmarkby0.20%.StuartBrennanisaclientofHarvest,whowritesbackto inform Grosky that the fund actually underperformed the benchmark. Groskyincorrectly blames the error on a computer program newly implemented at Harvest.GroskyleastlikelyviolatedtheStandardrelatingto:A. Misrepresentation.B. Misconduct.C. IndependenceandObjectivity.
4. SteveMiller is enrolled as a candidate in the CFA Program. Heworks as an assistant
manager in Trust Investment Bank. He enjoys drinking liquor during his lunch break.
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Miller’scolleagueshavenoticedthatheisvisiblyintoxicatedafterthelunchbreakandisnot in a position tomake rational investment decisions.Millermost likely violates theStandardof:A. Misconduct.B. KnowledgeoftheLaw.C. DisclosureofConflicts.
5. Isaac Dobrogost, a candidate in the CFA Program,works as an investment advisor for
ZenithMutualFund.Heisinvitedbyoneofhisclients,SaharaInc.(SI),amanufacturingcompany,tomeetwiththefinancedirectoralongwithafewlargestakeholdersofSI.InthemeetingDobrogostfindsoutthatthecompanyisgoingthroughaleanperiodandwillannounceadecreaseinearningsintheirnextquarterfinancialresults.CanDobrogostusethisinformationtochangetheratingofthecompanyfrom“buy”to“sell”?A. No.B. Yes,becausethisinformationisgivendirectlybythecompany.C. Yes,becauseithasbeendisseminatedtotheotherstakeholdersaswell.
6. Weinberg Inc., a global asset management company, has a large position in Wessner
Pharma.Thetradingvolumeofthisstockislow.Inordertoboosttheliquidityofthestock,multiple tradingdesksatWeinburgstartbuyingandsellingWessnershares fromeachother.TheCFAInstituteStandardmostlikelyviolatedbyWeinbergis:A. MarketManipulation.B. Misconduct.C. ActingonNonPublicInformation.
7. JaniceMcDowell,CFA,isthechiefinvestmentofficerofZenithInvestmentBankandwants
toimprovethediversificationofoneofitsbalancedfundsinordertoimproveitsreturns.Theinvestmentpolicystatementofthefundmentionslowriskinvestmentsinlarge‐capequities,governmentbondsofAAratings,andcorporatebondsofhighinvestmentgraderatings.However,anewIPOofferingofasmallpharmaceuticalcompanywithhighgrowthpotential promises high returns since the issue is being offered at a discount. Heimmediatelyallocatessomeportionoftheissuetohisfundwithoutexceedingthelimitonthe equity exposure of this fund. McDowell has least likely violated the CFA InstituteStandardsofProfessionalConductrelatingto:A. Loyalty,prudenceandcare.B. Suitability.C. Fairdealing.
8. EileenConnorsisachieftraderforAscotInvestments,amoneymanagementfirm.Shehas
beentoldrecentlybyhermostlucrativeclient,ShelbyCompany,thatiftheperformanceofitsaccountsdidnotimprovetheywillbeforcedtochangetheirmoneymanagers.Connors
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haspurchasedcertainsecuritiesafewdaysback,whosepricehasgoneupsignificantly.Shehas failed to allocate these trades due to her busy schedule. After the threat fromShelby,shedecidestoallocatetheprofitabletradestoShelby’saccount,whilespreadingthelosingtradestootherAscot’saccounts.HasConnorsviolatedanyStandard?A. Yes,relatedtoFairDealing.B. No.C. Yes,relatedtoDiligenceandReasonableBasis.
9. JessicaMoralesworks as an investment adviser for Chris Crosby, amiddle‐aged, risk‐
averseinvestor.Aspertheinvestmentpolicystatement,Moralesinvestsinlow‐risk,high‐incomeequities forCrosbykeeping inmindhis currentneedsandobjectives.RecentlyCrosby’s mother passed away leaving him with a significant inheritance. Moralescontinuestoinvestasbeforewithoutanychangeintheinvestmentstrategy.AccordingtotheCFAInstituteStandardsofProfessionalConduct,Moralesshould:A. stayabreastofchangesintheclient’snetworthandaccordinglyupdatetheinvestment
policytoreflectchangesininvestmentobjectives.B. considerthelong‐termaspectofMorales’investmentsandcontinuewiththecurrent
strategy.C. keepchangingtheassetallocationsinlinewithmarketchanges.
10. SaminaHaq a CFA candidate,works for SuperiorTrust Company.While reviewing the
performanceofoneofthetrustfunds,shefindsoutthatthetrustfundhasonanaverageperformedat5%forthelastthreeyears,yetthebrochureofherfundadvertisesanannualcompoundgrowthrateof20%whichhappenedonlyinthepastyear.Italsoboastsofaconsistent increment in the investmentvalueabove theentiremarket,whichalso tookplaceduringlastyear.Haq’shighestpriorityinavoidingaviolationoftheCFAInstituteStandardsofProfessionalConductisto:A. correcttheperformancecalculationandlengthoftime.B. continuewiththeadvertisementsinceitdidriseabovethemarket.C. usethefirm’saveragerateofreturninhermarketingmaterialforallaccounts.
11. PenelopeCoxisemployedbyJameasonInvestment,andprovidesinvestmentadvicetothe
trusteesofSYUUniversityinordertorecommendinvestmentsthatwouldgeneratecapitalappreciationinendowmentfunds.Coxhasbeengiveninternalreportsbythetrusteesthathighlight theexpansionof theuniversity.Cox isapproachedbyBradleyCooper,a localphilanthropistwhoisconsideringagenerouscontributiontoSYUandanotheruniversityinthearea,buthewouldliketoseetheexpansionplansofSYUbeforemakingthedonation.CoxknowsthathedoesnotwanttospeaktothetrusteeshenceshegivesacopyoftheinternalreporttoCooper.HasCoxviolatedtheCodeandStandards?A. No.B. Yes,preservationofconfidentiality.
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C. Yes,loyalty.12. LaraWhitman,CFA,workedforRapidResultsBrokerageCompany(RRBC)asatrader.She
recently resigned her position as a trader to join another competing investment andbrokerage firm.Whitmandidnotsignanynon‐competeagreementwhileatRRBC thatwouldhavepreventedherfromsolicitingformerclients.Whitman,however,hadsavedherclientlistandrecords,whileworkingatRRBC,inherpersonalcomputerathomeasasecond copy. She accesses this file to contact her former clients in her new job. TheStandardmostlikelyviolatedis:A. Loyalty.B. DutiestoClients.C. CommunicationswithClientsandProspectiveClients.
13. RobertBlakeisontheboardofdirectorsofRiceIndustriesandreceivesfreeticketsatthe
endofeachquarterforhisentirefamilytotraveltoanycityoftheirchoiceinEuropeforhisservicestotheboard.Blakedoesnotdisclosethisinformationtohisemployersinceitis not a monetary compensation. Has Blake violated any CFA Institute Standards ofProfessionalConduct?A. No.B. Yes,hehastoinformhisemployerofthebenefithereceives.C. Yes,becausehehasboughtstockofRiceforsomeofhisclientswhereappropriate.
14. AnnaBeckerisemployedbyJergenInvestmentManagementCompany(JIMC).Beckerisa
Level II candidate and is the only CFA candidate employed by JIMC. Becker is givensupervisoryresponsibilitiesofthecompliancedepartmentandaskedtoreviewthefirm’scompliancepoliciesandprocedures,whichshefindsinadequate.ShevoicesherconcernsduringameetingwiththeCEOwhotellshertosubmitherrecommendationsinareport,butthesewillnotbeimplementedsincethefirmisundergoingachangeinstructureandnocompliancechangeswillbeentertainedtillthen.AccordingtotheCodeandStandards,Beckershould:A. declinetoacceptsupervisoryresponsibilities.B. accept supervisory responsibilities and lay down the compliance policies and
proceduresforfuture.C. waittillanewstructureisimplementedandthenreviewtheentirefirm.
15. GregLouhasbeenaskedbyhisfirm,BinkleyInvestmentManagement,tofindanadviser
foroneof its fundswhich invests inderivativesandcomplexsecurities.Louselects12firmsbasedontheirannualtotalreturnperformanceandfinalizesontheadviserwiththehighestannualtotalreturn.WhichCFAInstituteStandardsofProfessionalConductdidLouviolate?A. CommunicationswithClientsandProspectiveClients.
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B. ProfessionalMisconduct.C. DiligenceandReasonableBasis.
16. AlexKarachanis,CFA,isanindependentfinancialadvisorwitharosterofover100clients.
Alongwithadvisoryservices,healsofacilitatesinexecutingthetradesforhisclientsandmanagestheirportfolio.AdoniaPapadakissignedupAlexinNovember2013toadviseandmanageher portfolio.After detaileddiscussions onAdonia’s circumstances and returnrequirements,itwasagreedthatonlylarge‐capequityinvestmentswillbemade.Inmid‐2013Alexfeltthatlarge‐capstockswereexcessivelyovervaluedandshifted50%oftheportfolio to small‐cap stocks. Over the next six months, small‐cap stocks significantlyoutperformedlarge‐capstocks.ItisnowJanuary2014andAdoniahasjustreceivedheraccount statement for 2013. She is very happywith the performance of her portfolio.WhichStandarddidAlexleastlikelyviolate?A. PerformancePresentation.B. CommunicationwithClientsandProspectiveClients.C. Loyalty,PrudenceandCare.
17. Raza Jafferyworks as an independent analyst for themedical equipment industry.His
reportsarebasedonananalysisofcustomerinterviews,manufacturers,on‐sitecompanyvisits,andsecondaryresearchfromotheranalysts.Jafferydoesnotmaintainanyrecordsorfilesfortheinformationhecollectsbuthementionsthesourceofhisresearchinhisreports.Iftheclientsneedinformationonthespecificwebsites,Jafferyalwaysprovidesthemwith the relevant information. Jafferymost likely violatedwhich of the followingStandards?A. RecordRetention.B. DiligenceandReasonableBasis.C. Misrepresentation.
18. Carla Simone, a CFA candidate and a research analyst, follows firms in the beverage
industry.ShehasbeenrecommendingthepurchaseofCitrusbecauseofitsintroductionof a popular new drink for athletes and exercise enthusiasts. Simone’s husband hasinherited,fromarelative,thestockofCitrusworth$3.5million.Simonehasbeenaskedtowrite a follow up report on Citrus. She writes the report and gives a strong buyrecommendation.Thereportdoesnotmentionherhusband’sownershipofthestock.HasSimoneviolatedtheCFAInstituteStandards?A. No.B. Yes,disclosureofconflicts.C. Yes,independenceandobjectivity.
19. IzzyZubeika,CFA,works forTopworthMutualFundand is aportfoliomanager foran
aggressivegrowthequityfund.Sheisplanningtosellalargeportionofherinvestmentto
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meet themedical costsofher ailinghusband.Zubeikawants to sell her stake inRoyalBeverages, but her firm has recently upgraded the stock from “hold” to “buy”.Nevertheless, after receiving approval from her employer she informs her broker toconduct the trade. Has Zubeika violated any CFA Institute Standards of ProfessionalConduct?
A. YesrelatedtoMarketManipulation.B. Yes,relatedtoPriorityofTransactions.C. No.
20. DaveDaisuke,CFA,works in thecorporate financedepartmentofAdvileSecurities.He
receives a non‐cash compensation for every referral he makes to the brokeragedepartment.Thisarrangementisanacceptednormwithinthecompanybuttheclientsare not informed because no cash is given out within the firm for interdepartmentalreferrals.AccordingtotheCFAInstituteStandards,themostappropriateactiontotakeforthefirmtoavoidaviolationisto:A. adjustthenon‐cashcompensationinthesalariesofthepersonnelincludingDaisuke
whoarereferringclientstothebrokeragedepartment.B. disclosetoclientsatthetimeofareferral,thereferralarrangementswithinAdvile’s
departments.C. stopthereferralpolicytoremoveanyconflictsofinterest.
21. LaurenCrawley is enrolled to take the Level I exam. As he tries hard to remember a
formulatocompleteaquestionhenoticesthatthepersoninfrontofhimgetsuptodrinkwaterandapieceofpaperslipsfromhispocketandfallsonCrawley’stable.Inordertoavoid a violation of the CFA Institute Standards of Professional Conduct, the leastappropriateactiontakenbyCrawleyisto:A. removeitwithoutlookingatitandcalltheproctor.B. immediatelycalltheproctortohertableandhavethepaperremoved.C. lookatthepaperandthenremoveitbeforeanyoneelsenoticesit.
22. Ankit Aacharya, CFA,whilemaking themarketingmaterial for his firmAakash Capital
writesinthebrochure,“AakashCapitaliscommittedtoachievingexcellentperformanceforitsclients.Ithiresthemosteligiblepersonnelinthefieldofinvestmentmanagement.Most of the employees have either completed the CFA Program or are enrolled ascandidatesintheCFAProgram.AsaCFAcharterholder,Iamthemostqualifiedtomanageclientinvestments.”AacharyamostlikelyviolatedtheStandardwithimproperreferencestothe:A. CFAdesignation.B. CFAProgram.C. CFAInstitute.
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R03 Guidance for Standards I-VII 2019 Level I Notes
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Solutions1. Ciscorrect.AccordingtoStandardI(A)KnowledgeoftheLawDilawezshouldadoptthe
stricterlaw.2. Biscorrect.Fritzshouldbeindependentandobjectiveinherreport.Alternatively,Brady
BrokeragecouldplaceSaber Inc.onarestricted listand issueonly factual information.StandardI(B)IndependenceandObjectivity.
3. Ciscorrect.StandardI(B)IndependenceandObjectivityinvolvesmembersandcandidates
not accepting any gifts or benefits that could be expected to compromise theirindependence and objectivity. Since no benefits were received Grosky has least likelyviolatedI(B).GroskymostlikelyviolatedtheStandardsI(C)Misrepresentation,andI(D)Misconductbecausesheknowinglymisrepresentsthecauseoftheerror.
4. Aiscorrect.RefertoStandardI(D)Misconduct.5. Aiscorrect.IftheinformationisnotpubliclydisseminatedbythecompanyandDobrogost
uses it, then it becomesmaterial nonpublic information, hence a violation of StandardII(A). A small group of stakeholders does not qualify as the public. He cannot use theinformation.
6. Aiscorrect.RefertoStandardII(B)MarketManipulation.Weinbergcreatedanappearance
ofgreaterliquidityofstockthroughitstradingstrategyandwasabletomanipulatethemarket.
7. C is correct. The Standards related to III(A) Loyalty, Prudence, and Care and III(C)
Suitability are violated. The IPSmentions low‐risk securities, and describes the assetclasses.Thereforeinvestmentinthepharmastockmaynotbesuitableforthisportfolio.
8. Aiscorrect.ConnorshasviolatedStandardIII(B)FairDealingbyfailingtodealfairlywith
allherclientsintakingtheseinvestmentactions.9. Aiscorrect.RefertoStandardIII(C)Suitability.10. Aiscorrect.AccordingtoStandardIII(D)PerformancePresentation,Haqneedstocorrect
thecalculationandlengthoftimespecifyingtheperformanceofhertrustfund.11. Biscorrect.Coxwasgiventheinternalreportsbythetrustees;becausetheinformation
wasconfidentialCoxshouldhaverefusedtodivulgeittoCooper.ThereforebyhandingtheinternalreportstohimCoxviolatesStandardIII(E)PreservationofConfidentiality.
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R03 Guidance for Standards I-VII 2019 Level I Notes
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12. Aiscorrect.StandardIV(A)Loyaltyismostlikelyviolated.Amembercannottakerecordsor work performed on behalf of the firm in paper copy or electronically withoutpermissiontoanotherfirm.Inthiscaseshecannotusethefirm’srecordsofclientswithoutthefirm’spermission.
13. Biscorrect.BlakehasviolatedStandardIV(B)AdditionalCompensationArrangementsby
failing todisclose tohisemployerbenefitsreceived inexchange forhisserviceson theboard.
14. A is correct.According to Standard IV(C)Responsibilities of Supervisors, amemberor
candidateshoulddeclineinwritingtoacceptsupervisoryresponsibilitiesuntilreasonablecompliance procedures are laid down by a firm for her to assume and exerciseresponsibility.
15. Ciscorrect.LouviolatedStandardV(A)DiligenceandReasonableBasisbynotconducting
sufficientreviewofpotentialfirms.16. A is correct. Standard III(D) Performance Presentation is not violated as Alex sends a
quarterly itemized statement of the funds and securities in his custody and thetransactionsthatoccurredduringthisperiod.StandardV(B)CommunicationwithClientsandProspectiveClientsisviolatedbecauseAlexshouldhavediscussedthechangewiththeclientbeforemovingtosmall‐capstocks.StandardIII(A)Loyalty,Prudence,andCareisviolatedbecausesmall‐capstocksmightnotcorrespondtoclient’sriskprofile.
17. Aiscorrect.RefertoStandardV(C)RecordRetention.Jafferymustcarefullydocumentand
maintaincopiesofall informationthatgoesinhisreportsinordertoavoidviolationofStandardV(C).
18. Biscorrect.Simonemustdiscloseherhusband’sownershipofthestocktoavoidviolation
ofStandardVI(A)DisclosureofConflicts.19. C is correct. No violation has occurred because she has received approval from her
employer. Standard VI(B) Priority of Transactions does not limit transactions ofemployeeswhicharedifferentfromthecurrentrecommendationsaslongastheydonotdisadvantagethecurrentclients.
20. B is correct.Disclosure to clients is important even if the referrals result in anoncash
compensation.RefertoStandardVI(C)ReferralFees21. Ciscorrect.RefertoStandardVII(A)ConductasParticipantsinCFAInstitutePrograms.
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R03 Guidance for Standards I-VII 2019 Level I Notes
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22. A is correct. CFA Institute and CFA designationwere improperly referenced. Refer toStandardVII(B)ReferencetoCFAInstitute,theCFAdesignation,andtheCFAProgram.
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R04 Introduction to GIPS 2019 Level I Notes
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R04IntroductiontoGIPS
Introduction
Thisreadingfocuseson: WhytheGIPSstandardswerecreatedandwhomdotheyapplyto? Whatarecompositesandwhatistheirpurposeinperformancereporting? WhocanclaimcompliancewithGIPS,andisthereaverificationprocess?
Note:mostofthematerialpresentedhereistakenfromthecurriculum.
1.WhyWeretheGIPSStandardsCreated?
GIPSstandardswerecreatedtomakeiteasiertocomparedifferentinvestmentmanagementfirms.Withoutastandard,differentfirmswouldselectthemethodwhichwouldmaketheirperformancelookbetter.
TheGIPSstandardsareapractitioner‐drivensetofethicalprinciplesthatestablishastandardized,industry‐wideapproachforinvestmentfirmstofollowincalculatingandpresentingtheirhistoricalinvestmentresultstoprospectiveclients.TheGIPSstandardsensurefairrepresentationandfulldisclosureofinvestmentperformance.Inotherwords,theGIPSstandardsleadinvestmentmanagementfirmstoavoidmisrepresentationsofperformanceandtocommunicateallrelevantinformationthatprospectiveclientsshouldknowinordertoevaluatepastresults.
MisleadingpracticesintheabsenceofGIPSincluded: Representativeaccounts:Showcasingonlythetop‐performingportfolioto
representthefirm’soverallinvestmentresults. Survivorshipbias:Excludingpoorlyperformingportfoliosandpresentingan
averageperformancehistory. Varyingtimeperiods:Presentingperformanceforaselectedtime‐periodduring
whichthemandateproducedexcellentreturns.
2.WhoCanClaimCompliance?
Anyinvestmentmanagementfirmcanclaimcompliance.ComplyingwiththeGIPSstandardsisvoluntary.Onlyinvestmentmanagementfirmsthatactuallymanageassetscanclaimcompliance.Plansponsorsandconsultantscannotclaimcomplianceunlesstheymanageassetsforwhichtheyclaimcompliance.
Complianceisafirm‐wideprocessthatcannotbeachievedonasingleproductorcomposite.AfirmhasonlytwooptionswithregardtocompliancewiththeGIPSstandards:
FullycomplywithallrequirementsoftheGIPSstandardsandclaimcompliancethroughtheuseoftheGIPSComplianceStatement;or
NotcomplywithallrequirementsoftheGIPSstandardsandnotclaimcompliancewith,ormakeanyreferenceto,theGIPSstandards.
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3.WhoBenefitsfromCompliance?
TwogroupsbenefitfromGIPScompliance:investmentmanagementfirmsandprospectiveclients.
FollowingtheGIPSstandardsallowsinvestmentmanagementfirmstoassureprospectiveclientsthatthehistoricaltrackrecordtheyreportisbothcompleteandfairlypresented.ComplianceenablestheGIPS‐compliantfirmtoparticipateincompetitivebidsagainstothercompliantfirmsthroughouttheworld.Achievingandmaintainingcompliancemayalsostrengthenthefirm’sinternalcontrolsoverperformance‐relatedprocessesandprocedures.
InvestorshaveagreaterlevelofconfidenceintheintegrityofperformancepresentationsofaGIPS‐compliantfirm.Investorscaneasilycompareperformancepresentationsfromdifferentinvestmentmanagementfirms.
CompliancewiththeGIPSstandardsdoesnoteliminatetheneedfordue‐diligence,butitenhancesthecredibilityofinvestmentmanagementfirmsthathavechosentoundertakethisresponsibility.
4.Composites
OneofthekeyrequirementsoftheGIPSstandardsistheuseofcomposites.Acompositeisanaggregationofoneormoreportfoliosmanagedaccordingtoasimilarinvestmentmandate,objective,orstrategy.Assumeafirmmanagesportfoliosbasedononeofthefollowingstrategies:
StrategyA:Aggressivegrowth.Underthisstrategythefirmselectssmall‐capstockswithstronggrowthpotentialoverthenextfewyears.
StrategyB.Largecapvalue.Underthisstrategylarge‐capvaluestocksareselected.
GivethisscenariothefirmshouldcreateacompositeforStrategyA,andanothercompositeforStrategyB.
Acompositemustincludeallactual,fee‐paying,discretionaryportfoliosmanagedinaccordancewiththesameinvestmentmandate,objective,orstrategy.By“actual”wemeantheseshouldberealandnotdummy/modelportfoliostosimulatethereturns.Portfoliosforwhichtheclientdoesnotpayafeemustnotbeincluded.Forinstance,theremaybecharitableorganizationsthatdonotpayafeefortheirassetsbeingmanaged.Theseshouldnotbeincluded.By“discretionary”,wemeantheinvestmentmanagementfirmhastherighttodetermineandpurchasesuitablesecuritiesforaportfolio.Ifthereisaportfoliowheretheclientdetermineswhatsecuritiesshouldbepurchased,thenitisnon‐discretionary.
Thedeterminationofwhichportfoliostoincludeinthecompositeshouldbedoneaccordingtopre‐establishedcriteria(i.e.onanex‐antebasis),notafterthefact.Thispreventsafirmfromincludingonlythebest‐performingportfolios.Thisisimportantbecauseperformancenumbersarereportedbasedoncomposites.
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R04 Introduction to GIPS 2019 Level I Notes
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5.Verification
FirmsthatclaimcompliancewiththeGIPSstandardsareresponsiblefortheirclaimofcomplianceandmaintainingthatcompliance.OnceafirmclaimscompliancewithGIPS,theymayvoluntarilyhireanindependentthird‐partytoperformverification.JustasGIPScomplianceisvoluntary,verificationisalsovoluntary.Verificationisperformedwithrespecttoanentirefirm.Itisnotdoneoncomposites,orindividualdepartments.
Verificationmustbeperformedbyanindependentthirdparty.Afirmcannotperformitsownverification.Third‐partyverificationbringsadditionalcredibilitytoafirm’sclaimofcompliance.Tounderstandwhyafirmwouldpaytobeverifiedifitisvoluntary,assumetherearetwofirms,AandB.FirmAclaimsGIPScomplianceandfirmBclaimsGIPScompliancewiththird‐partyverificationfromareputedfirm.Asaninvestor,whichfirmwouldyoubemorecomfortablewith?ObviouslyfirmB,andthatgivesfirmBanadvantageoverfirmA.
Verificationtestsinclude: Whethertheinvestmentfirmhascompliedwithallthecompositeconstruction
requirementsoftheGIPSstandardsonafirm‐widebasis,and Whetherthefirm’spoliciesandproceduresaredesignedtocalculateandpresent
performanceincompliancewiththeGIPSstandards.
6.TheStructureoftheGIPSStandards
Theprovisionswithinthe2010editionoftheGIPSstandardsaredividedintoninesections:
0. FundamentalsofCompliance
1. InputData
2. CalculationMethodology
3. CompositeConstruction
4. Disclosure
5. PresentationandReporting
6. RealEstate
7. PrivateEquity
8. WrapFee.SeparatelyManagedAccount(SMA)Portfolios
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R04 Introduction to GIPS 2019 Level I Notes
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Summary
LO.a:ExplainwhytheGIPSstandardswerecreated,whatpartiestheGIPSstandardsapplyto,andwhoisservedbythestandards.
TheGIPSstandardswerecreatedtoavoidmisrepresentationofperformance.Theyapplytoinvestmentmanagementfirms.Theyareintendedtoserveprospectiveandexistingclientsoftheinvestmentfirms.
LO.b:Explaintheconstructionandpurposeofcompositesinperformancereporting.
Acompositeisanaggregationofoneormoreportfoliosmanagedaccordingtoasimilarinvestmentmandate,objective,orstrategy.Whenusedinperformancereporting,compositeshelpclientsevaluatehowwellacompanyhasperformedwithdifferentinvestmentstyles.
LO.c:Explaintherequirementsforverification.
Verificationisperformedwithrespecttoanentirefirm.Itisnotdoneoncomposites,orindividualdepartments.
Verificationmustbeperformedbyanindependentthird‐party.Afirmcannotperformitsownverification.
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PracticeQuestions
1. WhocanmostlikelyclaimcompliancewithGIPSStandards?A. CFAcharterholders.B. Individuals.C. Investmentmanagementfirms.
2. According to the Global Investment Performance Standards (GIPS), the criteria for
includingportfoliosincompositesis:A. all actual fee‐paying, discretionary portfolios must be included in at least one
composite.B. alldiscretionaryportfoliosmustbeincludedinacomposite.C. allactualfee‐payingportfoliosmustbeincludedinacomposite.
3. VerificationofGIPScomplianceis:
A. donebyanindependentthird‐party.B. mandatorytoclaimcompliance.C. donevoluntarilybythefirmunderthesupervisionoftheCFAInstitute.
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Solutions1. C is correct. Only investment management firms can claim compliance. Individuals,
charterholders,andsoftwaretoimplementtheStandardscannotclaimcompliance.2. Aiscorrect.Allactualfee‐paying,discretionaryportfoliosmustbeincludedinatleastone
composite.3. Aiscorrect.VerificationofGIPScomplianceisdonebyanindependentthirdparty.Afirm
cannotperformitsownverification.
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R05 The GIPS Standard 2019 Level I Notes
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R05TheGIPSStandard
Introduction
Inthisreadingwefocuson: GoalsoftheGIPSExecutiveCommittee. KeyfeaturesoftheGIPSstandardsandthefundamentalsofcompliance. Howhistoricalperformancerecordmustbepresented. TheninemajorsectionsoftheGIPSstandard.
Note:mostofthematerialpresentedhereistakenfromthecurriculum.
GoalsoftheGIPSExecutiveCommittee
ThegoalsoftheGIPSExecutiveCommitteearepresentedbelow: Toestablishinvestmentindustrybest‐practicesforcalculatingandpresenting
investmentperformancethatpromoteinvestorinterestsandinstillinvestorconfidence.
Toobtainworldwideacceptanceofasinglestandardforthecalculationandpresentationofinvestmentperformancebasedontheprinciplesoffairpresentationandfulldisclosure.
Topromotetheuseofaccurateandconsistentperformancedata. Toencouragefairglobalcompetitionamonginvestmentfirmswithoutcreating
barrierstoentry;and Tofosterthenotionofindustry“self‐regulation”onaglobalbasis.
KeyFeaturesoftheGIPSStandards
ThekeyfeaturesofGIPSareasfollows: TheGIPSstandardsaretheethicalstandardsforinvestmentperformance
presentationtoensurefairrepresentationandfulldisclosureofinvestmentperformance.Inordertoclaimcompliance,firmsmustadheretotherequirementsincludedintheGIPSstandards.
MeetingtheobjectivesoffairrepresentationandfulldisclosureislikelytorequiremorethansimplyadheringtotheminimumrequirementsoftheGIPSstandards.Firmsshouldalsoadheretotherecommendationstoachievebestpracticeinthecalculationandpresentationofperformance.
TheGIPSstandardsrequirefirmstoincludeallactual,discretionary,fee‐payingportfoliosinatleastonecompositedefinedbyinvestmentmandate,objective,orstrategyinordertopreventfirmsfromcherry‐pickingtheirbestperformance.Thismeansfirmsmustcreatecompositesandeachactual,fee‐paying,discretionaryportfoliomustbeinatleastonecomposite.Ifaportfolioisnotincludedinanycomposite,thenthereturnsassociatedwithitwillnotbeincluded.
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R05 The GIPS Standard 2019 Level I Notes
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TheGIPSstandardsrelyontheintegrityofinputdata.Theaccuracyofinputdataiscriticaltotheaccuracyofperformancepresentation.Theunderlyingvaluationsofportfolioholdingsdrivetheportfolio’sperformance.Itisessentialthattheseandotherinputsareaccurate.TheGIPSstandardsrequirefirmstoadheretocertaincalculationmethodologiesandtomakespecificdisclosuresalongwiththefirm’sperformance.
FirmsmustcomplywithallrequirementsoftheGIPSstandards.
HistoricalPerformanceRecord
Afirmisrequiredtoinitiallypresent,ataminimum,fiveyearsofannualinvestmentperformancethatarecompliantwiththeGIPSstandards.Ifthefirmorthecompositehasbeeninexistenceforlessthanfiveyears,thefirmmustpresentperformancesincethefirm’sinceptionorthecomposite’sinceptiondate.
Laterthefirmmustpresentanadditionalyearofperformanceeachyear,buildinguptoaminimumof10yearsofGIPS‐compliantperformance.
Firmsmaylinknon‐GIPScompliantperformancetotheirGIPS‐compliantperformanceprovidedthatonlyGIPS‐compliantperformanceispresentedforperiodsafter1January,2000andthefirmdisclosestheperiodsofnon‐compliance.
Firmsthatmanageprivate‐equity,realestate,and/orwrapfee/separatelymanagedaccount(SMA)portfoliosmustalsocomplywithsections6,7,and8respectively,oftheprovisionsoftheGIPSstandardsthatbecameeffectiveasof1January,2006.
ConsiderFirmAwhichwasestablishedin2013anddecidestobecomeGIPScompliantin2014.Initially,itmustpresentperformanceinformationfor2013and2014.Later,itmustkeepaddingperformancedataeveryyearuntilitbuildsuptoaminimumof10years.
ConsiderFirmBwhichwasestablishedin2008anddecidestobecomeGIPScompliantin2014.Initially,itmustpresentperformanceinformationforfiveyearsfromtheperiodendingin2010totheperiodendingin2014.Later,itmustalsoaddanadditionalyearuntilithas10yearsofGIPS‐compliantperformance.
Compliance
Thedefinitionofthefirmisthefoundationforfirm‐widecomplianceandcreatesdefinedboundarieswherebytotalfirmassetscanbedetermined.
FirmsmusttakeallstepsnecessarytoensurethattheyhavesatisfiedalltherequirementsoftheGIPSstandardsbeforeclaimingcompliance.
Firmsarestronglyencouragedtoperformperiodicinternalcompliancechecks. Firmsmaychoosetohaveanindependentthird‐partyverificationthatteststhe
constructionofthefirm’scompositesaswellasthefirm’spoliciesandproceduresastheyrelatetocompliancewiththeGIPSstandards.Verificationisrecommended,butitisvoluntaryandmustbedonebyathird‐partyverifier.
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R05 The GIPS Standard 2019 Level I Notes
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Inadditiontoverification,firmsmayalsochoosetohavespecificallyfocusedcompositetesting(performanceexamination)performedbyanindependentthird‐partyverifiertoprovideadditionalassuranceregardingaparticularcomposite.
Theeffectivedateforthe2010editionoftheGIPSstandardsis1January,2011.Compliantpresentationsthatincludeaperformanceforperiodsthatbeginonorafter1January,2011mustbepreparedinaccordancewiththe2010editionoftheGIPSstandards.
ImplementingaGlobalStandard
ThepresenceofalocalsponsoringorganizationforinvestmentperformancestandardsisessentialforeffectiveimplementationandongoingsupportoftheGIPSstandardswithinacountry.ThecurriculumlistsGIPScountrysponsorsforafewcountries.
Countrysponsorensuresthatthecountry’sinterestsaretakenintoaccountastheGIPSstandardsaredeveloped.
TheGIPSexecutivecommitteestronglyencouragescountrieswithoutaninvestmentperformancestandardtopromotetheGIPSstandardsasthelocalstandard.Ifthereisnolocalstandardinacountry,thenitisidealforthecountrytopromoteandadoptGIPSasitisaglobalstandard,andwhenrequiredtranslatethemintothelocallanguage.
CompliancewithapplicablelawandrulesdoesnotnecessarilymeancompliancewithGIPS.
Incasesinwhichlawsand/orregulationsconflictwiththeGIPSstandards,firmsarerequiredtocomplywiththelawsandregulationsandmakefulldisclosureoftheconflictinthecompliantpresentation.FirmscanstillclaimcompliancewithGIPSbuttheymustdisclosewhereverthereisadeviationthatthelawofthelandisbeingfollowed.
NineMajorSectionsoftheGIPSStandards
Theprovisionswithinthe2010editionoftheGIPSstandardsaredividedintoninesections:0. FundamentalsofCompliance1. InputData2. CalculationMethodology3. CompositeConstruction4. Disclosure5. PresentationandReporting6. RealEstate7. PrivateEquity8. WrapFee/SeparatelyManagedAccount(SMA)portfolios
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Theprovisionsarecategorizedintorequirementsandrecommendations.Alltherequirementsmustbeimplementedtoclaimcompliance.
0.FundamentalsofCompliance
SeveralcoreprinciplescreatethefoundationfortheGIPSstandards,includingproperlydefiningthefirm,providingcompliantpresentationstoallprospectiveclients,adheringtoapplicablelawsandregulations,andensuringthatinformationpresentedisnotfalseormisleading.TwoimportantissuesthatafirmmustconsiderwhenbecomingcompliantwiththeGIPSstandardsarethedefinitionofthefirmandthefirm’sdefinitionofdiscretion.Thedefinitionofthefirmisthefoundationforfirm‐widecomplianceandcreatesdefinedboundarieswherebytotalfirmassetscanbedetermined.Thefirm’sdefinitionofdiscretionestablishescriteriatojudgewhichportfoliosmustbeincludedinacompositeandisbasedonthefirm’sabilitytoimplementitsinvestmentstrategy.
Samplefirmdefinition:XYXInvestmentFirmisabalancedportfolioinvestmentmanagerthatinvestssolelyinUS‐basedsecurities.XYZInvestmentFirmisdefinedasanindependentinvestmentmanagementfirmthatisnotaffiliatedwithanyparentorganization.
TherequirementsofProvision0arepresentedbelow(reproducedfromthecurriculum).
0.A.1:FirmsmustcomplywithalltherequirementsoftheGIPSstandards,includinganyupdates,GuidanceStatements,interpretations,Questions&Answers(Q&As),andclarificationspublishedbyCFAInstituteandtheGIPSExecutiveCommittee,whichareavailableontheGIPSstandardswebsite(www.gipsstandards.org)aswellasintheGIPSHandbook.
0.A.2:Firmsmustcomplywithallapplicablelawsandregulationsregardingthecalculationandpresentationofperformance.
Iftherearenoapplicablelawsandrules,thenGIPScompliantfirmsmustfollowtheGIPSstandards.But,ifacountryhasapplicablelawsandregulationsregardingthecalculationandpresentationofperformance,thenthecountrylawsmustbefollowedandanydifferenceswithGIPSmustbedocumented.
0.A.3:Firmsmustnotpresentperformanceorperformance‐relatedinformationthatisfalseormisleading.
0.A.4:TheGIPSstandardsmustbeappliedonafirm‐widebasis.
0.A.5:FirmsmustdocumenttheirpoliciesandproceduresusedinestablishingandmaintainingcompliancewiththeGIPSstandards,includingensuringtheexistenceandownershipofclientassets,andmustapplythemconsistently.
0.A.6:IfthefirmdoesnotmeetalltherequirementsoftheGIPSstandards,thefirmmustnotrepresentorstatethatitis“incompliancewiththeGlobalInvestmentPerformanceStandardsexceptfor...”ormakeanyotherstatementsthatmayindicatepartialcompliancewiththeGIPSstandards.
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FirmsarenotallowedtoclaimpartialcompliancewiththeGIPSstandards.
0.A.7:Statementsreferringtothecalculationmethodologyasbeing“inaccordance,”“incompliance,”or“consistent”withtheGlobalInvestmentPerformanceStandards,orsimilarstatements,areprohibited.
0.A.8:Statementsreferringtotheperformanceofasingle,existingclientportfolioasbeing“calculatedinaccordancewiththeGlobalInvestmentPerformanceStandards”areprohibited,exceptwhenaGIPS‐compliantfirmreportstheperformanceofanindividualclient’sportfoliotothatclient.
0.A.9:Firmsmustmakeeveryreasonableefforttoprovideacompliantpresentationtoallprospectiveclients.Firmsmustnotchoosetowhomtheypresentacompliantpresentation.Aslongasaprospectiveclienthasreceivedacompliantpresentationwithintheprevious12months,thefirmhasmetthisrequirement.
0.A.10:Firmsmustprovideacompletelistofcompositedescriptionstoanyprospectiveclientthatmakessucharequest.Firmsmustincludeterminatedcompositesonthefirm’slistofcompositedescriptionsforatleastfiveyearsafterthecompositeterminationdate.Acompositemustbeclearlydescribedastowhatmandateorstrategyitisfollowing:Forexample,small‐capequityvalue,Japan‐equity,fixed‐incomeetc.Ifacompositewasterminated,thenitsperformancemustbepresentedforatleastfiveyearsafterterminationtoovercomesurvivorshipbias.
0.A.11:Firmsmustprovideacompliantpresentationforanycompositelistedonthefirm’slistofcompositedescriptionstoanyprospectiveclientthatmakessucharequest.
AcompliantpresentationisonethatcomplieswithalltheGIPSprovisions.
0.A.12:Firmsmustbedefinedasaninvestmentfirm,subsidiary,ordivisionheldouttoclientsorprospectiveclientsasadistinctbusinessentity.
Scenario:AssumethereisafirmcalledUBLandithasasubsidiarycalledUBL‐AssetManagement(UBL‐AM).IfinvestorsapproachUBL‐AMtotradeandinvestinsecurities/funds,thenUBM‐AMisthefirmhere,andmustcomplywiththeGIPSstandards.
0.A.13:Forperiodsbeginningonorafter1January2011,totalfirmassetsmustbetheaggregatefairvalueofalldiscretionaryandnon‐discretionaryassetsmanagedbythefirm.Thisincludesbothfee‐payingandnon‐fee‐payingportfolios.
Donotconfusethiswithacomposite.Acompositemustincludeonlyactual,fee‐payingdiscretionaryportfolios.But,whenafirmreportsitstotalassets,itmustincludethefairvalueofalldiscretionaryandnon‐discretionaryassetsandallfee‐payingandnon‐feepayingportfolios.
0.A.14:Totalfirmassetsmustincludeassetsassignedtoasub‐advisorprovidedthefirmhasdiscretionovertheselectionofthesub‐advisor.
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0.A.15:Changesinafirm’sorganizationmustnotleadtoalterationofhistoricalcompositeperformance.
0.A.16:Whenthefirmjointlymarketswithotherfirms,thefirmclaimingcompliancewiththeGIPSstandardsmustbesurethatitisclearlydefinedandseparaterelativetootherfirmsbeingmarketed,andthatitisclearwhichfirmisclaimingcompliance.
Outlinedabovearerequirements.TheGIPSstandardsalsoincluderequirements.Forexample,assumeaninvestmentmanagementcompany,HS,hasdifferentgeographicaloffices,whichoperateunderthesamebrandnamebutasindividualinvestmentmanagementcompaniessuchasHSMaltaplc,HSSpain,HSIndiaLimited,HSMalaysiaLimited.Thefirmdefinitionshouldbebroadenoughtoincludeallgeographicalofficesunderoneumbrella.Thisisjustarecommendation,notarequirement.
Instructor’sNote:AtLevelIyouarerequiredtoknowthedetailsofProvision0(FundamentalsofCompliance).Forprovisions1–8youjustneedtoknowthebasicdescriptionswhicharegivenbelow:
1. InputdataConsistencyofinputdatausedtocalculateperformanceiscriticaltoeffectivecompliancewiththeGIPSstandardsandestablishesthefoundationforfull,fair,andcomparableinvestmentperformancepresentations.Forperiodsbeginningonorafter1January2011,allportfoliosmustbevaluedinaccordancewiththedefinitionoffairvalueandtheGIPSvaluationprinciples.
2. CalculationMethodologyAchievingcomparabilityamonginvestmentmanagementfirms’performancepresentationsrequiresuniformityinthemethodsusedtocalculatereturns.TheGIPSstandardsmandatetheuseofcertaincalculationmethodologiestofacilitatecomparability.
3. CompositeConstructionAcompositeisanaggregationofoneormoreportfoliosmanagedaccordingtoasimilarinvestmentmandate,objective,orstrategy.Thecompositereturnistheasset‐weightedaverageoftheperformanceofallportfoliosinthecomposite.Creatingmeaningfulcompositesisessentialtothefairpresentation,consistency,andcomparabilityofperformanceovertimeandamongfirms.Assumetherearetwoportfoliosinacomposite:portfolio1withavalueof$10millionandportfolio2withavalueof$90million.Thereturnsofthetwoportfoliosare10%and12%respectively.Theoverallreturnofthecompositemustbecloserto12%asthe12%returnhasa90%weightage.
4. DisclosureDisclosureallowsfirmstoelaborateonthedataprovidedinthepresentationandgivethereaderthepropercontextinwhichtounderstandtheperformance.TocomplywiththeGIPSstandards,firmsmustdisclosecertaininformationinallcompliantpresentationsregardingtheirperformanceandthepoliciesadoptedbythefirm.Oneoftheessentialdisclosuresfor
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everyfirmistheclaimofcompliance.OnceafirmmeetsalltherequirementsoftheGIPSstandards,itmustappropriatelyusetheclaimofcompliancetoindicatecompliancewiththeGIPSstandards.Theallowedformatforfirmsthatclaimcomplianceis:<<Nameoffirm>>claimscompliancewiththeGlobalInvestmentPerformanceStandards(GIPS)andhaspreparedandpresentedthisreportincompliancewiththeGIPSStandards.
5. PresentationandReportingAfterconstructingthecomposites,gatheringtheinputdata,calculatingreturns,anddeterminingthenecessarydisclosures,thefirmmustincorporatethisinformationinpresentationsbasedontherequirementsintheGIPSstandardsforpresentinginvestmentperformance.Nofinitesetofrequirementscancoverallpotentialsituationsoranticipatefuturedevelopmentsininvestmentindustrystructure,technology,products,orpractices.Whenappropriate,firmshavetheresponsibilitytoincludeinGIPS‐compliantpresentationsinformationnotaddressedbytheGIPSstandards.
6. RealEstateUnlessotherwisenoted,thissectionsupplementsalloftherequiredandrecommendedprovisionsinSections0‐5.Realestateprovisionswerefirstincludedinthe2005editionoftheGIPSstandardsandbecameeffective1January,2006.The2010editionoftheGIPSstandardsincludesnewprovisionsforclosed‐endrealestatefunds.Firmsshouldnotethatcertainprovisionsofsections0‐5donotapplytorealestateinvestmentsoraresupersededbytheprovisionswithinsection6.Theprovisionsthatdonotapplyhavebeennotedwithinsection6.
7. PrivateEquityUnlessotherwisenoted,thissectionsupplementsalloftherequiredandrecommendedprovisionsinsections0‐5.Privateequityprovisionswerefirstincludedinthe2005editionoftheGIPSstandardsandbecameeffective1January2006.Firmsshouldnotethatcertainprovisionsinsections0‐5donotapplytoprivateequityinvestmentsoraresupersededbytheprovisionswithinsection7.Theprovisionsthatdonotapplyhavebeennotedwithinsection7.
8. WrapFee/SeparatelyManagedAccount(SMA)PortfoliosUnlessotherwisenoted,thissectionsupplementsalloftherequiredandrecommendedprovisionsinsections0‐5.Firmsshouldnotethatcertainprovisionsinsections0‐5oftheGIPSstandardsdonotapplytowrapfee/SMAportfoliosoraresupersededbytheprovisionswithinsection8.Theprovisionsthatdonotapplyherehavebeennotedwithinsection8.
SamplePresentation
AsampleGIPS‐compliantpresentationreportispresentedbelow.Someoftheimportantaspectsthatyoucantakenoteofare:
Nameoffirm:Sample1InvestmentFirm;Composite:BalancedGrowth Grossreturn,netreturn,andno.ofportfoliosarerequireddatawhicharepresented.
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Sample1 InvestmentFirmBalancedGrowthComposite(fromthecurriculum)
1January2002through31December2011
Year CompositeGrossReturn(%)
CompositeNetReturn(%)
CustomBenchmarkReturn(%)
Composite3‐YrStDev(%)
Benchmark3‐YrStDev(%)
NumberofPortfolios
InternalDispersion(%)
CompositeAssets($M)
FirmAssets($M)
2002 ‐10.5 ‐11.4 ‐11.8 31 4.5 165 236
2003 16.3 15.1 13.2 34 2.0 235 346
2004 7.5 6.4 8.9 38 5.7 344 529
2005 1.8 0.8 0.3 45 2.8 445 695
2006 11.2 10.1 12.2 48 3.1 520 839
2007 6.1 5.0 7.1 49 2.8 505 1,014
2008 ‐21.3 ‐22.1 ‐24.9 44 2.9 475 964
2009 16.5 15.3 14.7 47 3.1 493 983
2010 10.6 9.5 13.0 51 3.5 549 1,114
2011 2.7 1.7 0.4 7.1 7.4 54 2.5 575 1,236
Sample1InvestmentFirmclaimscompliancewiththeGlobalInvestmentPerformanceStandards(GIPS®)andhaspreparedandpresentedthisreportincompliancewiththeGIPSstandards.Sample1InvestmentFirmhasbeenindependentlyverifiedfortheperiods1January2000through31December2010.Theverificationreportisavailableuponrequest.Verificationassesseswhether(1)thefirmhascompliedwithallthecompositeconstructionrequirementsoftheGIPSstandardsonafirm‐widebasisand(2)thefirm’spoliciesandproceduresaredesignedtocalculateandpresentperformanceincompliancewiththeGIPSstandards.Verificationdoesnotensuretheaccuracyofanyspecificcompositepresentation.
Notes:
1. Sample1InvestmentFirmisabalancedportfolioinvestmentmanagerthatinvestssolelyinUS‐basedsecurities.Sample1InvestmentFirmisdefinedasanindependentinvestmentmanagementfirmthatisnotaffiliatedwithanyparentorganization.Policiesforvaluingportfolios,calculatingperformance,andpreparingcompliantpresentationsareavailableuponrequest.
2. TheBalancedGrowthCompositeincludesallinstitutionalbalancedportfoliosthatinvestinlarge‐capUSequitiesandinvestment‐gradebondswiththegoalofprovidinglong‐termcapitalgrowthandsteadyincomefromawell‐diversifiedstrategy.Althoughthestrategyallowsforequityexposurerangingbetween50–70%,thetypicalallocationisbetween55–65%.Theaccountminimumforthecompositeis$5million.
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3. Thecustombenchmarkis60%YYYUSEquityIndexand40%ZZZUSAggregateBondIndex.Thebenchmarkisrebalancedmonthly.
4. ValuationsarecomputedandperformanceisreportedinUSdollars.
5. Gross‐of‐feesreturnsarepresentedbeforemanagementandcustodialfeesbutafteralltradingexpenses.Compositeandbenchmarkreturnsarepresentednetofnon‐reclaimablewithholdingtaxes.Net‐of‐feesreturnsarecalculatedbydeductingthehighestfeeof0.83%fromthemonthlygrosscompositereturn.Themanagementfeescheduleisasfollows:1.00%onthefirst$25million;0.60%thereafter.
6. ThiscompositewascreatedinFebruary2000.Acompletelistofcompositedescriptionsisavailableuponrequest.
7. Internaldispersioniscalculatedusingtheequal‐weightedstandarddeviationofannualgrossreturnsofthoseportfoliosthatwereincludedinthecompositefortheentireyear.
8. Thethree‐yearannualizedstandarddeviationmeasuresthevariabilityofthecompositeandthebenchmarkreturnsoverthepreceding36‐monthperiod.
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Summary
LO.a:DescribethekeyfeaturesoftheGIPSstandardsandthefundamentalsofcompliance.
Refertosections‘KeyFeaturesoftheGIPSStandards’and‘0.FundamentalsofCompliance’.
LO.b:DescribethescopeoftheGIPSstandardswithrespecttoaninvestmentfirm’sdefinitionandhistoricalperformancerecord.
InvestmentFirm’sDefinition Firmsmustbedefinedasaninvestmentfirm,subsidiary,oradivisionthatisheldout
toclientsandprospectsasa‘distinctbusinessentity’. Ifafirmhasdifferentgeographiclocations,alldoingbusinessunderthesamename,
thenthedefinitionofthefirmmustincludebranchesfromalllocations.
HistoricalPerformanceRecord
Initially, Afirmmustpresentaminimumoffiveyearsofcompliantpresentation. Ifthefirmorcompositehasbeeninexistenceforlessthanfiveyears,the
presentationshouldincludeperformancesinceinception.
Afterinitialcompliance, Thefirmmustaddoneyearofcompliantpresentationeachyear,
Sothatthefirmeventuallypresentsaminimumperformancehistoryof10years.
LO.c:ExplainhowtheGIPSstandardsareimplementedincountrieswithexistingstandardsforperformancereportinganddescribetheappropriateresponsewhentheGIPSstandardsandlocalregulationsconflict.
Incountrieswheretherearenoinvestmentperformanceregulations,useandpromotetheGIPSstandard.
Incountrieswherethereareexistinglawsandregulationsregardingperformancepresentation,adheretoGIPSinadditiontothelocallaws.
Incaseofaconflictwiththelocallaws,followthelocallawbutdisclosetheconflict
LO.d:DescribetheninemajorsectionsoftheGIPSstandards.
Refertosection‘NineMajorSectionsoftheGIPSStandards’.
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PracticeQuestions
1. WhichofthefollowingisnotakeyfeatureoftheGIPSstandards?A. Allactual,discretionary,fee‐paying,andnon‐feepayingportfoliosmustbeincluded
inatleastonecomposite.B. Firmsmustuseaccurateinputdata,followcertaincalculationmethodologies,and
disclosethemethodused.C. FirmsmustcomplywithallrequirementsoftheGIPSstandards.
2. Ifacompositehasbeeninexistenceforlessthanfiveyears,thenforwhatperiodisthe
firmmostlikelyrequiredtopresentGIPS‐compliantperformance?A. Twoyears.B. Oneyear.C. Sinceinceptiondate.
3. EritbaisasmallislandnationinthePacificwherelawsandregulationsexistforcalculation
andpresentationofinvestmentperformance.AccordingtotheGIPSstandards,whatlawsare firms in Eritba encouraged to complywith for the calculation and presentation ofinvestmentperformance?
A. GIPSstandardsonly.B. Applicablelaw,regulations,andGIPSstandards.C. Applicablelawandregulationsonly.
4. Which of the following is not one of the nine sections of the provisions of the Global
InvestmentPerformanceStandards?A. Disclosure.B. ProcessedData.C. RealEstate.
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Solutions1. Aiscorrect.Itisnotmandatoryfornon‐feepayingportfoliostobeincludedinatleastone
composite.2. Ciscorrect.Ifafirmhasbeeninexistenceforlessthanfiveyears,thenafirmisrequired
to present compliant presentation since the firm’s inception date, or the compositeinceptiondate.
3. B is correct. Firms are encouraged to comply with applicable laws and regulatory
requirements in addition to the GIPS Standards. This is because compliance withapplicablelawdoesnotimplycompliancewiththeGIPSStandards.
4. Biscorrect. ‘InputData’,not ‘ProcessedData’, isasectionoftheprovisionsoftheGIPS
standards.
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R06TimeValueofMoney
IntroductoryNote
FinancialCalculator:CFAInstituteallowsonlytwocalculatormodelsduringtheexam: TexasInstrumentsBAIIPlus(includingBAIIPlusProfessional)and
HewlettPackard12C(includingtheHP12CPlatinum,12CPlatinum25thanniversaryedition,12C30thanniversaryedition,andHP12CPrestige)
UnlessyouarealreadycomfortablewiththeHPfinancialcalculator,werecommendusingtheTexasInstrumentsfinancialcalculator.ExplanationsandkeystrokesinourstudymaterialsarebasedontheTexasInstrumentsBAIIPluscalculator.Beforeyoustartusingthecalculatortosolveproblems,werecommendthatyousetthenumberofdecimalplacesto‘floatingdecimal’.1.Introduction
Ifyouhave$100today,versusanoptiontoreceive$100afterthreeyears,whatwouldyouprefer?
Obviously,youwouldprefer$100today.Eventhoughyouhavethesameamount($100)inbothcases,youprefer$100today.Thismeansthattherehastobesomevalueassociatedwithtime,becauseyouareputtingmorevalueonthe$100thatyouaregettingtoday,relativetothe$100atalaterpointintime.Thisisknownas‘timevalueofmoney.’
Letussaythatyouareindifferentbetween$100dollarstodayversus$110afteroneyear.
Presentvalue(PV):Themoneytodayorthevaluetodayiscalledthepresentvalue(PV=100).Thiscouldbeaninvestmentwhichyoumakeattime0.
Futurevalue(FV):Thevalueatafuturepointintimeiscalledthefuturevalue(FV=110).
Interestrate(I):Therelationshiporthelinkbetweenpresentvalueandfuturevalueisestablishedthroughaninterestrate(I=10%).
Inthisreading,weareessentiallygoingtotalkabouttheseconcepts:presentvalue(PV),futurevalue(FV),andthewaywelinkthesetwoconceptsusinginterestrates(I).
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2.InterestRates:Interpretation
Let’sdiscussthedifferentinterpretationsofinterestratesusinganexample.Sayyoulend$900todayandreceive$990afteroneyear(–vesignindicatesoutflow).
Interestratescanbeinterpretedas:
1. Requiredrateofreturn:Thefactthatyouarewillingtogive$900todayontheconditionthatyouget$990afteroneyearmeansthattoengageinthistransaction,yourequireareturnof10%.(Simplecalculationwillshowyouthattheinterestrateinthistransactionis10%).
2. Discountrate:Youcandiscountthemoneythatyouwillreceiveafteroneyeari.e.$990at10%togetthepresentvalueof$900(990/1.1=900).Therefore,the10%canalsobethoughtofasadiscountrate.
3. Opportunitycost:Let’ssayinsteadoflendingthe$900,youspentitonsomethingelse.Youhavethenforgonetheopportunitytoearn10%interest.Therefore,10%canalsobethoughtofasanopportunitycost.
InterestRates:InvestorPerspective
Asaninvestor,wecanthinkoftheinterestrateasasumofthefollowingcomponents:
Interestrate=Realrisk‐freeinterestrate+Inflationpremium+Defaultriskpremium+Liquiditypremium+Maturitypremium
Let’slookatthedifferentcomponents.
Realrisk‐freeinterestrate:Thisistheratethatyougetonasecuritythathasnoriskandisextremelyliquid.Wemakeanassumptionherethatthereisnoinflation.
Inflationpremium:Wecanthenaddonaninflationpremium.Inflationpremiumistheexpectedannualinflationintheupcomingperiod.
Defaultriskpremium:Wecanalsothenaddadefaultriskpremium.Thisistheadditionalpremiumthatinvestorsrequirebecauseoftheriskofdefault.Example:Let'ssaythatyoulend$100eachtopersonAandpersonB.However,Bhasahighriskofdefault,soyouareworriedthathemightnotpay.ThereforeyoumightdemandahigherreturnfromBascomparedtoA,becauseoftheriskofdefault.Thisadditionalreturnthatyoudemandiscalledthedefaultriskpremium.
Liquiditypremium:Nextwehaveliquiditypremium.Thisisthepremiumthatinvestorsdemandbecauseofthelackofliquidityofaninvestment.
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Example:ThinkoftwoinvestmentsCandDwhicharesimilarinallregards.TheonlydifferenceisthatinvestmentCisextremelyliquid,whereasinvestmentDisnotthatliquid.Clearlyasinvestors,wewilldemandahigherreturnonDbecauseitisnoteasytosell.Thisadditionalreturnthatwedemandiscalledtheliquiditypremium.
Maturitypremium:Finallywehavethematuritypremium.Thisisthepremiumthatinvestorsdemandonasecuritywithlongmaturity.Thematuritypremiumcompensatesinvestorsfortheincreasedsensitivityofthemarketvalueofdebttoachangeinmarketinterestratesasmaturityisextended.Example:Let’ssaywehavetwosecurities,EandF.SecurityEhasamaturityof1yearandsecurityFhasamaturityof4years.Becauseofthelongermaturity,Fhasmorerisk,intermsofitspricebeingmoresensitivetochangesininterestrate.Instructor’sNote:Youwillunderstandthisconceptbetterwhenyoustudyfixedincomesecurities.Butfornow,youcantakeitasagiventhatFhashigherriskbecauseofthelongermaturity.Obviously,investorswilldemandsomecompensationforthehigherlevelofrisk.Thisadditionalreturnthatinvestorsdemandiscalledthematuritypremium.
Nominalriskfreerate:Nominalrisk‐freerate=Realrisk‐freeinterestrate+Inflationpremium.Soiftherealrisk‐freerateis3%andtheinflationpremiumis2%,thenthenominalrisk‐freerateis5%.Instructor’sNote:Ontheexamifyougetaterm‘risk‐freerate’withnomentionofwhethertherateisrealornominal,thentheassumptionisthatwearetalkingaboutthenominalrisk‐freerate.Example
InvestmentsMaturity(inyears)
Liquidity Defaultrisk InterestRates(%)
A 1 High Low 2.0B 1 Low Low 2.5C 2 Low Low rD 3 High Low 3.0E 3 Low High 4.0
1. ExplainthedifferencebetweentheinterestratesonInvestmentAandInvestmentB.
2. Estimatethedefaultriskpremium.
3. CalculateupperandlowerlimitsfortheinterestrateonInvestmentC,r.
Solution:
1. InvestmentsAandBhavethesamematurityandthesamedefaultrisk.However,BhasalowerliquidityascomparedtoA.Hence,investorswilldemandaliquiditypremiumonB.
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Thedifferencebetweentheirinterestratesi.e.2.5–2.0=0.5%isequaltotheliquiditypremium.
2. ConsiderinvestmentsDandE,theyhavethesamematurity,butdifferentliquidityanddifferentdefaultrisk.Let’smakeliquiditythesameandcreateanewlowliquidityversionofD.Thisversionwillhaveahigherinterestrate,becausenowinvestorswilldemandaliquiditypremium.Wehavealreadydeterminedthattheliquiditypremiumis0.5%.Therefore,thelowliquidityversionofDwillhaveaninterestrateof3.0+0.5=3.5%.NowcomparethisversionofDwithinvestmentE.Theonlydifferencebetweenthetwoisdefaultrisk.Ehasahigherdefaultrisk.Therefore,thedifferencebetweentheirinterestratesi.e.4.0–3.5=0.5%mustbeequaltothedefaultriskpremium.
3. NoticethatbetweenBandC,theonlydifferenceisthatChasalongermaturity.Therefore,interestrateofCmustbehigherthanB(2.5%).AlsonoticethatbetweenCandthelowliquidityversionofD,theonlydifferenceisthatChasashortermaturity.Therefore,interestrateonChastobelowerthanthelowliquidityversionofD(3.5%).SotherangeforCis2.5<r<3.5.
3.TheFutureValueofaSingleCashFlow
Let’sunderstandthisconceptwithasimpleexample.Saypresentvalue(PV)=$100andinterestrate(r)=10%.Whatisthefuturevalue(FV)afteroneyear?Whatisthefuturevalue(FV)aftertwoyears?
Thefuturevalueofasinglecashflowcanbecomputedusingthefollowingformula:
FV PV 1 r
where:FVN=futurevalueoftheinvestmentN=numberofperiodsPV=presentvalueoftheinvestmentr=rateofinterest
Therefore,
FV 100 1 0.1 $110
FV 100 1 0.1 $121
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Noticethatwithcompoundinterest,aftertwoyearswehave$121.Whereas,withsimpleinterest,aftertwoyearswewouldhave$120.Thedifferencebetweenthetwovalues($1)representstheinterestoninterestcomponent.InYear2,wenotonlyreceiveinterestonthe$100principal,butwealsoreceiveinterestonthe$10interestearnedinYear1thathasbeenreinvested.
Example
CyndiaRojersdeposits$5millioninhersavingsaccount.Theaccountholdersareentitledtoa5%interest.IfCyndiawithdrawscashafter2.5years,howmuchcashwouldshemostlikelybeabletowithdraw?
Solution:
FV PV 1 r
FV . 5 1 0.05 . $5.649million
FVCalculationusingaFinancialCalculator
YouwilloftenusethefollowingkeysonyourTIBAIIPluscalculator:N=numberofperiodsI/Y=rateperperiodPV=presentvalueFV=futurevaluePMT=paymentCPT=compute
OneimportantpointtonoteisthesignsusedforPVandFV.IfthevalueforPVisnegative“‐”,thenthevalueforFVispositive“+”.Aninflowisoftenrepresentedasapositivenumber,whileoutflowsaredenotedbynegativenumbers.Beforeyoubegin,setthenumberofdecimalpointsonyourcalculatorto9toincreaseaccuracy.
Keystrokes Explanation Display
[2nd][FORMAT][ENTER] Getintoformatmode DEC=9
[2nd][QUIT]Returntostandardcalcmode
0
Question:Youinvest$100todayat10%compoundedannually.Howmuchwillyouhavein5years?
Thekeystrokestocomputethefuturevalueofasinglecashflowareillustratedbelow.
Keystrokes Explanation Display
[2nd][QUIT] Returntostandardcalcmode 0
[2nd][CLRTVM] ClearsTVMWorksheet 0
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5[N] Fiveyears/periods N=5
10[I/Y] Setinterestrate I/Y=10
100[PV] Setpresentvalue PV=100
0[PMT] Setpayment PMT=0
[CPT][FV] Computefuturevalue FV=‐161.05
3.1.TheFrequencyofCompounding
Whenourcompoundingfrequencyisnotannual,weusethefollowingformulatocomputefuturevalue:
FV PV 1rm
where:rs=thestatedannualinterestrateindecimalformatm=thenumberofcompoundingperiodsperyearN=thenumberofyears
Let’sunderstandthisconceptusinganexample.
Youinvest$80,000ina3‐yearcertificateofdeposit.ThisCDoffersastatedannualinterestrateof10%compoundedquarterly.Howmuchwillyouhaveattheendofthreeyears?
Solution:Therearetwomethodstosolvethisquestion.FormulaMethodPVis$80,000.Thestatedannualrateis10%.Thenumberofcompoundingperiodsperyearis4.Thetotalnumberofperiodsis4x3=12.Thereforefuturevalueafter12quarters(3years)is
FV $80,000 1 0.025 $107,591
CalculatorMethodYoucanalsosolvethisproblemusingafinancialcalculator;thekeystrokesaregivenbelow:N=12,I/Y=2.5%,PV=$80,000,PMT=0,CPTFV=‐$107,591PMTis0becausetherearenointermediatepaymentsinthisexample.Example
Donaldinvested$3millioninanAmericanbankthatpromisestopay4%compoundeddaily.WhichofthefollowingisclosesttotheamountDonaldreceivesattheendofthefirstyear?Assume365daysinayear.A. $3.003millionB. $3.122million
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C. $3.562million
SolutionThecorrectanswerisB.FormulaMethod
FV PV 1
FV 3million 1 . $3.122million
CalculatorMethodN=365,I/Y=4/365%,PV=$3million,PMT=0;CPTFV=‐$3.122million
3.2.ContinuousCompounding
Wesawexampleswithannualcompounding.Thenwediscussedquarterlycompoundingandintheaboveexamplewelookedatdailycompounding.Ifwekeepincreasingthenumberofcompoundingperiodsuntilwehaveinfinitenumberofcompoundingperiodsperyear,thenwecansaythatwehavecontinuouscompounding.
Theformulaforcomputingfuturevalueswithcontinuouscompoundingis:
FV PVe
where:r=continuouslycompoundedrateN=thenumberofyears
Let’slookatanexample.
Aninvestmentworth$50,000earnsinterestthatiscompoundedcontinuously.Thestatedannualinterestis3.6%.Whatisthefuturevalueoftheinvestmentafter3years?
Solution:
PV=$50,000;r=0.036;N=3
FV 50,000e . $55,702
ConceptBuildingExercise
Assumethatthestatedannualinterestrateis12%.Whatisthefuturevalueof$100atdifferentcompoundingfrequencies?Whatisthereturn?
Frequency Futurevalueof$100 ReturnAnnual 112.00 12.00%Semiannual 112.36 12.36%Quarterly 112.55 12.55%Monthly 112.68 12.68%Daily 112.75 12.75%Continuous 112.75 12.75%
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Instructor’sNote:
1.Forthesamestatedannualrate,thereturnskeepgettingbetteraswecompoundmoreoften.
2.IfyouhavetwobanksthatofferthefollowingratesA:12.5%compoundedannuallyB:12%compoundeddailyWhichofferisbetter?
EventhoughA’s12.5%looksbetter,B’s12%compoundeddailywilleffectivelygiveyouareturnof12.75%.ThereforetheofferfrombankBisbetter.
3.3.StatedandEffectiveRates
Nowwecometotherelatedconceptofstatedversuseffectiverates.Intheaboveconcept‐buildingexercise,thestatedratewas12%acrosstheboard,buttheeffectiveratethataninvestoractuallyearnsdependsonthecompoundingfrequency.Theeffectiveratesweredifferentfordifferentcompoundingfrequencies.
Ifwearegivenacompoundingfrequency,wecancomputeeffectiveratesusingthefollowingformulae:
Effectiveannualratefordiscretecompounding:
EAR 1 periodicinterestrate – 1
where:m=numberofcompoundingperiodsinoneyear Fordailycompounding,m=365 Formonthlycompounding,m=12 Forquarterlycompounding,m=4 Forsemiannualcompounding,m=2
Forexample,forastatedannualrateof12%andquarterlycompounding,theEARwillbeequalto:
EAR=(1+0.12/4)4–1=1.1255–1=0.1255=12.55%
Instructor’sNote:Alotofpeoplegetconfusedaboutthe‐1attheendoftheformula.Theideaisactuallyfairlystraightforward.Basicallywehave1.034whichistellingushowmuch$1willbecomeattheendof4periods.$1isgoingtobecome$1.1255.Butthisisnotarate.Tofigureouttheratewehavetosubtracttheoriginal$1thatweinvested.Soweareleftwith0.1255whichisoureffectiverate.
EffectiveAnnualRateforcontinuouscompounding:EAR e 1
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wherer =statedannualinterestrate
Forexample,forastatedannualrateof12%andcontinuouscompounding,theEARwillbeequalto:
EAR=e0.12–1=1.1275–1=0.1275=12.75%
4.TheFutureValueofaSeriesofCashFlows
Thedifferenttypesofcashflowsbasedonthetimeperiodsoverwhichtheyoccurinclude: Annuity:Afinitesetofequalsequentialcashflows.Thetwotypesare
o Ordinaryannuity:Thefirstcashflowoccursoneperiodfromnow(indexedatt=1).
o Annuitydue:Thefirstcashflowoccursimmediately(indexedatt=0). Perpetuity:Asetofequalnever‐endingsequentialcashflowswiththefirstcashflow
occurringoneperiodfromtoday.(Theperiodisfiniteincaseofanannuitywhereasinperpetuityitisinfinite.)
4.1.EqualCashFlows–OrdinaryAnnuity
Let’ssaythatwehaveanordinaryannuitywithA=$1,000,r=5%andN=5,i.e.wearegoingtoreceiveapaymentof$1,000attheendofeachyearforthenext5yearsandourdiscountrateis5%.WecancomputetheFVofthisannuityusingthefollowingthreemethods:
Brute‐ForceMethod
Wecantakeeachindividualcashflowandseehowmucheachofthesewillbeworthattheendoffiveyears.ThenwecanaddallthevaluestocomputethetotalFVoftheannuity.
Forinstance,thefirst$1,000depositmadeatt=1willcompoundoverfourperiods;theseconddepositof$1,000willcompoundoverthreeperiodsandsoon.Wethenaddthefuturevaluesofallpaymentstoarriveatthefuturevalueoftheannuitywhichis$5,525.63.
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FormulaMethod
Thefuturevalueofanannuitycanalsobecomputedusingthefollowingformula:
FV A1 r – 1
r
where:A=annuityamountN=numberofyears
Theterminsquarebracketsisknownasthe‘futurevalueannuityfactor’(FVAF).Thisfactorgivesthefuturevalueofanordinaryannuityof$1perperiod.Hencetheformulagivenabovecanalsobewrittenas:FV=AxFVAF.
Therefore,usingtheformula:
FV 1,000 . –
.$5,525.63
CalculatorMethod
Givenbelowarethekeystrokesforcomputingthefuturevalueofanordinaryannuity.
Keystrokes Explanation Display
[2nd][QUIT] Returntostandardcalcmode 0
[2nd][CLRTVM] ClearsTVMWorksheet 0
5[N] Fiveyears/periods N=5
5[I/Y] Setinterestrate I/Y=5
0[PV] 0becausethereisnoinitialinvestment PV=0
1000[PMT] Setannuitypayment PMT=1000
[CPT][FV] Computefuturevalue FV=‐5525.63
Ontheexamyoushouldusethecalculatormethod,becausethisisthefastestmethodanddoesnotrequireyoutomemorizetheannuityformula.
Example
Haleydeposits$24,000inherbankaccountattheendofeveryyear.Theaccountearns12%perannum.Ifshecontinuesthispractice,howmuchmoneywillshehaveattheendof15years?
Solution:N=15,I/Y=12%,PV=0,PMT=$24,000;CPTFV=‐$894,713.15
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4.2.UnequalCashFlows
Ifcashflowstreamsareunequal,thefuturevalueannuityfactorcannotbeused.Inthiscase,wefindthefuturevalueofaseriesofunequalcashflowsbycompoundingthecashflowsoneatatime.
Thisconceptisillustratedinthefigurebelow.Weneedtofindthefuturevalueoffivecashflows:$1,000attheendofYear1;$2,000attheendofYear2;$3,000attheendofYear3;$4,000attheendofYear4;and$5,000attheendofYear5.
Thefuturevalueis$5,000+$4,000x1.05+$3,000x1.052+$2,000x1.053+$1,000x1.054
=$16,038.
5.ThePresentValueofaSingleCashFlow
Let'ssaythatoneyearfromtodayyouwillreceiveacashflowof$110.Whatisthevalueofthat$110today?(Assumethattheinterestrateis10%)
PVFV
1 0.1$110
1 0.1$100
The$110oneyearfromtodayhasapresentvalueof$100.Inotherwords,youwillbeindifferentbetween$100todayand$110oneyearfromtoday.
Whatifyouweregoingtoreceive$121attheendoftwoyears,whatisitspresentvalue?
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PVFV
1 0.1$121
1 0.1$100
UsingthesetwoexampleswecanwriteageneralformulaforcomputingPV.GivenacashflowthatistobereceivedinNperiodsandaninterestrateofrperperiod,thePVcanbecomputedas:
PVFV1 r
where:N=numberofperiodsr=rateofinterestFV=futurevalueofinvestment
Instructor’sNoteNoticethatthisformulacanalsobeobtainedbysimplyrearrangingtheformulaforFVthatwestudiedearlier.
FV PV 1 r PV
Basedonthisformulawecanmaketwoobservations
1. Foragivendiscountrate,thefartherinthefuturetheamounttobereceived,thesmallertheamount’spresentvalue.
Mathematicalexplanation:InthefirstcasethePVis$110/1.1,whereasinthesecondcasePVis$110/1.12.SincewearedividingbyalargernumberthePVwillbelowerinthesecondcase.
Intuitiveexplanation:Clearlyreceivingacertainamountofmoneysoonerisbetterthanreceivingthesameamountofmoneylatter.
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2. Holdingtimeconstant,thelargerthediscountrate,thesmallerthepresentvalueofafutureamount.
InthefirstcasePVis$110/1.1,whereasinthesecondcasePVis$110/1.2.ClearlythePVisgoingtobelowerinthesecondcase,becausewearedividingbyalargernumber.
Example
Liampurchasesacontractfromaninsurancecompany.Thecontractpromisestopay$600,000after8yearswitha5%return.WhatamountofmoneyshouldLiammostlikelyinvest?SolveusingtheformulaandTVMfunctionsonthecalculator.
Solution:FormulaMethod
PVFV1 r
$600,0001.05
$406,104
CalculatorMethod
N=8,I/Y=5%,PMT=0,FV=$600,000;CPTPVPV=‐$406,104Example
Mathewswishestofundhisson,Nathan’s,collegetuitionfee.Hepurchasesasecuritythatwillpay$1,000,000in12years.Nathan’scollegebegins3yearsfromnow.Giventhatthediscountrateis7.5%,whatisthesecurity’svalueatthetimeofNathan’sadmission?
Solution:
PV$1,000,0001.075
$521,583.47
ExampleOrlandoisamanageratanAustralianpensionfund.5yearsfromtodayhewantsalumpsumamountofAUD40,000.Giventhatthecurrentinterestrateis4%ayear,compoundedmonthly,howmuchshouldOrlandoinvesttoday?
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Solution:
Wehavemonthlycompounding,thereforetheinputstoourcalculatorwillbeN=5x12=60I=4/12%PMT=0FV=$40,000CPTPV=‐$32,760.12
6.ThePresentValueofaSeriesofCashFlows
6.1.ThePresentValueofaSeriesofEqualCashFlows
OrdinaryAnnuity
Anordinaryannuityisaseriesofequalpaymentsatequalintervalsforafiniteperiodoftime.Examplesofordinaryannuity:mortgagepayments,pensionincomeetc.
ConsideranordinaryannuitywithA=$10,r=5%andN=5.
WecancomputethePVofthisannuityusingthreemethods
Brute‐ForceMethod:
SimplytakeeachcashflowandcomputethePV.AddallvaluestogetthePVfortheannuity.
PV=$43.29.
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FormulaMethod:
Thepresentvaluecanalsobecomputedusingthefollowingformula:
PV A1
r
where:A=annuityamountr=interestrateperperiodcorrespondingtothefrequencyofannuitypaymentsN=numberofannuitypaymentsTheterminsquarebracketsiscalledthepresentvalueannuityfactor(PVAF).Hencetheequationabovecanalsobewrittenas:PV=AxPVAF.
Therefore,usingtheformulaweget,
PV 101
.
0.05$43.29
CalculatorMethod:
Thekeystrokestosolvethisusingafinancialcalculatoraregivenbelow:
Keystrokes Explanation Display
[2nd][QUIT] Returntostandardcalcmode 0
[2nd][CLRTVM] ClearsTVMWorksheet 0
5[N] Fiveyears/periods N=5
5[I/Y] Setinterestrate I/Y=5
0[FV]Setto0becausethereisnofinalpaymentotherthantheperiodicannuityamounts
FV=0
10[PMT] Setannuitypayment PMT=10
[CPT][PV] Computepresentvalue PV=‐43.29
AnnuityDueWithanannuityduethefirstpaymentisreceivedatthestartofthefirstperiod.SoifwehaveanannuityduewithA=$10,r=5%andN=5.Thecashflowswillbe
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Again,therearethreemethodstocalculatethePVofthisannuitydue.
Brute‐Forcemethod
TakeeachcashflowandcomputethePV.AddallvaluestogetthePVfortheannuity.
PV=$45.46.
Noticethatwithanannuitydueyouarereceivingmoneyfaster,whichmeansthatthe
PVannuitydue($45.46)>PVordinaryannuity($43.29).
Formulamethod:
Wecanalsousethefollowingformula:
PV A1
r1 r
where:A=annuityamountr=interestrateperperiodcorrespondingtothefrequencyofannuitypaymentsN=numberofannuitypayments
Thereforeusingtheformula,
PV 101
.
0.051 0.05 $45.46
Instructor’sNote:
NoticethatA isbasicallytheformulaforcomputingthePVofanordinaryannuity.
IfyouusetheordinaryannuityformulathePVthatyougetwillbeattimeperiod‐1.Sothisneedstobetakenforwardoneperiodbymultiplyingitby(1+r)
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CalculatorMethod:
SetthecalculatortoBGNmode.Thistellsthecalculatorthatpaymentshappenatthestartofeveryperiod.(ThedefaultcalculatorsettingisENDmodewhichmeansthatpaymentshappenattheendofeveryperiod).Thekeystrokesareshownbelow:
Keystrokes Explanation Display
[2nd][BGN][2nd][SET] Setpaymentstobereceivedatbeginningratherthanend
BGN
[2nd][QUIT] Returntostandardcalcmode BGN0
[2nd][CLRTVM] ClearsTVMWorksheet BGN0
5[N] Fouryears/periods BGNN=5
5[I/Y] Setinterestrate BGNI/Y=5
10[PMT] Setpayment BGNPMT=10
0[FV] Setfuturevalue BGNFV=0
[CPT][PV] Computepresentvalue BGN PV=‐45.46
[2nd][BGN][2nd][SET]Setpaymentstobereceivedattheend
END
[2nd][QUIT] Returntostandardcalcmode 0
AlwaysremembertoputyourcalculatorbackintheENDmodeafteryouaredonewiththecalculations.
6.2.ThePresentValueofanInfiniteSeriesofEqualCashFlows–Perpetuity
Aperpetuityisaseriesofneverendingequalcashflows.Thepresentvalueofperpetuitycanbecalculatedbyusingthefollowingformula:
PVAr
where:A=annuityamountr=discountrate
Let’ssaythatwehaveareallysimpleperpetuitywherewereceive$10attheendofeveryyearforever,andlet’ssaythattheinterestrateis5%.
ThePVofthisperpetuitycanbecomputedas:
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PV100.05
$200
Instructor’sNote:Keepinmindthatthepresentvalueof$200isoneperiodbeforethefirstcashflow.Manystudentsshowthepresentvalueof$200atthesametimeasthefirstcashflow,whichisincorrect.
6.3.PresentValuesIndexedatTimesOtherThant=0
Anannuityorperpetuitybeginningsometimeinthefuturecanbeexpressedinpresentvaluetermsoneperiodpriortothefirstpayment.Thatvaluecanthenbediscountedbacktotoday’spresentvalue.Let’ssayyouareofferedacashflowof$10attheendofyear5,endofyear6,andsoonforever.WhatisthePVofthesecashflows,assumingadiscountrateof10%?
ThePVoftheperpetuityattheendofyear4canbecomputedas:
PV100.1
$100
ThisvaluehastobediscountedbackfourperiodstogetthePVattimeperiod0.
PV0=$100/1.14=$68.30
ExampleBillGrahamiswillingtopayforaperpetualpreferredstockthatpaysdividendsworth$100peryearindefinitely.Thefirstpaymentwillbereceivedatt=4.Giventhattherequiredrateofreturnis10%,howmuchshouldMr.Grahampaytoday?
Solution:Thetimelineforthisscenariois
ThePVoftheperpetuityattheendofyear3canbecomputedas
PV1000.1
$1,000
Thisvaluehastobediscountedback3periodstogetthePVattimeperiod0.
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PV0=$1,000/1.13=$751.31
6.4.ThePresentValueofaSeriesofUnequalCashFlows
Whenwehaveunequalcashflows,wecanfirstfindthepresentvalueofeachindividualcashflowandthensumtherespectivepresentvalues.
Let’ssaythatwehavethefollowingcashflows:
Timeperiod CashFlow1 $1002 $2003 $300
Assumingadiscountrateof10%,thePVofthesecashflowscanbecomputedas:
PV=100/1.1+200/1.12+300/1.13=$481.59
Example
Andymakesaninvestmentwiththeexpectedcashflowshowninthetablebelow.Assumingadiscountrateof9%whatisthepresentvalueofthisinvestment?
TimePeriod CashFlow($)
1 50
2 100
3 150
4 200
5 250Solution:PV=50/1.09+100/1.092+150/1.093+200/1.094+250/1.095=$550.03
Wecanalsousethecashflowregisteronourfinancialcalculatortosolvethisproblemquickly.Thekeystrokesareasfollows:
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Keystrokes Explanation Display
[2nd][QUIT] Returntostandardmode 0
[CF][2nd][CLRWRK] ClearCFRegister CF=0
0[ENTER] Nocashflowatt=0 CF0=0
[↓]50[ENTER] EnterCFatt=1 C01=50
[↓][↓]100[ENTER] EnterCFatt=2 C02=100
[↓][↓]150[ENTER] EnterCFatt=3 C03=150
[↓][↓]200[ENTER] EnterCFatt=4 C04=200
[↓][↓]250[ENTER] EnterCFatt=5 C05=250
[↓][NPV][9][ENTER] Enterdiscountrate I=9
[↓][CPT] ComputeNPV 550.03
7.SolvingforRates,NumberofPeriods,orSizeofAnnuityPayments
7.1.SolvingforInterestRatesandGrowthRates
Aninterestratecanalsobeconsideredagrowthrate.Wecancomputetherateusingtheformulamethodorthecalculatormethod.Example:A$100deposittodaygrowsto$121in2years.Whatistheinterestrate?Useboththeformulaandthecalculatormethod.Usingtheformula100(1+r)2=121.Thereforer=0.1or10%Usingthecalculatormethod,inputstothecalculatorarePV=‐$100(WhenweenterbothPVandFV,theyshouldbegivenoppositesignstoavoidacalculatorerror.)FV=$121N=2PMT=0CPTII=10%Example:Thepopulationofasmalltownis100,000on1Jan2000.On31December2001thepopulationis121,000.Whatisthegrowthrate?InputstothecalculatorarePV=‐$100,000FV=$121,000N=2PMT=0CPTII=10%
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Example:Youinvest$900todayandreceivea$100couponpaymentattheendofeveryyearfor5years.Inaddition,youreceive$1,000andtheendofyear5.Whatistheinterestrate?InputstothecalculatorarePV=‐$900FV=$1,000N=5PMT=100CPTII=12.83%
7.2.SolvingfortheNumberofPeriods
Similarly,wecandeterminethenumberofperiodsgivenotherinformationsuchasfuturevalue,presentvalueandinterestrate.Example:Youinvest$2,500.Howmanyyearswillittaketotripletheamountgiventhattheinterestrateis6%perannumcompoundedannually?Useboththeformulaandthecalculatormethod.FormulaMethod:FV PV 1 r 7,500 2,500 1 0.06 1.06 3Nx ln 1.06 ln 3
Nln 3
ln 1.0618.85
CalculatorMethod:Usingthecalculator:I/Y=6%,PV=$2,500,PMT=0,FV=‐$7,500,CPTN=18.85.
7.3.SolvingfortheSizeofAnnuityPayments
Giventhenumberofperiods,interestrateperperiod,presentvalue,andfuturevalue,itiseasytosolvefortheannuitypaymentamount.Thisconceptcanbeappliedtomortgagesandretirementplanning.Considerthefollowingexample.
Example:Freddieboughtacarworth$42,000today.Hewasrequiredtomakea15%downpayment.Theremainderwastobepaidasamonthlypaymentoverthenext12monthswiththefirstpaymentdueatt=1.Giventhattheinterestrateis8%perannumcompoundedmonthly,whatistheapproximatemonthlypayment?
Loanamount=85%of$42,000=0.85x42,000=$35,700PV=$35,700N=12I/Y=8/12%FV=0 CPTPMTPMT=$3,105.48
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7.4.ReviewofPresentandFutureValueEquivalence
Let’ssaythatwehaveanordinaryannuitywithA=10,r=5%andN=5.
Asperourdiscussionsofar,wecancomputethePVandFVofthisannuityPV(attime0)=$43.29andFV(attime5)=$55.26Accordingtotheconceptofpresentandfuturevalueequivalence,alumpsumof$43.29attime0isequivalenttoanannuityof$10overfiveyears.Further,boththeseoptionsareequivalenttoalumpsumof$55.26attime5.Givenaninterestrateof5%,youwouldbeindifferentbetweenthesechoices.
7.5.TheCashFlowAdditivityPrinciple
Amountsofmoneyindexedatthesamepointintimeareadditive.Forexample,ifyouhavethefollowingcashflows:
Youcannotsimplyaddthesethreenumbers.Youhavetotakeeachofthesenumbersandbringthemtoaparticularpointintime.Let’ssaythatwefindthepresentvaluesattimezeroforeachofthesecashflows.Accordingtothisprinciple,thesepresentvaluesthatareallindexedtotimezerocanbeadded.
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Summary
LO.a:Interpretinterestratesasrequiredratesofreturn,discountrates,oropportunitycosts.
Aninterestrateistherequiredrateofreturn.Ifyouinvest$100todayontheconditionthatyouget$110afteroneyear,therequiredrateofreturnis10%.Ifthefuturevalue(FV)attheendofYear1is$110,youcandiscountat10%togetthepresentvalue(PV)of$100.Hence,10%canalsobethoughtofasadiscountrate.Finally,ifyouspent$100ontakingyourspouseoutfordinneryougaveuptheopportunitytoearn10%.Thus,10%canalsobeinterpretedasanopportunitycost.
LO.b:Explainaninterestrateasthesumofarealrisk‐freerate,andpremiumsthatcompensateinvestorsforbearingdistincttypesofrisk.
Interestrate=Realrisk‐freeinterestrate+Inflationpremium+Defaultriskpremium+Liquiditypremium+Maturitypremium.
Nominalriskfreerate=realriskfreerate+inflationpremium
LO.c:Calculateandinterprettheeffectiveannualrate,giventhestatedannualinterestrateandthefrequencyofcompounding.
Thestatedannualinterestrateisaquotedinterestratethatdoesnotaccountforcompoundingwithintheyear.Theeffectiveannualrate(EAR)istheamountbywhichaunitofcurrencywillgrowinayearwhenwedoconsidercompoundingwithintheyear.Example:Ifthestatedannualrateis12%withmonthlycompounding,theperiodicormonthlyrateis1%.Since$1investedatthestartoftheyearwillgrowto1.0112=1.1268,theEARis12.68%.
LO.d:Solvetimevalueofmoneyproblemsfordifferentfrequenciesofcompounding.
Whenourcompoundingfrequencyisnotannual,weusethefollowingformulatocomputefuturevalue:
FV PV 1rm
where:rs=thestatedannualinterestrateindecimalformatm=thenumberofcompoundingperiodsperyearN=thenumberofyears
Ifwekeepincreasingthenumberofcompoundingperiodsuntilwehaveinfinitenumberofcompoundingperiodsperyear,thenwecansaythatwehavecontinuouscompounding.Theformulatocomputefuturevalueis:
FV PVe where:
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r=continuouslycompoundedrate N=thenumberofyears
LO.e:Calculateandinterpretthefuturevalue(FV)andpresentvalue(PV)ofasinglesumofmoney,anordinaryannuity,anannuitydue,aperpetuity(PVonly),andaseriesofunequalcashflows.
Thefuturevalueandpresentvalueforasinglesumofmoneycanbecalculatedusingthefollowingformulae:
FV=PV(1+r)NandPV=FV/(1+r)N
Anannuityisafinitesetofequalsequentialcashflowsoccurringatequalintervals.Therearetwotypesofannuities:
Ordinaryannuity:Cashflowsoccurattheendofeveryperiod. Annuitydue:Cashflowsoccuratthestartofeveryperiod(hence,thePeriod1cash
flowoccursimmediately).Thefuturevalueofanordinaryannuitycanbecomputedusingthefollowingformula:
FV A1 r – 1
r
where:A=annuityamountN=numberofyears
Thepresentvalueofordinaryannuitycanbecomputedusingthefollowingformula:
PV A1
r
where:A=annuityamountr=interestrateperperiodcorrespondingtothefrequencyofannuitypaymentsN=numberofannuitypayments
Withanannuityduethefirstpaymentisreceivedatthestartofthefirstperiod.Theformulatocalculatepresentvalueofannuitydueisasfollows:
PV A1
r1 r
where:A=annuityamountr=interestrateperperiodcorrespondingtothefrequencyofannuitypaymentsN=numberofannuitypayments
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Alternatively,youmayalsousetheTVMkeysonthecalculatorinsteadoftheformulastocomputethepresentvaluesandthefuturevaluesofannuities.
Aperpetuityisaseriesofneverendingequalcashflows.Thepresentvalueofperpetuitycanbecalculatedbyusingthefollowingformula:
PVAr
where:A=annuityamountr=discountrate
LO.f:Demonstratetheuseofatimelineinmodelingandsolvingtimevalueofmoneyproblems.
Youcansolvetimevalueofmoneyquestionsbyshowingcashflowsonatimelinesuchastheoneshownbelow:
Sayyouwillreceive$150attheendofYear4,Year5,andYear6andyouwanttocalculatethePVattime0.YoucantreatthethreepaymentsasanannuityandcalculatethePVattheendofyear3.Thisvalue,assuminga10%discountrate,is:$373.03.Wecanthenfurtherdiscount$373.03totime0.Plug:FV=$373.03,N=3,I=10%,PMT=0.ComputePV.Youshouldget$280.26.
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PracticeQuestions
1. Interestratescanbeleastlikelyinterpretedas:A. discountrates.B. opportunitycosts.C. sunkcosts.
2. Thefollowinginformationisprovidedregardingasecuritywhosenominalinterestrateis
10%: Therealrisk‐freerateofreturnis4% Thedefaultriskpremiumis1% Thematurityriskpremiumis1% Theliquidityriskpremiumis2%An investor wants to determine the inflation premium in the security’s return. Theinflationpremiumisclosestto:A. 2%.B. 4%.C. 6%.
3. Which of the following fixed income instruments has thehighest effective annual rate
(EAR)? Compoundingfrequency AnnualinterestrateInstrument1 Monthly 6.20%Instrument2 Quarterly 6.25%Instrument3 Continuously 6.00%
A. Instrument1.B. Instrument2.C. Instrument3.
4. Howmuchshouldbeinvestedtodayat8%interestcompoundedquarterlytoaccumulate
$10,000fiveyearsfromtoday?Theamountthatmustbeinvestedtodayisclosestto:A. $6,210.B. $6,730.C. $6,840.
5. Theamountaninvestorwillhavein10years,if$1000isinvestedtodayatacontinuously
compoundedrateof7%,willbeclosestto:A. $2,014.B. $2,038.C. $2,044.
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6. Nancy Scott is buying a house. She expects her budget to allow amonthly payment of$2000ona20‐yearmortgagewithastatedannualinterestrateof6percent.IfMs.Scottputsa15percentdownpayment,themostshecanpayforthehouseisclosestto:A. $279,160.B. $328,425.C. $336,160.
7. A tenantpays rentof $800monthlydueon the firstdayof everymonth. If theannual
interestrateis7percent,thepresentvalueofafullyear’srentisclosestto:A. $9,245.B. $9,300.C. $9,355.
8. The preferred shares of Crane Industries are expected to pay a $10 dividend forever,
startingfromtheendofthisyear.Iftherequiredrateofreturnonequivalentinvestmentsis9%,ashareofCraneIndustriespreferredstockshouldbeworth:A. $90.50.B. $111.10.C. $124.60.
9. Aninvestmentisexpectedtoproducethecashflowsof$100,$200,and$300attheend
ofthenextthreeyears.Iftherequiredrateofreturnis10%,thepresentvalueofthisinvestmentisclosestto:A. $456.65.B. $475.83.C. $481.59.
10. JamesMillerwantstosaveforhisson’scollegetuition.Hewillhavetopay$40,000atthe
endofeachyearforthefouryearsthathissonattendscollege.Hehas6yearsuntilhissonstartscollegetosaveupforhistuition.Usinga8%interestratecompoundedannually,theamountMillerwouldhavetosaveeachyearfor6yearsisclosestto:A. $16,190.B. $18,060.C. $19,530.
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Solutions1. Ciscorrect.Interestratescanbeinterpretedas
Required rate of return: It is theminimum rate that the investors require tomakeinvestments.
Discountrate:Futurevaluescanbediscountedbyinterestratestoarriveatpresentvalues.
Opportunitycosts:Ifinsteadofinvesting,youspendthemoneyonsomethingelse,thenyouhavegivenuptheopportunitytoearninterest.
Sunkcostisacostthathasalreadybeenincurredandcannotberecovered.2. Aiscorrect.Nominalinterestrate=realrisk‐freerateofreturn+inflationpremium+risk
premiums(default,liquidity,maturitypremiums)Therefore,Inflationpremium=10%‐4%‐1%‐1%‐2%=2%
3. Biscorrect.UsetheEAR(effectiveannualrate)tocomparetheinvestments:
Instrument Formula EARInstrument1 (1+.062/12)^12–1 6.379%Instrument2 (1+.0625/4)^4–1 6.398%Instrument3 e^(0.060×1)–1 6.183%
4. Biscorrect.EnterintoyourfinancialcalculatorFV=10,000,N=5x4=20,I/Y=8/4=2,
PMT=0,andsolveforPV.PV=‐6,729.715. Aiscorrect.Thefuturevalueofanamountcalculatedusingcontinuouscompoundingis:
FV Pv e Thus:FV 1000 e . $2,013.75
6. Biscorrect.Theconsumer’sbudgetwillsupportamonthlypaymentof$2,000.Givena
20‐yearmortgageat6percent,theloanamountwillbe$279,161(N=20x12=240,%I=6/12=0.5,PMT=2,000,FV=0solveforPV).Ifshemakesa15%downpayment,thenthemostshecanpayforthenewhouse=$279,161/(1–0.15)=$328,424.7.
7. Biscorrect.Usingafinancialcalculator:PMT=800,I=7/12=0.583,n=12Computeannuity
duePV,PV=$9299.6(PutthecalculatorinBGNmodeforannuityduecalculations)8. Biscorrect.
PV/
$
.$111.11
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9. Ciscorrect.Usingyourcashflowkeys,(CF0=0),CF1=100,CF2=200,CF3=300,I=10
ComputePV,PV=$481.59
10. Biscorrect.Usingafinancialcalculator,wefirstneedtocalculatethetotalvalueofthetuitionfeesneededattheendof6years.Notethatthefirstpaymentof40,000needstobemade7yearsfromtoday.N=4,I/Y=8,PMT=40,000,FV=0ComputePV:PV=$132,485.07.Thisistheamountofmoneyneededattheendof6years.Using$132,485.07astheFVforthesavingphaseannuity,wecomputeyearlydepositswiththeinputs:N=6,I/Y=8,PV=0,FV=132,485.07ComputePMT:PMT=$18059.75~$18060.
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R07DiscountedCashFlowApplications
1.Introduction
Thisreadingcovers: Decisiontools:netpresentvalue(NPV)andinternalrateofreturn(IRR). DecisionrulesforNPVandIRR. ConflictingsituationsunderIRR,andwhatruletouseinsuchcases. Calculatingreturnsofaportfolio:money‐weightedreturnandtime‐weightedreturn. Calculatingdifferentyieldmeasuresformoneymarketinstruments.
2.NetPresentValueandInternalRateofReturn
Netpresentvalueandinternalrateofreturnareoftenappliedinallfieldsoffinance.Butperhapsthemostcommonandwellknownapplicationoftheseconceptsisinthefieldofcapitalbudgeting,wherecompaniesneedtomakedecisionsonwhichprojectstopursueandwhichprojectstoreject.
2.1NetPresentValueandtheNetPresentValueRule
Thenetpresentvalue(NPV)ofaninvestmentisthepresentvalueofitscashinflowsminusthepresentvalueofitscashoutflows.ThestepstocalculateNPVareasfollows:
Identifyallthecashflowsassociatedwithaninvestment(bothinflowsandoutflows). Determinetheappropriatediscountrate‘r’fortheinvestmentproject.‘r’isalso
knownasthecostofcapitalortheopportunitycost. Usingthediscountrate‘r’,findthepresentvalueofeachcashflow. Inflowsarepositiveandoutflowsarenegative.Sumthepresentvaluesofallcash
flows,includingtheinitialinvestment.Thisvaluerepresentstheinvestment’snetpresentvalue.
FormulaforcomputingNPVis:
NPV presentvalueofcashinflows– presentvalueofcashoutflows
NPVCF1 r
where:CFt=theexpectednetcashflowattimetN=theinvestment’sprojectedlifer=thediscountrateoropportunitycost
TounderstandtheNPVconcept,letusconsiderasimpleexample.
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Example
Aprojectrequiresaninitialoutlayof$750,000.Itisexpectedtoproduce$200,000inthefirstyear,$300,000inthesecondyear,and$400,000inthethirdyear.Thecostofcapitalforthisprojectis10%.WhatistheNPV?Shouldtheprojectbeaccepted?
Solution:FormulaMethod:
UsingtheformulaforNPV,
NPV CF0 CF11 r
CF21 r
CF31 r
NPV 750,000200,0001.1
300,0001.1
400,0001.1
NPV=‐19,722
Whilethismethodisconceptuallysimple,itcanbetediousifthenumberofcashflowsislarge.Itismucheasiertousethefinancialcalculator.Thestepsareoutlinedbelow:
CalculatorMethod:Keystrokes Explanation Display[2nd][QUIT] Returntostandardmode 0[CF][2nd][CLRWRK] ClearCFRegister CF=0750[+/‐][ENTER] InitialOutlay(in000’s) CF0=‐750[↓]200[ENTER] EnterCFatt=1 C01=200[↓][↓]300[ENTER] EnterCFatt=2 C02=300[↓][↓]400[ENTER] EnterCFatt=3 C03=400[↓][NPV][10][ENTER] Enterdiscountrate I=10[↓][CPT] ComputeNPV ‐19.722Thepresentvalueofcashinflowsis$730,278whichislessthanthecostof$750,000.Valueisbeingdestroyed.TheNPVisnegativeandhencethisprojectshouldberejected.
NPVDecisionRule
Forindependentprojects(whereyoucanmakeadecisiononeachprojectindependently): IftheNPVispositiveAccepttheproject. IftheNPVisnegativeRejecttheproject.
Formutuallyexclusiveprojects(whereonlyoneprojectcanbeaccepted): AccepttheprojectwiththehigherNPVaslongastheNPVispositive.
2.2TheInternalRateofReturnandtheInternalRateofReturnRule
Theinternalrateofreturn(IRR)isthediscountratethatmakesthenetpresentvalueequaltozero.Itis‘internal’becauseitdependsonlyonthecashflowsoftheinvestment;noexternaldataisneeded.TheformulaforIRRisasfollows:
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NPV CF CF
1 IRR
CF1 IRR
… CF
1 IRR0
where:CF usuallytheinitialinvestmentwhichisacashoutflowCFt=theexpectednetcashflowattimetNPV=netpresentvalueoftheinvestmentIRR=internalrateofreturn
TheIRRisasinglenumberwhichrepresentsthereturngeneratedbyaproject.Consideraverysimpleprojectwheretheinitialinvestmentis$100.Oneyearlatertheamountreceivedfromthisprojectis$110.Therearenoothercashflows.IfweapplytheformulaforIRRweget:
100110
1 IRR0
SolvingthisequationshowsthatIRR=0.1or10%.
Example
Consideraprojectthatrequiresaninitialinvestmentof$150,000.Estimatedcashflowsforthefollowingthreeyearsare$50,000,$100,000and$40,000respectively.WhatistheIRR?
Solution:WecansetupanequationwiththeinitialoutflowequaltothepresentvalueoffuturecashflowsandsolvefortheIRR:
CF0 CF1
1 IRR
CF21 IRR
CF3
1 IRR
Plugginginthevalues,weget:
$150,000 $50,0001 IRR
$100,0001 IRR
$40,0001 IRR
Whileitistheoreticallypossibletosolvetheaboveequation,itismuchsimplertousethefinancialcalculator.Keystrokes Explanation Display[2nd][QUIT] Returntostandardmode 0[CF][2nd][CLRWRK] ClearCFRegister CF=0150[+/‐][ENTER] Initialoutlay(in000’s) CF0=‐150[↓]50[ENTER] EnterCFatt=1 C01=50[↓][↓]100[ENTER] EnterCFatt=2 C02=100[↓][↓]40[ENTER] EnterCFatt=3 C03=40[↓][ÌRR][CPT] ComputeIRR 13.11%
TheIRRRule
Forindependentprojects:
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IfIRR>OpportunitycostAccepttheproject. IfIRR<OpportunitycostRejecttheproject.
Formutuallyexclusiveprojects: AccepttheprojectwiththehigherIRR,aslongastheIRR>Opportunitycost.
IRRusestheopportunitycostofcapitalasthehurdlerate.Forexample,ifatagivencompanythecostofcapital(opportunitycost)is10%,thenonlyprojectswithIRR>10%willbeaccepted.
Example
Billisinterestedinaprojectwhichrequiresaninvestmentof$1.5million.Theprojectshallpay$200,000peryearinperpetuity.Thefirstcashflowwillbereceived1yearfromtoday.Thecostofcapitalis8%.WhatistheIRR?ShouldBillinvestinthisproject?
Solution:IRRcanalsobethoughtofasthediscountratewhichmakestheinitialoutlayequaltothepresentvalueoffuturecashflows.Heretheinitialoutlayis$1,500,000.Becausetheproject’scashflowsareaperpetuity,thepresentvalueoffuturecashflowscanbewrittenas:$200,000/IRR.Hencetheequationbecomes:
1,500,000200,000IRR
WecansolveforIRRas:
IRR200,000
$1,500,0000.133or13.3%
SincetheIRRof13.3%isgreaterthanthecostofcapitalof8%,Billshouldinvestinthisproject.
2.3ProblemswiththeIRRRule
NPVandIRRrulesgivethesameacceptorrejectdecisionwhenprojectsareindependent.However,whendealingwithmutuallyexclusiveprojects,itispossiblethatthehighestNPVprojectisnotthesameasthehighestIRRproject.Thisiscalledarankingconflict.
IRRandNPVcanrankprojectsdifferentlywhen: Thesizeorscaleoftheprojectsdiffers. Timingoftheprojects’cashflowsdiffers.
Toillustratethefirstpoint(differenceinsize),consideracompanywith$100millionavailabletoinvest.Ithastwoinvestmentprojectsasshownbelow:
Project Investmentatt=0 Cashflowatt=1 IRR(%) NPVat10%A ‐100 120 20% 10D ‐1,000 1,150 15% 45
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TheIRRruleranksProjectAfirstbecauseofthehigherIRR.TheNPVrule,however,ranksProjectDfirstbecauseofthehigherNPV.
Toillustratethesecondpoint(differenceincashflowtiming),considerProjectsAandCasshowninthetablebelow:
Project CF0 CF1 CF2 CF3 IRR(%)NPVat10%
A ‐100 120 0 0 20 10C ‐100 0 0 170 19 28
TheIRRruleranksProjectAfirstbecauseofthehigherIRR.TheNPVrule,however,ranksProjectCfirstbecauseofthehigherNPV.
WheneverthereisaconflictinrankingbetweentheIRRruleandtheNPVrule,theNPVruleshouldbeusedtodecidebetweenmutuallyexclusiveprojects.ThisisbecausetheNPVrepresentstheexpectedadditiontoshareholderwealthfromaninvestment.Themaximizationofshareholderwealthisabasicfinancialobjectiveofacompanyandhence,theNPVrulemustbegivenpreference.
Therefore,inthefirstcaseyoushouldselectProjectDoverProjectA.Similarly,inthesecondcaseyouselectProjectCoverProjectA.
3.PortfolioReturnMeasurement
Portfolioperformancemeasurementinvolvescalculatingreturnsinalogicalandconsistentmanner.Forinstance,determiningthereturnsofaportfoliohelpsincomparingandrankingdifferentmutualfunds.Inthissection,wecoverthefollowingreturnmeasuresandidentifysituationswhenthesemeasuresaretobeused:
Holdingperiodreturn Money‐weightedrateofreturn(MWRR) Time‐weightedrateofreturn(TWRR)
HoldingPeriodReturnHoldingperiodreturn(HPR)isthereturnthataninvestorearnsoveraspecifiedholdingperiod.Theholdingperiodcanrangefromdaystoyears.TheformulaforcalculatingHPRforaninvestmentthatmakesone‐timecashpaymentattheendoftheholdingperiodisgivenbelow:
HPRP –P D
Pendingvalue– beginningvalue cashflow
beginningvalue
where:P0=initialinvestmentP1=pricereceivedattheendoftheholdingperiodD1=cashpaidbytheinvestmentattheendoftheholdingperiod
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Example
Assumewebuyastockfor$50.Sixmonthslater,thestockpricegoesupto$53andwereceiveadividendof$2.Calculatetheholdingperiodreturn.Solution:Thereturnforthesix‐monthholdingperiodisgivenbelow:
HPR= =0.10=10%
3.1Money‐WeightedRateofReturn
Themoney‐weightedrateofreturnistheinternalrateofreturn(IRR)ofaprojectoraninvestment.
Letusconsiderasimpleexampletoillustratethispoint.Attimet=0,aninvestorbuysasharefor$20.00.AttheendoftheYear1,hereceivesadividendof$0.50andpurchasesanothersharefor$22.50.AttheendoftheYear2,hesellsbothsharesfor$23.50eachafterreceivinganotherdividendof$0.50pershare.Whatisthemoney‐weightedreturn?
Sincethemoney‐weightedreturnistheIRR,wecanuseafinancialcalculator.Thefirststepistodeterminethenetcashflowsforeveryperiod.Thisisillustratedinthetablebelow:
Time(endofperiod)
Outflow(‐) Inflow(+)Netcashflow
0 ‐$20.00Topurchasethefirstshare
‐$20.00
1 ‐$22.50Topurchasethesecondshare
$0.50Dividendreceivedonfirstshare
‐$22.00
2 Dividendreceived=$0.50x2shares=$1.00Fromsalesof2shares=$47
+48.00
Afterenteringthesecashflows,usethecalculator’sIRRfunctiontofindthemoney‐weightedrateofreturnas9.39%.
3.2Time‐weightedRateofReturn
Thetime‐weightedrateofreturnmeasuresthecompoundgrowthrateof$1initiallyinvestedintheportfoliooverastatedmeasurementperiod.Thetime‐weightedreturncanbecalculatedusingthefollowingsteps:1. Breaktheoverallevaluationperiodintosub‐periodsbasedonthedatesofcashinflows
andoutflows.2. Calculatetheholdingperiodreturnontheportfolioforeachsub‐period.3. Linkorcompoundholdingperiodreturnstoobtainanannualrateofreturnfortheyear
(thetime‐weightedrateofreturnfortheyear).4. Iftheinvestmentisformorethanayear,takethegeometricmeanoftheannualreturns
toobtainthetime‐weightedrateofreturnoverthatmeasurementperiod.
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Considerthesameexamplewediscussedabovewiththefollowingcashflows:TimeOutflow Inflow0 $20.00topurchasethefirstshare
1$22.50topurchasethesecondshare
$0.50dividendreceivedonfirstshare
$1.00dividends($0.50x2shares);$47.00fromselling2shares@$23.50pershare
CalculatingtheTWRRforthisexampleisrelativelysimplebecausecashflowsonlyoccuratthestart/endofeveryyear.Wewillfollowthestepsmentionedearlier:
Steps1:Breakintoevaluationperiodandvaluetheportfolioatstart/endofeveryperiod. ValueoftheportfolioatthestartofYear1(t=0)is$20.00. ValueofportfolioattheendofYear1(t=1)beforethepurchaseofthenewshareis
22.50+0.50=$23.00.Notethatthedividendof$0.50onthefirstshareisreceivedattheendofYear1.
ValueoftheportfolioatthestartofYear2(t=1)afterthepurchaseofthesecondshareis22.50+22.50=$45.00.Thedividendof$0.50fromthefirstshareispaidoutandisnotconsideredaspartoftheportfolio.
ValueoftheportfolioattheendofYear2(t=2)is23.50+23.50+0.50+0.50=$48.00.Bothsharespayadividendof$0.50attheendofthesecondyear.
Step2:Calculatetheholdingperiodreturnontheportfolioforeachsub‐period. Inthisquestionthecashflowsaretakingplaceatthestart/endofeachperiod.Hence
therearenosub‐periods.Scenariosinvolvingsub‐periodswillbecoveredinthenextexample.
Step3:Linkorcompoundholdingperiodreturnstoobtainanannualrateofreturnfortheyear. Theannualrateofreturnisbasedontheportfoliovalueatthestartandendofeach
period. TheportfoliovalueatthestartofYear1was$20.00andthevalueattheendofYear1
was$23.00.Hencetheholdingperiodreturnwas15.00%. TheportfoliovalueatthestartofYear2was$45.00andthevalueattheendofYear2
was$48.00.Hencetheholdingperiodreturnwas6.67%.
Step4:Iftheinvestmentisformorethanayear,takethegeometricmeanoftheannualreturnstoobtainthetime‐weightedrateofreturnoverthatmeasurementperiod.
TheTWRRiscalculatedas: 1.15 ∗ 1.067 – 1=0.1077=10.77%.
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Example
Consideraninvestmentwherecashflowsoccuratthestart/endofeveryquarter.Hereeachquarterisconsideredasub‐period.Thereturnforeachsub‐periodhasalreadybeencalculatedandisshownbelow:
Calculatethetime‐weightedreturn.
Solution:
Step1(breakevaluationintosub‐periods)andstep2(calculateHPRforsub‐periods)havebeendoneforyou.
Step3:LinkthequarterlyreturnstodeterminethereturnforYears1and2respectively.Foryear1:(1+0.10)(1–0.05)(1+0.15)(1–0.10)=1.0816Foryear2:(1–0.20)(1+0.30)(1+0.20)(1+0)=1.2480
Step4:Determinetheannualizedreturnbytakingthegeometricmean.TWRR=(1.0816x1.2480)1/2‐1=0.1618=16.18%.
Money‐weightedv/stime‐weightedreturns
Themoney‐weightedrateofreturnisimpactedbythetimingandamountofcashflows.
Thetime‐weightedrateofreturnisnotimpactedbythetimingandamountofcashflows.
Thetime‐weightedreturnisanappropriateperformancemeasureiftheportfoliomanagerdoesnotcontrolthetimingandamountofinvestment.
Ontheotherhand,money‐weightedreturnisanappropriatemeasureiftheportfoliomanagerhascontroloverthetimingandamountofinvestment.
4.MoneyMarketYields
Themoneymarketisthemarketforshort‐termdebtinstruments(oneyearmaturityorless).Someinstrumentsrequiretheissuertorepaythelendertheamountborrowedplustheinterest.Othersarepurediscountinstrumentsthatpayinterestasthedifferencebetweentheamountborrowedandtheamountpaidback.
Thefollowingyieldmeasuresareusedwhendealingwithmoneymarketinstruments: Bankdiscountyield Holdingperiodyield Effectiveannualyield Moneymarketyield
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Bondequivalentyield
BankDiscountYieldThebankdiscountyieldiscomputedasfollows:
BDYDFx360t
where:BDY=theannualizedyieldonabankdiscountbasisD=thedollardiscount,whichisequaltothedifferencebetweenthefacevalueofthebillandthepurchasepriceF=facevalueofthebillt=theactualnumberofdaysuntilmaturity
Example
ConsideraT‐billwithafacevalue(orparvalue)of$100,000and150daysuntilmaturitywhichissellingfor$98,000.Thedollardiscount,D,is$2,000.Calculatethebankdiscountyield.
Solution:
BDY2,000100,000
x360150
0.048 4.8%
Thebankdiscountyield(BDY)istheindustrystandardmeasureforquotingT‐bills.However,theBDYisnotanaccuratemeasureofinvestors’returnsforthefollowingthreereasons:1. Theyieldisbasedonthefacevalueofthebond,notonitspurchaseprice.Intheabove
example,thedollardiscountof$2,000isdividedthebythefacevalueof$100,000.Amoreaccuratemeasureofreturncanbeobtainedifwedividebytheinvestmentamount(ortheT‐billprice)of$98,000.
2. Theyieldisannualizedbasedona360‐dayyearratherthana365‐dayyear.3. Thebankdiscountyieldannualizeswithsimpleinterest.Intheaboveexamplethe150‐
dayreturnismultipliedby360/150.Thisignorestheopportunitytoearninterestoninterest(compoundinterest).
HoldingPeriodReturnItisthereturnaninvestorwillearnbyholdingtheinstrumenttomaturity.Itisalsoknownasholdingperiodyield(HPY).
HPYP –P D
P
where:P0=initialpurchasepriceoftheinstrumentP1=pricereceivedfortheinstrumentatmaturity
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D1=cashpaidbytheinstrumentatmaturity
Note:ThisconcepthasbeendiscussedearlierinSection3.
Example
ConsideraT‐billwithafacevalueof$100,000and150daysuntilmaturitywhichissellingfor$98,000.Determinetheholdingperiodyield.
Solution:
HPY=(100,000–98,000+0)/98,000=0.0204=2.04%
MoneyMarketYieldThemoneymarketyieldiscomputedbyannualizingtheHPYassumingsimpleinterestanda360‐dayyear.Theformulaisasfollows:
MMYHPYx360
t
where:HPY=holdingpriceyield360=numberofdaysinayeart=theactualnumberofdaysuntilmaturity
Example
ConsideraT‐billwithafacevalue(orparvalue)of$100,000and150daysuntilmaturitywhichissellingfor$98,000.Calculatethemoneymarketyield.
Solution:
Weearliercalculatedtheholdingperiodyieldas2.04%.
MMY0.0204x360
1500.0490 4.90%
EffectiveAnnualYieldThemostaccuratemeasureofinvestors’returnsistheeffectiveannualyield(EAY).Theeffectiveannualyieldiscalculatedasfollows:
EAY 1 HPY – 1
where:
HPY=holdingpriceyield365=numberofdaysinayeart=theactualnumberofdaysremainingtomaturity
Theeffectiveannualyieldaddressesthethreeweaknessofthebankdiscountyield:1. TheHPYcorrectlygivesareturnwithrespecttotheinvestmentamountandnottheface
value.
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2. TheHPRisannualizedbasedona365‐dayyear,nota360‐dayyear.3. Byusinganexponent,compoundinterestisbeingusedratherthansimpleinterest.
ExampleConsideraT‐billwithafacevalue(orparvalue)of$100,000and150daysuntilmaturitywhichissellingfor$98,000.Determinetheeffectiveannualyield.
Solution:
Inanearlierexample,wecalculatedtheholdingperiodyieldas2.04%.
EAY 1 0.0204 – 1 0.0504 5.04%
BondEquivalentYield
Bondequivalentyieldiscomputedas:
Bondequivalentyield=2xsemiannualyield
Mostbondsmakecouponpaymentseverysixmonths.Considerabondworth$100andwhichmakesacouponpaymentof$4semi‐annually.Thesemi‐annualorsix‐monthyieldonthisbondis4/100=4%.Thebondequivalentyieldistwotimesthesix‐monthyield:2x4%=8%.Notethatforthisbondtheeffectiveannualyieldwillbe1.042–1=0.0816or8.16%.
Instructor’sNote:
Hereisasuggestiononhowtorememberthevariousmoneymarketyields.
Bankdiscountyield(BDY)=D/Fx360/t.Rememberfromthenamethatthereisadiscountinvolved.Thediscountisrelativetothefacevalue.HencewehaveD/FintheBDYexpression.NextD/Fneedstobeannualizedusingsimpleinterestsowemultiplyby360/twheretisthenumberofdaystomaturity.Sotheoverallformulabecomes:BDY=D/Fx360/t.Alsorememberthethreelimitationsofthismeasure:1)thediscountisdividedbyfacevalueratherthanprice,2)theuseof360daysinayearratherthan365days,and3)theuseofsimpleinteresttoannualizeratherthancompoundinterest.
Holdingperiodyield(HPY)=(Increaseinprice+anyothercashflow)/Investmentamount.Asthenameimpliesthisistheyieldorreturnforagivenholdingperiod.Itisdefinedasthegain(increaseinpriceplusanydividendorcouponpayment)overtheholdingperioddividedbytheoriginalinvestmentamount.Bydefinitionthisyieldmeasureisnotannualized.
Moneymarketyield(MMY)=HPYx360/t.HereweareannualizingtheHPYusinga360‐dayyearandsimpleinterest.SincetheHPYisbasedonthegaindividedbytheinvestmentamount,MMYaddressesthefirstandmostsignificantlimitationoftheBDY.Theothertwolimitationsremain.
Effectiveannualyield(EAY)=(1+HPY)365/t–1.ThismeasurecompoundstheHPYusinga365‐dayyear.HenceitaddressesallthreelimitationsoftheBDY.
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Convertingbetweenyieldmeasures
Thetablebelowsummarizeshowtoconvertbetweendifferentyieldmeasures:Thecurriculumoutlinesaformulaforconvertingabankdiscountyieldtoamoneymarketyield,butitiseasierandmoreintuitivetousetheprocessshowninthetablebelow:
Conversion Formula/MethodHPYtoMMY MMY=
HPYtoEAY EAY 1 HPY – 1HPYtoBDY(bankdiscountyield)
GiventhefacevalueandHPY,computepriceandthediscount.Usingthediscount,facevalueandnumberofdaystomaturity,computethebankdiscountyield.
BDYtoEAY FromtheBDY,computethediscount.Fromthediscount,computetheHPY.FromtheHPY,computetheEAY.
BDYtoMMY FromtheBDY,computethediscountandtheprice.Fromthediscountandtheprice,computetheHPY.FromtheHPY,computetheMMY.
ExampleConsideraT‐billwithafacevalueof$100,000and150daysuntilmaturity.Assumethebankdiscountyieldisgivenas4.80%.Determinetheholdingperiodyieldandthemoneymarketyield.
Solution:
1. Computethediscount:0.048x$100,000x $2,000andtheprice:
$100,000– $2,000 $98,0002. Fromthediscountandprice,wecancomputetheHPY:
$2,000$98,000
0.0204
3. FromtheHPY,computetheMMY:0.0204x =0.04896=4.90%
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Summary
LO.a:Calculateandinterpretthenetpresentvalue(NPV)andtheinternalrateofreturn(IRR)ofaninvestment.
Thenetpresentvalue(NPV)ofaninvestmentisthepresentvalueofitscashinflowsminusthepresentvalueofitscashoutflows.
Theinternalrateofreturn(IRR)isthediscountratethatmakesthenetpresentvalueequaltozero.
LO.b:ContrasttheNPVruletotheIRRrule,andidentifyproblemsassociatedwiththeIRRrule.
TheNPVruleforindependentprojectsistoaccepttheprojectiftheinvestment’sNPVispositiveandrejecttheprojectifNPVisnegative.However,formutuallyexclusiveprojectstheinvestormustchoosetheprojectwiththehighestpositiveNPV.
TheIRRruleforindependentprojectsistoaccepttheprojectiftheinvestment’sIRRisgreaterthanthecostofcapitalandrejecttheprojectifitislessthanthecostofcapital.Incaseofmutuallyexclusiveprojects,theprojectwiththehighestIRRmustbeselected.
ThereisatheoreticallimitationofIRR,wherebyinterimcashflowsareassumedtobereinvestedattheIRRrateandnotatthecostofcapital.Thisleadstoarankingconflict,i.e.whendecidingbetweenprojectswhicharenotindependent,theNPVandIRRrulesdonotalwaysleadtothesamedecision.WheneverthereisaconflictinrankingbetweentheIRRruleandtheNPVrule,theNPVruleshouldbeusedtodecidebetweenmutuallyexclusiveprojects.
LO.c:Calculateandinterpretaholdingperiodreturn(totalreturn).
HoldingPeriodReturn(HPR)isthereturnthataninvestorearnsoveraspecifiedholdingperiod.
HPRP –P D
P
where:P0=initialinvestment,P1=pricereceivedattheendoftheholdingperiod,D1=cashpaidbytheinvestmentattheendoftheholdingperiod.
LO.d:Calculateandcomparethemoney‐weightedandtime‐weightedratesofreturnofaportfolioandevaluatetheperformanceofportfoliosbasedonthesemeasures.
Themoney‐weightedrateofreturnaccountsforthetimingandamountofallcashflowsintoandoutofaportfolio.Itissimplytheinternalrateofreturn.
Thetime‐weightedrateofreturnmeasuresthecompoundrateofgrowthof$1initiallyinvestedintheportfoliooverastatedmeasurementperiod.
Money‐weightedv/stime‐weightedreturns
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Themoney‐weightedrateofreturnisimpactedbythetimingandamountofcashflows.
Thetime‐weightedrateofreturnisnotimpactedbythetimingandamountofcashflows.
Thetime‐weightedreturnisanappropriateperformancemeasureiftheportfoliomanagerdoesnotcontrolthetimingandamountofinvestment.
Ontheotherhand,money‐weightedreturnisanappropriatemeasureiftheportfoliomanagerhascontroloverthetimingandamountofinvestment.
LO.e:Calculateandinterpretthebankdiscountyield,holdingperiodyield,effectiveannualyield,andmoneymarketyieldforUSTreasurybillsandothermoneymarketinstruments.
BDY DF
∗360t
HPY P –P D
P
EAY 1 HPY 365/t 1
MMYHPY ∗ 360
t
LO.f:Convertamongholdingperiodyields,moneymarketyields,effectiveannualyields,andbondequivalentyields.
HPYtoBDY(bankdiscountyield)
GiventhefacevalueandHPY,computepriceandthediscount.
Usingthediscount,facevalue,andnumberofdaystomaturity,computethebankdiscountyield.
BDYtoEAY FromtheBDY,computethediscount.
Fromthediscount,computetheHPY.
FromtheHPY,computetheEAY.
BDYtoMMY FromtheBDY,computethediscountandtheprice.
Fromthediscountandtheprice,computetheHPY.
FromtheHPY,computetheMMY.
Bond‐equivalentyield=2xsemi‐annualYTM
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PracticeQuestions
1. Theincrementalafter‐taxcashflowsofaprojectaregivenbelow:Year 0 1 2 3 4Cashflow(€) ‐100,000 50,000 40,000 20,000 6,000
Thediscountrateforevaluatingtheprojectistakenas10%.TheNPV(in€)oftheprojectisclosestto:A. ‐2,363.B. 1,586.C. 2,458.
2. TheIndiangovernmentwishestoinvestinaprojectthatshallrequireaninitialinvestment
of$20million,andwillproducepositivecashflowsof$5millionforthefirstthreeyears,and$4millionforthenexttwoyears.Whatistheapproximateinternalrateofreturn(IRR)fortheinvestment?A. 3%.B. 4%.C. 5%.
3. As a projectmanager, Ronald Parker has to choose between threemutually exclusive
projects:A,B,andC.Hehasthefollowinginformationfromhisstaffregardingthethreeprojects:
NPV IRRA $11,000 8%B $15,000 10%C $10,000 12%
Basedon the informationgiven,whichprojectwouldbemostappropriate forParker’sdepartment?A. ProjectA.B. ProjectB.C. ProjectC.
4. NancyMillerpurchased100sharesofacompanyataprice$15pershareon1January.
Shesoldallthestockson30Juneofthesameyearatprice$18pershare.Shealsoreceiveddividendstotaling$80on30June.Theholdingperiodreturnontheinvestmentisclosestto:A. 20%.B. 25%.C. 30%.
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5. Aninvestorpurchasesoneshareofacompanyfor$50.Exactlyoneyearlater,thecompanypaysadividendof$5.00pershare.Thisisfollowedbytwomoreannualdividendsof$6.00and$6.50 in successiveyears.Uponreceiving the thirddividend, the investor sells thesharefor$60.Themoney‐weightedrateofreturnonthisinvestmentisclosestto:A. 15%.B. 16%.C. 17%.
6. Aninvestorpurchases100sharesofacompany.Thetablebelowoutlinesthehistoryofhis
investment:
Time Activity PriceperShare DividendperShare
StartofYear1 Buy100shares $10
EndofYear1 Buy10shares $11 $1EndofYear2 $13 $1.5EndofYear3 Sell110shares $12
Assumingthattheinvestordoesnotreinvesthisdividends,whicharetax‐free,thetime‐weightedrateofreturnontheinvestmentisclosestto:A. 12.2%.B. 13.7%.C. 14.8%.
7. AT‐Billwithaparvalueof$1,000and120daystomaturityistradingatapriceof$980.
ThebankdiscountyieldoftheT‐Billisclosestto:A. 5%.B. 6%.C. 7%.
8. A 180‐day U.S. Treasury bill with a face value of $1,000 sells for $990 when issued.
Assuming an investor holds the bill tomaturity, the investor’s moneymarket yield isclosestto:A. 1.19%.B. 2.02%.C. 3.50%.
9. ATreasury bill offers a bank discount yield of 5% and has 180 days tomaturity. The
effectiveannualyieldontheinstrumentisclosestto:A. 4.88%.B. 5.26%.C. 5.79%.
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Solutions1. Aiscorrect.
NPV of a project = Present value of the expected cash inflows – Present value of theexpectedcashoutflows.EnterthegivencashflowsandthegivendiscountrateintoafinancialcalculatorandsolveforNPV.CF0=–100,000,CF1=50,000,CF2=40,000,CF3=20,000,CF=6,000,i=10%.ComputePV.TheNPVis–2,363.
2. Ciscorrect.IRRisdefinedastherateofreturnthatequatesthePVofthecashinflowsto
thePVofthecashoutflows.Ciscorrect.EnterthegivencashflowsinthefinancialcalculatorCF0=‐20millionCF1=5millionCF2=5millionCF3=5millionCF4=4millionCF5=4millionIRRComputed=5.07%
3. Biscorrect.ProjectBhasthehighestNPVamongthethreeprojectsandthusresultsinthe
greatestadditiontoshareholderwealth.WhilethereisaconflictbetweentheNPVandIRRrulesforprojectsBandC,NPVruleistobegivenpreferenceforitssuperiorityoverIRRandhenceBwouldbethemostappropriatechoice.
4. Biscorrect.
HPRP P D
P
(18–15+80/100)/15=0.2533=25.33%.5. Ciscorrect.Themoney‐weightedrateofreturnistheinternalrateofreturn(IRR)ofthe
cashflowsassociatedwiththeinvestment.Usethecashflow(CF)functionofafinancialcalculatorandenterCF0=–50,CF1=5,CF2=6,andCF3=66.5.Calculate the IRR.Theansweris17.15%
6. Biscorrect.TWR=3√{[(11+1)/10]x[(13+1.5)/11]x[(12/13)]}–1=0.1344=13.45%.7. Biscorrect.Thebankdiscountyield=Discount/FaceValuex360/Noofdaystomaturity
=20/1000x360/120=0.06=6%.8. Biscorrect.Themoneymarketyieldis:2.02%=[(1,000/990)–1]x(360/180).
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MMY HPY360t
9. Biscorrect.First,calculatetheinitialprice(P0)oftheT‐bill:
0.05=D/100x360/180D=2.5P0=100–2.5=97.5Then, calculate the holding period yield (HPY) (recall that T‐bills are pure discountinstrumentsanddonotpaycoupons):HPY=(P1–P0)÷P0HPY=(100–97.5)÷97.5=0.0256Finally,converttheHPYintoeffectiveannualyield:EAY=(1+HPY)365/t–1EAY=(1+0.0256)365/180–1=0.05259=5.26%.
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R08StatisticalConceptsandMarketReturn
1.Introduction
Statisticsisapowerfultoolforanalyzingdataanddrawingconclusions.Asinvestors,weareconcernedaboutthereturnsonourinvestmentsandthedistributionofthosereturns.Weneedthisinformationtoevaluateourinvestments.
Forexample,weoftenlookforcentraltendency.Let’ssaythatthestockmarkethasreturnedonaverage14%overthelast10years.Obviously,weareconcernedwiththisaveragenumberbutwearealsoconcernedwiththedispersionwhichtellsushowspreadoutthereturnshavebeen.Oneofthesimplestmeasuresofdispersionisrange.Let’ssaythatoverthelast10yearsthestockmarkethasrangedbetween‐20%and+35%.Thistellsusabouttheriskinessofourinvestments.
Inthisreading,wewillstudystatisticalmethodsthatallowustosummarizereturndistributions.
Specifically,wewillexplorefourpropertiesofreturndistributions: Wherethereturnsarecentered(centraltendency). Howfarreturnsaredispersedfromtheircenter(dispersion). Whetherthedistributionofreturnsissymmetricallyshapedorlopsided(skewness). Whetherextremeoutcomesarelikely(kurtosis).
2.SomeFundamentalConcepts
2.1TheNatureofStatistics
Thetermstatisticscanhavetwobroadmeanings,onereferringtodataandtheothertoamethodusedtoanalyzedata.Statisticalmethodsinclude:
Descriptivestatistics:Itreferstohowlargedatasetscanbesummarizedeffectivelytodescribetheirimportantcharacteristics.
Inferentialstatistics:Itreferstomakingforecasts,estimatesorjudgmentsaboutalargedatasetbasedonasmallrepresentativeset.
Thefocusofthisreadingisondescriptivestatistics.Wewillcoverinferentialstatisticsinalaterreading.
2.2PopulationsandSamples
A‘population’isdefinedasallmembersofaspecifiedgroup.A‘parameter’describesthecharacteristicsofapopulation.
A‘sample’isasubsetdrawnfromapopulation.A‘samplestatistic’describesthecharacteristicofasample.
Allstockslistedontheexchangeofacountryisanexampleofpopulation.If30stocksareselectedfromamongthelistedstocks,thenthisisasample.
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2.3MeasurementScales
Thedifferenttypesofmeasurementscalesare:
Nominalscales:Thesescalescategorizedatabutdonotrankthem.Hence,theyareoftenconsideredtheweakestlevelofmeasurement.Anexamplewouldbetheclassificationofmutualfundsaccordingtotheinvestmentstrategyfollowed–growthfund,valuefund,incomefund,emergingequityfundetc.
Ordinalscales:Thesescalessortdataintocategoriesthatareorderedwithrespecttosomecharacteristic.AnexampleisStandard&Poor’sstarratingsformutualfunds.Onestarrepresentsthegroupofmutualfundswiththeworstperformance.Similarly,groupswithtwo,three,four,andfivestarsrepresentgroupswithincreasinglybetterperformance.
Intervalscales:Thesescalesnotonlyrankdata,butalsoensurethatthedifferencesbetweenscalevaluesareequal.TheCelsiusandFahrenheitscalesareexamplesofsuchscales.Thedifferenceintemperaturebetween10oCand11oCisthesameamountasthedifferencebetween40oCand41oC.However,thesescalesdonothaveatruezero.Forexample,0oCdoesnotrepresenttheabsenceoftemperature.Itissimplythefreezingpointofwater;itisnotatruezero.
Ratioscales:Thesescaleshaveallthecharacteristicsofintervalscalesaswellasatruezeropointastheorigin.Thisisthestrongestlevelofmeasurement.Therateofreturnonaninvestmentismeasuredonaratioscale.Areturnof0%meanstheabsenceofanyreturn.
3.SummarizingDataUsingFrequencyDistributions
Afrequencydistributionisatabulardisplayofdatasummarizedintoarelativelysmallnumberofintervals.Inordertoconstructafrequencydistribution,wecanfollowthefollowingprocedure:
1. Definetheintervals.2. Tallytheobservationsi.e.assignobservationstointervals.3. Counttheobservationsineachinterval.
Example
Sayyouareevaluating100stockswithpricesrangingfrom46to65thataredividedintothefollowingfourintervalsofstockpriceeachhavingawidthof5:
46‐50,51‐55,56‐60and61‐65.Assumethenumberofstockswhosepricesfallineachoftheseintervalsare25,35,29,and11respectively.
Calculatethecumulativefrequency,relativefrequency,andthecumulativerelativefrequencyforthestockpricesgiventhesetofintervalsabove.
Solution:
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StockPrice AbsoluteFrequency
CumulativeFrequency
RelativeFrequency
CumulativeRelativeFrequency
46‐50 25 25 0.25 0.2551‐55 35 60 0.35 0.6056‐60 29 89 0.29 0.8961‐65 11 100 0.11 1.00
Absolutefrequency:Theactualnumberofobservationsinagivenintervaliscalledtheabsolutefrequency,orsimplythefrequency,whichisgivenhere.
Cumulativefrequency:Foraninterval,itiscalculatedasthesumoftheabsolutefrequenciesofallintervalslowerthanandincludingthatinterval.
Relativefrequency:Itistheabsolutefrequencyofeachintervaldividedbythetotalnumberofobservations.
Cumulativerelativefrequency:Foraninterval,itiscalculatedasthesumoftherelativefrequenciesofallintervalslowerthanandincludingthatinterval.
4.TheGraphicPresentationofData
4.1TheHistogram
Itisabarchartofdatathathasbeengroupedtogetherintoafrequencydistribution.Theheightofeachbarisequaltotheabsolutefrequencyofeachinterval.
Theadvantageofthevisualdisplayisthatwecanquicklyseewheremostoftheobservationslie.
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4.2TheFrequencyPolygonandtheCumulativeFrequencyDistribution
AfrequencypolygonplotsthemidpointsofeachintervalontheX‐axisandtheabsolutefrequencyofthatintervalontheY‐axis.Eachpointisthenconnectedwithastraightline.
Anothergraphicaltoolisthecumulativefrequencydistribution.Suchagraphcanploteitherthecumulativefrequencyorcumulativerelativefrequencyagainsttheupperintervallimit.Thecumulativefrequencydistributionallowsustoseehowmanyorwhatpercentoftheobservationsliebelowacertainvalue.Thefigurebelowisanexampleofacumulativefrequencydistribution.
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5.MeasuresofCentralTendency
5.1TheArithmeticMean
Thearithmeticmeanisthesumoftheobservationsdividedbythenumberofobservations.Itisthemostfrequentlyusedmeasureofthemiddleorcenterofdata.
ThePopulationMean
Thepopulationmeanisthearithmeticmeancomputedforapopulation.Itisexpressedas:
μ∑ XN
where:NisthenumberofobservationsintheentirepopulationandXiistheithobservation
Considerthestockreturnsofacompanyoverthelast10years:2%,5%,4%,7%,8%,8%,12%,10%,8%,and5%.
Forthisdataset,thepopulationmeancanbecomputedas:
μ2 5 4 7 8 8 12 10 8 5
106.9%
TheSampleMeanThesamplemeaniscalculatedlikethepopulationmean,exceptthatweusethesamplevalues.Itisexpressedas:
X∑ Xn
where:nisthenumberofobservationsinthesample.
Ifthesampledatais:8,12,10,8and5,thesamplemeancanbecalculatedas:
X8 12 10 8 5
58.6
5.2TheMedian
Themedianisthemidpointofadatasetthathasbeensortedintoascendingordescendingorder.
Foroddnumberofobservations:2,5,7,11,14Median=7
Forevennumberofobservations:3,9,10,20Median=(9+10)/2=9.5
Ascomparedtoamean,amedianislessaffectedbyextremevalues(outliers).
5.3TheMode
Themodeisthemostfrequentlyoccurringvalueinadistribution.
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Forthefollowingdataset:2,4,5,5,7,8,8,8,10,12Mode=8
Adistributioncanhavemorethanonemode,orevennomode.Whenadistributionhasonemodeitissaidtobeunimodal.Ifadistributionhastwoorthreemodes,itiscalledbimodalortrimodalrespectively.
5.4OtherConceptsofMean
TheWeightedMeanHeredifferentobservationsaregivendifferentproportionalinfluenceonthemean.Theformulafortheweightedmeanis:
X w X
where:thesumoftheweightsequals1;thatis∑ w 1
ExampleConsideraninvestorwithaportfolioofthreestocks.$40isinvestedinA,$60inB,and$100inC.Ifreturnswere5%onA,7%onB,and9%onC,computetheportfolioreturnusingtheweightedmean.
Solution:
40200
x5% 60200
x7% 100200
x9% 7.6%
Anarithmeticmeanisaspecialcaseofaweightedmeanwhereallobservationsareequallyweightedbythefactor1/n.
TheGeometricMeanThemostcommonapplicationofthegeometricmeanistocalculatetheaveragereturnofaninvestment.Theformulais:
R 1 R 1 R … 1 R – 1
ExampleThereturnoverthelastfourperiodsforagivenstockis:10%,8%,‐5%and2%.Calculatethegeometricmean.
Solution:
1 0.10 1 0.08 1– 0.05 1 0.02 – 1 0.0358 3.58%
Giventhereturnsshownabove,$1investedatthestartofperiod1grewto:
$1.00x1.10x1.08x0.95x1.02 $1.151.Iftheinvestmenthadgrownat3.58%everyperiod,$1.00investedatthestartofperiod1wouldhaveincreasedto:
$1.00x1.0358x1.0358x1.0358x1.0358 $1.151.Asexpected,bothscenariosgivethesameanswer.3.58%issimplytheaveragegrowthrateperperiod.
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Instructor’sNoteInthereadingonDiscountedCashFlowApplications,weusedthegeometricmeantocalculatethetime‐weightedrateofreturn.
TheHarmonicMean
Theharmonicmeanisaspecialtypeofweightedmeaninwhichanobservation’sweightisinverselyproportionaltoitsmagnitude.Theformulaforaharmonicmeanis:
Xn
∑
where:Xi>0fori=1,2…n,andnisthenumberofobservations
Theharmonicmeanisusedtofindaveragepurchasepriceforequalperiodicinvestments.
ExampleAninvestorpurchases$1,000ofasecurityeachmonthforthreemonths.Thesharepricesare$10,$15and$20atthethreepurchasedates.Calculatetheaveragepurchasepricepershareforthesecuritypurchased.
Solution:
Theaveragepurchasepriceissimplytheharmonicmeanof$10,$15and$20.
Theharmonicmeanis:
3
$ $ $
$13.85.
Amoreintuitivewayofsolvingthisistotalmoneyspentpurchasingthesharesdividedbythetotalnumberofsharespurchased.
Totalmoneyspentpurchasingtheshares=$1,000x3=$3,000
Totalsharespurchased=sumofsharesboughteachmonth
$1,00010
$1,00015
$1,00020
=100+66.67+50=216.67
Averagepurchasepricepershare$3,000216.67
$13.85
ComparisonofAM,GMandHM Ifthereturnsareconstantovertime:AM=GM=HM. Ifthereturnsarevariable:AM>GM>HM. Thegreaterthevariabilityofreturnsovertime,themorethearithmeticmeanwill
exceedthegeometricmean.
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6.OtherMeasuresofLocation:Quantiles
Aquantileisavalueatorbelowwhichastatedfractionofthedatalies.Someexamplesofquantilesinclude:
Quartiles:Thedistributionisdividedintoquarters. Quintiles:Thedistributionisdividedintofifths. Deciles:Thedistributionisdividedintotenths. Percentile:Thedistributionisdividedintohundredths.
Theformulaforthepositionofapercentileinadatasetwithnobservationssortedinascendingorderis:
Ln 1 y100
where:yisthepercentagepointatwhichwearedividingthedistribution.nisthenumberofobservations.Lyisthelocation(L)ofthepercentile(Py)inanarraysortedinascendingorder.
Someimportantpointstorememberare: Whenthelocation,Ly,isawholenumber,thelocationcorrespondstoanactual
observation. WhenLyisnotawholenumberorinteger,Lyliesbetweenthetwoclosestinteger
numbers(oneaboveandonebelow)andweuselinearinterpolationbetweenthosetwoplacestodeterminePy.
ExampleConsiderthedataset:
47 35 37 32 40 39 36 34 35 3144
1. Findthe75thpercentilepoint2. Findthe1stquartilepoint3. Findthe5thdecilepoint4. Findthe6thdecilepoint.
Solutionto1:Firstarrangethedatainascendingorder:
31,32,34,35,35,36,37,39,40,44,47
Locationofthe75thpercentileisthe:L75=(11+1)(75/100)=9thvalue.i.e.P75=40
Withasmalldataset,suchasthisone,thelocationandthevalueisapproximate.Asthedatasetbecomeslarger,thelocationandpercentilevalueestimatesbecomemoreprecise.
Solutionto2:
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Locationofthe1stquartileisthe:
L25=(11+1)(25/100)=3rdvalue.i.e.P25=34
Solutionto3:Locationofthe5thdecileisthe:
L50=(11+1)(50/100)=6thvalue.i.e.P50=36
Solutionto4:L60=(11+1)(60/100)=7.2
Uselinearinterpolation,whichestimatesanunknownvalueonthebasisoftwoknownvaluesthatsurroundit.
Inthiscase,the7thvalueis37andthe8thvalueis39.The6thdecileis:P60=37+0.4(0.2timesthelineardistancebetween37and39).P60=37.4
7.MeasuresofDispersion
Inthissegmentwelookatmeasuresthattellushowspreadoutordispersedourdatamightbe.
7.1TheRange
Therangeisthedifferencebetweenthemaximumandminimumvaluesinadataset.Itisexpressedas:
Range=Maxvalue–MinValue
Iftheannualreturnsdatais:10%,‐5%,10%,25%.Whatistherange?
Herethemaximumreturnis25%andtheminimumreturnis‐5%.Therangeis25%–(‐5%)=30%.
7.2TheMeanAbsoluteDeviation
Itistheaverageoftheabsolutevaluesofdeviationsfromthemean.Itisexpressedas:
MAD |X X| /n
where:Xisthesamplemeanandnisthenumberofobservationsinthesample.
Example
Considerthefollowingdataset:8,12,10,8and5.Calculatethemeanabsolutedeviation.
Solution:
X=(8+12+10+8+5)/5=8.6
MAD|8 8.6| |12 8.6| |10 8.6| |8 8.6| |5 8.6|
5
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MAD0.6 3.4 1.4 0.6 3.6
51.92
7.3PopulationVarianceandPopulationStandardDeviation
Populationvarianceisthemeanofthesquareddeviationsfromthemean.Thepopulationvarianceiscomputedusingallmembersofapopulation.Itisexpressedas:
σ X μ /N
where:µisthepopulationmeanandNisthesizeofthepopulation
Populationstandarddeviationisdefinedasthepositivesquarerootofthepopulationvariance.
ExampleCalculatethepopulationvarianceandstandarddeviationforthisdataset:2%,5%,4%,7%,8%,8%,12%,10%,8%,and5%.
Solution:σ
. . . . . . . . . .
σ 7.89%
Populationstandarddeviation σ √7.89=2.81%
7.4SampleVarianceandSampleStandardDeviation
Samplevarianceapplieswhenwearedealingwithasubset,orsample,ofthetotalpopulation.Itisexpressedas:
s X X / n 1
where:Xisthesamplemeanandnisthenumberofobservationsinthesample.
Samplestandarddeviationisdefinedasthepositivesquarerootofthesamplevariance.
Example
Calculatethesamplevarianceforthefollowingdataset:8,12,10,8and5.
Solution:
s8 8.6 12 8.6 10 8.6 8 8.6 5 8.6
5 1
s 6.80%
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Thesamplestandarddeviationisthepositivesquarerootofthesamplevariance.Forthesampledatagivenabove, √6.80=2.61%
Usingafinancialcalculatortocalculatevarianceandstandarddeviations
Thepopulationandsamplestandarddeviationcaneasilybecomputedusingafinancialcalculator.Assumethefollowingdataset:10%,‐5%,10%,25%,thecalculatorkeystrokesareshownbelow:
Keystrokes Description Display[2nd][DATA] Entersdataentrymode [2nd][CLRWRK] Clearsdataregister X0110[ENTER] X01=10[↓][↓]5+/‐[ENTER] X02=‐5[↓][↓]10[ENTER] X03=10[↓][↓]25[ENTER] X04=25[2nd][STAT][ENTER] Putscalculatorintostatsmode [2nd][SET] Pressrepeatedlytillyousee 1‐V[↓] Numberofdatapoints N=4[↓] Mean X=10[↓] Samplestandarddeviation Sx=12.25[↓] Populationstandarddeviation σx=10.61
Noticethatthecalculatorgivesboththesampleandthepopulationstandarddeviation.Ontheexamwewillhavetodeterminewhetherwearedealingwithpopulationorsampledataandchoosetheappropriatevalue.
7.5Semivariance,Semideviation,andRelatedConcepts
Instructor’sNote:SemivarianceandsemideviationarenotemphasizedinthelearningoutcomesandhaveaverylowprobabilityofbeingtestedontheLevelIexam.Nevertheless,abriefexplanationisgivenbelow.
Varianceandstandarddeviationofreturnstakeaccountofreturnsaboveandbelowthemean,butofteninvestorsareconcernedonlywithdownsiderisk,forexamplereturnsbelowthemean.Asaresult,analystshavedevelopedsemivariance,semideviationandrelateddispersionmeasuresthatfocusondownsiderisk.Semivarianceisdefinedastheaveragesquareddeviationbelowthemean.Semideviationisthepositivesquarerootofsemivariance.
7.6Chebyshev’sInequality
AccordingtoChebyshev’sinequality,theproportionoftheobservationswithinkstandard
deviationsofthearithmeticmeanisatleast: – forallk>1.
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Tofindoutwhatpercentoftheobservationsmustbewithintwostandarddeviationsofthe
meanwesimplyplugintotheformulaandget: – – ¼ 0.75=75%.Hence,at
least75%ofthedatawillbebetweentwostandarddeviationsofthemean.
Chebyshev’sinequalitycanbeusedtomeasuremaximumamountofdispersion,regardlessoftheshapeofthedistribution.Noticethatherewedonotmakeanyassumptionsaboutwhetherthedistributionisnormalornotnormal.Thisinequalityappliesacrossalldistributions.
7.7CoefficientofVariation
Coefficientofvariationexpresseshowmuchdispersionexistsrelativetothemeanofadistributionandallowsfordirectcomparisonofdispersionacrossdifferentdatasets.Itisusedininvestmentanalysistocomparerelativerisks.Whenevaluatinginvestments,alowervalueisbetter.Coefficientofvariationisexpressedas:
CVsX
where:s=samplestandarddeviationofasetofobservationsandX=samplemean
ExampleInvestmentAhasameanreturnof7%andastandarddeviationof5%.InvestmentBhasameanreturnof12%andastandarddeviationof7%.Calculatethecoefficientsofvariation.
SolutionThecoefficientsofvariationcanbecalculatedasfollows:
CV5%7%
0.71
CV7%12%
0.58
ThismetricshowsthatInvestmentAisriskierthanInvestmentB.
7.8TheSharpeRatio
TheSharperatioistheratioofexcessreturntostandarddeviationofreturnforaportfolio.Excessreturnreferstothereturnabovetherisk‐freerate.Whenevaluatinginvestments,ahighervalueisbetter.TheformulaforcalculatingtheSharperatiois:
S R R
s
where:R =MeanreturntotheportfolioR =Meanreturntoarisk‐freeassets =Standarddeviationofreturnontheportfolio
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Example
Thetablebelowprovidesdatafortwoportfolios.Giventhatthemeanannualriskfreerateis10.5%,whichportfoliohasthehigherSharperatio?Portfolio Arithmeticmeanreturn(%) Varianceof(%)PortfolioA 16.4% 4.9%PortfolioB 12.6% 3.5%
Solution:
PortfolioA:16.4 10.5
√4.92.665
PortfolioB:12.6 10.5
√3.51.122
PortfolioAoffersahigherexcessreturnperunitofriskrelativetoPortfolioB.
8.SymmetryandSkewnessinReturnDistributions
SymmetricaldistributionAdistributionissaidtobesymmetricalwhenthedistributiononeithersideofthemeanisamirrorimageoftheother.
Inanormaldistribution,mean=median=mode.
Ifadistributionisnon‐symmetrical,itissaidtobeskewed.Skewnessisameasureoftheasymmetryoftheprobabilitydistribution.Skewnesscanbenegativeorpositive.
PositivelyskeweddistributionApositivelyskeweddistributionhasalongtailontherightside,whichmeansthattherewillbefrequentsmalllossesandfewlargegains.
Herethemean>median>mode.Theextremevaluesaffectthemeanthemostwhichispulledtotheright.Theyaffectthemodetheleast.
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Negativelyskeweddistribution
Anegativelyskeweddistributionhasalongtailontheleftside,whichmeansthattherewillbefrequentsmallgainsandfewlargelosses.
Herethemean<median<mode.Theextremevaluesaffectthemeanthemostwhichispulledtotheleft.Theyaffectthemodetheleast.
9.KurtosisinReturnDistributions
Kurtosisisameasureofthecombinedweightofthetailsofadistributionrelativetotherestofthedistribution.
Excesskurtosis=kurtosis‐3.Anexcesskurtosiswithanabsolutevaluegreaterthanoneisconsideredsignificant.
Aleptokurticdistributionhasfattertailsthananormaldistribution.Ithasanexcesskurtosisgreaterthan0.
Aplatykurticdistributionhasthinnertailsthananormaldistribution.Ithasanexcesskurtosislessthan0.
Amesokurticdistributionisidenticaltoanormaldistribution.Ithasanexcesskurtosisequalto0.
Thefollowingfigureshowsaleptokurticdistribution.Ascomparedtoanormaldistribution,aleptokurticdistributionismorelikelytogenerateobservationsinthetailregion.Itisalso
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morelikelytogenerateobservationsnearthemean.However,tohavethetotalprobabilitiessumto1,itwillgeneratefewerobservationsintheremainingregions(i.e.regionsbetweenthecentralandthetwotailregions)
10.UsingGeometricandArithmeticMeans
Thegeometricmeanisappropriatetomeasurepastperformanceovermultipleperiods.
ExampleTheportfolioreturnsforthepasttwoyearswere100%inyear1and‐50%inyear2.Whatwasthemeanreturn?
Solution:Pastreturn=geometricmean=(2x0.5)0.5–1=0%
Thearithmeticmeanisappropriateforforecastingsingleperiodreturns.
ExampleTwopossiblereturnsforthenextyearare100%and‐50%.Whatistheexpectedreturn?
Solution:Expectedreturn=Arithmeticmean=(100–50)/2=25%
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Summary
LO.a:Distinguishbetweendescriptivestatisticsandinferentialstatistics,betweenapopulationandasample,andamongthetypesofmeasurementscales.
TheNatureofStatistics Descriptivestatistics:Itreferstohowlargedatasetscanbesummarizedeffectivelyto
describetheirimportantcharacteristics. Inferentialstatistics:Itreferstomakingforecasts,estimates,orjudgmentsabouta
largedatasetbasedonasmallrepresentativeset.
PopulationandSample Population:Itincludesallmembersofaparticulargroup. Sample:Itisasubsetdrawnfromapopulation.
MeasurementScales:Datacanbemeasuredusingthefollowingscales: Nominalscale:Theyputdataincategoriesbutdonotrankthem. Ordinalscale:Nominalscale+datacanberankedwithrespecttosomecharacteristic. Intervalscale:Ordinalscale+thedifferencesinthedatavaluesaremeaningful. Ratioscale:Intervalscale+theratiosofvalue,suchastwiceorhalfasmuchare
meaningful.
LO.b:Defineaparameter,asamplestatistic,andafrequencydistribution.
Parameter:Adescriptivemeasureofapopulationiscalledaparameter.
Samplestatistic:Adescriptivemeasureofasampleiscalledasamplestatistic.
Frequencydistribution:Afrequencydistributionisatabulardisplayofdatacategorizedintoarelativelysmallnumberofintervalsorclasses.Itallowsustoevaluatehowdataisdistributed.
LO.c:Calculateandinterpretrelativefrequenciesandcumulativerelativefrequencies,givenafrequencydistribution.
Relativefrequency:Itiscalculatedastheabsolutefrequencyofanintervaldividedbythetotalnumberofobservations.
Cumulativerelativefrequency:Foraninterval,itiscalculatedasthesumoftherelativefrequenciesofallintervalslowerthanandincludingthatinterval.
LO.d:Describethepropertiesofadatasetpresentedasahistogramorafrequencypolygon.
Histogramisabarchartofdatathathasbeengroupedtogetherintoafrequencydistribution.Theheightofeachbarisequaltotheabsolutefrequencyofeachinterval.
AfrequencypolygonplotsthemidpointsofeachintervalontheX‐axisandtheabsolutefrequencyofthatintervalontheY‐axis.Eachpointisthenconnectedwithastraightline.
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LO.e:Calculateandinterpretmeasuresofcentraltendency,includingthepopulationmean,samplemean,arithmeticmean,weightedaverageormean,geometricmean,harmonicmean,median,andmode.
Arithmeticmeanissimplythesumofalltheobservationsdividedbythetotalnumberofobservations.
Medianisthemidpointofadatasetthathasbeensortedfromlargesttosmallestorvise‐versa.
Modeisthevaluethatoccursmostfrequentlyinadataset.
Thegeometricmeanisusedtocalculatecompoundgrowthrate.Itiscomputedas:
R 1 R 1 R …… . 1 R / 1
Inaweightedmean,differentobservationsaregivendifferentweightsaspertheirproportionalinfluenceonthemean.Itiscomputedas:
X w X
Harmonicmeanisusedtofindaveragepurchasepriceforequalperiodicinvestments.Itiscomputedas:
X n/1X
LO.f:Calculateandinterpretquartiles,quintiles,deciles,andpercentiles.
Aquantileisavalueatorbelowwhichastatedfractionofthedatalies.Someexamplesofquantilesinclude:
Quartiles:Thedistributionisdividedintoquarters. Quintiles:Thedistributionisdividedintofifths. Deciles:Thedistributionisdividedintotenths. Percentile:Thedistributionisdividedintohundredths.
Theformulaforthepositionofapercentileinadatasetwithnobservationssortedinascendingorderis:
Ly=(n+1)y/100
LO.g:Calculateandinterpret1)arangeandameanabsolutedeviationand2)thevarianceandstandarddeviationofapopulationandofasample.
Rangeisthedifferencebetweenthemaximumandminimumvaluesinadataset.Itiscalculatedas:
Range=Maximumvalue–Minimumvalue
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Meanabsolutedeviation(MAD)istheaverageoftheabsolutevaluesofdeviationsfromthemean.Itisexpressedas:
MAD |X X| /n
Varianceisdefinedasthemeanofthesquareddeviationsfromthearithmeticmean.Itiscalculatedas:
PopulationVarianceσ ∑ X μ /N
SampleVariances ∑ X X / n 1
Standarddeviationisthepositivesquarerootofthevariance.Itisoftenusedasameasureofrisk.
LO.h:CalculateandinterprettheproportionofobservationsfallingwithinaspecifiednumberofstandarddeviationsofthemeanusingChebyshev’sinequality.
AccordingtoChebyshev’sinequality,theproportionoftheobservationswithinkstandarddeviationsofthearithmeticmeanisatleast1‐1/k2forallk>1.
LO.i:CalculateandinterpretthecoefficientofvariationandtheSharperatio.
Coefficientofvariationmeasurestheriskperunitofreturn.Whenevaluatinginvestments,alowervalueisbetter.Itisexpressedas:
CVsX
Sharperatiomeasuresexcessreturnperunitofrisk.Whenevaluatinginvestments,ahighervalueisbetter.Itisexpressedas:
S R R
s
LO.j:Explainskewnessandthemeaningofapositivelyornegativelyskewedreturndistribution.
Skewdescribesthedegreetowhichadistributionisnotsymmetricaboutitsmean.Areturndistributionwithpositiveskewnesshasfrequentsmalllossesandafewextremegains.Areturndistributionwithnegativeskewnesshasfrequentsmallgainsandafewextremelosses.Zeroskewnessindicatesasymmetricdistributionofreturns.
LO.k:Describetherelativelocationsofthemean,median,andmodeforaunimodal,nonsymmetricaldistribution.
Forthepositivelyskewedunimodaldistribution,themodeislessthanthemedian,whichislessthanthemean.Forthenegativelyskewedunimodaldistribution,themeanislessthanthemedian,whichislessthanthemode.
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LO.l:Explainmeasuresofsampleskewnessandkurtosis.
Kurtosisisameasureofthecombinedweightofthetailsofadistributionrelativetotherestofthedistribution.
Excesskurtosis=kurtosis‐3.Anexcesskurtosiswithanabsolutevaluegreaterthanoneisconsideredsignificant.
Aleptokurticdistributionhasfattertailsthananormaldistribution. Aplatykurticdistributionhasthinnertailsthananormaldistribution. Amesokurticdistributionisidenticaltoanormaldistribution.
LO.m:Comparetheuseofarithmeticandgeometricmeanswhenanalyzinginvestmentreturns.
Toestimatetheaveragereturnsovermorethanoneperiod(timeseriesdata),youshouldusethegeometricmeanbecauseitcaptureshowthetotalreturnsarelinkedovertime.Ifyouwanttoestimatetheaveragereturnofmultipleinvestmentsoveraone‐periodhorizon(cross‐sectionaldata),youshouldusethearithmeticmean.
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PracticeQuestions
1. Ananalystratesstocksasunderweight,marketweight,oroverweight,referringtothesuggestedweightingofthestockinaportfolio.Themeasurementscaleusedbytheanalystcanbestbedescribedas:A. nominalscale.B. ordinalscale.C. intervalscale.
2. Aparameterdescribesthecharacteristicofa:
A. population.B. sample.C. populationandasample.
3. Forthefollowingfrequencydistribution,thenumberofintervals,thesamplesize,andthe
relativefrequencyofthethirdintervalareclosestto:
Returns Frequency‐10%upto0% 40%upto10% 1310%upto20% 520%upto30% 3
A. 4,25,20%.B. 1,20,10%.C. 3,30,15%.
4. Thefollowingtenobservationsareasampledrawnfromanormalpopulation:20,15,12,
6,4,‐11,19,14,‐3,and19.Thearithmeticmeanofthesampleisclosestto:A. 8.6.B. 9.5.C. 10.2.
5. Aportfolio has the following annual returns: 6%, 10%, ‐5%, 0%. The geometricmean
acrossthefour‐yearperiodisclosestto:A. 2.37%.B. 2.48%.C. 2.59%.
6. Considerthefollowingsetofnumbers:
‐20 ‐11 ‐3 0 13 5 6 9 10
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12 18 21 23 2528 39 40 54 60
Themedianvalueoftheaboveitemsisclosestto:A. 10.B. 11.C. 12.
7. Considerthefollowingsetofnumbers:
20 24 21 35 20 2424 22 20 26 28 2219 21 20 21 22 28
Themodeofthesampleisclosetto:A. 20.B. 21.C. 22.
8. Followingdataisprovidedonreturnsofaseriesoffunds:
Fund Returns(%)Fund1 6.15%Fund2 7.25%Fund3 8.95%Fund4 9.65%Fund5 10.35%Fund6 11.10%Fund7 12.35%Fund8 13.55%Fund9 14.05%Fund10 15.75%Fund11 16.95%Fund12 17.25%Fund13 18.30%
Thevalueofthesecondquintileisclosestto:A. 10.35%B. 10.80%.C. 11.30%.
9. Theannualreturnsofaportfolioaregivenbelow:
Year Portfolioreturn
Year1 6.5%
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Year2 8.2%
Year3 10.5%Year4 ‐5.4%
Year5 7.7%
Theportfolio’srangeandmeanabsolutedeviationforthefive‐yearperiodareclosestto:A. 15.90%and5.10%.B. 5.10%and4.36%.C. 15.90%and4.36%.
10. Thefollowingobservationsaredrawnfromanapproximatelynormalpopulation:
Observation 1 2 3 4 5Value 11 8 ‐6 4 ‐5
Thesamplestandarddeviationisclosestto:A. 6.83and46.65.B. 7.64and58.37.C. 7.64and2.76.
11. Asampleof240observationsisrandomlyselectedfromapopulation.Themeanofthe
sample is 120 and the standard deviation is 8. Based on Chebyshev’s inequality, theendpointsoftheintervalthatmustcontainatleast75%oftheobservationsareclosestto:A. 96and144.B. 112and128.C. 104and136.
12. GeorgeBaker, an equity fundmanagerhas the following information about a common
stockportfolio:
Arithmeticmeanreturn 11.8%Geometricmeanreturn 10.6%Portfoliobeta 1.2Risk‐freerateofreturn 4.25%Varianceofreturns 196
Fromthegiveninformation,thecoefficientofvariationisclosestto:A. 1.32.B. 1.24.C. 1.18.
13. Followinginformationaboutthreeportfoliosisgiven:
Portfolio Meanreturnonportfolio(%)
Standarddeviationofthereturns(%)
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A 15 28B 12 19C 10 7
Iftherisk‐freerateis4%,whichportfoliohasthehighestSharperatio?A. A.B. B.C. C.
14. Whichofthefollowingismostlikelytobetrueforapositivelyskeweddistribution?
A. Mode>Median>Mean.B. Median>Mode>Mean.C. Mean>Median>Mode.
15. Adistributionlesspeakedthanthenormaldistributionisbestdescribedasbeing:
A. platykurtic.B. mesokurtic.C. leptokurtic.
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Solutions
1. Biscorrect.Thisisanordinalscale.Theratingofunderweight,marketweightor
overweightorderstheratedsecuritiesintermsoflevelsofexpectedperformance.2. Aiscorrect.Aparameterdescribesthecharacteristicofapopulation,whileasample
statisticdescribesthecharacteristicofasample.3. Aiscorrect.Anintervalisthesetofreturnvaluesthatanobservationfallswithin.There
arefourintervals.Thesamplesizeisthesumofallofthefrequenciesinthedistribution:4+13+5+3=25.Therelativefrequencyisfoundbydividingthefrequencyoftheintervalbythetotalnumberoffrequencies:5/25=20%.
4. Biscorrect.Thesumofthetennumbersis95.Dividingby10givesthemeanof9.5.5. Ciscorrect.Thegeometricmeanreturniscalculatedas[(1+0.06)×(1+0.1)×(1‐0.05)
×(1+0.00)]1/4–1=0.0259≈2.59%.6. Biscorrect.Themedianisthevalueofthemiddleitemofasetofitems.Thetotalnumber
ofitemsare20,hencethemedianisthevaluebetween10thand11thobservation.Thevalueofthe10thitemis10;thevalueofthe11thitemis12.Theaverageof10and12is11.
7. Aiscorrect.Themodeisthemostfrequentvalueinthesetofitemsandthusisequalto
20.8. Biscorrect.Quintilesdividedataintofiveparts.Hencethefirstquintilecorrespondsto
the20thpercentileandthesecondquintilecorrespondstothe40thpercentile.Thelocationcanbedeterminedusing:Ly=(n+1)×(y/100)L40=(13+1)×(40/100)=5.6.Thevaluecorrespondingtolocation5(Fund5)is10.35%.Thevaluecorrespondingtolocation6(Fund6)is11.10%.Theapproximatevaluecorrespondingtolocation5.6canbeestimatedusinglinearinterpolation:10.35%+(0.6×(11.10%–10.35%))=10.80%
9. Ciscorrect.Range=Highestvalue–Lowestvalue=10.5%‐(‐5.4%)=15.9%
TocalculateMAD,firstcomputethemean:(6.5+8.2+10.5–5.4+7.7)/5=5.5%andcomputeMAD,(|6.5–5.5|+|8.2–5.5|+|10.5–5.5|+|–5.4–5.5|+|7.7–5.5|)/5=4.36%.
10. Biscorrect.Thesamplestandarddeviationcanbefoundas:
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Keystrokes Explanation Display
[2nd][DATA] Enterdataentrymode
[2nd][CLRWRK] Cleardataregisters X01
11[ENTER] X01=11
[↓][↓]8[ENTER] X02=8
[↓][↓]6+/‐[ENTER] X03=‐6
[↓][↓]4[ENTER] X04=4
[↓][↓]5+/‐[ENTER] X05=‐5
[2nd][STAT] Putscalculatorintostats
[2nd][SET] Pressrepeatedlytill 1‐V
[↓] Numberofdatapoints N=5
[↓] Mean X=2.4
[↓] Samplestandard Sx=7.64
[↓] Populationstandard σx=6.83
Thesamplevarianceissimplythesquareofsamplestandarddeviation:7.642=58.37.11. Ciscorrect.AccordingtoChebyshev’sinequality,theproportionoftheobservations
withinkstandarddeviationsofthearithmeticmeanisatleast1–1/k2forallk>1.Fork=2,thatproportionis1–1/22,whichis75%.Thelowerendpointis,therefore,themean(120)minus2times8(thestandarddeviation)andtheupperendpointis120plus2times8.120–(2x8)=104;120+2(8)=136.
12. Ciscorrect.Thecoefficientofvariationis:Standarddeviationofreturn/Meanreturn=
sqrt(196)/11.8=1.1813. Ciscorrect.TheSharperatioisdefinedasSp=( p‐ F)/ p
SA=(15–4)/28=0.3928SB=(12–4)/19=0.4210SC=(10–4)/7=0.8571
SharpeRatio i.e.excessreturnsperunitofrisk.Ahighernumberispreferred.
14. Ciscorrect.Forapositivelyskeweddistribution,themeanisgreaterthanthemedian,
whichisgreaterthanthemode.
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15. Aiscorrect.Platykurticdescribesadistributionthatislesspeakedthananormal
distribution.Leptokurticdescribesadistributionthatismorepeakedthanthenormaldistribution.Mesokurticisadistributionaspeakedasthenormaldistribution.
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R09 Probability Concepts 2019 Level I Notes
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R09ProbabilityConcepts
1.Introduction
Sincemanyinvestmentdecisionsaremadeinanenvironmentofuncertainty,itisessentialforportfoliomanagersandinvestmentmanagerstohaveafundamentalgraspofprobabilityconcepts.Inthisreading,wewillfocuson:
• Definitionsandrulesrelatedtoprobability.• Expectedvalueandvariance.• Covarianceandcorrelation.
2.Probability,ExpectedValue,andVariance
FundamentalConcepts
Arandomvariableisanuncertainquantity/number.Forexample,whenyourolladie,theresultisarandomvariable.
Anoutcomeistheobservedvalueofarandomvariable.Forexample,ifyourolla2,itisanoutcome.
Aneventcanbeasingleoutcomeorasetofoutcomes.Forexample,youcandefineaneventasrollinga2orrollinganevennumber.
Mutuallyexclusiveeventsareeventsthatcannothappenatthesametime.Forexample,rollinga2androllinga3areexamplesofmutuallyexclusiveevents.Theycannothappenatthesametime.
Exhaustiveeventsarethosethatcoverallpossibleoutcomes.Forexample,‘rollinganevennumber’or’rollinganoddnumber’areexhaustiveevents.Theycoverallpossibleoutcomes.
Thetwodefiningpropertiesofprobabilityare:• Theprobabilityofanyeventhastobebetween0and1.• Thesumoftheprobabilitiesofmutuallyexclusiveandexhaustiveeventsisequalto
1.WaysofEstimatingProbability
Themethodsofestimatingprobabilitiesare:• Empiricalprobability:Basedonanalyzingthefrequencyofanevent’soccurrencein
thepast.• Aprioriprobability:Basedonformalreasoningandinspectionratherthan
personaljudgment.• Subjectiveprobability:Informedguessbasedonpersonaljudgment.
Empiricalandaprioriprobabilitiesareoftengroupedasobjectiveprobabilitiesbecausetheydonotvaryfrompersontoperson.
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ProbabilityStatedasOdds
Oddsforaneventaredefinedastheprobabilityoftheeventoccurringtotheprobabilityoftheeventnotoccurring.OddsforE=P(E)/[1–P(E)].
GivenoddsforEof“atob”,theimpliedprobabilityofEisa/(a+b).
Example
Iftheprobabilityofaneventis0.2,whataretheoddsofitoccurring?Alternatively,iftheoddsare1to4,whatistheprobabilityofthisevent?
Solution:
Theoddsoftheeventoccurringare= ..=1/4.Thisisstatedasoddsof1to4.
Giventheodds,theprobabilityoftheeventoccurringis
=0.20.
Oddsagainstaneventaredefinedastheprobabilityoftheeventnotoccurringtotheprobabilityoftheeventoccurring.OddsagainstE=[1–P(E)]/P(E).
GiveoddsagainstEof“atob”,theimpliedprobabilityofEisb/(a+b).
Example
IfP(E)=0.2,whataretheoddsagainsttheeventoccurring?Iftheoddsagainstaneventare4to1,whatistheprobabilityoftheevent?
Solution:
P(E)= ..= .HencetheoddsagainstEare4to1.
Giventheoddsagainstanevent,theprobabilityoftheeventis =0.2
Conditionalv/sUnconditionalprobabilities
Unconditionalprobabilityistheprobabilityofaneventoccurringirrespectiveoftheoccurrenceofotherevents.ItisdenotedasP(A).Unconditionalprobabilityisalsocalled‘marginal’probability.
Conditionalprobabilityistheprobabilityofaneventoccurringgiventhatanothereventhasoccurred.ItisdenotedasP(A|B),whichistheprobabilityofeventAgiventhateventBhasoccurred.
JointProbabilityandMultiplicationRule
Multiplicationruleisusedtodeterminethejointprobabilityoftwoevents.Itisexpressedas:
P(AB)=P(A|B)P(B)
Rearrangingtheequationwegettheformulaforcomputingconditionalprobabilities:
P(A|B)=P(AB)/P(B)
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Example
P(interestrateswilldecrease)=P(D)=40%P(stockpriceincreases)=P(S)P(stockpricewillincreasegiveninterestratesdecrease)=P(S|D)=70%
Computeprobabilityofastockpriceincreaseandaninterestratedecrease.
Solution:
P(SD)=P(S|D)xP(D)=0.7x0.4=0.28=28%
AdditionRuleforProbabilities
Additionruleisusedtodeterminetheprobabilitythatatleastoneoftheeventswilloccur.Itisexpressedas:
P(AorB)=P(A)+P(B)–P(AB)
Example
P(priceofAincreases)=P(A)=0.5P(priceofBincreases)=P(B)=0.7P(priceofAandBincreases)=P(AB)=0.3
ComputetheprobabilitythatthepriceofstockAorthepriceofstockBincreases.
Solution
P(AorB)=0.5+0.7–0.3=0.9
IndependentandDependentEvents
Iftheoccurrenceofoneeventdoesnotinfluencetheoccurrenceoftheotherevent,thenthetwoeventsarecalledindependentevents.
i.e.P(A|B)=P(A)orP(B|A)=P(B)
Multiplicationruleforindependentevents:P(AB)=P(A)P(B)
Additionruleforindependentevents:P(AorB)=P(A)+P(B)–P(AB).(Theadditionruledoesnotchange.)
Iftheprobabilityofaneventisaffectedbytheoccurrenceofanothereventthenitiscalledadependentevent.
TotalProbabilityRule
Thetotalprobabilityruleisusedtocalculatetheunconditionalprobabilityofanevent,givenconditionalprobabilities.
Ininvestmentanalysis,weoftenformulateasetofmutuallyexclusiveandexhaustivescenariosandthenestimatetheprobabilityofaparticularevent.Forexample,let’ssaythatwehavetwoscenariosSandnon‐Sthataremutuallyexclusiveandexhaustive.
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Accordingtothetotalprobabilityrule,theprobabilityofanyeventP(A)canbeexpressedas:
P(A)=P(AS)+P(ASC)
Usingthemultiplicationruleweget,
P(A)=P(A|S)P(S)+P(A|SC)P(SC)
Ifwehavemorethantwoscenarios,wecangeneralizethisequationto:
P(A)=P(AS1)+P(AS2)+…+P(ASn)=P(A|S1)P(S1)+P(A|S2)P(S2)+…+P(A|Sn)P(Sn)
ExpectedValueofaRandomVariable
Theexpectedvalueofarandomvariablecanbedefinedastheprobability‐weightedaverageofthepossibleoutcomesoftherandomvariable.ForarandomvariableX,theexpectedvalueofXisdenotedasE(X)andiscalculatedas:
E X P X X
where:Xi=OneofnpossibleoutcomesoftherandomvariableXP(Xi)=ProbabilityofXi
VarianceofaRandomVariable
Theexpectedvalueisourforecast,butwecannotcountontheindividualforecastbeingrealized.Thisiswhyweneedtomeasuretheriskweface.Varianceandstandarddeviationareexamplesofhowwecanmeasurethisrisk.Thevarianceofarandomvariableistheprobability‐weightedsumofthesquareddifferencesbetweeneachpossibleoutcomeandtheexpectedvalueoftherandomvariable.Itisexpressedas:
σ X P X X E X
Varianceisanumbergreaterthanorequalto0becauseitisthesumofsquaredterms.Ifvarianceis0,thereisnodispersionorrisk.TheoutcomeiscertainandthequantityXisnotrandomatall.Standarddeviationisthepositivesquarerootofvariance.
Wecancalculatetheexpectedvalueandvarianceofarandomvariableusingafinancialcalculatorasshownbelow:
Example
Aproject’scashflowfortheupcomingyeardependsonthestateoftheeconomy,asshowninthetablebelow.Whatisthevarianceofthecashflow?Whatisthestandarddeviation?
StateofEconomy Probability CashFlow
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Good 0.3 50
Average 0.5 40
Weak 0.2 20Solution:
Usingafinancialcalculator:
Keystrokes Explanation Display
[2nd][DATA] Entersdataentrymode
[2nd][CLRWRK] Clearsdataregister X01
50[ENTER] 1stpossiblevalueofrandomvariable X01=50
[↓]30[ENTER] Probabilityof30%forX01 Y01=30
[↓]40[ENTER] 2ndpossiblevalueofrandomvariable X02=40
[↓]50[ENTER] Probabilityof50%forX02 Y02=50
[↓]20[ENTER] 3rdpossiblevalueofrandomvariable X03=20
[↓]20[ENTER] Probabilityof20%forX03 Y03=20
[2nd][STAT] Putscalculatorintostatsmode
[2nd][SET] Pressrepeatedlytillyousee 1‐V
[↓] Totalnumberofentries N=100
[↓] Expectedvalueofrandomvariable X=39
[↓] Samplestandarddeviation Sx=10.49
[↓] Populationstandarddeviation σx=10.44
Wecanthensquarethepopulationstandarddeviationof10.44togetthevariancei.e.10.442=109.00
TotalProbabilityRuleforExpectedValue
Justlikethetotalprobabilityrulestatesunconditionalprobabilitiesintermsofconditionalprobabilities,thetotalprobabilityruleforexpectedvaluesstatesunconditionalexpectedvaluesintermsofconditionalexpectedvalues.
E(X|S)=P(X1|S)X1+P(X2|S)X2+…+P(Xn|S)Xn
Instructor’sNoteNoticethatthisformulaisexactlysimilartothetotalprobabilityruleformula.
P(A)=P(A|S1)P(S1)+P(A|S2)P(S2)+…+P(A|Sn)P(Sn)
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Example
What is the expectedpriceof a stockat theendof the currentperiodgiven the followinginformation:probabilitythatinterestrateswilldecline=0.4.Ifinterestratesdeclinethereisa75%chancethatstockpricewillbe$100versusa25%chancethatthestockpricewillbe$90. If interestratesdonotdecline there isa50%chance that thestockpricewillbe$80versusa50%chancethatstockpricewillbe$70.
Solution:
Wecanplottheprobabilitiesusingatreediagram.
Considerthefirstnode(topright).Itreferstotheprobabilitythatthestockpricewillbe$100given a decline in interest rates. We can calculate the probability of that happening bymultiplyingtheprobabilityofadeclineininterestrates(0.4)bytheprobabilityofthestockpricebeing$100ifthathappens(0.75).Thisgivesusaconditionalprobabilityof0.30.Inshort,it is the joint probability of the stock price being $100 given a decline in interest rates.Similarly,probabilitiesarecalculatedforeachoftheotherthreenodes.Wecanthencalculate:
E(Price│declineininterestrates)=0.75($100)+0.25($90)=$97.50
E(Price│nodeclineininterestrates)=0.50($80)+0.50($70)=$75.00
Nowweusethetotalprobabilityruleforexpectedvalueofstockpriceattheendofthecurrentperiod:
E(Price)=E(Price│declineininterestrates)P(declineininterestrates)+E(Price│nodeclineininterestrates)P(nodeclineininterestrates)
E(Price)=$97.50(0.40)+$75.00(0.60)E(Price)=$84.00
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3.PortfolioExpectedReturnandVarianceofReturn
ExpectedReturn
Aportfolio’sexpectedreturncanbecalculatedas:
E R w E R w E R … w E R
where:wn=portfolioweightofnthsecurityintheportfolioRn=expectedreturnofnthsecurityintheportfolion=numberofsecuritiesintheportfolio
Wewilldiscussportfolioexpectedreturnandvarianceofreturnusingatwo‐stockportfolio.
Example
40%oftheportfolioisinvestedinStockAand60%isinvestedinStockB.Asshowninthetablebelow,theexpectedreturnofeachstockdependsontheeconomicscenario.
Scenario P(Scenario) ExpectedreturnsofA ExpectedreturnsofB
Recession 0.25 2% 4%
Normal 0.50 8% 10%
Boom 0.25 12% 16%ThisinformationcanalsobepresentedasajointprobabilityfunctionofA’sandB’sreturns: RB=4% RB=10% RB=16%RA=2% 0.25 0 0RA=8% 0 0.50 0RA=12% 0 0 0.25
Row1andColumn1representthereturnsofAandBrespectively.Theothercellscontainprobabilities.CalculatetheexpectedreturnofAandB.
Solution:
Giventhedatapresentedabove:
TheexpectedreturnofAis:0.25x2+0.50x8+0.25x12=7.5%.
TheexpectedreturnofBis:0.25x4+0.50x10+0.25x16=10%.
Expectedreturnoftheportfolio=weightofAintheportfolioxexpectedreturnofA+weightofstockBintheportfolioxexpectedreturnofB=0.4x7.5+0.6x10=9%
Theexpectedportfolioreturnis9%.Asthetermimplies,thisistheexpectedreturn.Theactualreturnwillvaryaround9%.Theamountofvariabilityismeasuredbythevariance.Inordertodeterminethevarianceofreturn,wemustfirstcalculatethecovariance.
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Covariance
Covariancetellsushowmovementsinarandomvariablevarywithmovementsinanotherrandomvariable,whereasvariancetellsushowarandomvariablevarieswithitself.AssumetherearetworandomvariablesRiandRj.ThecovariancebetweenRiandRj(usedtomeasurehowtheymovetogether)isgivenby:
Cov R , R E R –ER R –ER
where:ERi=expectedreturnforvariableRiERj=expectedreturnforvariableRj
Example
Continuingwithourpreviousexample,calculatethecovarianceofreturnsbetweenAandB.
Solution:
SayRirepresentsthereturnonAandRjrepresentsthereturnonB,wehavealreadycalculatedtheexpectedreturnsofAandBas7.5%and10%respectively.Thecovarianceofreturnsis:
E Ri– 7.5 Rj– 10
=0.25(2%‐7.5%)(4%‐10%)+0.5(8%‐7.5%)(10%‐10%)+0.25(12%‐7.5%)(16%‐10%)
=0.000825+0+0.000675=0.0015
Correlation
Theproblemwithcovarianceisthatitcanvaryfromnegativeinfinitytopositiveinfinitywhichmakes it difficult to interpret. To address this problem, we use another measure calledcorrelation. Correlation is a standardizedmeasure of the linear relationship between twovariableswithvaluesrangingbetween‐1and+1.
Acorrelationof0(uncorrelatedvariables)indicatesanabsenceofanylinear(straight‐line)relationshipbetweenthevariables.
Acorrelationof+1indicatesaperfectpositiverelationship. Acorrelationof‐1indicatesaperfectnegativerelationship.
Itiscomputedas:
ρ R , R Cov R , R /σ R σ R
WewillnowapplythisformulatocalculatethecorrelationbetweenthereturnsofAandBfromourexample.Wehavealreadyshownthatthecovarianceofreturnsis0.0015.Inorderto calculate the correlation,we need the standard deviation of A and B. Using a financialcalculator,we can determine that the standard deviation of A is 0.0357 and the standard
deviationofBis0.0424.Thecorrelation,ρ A, B , =0.0015/ 0.0357x0.0424 =0.99.
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Thecorrelationof0.99 (almost1) impliesaverystrongpositive relationshipbetween thereturnsofAandB.Thisismoremeaningfulthanthecovariancenumberof0.0015whichtellsusthatthereisapositiverelationshipbetweenthereturnsofAandBbutdoesnotgiveasenseforthestrengthoftherelationship.
Definitionof Independence forRandomVariables. Two random variables X and Y areindependentifandonlyifP(X,Y)=P(X)P(Y).
For example, given independence, P(5,6) = P(5)P(6). Joint probabilities are obtained bymultiplying the individual probabilities. Independence is a stronger property thanuncorrelatednessbecausecorrelationaddressesonlylinearrelationships.
Thefollowingconditionholdsforindependentrandomvariablesand,therefore,alsoholdsforuncorrelatedrandomvariables.
Multiplication Rule for Expected Value of the Product of Uncorrelated RandomVariables.Theexpectedvalueoftheproductofuncorrelatedrandomvariablesistheproductoftheirexpectedvalues.
E(XY)=E(X)E(Y)ifXandYareuncorrelated.
Manyfinancialvariables,suchasrevenue(pricetimesquantity),aretheproductofrandomquantities.
Varianceofreturns
Onceweknowthecovariance,wecancalculatethevarianceofaportfoliousingthisformula:
σ R w σ R w σ R 2w w Cov R R
Example
Continuingwithourexample,thevarianceoftheportfoliois Weightofthefirstasset,w1=0.40 Weightofthesecondasset,w2=0.60 Standarddeviationoffirstasset=0.0357 Standarddeviationofsecondasset=0.0424 Covariancebetweenthetwoassets=0.0015
Varianceoftheportfolio=0.42x0.03572+0.62x0.04242+2x0.4x0.6x0.0015=0.00157
Standarddeviationoftheportfolio=√0.00157 0.0396
4.TopicsinProbability
4.1.Bayes’Formula
Bayes’formulaisarationalmethodforupdatingoradjustingtheprobabilityofaneventbasedonnewinformation.AccordingtoBayes’formula,theupdatedprobabilityofaneventgivennewinformationis:
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P(Event│Information)=P(Information│Event)
P(Information) P(Event)
Example
Considerafactorythathasthreeassemblylines.Thepercentageofoutputproducedateachassemblylineisasfollows:LineA=45%,LineB=35%,LineC=20%.Theoutputdefectivefromeach line is estimated tobe3%,5%, and4%, respectively.Given that theproduct isdefective,whatistheprobabilitythatitcamefromLineC?
Solution:
WhendealingwithquestionsrelatedtoBayes’formula,thefirststepistoreproducetheinformationinprobabilitynotation:
P(LineA)=0.45;P(NotLineA)=0.55
P(LineB)=0.35;P(NotLineB)=0.65
P(LineC)=0.20;P(NotLineC)=0.80
P(Defective|LineA)=0.03,P(Defective|LineB)=0.05,P(Defective|LineC)=0.04
P(Defective)=0.45x0.03+0.35x0.05+0.20x0.04=0.039
NextwritedowntheBayesformula:
P(Event│Information)=P(Information│Event)
P(Information)xP(Event)
Wethenhavetodistinguishbetweentheeventandtheinformationandplugtherelevantvaluesintotheformula.Inthiscase,theinformationisthattheproductisdefective.Hence,theformulacanbewrittenas:
P LineC|Defective | ∗
. ∗ .
.=20.51%
4.2.PrinciplesofCounting
Incounting,enumeration(countingtheoutcomesonebyone)isthemostbasicresource.Thisprocessisdifficultandispronetoerror.Wewilldiscussshortcutsandprinciplesofcounting,whichmaketheprocesseasier.
MultiplicationRuleofCounting
Thefirstoftheseprinciplesisthemultiplicationrule.Itstatesthat‘ifonetaskcanbedoneinn1ways,andasecondtask,giventhefirst,canbedoneinn2ways,andathirdtask,giventhefirsttwotasks,canbedoneinn3waysandsoonforktasks,thenthenumberofwaysthektaskscanbedoneis(n1)(n2)(n3)…(nk).Sothemultiplicationruleforcountingcanbeexpressedas:
Numberofwaysofdoingktasks=n xn xn …n
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where:n =numberofwaysofdoingthefirsttask,n =numberofwaysofdoingthesecondtaskandsoon
Example
Considerasimpleexample.Supposewehavethreestepsinaninvestmentdecisionprocess.Thefirststepcanbedonein2ways,thesecondstepcanbedonein4waysandthethirdin3ways.Inhowmanywayscantheinvestmentdecisionbemade?
Solution:
Followingthemultiplicationrule,thereare(2)(4)(3)=24waysofmakingtheinvestmentdecision.
Noticethattherearethreegroupingsinthisproblem.Fromeachgroup,onlyonestepcanbeselected.
Factorial
Another counting principle relates to the assignment of members of a group to an equalnumberofpositions.Thenumberofwayswecanassigneverymemberofagroupofsizentonslots isn!(readasnfactorial)=n(n‐1)(n‐2)(n‐3)…1.Byconvention,0!=1.Thedifferencebetweenthemultiplicationruleandfactorial isthatthereisonlyonegroupinafactorial.Itinvolvesarrangingthesetofitemswithinthegroupandtheorderinwhichtheitemsarearrangedmatters.Theformulais:
Numberofwaysofassigninggroupofsizentontasks=n!
Example
Therearefiveequityanalystscoveringfiveemergingcountries.Inhowmanywayscanthecountriesbeassignedtotheanalysts?
Solution:
Thetotalnumberofwaystheassignmentscanbemade=5!=120
Labeling
Labelingreferstothenumberofwaysthatnitemscanbelabelledwithkdifferentlabelswithn,ofthefirsttype,nofthesecondtype,andsoon.Thiscanbeexpressedas:
Numberofwaysinwhichnitemscanbelabelledusingklabels=n!
n ! n ! … n !
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Example
Aportfolioconsistsofeightstocks.Thegoalistodesignatefourofthestocksas"long‐termholds,"threeofthestocksas"short‐termholds,"andonestocka"sell."Howmanywayscantheselabelsbeassignedtotheeightstocks?
Solution:
Noticethatthereareeightitems(stocks)thataretobelabelledinthreedifferentways.8!
4! 3! 1!280
Combination
Aspecialcaseofthelabellingisthecombinationformula.Itisthenumberofwaystochooserobjects froma totalofnobjects,whentheorder inwhich therobjectsare listeddoesnotmatter.Thiscanbeexpressedas:
C n!/ n r ! r!
where:n=numberofobjectsr=numberofobjectschosenfromnobjects
C =numberofwaystochooserobjectsfromnobjectswhereorderdoesnotmatter
Example
Aportfoliomanagerwantstoeliminatefourstocksfromaportfoliothatconsistsofsixstocks.HowmanywayscanthefourstocksbesoldwhentheorderofthesaleisNOTimportant?
Solution:
Usingtheformulaforcombination,wegetthenumberofwaysthefourstockscanbesold
=6!/[(6–4)!4!]=15.
Permutation
Permutationisthenumberofwaystochooserobjectsfromatotalofnobjects,whentheorderinwhichtherobjectsarelisteddoesmatter.Itisexpressedas:
P n!
n r !
where:n=numberofobjectsr=numberofobjectschosenfromnobjects
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Instructor’sNote:givenaproblem,usethefollowingpointerstoidentifythecorrectcountingmethodtoapply. Factorial:ifthereisonegroupofsizenandnitems/taskstobeassigned,numberofways
=n! Labeling:usedwhentherearethreeormorelabels.Eachitem/memberofagroupmust
beappliedalabel. Combination: used when there are two groups of a certain size, say n and r. Use
combinationwhentheorderofchoosingrobjectsfromnobjectsdoesNOTmatter. Permutation: used when there are two groups of a certain size, say n and r. Use
permutationwhentheorderofchoosingrobjectsfromnobjectsdoesmatter.
Combination and permutation functions are available on the financial calculator andshouldbeusedratherthantheformula.
Example
Assumethatinaportfolioofeightstocks,wedecidetosellthreestocks.Howmanywayscanwechoosethreeoftheeighttoselliftheorderofsaledoesmatter?
Solution:
Usingtheformulaforpermutation,wecanfindthenumberofwaystosellthreeoftheeightstockswhereordermatters:8!
8– 3 !336
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Summary
LO.a:Definearandomvariable,anoutcome,anevent,mutuallyexclusiveevents,andexhaustiveevents.
Arandomvariableisanuncertainquantity/number. Anoutcomeistheobservedvalueofarandomvariable. Aneventcanbeasingleoutcomeorasetofoutcomes. Mutuallyexclusiveeventsareeventsthatcannothappenatthesametime. Exhaustiveeventsarethosethatincludeallpossibleoutcomes.
LO.b:Statethetwodefiningpropertiesofprobabilityanddistinguishamongempirical,subjective,andaprioriprobabilities.
Thetwodefiningpropertiesofaprobabilityare: TheprobabilityofanyeventEisanumberbetween0and1:0≤P(E)≤1. Thesumof theprobabilitiesofanysetofmutuallyexclusiveandexhaustiveevents
equals1.
Themethodsofestimatingprobabilitiesare: Empiricalprobability:Basedonanalyzingthefrequencyofanevent’soccurrenceinthe
past. Aprioriprobability:Basedonformalreasoningandinspectionratherthanpersonal
judgment. Subjectiveprobability:Informedguessbasedonpersonaljudgment.
LO.c:Statetheprobabilityofaneventintermsofoddsforandagainsttheevent.
OddsforE=P(E)/[1–P(E)].
OddsagainstE=[1–P(E)]/P(E).
LO.d:Distinguishbetweenunconditionalandconditionalprobabilities.
Unconditional probability (marginal probability) is the probability of an event occurringirrespectiveoftheoccurrenceofotherevents.ItisdenotedasP(A).
Conditionalprobabilityistheprobabilityofaneventoccurringgiventhatanothereventhasoccurred.ItisdenotedasP(A|B),whichistheprobabilityofeventAgiventhateventBhasoccurred.
LO.e:Explainthemultiplication,addition,andtotalprobabilityrules.
Multiplicationruleisusedtodeterminethejointprobabilityoftwoevents.Itisexpressedas:
P(AB)=P(A|B)P(B)
Additionruleisusedtodeterminetheprobabilitythatatleastoneoftheeventswilloccur.Itisexpressedas:
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P(AorB)=P(A)+P(B)–P(AB)
Thetotalprobabilityruleisusedtocalculatetheunconditionalprobabilityofanevent,givenconditionalprobabilities.Itisexpressedas:
P(A)=P(A|S1)P(S1)+P(A|S2)P(S2)+…+P(A|Sn)P(Sn)
LO.f:Calculateandinterpret1)thejointprobabilityoftwoevents,2)theprobabilitythatat leastoneoftwoeventswilloccur,giventheprobabilityofeachandthe jointprobabilityofthetwoevents,and3)ajointprobabilityofanynumberofindependentevents.
ConsidertheexamplethatyouhavetwostocksAandB.TheprobabilitythatstockAwillpayoutadividendthisquarteris60%andtheprobabilitythatstockBwillpayoutadividendthisquarteris50%.Assumethatthetwoeventsareindependent.ThejointprobabilityofAandBi.e.bothAandBissueadividendthisquarteris0.6x0.5=0.3.
Theprobabilitythatatleastoneoftwoevents,AorB,willoccurisP(AorB)=P(A)+P(B)–P(AB)=0.6+0.5–0.6x0.5=0.8.
LO.g:Distinguishbetweendependentandindependentevents.
Iftheoccurrenceofoneeventdoesnotinfluencetheoccurrenceoftheotherevent,thentheeventsarecalledindependentevents.
i.e.P(A|B)=P(A)orP(B|A)=P(B)
Iftheprobabilityofaneventisaffectedbytheoccurrenceofanothereventthenitiscalledadependentevent.
LO.h:Calculateandinterpretanunconditionalprobabilityusingthetotalprobabilityrule.
UsingthetotalprobabilityruletheunconditionalprobabilityofAcanbecomputedas:
P(A)=P(A|S1)P(S1)+P(A|S2)P(S2)+…+P(A|Sn)P(Sn)
WhereS1,S2..Snaremutuallyexclusiveandexhaustiveevents.
LO.i:Explaintheuseofconditionalexpectationininvestmentapplications.
The expected value is heavily used in investment applications e.g. forecasting EPS of acompany, estimating rewards of alternative investments, etc. When you refine yourexpectationsorforecasts,youaretypicallymakingadjustmentsbasedonnewinformationorevents;thisisactuallytheuseofconditionalexpectedvalues.
LO.j:Explaintheuseofatreediagramtorepresentaninvestmentproblem.
The tree diagram in an investment problem can help plot the probabilities of variousoutcomesanddepictexpectedvaluesbasedonthepathschosenandselectionmadeateachnode.Forexample:
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LO.k:Calculateandinterpretcovarianceandcorrelation.
Covarianceisameasureofhowtwovariablesmovetogether.GiventworandomvariablesRiandRj,thecovariancebetweenRiandRjisgivenby:
Cov(Ri,Rj)=E[(Ri–ERi)(Rj–ERj)]Where,ERi=expectedreturnforvariableRiERj=expectedreturnforvariableRj
Correlationisastandardizedmeasureofthelinearrelationshipbetweentwovariableswithvaluesrangingbetween‐1and+1.Theformulaisgivenby:
ρ(A,B)=Cov(A,B)/σ(A)σ(B)
LO.l:Calculateandinterprettheexpectedvalue,variance,andstandarddeviationofarandomvariableandofreturnsonaportfolio.
Theformulaforcalculatingtheexpectedportfolioreturnis:
E(RP)=w1E(R1)+w2E(R2)+…+wnE(Rn)
Variancecanbecomputedas:
σ R w σ R w σ R 2w w Cov R R
LO.m:Calculateandinterpretcovariancegivenajointprobabilityfunction.
GiventworandomvariablesRiandRj,thecovariancebetweenRiandRjisgivenby:
Cov(Ri,Rj)=E[(Ri–ERi)(Rj–ERj)]
where:ERi=expectedreturnforvariableRiERj=expectedreturnforvariableRj
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LO.n:CalculateandinterpretanupdatedprobabilityusingBayes’formula.
Bayes’formulaisarationalmethodforupdatingoradjustingtheprobabilityofaneventbasedonnewinformation.AccordingtoBayes’formula,theupdatedprobabilityofaneventgivennewinformationis:
P(Event│Information)=P(Information│Event)
P(Information) P(Event)
LO.o:Identifythemostappropriatemethodtosolveaparticularcountingproblem,andsolvecountingproblemsusingfactorial,combination,andpermutationconcepts.
Thenumberofwayswecanassigneverymemberofagroupofsizentonslotsisn!
Numberofwaysinwhichnitemscanbelabelledusingklabels= !
! ! … !
The combination formula gives the number ofways to choose r objects from a total of nobjects,whentheorderinwhichtherobjectsarelisteddoesnotmatter.
nr
n!
n r ! r!
The permutation formula gives the number ofways to choose r objects from a total of nobjects,whentheorderinwhichtherobjectsarelisteddoesmatter.
P n!
n r !
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PracticeQuestions
1. IfeventsAandBaremutuallyexclusive,thenwhichofthefollowingistrue?A. P(A|B)=P(A).B. P(AB)=P(A)xP(B).C. P(AorB)=P(A)+P(B).
2. Whichofthefollowingvaluescanbetheprobabilityofanevent?
A. ‐0.23.B. 0.68.C. 1.36.
3. Whichofthefollowingismostlikelyanempiricalprobability?A. The probability of a particular outcome when exactly 6 equally likely possible
outcomesexist.B. TheprobabilitythatUSstockreturnsexceedlong‐termcorporatebondreturnsovera
5yearperiod,basedonZellerFinancialdata.C. AnupdatedprobabilityofaneventarrivedatusingBayes’formulaandtheperceived
priorprobabilityoftheevent.
4. Theprobabilitythatthestockmarketwillincreasetomorrowis3/5.Theprobabilityofanincreaseinthestockmarketstatedas'oddsfor’is:A. three‐to‐two.B. two‐to‐three.C. three‐to‐five.
5. Afundmanagerhasnotedthatduringthepastfiveyears60percentofthestocksinhisportfoliohavepaidacashdividendand20percentofthestockshavepaidastockdividend.If65percentofthestockshavepaidadividendofanykind,thejointprobabilityofastockpayingbothacashdividendandastockdividendisclosestto:A. 10%.B. 15%.C. 20%.
6. Twoeventsaresaidtobeindependentiftheoccurrenceofoneevent:A. impliesthatthesecondeventcannotoccur.B. impliesthatthesecondeventiscertaintooccur.C. doesnotaffecttheprobabilityoftheoccurrenceoftheotherevent.
7. ThecorrelationofreturnsbetweenStocksAandBis0.60.Thecovariancebetweenthesetwosecuritiesis0.0056andthestandarddeviationofthereturnsofStockBis18%.ThevarianceofreturnsforStockAis:
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A. 0.0027.B. 0.0035.C. 0.0048.
8. Thefollowinginformationontwoportfoliosisgiven:
FundA FundBPortfolioweights(%) 40 60Expectedreturns(%) 15 10Standarddeviations(%) 20 16Correlation between the returnsofFundAandFundB
0.5
Theexpectedreturnandthestandarddeviationoftheportfolioarerespectivelyclosestto:A. 12.5%and22.3%.B. 12%and15.2%.C. 13%and16.5%.
9. ThejointprobabilitiesforXandYareP(X=10,Y=3)=0.4,andP(X=20,Y=6)=0.6,thentheCovarianceofXYisclosestto:A. 7.2B. 6.5.C. 6.6.
10. Aresearcherisstudyingthelinkbetweenexchangeratemovementsandthediscountrateset by the country’s bank. He uses historical data to determine that the probability ofexchangeraterisingorfallingoverthenextmonthis60%and30%respectivelywhiletheprobability that theexchangerate stays thesame is10%.Somedays later,he receivesinformationthatthecentralbankwillincreasethediscountrate.Theresearchercomesup with the following subjective probabilities that the central bank will increase thediscountrategiventhescenariosthatexchangeraterises,fallsorstaysthesame:
P(increaseddiscountrate|exchangerateincreases)=65% P(increaseddiscountrate|exchangeratestayssame)=15% P(increaseddiscountrate|exchangeratedecreases)=20%
Whatistheprobabilitythattheexchangeratewillfallgiventhenewinformationthatthecentralbankwillincreasethediscountrate?A. 18.79%.B. 15.65%.C. 12.90%
11. Aninvestorwantstopurchase7stocksforhisportfoliofromauniverseof10stocks.Iftheorderinwhichhebuysthestocksisnotimportant,thenhowmanypotential7stockcombinationsdowehave?
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A. 120.B. 140.C. 160.
12. Afundmanagerwantstosell3bondsfromhisportfolioof8bonds.Iftheorderinwhichhesellsthebondsisimportant,thenhowmanypotential3‐bondcombinationsdowehave?A. 56.B. 336.C. 512.
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Solutions
1. Ciscorrect.Mutuallyexclusiveeventsarethoseeventswhichcannothappentogether,i.e.thereisnointersectionbetweenthetwoevents.Therefore,bothP(A|B)andP(AB)mustbeequaltozero.
2. Biscorrect.Theprobabilityofaneventhastobebetween0and1.
3. B is correct. This is an example of empirical probability since it is basedonpast data.OptionAisAprioriprobabilitysinceitisbasedonlogicalreasoning.OptionCissubjectiveprobabilitysinceitisbasedonpersonaljudgment.
4. Aiscorrect.OddsforE=P(E)/[1–P(E)]=(3/5)/(2/5)=3/2=threetotwo.
5. Biscorrect.Theprobabilitythatat leastoneoftwoeventswilloccuristhesumoftheprobabilitiesoftheseparateeventslessthejointprobabilityofthetwoevents.P(AorB)=P(A)+P(B)–P(AB)65%=60%+20%–P(AB);thereforeP(AB)=15%
6. Ciscorrect.Twoeventsaresaidtobeindependentiftheoccurrenceofoneeventdoesnotaffecttheprobabilityoftheoccurrenceoftheotherevent.
7. Aiscorrect.
Corr A, BCov A, Bσ A σ B
0.60.0056σ A 0.18
Therefore 0.0518.ThevarianceofreturnsforstockA=0.0518 0.0027
8. Biscorrect.Theexpectedreturnontheportfoliois0.4x15%+0.6x10%=12%Calculatetheportfoliostandarddeviationofreturnsasfollows:√(.402x.202+.602x.162+2x.40x.60x.5x.20x.16)=0.152and15.2%
9. Aiscorrect.Thejointprobabilitiesinthequestionaregivenasfollows:
X,Y 3 610 0.4 20 0.6
E[X]=0.4(10)+0.6(20)=16E[Y]=0.4(3)+0.6(6)=4.8Cov[XY]=0.4(10‐16)(3‐4.8)+0.6(20‐16)(6‐4.8)=7.2
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10. Ciscorrect.AccordingtoBayes’Theorem:Updatedprobabilityofeventgiventhenewinformation= (Probability of new information given event ÷ unconditional probability of newinformation)xpriorprobabilityofeventInordertoproceedwiththegivendata,weneedtocalculatetheunconditionalprobabilityofnewinformationi.e.theprobabilityofanincreaseinthediscountrate.P(increaseddiscountrate)=P(increaseddiscountrate|exchangerateincreases)xP(exchangerateincreases)+P(increaseddiscountrate|exchangeratestayssame)xP(exchangeratestayssame)+P(increaseddiscountrate|exchangeratedecreases)xP(exchangeratedecreases)=(0.65x0.60)+(0.15x0.1)+(0.2x0.3)=0.465=46.5%
P E/I P E /
Using the unconditional probability and Bayes’ Theorem, we can calculate updatedprobabilityoftheeventgiventhenewinformationaboutdiscountratesas:P(exchangeratedecreases|increaseddiscountrate)==[P(increaseddiscountrate|exchangeratedecreases)÷P(increaseddiscountrate)]xP(exchangeratedecreases)=(0.20÷0.465)x0.30=12.90
11. Aiscorrect.Sincetheorderisnotimportantwewillusecombination.10C7=120
12. Biscorrect.Sincetheorderisimportantwewillusepermutation.8P3=336.
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R10CommonProbabilityDistributions
1.Introduction
Innearlyallinvestmentdecisions,weworkwithrandomvariables.Tomakeprobabilitystatementsaboutarandomvariable,weneedtounderstanditsprobabilitydistribution.Aprobabilitydistributionspecifiestheprobabilitiesofallpossibleoutcomesofarandomvariable.Inthisreading,wewilllookatthefollowingfourprobabilitydistributions:
Uniform Binomial Normal Lognormal
2.DiscreteRandomVariables
Arandomvariableisavariablewhoseoutcomecannotbepredicted.Therearetwobasictypesofrandomvariables:
Adiscreterandomvariableisonewherewecanlistallthepossibleoutcomes.Forexample,thestockstradedontheNewYorkStockExchangearequotedinticksof$0.01.Quotedstockpriceisthereforeadiscreterandomvariable.
Acontinuousrandomvariableiswherethenumberofpointsbetweenthelowerandupperboundsareessentiallyinfinite.Rateofreturnisanexampleofacontinuousrandomvariable.
Probabilitydistributionspecifiestheprobabilitiesofallthepossibleoutcomesforarandomvariable.
Probabilityfunctionspecifiestheprobabilitythatarandomvariabletakesonaspecificvalue.
Probabilitydensityfunctionisusedforcontinuousrandomvariables.
2.1.TheDiscreteUniformDistribution
Thediscreteuniformdistributionhasafinitenumberofspecifiedoutcomesandeachoutcomeisequallylikely.Considerarollofadice.Theoutcomeisarandomvariableanditcantakeavalueof1to6.Theprobabilitythattherandomvariabletakesonanyofthesevaluesisthesameforalloutcomes.Withsixoutcomes,p(x)=1/6forallvaluesofX(X=1,2,3,4,5,6).Thetablebelowsummarizesthetwoviewsofthisrandomvariable–theprobabilityfunctionandthecumulativedistributionfunction.
X=x ProbabilityFunctionp(x)=P(X=x)
CumulativeDistributionFunctionF(x)=P(X≤x)
1 1/6 1/62 1/6 2/63 1/6 3/6
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4 1/6 4/65 1/6 5/66 1/6 6/6
2.2.TheBinomialDistribution
ThebuildingblockofthebinomialdistributionistheBernoullirandomvariable.ABernoullitrialisonewherethereareonlytwopossibleoutcomes:successorfailure.FlippingacoinisanexampleofaBernoullitrial–youeithergetheadsortails,butnothingelse.Thiscanbeexpressedas:
P(Y=1)=pP(Y=0)=1–p
where:p=probabilitythatthetrialisasuccess
Inabinomialdistribution,therandomvariable,X,isthenumberofsuccessesinagivennumberofBernoullitrials.Continuingwiththecoinexample,sayweflipthecoin10timesandwedefinesuccessas‘Heads’.Clearlywith10flipswecanget0to10successes.
Theprobabilitydistributionofabinomialrandomvariablefortheprobabilityof"x"successin"n"trialsiscalculatedusingthefollowingformula:
P x P X x C p 1 p –
where:p=theprobabilityofsuccessoneachtrial
Example
Usingthetableabove,findthefollowingprobabilities:1. F(4)2. P(3≤X<6)3. F(9)Solutionto1:
TofindF(4),wemustfindthecumulativeprobabilityofP(X≤4)usingthecumulativedistributionfunction(thirdcolumn).Fromthetable,wecanseethatP(X≤4)=4/6=2/3.Therefore,theprobabilityis2/3.
Solutionto2:
TofindP(3≤X<6),weneedtofindthesumofthreeprobabilities:p(3),p(4),p(5).Thisis1/6+1/6+1/6=3/6=1/2.
Solutionto3:
TofindF(9),wemustfindthecumulativeprobabilityofP(X≤9).Thisincludesallpossibleoutcomes,hencetheprobabilityis1.
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x=numberofsuccessesn=numberoftrials
Instructor’sNote:
Twoimportantpointshelpillustratetheintuitionbehindtheformula: Thesuccessescanbeinanyorder.Thatiswhyweusethecombinationfunctionandnot
thepermutationfunction. Theeventsareindependent.Thatiswhywesimplymultiplytheprobabilityofeach
event.ExampleIfweflipafaircoin(p=0.5)tentimes(n=10),whatistheprobabilityofsevensuccesses?
Solution:P(7)=P(X=7)=10C70.570.53=0.117
Meanandvarianceofabinomialvariable
Themeanandvarianceofabinomialvariablecanbecalculatedas:
Forourcoin‐flipexample,themeanvalueofthebinomialrandomvariableisnp=10x0.5=5.Theintuition:ifweperformthebinomialexperimentseveraltimes,whereeachexperimentrefersto10coin‐flips,onaveragewewillhave5successes.Theactualnumberofsuccesseswillbedistributedequallyoneithersideofthemeanvalue.Therandomvalueforeverytrialmovesclosertotheexpectedvalueasthenumberoftrialsgrows.
Example
Overthelast10years,Abrocorporation’sEPSincreasedyearoveryearsixtimesanddecreasedyearoveryearfourtimes.YoudecidetomodelthenumberofEPSincreasesforthenextdecadeasabinomialrandomvariable.1. IfsuccessisdefinedasanincreaseintheannualEPS,determinetheprobabilityof
success.2. WhatistheprobabilitythatEPSwillincreaseinexactly5ofthenext10years?3. CalculatetheexpectednumberofyearlyEPSincreasesduringthenext10years.4. CalculatethevarianceandstandarddeviationofthenumberofyearlyEPSincreases
duringthenext10years.
Solutionto1:Thereareonlytwopossibleoutcomes:increaseintheEPSandnoincreaseintheEPS.Probabilityofsuccess:p=6/10=0.6Probabilityoffailure:1–p=1–0.6=0.4
RandomVariable Mean VarianceBernoulli,B(1,p) p p(1‐p)Binomial,B(n,p) np np(1‐p)
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Solutionto2:Usingthebinomialmodel:P X 5 C p q P X 5 C 0.6 0.4 P X 5 252 0.07776 0.01024 20.06%
Solutionto3:ExpectednumberofyearlyEPSincreases:E x np 10 0.6 6
Solutionto4:Variance=np 1– p 6 0.4 2.4StandardDeviation=√2.4=1.549 Thevarianceofthedistributioniscalculatedasnp(1–p)=10x0.5x(1–0.5)=2.5
Binomialtree
Abinomialtreecanbeusedtomodelstockpricemovements.Refertothetreediagrambelow.‘S’representstheinitialstockprice.‘u’representsanupmoveand‘d’representsadownmove.Thenodesshoweachpossiblevalueofthestockafter1,2and3timeperiods.
Theexpectedstockpriceaftereachperiodisequaltothesumofpossiblestockpricesattheendoftheperiodmultipliedbytheirrespectiveprobabilities.
Example
Consideraninitialstockpriceof$100.Inonetimeperiod,thestockcaneitherrisebyafactorof1.1orgodownbyafactorof1/1.1.Inanygiventimeperiod,theprobabilityofanupmoveis0.6andtheprobabilityofadownmoveis0.4.Aftertwoperiods,whatarethepossiblestockpricesandtheirrespectiveprobabilities?Whatistheexpectedstockprice?
Solution:
uuS=1.1x1.1x100=121withprobability0.6x0.6=0.36udS=1.1x1/1.1x100=100withprobability0.6x0.4=0.24duS=1/1.1x1.1x100=100withprobability0.4x0.6=0.24
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ddS=1/1.1x1/1.1x100=82.64withprobability0.4x0.4=0.16Expectedstockprice=121x0.36+100x0.24+100x0.24+82.64x0.16=$104.78
3.ContinuousRandomVariables
3.1.ContinuousUniformDistribution
Thecontinuousuniformdistributionisdefinedoverarangefromalowerlimit‘a’toanupperlimit‘b’.Theselimitsserveastheparametersofthedistribution.
Theprobabilitythattherandomvariablewilltakeavaluebetweenx1andx2,wherex1andx2bothliewithintherangeisgivenby:
P x X x x xb a
Example
Xisauniformlydistributedcontinuousrandomvariablebetween10and20.CalculatetheprobabilitythatXwillfallbetween12and18.
Solution:
P 12 X 18 18 1220 10
0.6
Thecumulativedistributionfunctionforacontinuousrandomvariableisshownbelow:
Example
Acommodityanalystpredictsthatthepriceperounceofgoldthreeyearsfromnowwillbebetween$1,500and$1,700.Assumegoldpricesfollowacontinuousuniformdistribution.Whatistheprobabilitythatthepricewillbelessthan$1,600threeyearsfromnow?
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Solution:
F(1,600)= , – ,
, ,=50%Theprobabilitythatgoldpricewillbelessthan$1,600per
ouncethreeyearsfromnowis50%.
3.2.TheNormalDistribution
Thenormaldistributionisthemostextensivelyusedprobabilitydistributioninquantitativework.Anormaldistributionissymmetricalandbell‐shapedasshowninthegraphbelow:
Inthisfigure‘m’standsformean,1smeansonestandarddeviation,2smeanstwostandarddeviations,andsoon.Wecanmakethefollowingprobabilitystatementsforanormaldistribution:
Approximately68%ofallobservationsfallintheintervalm±1s. Approximately95%ofallobservationsfallintheintervalm±2s. Approximately99%ofallobservationsfallintheintervalm±3s.
Theintervalsindicatedaboveareeasytorememberbutareonlyapproximateforthestatedprobabilities.Morepreciseintervals(confidenceintervals)are:
90%ofallobservationsareintheintervalm±1.65s. 95%ofallobservationsareintheintervalm±1.96s. 99%ofallobservationsareintheintervalm±2.58s.
Thecharacteristicsofanormaldistributionareasfollows: Thenormaldistributioniscompletelydescribedbytwoparameters–itsmean,µ,and
variance,σ2.WeindicatethisasX~N(µ,σ2). Thenormaldistributionhasaskewnessof0(itissymmetric)andakurtosis
(measureofpeakedness)of3.Duetothesymmetry,themean,medianandmodeareallequalforanormalrandomvariable.
Alinearcombinationoftwoormorenormalrandomvariablesisalsonormallydistributed.
Standardnormaldistribution
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Thenormaldistributionwithmean(µ)=0andstandarddeviation(σ)=1iscalledthestandardnormaldistribution.
TheformulaforstandardizingarandomvariableXis:
ZX μσ
where:μisthepopulationmean.σisthepopulationstandarddeviation.
TheZ‐tableisusedtofindtheprobabilitythatXwillbelessthanorequaltoagivenvalue.Supposewehaveanormalrandomvariable,X,withµ=10andσ=2.IfthevalueofXis11,westandardizeXwithZ=(11–10)/2=0.5.
Theprobabilitythatwewillobserveavaluelessthan11forX~N(10,2)isexactlythesameastheprobabilitythatwewillobserveavaluelessthan0.5forZ~N(0,1).
WecananswerprobabilityquestionsaboutXusingstandardizedvaluesandprobabilitytablesforZ.Asnapshotofatableshowingcumulativeprobabilitiesforastandardnormaldistributionisshownbelow.
Tofindtheprobabilitythatastandardnormalvariableislessthanorequalto0.5,forexample,locatetherowthatcontains0.50,lookatthe0column,andfindtheentry0.6915.Thus,P(Z≤0.5)=0.6915or69.15%.
Theprobabilitythatastandardnormalvariableislessthanorequalto0is0.5000.Thisistruebydefinitionbecausethemeanofastandardnormaldistributionis0.Thetableabovevalidatesthisfact.
Foranon‐negativenumberx,wecanuseN(x)directlyfromthetable.Foranegativenumber–x,N(‐x)=1.0–N(x).Essentially,weareusingthefactthatthenormaldistributionissymmetricaroundthemean.
Example
Aportfoliohasameanreturnof15%andastandarddeviationofreturnof20%peryear.Whatistheprobabilitythattheportfolioreturnwouldbebelow18%?Wearegiventhe
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followinginformationfromthez‐table:P(Z<0.15)=0.5596,P(Z>0.15)=0.4404,P(Z<0.18)=0.5714,P(Z>0.18)=0.4286.
Solution:
P ZX μσ
P Z0.18 0.15
0.20P Z 0.15 0.5596
Univariatev/smultivariatedistribution
Univariatedistribution
Aunivariatedistributiondescribestheprobabilitydistributionofasinglerandomvariable.Forexample,thedistributionofexpectedreturnofonestockfromaportfolio.
Multivariatedistribution
Amultivariatedistributiondescribestheprobabilitydistributionforagroupofrelatedrandomvariables.Forexample,thedistributionofexpectedreturnofaportfoliowithmultiplestocks.
Amultivariatenormaldistributionforthereturnsonnstocksiscompletelydefinedbythefollowingthreesetsofparameters:
Meanreturnsontheindividualstocks(nmeansintotal). Variancesoftheindividualstocks(nvariancesintotal). Pairwisereturncorrelationsbetweenthestocks(n(n‐1)/2distinctcorrelationsin
total).
3.3.ApplicationsoftheNormalDistribution
Shortfallrisk
Shortfallriskistheriskthatportfolio’sreturnwillfallbelowaspecifiedminimumlevelofreturnoveragivenperiodoftime.
Safetyfirstratio
Safetyfirstratioisusedtomeasureshortfallrisk.Itiscalculatedas:
SFRatioR –Rσ
where:Rp=ExpectedportfolioreturnRL=Thresholdlevel=Standarddeviationofportfolioreturns
TheportfoliowiththehighestSF‐Ratioispreferred,asithasthelowestprobabilityoffallingbelowthetargetreturn.
Example
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AninvestorisconsideringtwoportfoliosAandB.PortfolioAhasanexpectedreturnof10%andastandarddeviationof2%.PortfolioBhasanexpectedreturnof15%andastandarddeviationof10%.Theminimumacceptablereturnfortheinvestoris8%.AccordingtoRoy’ssafetyfirstcriteria,whichportfolioshouldtheinvestorselect?
Solution:
SF 10 82
1
SF 15 810
0.7
SinceAhasahighersafetyfirstratio,theinvestorshouldselectportfolioA.
Roy’ssafetyfirstcriteria
Itstatesthatanoptimalportfoliominimizestheprobabilitythattheactualportfolioreturnwillfallbelowthetargetreturn.
3.4.TheLognormalDistribution
Ifxisarandomvariablethatisnormallydistributed,thentocreatealognormaldistributionofxwetakeexandplotthevaluesonagraph.
NormalDistribution LognormalDistribution
Thepropertiesofalognormaldistributionare: Itcannotbenegative. Theupperendofitsrangeextendstoinfinity. Itispositivelyskewed.
Instructor’sNote:Anormaldistributionismoresuitableasamodelforreturnsthanforassetprices,becausereturnsgenerallyvaryaboutthemean,withahighprobabilityofreturnsbeingclosetothemean.However,assetpricesdonotvaryequallyaboutameanprice,sincetheprobabilityofextremechangesinpricedecreasesasthepriceapproacheszero.Thismeansassetpriceswillnotformasymmetricalgraphlikethatofthenormaldistribution.Instead,assetpricesfollowalognormaldistribution,whichisskewedtotherightandcannotbenegative.
Discretelyversuscontinuouslycompoundedratesofreturn
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Discretelycompoundedratesofreturnshavedefinedcompoundingperiodssuchasquarterly,monthlyetc.Aswedecreasethelengthofthecompoundingperiod,theeffectiveannualraterises.Forcontinuouscompounding,theEARisgivenby:
EAR=er–1
Ifwearegiventheholdingperiodreturnoveranytimeperiod,wecancalculatetheequivalentcontinuouslycompoundedrateofreturnforthatperiodas:
r=ln(HPR+1)
Example
Iftheholdingperiodreturnofastockwas10%foraperiodofoneyear.Whatistheequivalentcontinuouslycompoundedrateofreturnfortheyear?
Solution:r=ln(0.1+1)=0.0953=9.53%
4.MonteCarloSimulation
MonteCarlosimulationisacomputersimulationusedtosimulatepossiblesecuritypricesbasedonriskfactors.Asinput,itusesrandomlygeneratedvaluesforriskfactorsbasedontheirassumeddistributions.Itprocessesthisinformationasperthespecifiedmodelandrunsthousandsofiterations.Thenitgivesthedistributionoftheexpectedvalueofthesecurityasoutput.
Majorapplicationsinclude: financialplanning developingVARestimates valuingcomplexsecurities
Limitationsinclude: Itisfairlycomplexandwillprovideanswersthatarenobetterthantheassumptions. Simulationisnotananalyticalmethodbutastatisticalone.
MonteCarlosimulationversushistoricalsimulation
Thehistoricalsimulationusesactualpastdistributionofriskfactorsasinput.Whereas,MonteCarlosimulationusesrandomlygeneratedvaluesoftheriskfactorsbasedontheirassumeddistributions.
Thelimitationsofhistoricalsimulationare: Itcannottakeintoaccounttheeffectofsignificanteventsthatdidnotoccurduring
thesampleperiod.
Itcannotperforma‘whatif’analysiswhenthe‘if’scenariohasnothappenedinthepast.
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Summary
LO.a:Defineaprobabilitydistributionanddistinguishbetweendiscreteandcontinuousrandomvariablesandtheirprobabilityfunctions.
Arandomvariableisavariablewhoseoutcomecannotbepredicted.Aprobabilitydistributionlistsallpossibleoutcomesofarandomvariablealongwiththeirassociatedprobabilities.
Adiscreterandomvariableisoneforwhichthenumberofpossibleoutcomescanbecounted.Ithasmeasurableprobabilitiesassociatedwitheachspecificoutcome.
Acontinuousrandomvariableisoneforwhichwecannotcountthenumberofpossibleoutcomes.Therefore,probabilitiescannotbeassociatedwithspecificoutcomes,instead,ithastobeassignedtoaparticularrange.
LO.b:Describethesetofpossibleoutcomesofaspecifieddiscreterandomvariable.
Thesetofpossibleoutcomesofadiscreterandomvariableisfinite. p(x)=0meansthatxcannotoccur. p(x)>0meansthatxcanoccur. p(x)=1meansthatxistheonlypossibleoutcome.
LO.c:Interpretacumulativedistributionfunction.
Thecumulativedistributionfunctiongivestheprobabilitythattherandomvariablewillbelessthanorequaltoaspecificvalue.
ItisdenotedbyF(x)=P(X≤x).
LO.d:Calculateandinterpretprobabilitiesforarandomvariable,givenitscumulativedistributionfunction.
Theprobabilitythatanoutcomewillbelessthanorequaltoaspecificvalueisrepresentedbytheareaunderthecumulativeprobabilitydistributiontotheleftofthatvalue.
LO.e:Defineadiscreteuniformrandomvariable,aBernoullirandomvariable,andabinomialrandomvariable.
Adiscreteuniformrandomvariableisonewheretheprobabilityofallthepossibleoutcomesisequal.Forexample,therollofadice.
ABernoullitrialisanexperimentthathasonlytwopossibleoutcomes:asuccessorafailure.Forexample,thetossofacoin.
Iftheexperimentiscarriedoutntimes,thenumberofsuccess(denotedbyX)iscalledaBernoullirandomvariable.
ThedistributionthatXfollowsisknownasthebinomialdistribution.
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LO.f:Calculateandinterpretprobabilitiesgiventhediscreteuniformandthebinomialdistributionfunctions.
Probabilitiesforadiscreteuniformdistribution:Ifthetotalnumberofoutcomesisn,thentheprobabilityofeachoutcome=1/n.
Probabilitiesforauniformrandomvariable:Theprobabilitydistributionofabinomialrandomvariablefortheprobabilityofxsuccessesinntrialsiscalculatedusingthefollowingformula:
P(x)=P(X=x)=nCxpx(1‐p)n–x
LO.g:Constructabinomialtreetodescribestockpricemovement.
Abinomialtreecanbeusedtomodelstockpricemovements.‘S’representstheinitialstockprice.‘u’representsanupmoveand‘d’representsadownmove.Thenodesshoweachpossiblevalueofthestockafter1,2and3timeperiods.
LO.h:Definethecontinuousuniformdistributionandcalculateandinterpretprobabilities,givenacontinuousuniformdistribution.
Thecontinuousuniformdistributionisdefinedoverarangefromalowerlimit‘a’toanupperlimit‘b’.Theprobabilitythattherandomvariablewilltakeavaluebetweenx1andx2,wherex1andx2bothliewithintherangeisgivenby:
P x X x x xb a
LO.i:Explainthekeypropertiesofthenormaldistribution.
Anormaldistributionisabell‐shapedcurve,withtwoidenticalhalves.
Itiscompletelydescribedbytwoparametersitsmean(µ)anditsvariance(σ2).ThisisstatedasX~N(µ,σ2).
Ithasaskewnessof0andakurtosisof3.
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Alinearcombinationoftwoormorerandomvariablesisalsonormallydistributed.
LO.j:Distinguishbetweenaunivariateandamultivariatedistribution,andexplaintheroleofcorrelationinthemultivariatenormaldistribution.
Aunivariatedistributiondescribesasinglerandomvariable.Anexampleistheexpectedreturnonaparticularstock.Amultivariatedistributionspecifiestheprobabilitiesforagroupofrelatedrandomvariables.Anexampleistheexpectedreturnonaportfolioofmultiplestocks.
Amultivariatenormaldistributionforthereturnsonnstocksiscompletelydefinedbythreelistsofparameters:
Thelistofthemeanreturnsontheindividualsecurities(nmeansintotal). Thelistofthesecurities’variancesofreturn(nvariancesintotal). Thelistofallthedistinctpairwisereturncorrelations(n(n‐1)/2distinct
correlationsintotal).
LO.k:Determinetheprobabilitythatanormallydistributedrandomvariableliesinsideagiveninterval.
Thepropertyofnormaldistributiongivesusintervalsstatedbelow: 90%ofallobservationsareintheintervalm±1.65s. 95%ofallobservationsareintheintervalm±1.96s. 99%ofallobservationsareintheintervalm±2.58s.
Thisimpliesthatifarandomvariableislessthanorequaltom±1.65s,thentheprobabilityofitlyinginsidethedistributionis90%.
LO.l:Definethestandardnormaldistribution,explainhowtostandardizearandomvariable,andcalculateandinterpretprobabilitiesusingthestandardnormaldistribution.
Thenormaldistributionwithµ=0andσ=1iscalledthestandardnormaldistribution.TheformulaforstandardizingarandomvariableXis:
Z X μσ
LO.m:Defineshortfallrisk,calculatethesafety‐firstratio,andselectanoptimalportfoliousingRoy’ssafety‐firstcriterion.
Shortfallriskistheriskthatportfoliovaluewillfallbelowsomeminimumacceptableleveloversometimehorizon.
SFRatioE R –R
σ
ToselecttheoptimalportfolioaccordingtoRoy’scriterion,wefollowthefollowingsteps:
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Calculateeachportfolio’sSF‐Ratio. ChoosetheportfoliowiththehighestSF‐Ratio.
LO.n:Explaintherelationshipbetweennormalandlognormaldistributionsandwhythelognormaldistributionisusedtomodelassetprices.
Ifxisarandomvariablethatisnormallydistributed,thentocreatealognormaldistributionofxwetakeexandplotthevaluesonagraph.
Alognormaldistributionisoftenusedtomodelassetpricesbecausetheassetpricesneedtobepositive,theycannotbenegative.
LO.o:Distinguishbetweendiscretelyandcontinuouslycompoundedratesofreturn,andcalculateandinterpretacontinuouslycompoundedrateofreturn,givenaspecificholdingperiodreturn.
Discretelycompoundedratesofreturnshavedefinedcompoundingperiodssuchasquarterly,monthly.Aswedecreasethelengthofthecompoundingperiod,theeffectiveannualraterises.Forcontinuouscompounding,theEARisgivenby:EAR=er–1.
Ifwearegiventheholdingperiodreturnoveranytimeperiod,wecancalculatetheequivalentcontinuouslycompoundedrateofreturnforthatperiodas:r=ln(HPR+1)
LO.p:ExplainMonteCarlosimulationanddescribeitsapplicationsandlimitations.
MonteCarlosimulationisacomputersimulationthatproducesadistributionofpossiblesecuritypricesusingrandomlygeneratedvaluesforriskfactors,basedontheirassumeddistributions.
Limitationsinclude: Itisfairlycomplexandwillprovideanswersthatarenobetterthantheassumptions. Simulationisnotananalyticalmethodbutastatisticalone.
LO.q:CompareMonteCarlosimulationandhistoricalsimulation.
Thehistoricalsimulationusesactualpastdistributionofriskfactorsasinput.Whereas,MonteCarlosimulationusesrandomlygeneratedvaluesoftheriskfactorsbasedontheirassumeddistributions.
Thelimitationsofhistoricalsimulationare: Itcannottakeintoaccounttheeffectofsignificanteventsthatdidnotoccurduring
thesampleperiod. Itcannotperforma‘whatif’analysiswhenthe‘if’scenariohasnothappenedinthe
past.
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PracticeQuestions
1. Whichofthefollowingismostlikelyanexampleofadiscreterandomvariable?A. Thereturnsonaportfolio.B. Thetimespentbyananalystonresearch.C. Thenumberofstocksinaportfolio.
2. ForacontinuousrandomvariableX,theprobabilityofanysinglevalueofXis:
A. 0.B. 1.C. determinedbythecumulativedistributionfunction.
3. TheprobabilitydistributionofadiscreterandomvariableXisgivenbelow
X 0 1 2 3 4 5 6P(X) 0.15 0.25 0.12 0.16 0.08 0.13 0.11
Whatisthecdfof4orF(4)?A. 0.08.B. 0.76.C. 0.68.
4. ThecumulativedistributionfunctionofadiscreterandomvariableXisgivenbelow:
X CumulativeDistributionFunction
0 0.151 0.402 0.523 0.684 0.765 0.896 1
TheprobabilityofXgreaterthanorequalto2andlessthanorequalto5isclosestto:A. 0.37.B. 0.52.C. 0.89.
5. Whichofthefollowingisleastlikelyaconditionofabinomialexperiment?
A. Thetrialsareindependent.B. Thereareonlytwotrials.C. Theprobabilityofsuccess+probabilityoffailure=1.
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6. CastleHockeyClub,anemerginghockeyteam,hadatoughlastseasonwithawintolossrecordof1to4.Inordertocontestandincreaseitschancesofwinning,theteamsigned3newplayersanditisestimatedthatthechancesofwinningagameinthenextseasonare70%.Assumingthatwinningasinglegameisindependentofothergames,theprobabilitythattheteamwillwin3outofnext5gamesisclosestto:A. 0.3087.B. 0.3698.C. 0.4125.
7. Astock’spredictedpriceoverthenexttwoperiodsisasshownbelow.
Time=0 Time=1 Time=2S0=100 Su=104 Suu=108 Sd=96 Sud,du=101 Sdd=92
Theinitialvalueofthestockis100.Fromhistoricaldata, ithasbeenobservedthattheprobabilityofanupmoveinanygivenperiodis60%andtheprobabilityofadownmoveinanygivenperiodis40%.Usingtheabovedata,theprobabilitythatthestock’spricewillbeequalto101attheendofperiod2isclosestto:A. 24%.B. 36%.C. 48%.
8. Forafixedincomearbitragestrategy,thereturnsforasingletradeisuniformlydistributed
between3%and8%.Ifanewtradeisplacedtoday,whatistheprobabilitythatthereturnswillbemorethan5%?A. 0.4.B. 0.6.C. 0.8.
9. ForastandardnormaldistributionF(0)is:
A. 0.B. 0.5C. 1.0.
10. Forastandardnormaldistribution,P(0≤Z≤1.65)is:
A. 0.450.B. 0.475.C. 0.900.
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11. GiventhatXfollowsanormaldistributionwithameanof5andstandarddeviationof1.25,thestandardizedvaluecorrespondingtoX=9wouldbeclosestto:A. 3.2.B. 4.0.C. 5.0.
12. Followingdataonthethreeportfoliosisgiven:
Portfolio ExpectedReturn StandardDeviation1 10% 3%2 15% 5%3 20% 10%
Assumingtheminimumacceptablerateofreturnis5%,underRoy’ssafety‐firstcriterion,whichofthefollowingportfoliosisthemostappropriatechoice?A. Portfolio1.B. Portfolio2.C. Portfolio3.
13. Analyst1:Normaldistributionsaresuitableforassetreturns.
Analyst2:Lognormaldistributionsaresuitablefordescribingdistributionsofassetprices.A. Analyst1iscorrect.B. Analyst2iscorrect.C. Bothanalystsarecorrect.
14. Astock’spriceatthestartoftheyearwas$10anditsyear‐endpricewas$12,thenits
continuouslycompoundedannualrateofreturnis:A. 16.45%.B. 18.23%.C. 20.00%.
15. Whichofthefollowingsimulationscanbeusedfor‘whatif’analysis?
A. MonteCarlosimulation.B. Historicalsimulation.C. BothMonteCarloandhistoricalsimulation.
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Solutions1. Ciscorrect.Adiscreterandomvariableisoneforwhichthenumberofpossible
outcomescanbecounted.Acontinuousrandomvariableisoneforwhichthenumberofpossibleoutcomesisinfinite.Returnsandtimeareusuallycontinuouslyrandomvariables.Thenumberofstocksinaportfolioisadiscreterandomvariable.
2. Aiscorrect.Foracontinuousdistributionp(x)=0forallX;onlyrangesofvalueofXhave
positiveprobabilities.3. Biscorrect.Acumulativedistributionfunction(CDF)givestheprobabilitythatarandom
variablewillbelessthanorequaltospecificvalues.Therefore:F(4)=0.15+0.25+0.12+0.16+0.08=0.76.
4. Aiscorrect.P(X≤5)=0.89andP(X≤2)=0.52.Therefore,P(2≤X≤5)=0.89–0.52=
0.37.5. Biscorrect.Theremaybeanynumberofindependenttrials,eachwithonlytwopossible
outcomes.6. Aiscorrect.UsingBinomialdistributiontocalculatetheprobabilityof3winsoutof5
games:P(x)=P(X=x)=[numberofwaystochoosexfromn]×px×(1‐p)n‐xP(Win)=0.7P(Lose)=0.3P(3out5)=5C3x0.73x(0.3)2=0.3087
7. Ciscorrect.Therearefourpossibilitiesthatstockpricecantake.Itcanmoveup‐up,up‐
down,down‐upanddown‐down.Inordertoreach101,astock’spricecaneithergoupfirstandthendownortheotherway.Theprobabilityforthestockgoingupfirstandthendownis0.6x0.4=0.24Thisprobabilitywillbethesameforthestockgoingdownfirstandthenupwhichis,0.4x0.6=0.24.Therefore,theprobabilityofthestock’spricereaching101is48%(24%+24%)
8. Biscorrect.Inuniformdistribution,theprobabilitycanbefoundofarangeonlyinstead
ofapoint.Thereturnisuniformlydistributedfrom3%to8%,i.e.therangeis5%.Ifanewtradeisplacedthenreturnsgreaterthan5%leavesa3%buffer(8%‐5%=3%).Therefore,theprobabilityis3/5or0.6.
9. Biscorrect.Thenormaldistributionissymmetricaroundameanof0.F(0)=0.5since
halfofthedistributionliesoneachsideofthemean.
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10. Aiscorrect.FromthetableF(1.65)=0.95,andF(0)=0.5.Thereforetheansweris0.95–
0.5=0.45.Alternatively,weknowthat90%lieswithin‐1.65and+1.65andthat0isthemidpoint,therewecansaythathalfof90%i.e45%liesbetween0and+1.65.
11. Aiscorrect.IfXfollowsanormaldistributionwithparametersμandσ,Xcanbestandardizedusingtheformula:
ZX μσ
=(9–5)÷1.25=3.2
12. Biscorrect.TheportfoliowiththehighestSFRatioispreferred.TheSFRatiois
calculatedbyE R R
σ
TheSFratiosfortheportfoliosare:Portfolio1:1.66Portfolio2:2Portfolio3:1.5
13. Ciscorrect.Anormaldistributionissuitablefordescribingassetreturns.However,the
normaldistributionisnotsuitableforassetpricesbecauseassetpricescannotbenegative.Thelognormaldistributionisboundedbyzero(skewedtotheright)andissuitablefordescribingdistributionsofassetprices.
14. Biscorrect.
Ln(EndingPrice/StartingPrice)Ln(12/10)=0.1823=18.23%
15. Aiscorrect.ComparedwithMonteCarlosimulation,thehistoricalsimulationcannotbe
usedfora“whatif”analysis.
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R11SamplingandEstimation
1.Introduction
Asampleisasubsetofapopulation.Wecanstudyasampletoinferconclusionsaboutthepopulationitself.Forexample,ifallthestockstradingintheUSareconsideredapopulation,thenindicessuchastheS&P500aresamples.WecanlookattheperformanceoftheS&P500anddrawconclusionsabouthowallstocksintheUSareperforming.Thisprocessisknownassamplingandestimation.
2.Sampling
Therearevariousmethodsforobtaininginformationonapopulationthroughsamples.Theinformationweobtainusuallyconcernsaparameter,aquantityusedtodescribeapopulation.Toestimateaparameter,weusesamplestatistics.Astatisticisaquantityusedtodescribeasample.
Therearetworeasonswhysamplingisused:• Timesaving:Inmanycasesitwillbeverytimeconsumingtoexamineeverymember
ofthepopulation.• Monetarysaving:Insomecases,examiningeverymemberofthepopulation
becomeseconomicallyinefficient.
2.1.SimpleRandomSampling
Simplerandomsamplingistheprocessofselectingasamplefromalargerpopulationinsuchawaythateachmemberofthepopulationhasthesameprobabilityofbeingincludedinthesample.
Samplingdistribution
Ifwedrawsamplesofthesamesizeseveraltimesandcalculatethesamplestatistic,thesamplestatisticwillbedifferenteachtime.Thedistributionofvaluesofthesamplestatisticiscalledasamplingdistribution.
Forexample,sayyouselect100stocksfromauniverseof10,000stocksandcalculatetheaverageannualreturnsofthese100stocks.Let’ssayyougetanaveragereturnof15%.Yourepeatthisprocesswithasecondsampleof100stocks.Thistime,yougetanaveragereturnof14%.Youkeeprepeatingthisprocessandeachtimeyougetadifferentaveragereturn.Thedistributionofthesesampleaveragereturnsiscalledasamplingdistribution.
Samplingerror
Samplingerroristhedifferencebetweenasamplestatisticandthecorrespondingpopulationparameter.Thesamplingerrorofthemeanisgivenby:
Samplingerrorofthemean x μ
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Forexample,let’ssayyouwanttoestimatetheaveragereturnsof10,000stocks.Youdrawasampleof100stocksandcalculatetheaveragereturnofthese100stocksas15%.However,theactualaverageofthe10,000stockswas12%.Thenthesamplingerror=15%‐12%=3%.
2.2.StratifiedRandomSampling
Instratifiedrandomsampling,thepopulationisdividedintosubgroupsbasedononeormoredistinguishingcharacteristics.Samplesarethendrawnfromeachsubgroup,withsamplesizeproportionaltothesizeofthesubgrouprelativetothepopulation.Finally,samplesfromeachsubgrouparepooledtogethertoformastratifiedrandomsample.
Theadvantageofstratifiedrandomsamplingisthatthesamplewillhavethesamedistributionofkeycharacteristicsastheoverallpopulation.Thiscanhelpreducethesamplingerror.Stratifiedrandomsamplingthereforeproducesmorepreciseparameterestimatesthansimplerandomsampling
Forexample,youdividetheuniverseof10,000stocksaspertheirmarketcapitalizationsuchthatyouhave5,000largecapstocks,3,000midcapstocks,and2,000smallcapstocks.Instratifiedrandomsampling,toselectatotalsampleof100stocks,youwillrandomlyselect50largecapstocks,30midcapstocks,and20smallcapstocksandpoolallthesesamplestogethertoformastratifiedrandomsample.
Example
Paulwantstocategorizepubliclylistedstocksforhisresearchproject.Hefirstdividesthestocksinto15industries.Thenfromeachindustry,hecategorizescompaniesintothreegroups:small,medium,large.Finally,hedividestheseintovalueversusgrowthstocks.Howmanycellsorstratadoesthesamplingplanentail?A. 20B. 45C. 90
Solution:
Ciscorrect.Thisisanapplicationofthemultiplicationruleofcounting.Thetotalnumberofcellsistheproductof15,3,and2.Thustheansweris90.
2.3.Time‐SeriesandCross‐SectionalData
Time‐seriesdata
Time‐seriesdataconsistsofobservationsforasinglesubjecttakenatspecificandequallyspacedintervalsoftime.Forexample,themonthlyreturnsonMicrosoftstockfromJanuary1995toJanuary2005.
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Cross‐sectionaldata
Cross‐sectionaldataconsistsofobservationsformultiplesubjectstakenataspecificpointintime.Forexample,thesampleofreportedearningspershareofallNASDAQcompaniesfor2005.
Forbothtime‐seriesandcross‐sectionaldata,therandomsamplemustberepresentativeofthepopulationwewishtostudy.
A‘longitudinal’dataor‘panel’datakeepsthesamesampleforeachobservationovertime.
3.DistributionoftheSampleMean
Thesamplemeanisarandomvariablewithaprobabilitydistributionknownasthestatistic’ssamplingdistribution.Tounderstandthisconcept,considerthefollowingpopulation:lastyear’sreturnsoneverystocktradedintheUnitedStates.Weareinterestedinthemeanreturnofallstocksbutdonothavetimetocalculatethepopulationmean.Hence,wedrawasampleof50stocksandcomputethesamplemean.Wethendrawanothersampleof50stocksandcomputethesamplemean.Thisexercisecanberepeatedseveraltimesgivingusadistributionofsamplemeans.Thisdistributioniscalledthestatistic’ssamplingdistribution.Thecentrallimittheorem,explainedbelow,helpsusunderstandthesamplingdistributionofthemean.
3.1.TheCentralLimitTheorem
Accordingtothecentrallimittheorem,ifwedrawasamplefromapopulationwithameanµandavarianceσ2,thenthesamplingdistributionofthesamplemean:
willbenormallydistributed(irrespectiveofthetypeofdistributionoftheoriginalpopulation).
willhaveameanofµ. willhaveavarianceofσ2/n.
Forexample,supposetheaveragereturnoftheuniverseof10,000stocksis12%anditsstandarddeviationis10%.Throughcentrallimittheoremwecanconcludethatifwekeepdrawingsamplesof100stocksandplottheiraveragereturns,wewillgetasamplingdistributionthatwillbenormallydistributedwithmean=12%andvarianceof102/100=1%.
Standarderrorofthesamplemean
Thestandarddeviationofthedistributionofthesamplemeansisknownasthestandarderrorofthesamplemean.
Whenweknowthepopulationstandarddeviation,thestandarderrorofthesamplemeancanbecalculatedas:
σ σ
√n
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Whenwedonotknowthepopulationstandarddeviation(σ)wecanusethesamplestandarddeviation(s)toestimatethestandarderrorofthesamplemean:
s s
√n
Example
Themeanofapopulationis12andthestandarddeviationis3.Giventhatthepopulationcomprisesof64observations,whatisthestandarderrorofthesamplemean?A.0.375B.0.378C.0.667
Solution:
Aiscorrect.StandardError=σ/√n=3/√64=0.375
4.PointandIntervalEstimatesofthePopulationMean
Statisticalinferenceconsistsoftwobranches:1)hypothesistestingand2)estimation.Hypothesistestingaddressesthequestion‘Isthevalueofthisparameterequaltosomespecificvalue?’Thisisdiscussedindetailinthenextreading.Inthissection,wewilldiscussestimation.Estimationseekstoanswerthequestion‘Whatisthisparameter’svalue?’Inestimation,wemakethebestuseoftheinformationinasampletoformoneofseveraltypesofestimatesoftheparameter’svalue.
Apointestimateisasinglenumberthatestimatestheunknownpopulationparameter.
Intervalestimates(orconfidenceintervals)arearangeofvaluesthatbrackettheunknownpopulationparameterwithsomespecifiedlevelofprobability.
4.1.PointEstimators
Theformulasthatweusetocomputethesamplemeanandallothersamplestatisticsareexamplesofestimationformulasorestimators.Theparticularvaluethatwecalculatefromsampleobservationsusinganestimatoriscalledanestimate.Forexample,thecalculatedvalueofthesamplemeaninagivensampleiscalledapointestimateofthepopulationmean.
Thethreedesirablepropertiesofanestimatorare: Unbiasedness:Itsexpectedvalueisequaltotheparameterbeingestimated. Efficiency:Ithasthelowestvarianceascomparedtootherunbiasedestimatorsofthe
sameparameter. Consistency:Assamplesizeincreases,thesamplingerrordecreasesandthe
estimatesgetclosertotheactualvalue.
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4.2.ConfidenceIntervalsforthePopulationMean
Aconfidenceintervalisarangeofvalues,withinwhichtheactualvalueoftheparameterwillliewithagivenprobability.Confidenceintervaliscalculatedas:
Confidenceinterval=pointestimate±(reliabilityfactorxstandarderror)
where:pointestimate=apointestimateoftheparameterreliabilityfactor=anumberbasedontheassumeddistributionofthepointestimateandthedegreeofconfidence(1‐α)fortheconfidenceintervalstandarderror=standarderrorofthesamplestatisticprovidingthepointestimate
Calculatingconfidenceintervals
Tocalculateaconfidenceintervalforapopulationmean,refertothetablebelowandselecttstatisticorzstatisticasperthescenario.
SamplingfromSmallsamplesize(n<30)
Largesamplesize(n≥30)
Normaldistribution
Varianceknown z zVarianceunknown t t(orz)
Non–normaldistribution
Varianceknown NA zVarianceunknown NA t(orz)
Usethefollowingformulaetocalculatetheconfidenceinterval:
Confidenceinterval X z / σ
√n
Confidenceinterval X t / s
√n
SamplingfromanormaldistributionwithknownvarianceThemostbasicconfidenceintervalforthepopulationmeanariseswhenwearesamplingfromanormaldistributionwithknownvariance.
Theconfidenceintervalwillbecalculatedas:
ConfidenceInterval X z / σ
√n
where:X=samplemeanz / =reliabilityfactor
σ/√n=standarderrorThereliabilityfactor(z / )dependspurelyonthedegreeofconfidence.Ifthedegreeofconfidence(1–α)is95%or0.95,thelevelofsignificance(α)is5%or0.05.α/2=0.025.α/2istheprobabilityineachtailofthestandardnormaldistribution.Thisisshowninblueinthefigurebelow:
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Thereliabilityfactorsthataremostfrequentlyusedwhenweconstructconfidenceintervalsbasedonthestandardnormaldistributionare:
• 90%confidenceintervals:α=0.1,α/2=0.05.Reliabilityfactor=z0.05=1.65• 95%confidenceintervals:α=0.05,α/2=0.025.Reliabilityfactor=z0.025=1.96• 99%confidenceintervals:α=0.01,α/2=0.005.Reliabilityfactor=z0.005=2.58
Memorizetheseconfidenceintervalsandthecorrespondingreliabilityfactors.
Example
YoutakearandomsampleofstocksontheNationalStockExchange(NSE).Thesamplesizeis100andtheaverageSharperatiois0.50.AssumethattheSharperatiosofallstocksontheNSEfollowanormaldistributionwithastandarddeviationof0.30.Whatisthe90%confidenceintervalforthemeanSharperatioofallstocksontheNSE?
Solution:
ConfidenceInterval X z / σ
√n 0.50 1.65
0.30
√100=0.50 0.0495
Therefore,the90%confidenceintervalforthemeanSharperatioofallstocksontheNSEis:0.4505to0.5495.
Asweincreasethedegreeofconfidence,theconfidenceintervalbecomeswider.Ifweusea95%confidenceinterval,thereliabilityfactoris1.96.Andtheconfidenceintervalrangesfrom0.50–1.96x0.03to0.50+1.96x0.03whichis:0.4412to0.5588.Thisrangeiswiderthanwhatwehadwitha90%confidenceinterval.
Samplingfromanormaldistributionwithunknownvariance
Ifthedistributionofthepopulationisnormalwithunknownvariance,wecanusethet‐distributiontoconstructaconfidenceinterval.Letusfirstunderstandwhatat‐distributionisandcontrastitwithanormaldistribution.
Student’st‐distributionhasthefollowingproperties: Itissymmetrical,bell‐shapedandsimilartoanormaldistribution. Ithasalowerpeakandfattertailsascomparedtoanormaldistribution. Itisdefinedbyasingleparameter,degreesoffreedom(df)=n–1.
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Thevalueofdegreesoffreedom,isusedtodescribehowwellthetstatisticrepresentsaz‐score.Also,thevalueofdfwilldeterminehowwellthedistributionoftapproximatesanormaldistribution.Forlargevaluesofdf,thetdistributionwillbenearlynormal,butwithsmallvaluesfordf,thetdistributionwillbeflatterandmorespreadoutthananormaldistribution.Refertothefigurebelow.
Theconfidenceintervalcanbecalculatedusingthefollowingformula:
ConfidenceInterval X t / s
√n
Thisrelationshipissimilartowhatwe’vediscussedbeforeexcepthereweusethet‐distribution.Sincethepopulationstandarddeviationisnotknown,wehavetousethesamplestandarddeviationwhichisdenotedbythesymbol‘s’.Wewillnowseehowtoreadthet‐distributiontableusinganexample.
Example
Givenasamplesizeof20,whatisthereliabilityfactorfora90%confidencelevel?
Solution:
Inordertoanswerthisquestion,weneedtorefertothet‐table.Asnapshotofthetableisgivenbelow.Thistableshowsthelevelofsignificanceforone‐tailedprobabilities.df P=0.10 P=0.05 P=0.025 P=0.01 P=0.0051 3.078 6.314 12.706 31.821 63.6572 1.886 2.920 4.303 6.965 9.9253 1.638 2.353 3.182 4.541 5.8414 1.533 2.132 2.776 3.747 4.6045 1.476 2.015 2.571 3.365 4.0326 1.440 1.943 2.447 3.143 3.707
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7 1.415 1.895 2.365 2.998 3.4998 1.397 1.860 2.306 2.896 3.3559 1.383 1.833 2.262 2.821 3.25010 1.372 1.812 2.228 2.764 3.16911 1.363 1.796 2.201 2.718 3.10612 1.356 1.782 2.179 2.681 3.05513 1.350 1.771 2.160 2.650 3.01214 1.345 1.761 2.145 2.624 2.97715 1.341 1.753 2.131 2.602 2.94716 1.337 1.746 2.120 2.583 2.92117 1.333 1.740 2.110 2.567 2.89818 1.330 1.734 2.101 2.552 2.87819 1.328 1.729 2.093 2.539 2.86120 1.325 1.725 2.086 2.528 2.845Thedegreesoffreedominthiscasearen–1=20–1=19.Thelevelofsignificanceiscalculatedas:100(1‐α)%=90%andα=0.10.Inordertocalculatethereliabilityfactor
/ = . / = . ,welookattherowwithdf=19.Wethenlookatthecolumnwithp=0.05.Thevaluethatsatisfiesthesetwocriteriais1.729.Thisisthereliabilityfactor.Example
AnanalystwantstoestimatethereturnontheHangSengIndexforthecurrentyearusingthefollowingdataandassumptions: Samplesize=64stocksfromtheindex Meanreturnforthestocksinthesampleforthepreviousyear=0.12 Variance=0.081
Itisgiventhatthereliabilityfactorfora95%confidenceintervalwithunknownpopulationvarianceandsamplesizegreaterthan64is1.96.Assumingthattheindexreturnthisyearwillbethesameasitwaslastyear,whatistheestimateofthe95%confidenceintervalfortheindex’sreturnthisyear?
Solution:
ConfidenceInterval X t / √=0.12 1.96 √ .
√0.12 0.07=0.05to0.19
Instructor’sNote:Aconservativeapproachtoconfidenceintervalsreliesonthet‐distributionratherthanthenormaldistribution,anduseofthet‐distributionwillincreasethereliabilityoftheconfidenceinterval.
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4.3.SelectionofSampleSize
Thechoiceofsamplesizeaffectsthewidthofaconfidenceinterval.Alargersamplesizedecreasesthewidthofaconfidenceintervalandimprovestheprecisionwithwhichwecanestimatethepopulationparameter.Thisisobviouswhenweconsidertheconfidenceintervalrelationship,shownbelow:
ConfidenceInterval X t / s
√n
Allelsebeingequal,whenthesamplesize(n)isincreased,thestandarderror(s/√ )decreasesandwehaveamoreprecise(narrower)confidenceinterval.Basedonthisdiscussionitmightappearthatweshoulduseaslargeasamplesizeaspossible.However,wemustconsiderthefollowingissues:
Increasingthesamplesizemayresultinsamplingfrommorethanonepopulation. Increasingthesamplesizemayinvolveadditionalexpensesthatoutweighthevalue
ofadditionalprecision.
5.MoreonSampling
Therearemanyissuesinsampling.Herewediscussfourmainissues.
5.1Data‐MiningBias
Data‐miningisthepracticeofanalyzingthesamedataagainandagain,tillapatternthatworksisidentified.
Therearetwosignsthatcanwarnanalystsaboutthepotentialexistenceofdatamining:• Toomuchdigging/toolittleconfidence:Manydifferentvariablesweretested,until
significantoneswerefound.Unfortunately,manyresearchersdonotdisclosethenumberofvariablesexaminedindevelopingamodel.
• Nostory/nofuture:Withoutareasonableeconomicrationaleorstoryforwhyavariableshouldwork,thevariableisunlikelytohavepredictivepower.
Thebestwaytoavoidthisbiasistotestthepatternonout‐of‐sampledatatocheckifitholds.
5.2SampleSelectionBias
Whendataavailabilityleadstocertainassetsbeingexcludedfromtheanalysis,theresultingproblemisknownassampleselectionbias.Forexample,manymutualfunddatabasesprovidehistoricalinformationaboutonlythosefundsthatcurrentlyexist.Atypeofsampleselectionbiasisthesurvivorshipbias,inwhichcompaniesareexcludedfromanalysisbecausetheyhavegoneoutofbusiness.Asamplecanalsobebiasedbecauseoftheremoval(ordelisting)ofacompany’sstockfromanexchange.
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5.3Look‐AheadBias
Atestdesignissubjecttolook‐aheadbiasifitusesinformationthatwasnotavailabletomarketparticipantsatthetimethemarketparticipantsactinthemodel.Forexample,ananalystwantstousethecompany’sbookvaluepersharetoconstructtheP/Bvariableforthatparticularcompany.Althoughthemarketpriceofastockisavailableforallmarketparticipantsatthesamepointintime,fiscalyear‐endbookequitypersharemightnotbecomepubliclyavailableuntilsometimeinthefollowingquarter.
5.4Time‐PeriodBias
Atestdesignissubjecttotime‐periodbiasifitisbasedonatimeperiodthatmaymaketheresultstime‐periodspecific.Ashorttimeseriesislikelytogiveperiod‐specificresultsthatmaynotreflectalongerperiod.Ifatimeseriesistoolong,fundamentalstructuralchangesmayhaveoccurredinthattimeperiod.
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Summary
LO.a:Definesimplerandomsamplingandasamplingdistribution.
Simplerandomsamplingistheprocessofselectingasamplefromalargerpopulationinsuchawaythateachelementofthepopulationhasthesameprobabilityofbeingincludedinthesample.
Ifwedrawsamplesofthesamesizeseveraltimesandcalculatethesamplestatistic,thesamplestatisticwillbedifferenteachtime.Thedistributionofvaluesofthesamplestatisticiscalledasamplingdistribution.
LO.b:Explainsamplingerror.
Samplingerroristhedifferencebetweenasamplestatisticandthecorrespondingpopulationparameter.
Samplingerrorofthemean x μ
LO.c:Distinguishbetweensimplerandomandstratifiedrandomsampling.
Instratifiedrandomsampling,thepopulationisdividedintosubgroupsbasedononeormoredistinguishingcharacteristics.Samplesarethendrawnfromeachsubgroup,withsamplesizeproportionaltothesizeofthesubgrouprelativetothepopulation.Finally,samplesfromeachsubgrouparepooledtogethertoformastratifiedrandomsample.
LO.d:Distinguishbetweentimeseriesandcross‐sectionaldata.
Timeseriesdataconsistsofobservationsforasinglesubjecttakenatspecificandequallyspacedintervalsoftime.
Cross‐sectionaldataconsistsofobservationsformultiplesubjectstakenataspecificpointintime.
LO.e:Explainthecentrallimittheoremanditsimportance.
Accordingtothecentrallimittheorem,ifwedrawasamplefromapopulationwithameanµandavarianceσ2,thenthesamplingdistributionofthesamplemean:
willbenormallydistributed(irrespectiveofthetypeofdistributionoftheoriginalpopulation).
willhaveameanofµ. willhaveavarianceofσ2/n.
LO.f:Calculateandinterpretthestandarderrorofthesamplemean.
Thestandarddeviationofthedistributionofthesamplemeansisknownasthestandarderrorofthesamplemean.
Whenweknowthepopulationstandarddeviation,thestandarderrorofthesamplemeancanbecalculatedas:σ
√
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Whenwedonotknowthepopulationstandarddeviation(σ)wecanusethesamplestandarddeviation(s)toestimatethestandarderrorofthesamplemeans
√
LO.g:Identifyanddescribedesirablepropertiesofanestimator.
Thethreedesirablepropertiesofanestimatorare: Unbiasedness:Itsexpectedvalueisequaltotheparameterbeingestimated. Efficiency:Ithasthelowestvarianceascomparedtootherunbiasedestimatorsofthe
sameparameter. Consistency:Assamplesizeincreases,thesamplingerrordecreasesandthe
estimatesgetclosertotheactualvalue.
LO.h:Distinguishbetweenapointestimateandaconfidenceintervalestimateofapopulationparameter.
Apointestimateisasinglevalueestimatethatservesasanapproximationfortheactualvalueoftheparameter.
Aconfidenceintervalisarangeofvalues,withinwhichtheactualvalueoftheparameterwillliewithagivenprobability.
Confidenceinterval=Pointestimate±(reliabilityfactorxstandarderrorofpointestimate)
LO.i:DescribepropertiesofStudent’st‐distributionandcalculateandinterpretitsdegreesoffreedom.
Student’st‐distributionhasthefollowingproperties: Itissymmetrical,bell‐shaped,andsimilartoanormaldistribution. Ithasalowerpeakandfattertailsascomparedtoanormaldistribution. Itisdefinedbyasingleparameter:degreesoffreedom(df)=n‐1 Asthedegreesoffreedomincrease,theshapeofthet‐distributionstartsapproaching
theshapeofthenormaldistribution.
LO.j:Calculateandinterpretaconfidenceintervalforapopulationmean,givenanormaldistributionwith1)aknownpopulationvariance,2)anunknownpopulationvariance,or3)anunknownpopulationvarianceandalargesamplesize.
Refertothetablebelowandselecttstatisticorzstatisticasperthescenario.
Samplingfrom Smallsamplesize(n<30)
Largesamplesize(n≥30)
Normaldistribution
Varianceknown z zVarianceunknown t t(orz)
Non–normaldistribution
Varianceknown NA zVarianceunknown NA t(orz)
Usethefollowingformulaetocalculatetheconfidenceinterval:
Confidenceinterval X z / σ
√n
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Confidenceinterval X t / s
√n
LO.k:Describetheissuesregardingselectionoftheappropriatesamplesize,data‐miningbias,sampleselectionbias,survivorshipbias,look‐aheadbias,andtime‐periodbias.
Increasingthesamplesizereducesthestandarderrorandgivesusnarrowerconfidenceintervals.However,whileincreasingsamplesizewemustconsidertwothings:
Costinvolved:Comparethecostofgettingmoredatatothepotentialbenefitsofincreasingprecision.
Riskofsamplingfromadifferentpopulation:Intheprocessofincreasingsamplesizeifwegetdatafromadifferentpopulation,thentheaccuracywillnotimprove.
Biasesobservedinsamplingmethodsare: Data‐miningbias:Analyzingthesamedataagainandagain,tillapatternthatworksis
identified.Thebestwaytoavoidthisbiasistotestthepatternonout‐of‐sampledatatocheckifitholds.
Sampleselectionbias:Excludingcertainassetsfromtheanalysisduetounavailabilityofdata.Atypeofsampleselectionbiasisthesurvivorshipbias,inwhichcompaniesareexcludedfromanalysisbecausetheyhavegoneoutofbusinessanddataforthemwasnoteasilyavailable.
Look‐aheadbias:Usinginformationthatbecameavailableatlaterperiodsintimeintheanalysis.
Time‐periodbias:Iftheselectedtimeperiodistooshort,theresultsmayonlyholdforthattimeperiod.Ifthetimeperiodistoolong,thentheresultsmightnotconsidermajorstructuralchangesintheeconomy.
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PracticeQuestions
1. A simple random sample is a sample drawn in such a way that each member of thepopulationhas:A. somechanceofbeingselectedinthesample.B. anequalchanceofbeingselectedinthesample.C. isincludedinthesample.
2. Supposewetakearandomsampleof40companiesinanindustrywith100companies.
Wecalculatethesamplemeanofthedebt‐to‐equityratiofortheprioryear.Wefindthatthisratiois2.5percent.Subsequently,welearnthatthepopulationdebt‐to‐equityratio(takingaccountofall100companies) is2.What is theexplanation for thediscrepancybetweenthesamplemeanof2.5percentandthepopulationmeanof2?A. Samplingerror.B. Bias.C. Alackofconsistency.
3. AnanalystcompilesEPSdataforasampleofcompaniesrandomlydrawnfromtheS&P
500.Hegathersthedatafromthecompanies’fiscalyear2015annualreports.Thisdataisbestcharacterizedas:A. time‐seriesdata.B. longitudinaldata.C. cross‐sectionaldata.
4. Thepopulationdistributionofhedgefundreturnsinacountryisfoundtobenegatively
skewedinaparticularyear.Giventhatthesamplesizeislarge,thesamplingdistributionofthesamplemeanreturnswouldbecharacterizedby:
Distribution Mean VarianceA Negativeskewed Lessthanpopulation
meanEqualtopopulationvariance
B Normaldistribution
Equaltopopulationmean Lessthanpopulationvariance
C Normaldistribution
Lessthanpopulationmean
Equaltopopulationvariance
5. Asampleof50observationshasameanof10andastandarddeviationof2.Thestandard
errorofthesamplemeanisclosestto:A. 0.04B. 0.28.C. 1.41.
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6. Ananalystwhilegeneratinganestimateofapopulationparameterisconsideringdrawinga larger sample size. In doing so, a larger sample size will most likely improve theestimator’s:A. efficiency.B. consistency.C. unbiasedness.
7. JohnClarkisunsureoftheunderlyingpopulationdistributionandwantstoincreasethe
reliabilityoftheparameterestimates.Whichofthefollowingisleastlikelytoachievehisobjective?A. Increaseinthesamplesize.B. Useofpointestimatesratherthanconfidenceintervals.C. Useof thet‐distributionratherthanthenormaldistributiontoestablishconfidence
intervals.
8. Analyst1:Asdegreesoffreedomincrease,at‐distributionwillbecomemorepeaked.Analyst2:Asdegreesoffreedomincrease,thetailsofthet‐distributionwillbecomelessfat.A. Analyst1iscorrect.B. Analyst2iscorrect.C. Bothanalystsarecorrect.
9. Robert Scottwants to calculate the confidence intervals for thepopulationmeanof an
approximately normal distribution. Assuming the sample size is small, the Student’s t‐distributionisthepreferredmethodwhenthevarianceis:A. unknown.B. tooLarge.C. negative.
10. Arandomsampleof100coffeeshopcustomersspentanaverageof25minsatthestore.
Assumingthedistributionisnormalandthepopulationstandarddeviationis4mins,the95%confidenceintervalforthepopulationmeanisclosestto:A. 21.00to29.00.B. 24.25to25.78.C. 23.78to26.04.
11. Asampleof25recentordersatarestaurantshowedthatthemeantimetoserveadish
was19minswithasamplestandarddeviationof3mins.Assumingthepopulationisnormallydistributed,the99%confidenceintervalforthepopulationmeanis:A. 17.32to20.67.B. 16.21to21.96.
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C. 15.24to22.38.12. DavidJonesisconductingaresearchonS&P500stocks.Inhisresearch,heuseshistorical
datathatwasnotpubliclyavailableatthetimeperiodbeingstudied.Hissamplewillmostlikelyhavea:A. look‐aheadbias.B. time‐periodbias.C. sampleselectionbias.
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Solutions
1. B is correct. In a simple random sample, eachmember of the populationhas an equalprobabilityofbeingselected.
2. Aiscorrect.Thediscrepancyarisesfromsamplingerror.Samplingerroristhedifferencebetweenasamplestatisticanditscorrespondingpopulationparameter.Asamplingerrorexistswheneveronefailstoobserveeveryelementofthepopulation,becauseasamplestatisticcanvaryfromsampletosample.Wedonotexpectthesamplemeantoexactlyequalthepopulationmeaninanyonesamplewemaytake.
3. Ciscorrect.Dataonsomecharacteristicsofcompaniesatasinglepointintimearecross‐sectionaldata.
4. Biscorrect.AccordingtotheCentralLimitTheorem,thesamplingdistributionofsamplemeansisapproximatelyanormaldistributionwithitsmeanequaltothepopulationmean.Itsvarianceisequaltopopulationvariancedividedbythesamplesizeandhencewouldbelessthanpopulationvariance.TheCentralLimitTheoremisindependentoftheprobabilitydistributionofthegivenpopulationwhenthesamplesizeislargeandthustheskewnessofpopulationdoesnotmatter.
5. Biscorrect.Thestandarderrorofthesamplemean,whenweknowthesamplestandarddeviation,issamplestandarddeviationdividedbysquarerootofsamplesize:2/√50=0.28
6. B is correct. Unbiasedness and efficiency are properties of an estimator’s samplingdistribution that hold for any size sample.A consistent estimator is one forwhich theprobabilityofestimatesclosetothevalueofthepopulationparameterincreasesassamplesizeincreases.
7. B is correct. Point estimates are not as reliable as confidence interval estimates. Aconservativeapproachtoconfidenceintervalsreliesonthet‐distributionratherthanthenormal distribution, and use of the t‐distribution will increase the reliability of theconfidenceinterval.Increasingthesamplesizeincreasesthereliabilityoftheconfidenceintervals.
8. Ciscorrect.Asdegreesoffreedomincrease,thet‐distributionwillmorecloselyresembleanormaldistribution,becomingmorepeakedandhavinglessfattails.
9. Aiscorrect.TheStudent’st‐distributionisthepreferredoptionwhenthesamplesizeissmallandthevarianceisunknownBelowtableprovidestheappropriatetestgivenascenario:
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SamplingFromStatisticforSmallSampleSize
StatisticforLargeSampleSize
Normaldistributionwithaknownvariance
z z
Normaldistributionwithunknownvariance
t torz
Non‐normaldistributionwithknownvariance
NotAvailable z
Non‐normaldistributionwithunknownvariance
NotAvailable torz
10. Biscorrect.Sincethepopulationvarianceisknownandn≥30,theconfidenceintervalisdeterminedas ̅ / /√ Z0.025=1.96Confidenceinterval=25±1.96(4/sqrt(100)=24.216to25.784
11. Aiscorrect.Sincethepopulationvarianceisunknownandn<30,theconfidenceintervalisdeterminedas̅ / /√ .Thecriticalvalueoft0.005anddf=n‐1=24is2.797.Sotheconfidenceintervalis19±2.797(3/5)=17.32to20.67
12. Aiscorrect.Thisisanexampleoflook‐aheadbias.
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R12HypothesisTesting
1.Introduction
Hypothesistestingistheprocessofmakingjudgmentsaboutalargergroup(apopulation)onthebasisofobservingasmallergroup(asample).Theresultsofsuchatestthenhelpusevaluatewhetherourhypothesisistrueorfalse.
Forexample,let’ssayyouarearesearcherandyoubelievethattheaveragereturnonallAsianstockswasgreaterthan2%.TotestthisbeliefyoucandrawsamplesfromapopulationofallAsianstocksandemployhypothesistestingprocedures.Theresultsofthistestcantellyouifyourbeliefisstatisticallyvalid.
2.HypothesisTesting
Ahypothesisisdefinedasastatementaboutoneormorepopulations.Inordertotestahypothesis,wefollowthesesteps:
1. Statingthehypothesis.2. Identifyingtheappropriateteststatisticanditsprobabilitydistribution.3. Specifyingthesignificancelevel.4. Statingthedecisionrule.5. Collectingthedataandcalculatingtheteststatistic.6. Makingthestatisticaldecision.7. Makingtheeconomicorinvestmentdecision.
Instructor’sNoteThoughthecurriculumsuggestsasevenstepprocessforhypothesistesting,youcanarriveatadecisionquicklyusingthesefoursteps:1. Statethehypothesis.2. Computetheteststatistic.3. Determinethecriticalvaluebasedonsignificancelevel.4. Comparetheteststatisticwiththecriticalvalueanddeterminewhetherornottoreject
thenullhypothesis.
Let’sunderstandthesestepswiththehelpofafewexamples.
RightTailedTest
SupposeyouarearesearcherandbelievethattheaveragereturnonallAsianstockswasgreaterthan2%.Inthiscase,youaremakingastatementaboutthepopulationmean(µ)ofallAsianstocks.
Step1:Statingthehypothesis
Thefirststepisstatingthetwohypotheses:thenullhypothesis(H0)andthealternativehypothesis(Ha).
Nullhypothesis(H0):Itisthehypothesisthattheresearcherwantstoreject.
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Alternativehypothesis(Ha):Itisthehypothesisthattheresearcherwantstoprove.Ifthenullhypothesisisrejectedthenthealternativehypothesisisconsideredvalid.
Forourexample,thenullandalternativehypothesesare:
H0:µ≤2%
Ha:µ>2%
(Thevalue2%isknownasµ0,thehypothesizedvalueofthepopulationmean.)
Instructor’sNote:Aneasywaytodifferentiatebetweenthetwohypothesesistorememberthatthenullhypothesisalwayscontainssomeformoftheequalsign.
Step2:Computetheteststatistic.
Ateststatisticiscalculatedfromsampledataandiscomparedtoacriticalvaluetodecidewhetherornotwecanrejectthenullhypothesis.Theformulaforcomputingteststatisticis:
teststatistic samplestatistic valueoftheparameterunderH
standarderrorofthesamplestatistic
Continuingwithourexample,let’sfurthersupposethatthesamplemeanof36observationsofAsianstocksis4andthestandarddeviationofthepopulationis4.Therefore,
teststatisticX μ
√
4 2
√
3
Step3:Determinethecriticalvaluebasedonsignificancelevel
ContinuingwithourexampleofAsianstocks,supposewewanttotestourhypothesisatthe5%significancelevel.Thisisaone‐tailedtestbecausewearetryingtoassesswhetherthepopulationmeanisgreaterthan2%ornot.Hence,weareonlyinterestedintherighttailofthedistribution.Ifweweretryingtoassesswhetherthepopulationmeanislessthan2%wewouldbeinterestedinthelefttail.
Instructor’sNoteThesigninthealternativehypothesispointstothedirectionofthetailthatweshoulduseinourtest.Sinceinourexamplethealternativehypothesishasa‘>’signitpointstotheright,thereforeweareinterestedintherighttail.
Thecriticalvalueisalsoknownastherejectionpointfortheteststatistic.Graphically,thispointseparatestheacceptanceandrejectionregionsforasetofvaluesoftheteststatistic.Thisisshownbelow:
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Theregiontotheleftoftheteststatisticisthe‘acceptanceregion’.Thisrepresentsthesetofvaluesforwhichwedonotreject(accept)thenullhypothesis.Theregiontotherightoftheteststatisticisknownasthe‘rejectionregion’.
UsingtheZ–tableand5%levelofsignificance,thecriticalvalue=Z0.05=1.65
Step4:Comparetheteststatisticwiththecriticalvalueanddeterminewhetherornottorejectthenullhypothesis
Iftheteststatistic>criticalvalue,i.e.iftheteststatisticliesintherejectionregionwewillrejectH0.
Ontheotherhand,iftheteststatistic<criticalvalue,i.e.iftheteststatisticliesintheacceptanceregion,thenwecannotrejectH0.
Inourexample,becausetheteststatisticz=3isgreaterthanthecriticalvalueof1.645,werejectthenullhypothesisinfavorofthealternativehypothesisthattheaveragereturnonallAsianstocksisgreaterthan2%.
LeftTailedTest
Weusealefttailedtesttodeterminewhethertheestimatedvalueofapopulationparameterislessthanahypothesizedvalue.
ExampleAnanalystbelievesthattheaveragereturnonallAsianstockswaslessthan2%.Thesamplesizeis36observationswithasamplemeanof‐3.Thestandarddeviationofthepopulationis4.Willherejectthenullhypothesisatthe5%levelofsignificance?
Solution:Inthiscase,ournullandalternativehypothesesare:
H0:µ≥2
Ha:µ<2
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Thestandarderrorofthesampleis:σ √
√
0.67
Theteststatisticis:
teststatistic samplestatistic valueoftheparameterunderH
standarderrorofthesamplestatistic3 20.67
7.5
Thecriticalvaluescorrespondingtoa5%levelofsignificanceis‐1.65.
Whenweconsiderthelefttailofthedistribution,ourdecisionruleisasfollows:Rejectthenullhypothesisiftheteststatisticislessthanthecriticalvalueandviceversa.Sinceourcalculatedteststatisticof‐7.5islessthanthecriticalvalueof‐1.65,werejectthenullhypothesis.
Two‐tailedtest
Weuseatwo‐tailedhypothesistesttodeterminewhethertheestimatedvalueofapopulationparameterisdifferentfromthehypothesizedvalue.Inatwo‐tailedtest,werejectthenullinfavorofthealternativeiftheevidenceindicatesthatthepopulationparameteriseithersmallerorlargerthanthevalueoftheparameterunderH0.
Forexample,webelievethattheaveragereturnonallAsianstockswasnot0%.Wetakeasampleof36observationswithasamplemeanof1andapopulationstandarddeviationof4.Inthiscaseournullandalternativehypothesesare:
H :µ=0
H :µ≠0
Thestandarderrorofthesampleisunchangedat0.67:
σ σ
√n4
√360.67
Theteststatisticis:
teststatistic samplestatistic valueoftheparameterunderH
standarderrorofthesamplestatistic1 00.67
1.5
Inatwo‐tailedtest,twocriticalvaluesexist,onepositiveandonenegative.Foratwo‐sided
testatthe5%levelofsignificance,wecalculatethez‐valuesthatcorrespondto . =0.025
levelofsignificance.Theseare+1.96and‐1.96.Therefore,werejectthenullhypothesisifwefindthattheteststatisticislessthan‐1.96orgreaterthan+1.96.Wefailtorejectthenullhypothesisif‐1.96≤teststatistic≤+1.96.Graphically,thiscanbeshownas:
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Relationshipbetweenconfidenceintervalandhypothesistests
Theabovefigurealsoillustratestherelationshipbetweenconfidenceintervalsandhypothesistests.Aconfidenceintervalspecifiestherangeofvaluesthatmaycontainthehypothesizedvalueofthepopulationparameter.The5%levelofsignificanceinthehypothesistestscorrespondstoa95%confidenceinterval.Whenthehypothesizedvalueofthepopulationparameterisoutsidethecorrespondingconfidenceinterval,thenullhypothesisisrejected.Whenthehypothesizedvalueofthepopulationparameterisinsidethecorrespondingconfidenceinterval,thenullhypothesisisnotrejected.
Summary:One‐tailedtestversustwo‐tailedtests
One‐tailedtestsareusedtotestifthepopulationparameterisgreaterthanorlessthanahypothesizedvalue.Theycanbeeitherright‐tailedtestsorleft‐tailedtests.
Two‐tailedtestsareusedtotestifthepopulationparameterisnotequaltothehypothesizedvalue.Theyhavetworejectionpoints:onepositiveandonenegative,becausehereweareinterestedinbothtails.
p‐value
Thep‐valueisthesmallestlevelofsignificanceatwhichthenullhypothesiscanberejected.Itcanbeusedinthehypothesistestingframeworkasanalternativetousingrejectionpoints.
Ifthep‐valueislowerthanourspecifiedlevelofsignificance,werejectthenullhypothesis.
Ifthep‐valueisgreaterthanourspecifiedlevelofsignificance,wedonotrejectthenullhypothesis.
Forexample,ifthep‐valueofatestis4%,thenthehypothesiscanberejectedatthe5%levelofsignificance,butnotatthe1%levelofsignificance.
Relationshipbetweentest‐statisticandp‐value
Ahightest‐statisticimpliesalowp‐value.
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Alowtest‐statisticimpliesahighp‐value.
TypeIandTypeIIerrors
Inreachingastatisticaldecision,wecanmaketwopossibleerrors: TypeIerror:Wemayrejectatruenullhypothesis. TypeIIerror:Wemayfailtorejectafalsenullhypothesis.
Thefollowingtableshowsthepossibleoutcomesofatest.
DecisionTruecondition
H0true H0falseDonotrejectH0 Correctdecision TypeIIerrorRejectH0(acceptHa) TypeIerror Correctdecision
Thesignificancelevel“α”istheprobabilityoftypeIerror.
Powerofatest
Thepowerofatestistheprobabilityofcorrectlyrejectingthenull(rejectingthenullwhenitisfalse).Itisexpressedas:
Powerofatest=1–P(TypeIIerror)
Statisticalresultv/seconomicallymeaningfulresult
Astatisticaldecisionsimplyconsistsofrejectingornotrejectingthenullhypothesis.Whereas,aneconomicdecisiontakesintoconsiderationalleconomicissuesrelevanttothedecision,suchastransactioncosts,risktolerance,andtheimpactontheexistingportfolio.Sometimesatestmayindicateastatisticallysignificantresultwhichmaynotbeeconomicallysignificant.
3.HypothesisTestsConcerningtheMean
3.1.TestsConcerningaSingleMean
Oneofthedecisionsweneedtomakeinhypothesistestingisdecidingwhichteststatisticandwhichcorrespondingprobabilitydistributiontouse.Weusethefollowingtabletomakethisdecision:
Samplingfrom Smallsamplesize(n<30)
Largesamplesize(n≥30)
Normaldistribution
Varianceknown z zVarianceunknown t t(orz)
Non–normaldistribution
Varianceknown NA zVarianceunknown NA t(orz)
Inthehypothesistestswesawsofar,thepopulationvariancewasknownandoursamplesizewaslarge(n≥30),henceweusedthez‐statisticandz‐distributiontocomputethecriticalvalue.
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However,ifwedonotknowthepopulationvarianceandwehaveasmallsamplesize,thenwehavetousethet‐statisticandt‐distributiontocomputethecriticalvalues.
ExampleFundAlphahasbeeninexistencefor20monthsandhasachievedameanmonthlyreturnof2%withasamplestandarddeviationof5%.Theexpectedmonthlyreturnforafundofthisnatureis1.60%.Assumingmonthlyreturnsarenormallydistributed,aretheactualresultsconsistentwithanunderlyingpopulationmeanmonthlyreturnof1.60%?
Solution:Thenullandalternativehypothesesforthisexamplewillbe:
H0:µ=1.60versusHa:µ≠1.60
teststatistic X μ
√
2 1.60
√
0.36
Usingthisformula,weseethatthevalueoftheteststatisticis0.36.
Thecriticalvaluesata0.05levelofsignificancecanbecalculatedfromthet‐distributiontable.Sincethisisatwo‐tailedtest,weshouldlookata0.05/2=0.025levelofsignificancewithdf=n‐1=20–1=19.Thisgivesustwovaluesof‐2.1and+2.1.
Sinceourteststatisticof0.35liesbetween‐2.1and+2.1,i.e.,theacceptanceregion,wedonotrejectthenullhypothesis.
3.2.TestsConcerningDifferencesbetweenMeans
Instructor’sNote:Focusonthebasicsofthistopic,theprobabilityofbeingtestedonthedetailsislow.
Inthissection,wewilllearnhowtocalculatethedifferencebetweenthemeansoftwoindependentandnormallydistributedpopulations.Wecanusetwokindsoft‐tests.Inonecasethepopulationvariances,althoughunknown,canbeassumedtobeequal.Inthesecondcasethepopulationvariancesareassumedtobeunknownandunequal.
UnknownButEqualVariance
Whenweassumethatthetwopopulationsarenormallydistributedandthattheunknownpopulationvariancesareequal,thet‐testbasedonindependentrandomsamplesisgivenby:
t X X μ μ
/
Theterm isknownasthepooledestimatorofthecommonvariance.Itiscalculatedbythefollowingformula:
s n 1 s n 1 s
n n 2
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Thenumberofdegreesoffreedomisn1+n2–2.
UnknownandUnequalVariance
Whenwecanassumethatthetwopopulationsarenormallydistributedandthattheunknownpopulationvariancesareunequal,anapproximatet‐testbasedonindependentrandomsamplesisgivenby:
t X X μ μ
/
Inthisformula,weusethetablesofthet‐distributionusingthe‘modified’degreesoffreedom.The‘modified’degreesoffreedomarecalculatedusingthefollowingformula:
df
/ /
ExampleYoubelievethemeanreturnonNYSEstockswasdifferentfromthemeanonNSEstockslastmonth.Totestyourhypothesisyoucollectthefollowingdata: SampleSize(n) SampleMean(X) SampleStandardDeviationNSE 20 2% 4NYSE 40 3% 5Determinewhethertorejectthenullhypothesisatthe0.10levelofsignificance.
Solution:Thefirststepistoformulatethenullandalternativehypotheses.Sincewewanttotestwhetherthetwomeanswereequalordifferent,wedefinethehypothesesas:H0:µ1‐µ2=0Ha:µ1‐µ2≠0
Sincethepopulationstandarddeviationisunknownandwecannotassumethatitisequal,weusethefollowingformulatocalculatetheteststatistic:
t X X μ μ
/2 3 0
/0.84
Next,wecalculatethemodifieddegreesoffreedom:
df
/ /
/ / 48
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Fora0.10levelofsignificance,wefindthet‐valuefor0.10/2=0.05usingdf=48.Thet‐valueisthereforeta/2=‐1.677and+1.677.Sinceourteststatisticof‐0.84liesintheacceptanceregion,wefailtorejectthenullhypothesis.
3.3.TestsconcerningMeanDifferences
Instructor’sNote:Focusonthebasicsofthistopic,theprobabilityofbeingtestedonthedetailsislow.
Intheprevioussection,inordertoperformhypothesistestsondifferencesbetweenmeansoftwopopulations,weassumedthatthesampleswereindependent.Whatifthesamplesarenotindependent?Forexample,supposeyouwanttoconducttestsonthemeanmonthlyreturnonToyotastockandmeanmonthlyreturnonHondastock.Thesetwosamplesarebelievedtobedependent,astheyareimpactedbythesameeconomicfactors.
Insuchsituations,weconductat‐testthatisbasedondataarrangedinpairedobservations.Pairedobservationsareobservationsthataredependentbecausetheyhavesomethingincommon.
Wewillnowdiscusstheprocessforconductingsuchat‐test.SupposethatwegatherdataregardingthemeanmonthlyreturnsonstocksofToyotaandHondaforthelast20months,asshowninthetablebelow:
Month MeanreturnofToyotastock
MeanmonthlyreturnofHondastock
Differenceinmeanmonthlyreturns(di)
1 0.5% 0.4% 0.1%2 0.7% 1.0% ‐0.3%3 0.3% 0.7% ‐0.4%… … … …20 0.9% 0.6% 0.3%Average 0.750% 0.600% 0.075%
Hereisasimplifiedprocessforconductingthehypothesistest:
Step1:Definethenullandalternatehypotheses
Webelievethatthemeandifferenceisnot0.Hencethenullandalternatehypothesesare:
H :μ μ versusH :μ μ
µdstandsforthepopulationmeandifferenceandµd0standsforthehypothesizedvalueforthepopulationmeandifference.
Step2:Calculatethetest‐statistic
Determinethesamplemeandifferenceusing:
d 1n
d
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Forthedatagiven,thesamplemeandifferenceis0.075%.
Calculatethesamplestandarddeviation.Theprocessforcalculatingthesamplestandarddeviationhasbeendiscussedinanearlierreading.Thesimplestmethodistoplugthenumbers(0.1,‐0.3,‐0.4…0.3)intoafinancialcalculator.Theentiredatasethasnotbeenprovided.We’lltakeitasagiventhatthesamplestandarddeviationis0.150%.
Usethisformulatocalculatethestandarderrorofthemeandifference:
s s
√n
Forourdatathisis0.150/√20=0.03354.
Wenowhavetherequireddatatocalculatetheteststatisticusingat‐test.Thisiscalculatedusingthefollowingformulausingn‐1degreesoffreedom:
t d μs
Forourdata,theteststatisticis . –
.2.24.
Step3:Determinethecriticalvaluebasedonthelevelofsignificance
Wewillusea5%levelofsignificance.Sincethisisatwo‐tailedtestwehaveaprobabilityof2.5%(0.025)ineachtail.Thiscriticalvalueisdeterminedfromat‐tableusingaone‐tailedprobabilityof0.025anddf=20–1=19.Thisvalueis2.093.
Step4:Comparetheteststatisticwiththecriticalvalueandmakeadecision
Inourcase,theteststatistic(2.23)isgreaterthanthecriticalvalue(2.093).Hencewewillrejectthenullhypothesis.
Conclusion:Thedataseemstoindicatethatthemeandifferenceisnot0.
Thehypothesistestpresentedaboveisbasedonthebeliefthatthepopulationmeandifferenceisnotequalto0.Ifμ isthehypothesizedvalueforthepopulationmeandifference,thenwecanformulatethefollowinghypotheses:
1. Ifwebelievethepopulationmeandifferenceisgreaterthan0:H :μ μ versusH :μ μ
2.Ifwebelievethepopulationmeandifferenceislessthan0:H :μ μ versusH :μ μ
3.Ifwebelievethepopulationmeandifferenceisnot0:H :μ μ versusH :μ μ
4.HypothesisTestsConcerningVariance
Instructor’sNote:Focusonthebasicsofthistopic,theprobabilityofbeingtestedonthedetailsislow.
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4.1.TestsConcerningaSingleVariance
Intestsconcerningthevarianceofasinglenormallydistributedpopulation,weusethechi‐squareteststatistic,denotedbyχ2.
Propertiesofthechi‐squaredistribution
Thechi‐squaredistributionisasymmetricalandlikethet‐distribution,isafamilyofdistributions.Thismeansthatadifferentdistributionexistsforeachpossiblevalueofdegreesoffreedom,n‐1.Sincethevarianceisasquaredterm,theminimumvaluecanonlybe0.Hence,thechi‐squaredistributionisboundedbelowby0.Thegraphbelowshowstheshapeofachi‐squaredistribution:
Therearethreehypothesesthatcanbeformulated(σ2representsthetruepopulationvarianceandσ02representsthehypothesizedvariance):
1. H :σ σ versusH :σ σ .Thisisusedwhenwebelievethepopulationvarianceisnotequalto0,oritisdifferentfromthehypothesizedvariance.Itisatwo‐tailedtest.
2. H :σ σ versusH :σ σ .Thisisusedwhenwebelievethepopulationvarianceislessthanthehypothesizedvariance.Itisaone‐tailedtest.
3. H :σ ≤σ versusH :σ >σ .Thisisusedwhenwebelievethepopulationvarianceisgreaterthanthehypothesizedvariance.Itisaone‐tailedtest.
Afterdrawingarandomsamplefromanormallydistributedpopulation,wecalculatetheteststatisticusingthefollowingformulausingn‐1degreesoffreedom:
χn 1 s
σ
where:n=samplesizes=samplevariance
Wethendeterminethecriticalvaluesusingthelevelofsignificanceanddegreesoffreedom.Thechi‐squaredistributiontableisusedtocalculatethecriticalvalue.
ExampleConsiderFundAlphawhichwediscussedinanearlierexample.Thisfundhasbeeninexistencefor20months.Duringthisperiodthestandarddeviationofmonthlyreturnswas
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5%.Youwanttotestaclaimbythefundmanagerthatthestandarddeviationofmonthlyreturnsislessthan6%.
Solution:Thenullandalternatehypothesesare:H0:σ2≥36versusHa:σ2<36
Notethatthestandarddeviationis6%.Sincewearedealingwithpopulationvariance,wewillsquarethisnumbertoarriveatavarianceof36%.
Wethencalculatethevalueofthechi‐squareteststatistic:
2=(n‐1)s2/σ02=19x25/36=13.19
Next,wedeterminetherejectionpointbasedondf=19andsignificance=0.05.Usingthechi‐squaretable,wefindthatthisnumberis10.117.
Sincetheteststatistic(13.19)ishigherthantherejectionpoint(10.117)wecannotrejectH0.Inotherwords,thesamplestandarddeviationisnotsmallenoughtovalidatethefundmanager’sclaimthatpopulationstandarddeviationislessthan6%.
4.2.TestsConcerningtheEquality(Inequality)ofTwoVariances
Inordertotesttheequalityorinequalityoftwovariances,weuseanF‐testwhichistheratioofsamplevariances.
TheassumptionsforaF‐testtobevalidare: Thesamplesmustbeindependent. Thepopulationsfromwhichthesamplesaretakenarenormallydistributed.
PropertiesoftheF‐distribution
TheF‐distribution,likethechi‐squaredistribution,isafamilyofasymmetricaldistributionsboundedfrombelowby0.EachF‐distributionisdefinedbytwovaluesofdegreesoffreedom,calledthenumeratoranddenominatordegreesoffreedom.Asshowninthefigurebelow,theF‐distributionisskewedtotherightandistruncatedatzeroonthelefthandside.
Therejectionregionisalwaysintherightsidetailofthedistribution.
WhenworkingwithF‐tests,therearethreehypothesesthatcanbeformulated:
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1. H :σ σ versusH :σ σ .Thisisusedwhenwebelievethetwopopulationvariancesarenotequal.
2. H :σ σ versusH :σ σ .Thisisusedwhenwebelievethevarianceofthefirstpopulationisgreaterthanthevarianceofthesecondpopulation.
3. H :σ σ versusH :σ σ .Thisisusedwhenwebelievethevarianceofthefirstpopulationislessthanthevarianceofthesecondpopulation.
Thetermσ12representsthepopulationvarianceofthefirstpopulationandσ22representsthepopulationvarianceofthesecondpopulation.
TheformulafortheteststatisticoftheF‐testis:
F ss
where:=thesamplevarianceofthefirstpopulationwithnobservations=thesamplevarianceofthesecondpopulationwithnobservations
Aconventionistoputthelargersamplevarianceinthenumeratorandthesmallersamplevarianceinthedenominator.
df1=n1–1numeratordegreesoffreedomdf2=n2–1denominatordegreesoffreedom
TheteststatisticisthencomparedwiththecriticalvaluesfoundusingthetwodegreesoffreedomandtheF‐tables.
Finally,adecisionismadewhethertorejectornottorejectthenullhypothesis.
ExampleYouareinvestigatingwhetherthepopulationvarianceoftheIndianequitymarketchangedafterthederegulationof1991.Youcollect120monthsofdatabeforeandafterderegulation.Varianceofreturnsbeforederegulationwas13.Varianceofreturnsafterderegulationwas18.Checkyourhypothesisataconfidencelevelof99%.
Solution:Nullandalternatehypothesis:H0:σ12=σ22versusHA:σ12≠σ22
F‐statistic: 1.4
df=119forthenumeratoranddenominator
α=0.01whichmeans0.005ineachtail.FromtheF‐table:criticalvalue=1.6
SincetheF‐statislessthanthecriticalvalue,donotrejectthenullhypothesis.
Summaryoftypesofteststatistics
Hypothesistestof UseOnepopulationmean t‐statisticorz‐statistic
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Twopopulationmean t‐statisticOnepopulationvariance Chi‐squarestatisticTwo‐populationvariance F‐statistic
5.OtherIssues:NonparametricInference
Thehypothesis‐testingprocedureswehavediscussedsofarhavetwocharacteristicsincommon:
Theyareconcernedwithparameters,suchasthemeanandvariance. Theirvaliditydependsonasetofassumptions.
Anyprocedurewhichhaseitherofthetwocharacteristicsisknownasaparametrictest.
Nonparametrictestsarenotconcernedwithaparameterand/ormakefewassumptionsaboutthepopulationfromwhichthesamplearedrawn.Weusenonparametricproceduresinthreesituations:
Datadoesnotmeetdistributionalassumptions. Dataaregiveninranks.(Example:relativesizeofthecompanyanduseof
derivatives.) Thehypothesisdoesnotconcernaparameter.(Example:Isasamplerandomornot?)
TheSpearmanrankcorrelationcoefficienttestisapopularnonparametrictest.Thecoefficientiscalculatedbasedontheranksoftwovariableswithintheirrespectivesamples.
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Summary
LO.a:Defineahypothesis,describethestepsofhypothesistesting,anddescribeandinterpretthechoiceofthenullandalternativehypotheses.
Ahypothesisisastatementaboutthevalueofapopulationparameterdevelopedforthepurposeoftestingatheory.
Inordertotestahypothesis,wefollowthesesteps:1. Statethehypothesis.2. Identifytheappropriateteststatistic.3. Specifythelevelofsignificance.4. Stateadecisionruletoacceptorrejectthehypothesis.5. Collectsampledataandcalculatetheteststatistic.6. Decideifthehypothesiscanbeaccepted/rejected.7. Makeaneconomicorinvestmentdecision.
Thenullhypothesis(H0)isthehypothesisthattheresearcherwantstoreject.Itshouldalwaysincludesomeformofthe‘equalto’condition.
Thealternativehypothesis(Ha)isthehypothesisthattheresearcherwantstoprove.Ifthenullhypothesisisrejectedthenthealternativehypothesisisconsideredvalid.
LO.b:Distinguishbetweenone‐tailedandtwo‐tailedtestsofhypotheses.
Inone‐tailedtests,weareassessingifthevalueofapopulationparameterisgreaterthanorlessthanahypothesizedvalue.
Intwo‐tailedtests,weareassessingifthevalueofapopulationparameterisdifferentfromahypothesizedvalue.
LO.c:Explainateststatistic,TypeIandTypeIIerrors,asignificancelevel,andhowsignificancelevelsareusedinhypothesistesting.
Ateststatisticisaquantity,calculatedonthebasisofasample,andisusedtodecidewhethertorejectornottorejectthenullhypothesis.Theformulaforcomputingtheteststatisticis:
teststatistic samplestatistic valueoftheparameterunderH
standarderrorofthesamplestatistic
Inreachingastatisticaldecision,wecanmaketwopossibleerrors:Wemayrejectatruenullhypothesis(aTypeIerror),orwemayfailtorejectafalsenullhypothesis(aTypeIIerror).
ThelevelofsignificanceofatestistheprobabilityofaTypeIerror.
Asαgetssmallerthecriticalvaluegetslargeranditbecomesmoredifficulttorejectthenullhypothesis.
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LO.d:Explainadecisionrule,thepowerofatest,andtherelationbetweenconfidenceintervalsandhypothesistests.
Adecisionruleconsistsofcomparingthecomputedteststatistictothecriticalvalues(rejectionpoints)basedonthelevelofsignificancetodecidewhethertorejectornottorejectthenullhypothesis.
Thepowerofatestistheprobabilityofcorrectlyrejectingthenull(rejectingthenullwhenitisfalse).Itisexpressedas:
Powerofatest=1–P(TypeIIerror)
Aconfidenceintervalgivesustherangeofvalueswithinwhichapopulationparameterisexpectedtolie.Confidenceintervalsandhypothesistestsarelinkedthroughcriticalvalues.Thenullhypothesiswillberejectedonlyiftheteststatisticliesoutsidetheconfidenceinterval.
LO.e:Distinguishbetweenastatisticalresultandaneconomicallymeaningfulresult.
Thestatisticaldecisionconsistsofrejectingornotrejectingthenullhypothesis.Theeconomicdecisiontakesintoconsiderationalleconomicissuesrelevanttothedecision.
LO.f:Explainandinterpretthep‐valueasitrelatestohypothesistesting.
Thep‐valueisthesmallestlevelofsignificanceatwhichthenullhypothesiscanberejected.Itcanbeusedinthehypothesistestingframeworkasanalternativetousingrejectionpoints.
Ifthep‐valueislowerthanourspecifiedlevelofsignificance,werejectthenullhypothesis.
Ifthep‐valueisgreaterthanourspecifiedlevelofsignificance,wedonotrejectthenullhypothesis.
LO.g:Identifytheappropriateteststatisticandinterprettheresultsforahypothesistestconcerningthepopulationmeanofbothlargeandsmallsampleswhenthepopulationisnormallyorapproximatelydistributedandthevarianceis1)knownor2)unknown.
Weusethefollowingtabletodecidewhichteststatisticandwhichcorrespondingprobabilitydistributiontouseforhypothesistesting.
Samplingfrom Smallsamplesize(n<30)
Largesamplesize(n≥30)
Normaldistribution
Varianceknown z zVarianceunknown t t(orz)
Non–normaldistribution
Varianceknown NA zVarianceunknown NA t(orz)
LO.h:Identifytheappropriateteststatisticandinterprettheresultsforahypothesistestconcerningtheequalityofthepopulationmeansoftwoatleastapproximately
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normallydistributedpopulations,basedonindependentrandomsampleswith1)equalor2)unequalassumedvariances.
Whenwecanassumethatthetwopopulationsarenormallydistributedandthattheunknownpopulationvariancesareequal,thet‐testbasedonindependentrandomsamplesisgivenby:
t X X μ μ
/
Thenumberofdegreesoffreedomisn1+n2–2.Theterm isknownasthepooledestimatorofthecommonvariance.Apooledestimateisanestimatedrawnfromthecombinationoftwodifferentsamples.Itiscalculatedas:
s n 1 s n 1 s
n n 2
Whenwecanassumethatthetwopopulationsarenormallydistributedandthattheunknownpopulationvariancesareunequal,anapproximatet‐testbasedonindependentrandomsamplesisgivenby:
t X X μ μ
/
Inthisformula,weusethetablesofthet‐distributionusingthe‘modified’degreesoffreedom.The‘modified’degreesoffreedomarecalculatedas:
df
/ /
LO.i:Identifytheappropriateteststatisticandinterprettheresultsforahypothesistestconcerningthemeandifferenceoftwonormallydistributedpopulations.
Incaseswherewehaveatestconcerningthemeandifferenceoftwonormallydistributedpopulationsthataredependent,weconductat‐testthatisbasedondataarrangedinpairedobservations.
Thehypothesisisformedonthedifferencebetweenmeansoftwopopulationse.g.H0:µd=µd0versusHa:µd≠µd0
Inordertoarriveattheteststatistic,wefirstdeterminethesamplemeandifferenceusing:
d 1n
d
Andthestandarderrorofthemeandifferenceiscomputedasfollows:
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s s
√n
Oncewehavethesetwovalues,wecancalculatetheteststatisticusingat‐test.Thisiscalculatedusingthefollowingformulausingn‐1degreesoffreedom:
t d μs
Thevalueofcalculatedteststatisticiscomparedwiththet‐distributionvaluesintheusualmannertoarriveatadecisiononourhypothesis.
LO.j:Identifytheappropriateteststatisticandinterprettheresultsforahypothesistestconcerning1)thevarianceofanormallydistributedpopulation,and2)theequalityofthevariancesoftwonormallydistributedpopulationsbasedontwoindependentrandomsamples.
Intestsconcerningthevarianceofasinglenormallydistributedpopulation,weusethechi‐squareteststatistic,denotedbyχ2.Afterdrawingarandomsamplefromanormallydistributedpopulation,wecalculatetheteststatisticusingthefollowingformulausingn‐1degreesoffreedom:
χn 1 s
σ
Wethendeterminethecriticalvaluesusingthelevelofsignificanceanddegreesoffreedom.Thechi‐squaredistributiontableisusedtocalculatethecriticalvalue.
Inordertotesttheequalityorinequalityoftwovariances,weuseanF‐test.Thecriticalvalueiscomputedas:
F ss
TheteststatisticisthencomparedwiththecriticalvaluesfoundusingthetwodegreesoffreedomandtheF‐tables.Finally,adecisionismadewhethertorejectornottorejectthenullhypothesis.
LO.k:Distinguishbetweenparametricandnonparametrictestsanddescribesituationsinwhichtheuseofnonparametrictestsmaybeappropriate.
Aparametrictestisahypothesistestconcerningaparameterorahypothesistestbasedonspecificdistributionalassumptions.Incontrast,anonparametrictestiseithernotconcernedwithaparameterormakesminimalassumptionsaboutthepopulationfromwhichthesampleisdrawn.
Anonparametrictestisprimarilyusedinthreesituations:whendatadonotmeetdistributionalassumptions,whendataisgiveninranks,orwhenthehypothesisweareaddressingdoesnotconcernaparameter.
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PracticeQuestions
1. DavidJonesisaresearcherandwantstotestifthemeanreturnsofhisbondinvestmentsismorethan5%peryear.Inthiscase,thenullandalternativehypothesiswouldbebestdefinedas:A. H0:µ=5versusHa:µ≠5.B. H0:µ≤5versusHa:µ>5.C. H0:µ≥5versusHa:µ<5.
2. Whichofthefollowingstatementsrequiresatwo‐tailedtest?
A. Ho:µ≤0versusHa:µ>0.B. Ho:µ≥0versusHa:µ<0.C. Ho:µ=0versusHa:µ≠0.
3. Allelsebeingequal,specifyingasmallersignificancelevelinahypothesistestwillmost
likelyincreasetheprobabilityof:A. typeIerror.B. typeIIerror.C. bothtypeIandtypeIIerrors.
4. Allelsebeingequal,increasingthesamplesizeforahypothesistestwillmostlikely
decreasetheprobabilityof:A. typeIerror.B. typeIIerror.C. bothtypeIandtypeIIerrors.
5. Ifthesignificancelevelofatestis0.05andtheprobabilityofaTypeIIerroris0.2.Whatis
thepowerofthetest?A. 0.05.B. 0.80.C. 0.95.
6. Aresearcherformulatesanullhypothesisthatthemeanofadistributionisequalto10.He
obtainsap‐valueof0.02.Usinga5%levelofsignificance,thebestconclusionisto:A. rejectthenullhypothesis.B. acceptthenullhypothesis.C. decreasethelevelofsignificance.
7. Which of the following statistic is most likely used for the mean of a non‐normal
distributionwithunknownvarianceandasmallsamplesize?A. z‐teststatistic.
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B. t‐teststatistic.C. Thereisnoteststatisticforsuchascenario.
8. YoubelievethattheaveragereturnsofallstocksintheS&P500isgreaterthan10%.You
drawasampleof49stocks.Theaveragereturnofthese49stocksis12%.ThestandarddeviationofreturnsofallstocksintheS&P500is4.Usinga5%levelofsignificance,whichofthefollowingconclusionsismostappropriate?A. WecanconcludethattheaveragereturnsofallstocksintheS&P500isgreaterthan
10%.B. WecanconcludethattheaveragereturnsofallstocksintheS&P500islessthan10%.C. WecanconcludethattheaveragereturnsofallstocksintheS&P500isequalto10%.
9. Theappropriateteststatistictotestthehypothesisthatthevarianceofanormally
distributedpopulationisequalto8isthe:A. t‐test.B. F‐test.C. χ2test.
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Solutions
1. Biscorrect.Thenullhypothesis iswhattheresearcherwantstoreject.Thealternativehypothesis is what the researcher wants to prove, and it is accepted when the nullhypothesisisrejected.
2. Ciscorrect.Atwo‐tailedtestforthepopulationmeanisstructuredas:Ho:µ=0versusHa:
µ≠0.
3. Biscorrect.SpecifyingasmallersignificanceleveldecreasestheprobabilityofaTypeIerror(rejectingatruenullhypothesis),butincreasestheprobabilityofaTypeIIerror(notrejectingafalsenullhypothesis).Asthelevelofsignificancedecreases,thenullhypothesisislessfrequentlyrejected.
4. Ciscorrect.Theonlywaytoavoidthetrade‐offbetweenthetwotypesoferrorsisto
increasethesamplesize;increasingsamplesize(allelsebeingequal)reducestheprobabilityofbothtypesoferrors.
5. Biscorrect.Thepowerofatest=1‐P(TypeIIerror).=1–0.2=0.86. Aiscorrect.Thep‐valueforahypothesisisthesmallestsignificancelevelforwhichthe
hypothesiswouldberejected.Asthep‐valueislessthanthestatedlevelofsignificance,werejectthenullhypothesis.
7. Ciscorrect.Thestatisticforasmallsamplesizeofanon‐normaldistributionwith
unknownvarianceisnotavailable.z‐teststatisticisusedforalargesamplesizeofanon‐normaldistributionwithknownvariancewhilet‐teststatisticisusedforlargesamplesizeofanon‐normaldistributionwithunknownvariance.
SamplingFrom SmallSampleSize
LargeSampleSize
NormalDistribution Varianceknown z z
Varianceunknown t t(orz)
Non–normalDistribution
Varianceknown NA z
Varianceunknown NA t(orz)
8. Aiscorrect.
Step1:StatethehypothesisH0:µ≤10%Ha:µ>10%
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Step2:CalculatetheteststatisticThepopulationvarianceisknownhencewewillusez‐statistic.
z statisticX μ
√
12 10
√
3.5
Step3:CalculatethecriticalvalueThisisaone‐tailedtestandwewillbelookingattherighttail.UsingtheZ–tableand5%levelofsignificanceCriticalvalue=Z0.05=1.65Step4:Decision
Sincetheteststatistic(3.5)>criticalvalue(1.65),werejectH0.Henceat5%levelofsignificance,yourbeliefthattheaveragereturnsofallstocksintheS&P500isgreaterthan10%iscorrect.
9. Ciscorrect.Intestsconcerningthevarianceofasinglenormallydistributedpopulation,
weusethechi‐squareteststatistic,denotedbyχ2.TypesofTestStatistics
Hypothesistestof UseOnepopulationmean t‐statisticorz‐statisticTwopopulationmean t‐statisticOnepopulationvariance Chi‐squarestatisticTwo‐populationvariance F‐statistic
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R13 Technical Analysis 2019 Level I Notes
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R13TechnicalAnalysis
1.Introduction
Technicalanalysishaslongbeenusedbytradersandanalysts,buthasonlyrecentlyreceivedacceptancefromregulatorsandtheacademiccommunity.Althoughcertainaspectsoftechnicalanalysis,suchasthecalculationofindicators,havespecificrules,theinterpretationoffindingsisoftensubjective.
2.TechnicalAnalysis:DefinitionandScope
Technicalanalysisisaformofsecurityanalysisthatusespriceandvolumedataindecisionmaking.Thedataisoftengraphicallydisplayed.
Technicalanalysisisbasedonthefollowinglogic: Supplyanddemanddetermineprices. Changesinsupplyanddemandcancausechangesinprices. Pricescanbeprojectedwithchartsandothertechnicaltools.
Technicalanalysisofanyfinancialinstrumentdoesnotrequiredetailedknowledgeofthatinstrument.Investorsandtradersoftenprefertechnicalanalysisoverfundamentalanalysisintheshorttermbecausefundamentalanalysisismoretimeconsuming.
2.1.PrinciplesandAssumptions
Fundamentaltheoristsbelievethatmarketsarerationalandefficient.Ontheotherhand,techniciansbelievethathumanbehaviorisoftenerraticanddrivenbyemotion.Therefore,theybelievethatmarkettrendsandpatternsreflectthisirrationalhumanbehavior.Theyrelyonrecognitionofsuchtrendsandpatternsinthepasttoprojectfuturepatternsofsecurityprices.
Anotherprincipleoftechnicalanalysisisthatthemarketreflectsthecollectiveknowledgeandsentimentofmanyparticipantssuchasinvestors,hedgers,insiders,andotherstakeholders.Marketparticipants,whobuyandsellsecurities,haveanimpactonprice.Thegreaterthevolumeofaparticipant’strades,themoreimpacttheparticipantwillhaveonprice.
Bystudyingmarkettechnicaldata(priceandvolumetrends),techniciansseektounderstandinvestorsentiment.
Somefinancialinstrumentshaveanassociatedincomestreamthataddstothesecurity’sintrinsicvaluesuchascouponpaymentsforbondsanddividendsforequityshares.Afundamentalanalystcanusethesecashflowstoarriveatapresentvalueofthesecurity.However,forotherassetssuchascommodities,whichdonothaveunderlyingincomestreamsorfinancialstatements,technicalanalysisiscommonlyused.
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2.2.TechnicalandFundamentalAnalysis
Technicalandfundamentalanalysesapproachthemarketindifferentways,butarebothuseful.Keydifferencesbetweenthetwoarelistedbelow:
Techniciansfocussolelyonanalyzingmarketsandthetradingoffinancialinstruments.Fundamentalanalysis,ontheotherhand,focusesonfinancialandeconomicanalysisaswellassocietalandpoliticaltrendsanalysis.
Technicalanalysisisbasedonpriceandvolumedata(i.e.tradingdata),whilefundamentalanalystsincorporateexternalmarketdata,withcompany’sfinancialstatements,topredictsecuritypricemovements.Itisimportanttonotethatthecompany’sfinancialstatementsareoftensubjective,whilepriceandvolumedataareobjective.
Fundamentalanalysisisconsideredamoretheoreticalapproach,whiletechnicalanalysisisconsideredamorepracticalapproach.
Drawbacksoftechnicalanalysisare: Techniciansarelimitedtostudyingmarketmovementsanddonotuseother
predictiveanalyticalmethods. Marketmovementsandtrendsmaytakesometimetobecomeevident.Therefore,
techniciansmaybelateinidentifyingchangesintrendsandpatterns. Inilliquidmarketsandmarketsthataresubjecttolargeoutsidemanipulation(such
asactionsofcentralbanks),theapplicationoftechnicalanalysisislimited.
3.TechnicalAnalysisTools
3.1.Charts
Thevarioustypesofchartsusedintechnicalanalysisare:
LinechartLinechartsareasimplegraphicdisplayofpricetrendsovertime.Usually,thechartisaplotofdatapoints,suchasshareprice,withalineconnectingthesepoints.Theverticalaxis(yaxis)representspricelevelandthehorizontalaxis(xaxis)istime.Anexampleofalinechartisshownbelow.Thelinechartshowsthatthepriceofthestockduringthefirstupwardmovementofthepriceishigherthanthesecondhigh.
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Barchart
Alinecharthasonlyonedatapointpertimeinterval.Abarchart,incontrast,hasfourbitsofdataineachentry‐theopeningandclosingprices,andthehighandlowpricesduringtheperiod.
BarchartnotationThefigureontheleftshowshowthedatapointforeachintervalisconstructed.Averticallineconnectsthehighandlowpricefortheday.Across‐hatchtotherightindicatestheclosingprice,andacross‐hatchtotheleftindicatestheopeningprice.
Ashortbarindicateslittlepricemovementwhilealongbarindicatesawidedivergencebetweenthehighandthelowfortheday.Anexampleofabarchartisshowninthefigurebelow:
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Candlestickchart
Acandlestickchartalsoprovidesfourpricesperdataentrypoint:theopeningandclosingprices,andthehighandlowpricesduringtheperiod.
Thebodyofthecandleiseitherwhiteorshaded.Awhitebodymeansthatthemarketclosedup.Ashadedbodymeansthatthemarketcloseddown.Anexampleofacandlestickchartisshownbelow:
Anadvantageofthecandlestickchartoverthebarchartisthatpricemovesaremuchmorevisible,whichallowsforfasteranalysis.
Pointandfigurechart
ApointandfigurechartisdrawnonagridandconsistsofcolumnsofX’salternatingwithcolumnsofO’s.XrepresentsanincreaseinpricewhileanOrepresentsadecreaseinprice.Neithertimenorvolumeisrepresentedonthischart.Instead,thefocusisonchangeinprices,whichisrepresentedonthehorizontalaxis.Anexampleofapointandfigurechartisgivenbelow.
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Thefollowingstepsneedtobefollowedinordertoconstructapointandfigurechart: Theanalystmustfirstdeterminetheboxsize.Boxsizereferstothechangeinprice
representedbytheheightofeachbox. Next,theanalystmustdeterminethereversalsize.Iftherearenosignificantchangesin
thestockprice,theanalyststaysinthesamecolumn.Onlyifthereisasubstantialreversal,theanalystmovestoanothercolumn.
AtechnicianfillsinaboxwithXeverytimethesecurity'spriceclosesupbytheamountoftheboxsize.Ifthepriceincreasesbytwicetheboxsize,thetechnicianfillsintwoboxes,oneontopoftheother.Ifthepricedoesnotincreasebyatleasttheboxsize,noindicationismadeonthechart.
Forpricedecreases,atechnicianusesthereversalsizetodeterminewhentomakeanindicationonthechart.Ifourreversalsizeis3,theboxsizeis$1,andthereisapricedeclineof$3,thenthetechnicianwillshifttothenextcolumnandbeginacolumnofO’s.
Pointandfigurechartsareparticularlyusefulformakingtradingdecisionsbecausetheyclearlyillustratepricelevelsthatmaysignaltheendofadeclineoradvance.
ScaleTheverticalaxiscanbeconstructedwitheither:
Linear/Arithmeticscale:Suitablefornarrowerranges,forexample,pricesfrom$20to$35
Logarithmicscale:Suitableforrangeofvaluesrepresentingseveralordersofmagnitude,forexample,$10to$10,000.
Thehorizontalaxisusuallyshowsthepassageoftime.Theappropriatetimeintervaldependsonthenatureoftheunderlyingdata.Wecanhave5‐min,30‐min,1‐hour,daily,weeklyorevenmonthlycharts.
VolumechartsTheyareoftendisplayedbelowaline,barorcandlestickchart.ThenumberofunitsofthesecuritytradedisplottedontheY‐axisandtimeontheX‐axis.
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Relativestrengthanalysis
Relativestrengthanalysisisusedtocomparetheperformanceofaparticularasset,suchasastock,withthatofsomebenchmarkindexortheperformanceofanotherstock.Typically,theanalystpreparesalinechartoftheratioofthetwoprices,withtheassetunderanalysisasthenumeratorandthebenchmarkorothersecurityasthedenominator.Arisinglineshowsthattheassetisperformingbetterthanthebenchmark;adeclininglineshowsthattheassetisunderperforming.Aflatlineshowsneutralperformance.
3.2.Trend
Trendanalysisisbasedontheobservationthatmarketparticipantstendtoactinherdsandthattrendstendtostayinplaceforsometime.
UptrendAsecurityissaidtobeinanuptrendifpricesarereachinghigherhighsandhigherlows.Anupwardtrendlinecanbedrawnbyconnectingtheincreasinglowpointswithastraightline.Anuptrendindicatesthatthedemandismorethansupply.
DowntrendAsecurityissaidtobeinadowntrendifpricesarereachinglowerhighsandlowerlows.Adownwardtrendlinecanbedrawnbyconnectingthedecreasinghighpointswithastraightline.Adowntrendindicatesthatthesupplyismorethandemand.
Support
Itisthepricelevelatwhichthereissufficientbuyingpressuretostopafurtherdeclineinprices.
Resistance
Itisthepricelevelatwhichthereissufficientsellingpressuretostopafurtherincreaseinprices.
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Changeinpolarity
Onceasupportlevelisbreached,itoftenbecomesanewresistancelevel.Similarly,oncearesistancelevelisbreached;itoftenbecomesanewsupportlevel.
3.3.ChartPatterns
Chartpatternsareformationsthatcreatearecognizableshape;commonpatternsappearrepeatedlyandleadtosimilarsubsequentpricemovements.Chartpatternscanbedividedintotwocategories:reversalpatternsandcontinuationpatterns.
Reversalpatterns
Theysignaltheendofatrend.Thefourkindsofreversalpatternsare:
Headandshoulderspattern:
Itconsistsoftheleftshoulder,thehead,andtherightshoulder.Thispatternindicatestheendofanuptrend.Youcanprofitbygoingshortonthesecurity,thepricetargetis:
Pricetarget=neckline–(head–neckline)
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Inverseheadandshoulderspattern:
Itisamirrorimageoftheheadandshoulderspattern.Thispatternindicatestheendofadowntrend.Youcanprofitbygoinglongonthesecurity,thepricetargetis:
Pricetarget=neckline+(head–neckline)
ExampleInaninvertedheadandshoulderspattern,ifthenecklineisat€125,theshouldersat€80,andtheheadat€95,thepricetargetisclosesttowhichofthefollowing?A. €155.B. €110.C. €95.
Solution:InvertedHeadandshoulderpattertargetprice=Neckline+(Neckline–Head)
TargetPrice=125+(125–95)
TargetPrice=155
Doubletopsandbottoms:
Adoubletopisformedwhenpriceshitthesameresistanceleveltwiceandfalldown.Itindicatestheendofanuptrend.
Adoublebottomisformedwhenpricesbouncebackfromthesamesupportleveltwice.Itindicatestheendofadown‐trend.
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Tripletopsandbottoms:
Tripletopsareformedwhenpriceshitthesameresistancelevelthrice.
Triplebottomsareformedwhenpricesbouncebackfromthesamesupportlevelthrice.
Continuationpatterns
Theysignalatemporarypauseinthetrend,andthatthetrendwillcontinueinthesamedirectionasbefore.Thefourkindsofcontinuationpatternsare:
Triangles:
Onetrendlineconnectsthehighsandasecondtrendlineconnectsthelows.Asthedistancebetweenthehighsandlowsnarrows,thetrendlinesconverge,formingatriangle.Therearethreeforms‐ascendingtriangles,descendingtriangles,andsymmetrictriangles.
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Rectangles:
Onetrendlineconnectsthehighsandasecondtrendlineconnectsthelows.Asthedistancebetweenthehighsandlowsisconstant,thetrendlinesareparalleltoeachotherandformarectangle.
Flags:
Theyaresimilartoarectangleandareformedbytwoparalleltrendlines.However,theyformoveramuchshortertimeinterval.
Pennants:
Theyaresimilartoatriangleandareformedbytwoconvergingtrendlines.However,theyformoveramuchshortertimeinterval.
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3.4.TechnicalIndicators
Therearefourkindsoftechnicalindicatorsthatwewilldiscuss;price‐basedindicators,momentumoscillators,sentimentindicatorsandflow‐of‐fundsindicators.
Price‐basedindicators
Theyincorporatetheinformationcontainedinthecurrentandpastmarketprices.Thecommontypesare:
Movingaverage:
Itistheaverageoftheclosingpricesoveraspecifiednumberofperiods.Theyareusedtosmoothoutshort‐termpricefluctuationsandhelpidentifythetrend.Whenashort‐termmovingaveragecrossesfromunderneathalonger‐termaverage,thismovementisconsideredbullishandisknownasagoldencross.Whenashort‐termmovingaveragecrossesfromabovealonger‐termaverage,thismovementisconsideredbearishandisknownasadeadcross.
Bollingerbands:
Bollingerbandsconsistofamovingaverageplusahigherlinerepresentingasetnumberofstandarddeviationsandalowerlinerepresentingasetnumberofstandarddeviations.ThefigurebelowshowsaBollingerbandandamovingaverage.
Themorevolatilethesecuritybecomes,thewidertherangebecomesbetweenthetwoouterlinesorbands.AcommonuseofaBollingerbandistocreatetradingstrategiessuchasacontrarianstrategy.Inthisstrategy,aninvestorsellswhenasecurity'spricereachestheupperbandandbuyswhenitreachesthelowerband.Thecontrarianstrategyassumesthatthesecurity'spricewillstaywithinthebands.
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Momentumoscillators
Theyhelptoidentifychangesinthemarketsentiment.Thecommontypesare:
Rateofchange(ROC)oscillator:
Itoscillatesaround0(oraround100ifanalternativeformulaisusedforcalculation).WhentheROCoscillatorcrosseszerointothepositiveterritory,itisconsideredbullish.WhentheROCoscillatorcrosseszerointothenegativeterritory,itisconsideredbearish.
Relativestrengthindex(RSI):
RSIgraphicallycomparesasecurity’sgainswithitslossesoveragivenperiod.Thepopulartimeperiodis14days.ThevalueoftheRSIisalwaysbetween0and100.Avalueabove70representsanoverboughtsituationwhileavaluebelow30suggeststhatanassetisoversold.
Stochasticoscillator:
Itisbasedontheobservationthatinuptrends,pricestendtocloseatornearthehighendoftheirrecentrange.Similarly,indowntrends,theytendtoclosenearthelowend.Itiscomposedoftwolines,called%Kand%Dthatarecalculatedasfollows:
%K 100C L14H14 L14
where:
C=latestclosingpriceL14=lowestpriceinpast14daysH14=highestpriceinpast14days%D=averageofthelastthree%Kvaluescalculateddaily
%Distheaverageofthree%Kvalues.Itisslowermovingandisalsocalledthesignalline.
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Whenthe%Kmovesfrombelowthe%Dlinetoaboveit,thismoveisconsideredabullishsignal.Ontheotherhand,when%Kmovesfromabovethe%Dlinetobelowit,thispatternisconsideredbearish.
Thestochasticoscillatorhasadefaultsettingof14‐days.
Moving‐averageconvergence/divergenceoscillator:
Itisthedifferencebetweenashort‐termandalong‐termmovingaverageofthesecurity’sprice.Itiscomposedoftwolines‐MACDlineandsignalline.
MACDline:differencebetweentwoexponentiallysmoothedmovingaverages,usually12and26days.
Signalline:exponentiallysmoothedaverageofMACDline,usually9days.
Theindicatoroscillatesaround0andhasnoupperorlowerlimit.
MACDisusedintechnicalanalysisinthreeways. CrossoversoftheMACDlineandsignallinemayindicateachangeintrend. IftheMACDisoutsideitsnormalrangeforagivensecurity,thenthismayindicatea
reversal. IftheMACDistrendinginthesamedirectionasprice,thenthisindicatesa
convergencepattern.Ontheotherhand,whenthetwoaretrendinginoppositedirections,thenthisindicatesadivergencepattern.
Instructor’sNote:Themostknownuseofmomentumoscillatorsistoindicatetheoverboughtoroversoldpositionofasecurity.Thus,theyhelpinprovidingsignalforbuyingorsellingsecuritybutdonothelptosetthetargetprice.
Sentimentindicators
Theygaugeinvestoractivityforsignsofbullishnessorbearishness.Thecommontypesare:
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Opinionpolls:
Regularpollsareconductedofinvestorsandinvestmentprofessionalstogaugetheoverallmarketsentiment.
Calculatedstatisticalindices: Theput/callratioisthevolumeofputoptionstraded, dividedbythevolumeofcall
optionstraded.Ahighratioindicatesthatthemarketisbearish.Whereas,alowratioindicatesthatthemarketisbullish.
TheCBOEvolatilityindex(VIX)isameasureofnear‐termmarketvolatilitycalculatedfromoptionpricesofS&P500stocks.TheVIXriseswhenmarketparticipantsbecomefearfulofamarketdecline.
Margindebtisloanstakenbyindividualinvestorstofundtheirstockpurchases.Whenstockmargindebtisincreasing,investorsareaggressivelybuyingandthestockpriceswillrisebecauseofincreaseddemand.
Shortinterestreferstothenumberofsharesofaparticularsecuritythatarecurrentlysoldshort.Theshortinterestratioiscalculatedas:
ShortinterestratioShortinterest
Averagedailytradingvolume
Ahighratiosuggestsanoverallnegativeoutlookonthesecurity.
Flow‐of‐fundsindicators
Theyindicatethechangeinpotentialdemandandsupply.Thecommontypesare:
TheArmsindex:(alsoknownasTRIN)
Itiscalculatedas:
Armsindexnumberofadvancingissues numberofdecliningissuesvolumeofadvancingissues volumeofdecliningissues
Whenthisindexisnear1,themarketisinbalance.Avalueabove1meansthatthereismorevolumeindecliningstocksandthatthemarketisinasellingmood.Avaluebelow1meansthatthereismorevolumeinincreasingstocksandthatthemarketisinabuyingmood.
Margindebt:
Marginloansmayincreasethepurchasesofstocksanddecliningmarginbalancesmayforcethesellingofstocks.
Mutualfundscashposition:
Mutualfundsmustholdsomeoftheirassetsincashtopayformiscellaneousexpensesandtofundredemptions.Duringabullishmarket,thecashpositionstendtobelow.Duringabearishmarket,thecashpositionstendtobehigh.
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Newequityissuance:
IPOsareoftentimedwithbullishmarketstogetthebestvaluations.AlargenumberofIPOsmayindicatethatamarketisnearitspeak.
Secondaryofferings:
LikeIPOs,techniciansalsomonitorsecondaryofferingstogaugepotentialchangesinthesupplyofequities.
3.5.Cycles
Techniciansusevariouscyclestopredictfuturemovementsinsecurityprices;evencyclesinfieldssuchasastronomyandclimatecaninfluencetheeconomyandhencecapitalmarkets.Commonlyreferencedcyclesarediscussedbelow:
Kondratieffwave:Thisisthelongestofthewidelyrecognizedcycles,discoveredbyNikolaiKondratieffinthe1920s.HesuggestedthatWesterneconomieshavea54‐yearoldcycle.ThiscycleisalsoknownastheKWave.
18‐yearcycle:Three18‐yearcyclesmakeupthelonger54‐yearKondratieffWave.The18‐yearcycleisoftenmentionedinconnectionwithrealestateprices,butitcanalsobefoundinequitiesandothermarkets.
Decennialpattern:Thispatternconnectsaveragestockmarketreturnswiththelastdigitoftheyear.Yearsendingin0haveshownpoorperformancewhileyearsendingin5haveshowngoodperformance.
Presidentialcycle:ThiscycleintheUnitedStatesconnectstheperformanceofthemarketwithpresidentialelections.Inthistheory,thethirdyearfollowinganelectionshowsthebestperformance.
4.ElliotWaveTheory
Accordingtothistheory,themarketmovesinregularwavesorcycles.Inabullmarket,themarketmovesupinfivewaves1=up,2=down,3=up,4=down,and5=up.(Impulsephase)anddownwardmoveoccursinthreewaves1=down,2=up,3=down(Correctivephase).
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Eachwavecanbebrokenintosmallerwavesoverashortertimeperiod.MarketwavesfollowpatternsthatareratiosofthenumbersintheFibonaccisequence.Hence,ratiosofthenumbersintheFibonaccisequencecanbeusedtosetpricetargetswhiletrading.
TheFibonaccisequencestartswiththenumbers0,1,1,andtheneachsubsequentnumberinthesequenceisthesumofthetwoprecedingnumbers:
0,1,1,2,3,5,8,13,21,34…
5.Inter‐marketAnalysis
Inter‐marketanalysisisbasedontheprinciplethatallmarketsareinterrelatedandinfluenceeachother.Here,technicianslookforinflectionpointsinonemarketasawarningsigntostartlookingforachangeinanotherrelatedmarket.Toidentifytheseinter‐marketrelationships,acommonlyusedtoolistherelativestrengthanalysis.Therelativestrengthanalysiscanalsobeusedtoidentifythestrongestperformingsecuritiesinasectorandtoidentifythesectorsoftheequitymarkettoinvestin.Lastly,observationsbasedoninter‐marketanalysiscanalsohelpinallocatingfundsacrosssecuritiesfromdifferentcountries.
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Summary
LO.a:Explainprinciplesoftechnicalanalysis,itsapplications,anditsunderlyingassumptions.
Technicalanalysisisaformofsecurityanalysisthatinvolvesexaminationofpastpriceandvolumedatatopredictfuturebehaviorofthemarketorindividualsecurity.
Assumptions: Marketpricesaredeterminedbysupplyanddemand. Marketpricesreflectbothrationalandirrationalinvestorbehavior. Investorbehaviorisreflectedintrendsandpatternsthattendtorepeat. Priceandvolumeinformationcanbeusedtounderstandinvestorsentimentand
makeinvestmentdecisions.
Technicalanalysiscanalsobeusedonassetssuchascommodities,currencies,andfuturesthatdonothaveunderlyingincomestreamsorfinancialstatements.
LO.b:Describetheconstructionofdifferenttypesoftechnicalanalysischartsandinterpretthem.
Linecharts Graphicdisplayofpricesovertime. Ithasonlyonedatapointpertimeinterval–theclosingprice. PriceisplottedontheY‐axisandtimeontheX‐axis. Theclosingpricesforeachtradingperiodareconnectedbyaline.
Barcharts Ithasfourdatapointspertimeinterval–openingprice,highestandlowestprice,and
closingprice. PriceisplottedontheY‐axisandtimeontheX‐axis Theygiveabettersenseofthetrendinthemarket. Ashortbarindicateslowvolatility,alongbarindicateshighvolatility
Candlestickcharts Ithasthesamefourdatapointspertimeintervalasabarchart–openingprice,
highestandlowestprices,andclosingprice. PriceisplottedontheY‐axisandtimeontheX‐axis. Ifthemarketclosedup,thebodyofthecandleisclear. Ifthemarketcloseddown,thebodyofthecandleisshaded.
Volumecharts Oftendisplayedbelowaline,barorcandlestickchart. NumberofunitsofthesecuritytradedisplottedontheY‐axisandtimeontheX‐axis.
Pointandfigurecharts
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DrawnasagridconsistingofcolumnsofX’salternatingwithcolumnsofO’s.XrepresentsanincreaseinpricewhileanOrepresentsadecreaseinprice.
Y‐axismeasuresboxsizeincrementsinprice,whereasX‐axismeasuresanumberofpricechanges.
Toconstructthischart,youneedtospecifyaboxsizeandareversalsize.
LO.c:Explainusesoftrend,support,resistancelines,andchangeinpolarity.
Uptrend:Asecurityissaidtobeinanuptrendifpricesarereachinghigherhighsandhigherlows.Anupwardtrendlinecanbedrawnbyconnectingtheincreasinglowpointswithastraightline.
Downtrend:Asecurityissaidtobeinadowntrendifpricesarereachinglowerhighsandlowerlows.Adownwardtrendlinecanbedrawnbyconnectingthedecreasinghighpointswithastraightline.
Support:Itisthepricelevelatwhichthereissufficientbuyingpressuretostopafurtherdeclineinprices.
Resistance:Itisthepricelevelatwhichthereissufficientsellingpressuretostopthefurtherincreaseinprices.
Changeinpolarity:Onceasupportlevelisbreached,itoftenbecomesanewresistancelevel.
Similarly,oncearesistancelevelisbreached;itoftenbecomesanewsupportlevel.
LO.d:Describecommonchartpatterns.
Reversalpatterns:Theysignaltheendofatrend.Thefourkindsofreversalpatternsare: Headandshoulderspattern Inverseheadandshoulderspattern Doubletopsandbottoms Tripletopsandbottoms
Continuationpatterns:Theysignalatemporarypauseinthetrend,andthatthetrendwillcontinueinthesamedirectionasbefore.Thefourkindsofcontinuationpatternsare:
Triangles Rectangles Flags Pennants
LO.e:Describecommontechnicalanalysisindicators(price‐based,momentumoscillators,sentiment,andflowoffunds).
Price‐basedindicators:Theyincorporatetheinformationcontainedinthecurrentandpastmarketprices.Thecommontypesare:
Movingaverage Bollingerbands
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Momentumoscillators:Theyhelptoidentifychangesinthemarketsentiment.Thecommontypesare:
Rateofchange(ROC)oscillator Relativestrengthindex(RSI) Stochasticoscillator Moving‐averageconvergence/divergenceoscillator
Sentimentindicators:Theygaugeinvestoractivityforsignsofbullishnessorbearishness.Thecommontypesare:
Opinionpolls Calculatedstatisticalindices
o put/callratioo Volatilityindex(VIX)o Margindebto Shortinterest
Flow‐of‐fundsindicators:Theyindicatethechangeinpotentialdemandandsupply.Thecommontypesare:
TheArms Margindebt Mutualfundscashposition Newequityissuance Secondaryofferings
LO.f:Explainhowtechnicalanalystsusecycles.
Kondratieffwave(K‐Wave) ItstatesthatWesterneconomieshavea54‐yearoldcycle.
18‐yearcycle Three18‐yearcyclesmakeupthelonger54‐yearKondratieffwave. Thiscycleisoftenmentionedinrealestatemarkets,butitcanalsobefoundin
equitiesandothermarkets.
Decennialpattern Thispatternlinksaveragestockmarketreturnswiththelastdigitoftheyear. Yearsendingin0haveshownpoorperformance,whereasyearsendingin5have
showngoodperformance.
Presidentialcycle ThiscycleconnectstheperformanceoftheUSmarketwiththeUSpresidential
elections. Historically,thethirdyearfollowinganelectionhasshownthebestperformance.
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LO.g:DescribethekeytenetsofElliottWaveTheoryandtheimportanceofFibonaccinumbers.
Accordingtothistheory,themarketmovesinregularwavesorcycles.Inabullmarket,themarketmovesupinfivewavesinthefollowingpattern:1=up,2=down,3=up,4=down,and5=up.Thiswaveisknownastheimpulsewave.Eachwavecanbebrokenintosmallerwavesoverashortertimeperiod.MarketwavesfollowpatternsthatareratiosofthenumbersintheFibonaccisequence.Hence,theratiosofthenumbersintheFibonaccisequencecanbeusedtosetpricetargetswhiletrading.
LO.h:Describeintermarketanalysisasitrelatestotechnicalanalysisandassetallocation.
Intermarketanalysisisbasedontheprinciplethatdifferentmarketssuchasstocks,bonds,commodities,currenciesetc.areinterrelatedandinfluenceeachother.Techniciansoftenuserelativestrengthanalysistolookfortheinflectionpointinonemarketasawarningsigntostartlookingforachangeinanotherrelatedmarket.Therelativestrengthanalysiscanalsobeusedtoidentifyattractiveassetclassesandattractivesectorswithintheseclassestoinvestin.
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PracticeQuestions
1. Technicalanalysismostlikelyreliesupon:A. priceandvolumeinformation.B. fundamentalanalysistoconfirmconclusions.C. financialstatements.
2. Which of the following charts does not show the high and lowprices for each trading
period?A. Barchart.B. Pointandfigurechart.C. Candlestickchart.
3. Anupwardtrendlineisconstructedbydrawingalineconnectingthe:
A. thehighsofthepricechart.B. thelowsofthepricechart.C. thehighesthightothelowestlowofthepricechart.
4. Whichofthefollowingstatementsmostlikelyexplainstheprincipleof‘changein
polarity’?A. Onceadowntrendisbrokenitbecomesanuptrend.B. Theshort‐termmovingaveragehascrossedthelong‐termmovingaverage.C. Onceasupportlevelisbreached,itbecomesaresistancelevel.
5. Lucy,atechnicalanalyst,observesaheadandshoulderspatterninastockshehasbeen
following.Shenotesthefollowinginformation:
HeadPrice $46.50ShoulderPrice $41.50NecklinePrice $38.25
Herestimatedpricetargetisclosestto:A. $21.00.B. $25.50.C. $30.00.
6. Whichofthefollowingwouldatechnicalanalystmostlikelyinterpretasasellsignal?
A. 100‐daymovingaveragecrossesbelowa50‐daymovingaverage.B. 50‐daymovingaveragecrossesbelowa200‐daymovingaverage.C. 30‐daymovingaveragecrossesabovea100‐daymovingaverage.
7. MomentumOscillatorsaremostlikelyusedto:
A. indicateanoverboughtoroversoldposition.
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B. setthetargetprice.C. analyzethemovementofpriceofsecuritywithrespecttoeconomicchanges.
8. Avalueof1.2intheshort‐termtradingindex(TRIN)mostlikelyindicatesthat:
A. tradingvolumeisheavierindecliningissuesthaninadvancingissues.B. tradingvolumeisheavierinadvancingissuesthanindecliningissues.C. marketisoversold.
9. Kondratieffconcludedthatwesterneconomiesgenerallyfollowedacycleofhowmany
years?A. 44years.B. 54years.C. 64years.
10. InElliotWavetheory,Fibonaccinumbersareusedtoforecastthe:
A. sizeofthewaves.B. numberofsubwaveswithinalargerwave.C. timingofthewavedirectionchange.
11. Whichofthefollowingisamostcommonlyusedtoolforintermarketanalysis?
A. Relativestrengthanalysis.B. Stochasticoscillators.C. Momentumoscillators.
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Solutions1. Aiscorrect.Technicalanalysisisthestudyofmarkettrendsorpatternsandreliesupon
priceandvolumedata.2. Biscorrect.Apointandfigurechartisbasicallyusedtomapthechangeindirectionof
shareprices.Onlytheopeningandclosingpriceisincorporatedintopointandfigurechart.Aboxisfilledwitheither“x”signor“o”signdependsondirectionofpricechange.Thischartdoesnotincorporatethehighandlowprices.
3. Biscorrect.Anupwardtrendlineisconstructedbydrawingalineconnectingthelowsof
thepricechart.4. Ciscorrect.5. Ciscorrect.Pricetarget=Neckline−(Head−Neckline)=38.25–(46.50–38.25)=30.006. Biscorrect.Whenusingmovingaveragestogeneratetradingsignals,a"goldencross"of
ashorter‐termaverageabovealonger‐termaverageisabuysignal,whilea"deadcross"underthelonger‐termaverageisasellsignal.
7. Aiscorrect.ThemostknownuseofMomentumOscillatorsistoindicatetheoverbought
oroversoldpositionofasecurity.Thus,ithelpsinprovidingthesignalforbuyingorsellingsecurity,butitdoesnothelptosetthetargetprice.Economicconditions,neitheraffecttechnicalanalysisnoraretheyusedintechnicalanalysis.
8. A is correct.TheTRINorArms index isa flowof funds indicator.Values less thanone
indicatemoretradingvolumeinadvancingstocksthanindecliningstocks,whilevaluesgreaterthanonemeanmorevolumeisindecliningstocksthaninadvancingstocks.
TRINNumberofadvancingissues/NumberofdecliningissuesVolumeofadvancingissues/Volumeofdecliningissues
9. B is correct. Kondratieff wave is a cycle of 54 years. This is the longest and a widely
recognizedcycle.10. Aiscorrect.InElliotWavetheory,thesizeofthewavesisbelievedtocorrespondtothe
ratioofFibonaccinumbers.
11. Aiscorrect.Relativestrengthanalysisisoftenusedtocomparetwoassetclassesortwosecurities.
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Notes
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Notes