READING 32 (INT’L EQUITY BENCHMARKS)

LOS32a. Discuss the need for float adjustment in the construction of international equity benchmarks;

Why do we need float adjustments?High weights of some companies as a result of cross holdings with other companies and high PE multiples. When a benchmark index is either very easy or very difficult for a large proportion of managers to beat, something is probably wrong with the benchmark. No international equity benchmark uses full capitalization anymore

LOS32b. Discuss the trade-offs involved in constructing international indexes, including (1) breadth versus investability, (2) liquidity and crossing opportunities versus index reconstitution effects, (3) precise float adjustment versus transactions costs from rebalancing, and (4) objectivity and transparency versus judgment;

1. Breadth v Investability Some international indexes including emerging market indices include stocks that include illiquid and closely held small stocks and investor should choose the index with less breadth and greater liquidity

2. Liquidity and crossing opportunities v index reconstitution effects Crossing is trading w/o broker. Popular indexes have greater index-level liquidity. But these indices suffer from reconstitution (inclusion and deletion) effects. So index level liquidity and crossing opportunities may have poorer performance because of reconstitution effects.

3. Precise float adjustment v transaction costs from rebalancing Some indexes make precise float adjustments and revise these adjustments frequently impose higher transaction costs on those benchmarking against them than indexes that use float bands or broad categories. Float makes sense because transactions costs are real expenses and what is to be gained by replicating the float of the market exactly is not as clear.

4. Objectivity and transparency v judgment Strict rules versus index committees

LOS32c. Discuss the effect that a country’s classification as either a developed or an emerging market can have on market indexes and on investment in the country’s capital markets.

Classification of Countries as developed or emerging and effects on market indexes and capital markets

Being a part of developed market index is highly desirable because far more assets are committed to developed than to emerging markets.

The inclusion of a country in an index has a real impact on the average company size and average level of country development in that index.

There’s no reason for developed, emerging markets segregation. The historical reason for managers defining themselves as emerging or developed

markets specialists is that they are not taking undue risk. They pursue this goal by investing only in developed markets believed to have

transparent accounting rules, liquid exchanges and stable currencies. But today it’s different.

READING 33 (CORPORATE GOVERNANCE)

LOS33a. Explain the ways in which management may act that are not in the best interest of the firm’s owners (moral hazard) and illustrate how dysfunctional corporate governance can lead to moral hazard;

The ways which management may not act in the firm’s best interest:1. Insufficient effort; in wage negotiations, employment supervision, cutting costs2. Extravagant investments; (oil industry) investment in noncore industries3. Entrenchment strategies; taking actions that hurt shareholders as in creative

accounting to mask bad performance, taking too much or too little risk, resist hostile takeovers, investing in activities that make them indispensable

4. Self-dealing; managers may increase their private benefits ranging from benign to outright illegal activities easier to discover than insufficient effort, extravagant investments or entrenchment strategies.

LOS33a. Explain the ways in which management may act that are not in the best interest of the firm’s owners (moral hazard) and illustrate how dysfunctional corporate governance can lead to moral hazard;

LOS33b. Evaluate explicit and implicit incentives that can align management’s interests with those of the firm’s shareholders;

LOS33c. Explain the shortcomings of boards of directors as monitors of management and state and discuss prescriptions for improving board oversight;

LOS33d. Explain investor activism in relation to corporate governance and discuss the limitations of investor activism;

LOS33e. Critique the effectiveness of debt as a corporate governance mechanism;

LOS33f. Explain the social responsibilities of the corporation in a “stakeholder society” and evaluate the advantages and disadvantages of a corporate governance structure based on stakeholder rather than shareholder interests;

LOS33g. Discuss the Cadbury Report recommendations for best practice in maintaining an effective board of directors whose interests are aligned with those of shareholders.

READING 34 (ALTERNATIVE INVESTMENTS PORTFOLIO MANAGEMENT)

LOS34a. Characterize the common features of alternative investments and their markets, and discuss how they may be grouped by the role they typically play in a portfolio;

Common Features: Relative illiquidity Diversifying potential High due diligence costs: Due diligence takes time, average 3 months, and is a

limiting factor for smaller portfolios. Difficult performance appraisal (no valid benchmark)

They offer greater scope for adding value through skill superior information.

Groups by the primary role they play in a portfolio: The investments that provide exposure to risk factors not easily accessible

through traditional stock and bond investments: Real estate, commodities Investments that provide specialized investment strategies run by an outside

manager: HFs and Managed Futures The investment that combine two: Distressed funds, PE

LOS34b. Explain and justify the major due diligence checkpoints involved in selecting active managers of alternative investments;

Market opportunity Investment process Organization People Terms and structure Service providers Documents Write-up

LOS34c. Explain the special issues that alternative investments raise for investment advisers of private wealth clients;

Tax issues: these investments have distinct tax issues compared with traditional assets.

Determining suitability: Individual investors has multistage investment horizons and that changes quickly compared with a pension fund

Communication with client: it’s difficult to communicate with nonprofessional investors on complex investments

Decision risko Negatively skewed returnso High kurtosis

Concentrated equity position of the client in a closely held company

LOS34d. Distinguish among the principal classes of alternative investments, including real estate, private equity, commodity investments, hedge funds, managed futures, buy-out funds, infrastructure funds, and distressed securities;

REAL ESTATE Homebuilders and real estate operating companies Real estate investment trusts (REITs) Commingled Real Estate Funds (CREFs) Separately managed accounts Infrastructure funds

LOS34e. Discuss the construction and interpretation of benchmarks and the problem of benchmark bias in alternative investment groups;Biases in Index CreationPrimary concern is that most data bases are self-reported; that is HF managers chooses which databases to report to and provides the return dataThe reasons for low correlations between “similar strategy” indices are size and age restrictions indices impose and weighting schemes.The differences among indices often reflect differences in the weights of different strategy groupsValue weighting may result in a particular index taking on the return characteristics of the best performing hedge funds in a particular time period: as top-performers grow and poor ones shrink. Equal-weighted indices may reflect potential diversification of hedge funds better than value weighted indices

Survivorship BiasSurvivorship bias varies among HF strategies: minor for event-driven strategies, higher for hedged equity and considerable for currency funds.Survivorship bias may be reduced by conducting superior due diligence, and FOFs mitigates that problem by screening managers.

Stale Price BiasLack of trading as you use appraisal values and frequency of the data used result in stale price bias. That causes lower correlations or higher or lower standard deviations. There’s little evidence that stale prices present significant bias.

Backfill Bias (Inclusion Bias)Similar to survivorship data as the missing data is filled at the discretion of the component. Good data is provided by HFs.

Investment CharacteristicsWeakly correlated or uncorrelated with traditional stock and bond marketsReturn drivers based on trading strategy factors (option-like payoffs) and location factors (payoffs from a buy and hold policy) help to explain returns of each strategy.HF strategies attempt to be less affected by the direction of the underlying stock and bond markets as they don’t have “long bias”

LOS34f. evaluate and justify the return enhancement and/or risk diversification effects of adding an alternative investment to a reference portfolio (for example, a portfolio invested solely in common equity and bonds);

LOS34g. Evaluate the advantages and disadvantages of direct equity investments in real estate;

REITS

Equity REITS:Own and manage properties

Mortgage REITS:More than 75% of assets in

mortgages

Advantages and Disadvantages of direct equity real-estate investing (pg268)

ADVANTAGES DISADVANTAGESTax subsidies Parcels are not easy to divide, block sale

increases riskMore financial leverage for borrowers who use mortgage loans

Cost of acquiring information is high

Investors have direct control over their property

Brokers charge high commissions

Geographic diversification is effective when correlations are low(and also disasters)

Substantial operating and maintenance costs

Returns have relatively low volatility compared with public equities

Risk of neighborhood deterioration

Tax benefits can be removed by politicians

LOS34h. Discuss the major issuers and buyers of venture capital, the stages through which private companies pass (seed stage through exit), the characteristic sources of financing at each stage, and the purpose of such financing;

Major issuers:1. Formative stage companies2. Expansion stage companies

Major buyers:1. Angel investors2. Venture Capitalists3. Large companies

Stages: Early Stage

o Seed Stage The small amount of money provided by the entrepreneur to get the idea off the ground

o Start-up usually a pre-revenue stage that brings the entrepreneur’s idea to commercialization

o First-Stage additional funds, if the idea is sound but start-up funds have run out

Later Stage: occurs after revenue has started and funds are needed to expand sales Exit Stage: is the time when the venture capitalist realizes the value of the

investment. IPO, sale or merger

LOS34i. Compare and contrast venture capital funds to buyout funds;

The differences between buyout funds and VC funds: Buyout funds are highly leveraged: VC funds use no debt The cash flow to buyout fund investors come earlier and are often steadier than

those to VC fund investors: because buyouts purchase established companies and earlier the investment the greater the risk and the potential

The returns to VC fund investors are subject to greater error in measurement: less uncertainty for buyout funds investing in established companies

LOS34j. Discuss the use of convertible preferred stock in direct venture capital investment;

1. Direct venture capital investment convertible preferred rather than common stock is used. The terms of the preferred stock require that the corporation pay cash equal to some multiple of preferred shareholders’ original investment before any cash can be paid on the common stock, which is the equity investment of the founders. Preferred stock is senior to common stock also in its claims on liquidation value. This financing structure mitigates the risk that the company will take on the venture capital investment and distribute it to the owners/ founders. It also provides an incentive to the company to meet the return goals of the outside investors. Shares issued in later rounds are more valuable than shares issued in earlier rounds, which in turn, are more valuable than the founders’ common shares.

LOS34k. Explain the typical structure of a private equity fund, including the compensation to the fund’s sponsor (general partner), and typical timelines;

1. Limited Partnerships Sponsor is “General Partner”2. LLC Sponsor is “Managing Director”. Provides more influence on the fund’s

operations than does a limited partnership interest, in particular, more control over the raising of additional committed capital. The limited partners or shareholders do not bear any liability beyond the amount of their investment.

The compensation to the fund manager of a private equity fund consists of a management fee plus an incentive fee

1. The management fee is usually a percentage of limited partner commitments to the fund. (If the investor has made a capital commitment of US$50 million but actually invested US$10 million, the investor generally pays a management fee on the US$50 million committed.)

2. The fund manager’s incentive fee, the carried interest (incentive fee), is the share of the private equity fund’s profits that the manager is due once the fund has returned the outside investors’ capital. Carried interest is usually expressed as a percentage (usually 20%) of the total profits of the fund.

3. In some funds, the carried interest is computed on only those profits that represent a return in excess of a hurdle rate (the hurdle rate is also known as the preferred return)

4. Claw-back provision

Timeline: Commitment period (when capital calls made) then period till liquidation.

LOS34l. State and discuss the issues that must be addressed in formulating a private equity investment strategy;

Investment Characteristics: Illiquidity as convertible preferred shares does not trade in the secondary

market and investors are more restricted opportunities to withdraw funds Long-term commitments required Higher risks than seasoned public equity investments High expected IRR required Limited information

LOS34m. Compare and contrast indirect and direct commodity investment;Investment in publicly traded equities of commodity-linked businesses has probably been the most common approach for both individual and institutional investors to obtain exposure, albeit indirectly, to commodities.

1. Direct Commodity Investments: cash market purchase, storage and carry costs or exposure to spot market via futures

2. Indirect Commodity Investments: equity in companies specializing in commodity production (but they do not provide effective exposure to commodity price changes)

LOS34n. Explain the three components of return for a commodity futures contract and the effect that an upward- or downward-sloping term structure of futures prices will have on roll yield;

Commodity Index returns components1. Price (spot) Return: when the spot price goes up, so does the futures prices, giving

rise to a positive (negative) return to a long futures 2. Collateral Return: is related to the assumption that when an investor invests in the

commodity futures index, the full value of the underlying futures contracts is invested at a risk-free interest rate

3. Roll Return: arises from rolling long futures positions forward through time and may capture a positive return when the term structure of futures prices is downward sloping. The closer the futures contract is to maturity, the greater the roll return/ yield is.

Roll Return = Change in Futures Price – Change in Spot Price

Total Return for= Collateral Return + Roll Return + Spot ReturnCommodity Index

Convenience Yield Future Price < Spot Price Backwardation Positive Roll Yield Downward-sloping term structure is profitable

When the futures markets are in backwardation, a positive return will be earned from a simple buy and hold strategy. The positive return is earned because as the futures contract gets closer to the maturity, its price must converge to that of the spot price of the commodity. Because in backwardation the spot price is greater than the futures price, the futures price must increase in value. (The opposite is true with an upward-sloping term structure of futures prices, or contango.) All else being equal, an increase in commodity’s convenience yield should lead to futures market conditions offering higher roll returns; the converse holds for a decline in convenience yields.

LOS34o. Discuss the relationship between commodities and inflation and explain why some commodity classes may provide a better hedge against inflation than others;

Direct investment in energy and, to a lesser degree, industrial and precious metals may provide significant inflation hedge.

Two factors determine whether a commodity is a good inflation hedge:1. Storability: Good inflation hedge if it’s storable. Negative inflation hedge if it’s

not storable2. Demand relative to economic activity: better inflation hedge when demand

increases with economic activity. Commodities that have constant demand provide little inflation hedge.

LOS34p. Identify and explain the style classification of a hedge fund, given a description of its investment strategy;

Prime Brokerage is an important revenue source for IBsArbitrage here is not “risk-free” but “low risk”

Types of HF investments: Equity Market Neutral: Combined long and short positions for over-undervalued

securities while neutralizing the portfolio’s exposure to market risk by combining long and shirt positions. Constraint on shorting securities for some investors make correction slower for overvalued securities

Convertible arbitrage: Buy the convertible bond short the stock. Fixed income arbitrage Distressed securities Merger arbitrage: Long target, short acquirer Hedged equity (Equity L/S): Portfolios not structured to be market industry and sector

neutral. Identify over-undervalued securities. Global macro: They concentrate on major market trends rather than on individual

security opportunities Emerging markets Fund of Funds(FOF): For diversification, two layer of fees

Strategies: Relative value Event Driven Equity hedge Global asset allocators Short selling

LOS34q. Explain the typical structure of a hedge fund, including the fee structure and the rationale for high water marks;The fees are 2-20% on AUM and profits respectively. High-Water Mark (HWM) provision The purpose of HWM provision is to ensure that the HF manager earns an incentive fee only once for the same gain. For HF manager, the HWM is like a call option on a fraction of the increase in the value of the fund’s NAV. Lock-up periods to avoid unwinding positions early

Rationales for incentive fees:1. Investor pays for the absolute returns not for easy “beta” exposure2. HF contributes to controlling a portfolio’s downside risk, like a protective put, so

should earn a premium

LOS34r. Explain the purpose and special characteristics of fund-of-funds hedge funds;The purpose is to achieve diversification FOFs shorten the due diligence process to a single manager.Randomly selected five to seven HFs has a standard deviation similar to that of the population from which it’s drawn. Correlation is around 0.90Funds of funds: FOFs may provide a more accurate prediction of future fund returns thanthat provided by the more generic indices. However classification and style drift are issues with FOFs. As a result FOFs that change over time in response to rebalancing may not fit well into strict asset allocation modeling.

LOS34s. Critique the conventions and special issues involved in hedge fund performance evaluation, including the use of hedge fund indices and the Sharpe ratio;

Conventions:1. Young funds outperform old ones on total return basis2. Large funds underperform small funds3. Funds with longer (quarterly) lock-ups have higher returns than similar strategy

funds with shorter (monthly) lock-ups.

Returns: Leverage is important. The calculation convention followed in the HF industry is to “look through” the leverage as if the asset were fully paid. Also rolling return method is used.

Volatility and Downside Volatility: The assumption is the returns follows normal distribution but HF returns do not. So standard deviation incorrectly represents the actual risk of a hedge fund’s strategies. Semideviation uses a threshold return, which can be zero or a short-term rate. Manager is not penalized for positive returnsDrawdown is the largest point between HWM value and subsequent low point until new HW is reached.

Performance Appraisal Measures:Annual Sharpe ratio is commonly used (One year T-bill rate for risk-free rate).But Sharpe ratio has limitations.

1. Time dependency higher for longer time periods2. Assumes normality inappropriate for skewed return distributions3. Assumes liquidity Illiquid holdings have upward SRs4. Assumes uncorrelated returns Returns correlated across time will artificially

lower standard deviation (when market is trending). Serially correlated returns also result when assets are illiquid and current prices are not available.

5. Stand-alone measure: Does not automatically consider diversification effects.

Sharpe ratio can be gamed; that is reported SR can be increased w/o the investment really delivering higher risk-adjusted returns. It can be done by:

Lengthening the measurement period, daily volatility is higher than the monthly volatility.

Compounding the monthly returns but calculating the standard deviation from the (not compounded) monthly returns.

Writing out-of-the money puts and calls. Smoothing of returns Getting rid of extreme returns

LOS34t. Explain the market opportunities that may be exploited to earn excess returns in derivative markets that are otherwise zero-sum games;

Since not all market participants can use derivatives, as with short selling and investing in distressed debt, investors in derivatives may be able to capture returns not available to all investors

LOS34u. Discuss the sources of distressed securities and explain the major strategies for investing in them;

The advantage in distressed security investing:1. Regulatory constraint or investment policy restrictions for companies in distressed

investing2. Low analyst coverage3. Skill in influencing management and skill in negotiation is important

Investors look to distressed securities investing primarily for the possibility of high returns from security selection (exploiting mispricing) activism and other factors.

1) Long-only Value Investing: When distressed securities are public debt, this approach is high-yield investing.

2) Distressed Debt Arbitrage: Long bond, short equity. In times of distress equity will fall more than bond and three will be gains and vice versa in good times as bonds are more senior.

3) Private Equity: This is an active approach in distressed investing with prepackaged bankruptcy strategy. Buy the debt and become majority owner, involve in reorganization, turn the company around, get the equity and sell it at profit.

LOS34v. Explain the importance of event risk, market liquidity risk, market risk, and “J factor risk” for distressed securities investors.

Event Risk: unexpected company-specific risk or situation-specific risk “Judge” factor risk judge’s track record in adjudicating bankruptcies and

restructuring. Liquidity risk Market risk, the economy, interest rates, the state of the equity markets (not very

important)

As the value goes up gradually it takes longer to payoff your investment. Outcome depends on legal process and takes many years. Stale pricing is inevitable for illiquid securities.

Absolute priority rule is in effect under Chapter 11.

READING 36 (COMMODITY FORWARDS AND FUTURES)

LOS36a. Discuss the unique pricing factors for commodity forwards and futures, including storability, storage costs, production, and demand, and their influence on lease rates and the forward curve;

If a commodity is non-storable, large price swings over the day primarily reflect changes in the expected spot price, which in turn reflects changes in demand over the day

FORWARD PRICING

( )0, 0Price r T

TForward F S e

dividend yield

Lease rate is unlike dividend yield, the lease rate is income earned only if the pencil is loaned. The equation holds whether or not the commodity can be or is stored.... So the lender being able to lease the commodity reduces the forward price

Cash and Carry Arbitrage Cash FlowsTransaction Time 0 Time TShort forward @ 0,TF 0

0,T TF S

Buy lTe commodity and lend @ l 0lTS e TS

Borrow @ r 0

lTS e ( )0

lr TS e Total 0 ( )

0, 0lr T

TF S e

Reverse Cash and Carry Arbitrage Cash FlowsTransaction Time 0 Time TLong forward @ 0,TF 0

0,T TS F

Short lTe commodity units with lease rate @ l 0lTS e TS

Lend @ r 0

lTS e ( )0

lr TS e Total 0 ( )

0 0,lr T

TS e F

NO-ARBITRAGE PRICING( ) ( )

0 0, 0r c T r T

TS e F S e

FORWARD PRICE WITH A LEASE RATE( )

0, 0r T

TF S e

ANNUALIZED LEASE RATE

0,

1ln( / )Tr F S

T

EFFECTIVE ANNUAL LEASE RATE

1

0,

(1 )1

( / )l

TT

r

F S

Contango occurs when the lease rate is less than the risk-free rate Backwardation occurs when the lease rate exceeds the risk-free rate

LOS36b. Identify and explain the arbitrage situations which arise as a result of the convenience yield of a commodity and commodity spreads;

LOS36c. Compare and contrast the basis risk of commodity futures with that of financial futures.

It is a generic problem with commodities because of storage and transportation costs and quality differences.

Basis risk can also arise with financial futures

Strip Hedge Locking in the price and supply on month-on-month basis.

Stack and Roll HedgeStacking futures contracts in the near-term contract and rolling over into the new near-term contract. Why we use stack hedge:

1. Near term have high volume and more liquid, lower bid-ask spreads. Lower transaction costs

2. Manager may wish to speculate the shape of the yield curve looks steep and then flattens then you will have locked all your oil at the relatively cheap near-term price and implicitly made gains from not having locked in the relatively high strip prices.

READING 37 (RISK MANAGEMENT)

LOS37a. Compare and contrast the main features of the risk management process, risk governance, risk reduction, and an enterprise risk management system;

Risk management is a process involving the identification of the exposures to risk, the establishment of appropriate ranges for exposures, the continuous measurement of these exposures, and the execution of appropriate adjustments to bring the actual level and desired level of risk into alignment. Businesses need to take risk in areas in which they have expertise and possibly a comparative advantage in order to earn profits.

Risk governance refers to the process of setting risk management policies and standards for an organization. Senior management, which is ultimately responsible for all organizational activities, must oversee the process.

ERP is a centralized risk management system whose distinguishing feature is a firmwide or across-enterprise perspective on risk. Overall risk will be less than the sum of individual risks due to the correlations between the risk exposures

LOS37b. Recommend and justify the risk exposures an analyst should report as part of an enterprise risk management system;

Financial Risk:1. Market Risk

a. Interest ratesb. Stock pricesc. Exchange ratesd. Commodity prices

2. Credit Risk-The nature of credit risk has changed as the introduction of credit instruments, without the underlying probability of default changing

3. Liquidity Risk, bid-ask spread / security prices

Non-Financial Risk:1. Operational Risk2. Model Risk3. Settlement Risk: The possibility that one side of a position is paying while the

other side is defaulting. It is a problem in FX markets.4. Regulatory Risk5. Legal/Contract Risk6. Tax Risk

7. Accounting Risk8. Sovereign and Political Risks (when a company invests overseas, goes hand in

hand w/ FX risk)9. Other Risks (ESG Risk, Performance Netting Risk for HFs)

LOS37c. Evaluate the strengths and weaknesses of a company’s risk management processes and the possible responses to a risk management problem;

Centralized risk management puts the responsibility on a level closer to senior management, where it belongs to. Centralization permits economies of scale and allows a company to recognize the offsetting nature of distinct exposures that an enterprise might assume in its day-to-day operations.Decentralization has the advantage of allowing the people closer to the actual risk taking more directly manage it. However it doesn’t account for portfolio effects across unitsThe centralized type of risk management is now called ERM. In ERM, an organization must consider each risk factor to which it is exposed- both in isolation and in terms of any interplay among them.

LOS37d. Evaluate a company’s or a portfolio’s exposures to financial and non-financial risk factors;

Standard deviation, Market risk had two dimensions:

1. The sensitivity of the assets to the factor (duration)2. Changes in that sensitivity to that factor (convexity)

Power outage, sovereign risk.

LOS37f. Compare and contrast the analytical (variance–covariance), historical, and Monte Carlo methods for estimating VAR and discuss the advantages and disadvantages of each;

1) The Analytical or Variance-Covariance MethodAssumes portfolios are normally distributed. Some approaches estimate VAR use zero expected value. This has several features:

Offers slightly more aggressive results Avoids having to estimate expected return (because E(r) is zero) Makes easier to adjust the VAR for a different time period.

( )( )P PVAR R z V

Advantages: Easy to calculate, easy to understood Allows modeling the correlation of risks Can be applied to different time periods according to industry custom

Disadvantages: Reliance of simplified assumptions such as normality. Real life returns show

negative skewness and leptokurtic. Also normality is not good for portfolios contain options (limited downside and unlimited upside).

The difficulty in estimating the correlations between individual assets in very large portfolios

2) Historical Simulation MethodUse Historical returns and rank them then find the worst 5th return, this is the VAR.

Advantage: NONPARAMETRIC. No need probability distribution assumptions Easy to calculate and easy to understood Can be applied to different time periods

Disadvantage: Historical data it uses may not hold in the future. Bonds and derivatives behave differently at different times in their lives

Take the averages if Nth return is not a discrete number

3) Monte Carlo Simulation

Advantage: Any return distribution can be used. It does not require a normal distribution but

it’s common.

Disadvantage: The analyst must make thousands of assumptions about the returns distributions

for all inputs as well as their correlations.

LOS 37.g. Discuss the advantages and limitations of VAR and its extensions, including cash flow at risk, earnings at risk, and tail value at risk;

The Advantages and Limitations of VAR Difficult to estimate and different estimation methods can give quite different

values Gives a false sense of security by giving the impression that risk is properly

measured and under control Underestimates the magnitude and the frequency of the worst returns although

this problem often derives from erroneous assumptions and models Difficult to obtain for complex organizations (such as banks) VAR fails to incorporate positive results into its risk profile, and such, it arguably

provides an incomplete picture of overall exposures Quantify the potential losses in simple terms and can be easily understood. Can be easily understood by senior management and quantifies the loss in simple

terms. It’s versatile as companies use it as a measure of their capital at risk.

Backtesting should be applied to portfolios to see the same patterns fit. Also it should be applied for different time intervals.

Incremental VAR The portfolio’s VAR while including a specified asset and the portfolio’s VAR with that asset eliminated.CFAR The minimum cash flow lossEARMinimum earnings lossThose two are used for companies that generate cash flows or profits but cannot readily valued publiclyTVAR VAR+ the expected loss in excess of VAR when such excess loss occurs.

LOS37.h. Compare and contrast alternative types of stress testing and discuss the advantages and disadvantages of each;

Scenario analysis:

Stylized scenarios it involves simulating a movement in at least one interest rate, exchange rate, stock price, or commodity price relevant to the portfolio. Some stylized scenarios are industry standards. One problem with stylized scenario approach is that the shocks tend to be applied to variables in a sequential fashion. In reality, these shocks happen at the same time.

Actual extreme events The analyst measures the impact of major past events on the portfolio value.

Hypothetical events that have never happened but might occur.

Stressing Models:

Factor Push to push the prices and risk factors of an underlying model in a most disadvantageous way and work out the combined effect on the portfolio’s value. (Disadvantage=enormous model risk in extreme risk climate)

Maximum loss optimization it tries to optimize mathematically the risk variable that will produce the maximum loss.

Worst-case scenario analysis

LOS37i. Evaluate the credit risk of an investment position, including forward contract, swap, and option positions;

Two different time perspectives in credit risk:1. Risk associated with immediate credit events jump-to-default risk.2. Risk associated with events that may happen later potential credit risk

Cross-default provision a creditor defaults on any outstanding credit obligations; the borrower is in default on them all.

Credit VAR the main focus is upper tail, not lower tail like original VAR.

Option Pricing Theory and Credit Risk The bondholders have implicitly written the stockholders a put on the assets. From the stockholders’ perspective, this put is their right to fully discharge their liability by turning over the assets to the bondholders, even though those assets could be worth less than the bondholders’ claim.

The Credit Risk of Forward ContractsEach side assumes credit risk until settlement.The forwards market value is important because it indicates the amount of a claim that would be subject to loss in the event of a default.

0

0

1

0.75

(1 )

$100

1

5%

$100*(1.05) $105

3 :

$102

$105$102 $0.7728

(1.05)

long T n

ForwardValue Spot

r

P

n

r

F

after months

P

Value

The Credit Risk of SwapsFor interest and equity swaps the potential credit risk is largest during the middle period of the swap’s tenor. As the counterparties perform sufficient credit research for each other at the beginningFor FX swaps the greatest risk is between the midpoint and the end of the life of the swap.

inf

* *

manager lows outflows

managerdomestic foreign

Value PV PV

Notional ForwardRate Notional SpotRateValue

RFR RFR

The Credit Risk of OptionsForward contracts and swaps have bilateral risks, Options have unilateral risks. The buyer of an option pays a cash premium at the start and owes nothing more unless he decides to exercise the option.Like forwards European options have no current credit risk until expiration. But for American options risk is greater as option holder decides to exercise the option early.

LOS37.j. demonstrate the use of risk budgeting, position limits, and other methods for managing market risk;

This is mainly related with Risk Budgeting. RB is about efficiently allocating risk among the units, divisions, portfolio managers or individuals (traders). The enterprise allocates risk capital before the fact in order to provide guidance on the acceptable amount of risky activities that a given unit can undertake.The sum of risk budgets for individual units will typically exceed the risk budget for the organization as a whole because of the impacts of diversification. RB is used to allocate funds to PMs based on their IRs.

LOS37.k Demonstrate the use of exposure limits, marking to market, collateral, netting arrangements, credit standards, and credit derivatives to manage credit risk;

Managing Credit Risk: 1. Reducing credit risk by limiting exposure is the primary means of managing

credit risk.2. Reducing credit risk by Marking-to-Market (recalculate the forward or swap price

after negative value pays the positive value party. OTC options are not MTM because their value is always positive to one side of the transaction)

3. Reducing credit risk with collateral 4. Reducing credit risk with netting. (It reduces the credit risk by reducing the

amount of money that must be paid) o Payment nettingo Closeout netting(bankruptcy related)o Cherry picking(bankruptcy related)

5. Reducing credit risk with Minimum credit standards and enhanced derivative product companies (as some companies will not do business with an enterprise unless its rating from these agencies meets a prescribed level of credit quality.

6. Transferring credit risk with credit derivatives (CDS, Total Return Swap, Credit Spread Option, Credit Spread Forward)

LOS37.l. compare and contrast the Sharpe ratio, risk-adjusted return on capital, return over maximum drawdown, and the Sortino ratio as measures of risk-adjusted performance;

Sortino ratio uses minimum return objective instead of RFR and downside deviation instead of standard deviation.

Sharpe Ratio Sortino and Sharpe ratios can tell a more detailed story of risk-adjusted return than either will in isolation, but SR is better grounded in financial theory and analytically more tractable. Principal drawback to applying the Sharpe is the assumption of normality in the excess return distribution. This is a problem when the portfolio contains options and other instruments with non-symmetric payoffs

Risk Adjusted Return on Capital (RAROC) expected return on an investment divided by a measure of capital at risk.

Return over Maximum Drawdown (RoMAD) is simply the average return in a given year that a portfolio generates, expressed as a percentage of this drawdown figure. It is more intuitive than standard deviation as a measure of risk, because it deals with more “concrete” numbers. However, like standard deviation, it implicitly assumes that historical return pattern will continue.

pRROMAD

Maximum Drawdown

Am I willing to accept an occasional drawdown of X percent in order to generate an average return of Y percent? An investment with X=10% and Y=15% (RoMAD = 1.5) would be more attractive than an investment with X=40% and Y=10% (RoMAD = 0.25)

LOS37.m. demonstrate the use of VAR and stress testing in setting capital requirements.

1. Nominal (notional) position limits2. VAR-based position limits3. Maximum loss limits4. Internal capital requirements5. Regulatory capital requirements

READING 38 (RISK MANAGEMENT APPLICATIONS OF FORWARD AND FUTURES STRATEGIES)LOS.38a. demonstrate the use of equity futures contracts to achieve a target beta for a stock portfolio and calculate and interpret the number of futures contracts required;

( )T S f fS S N f contractvalue

So to adjust the beta,

( )T S

ff

SN

f contractvalue

To completely hedge the risk,

( )S

ff

SN

f contractvalue

LOS38b. Construct a synthetic stock index fund using cash and stock index futures (equitizing cash);

Long stock + Short futures = Long risk-free bond

Consider the Cash flows of both sides and you can get the following:

Return on future contracts = Ft(Future price at time t) - St( spot at time t) = S0(1+Rf)^t -St

Return on long stock = St - S0

Add both you get:

Return = S0(1+Rf)^t - St + St - S0

To make it easier Take t = 1 ( one year holding period)

Return = S0*Rf = risk free return on original investment.

We would like to replicate owning the stock and reinvesting the dividends.

Long stock - Short futures = Long risk-free bond

Long stock = Long risk-free bond + Long futures (this one replicates the underlying)

Starting Money = V

This money will grow to *(1 )TV r and we’ll deliver it when the contact expires.

So we need to buy * (1 )

*

T

f

V rN

q f

futures

Round N, and the actual money invested to the index is:

* * *

(1 )f

T

N q fV

r

The number of units of stock that we have effectively purchased at the start is

* *

(1 )f

T

N qV

When rebalancing portfolio and adjustment of duration was asked at the same time;1. First rebalance the portfolio and find synthetic positions or number of contracts to

adjust the share of stock and equity2. Then find the number of contracts to adjust the beta of the stock portfolio and the

duration of the equity portfolio.

LOS38c. Create synthetic cash by selling stock index futures against a long stock position;

Just the sign changes

* (1 )

*

T

f

V rN

q f

LOS38d. Demonstrate the use of equity and bond futures to adjust the allocation of a portfolio between equity and debt;$300 million portfolio 80% stock ($240 million) 20% bonds ($60 million)Beta of the equity=1.1Duration of bonds= 6.5Equity futures beta = 0.96Bond futures duration = 7.2Contract price (stock) = $200,000Contract price (bonds) = $105,250

T Sf

f

SN

f

0 1.1 $90,000,000

0.96 $200,000fN

=-515.63

In order to change the allocation 50-50%,

Sell stock futures and buy bond futures,

T Bf

f b

MDUR MDUR BN

MDUR f

6.5 0 $90,000,000

7.2 $105, 250fN

= 772

LOS38e. Demonstrate the use of futures to adjust the allocation of a portfolio across equity sectors and to gain exposure to an asset class in advance of actually committing funds to the asset class;

ADJUSTING THE ALLOCATION BETWEEN ONE BOND CLASS AND ANOTHER

$30 million bond portfolioDuration of bonds= 6.5Bond futures duration = 7.2Contract price (bonds) = $105,250

2 goals:

1) Move $10 million into cash = 0 6.5 $10,000,000

7.2 $105, 250fN

=

2) Change the target duration for $20 million of the portfolio to 7.5 = 7.5 6.5 $20,000,000

7.2 $105,250fN

LOS38f. Discuss the three types of exposure to exchange rate risk and demonstrate the use of forward contracts to reduce the risk associated with a future transaction (receipt or payment) in a foreign currency;

Transaction Exposure Is the FX risk that foreign traders exposed, when exporting or importingTranslation Exposure Is the FX risk exposure while consolidating foreign subsidiaries financial statements to the parents’ financial statementsEconomic Exposure even the companies do not trade goods they are exposed the FX valuation of home countries because an overvalued currency hurts travel to the country and more people visit other countries instead of local spots.

Managing the risk of a FX Receipt (exporter) because the exporter is effectively long the FC, he will take a short position on the FC in the forward marketManaging the risk of a FX Payment (importer) because the importer is effectively short the FC, he will take a long position on the FC in the forward market

In both cases the future spot rate does not matter because the investor is hedged as long as the basis doesn’t change.

LOS38g. Explain the limitations to hedging the exchange rate risk of a foreign market portfolio and discuss two feasible strategies for managing such risk.

It is tempting to believe that the managers should accept the foreign market risk, using it to further diversify the portfolio, and hedge the foreign currency risk. In fact, many assets managers claim to do so. A closer look, however, reveals that is virtually impossible to actually do this. Because the future amount of the portfolio to be hedged is uncertain.

Once the company hedges the foreign market return, it can expect to earn only the foreign risk-free rate. If it hedges the foreign market return and the exchange rate, it can expect to earn only its domestic risk-free rate. Neither strategy makes sense in the LR. In the short run, however, this strategy can be a good tactic for investors who are already in foreign markets and who wish to temporarily take a more defensive position without liquidating the portfolio and converting it to cash.

Two feasible strategies1. Hedge foreign market risk only and earn foreign RFR but FX risk still exists2. Hedge foreign market risk and foreign currency risk by forwards so earn domestic

RFR

READING 39 (RISK MANAGEMENT APPLICATIONS OF OPTION STRATEGIES)

LOS39a. Determine and interpret the value at expiration, profit, maximum profit, maximum loss, breakeven underlying price at expiration, and general shape of the graph for the major option strategies (bull spread, bear spread, butterfly spread, collar, straddle, box spread);

Money Spreads Different exercise price, same expirationTime Spreads Different exercise price, different expiration (these trades are designed toe exploit differences in perceptions of volatility of the underlying)

Bull Spread: designed to make money when market goes up. Sell a call and buy a call with the lower exercise price. As C1>C2 the spread will require a net outlay of funds

Bear Spread: designed to make money when market drops. The maximum profit occurs when both puts expire in the money. Two ways to design the strategy:

1. Buy a call and sell a call with the lower exercise price (the reverse of the bull spread)

2. Sell a put and buy a put at the higher exercise price. (more intuitive way)

Butterfly Spreads: Buying calls with the exercise prices of X1 and X3 and selling two calls with the exercise prices of X2.If the exercise prices are equally spaced as X1=30, X2=40 and X3=50, so 2X2-X1-X3 will be zero.

Also 0 1 2 32V c c c is always a positive number. Because the bull spread we buy is

more expensive than the bull spread we sell.

The investor believes that the underlying will be less volatile than the market expects. If the investor buys the butterfly spread and the market is more volatile than expected, the strategy is likely result in a loss.

If you believe the market will be more volatile, sell the butterfly spread as selling calls with the exercise prices of X1 and X3 and buying two calls with the exercise prices of X2.

PUT-CALL PARITY

0 0 0rTP S C Xe

Collars: Sell a call on a protective put with the same put price (to cover the cost of the put). The call’s exercise price will be above the current price of the underlying. When the premiums offset it is called zero-cost collar. The investor is giving up gains above a certain level buy writing the call. It is a modified version of a protective put and a covered call. Asset managers often use them to guard against losses without having to pay cash up front for the protection. They are virtually the same as bull spreads. They perform based on the direction of the movement in the underlying.

http://www.cboe.com/Strategies/EquityOptions/EquityCollars/Part1.aspx

Straddles: Buying the volatility by buying a call and a put at the same strike price when you have no idea about the direction. An investor who leans one way or the other might consider adding a call or a put to the straddle.

Adding a call is strap Adding a put is strip

Box Spread: It is an arbitrage strategy and does not require binomial, B-S models and estimating volatility, low cost and faster execution. It is a combination of a bull spread and a bear spread

The profit is:

2 1 1 2 2 1X X c c p p The payoff at the expiration is:

2 1X XThe initial value:

1 2 2 1c c p p As the strategy is risk free, the present value of the payoff at the expiration must be equal to the initial value:

2 11 2 2 1

( )

(1 )n

X Xc c p p

rfr

LOS39b. Determine the effective annual rate for a given interest rate outcome when a borrower (lender) manages the risk of an anticipated loan using an interest rate call (put) option;

In either case when you buy an interest rate call option or put option the payout is paid at the end of the loan term and the interest is calculated on the LIBOR on exercise date.When you buy an interest rate call option you pay the premium upfront and borrow the whole premium. The initial outlay is:= Loan principal - FV of the option premium on the expiration date

When you buy an interest rate put option you pay the premium upfront and lend the whole premium. The initial outlay is:

= Loan principal + FV of the option premium on the expiration date

FV(premium) = premium[1+(current LIBOR + spread) ( maturity / 360)]

**** add the spread on LIBOR for FV of the premium

Loan Amount $40,000,000Underlying 180-days LIBORSpread 200bps over LIBORCurrent LIBOR 5.5%Today 14 AprilExpiration 20 August (128 days later)Exercise Rate 5.00%Call Premium $100,000Libor on August 20 8.00%

FV of call premium $100,000*[1+(5.5%+200bps)*128/360] = $102,667Loan Proceeds (inflow) $40,000,000 - $102,667 = $39,897,333Option Payoff $40,000,000*(8%-5%)*(180/360) = $600,000Loan Interest $40,000,000*(8%+200bps)*(180/360) = $2,000,000EAR [($40,000,000+$2,000,000-$600,000)/

$39,897,333]^(365/180)-1 = 7.79%

Effective Annual rate is calculated by exponential 365, whereas all other calculations are in days/360 (LIBOR)

INTEREST RATE COLLAR BUY CAP-SELL FLOOR (FROM BORROWERS POW)

EQUITY COLLAR BUY PUT-SELL CALL (HOLDING SECURITY IS REQ’D)

The collar establishes a range, the cap exercise rate minus the floor exercise rate, within which there is interest rate risk. The borrower will benefit from falling rates and be hurt by rising rates within that range. Any rate increases above the cap rate will have no effect, and any rate decreases below the floor exercise rate will have no effect. The net cost of this position is zero, provided that the floor premium offsets the cap premium. It is probably easy to see that collars are popular among borrowers.

LOS39d. Explain why and how a dealer delta hedges an option portfolio, why the portfolio delta changes, and how the dealer adjusts the position to maintain the hedgeCovered-call Buy one share of stock sell one call optionDelta-Hedging Buy (#of calls*delta shares of stock) sell one call option

Delta hedged position grows at the risk-free rate over time.

Assume you shorted a call option. There are various ways to hedge: Find the exact opposite trade (buy call) which is not easy Use put call parity c = p + S – X/(1+rfr)^T. This is a static hedge because you do

not need to change the position as time passes. Hedging with another derivative maybe other calls as, trading derivatives are

often easier and more cost effective than trading underlying (As we did in delta hedge)

There are three complicating issued:1. Delta is just an approximation2. Delta Changes if anything else changes, such as the price of underlying and time.3. The underlying units per option must be rounded off. This creates imprecision,

Two patterns become apparent for delta hedging:1. The further away we move from the current price, the worse the delta-based

approximation2. The effects are asymmetric. A given move in one direction does not have the

same effect on the option as the same move in opposite direction.a. Especially for calls the delta underestimates the effects of increases and

overestimates the effects of decreased in the underlying

Delta = 1 if the option expires ITMDelta = 0 if the option expires OTMDuring its life delta will tend to be over 0.5 if the option is ITM and below 0.5 if the option is OTM.Largest moves occur before expiration for ATM options which delta’s move to 1.0 or to 0. When gammas are large delta hedgers choose to also gamma hedge.

LOS39e. Identify the conditions in which a delta-hedged portfolio is affected by the second-order gamma effect.

Gamma Hedging =Gamma is the options convexity. If the delta hedged position were risk-free, its gamma would be zero. The larger the gamma, the more the delta-hedged position deviates from being risk-free.Dealers usually monitor their gammas and in some cases hedge their gammas by adding other options to their positions such that the gammas offset.Gamma is highest when option is ATM or close to expiration.

READING 40 (RISK MANAGEMENT APPLICATIONS OF SWAP STRATEGIES)

LOS40a. Demonstrate how an interest rate swap can be used to convert a floating-rate (fixed-rate) loan to a fixed-rate (floating-rate) loan

FROM BORROWERS PERSPECTIVEIf you pay floating interest, buy a pay fixed-receive floating swapIf you pay fixed interest, buy a pay floating-receive fixed swap

Pay fixed swap counterparty benefits from rising interest rates.

LOS40b. Calculate and interpret the duration of an interest rate swap;

pay floating Fixed Leg Floating LegD D D

The duration of a floating rate bond is ½ of the length of payment interval: Semiannual (1/2)/2 = 0.25 Quarterly (1/4)/2 = 0.125 Monthly (1/12)/2= 0.042

The duration of a fixed rate bond is 75% of its maturity

***DO NOT FORGET to add or subtract duration of the other loan that is hedged!!!

So, for one year pay fixed-receive floating swap the duration is 0.125-0.75 = -0.625.The buyer of this swap benefits from rising interest rates and falling market value.

LOS40c. Explain the impact to cash flow risk and market value risk when a borrower converts a fixed-rate loan to a floating-rate loan;

The company which uses swaps to convert floating to fixed payments does not appear to be exposed to the uncertainty of changing LIBOR, but we shall see that it is indeed exposed.

Because the duration of floating rate only payments are roughly equal to the -0.125 and when the duration of the position when we combine this position to convert it to a fixed position is 6 times as we effectively paying a fixed rate loan. The declining rates and increasing market values will hurt fixed-rate borrower. The advantages and disadvantages are: From cash flow perspective it is a hedge as we pay fixed. This is a hedge from

accounting and budgeting perspective From market value perspective it is highly speculative as the objective of the

corporation is maximizing shareholder value. Such a transaction despite stabilizing a company’s cash outflows, however,

increases the risk of the company’s market value.

LOS40d. Determine the notional principal value needed on an interest rate swap to achieve a desired level of duration in a fixed-income portfolio;

Find the duration of fixed and floating rates, then find the duration of the swap. Then use it in below formula.

$500,000,000(6.75) ( ) $500,000,000(3.5)

*

swap

TARGET PORT

SWAP

NP MDUR

MDUR MDURNP B

MDUR

To reduce the duration:1. We need to hold a position that moves directly with interest rates2. The swap should be pay-fixed receive floating3. This means negative swap duration

To reduce the duration:1. We need to hold a position that moves inversely with interest rates2. The swap should be pay floating-receive fixed3. This means positive swap duration

Here the key point is when you select a swap with too small duration you get a very large swap to execute.

LOS40e. Explain how a company can generate savings by issuing a loan or bond in its own currency and using a currency swap to convert the obligation into another currency;

LOS40f. Demonstrate how a firm can use a currency swap to convert a series of foreign cash receipts into domestic cash receipts

The plain vanilla swap rates on both currencies will be given and notional values will be found by using the swap payments and the interest rates given on plain vanilla swaps.There’s no initial and final exchange of the principals.

LOS40g. Explain how equity swaps can be used to diversify a concentrated equity portfolio, provide international diversification to a domestic portfolio, and alter portfolio allocations to stocks and bonds

The most important issue is the CASH OUTFLOWS that will result in actual sale of stock when the stock outperforms the market return. The diversification can be achieved by selling stock return and buying index return in exchange.

For International Diversification case, the main issue is the stock holding may have a high tracking error (with the benchmark) and the obligation to swap the returns on domestic benchmark may create cash flow problems. In addition the company has a currency and market risk and passes on to USRM its costs of hedging that risk.

For changing the allocations to stocks and bonds; of course, the transactions will not completely achieve TMM’s goals as the performance of various sectors and of its equity and fixed-income portfolios are not likely to match; tracking error. Also the actual stock and bond portfolio will generate cash only from dividends and interest. The capital gains on the stock and bond portfolio will not be received in cash unless a portion of the portfolio is liquidated. But avoiding liquidation of the portfolio is the very reason that the company wants to use swaps.

LOS40h. Demonstrate the use of an interest rate swaption (1) to change the payment pattern of an anticipated future loan and (2) to terminate a swap.

In using a swaption to terminate a current swap is set the exercise rate the same as the fixed rate paid received on the swap so swap is terminated. The moneyness determines whether the swaption will be exercised or not.

READING 41 (EXECUTION OF PORTFOLIO DECISIONS)

LOS41a. Compare and contrast market orders to limit orders, including the price and execution uncertainty of each

Market Orders Price uncertainty, Execution certaintyLimit Orders Price certainty, Execution uncertainty

LOS41b. Calculate and interpret the effective spread of a market order and contrast it to the quoted bid-ask spread as a measure of trading cost

Inside bid-ask spread (DIFFERENCE BETWEEN LOWEST ASK, HIGHEST BID) or market bid-ask spread will be less than any individual dealers’ bid-ask spread if the dealers’ best bid and best ask spreads are different.

Effective Spread is two times the deviation between the executed price and previously quoted mid-point price. It is a better spread measure because:

It captures both price improvement and, The tendency for large orders to move prices (market impact)

Limit BOOK at the time before order Bid price $19.97 Ask price $20.03 so spread is $0.06 (the cost of round trip transaction)

The trader enters market order 500 shares to buy, and the dealer reduces the ask price to $20.01“step in front of”

The quoted bid-ask spread is $0.06The midquote is ($20.03+$19.97)/2 = $20.00The effective spread is 2*($20.01-$20.00) = $0.02 so the effective spread is $0.04 less than the quoted spread.

LOS41c. Compare and contrast alternative market structures and their relative advantages

1. Quote-driven markets (Dealer Markets): Trading with dealers (Our Focus)2. Order-driven markets: Trading with each other (no intermediation), not limited to

dealers. There might be more competition for orders, because a trader does not have to transact with a dealer. A trader cannot choose with whom he or she tradeswith.

a. Electronic Crossing Networksi. They mainly serve institutional investors.

ii. The cost of trading low because commissions are low and traders don’t pay dealers bid-ask spread.

iii. No order execution guarantee. Because liquidity is poor as there may not be a dealer willing to maintain an inventory. Traders do not know the size of the trade whether it is filled or not.

iv. Anonymity as trader do not know the counterparty’s identity and trade size so the prices do not react to supply and demand conditions so no price discovery

b. Auction Markets Provide price discovery which results in less frequent partial filling of orders than in electronic crossing networks.

c. Automated Auctions (Electronic Limit Order Markets)i. Electronic Communication Networks (ECNs).

ii. They provide anonymity and computer based. They operate continuously.

iii. There’s price discovery as auction markets. Also, it’s not completely order or quote driven market.

iv. ECNs is a blend of order and quote driven markets as dealers, traders and brokers trade at the same time.

3. Brokered markets: exist in countries where the underlying public markets are relatively small or where it is difficult to find liquidity in size.

i. Brokered markets are mostly used for block transactionsii. There is anonymity

LOS41d. Compare and contrast the roles of brokers and dealers

They have opposing interests.Execution services secured through a broker include the following: representing the order, finding the buyer, market information for the investor, discretion and secrecy, escrow, and support of the market mechanism. A trader’s broker stands in an agency relationship to the trader, in contrast to dealers.Dealers provide bridge liquidity to buyers and sellers in that they take the other side of the trade when no other liquidity is present. They have adverse selection risk (the risk of trading with a more informed trader).

LOS41e. Explain the criteria of market quality and evaluate the quality of a market when given a description of its characteristics

The market has relatively low bid-ask spreads. Little price changes at high volume orders

The market is deep: Depth means that big trades tend not to cause large price movements. Deep markets have high quoted depths.

The market is resilient; fast correction of misvaluation.

Corporations benefit from liquidity as they attract more capital and the higher prices will lower cost of capital. Investors pay premium for more liquid securities. Also:

Many buyers and sellers Diversity of opinion, finding the other side of the trade with an opposite opinion Convenience: a readily accessible physical location or an easily mastered and

well-thought-out electronic platform attracts investor. Market Integrity, more fair and honest treatment more trading again. Pre-trade transparency v post-trade transparency Assurity of the contract

LOS41f. Review the components of execution costs, including explicit and implicit costs, and evaluate a trade in terms of these costs

Explicit Costs Direct costs of trading, such as broker commission costs, taxes, stamp duties and

fees paid to exchanges

Implicit Costs The bid-ask spread Market Impact Missed trade opportunity costs: it arises from the failure to execute a trade in a

timely manner Delay costs: Inability to complete a trade due to its size and the liquidity of the

markets

VWAP Volume weighted average priceIt shows to identify when the trade is transacted at a higher or lower price than security’s average trade price during the day. Sometimes it is less informative because:

1. For trades that represent a large fraction of total volume. You are the MARKET2. Brokers have discretion to game the number.

HOW TO GAME THE PERFORMANCE AGAINST A BENCHMARK NUMBER?

If OPENING PRICE used and order is sell and market is up fill it immediately as the price will be higher than VWAP, if market down wait for the next day. Do the reverse for buy orders.

If CLOSING PRICE is benchmark wait till closing to match the trade price If VWAP is benchmark, split the order and spread its execution throughout the

day so the transaction price is close to the market VWAP

Gaming the Effective Spread: One trader may wait for other traders to come to them. By doing so, the first trader can trade at favorable bid and ask spreads. However, the delay may result in forgone profits.

Estimated Implicit Costs = Trade Size*(Trade Price-Benchmark Price) -----FOR BUY-----Estimated Implicit Costs = Trade Size*(Benchmark Price-Trade Price) -----FOR SELL-----

Benchmark Price can be, opening, closing price and VWAP

Estimated implicit costs may be quite sensitive to the choice of benchmark

LOS41g. Calculate, interpret, and explain the importance of implementation shortfall as a measure of transaction costs

Implementation shortfall approach (see page 303 for breakdown). It is the return on paper portfolio minus portfolio’s actual returns. It correctly captures all elements of all transaction costs (all of the explicit and implicit costs).

Decision made:# of shares=1,000Price= $10.00

Paper Portfolio Value (at cost) = 1,000*$10.00=$10,000

Real Purchase Price=10.07# of shares bought=700Commissions and fees=$14

Last Closing Price=10.08

Paper Portfolio Value=1,000*$10.08=$10,080Paper Portfolio Return= $10,080-$10,000= $80.00

Real Portfolio Value (at cost) =700*$10.07= $7,049+$14=$7,063Paper Portfolio Return= $7,056-$7,063= -$7

Implementation shortfall = $80 – (-$7) = $87

$87/$10,000=0.87%

****THE SHORTFALL COMPUTATION IS REVERSED FOR SELLS.

1. Commissions and fees are calculated naturally as 14/10,000 = 0.14%2. Realized profit/loss reflects the difference between the execution price and the

relevant decision price (closing price of the previous day):

10.07 10.05 7000.14%

10.00 1,000

3. Delay Costs reflect the price difference due to delay in filling order. The calculation is based on the amount of the order actually filled:

10.05 10.00 7000.35%

10.00 1,000

4. Missed trade opportunity cost reflects the difference between the cancellation price and the original benchmark price. The calculation is based on the amount of the order that was not filled:

10.08 10.00 3000.24%

10.00 1,000

Implementation cost as a percent is 0.14% + 0.14% +0.35% +0.24% =0.87%

LOS41h. Contrast volume weighted average price (VWAP) and implementation shortfall as measures of transaction costs;

LOS41i. Explain the use of econometric methods in pre-trade analysis to estimate implicit transaction costs

The relationship between the variables and estimated costs can be non-linear. These estimates can be used in two ways:

1. To form a pre-trade estimate of the cost of trading that can be juxtaposed against the actual realized cost once trading is completed to assess execution quality.

2. to help the portfolio manager gauge the right trade size to order in the first place

LOS41j. Discuss the major types of traders, based on their motivation to trade, time versus price preferences, and preferred order types

1. Information-motivated traders fast execution and block trades2. Value-motivated traders they trade infrequently, only motivated by value and

price. They use limit orders. 3. Liquidity-motivated traders they trade to use liquidity to convert securities

to cash or reallocate their portfolio from cash. Profit is not the driver. They execute trades within a day.

4. Passive traders Passive investors and ETFs. They are more focused on trading costs. No urgency in trades. Favor limit orders, portfolio trades and crossing networks.

LOS41k. Describe the suitable uses of major trading tactics, evaluate their relative costs, advantages, and weaknesses, and recommend a trading tactic when given a description of the investor’s motivation to trade, the size of the trade, and key market characteristics

1. Liquidity-at-Any-Cost Trading Focus these trades demand high liquidity on short notice. An information trader or a MF that must liquidate its shares quickly to satisfy redemptions in their fund.

2. Costs-Are-Not-Important Trading FocusMarket orders and the variations of this type. Because they require little effort and risk taking by market makers, they are inexpensive for brokers to execute and have been used to produce “soft dollar” commissions in exchange for broker-supplied services. All trading discretion s surrendered.

3. Need-Trustworthy-Agent Trading Focus Brokers used. Immediate execution is not of primary importance, so such orders are less useful for information-motivated traders. Commissions may be high.

4. Advertise-to-Draw Liquidity Trading Focus There is public display the trading interest in advance of the actual order.

5. Low-Cost-Whatever-the-Liquidity Trading Focus Limit orders are the chief example of this type of order. This order type is best suited to passive and value-motivated trading situations. There’s execution uncertainty that could end up “chasing the market”

LOS41l. Explain the motivation for algorithmic trading and discuss the basic classes of algorithmic trading strategies

Algorithmic Trading = Slice and Dice the Orders to reduce market impact

Decimalization led to smaller spreads but also led to reduced quoted depth which is a disadvantage for institutional orders that are large relative to normal trading volume. The underlying logic behind the algorithmic trading is to exploit market patterns of trading volume so as to execute orders with controlled risk and costs. This approach typically involves breaking large orders up into smaller orders that blend into the normal flow of trades in a sensible way to moderate price impact

Basic classes are:1. Logical Participation Strategies

a. Simple Logical Participation Strategiesi. VWAP Strategy The objective is to match or improve upon the

VWAP of the dayii. TWAP Strategy The objective is to match or beat time-weighted

average priceiii. In the % of Volume Strategy the order is traded at 5-20% of

normal trading volume until the order is filled.

b. Implementation Shortfall Strategies seek to minimize implementation shortfall over time and they are “front-loaded” in the sense of attempting to exploit market liquidity early in the trading day. Because sooner order is made available to the market, better the opportunity for finding the other side of the trade.

2. Opportunistic Strategies: Trade passively over time but increase trading when liquidity is present.

3. Specialized Strategies: Include passive strategies and others.

LOS41m. Discuss and justify the factors that typically determine the selection of a specific algorithmic trading strategy, including order size, average daily trading volume, bid-ask spread, and the urgency of the order

Low UrgencyLow size of the order relative to the daily volumeVWAPHigh UrgencyLow size of the order relative to the daily volumeImplementation ShortfallLow UrgencyHigh size of the order relative to the daily volume and Large SpreadBroker/ Crossing Sys

LOS41n. Explain the meaning and criteria of best execution

Meaning = the trading process Firms apply that seeks to maximize the value of a client’s portfolio within the client’s stated investment objectives and constraints. Prudence addresses the appropriateness of holding certain securities, while Best Execution addresses the appropriateness of the methods by which securities are acquired or disposed.

Criteria of best execution (EXHIBIT 14):-It cannot be known ex-ante-It can be analyzed over time on an ex-post basis.-It is tied to portfolio-decision value and cannot be evaluated independently

LOS41p. Discuss the role of ethics in tradingThe code is self-enforcing: Any trader who does not adhere to it quickly finds that no one is willing to deal with him