# CFA Level 2 Review: Options, Swaps and Rate Derivatives

Study session 17 in the CFA Level 2 curriculum concludes the material on derivatives with four readings (50-53) on options, swaps, and rate derivatives.

Option Markets and Contracts
If you’re familiar with the options markets, the material is pretty basic and will be easy points. For those without prior experience, you’ll need to spend a little more time because it is fairly testable stuff. Understand the difference between European-style and American Options but all the formulas and quant material is based on expiration so there won’t be a difference.

Start with the put-call parity equation and be able to solve for any of the variables; call price, put price or stock price. This will get you through any questions on synthetic positions.

Understand how to create a delta hedge through the number of calls to sell or the total number of shares to purchase. The number of calls to sell equals the number of shares you want to hedge divided by the delta of the option. The total shares to purchase is the number of options you are short times their delta.

You won’t need to do the math for the Black-Scholes Merton equation but you may need to know the assumptions and limitations.

• Lognormal distribution skewed to the right side but limited to zero on the left side of the distribution
• Continuous risk-free rate is constant and known
• Volatility of the underlying asset is constant and known
• Markets are frictionless (no taxes, transaction costs, or restrictions on short sales)
• Underlying asset has no cash flows
• Options valued are European and cannot be exercised early

Know the Greeks and their respective measures. You will need to know how to delta hedge an asset but the rest of the Greeks are just conceptual. Three of the Greeks start with the same letter as the definitional word which is how I remembered them.

• Delta- sensitivity to price change
• Gamma- sensitivity to delta change
• Rho – sensitivity to rate change
• Theta – sensitivity to time change
• Vega – sensitivity to volatility

Swap Markets and Contracts

This was probably one of the most difficult readings for me when studying for the Level 2 exam. There are some lengthy and detailed calculations here and you will probably need to spend some time to get them down. I would start with getting the underlying concept first which will help to remember how to put the formulas together. Flash cards work well for drilling the specific equations until you can remember them.

The fixed rate (swap rate) is determined at the contract initiation date and makes the present value of the fixed rate component equal to the present value of the floating rate component. Determining this rate is called “pricing” the swap. The floating rate is reset at the beginning of each settlement period and is based on the short-term rates (LIBOR).

The market value of the swap at any time is equal to the difference between the value of the float-rate side and the value of the fixed-rate side.

A rate swap is an agreement between two parties to exchange fixed for floating rate payments. There is no exchange of principal at initiation. Since currency swaps are for two notional principals, there is usually an exchange at the beginning and end of the swap.

Payer swaptions are the right to enter into a specific swap as the fixed rate payer while receiver swaptions are the right to enter into a swap as the fixed rate receiver.

Interest Rate Derivative Instruments
Caps or ceilings are agreements where one party pays another the when a reference rate exceeds a contracted point. Basically, the buyer needs to limit their risk that rates will increase and enters into a call option on rates (possibly someone paying on floating-rate debt).

Conversely, Floors are agreements where one party pays another when a reference rate drops below a contracted point. A floor is similar to a put option on rates. The calculations for caps and floors are not too difficult, just tedious because you often need to do calculations for multiple periods. Just remember, the payoff is either (0) where the market rate is higher than the floor or lower than the ceiling, or the payoff is the difference between the market rate and the contract rate times the notational and the time fraction (i.e. 90/360).

Credit Derivatives: An Overview
Like the title says, this is really just an overview and there isn’t too much detail. Make sure you get the concepts along with the terms.

Credit default swaps transfer the default risk of an asset to another party. The protection buyer makes a fixed periodic payment to the seller during the term. If the default ‘event’ occurs then the seller pays the buyer according to the contract. Note- this involves counterparty risk that the seller can deliver.

Defalt triggers on CDS instruments can be a number of events including; failure to make a debt payment, bankruptcy, restructuring, moratoriums, or any technical defaults. The settlement of the CDS may be in delivery or a cash settlement.

Understand the various participants in the CDS market and why they might need protection.

Study session 18 in the CFA Level 2 curriculum covers three readings in portfolio management.

‘til next time, happy studyin’
Joseph Hogue, CFA

# CFA Level 1 Review, Valuation of Debt Securities

Study session 16 in the CFA Level 1 curriculum concludes the topic area with three more readings in fixed income (56-59) covering analysis and valuation.

Introduction to Valuation of Debt Securities
Conceptually, there is little here that you haven’t seen in the equities section. The value of any financial asset is just the present value of expected cash flows. The cash flow function and the Present Value function on your calculator can do most of the work for you but you need to understand the concept and the ‘why’. *Important: Always remember that most bond problems will be semiannual coupons so you need to double the years and divide the rate and the payment by two for your PV calculator work.

The relationship between the coupon rate, discount rate (i.e. current rates in the market) and the price (relative to par) is an important note and will come back throughout the other two exams.

• If the coupon rate is above the current rate for similar instruments in the market, the bond will be priced higher than par. If you can get a higher rate, you would expect to pay more than the face value.
• If the coupon rate is less than the current rate in the market, the bond will be priced at a discount. You wouldn’t pay face value for something to get less than offered in the market.

Understand the process behind the binomial model and Monte Carlo simulation for valuation, as well as advantages/limitations but you really do not need to know much more than a conceptual basis just yet.

Yield Measures, Spot Rates, and Forward Rates

Don’t confuse the current yield with the coupon rate. The current yield is the coupon divided by the bond price, the actual yield given the price. The coupon rate is the coupon divided by par, the stated yield.

Understand Yield to Maturity and that it is only realized if the bond is held and under the assumption of reinvestment. If the security is sold earlier than maturity, the investor faces interest rate risk.

Understand how to work through a bond equivalent yield problem and converting it to an annual-pay YTM. The conceptual material on yield-to-call and yield-to-put is important. Understand the assumptions and what it means for an investor holding the debt. The calculations are fairly basic and can be done on the PV function.

Introduction to the Measurement of Interest Rate Risk
Understand both the full valuation and duration/convexity approach with a focus on advantages/disadvantages to each. The full valuation approach is appropriate for a parallel and non-parallel change in the yield curve but is very time consuming with a large portfolio. The duration/convexity approach is simpler but is not appropriate for non-parallel shifts in the yield curve.

The concept behind options is very important, especially call options and negative convexity. Understand the difference between  the price of a security at high or low rates when there is a call or put option. You’ll see this again on the Level 2 exam so learn it now.

Duration is another topic that I could just copy/paste from the Level 2 notes. You need to understand the concept and the formula. Start with the standard formula before you worry about modified duration or the Macaulay formula.

Fundamentals of Credit Analysis
The reading is like a 101 on credit analysis and good for your general knowledge of the industry. There are a few important concepts but they are all overall general concepts.

Understand the forms of credit risk:

• Spread risk is the loss of value from an increase in yield spread over other bonds due to the perceived increase in default risk of the issuer, notice it is from the perception of risk but not necessarily an actual downgrade
• Downgrade risk is the loss when an issuer is downgraded by an agency due to creditworthiness
• Market liquidity risk is the loss due to lack of sufficient participation to buy/sell the bonds in the quantity desired

Understand the difference between equity and credit analysis, and the four Cs of Credit

• Capacity is the ability of the borrower to meet debt obligations
• Collateral is the quality and value of the assets supporting the debt
• Covenants are the terms and conditions in a bond agreement
• Character is the quality of management and willingness to satisfy debt obligations

The different ratios and ratio analysis in the reading are extremely important but reviewed in other sections. You can address them here or in the other sections, but you must know them.

Know the difference between affirmative covenants (obligations the company must hold like paying interest, taxes and submitting audited statements) and negative covenants (limitations on the company like debt ratios and the amount of cash that can be paid out to equity holders).

Study session 17 in the CFA Level 1 curriculum consists of six readings covering derivatives. The material is still fairly conceptual but is pretty lengthy.

‘til next time, happy studyin’
Joseph Hogue, CFA

Last updated: October 27, 2017 at 2:50 am

# Finding the Motivation the Second Time Around

We’ve had a lot of emails about finding the motivation to review the same material after you’ve failed the exam. This is a tough one because you’ve already spent a ton of time and the material doesn’t really change much from year-to-year. If it wasn’t interesting enough to stick the first time around, what’s a candidate to do the second time?

As for motivation, I wish I could tell you that repeat testers have a higher pass rate than first-timers. You’ve got to think it’s probable but there isn’t much data to go on. I recently conducted a poll on the LinkedIn group asking candidates on which subsequent try did they pass. Of the 17 votes, 55% of the retesters passed on the second attempt with another 11% on the third attempt.

The best advice I can offer, for anyone studying those arduous 300 hours per exam, is not to think of it as an exam. Going into this as an exam, where you rationalize the hard work just to get through the next test, is a sure recipe for boredom. You’re not really enjoying the material, just muddling along thinking of it as a job.

I’ve talked on the blog a few times about the reward to your professional ability that comes with the CFA curriculum and I think that’s really the way you need to approach the exams. Looking for the quick payday or job opportunity from achieving the CFA designation is going to leave you surprised when you realize that even us charterholders have to work for it. Yeah, you will have more opportunities and will probably see a higher income but the charter isn’t something that is going to set you on easy street.

When you accept that the time you spent studying becomes ‘research’ after you pass the exams, the idea of covering the curriculum becomes a little easier and a lot more interesting. Embrace the fact that time spent learning about asset classes, risk management and portfolio management is just a part of your career. Time spent covering topic areas outside the narrow view of your current job or the job you think you want will make you a stronger professional and open up tons of opportunities in the future.

As for the practical side of studying the material, the best way to avoid boredom and frustration from covering the same material multiple times is to focus on practice problems and question banks.

Coming up to the final month of studying, this is also the method I’d recommend everyone wrap up their study plans. Time is critical at this point and no one can afford to keep covering material that they already understand. Complete at least 30-60 problems at a time to give yourself a good idea of how you are doing within a specific topic area.  By keeping track of your score within the individual topic areas and even down to the reading level, you can focus your reviews where you need it most.

Five weeks left. Stay strong and push through to the end. You’re almost there!

‘til next week, happy studyin’
Joseph Hogue, CFA

# CFA Level 3 Review, Monitoring and Rebalancing

Study session 16 in the CFA Level 3 curriculum covers execution of portfolio decisions with two readings (39-40) on monitoring and rebalancing. The material is part of the large Portfolio Management topic area which is worth approximately half of your total test score.

Execution of Portfolio Decisions
Know the basic types of orders (market, limit, participate, portfolio, reserve) and what each means for price, timing, and liquidity.

Understand the basics for the type of markets (crossing networks, auction, dealer, and automated auctions). Don’t confuse electronic crossing networks (automated markets for institutionals that match buy and sell orders at specific times during the day) and Electronic communications Networks (ECN, computer-based auctions that operate throughout the day.

Understand the differences and roles of brokers and dealers. The relationship between the trader and dealer is adversarial while the broker represents the trader. Brokers help to find the opposite side of a trade, can supply market information, provide discretion and secrecy, and can provide other supporting investment services.

The material on transaction costs is the most testable portion of the reading and often shows up on the essay portion. Make sure you can work through an implementation shortfall problem and calculate explicit costs, realized profit/loss, delay costs, and the missed trade opportunity costs.

Be able to calculate the volume-weighted average price and describe differences between the two approaches.

Understand the motivations for each of the different types of traders (informational, value, liquidity, and passive) and what it means for timing and liquidity.

Monitoring and Rebalancing
The material on monitoring is basically understanding the constraints on the IPS and being able to see when an investor’s situation changes materially enough to take action. The curriculum is fairly basic and you should be able to work through it if you’ve spent the time on the individual/institutional management portions.

The rebalancing portion of the reading is the more testable. Understand the costs of rebalancing (transaction costs and taxes) and the two methods for rebalancing, calendar and percentage of portfolio.

Calendar rebalancing is simple and less costly because there is no need for monitoring but it is unrelated to market behavior so costs may outweigh benefits if the portfolio weights have not moved much. The percent-of-portfolio method requires frequent monitoring but has a relatively tighter control on allocations especially in a volatile market.

Understand the effect of transaction costs, risk tolerance, asset correlations, and volatility on the optimal corridor width.

The buy-and-hold, constant mix, and constant proportion portfolio insurance methods are also highly testable and you absolutely must understand the differences and how to calculate affect on the portfolio given different types of markets.

Study session 16 in the CFA Level 3 curriculum concludes the portfolio management topic area with two readings on performance evaluation and attribution.

‘til next time, happy studyin’
Joseph Hogue, CFA

Last updated: October 27, 2017 at 3:16 am

# CFA Level 2 Review, Forwards and Futures

Study session 16 in the CFA Level 2 curriculum starts the material on derivatives with two readings (48-49) on forwards and futures. The topic is worth between 5% to 15% on both the Level 2 and Level 3 exams so you will definitely see at least one item set and possibly more.

Forward Markets and Contracts
The forward price is based off of a no-arbitrage assumption that you shouldn’t be able to earn a riskless return above the risk-free rate. The price is a function of the spot price, the risk-free rate and the term of the contract = S0*(1+Rrf)T

You need to understand this simple equation to be able to calculate a cash and carry arbitrage, which often finds its way onto the exams.  This is where you borrow at the risk free rate, buy the bond and simultaneously short/long the forward contract to profit on the difference.

Example: You calculate the no arbitrage price on a four-month contract of \$813.10 with a risk-free rate of 5% but the forward is priced in the market at \$850. The cash and carry is borrow \$800 at the risk-free and buy the bond while shorting the forward contract. At the settlement date, the short forward is satisfied by delivering the bond for a payment of \$850 and used to repay the \$800 loan. The total amount to repay the loan over the four month term is \$800*(1.05).333 = \$813.10 with an arbitrage profit of \$850 – \$813.10 or \$36.89 (try several practice problems for this until you can easily do it for under- or over-priced forwards)

Once you have the basic formula down and can do a cash/carry example, the rest of the iterations on forward pricing are fairly easy. The forward rate agreement (FRA) is a little harder, but it is another highly testable item and you need to practice it until you know it. Remember to use 360 for the annual term in the denominator.

Futures Markets and Contracts
Make sure you understand the differences between futures and forward markets and products. Futures are marked to market, traded on organized exchanges, standardized, involve a third-party clearinghouse, and are regulated. Forwards are between private parties, not marked to market, customized and not regulated. Understand how this affects counter-party risk, liquidity, price and margin.

The futures price is also built on the same no-arb assumption so be ready to calculate it and work a cash/carry example.

Backwardation and contango are two important terms on which the curriculum has focused. Backwardation is where the futures price is less than the spot while the spot is less than the future price in Contango. Understand the basics of how these two phenomenon affect market participants for futures (growers and speculators).

Study session 17 in the CFA Level 2 curriculum concludes the material on derivatives with four readings on options, swaps, and rate derivatives.

‘til next time, happy studyin’
Joseph Hogue, CFA

Last updated: October 27, 2017 at 3:16 am

# CFA Level 1 Review, Fixed Income Overview

Study session 15 in the CFA Level 1 curriculum begins the fixed income topic area with four readings (52-55) covering the basic concepts in debt securities. The topic is worth 12% of your Level 1 score but you really need these core concepts to understand the later material the other two exams. The topic will be worth about 10% and 15% of your Level 2 and Level 3 exams.

Looking back on the Level 1 curriculum for these posts, it strikes me how effectively the Institute manages to work candidates into a topic with basic concepts and ideas. I’ve heard the Level 1 exam described as a mile wide and an inch deep because of the breadth of information involved but the difficulty is offset by not requiring too much detail.

This is a key point you need to remember when studying for the first exam. Get the key concepts and vocabulary first. Not getting caught up in too much detail is going to help you cover the curriculum as many times as possible. Going over the material multiple times helps to commit it to memory and helps you pick out the correct answer out of three choices. You’ll still need a fair amount of detail, but the first exam is definitely a bird’s eye view of the material.

Features of Debt Securities
Understand the basic types of affirmative and negative covenants like paying interest & taxes, meeting financial ratios, limitations on additional debt, and restrictions on asset sales.

Definitions and just knowing the lingo is always important. Know what a coupon is and understand what happens to the price if the coupon rate is higher or lower than current market rates. Think about it intuitively. If a bond offers a higher coupon rate than you can find in the market, you are going to be willing to pay a premium on the price, and the opposite is true for a coupon rate below the current market yield.

Understand the basic idea behind call and put provisions, sinking funds, repurchase agreements and prepayment. Remember, the full or dirty price is the agreed price plus all accrued interest.

Risks Associated with Investing in Bonds
There are 11 basic risks listed with bonds: interest rate, call and prepayment, yield curve, reinvestment, credit, liquidity, exchange-rate, volatility, inflation, event, and sovereign risk. Some (interest rate, prepayment, yield curve) are extremely important and you will be seeing a lot of the curriculum focus on detail but you need to have an understanding of the basic factors within each.

The inverse relationship between rates and price underlies interest rate risk. As rates increase, the price of a bond decreases because investors can get a better rate in other products. Understand how maturity of the bond affects the change in price, i.e. longer time left means bigger price swings because you could be earning more/less for a longer time. Duration is the measure of rate risk and you need to remember the formula for the exam = (Price at lower rate – Price at higher rate)/ (2*initial price* change in yield)

Prepayment risk is when the bond issuer (or mortgage holder) has the option to buy back the product. Remember, all options have value and the value of this call feature will be more valuable as rates decrease.

Reinvestment risk is associated with the need to reinvest payments of interest and principal at lower rates than the bond offers. Zero coupon bonds have no reinvestment risk because they have no payments until maturity while amortizing securities have more risk because they pay off principal and interest.

Understand the three types of credit risk: default, credit spread, and downgrade risk.

Understand the threat that inflation poses to bonds as fixed-income products. This means that even as the value of the currency depreciates, the investor only receives the set coupons and principal so the bond is worth less in real terms.

Overview of Bond Sectors and Instruments
This reading is of secondary importance and you really only need a basic idea of the seven sectors of the bond market and an overview of their characteristics.

Sovereign bonds: Government issued and relatively lower risk. They can be issued in local or foreign currencies. Understand the basic differences of the U.S. debt like T-notes, T-bonds, Strips and TIPS.

Semi-government: These are issued by a quasi-government agency and often carry an implicit guarantee. The focus is on agency mortgage debt and the types of CMO and MBS, think Fannie Mae and Freddie Mac a few years ago.

Municipal or province: Like sovereign bonds but issued by smaller authorities like towns and cities. Understand the difference between tax-backed and revenue bonds and the effect on risk. The interest is often tax-advantaged for taxes owed to the issuing municipality or state.

Corporate Bonds: Understand the four factors used by credit rating agencies (character, capacity, collateral, and covenants). This section has a few formulas and is probably one of the more testable in the reading.

Mortgage backed securities: Understanding structure and prepayment risk is the important material here and will be used for more detail in the Level 2 exam.

Asset backed securities: Understand the types of internal and external credit enhancements as well as the role of special purpose vehicles.

Collateralized debt obligations: These are basically the same as asset-backed debt but the backing for the bond is a diversified pool of different debts, i.e. domestic/foreign bonds, bank loans, distressed debt, ABS, and MBS.

An extremely important reading and the setup for many formulas in the Level 2 exam. Understand the effect of monetary policy (open market operations, discount rate, reserve requirements, and verbal notes) on rates.

Understand the theory behind the four shapes to the yield curve and what they say about the outlook for rates and the economy: positively-sloped (normal), flat, inverted (downward-sloping), and humped.

Understand the three theories of term structure: pure expectations, liquidity preference, and market segmentation.

1)      Pure expectations says that forward rates represent expected future spot rates and are not based on other systematic factors. It predicts that the expected spot rate in one year is equal to the implied 1-year forward, implying that expectations are unbiased and the shape of the yield curve depends on expectations.

2)      Liquidity preference states that long-term rates not only reflect expectations but also include a premium for investing in the long-term bonds, a liquidity premium. Rates are biased as holding long-term maturity requires the premium and that a yield curve may have any shape because the size of the liquidity premium is positively related to investor risk aversion.

3)      Market segmentation states that the slope of the curve depends on supply and demand conditions in the long and short-term markets. An upward-sloping curve indicates that there is less demand for short-term relative to long-term while a downward sloping curve would imply the opposite.

Study session 15 in the CFA Level 1 curriculum concludes the topic area with four more readings in fixed income.

‘til next time, happy studyin’
Joseph Hogue, CFA

Last updated: October 27, 2017 at 3:16 am

# The Best Vacation You Ever Had

With a little over a month left to the tests, I started to get nostalgic for the bygone days of last-minute cramming for the CFA exams. I always took the last week before the exam off from work to dedicate my time to studying. A 40-hour plus week of mock exams, flash cards and review sheets may not sound like a vacation, but it beats the normal 9-5 routine and the curriculum can be pretty interesting if you let it. My full schedule is described in a prior post and linked here.

Instead of rehashing my own schedule for the last week, I thought I would pass along an idea from a friend in Chicago on how he spent his last week before the exams. I’ve talked to others about their last-week plans, but his yearly ritual wins hands-down.

Instead of staying in Chicago and locking himself away at the library for the six days before the exam, my usual approach, he would hop a flight to San Diego for a real vacation. He still put in the 8-10 hours of studying but spent it relaxing in the park or at the beach. Mornings would start early with a run on the beach at 6am followed by breakfast and studying by 8am. He would study through the day to about 4-5pm, stopping an hour for lunch. After relaxing for a few hours, he would put in another hour or two studying before bed.

Talking through his daily routine, it struck me that it really wasn’t that different from others. Mock exams every other day help to fine-tune the review and focus on those topics where you need the most work. Flash cards and condensed summary sheets help to break up the monotony of practice problems and reading. There are a lot of advantages to going away on a trip though.

First, all your meals are prepared for you so that’s one less thing to worry about or on which to spend time. Your friends and family know you are away so they don’t expect you to go out and party (I had more than a few friends that couldn’t understand why I wouldn’t want to stay out later during a week off from work when I was studying). Finally, you’ve spent the last five months (more or less) studying in the same place. Spending that last week studying at home as well can be extremely boring.

Of course there are risks to the vacation plan. My friend said he did enjoy a drink or two at night but never gave in to temptation and drank too much. A couple of drinks isn’t going to kill too many brain cells but be careful not to stay out too late. Don’t spend too much time worrying about where you are going to study or what you want to see. Pay a little extra for a nice hotel that is well-centered on the places you want to go. One caveat is to plan on coming back home Thursday to make sure flight cancellations do not keep you from getting home on time.

The idea is to relax and have as much fun as possible over that last week while still hitting the curriculum hard for those last points to put you over. Going into the test with burnout and just ready to get it over with isn’t going to help you pass.

‘til next week, happy studyin’
Joseph Hogue, CFA

# CFA Level 3 Review, Risk Management with Derivatives

Study session 15 in the CFA Level 3 curriculum concludes the readings on risk management with three readings (36-38) on applications of derivatives. The last three readings are a little more quantitatively intense. Resist the temptation to skip over the difficult parts. Instead use the practice problems until you are confident that you could reproduce the concepts in an essay question.

Risk Management Applications of Forward and Futures Strategies
The number of futures contracts for a portfolio hedge is extremely testable and you need to know how to work through the calculation. Think through the formula to understand what is going on and it will become easier to remember.  # Futures contracts =

• (desired beta minus current beta) divided by beta on futures      contracts: if you want to decrease the portfolio beta (decreasing      risk) then you will be selling futures contracts and you’re answer should      have a negative sign. Here you are taking the difference between the risk      you want and the risk you have and dividing by the riskiness of the      futures contracts to answer how much each futures contract will change the      risk of your portfolio.
• Multiplied by (value portfolio divided by price of a futures      contract): This tells you how many futures contracts you need given      the portfolio size.
• * A common question is to reduce beta to zero so the formula would      change to (0-portbeta)/futuresbeta * (portfolio      value/ futures contract price)
• Pre-investing is also a common question and really just the      opposite of the above. Here you need to create index beta from 0 so it      would be (indexbeta-0/ futuresbeta)

Remember, a futures hedge on a portfolio is only a hedge for the similarity in risks between the index used for the futures contract and the portfolio. Example, the futures sold on the S&P500 would not be a good hedge on a portfolio of small-cap stocks because the index is a lg-cap index.

The formulas for creating a synthetic index fund and creating cash out of equity are also testable so do not avoid them.

Remember the advantages to using futures to manage risk (i.e. lower transaction costs, greater liquidity, provide better timing and allocation strategies, require less capital to trade).

Risk Management Applications of Options Strategies
Know the basic strategies (covered calls, protective puts, spreads, straddles, and collars) and how to figure out value at expiration. Here I think the curriculum is a little convoluted with the formulas when it is really a pretty basic concept.

Covered calls are holding a long stock position and selling calls against it to reduce some downside risk so you are going to deduct the collected premiums from your costs. Your upside is capped at the strike price plus the premium while you still risk losing everything except the premium (if the stock goes to zero).

Protective puts offer greater risk reduction and retain upside in the shares but cost more. The are formed by buying puts against a long stock position so you are going to add the cost of the puts into your costs.

Whether bull or bear, spreads involve two option strikes one higher and one lower so your costs will just be the difference in the premiums. Your risk is limited to the net difference in premiums while your upside is limited to the difference in the strike prices.

Collars involve both a call and a put option with the sell of one financing the purchase of the other. The most used example is a zero-cost collar where a call option is sold to fully finance a put option which provides downside protection at the expense of giving up upside potential.

Straddles involve buying a put and a call with the same strike and the same expiration and can be costly. The investor makes money if the shares move higher or lower than the combined price of the two options.

Risk Management Applications of Swap Strategies
For me, this was one of the most difficult readings in the curriculum. You need to be able to work through an example of a swap for interest rates, currency and equities and explain who has the risk in the transaction.

Remember, market value risk is the uncertainty associated with the value of an asset or liability while cash flow risk is the uncertainty associated with the size and timing of cash flows. Credit risk is the uncertainty that the other side of the transaction will be able to make their payment.

*Currency swaps usually involve the payment of notational principal at initiation and payments are not netted because they involve different currencies. This is different than other swaps where there is usually no initial principal exchanged and payments are netted.

Swaptions are options to enter into a swap either as payer or receiver. The payer swaption allows the holder to be a fixed-rate payer/floating-rate receiver and is similar to a bond put. The receiver swaption allows the holder to be the fixed-rate receiver/floating-rate payer and is similar to a bond call.

Study session 16 in the CFA Level 3 curriculum covers execution of portfolio decisions with two readings on monitoring and rebalancing.

‘til next time, happy studyin’
Joseph Hogue, CFA

Last updated: October 27, 2017 at 3:19 am

# CFA Level 2 Review, Structured Securities

Study session 15 in the CFA Level 2 curriculum concludes the fixed income material with three readings (45-47) on structured securities. As it is with much of the topic areas in the Level 2 curriculum, the formulas can get pretty intense but you need to spend some time and master them. The topic area is worth about 10% of your exam score and another 15% in the Level 3 exam.

Mortgage-Backed Bonds
The reading starts out pretty basic with a glossary of MBS terms and differences between types of structure. Be able to calculate the mortgage payment, an easy task on the PV function of your calculator.

The two types of prepayment risk are important and you should know the difference between them. Contraction risk is that a security’s life will decrease when rates come down and borrowers prepay their loan. This means the investor will need to reinvest proceeds at a lower rate. Extension risk, that the security’s life will increase, is when rates increase and prepayments decrease. The price of the security will decline and the investor will be stuck in the lower rate longer.

Be able to calculate the single monthly mortality (SMM) and the conditional prepayment rate (CPR) assuming a PSA. The two formulas may seem inconsequential but they are probably the most easily testable part of the reading which is largely conceptual.

SMM = prepayment in month i/(beginning mortgage balance for month i – scheduled principal pmt month i)
CPR = 1- (1-SMM)12

The rest of the reading is fairly conceptual. Understand the tranche structure of CMO and the different classes of stripped MBS.

Asset-Backed Bonds
Understand the basic process of securitization and the parties involved. Types of credit enhancements is fairly testable, as much of the list material is.

External enhancements like a third-party guarantee, letter of credit or corporate guarantee expose the investor to third-party risk. Internal enhancements like reserve funds, excess spreads, overcollateralization, and senior-subordinate structures do not have the third-party risk.

The structure is similar for most of these securities, the differences in prepayment risk is probably the most important area. Credit cards and mobile homes do not have prepayment risk. Student loan prepayments are not sensitive to rates.

Know the concepts and structure for CDOs. There is a some quantitative material around an arbitrage transaction that you should do a few practice problems to understand but I’m not sure it is as testable as the other formulas in the topic.

Valuing Mortgage and Asset-Backed Securities
Understand the three assumptions (prepayment rate, reinvested at yield, held to maturity) of cash flow yield and be able to calculate the bond equivalent yield, BEY = 2((1+im)6 – 1)

As is the case throughout the curriculum, pay attention to the limitations on each yield measure (usually based around the assumptions).

Know the basic idea behind the five steps to valuation using Monte Carlo simulation:

• simulate interest rate      path and cash flow using rates, volatility, and spread assumptions;
• calculate the PV of cash      flows along 1,000 paths;
• calculate theoretical      value of MBS as the average PV along all paths;
• calculate OAS as the      spread that makes PV equal to market price;
• calculate the option cost      as the zero-volatility spread minus the OAS

Duration is probably the most testable material in the reading, especially since you will need it in other topics. The formula may look intimidating at first but it is pretty intuitive. The price sensitivity to changes in rates is the (value at the lower rate minus value at the higher rate) divided by( twice the initial price times the change in rates)

Understand the different types of duration methods (cash flow, effective duration, coupon curve, empirical duration) and their limitations. The major criticism of cash flow duration is that it is based on the assumption of a single prepayment rate over the life of the security.

Study session 16 in the CFA Level 2 curriculum starts the material on derivatives with two readings on forwards and futures.

‘til next time, happy studyin’
Joseph Hogue, CFA

# CFA Level 1 Review, Equity Investments

Study session 14 in the CFA Level 1 curriculum concludes the equity topic area with three readings (49-51) on valuation of equity securities. The topic area is arguably one of the single most important in the entire curriculum. It is worth 10% of your Level 1 exam, about 25% of your Level 2 test and 10% of your last exam. As with most of the curriculum throughout the first exam, you will need a strong base to be able to move into deeper detail for the other exams.

Overview of Equity Securities
This is a very basic reading and almost entirely conceptual. Look for the list material and any comparisons with other types of investments, i.e. the differences between debt and equity.

Understand the differences between common and preferred shares like: payment order of dividends, distribution of net assets in a liquidation, and voting rights.

The characteristics of a depository receipt and the types of ADRs is important. You probably won’t need the full detail on types of ADRs but remember that Level  II and III are traded on the exchanges. Level I ADRs are subject to limited reporting requirements and only trade on the OTC market. Regulation S depository receipts are not subject to registration requirements and are only privately placed.

Understand the basic return and risk characteristics of equities, pay attention to standard deviation.

The material on ROE, the cost of equity and investors’ required rates of return is probably the most important in the reading. These will be fundamental concepts across the three exams. Understand how to use the DuPont formula to analyze the sources of changes in a company’s ROE.

Introduction to Industry and Company Analysis
Writing blog entries for the 18 study sessions across the three exams, I am struck with a sense of déjà vu because the same concepts reappear so many years. You will revisit industry and company analysis in both the Level 2 and 3 exams. I know you are tired of studying and trying to find time as it is but spending a little extra time on the Level 1 curriculum to absolutely master the material will pay off big time in the next two years.

Understand the differences between cyclical and non-cyclical companies like stability of demand for products/services and variability in profits due to fixed costs. Understand the basic differences between the sectors, i.e. basic product category and demand stability. If it helps, you might try looking at the fact sheet to the Select Sector SPDRs ETF funds which provide descriptions of each sector.

Porter’s Five Forces Framework is something you will see again so you need to understand it in detail. Understand each of the five forces and how it relates to industry analysis. Beyond the exam, the concept is pretty well known in the business world and you’ll need to know it sooner or later.

• Greater rivalry (competition) within the industry means lower profitability as companies compete on price and brand identification.
• The higher the threat of new entrants the lower profitability will be as companies lower prices to avoid attracting competitors. Barriers to entry like high capital expenses or regulation important here.
• The lower the threat of substitutes the higher the profitability as companies can exercise more control on prices. Pay attention to switching costs for consumers.
• Bargaining power of buyers is relative to the number of consumers and relative size of each for the product.
• Bargaining power of suppliers is relative to the number of suppliers for an input and how easily it is to switch suppliers.

The Industry Life Cycle model is also pretty testable so understand the stages (embryonic, growth, shakeout, mature, and decline) and characteristics of each.

Equity Valuation: Concepts and Basic Tools
Understand the differences and advantages/limitations of each of the three major categories of valuation models:

1)      Present value or DCF models provide an intrinsic value estimate of the shares as the sum of future cash flows.

1. Understand the Gordon growth model and its assumptions, i.e. growth remains constant indefinitely, dividends grow at a constant rate, and the growth rate is less than the required rate of return. A multi-stage DDM is necessary when growth is not constant.
2. Pay attention to the FCFE model and how it can be used on non-dividend paying stocks

2)      Market multiple models estimate value through a multiplier with earnings, sales, enterprise value or asset-values. These can be applied on a trailing or forward basis.

1. These are fairly easy to understand but you need to know the limitations, i.e. the multiples are based on trailing (past) data and may not be a good predictor of the future, the multiples reflect relative valuation compared to peers or the index but not intrinsic value.
2. Understand the difference between the trailing multiple (past data) and the justified (forward) multiple which is based on forecasted data.

Enterprise value is the market cap plus market value of preferred and debt minus any cash and short-term investments. It reflects the real economic value of the company and is helpful when comparing companies with different capital structures.

Study session 15 in the CFA Level 1 curriculum begins the fixed income topic area with four readings.

‘til next time, happy studyin’
Joseph Hogue, CFA

# How to Pass the CFA Exam in Six Weeks

With just six weeks left to the exam, candidates are asking themselves if they have studied enough and what their chances are at passing the exam. For those that have followed our 21-week study plan, you should be starting the last few study sessions and tracking your progress through practice problems.

There are many candidates who have just recently started working through the curriculum and are wondering if six weeks is enough time. The short answer is probably not unless you are able to completely devote yourself to the exam over that period. Remember, the average candidate spends about 300 hours studying for each exam. Even if you are particularly bright, and not just overconfident and can get by on 250 hours, that is still more than 40 hours a week.

Even candidates that have been studying over the last several months may want to re-evaluate their progress. Our study plan has covered to study sessions 14 in the exams but this is still just the first time through the material. Candidates retesting material seen in the first couple of study sessions may find that they have forgotten some of the important concepts.

This is why you may want to change things up for this last six weeks and incorporate a few other resources. You’ll still need to finish the curriculum to the last study session, but you need to revisit the concepts in earlier study sessions through practice problems, flash cards and study notes.

The resources below are some of my favorite for quick review and being able to get the most important parts of the curriculum in the most condensed form:

• Study guides are still going to be your ‘core’ resource. Hopefully, you don’t need to re-read all the material but you should try to get through your problem areas again.
• Flash cards! I’ve covered these in a previous post. This is one of the most useful resources at this point because you can carry them around easily and focus on specific questions/formulas.
• Topic area summaries are worth the cost for their portability. Not quite as useful for formulas (practice is best) but you can easily review a summary page a few times a day and get core concepts down.
• I would be spending the majority of time on practice problems and mock exams. Don’t just grade your answers but study the guideline answer for those you got wrong. I cannot think of a better way of focusing in on the stuff you don’t know yet.

For the most efficient use of your study time, I would start doing at least one mock exam or practice test each week. Sit down with a question bank of practice problems in the approximate weights from the exam and complete two, three-hour sessions. For each topic area, you need to be aiming for at least 70% but you’ll want to score higher in the core areas like ethics, financial statements, and equity analysis. Knowing approximately how well you are doing in each topic area will help you to allocate your study time over the next week.

Of course, the last week before the exam is still the ‘superman’ week. You might want to consider taking the entire week off from work and planning an intensive review of the material. We’ll cover how to plan the last week in a coming post. Let me know if you have any questions or comments.

‘til next week, happy studyin’
Joseph Hogue, CFA

Last updated: October 27, 2017 at 3:19 am

# CFA Level 3 Review, Risk Management

Study session 14 in the CFA Level 3 curriculum begins the readings on Risk Management with two readings (34-35). The Level 3 exam puts a lot of emphasis on the topic area and it is extremely testable. There is typically a question in the morning essay section, in fact last year was the first time since 2007 that there was no risk management essay. REVIEW THOSE PAST ESSAY QUESTIONS.

Risk Management
The reading starts of with some basic concepts and is important but secondary to the later material. Understand the advantages and disadvantages of both a centralized risk management system versus a decentralized system. A centralized system is led by a senior management employee within its own department and benefits from economies of scale and can provide an integrated picture of the company’s risks. In a decentralized system, each department handles their own risks and allows people closer to the actual risk to directly manage it.

Understand the different categories of risk: financial, non-financial, and sovereign  and the risks within each category:

Financial risks: market, credit, and liquidity
Non-financial risks: operational, model, regulatory and settlement

The measures of market risk are the more important material. You must understand standard deviation and value at risk, and the three methods of calculating value at risk.

Analytical– VAR = E® – z value (StDev)
Remember, you may need to adjust the standard deviation and expected return depending on the data provided and the question.  Daily StDev =Annual StDev/(square root of 250)
Historical Method– uses actual historical returns ranking in decending order and picks out corresponding return for the % probability. For example, if there are 100 observations and we want a 5% probability, then we would select the fifth worst return (or the average of the two closest).
Monte Carlo Simulation – generates random outcomes according to assumed probability distribution and a set of parameters to estimate the VAR.

Understand the extensions/supplements to VAR like stress testing and scenario analysis, as well as the performance measures like the Sharpe and Sortino ratios.

Currency Risk Management
The reading can get pretty detailed and quantitatively intense but you need to be able to work through all the hedging exercises. Pay attention to whether the question asks for the return in the local or domestic currency and whether the expected future value is hedged or only the principal.

Understand the differences between hedging with futures and using options. Futures are less expensive and appropriate when the investor risks volatility in rates but has a clear view of the direction of change. Options may be more expensive but provide more precision and are appropriate when exposures are uncertain with respect to timing and magnitude of exchange rate changes.

Understand the concepts behind strategic and tactical currency risk management. The three types of approaches are strategic management with a balanced mandate, currency overlay (tactical management), and treating the currency as a separate asset class.

Study session 15 in the CFA Level 3 curriculum concludes the readings on risk management with three readings on applications of derivatives.

‘til next time, happy studyin’
Joseph Hogue, CFA

# CFA Level 2 Review, Fixed Income

Study session 14 in the CFA Level 2 curriculum begins the material on fixed income with three readings (42-44) on valuation concepts. The material is not as recognizable for many candidates as the stuff on equity investments and can get tough at times. The first reading is fairly basic and secondary to the more practical information in the second reading. The topic is worth 10% of your Level 2 exam and you’ll need the concepts for Fixed Income in the next exam.

Fundamentals of Credit Analysis

The reading is like a 101 on credit analysis and good for your general knowledge of the industry. There are a few important concepts but they are all overall general concepts.

Understand the forms of credit risk:

• Spread risk is the loss of value from an increase in yield spread over other bonds due to the perceived increase in default risk of the issuer, notice it is from the perception of risk but not necessarily an actual downgrade
• Downgrade risk is the loss when an issuer is downgraded by an agency due to creditworthiness
• Market liquidity risk is the loss due to lack of sufficient participation to buy/sell the bonds in the quantity desired

Understand the difference between equity and credit analysis, and the four Cs of Credit

• Capacity is the ability of the borrower to meet debt obligations
• Collateral is the quality and value of the assets supporting the debt
• Covenants are the terms and conditions in a bond agreement
• Character is the quality of management and willingness to satisfy debt obligations

The different ratios and ratio analysis in the reading are extremely important but reviewed in other sections. You can address them here or in the other sections, but you must know them.

Know the difference between affirmative covenants (obligations the company must hold like paying interest, taxes and submitting audited statements) and negative covenants (limitations on the company like debt ratios and the amount of cash that can be paid out to equity holders).

Term Structure and Volatility of Interest Rates

Know the basis and implications behind the shapes of the yield curve (normal, flat, inverted, and humped). Understand the types of yield curve shifts (parallel and non-parallel) and what it means for relative value of bonds.

The curriculum spends a lot of time explaining how to construct the theoretical spot rate curve for treasuries. Other than bootstrapping, it is still fairly conceptual so understand the basis behind each methodology (coupon strips, on-the-run treasuries, on-the-run plus select off-the-run, all treasury coupons and bills) as well as advantages or limitations.

Bootstrapping is a methodology that can be used to construct the spot curve when using securities with different maturities. The defined process is easily testable so put an example on a flashcard and drill it.

Example: 6-month U.S. Treasury bill has an annualized yield of 5% and the 1-year Treasury STRIP has an annualized yield of 4.5%. The yields are spot rates since these are discount securities. Assume that the 1.5 year Treasury is priced at \$98 and its coupon rate is 5% (\$2.5 every six months).

The 1.5-year spot rate is:
Price = \$2.5/ (1+ (5%/2)) + \$2.5/ (1/ 4.5%/2))2 + \$102.5/(1+(18month spot /2))3
18-month spot rate = 6.464%

The four theories of the term structure of rates are also fairly testable but you really only need to know the basics.

1)      Pure expectations says that forward rates represent expected future spot rates and are not based on other systematic factors. It predicts that the expected spot rate in one year is equal to the implied 1-year forward, implying that expectations are unbiased and the shape of the yield curve depends on expectations.

2)      Liquidity preference states that long-term rates not only reflect expectations but also include a premium for investing in the long-term bonds, a liquidity premium. Rates are biased as holding long-term maturity requires the premium and that a yield curve may have any shape because the size of the liquidity premium is positively related to investor risk aversion.

3)      Preferred habitat states that rates are set by expectations  and a risk premium to compensate investors for buying bonds outside their “preferred” maturity.

4)      Market segmentation states that the slope of the curve depends on supply and demand conditions in the long and short-term markets. An upward-sloping curve indicates that there is less demand for short-term relative to long-term while a downward sloping curve would imply the opposite.

The quant material used to measure curve risk (rate duration, effective duration, and key rate duration) is extremely important and you will need it again in the third exam. Learn it now and save yourself the time next year.

Valuing Bonds with Embedded Options

The reading starts out fairly conceptual and easy with the interpretation of different spread measures. Understand the main differences between nominal, zero volatility, and option-adjusted spread.

The rest of the reading gets pretty intense with different methodologies for valuation of bonds with options. If nothing else, make sure you understand the concepts behind all the methods and the detail for constructing a binomial interest rate tree.

1)      Given the coupon rate and maturity, use the yield on the current 1-year on-the-run issue for today’s rate.

2)      Assume the level of rate volatility

3)      Given the coupon rate and market value of the 2-year on-the-run issue, select a value of the lower rate and compute the upper rate. R1,u= r1,l * e2volatility

Where:
R1,u is the upper rate (1 reflects the interest rate starting in year 1 and u reflects the higher of the two rates in year 1)
Volatility is the assumed volatility of the 1-period rate
e is the natural antilogarithm, 2.71828

4)      Compute the bond’s value one year from now using the interest rate tree

5)      If the value calculated using the model is greater than the market price, use the higher rate of r1,l and recomputed r1,u and then calculate the new value of the on-the-run issue using new rates. If the value is too low, decrease the interest rates in the tree.

6)      The five steps are repeated with a different value for the lower rate until the value estimated by the model is equal to the market price.

It’s a tough exercise to work through but often shows up on the exam so you need to get an understanding of it.

Study session 15 in the CFA Level 2 curriculum concludes the fixed income material with three readings on structured securities.

‘til next time, happy studyin’
Joseph Hogue, CFA

# CFA Level 1 Review, Equity Investments

Study session 13 in the CFA Level 1 curriculum begins the material on equity investments with three readings (46-48) in equity market structure and efficiency. The material is almost completely conceptual and any student of finance will already have seen it. If you are new to the industry, spend a little time to get the vocabulary and concepts. The topic area is only worth about 10% of your first exam but is extremely important in the other two tests.

Market Organization and Structure
This is almost entirely a vocabulary lesson on the market and participants. It is important that you know the information for general knowledge but it is not as testable as some of the other readings. The key terms are good for flashcards with a quick rundown until you’ve got them.

Understand how to calculate returns on leveraged positions, maintenance margin requirement and the margin call price. If a buyer will receive a margin call when the value of equity drops below 25% of the maintenance margin requirement, with an initial stock price of \$20 leveraged with 60% margin: the margin call price is (\$8 +Price – \$20) / Price = \$16

Pay special attention to the information on orders as you will need it for attribution analysis in the Level 3 exam and it is highly testable in the first exam.

Security Market Indices
The differences and calculations for the indices (price-weighted, equal-weighted, market cap, and fundamentally-weighted) are important information and have shown up on the exam. It’s really not difficult information, just understand how they are constructed and how to calculate returns.

They construction and limitations of alternative asset indices shows up several times in the curriculum, so spend some time on this section. Pay special attention to the possible biases within each index.

Market Efficiency
The efficient markets theory is a huge concept in the industry and for the exams. You do not necessarily need to know all the data and details that support it, but you should know the implications of each level of efficiency. Understand what it means for technical analysis and transaction costs in trading.

The Institute does not ask you to take a position on the efficient market hypothesis but regardless of how you believe the markets behave, when you are taking the exam the curriculum is the ultimate truth. Know that there is considerable evidence supporting the semi-strong form of efficiency and some evidence to support the strong form.

The list of market anomalies is testable vocabulary and can be fun to read through. Again, mostly a flashcard exercise until you can recognize the terms and their basic idea.

Study session 14 in the CFA Level 1 curriculum continues the equity topic area with three readings on valuation of equity securities.

‘til next time, happy studyin’
Joseph Hogue, CFA

# CFA Level 3 2011 Essay Question #3

You will always have an institutional portfolio management question in the essay portion. The question from 2011 was worth 26 points (14.4% of morning session and 7.2% of total exam points) while last year’s question was worth 34 points (almost 10% of your total exam score!).

We covered the reading on institutional investors back in February, linked here. Each type of institution (pensions, foundations, endowments, insurance, and banks) have their own special idiosyncracies but there are some commonalities as well. As with the individual investor material, you need to understand their risk and return needs and how the five IPS constraints fit into them.

The question from 2011 had five parts, each with a couple of sub-questions. I read the questions quickly to find out the specific data for which I am looking but a lot of candidates start by reading the vignette.  You absolutely must be practicing these old essay exams to figure out what information the Institute is looking for and how you will approach the questions.

Skimming the questions, we see that we need:

• Return objective- *** Remember, this is an explicit statement of what the investor needs or wants. Just writing out a numerical return percentage won’t cut it. These are easy points, most of the objective will be a cut and paste from within the vignette. Things like, the investor needs to grow assets at a rate sufficient enough to cover X% of the institution’s spending needs and maintain the real value of the portfolio.
• Calculate a required return- the instructions say SHOW YOUR CALCULATIONS for a reason. Show all steps to make sure you at least get some partial credit.
• Factors in Risk Tolerance, remember risk tolerance is compose of both willingness and ability. You need to know what factors influence each. When in doubt, go with the more risk averse objective.
• Liquidity and Time Horizon constraints for the IPS
• Spending rule affect on goals and funding
• More risk tolerance factors

endowments & foundations are often tested together because they are similar but with important differences.

• Know the spending rules: volatility/riskiness in funding and why would you choose each
• A simple spending rule is just a percentage rate times the portfolio’s market value. This rule can lead to volatile spending and would necessitate a lower risk tolerance to avoid volatility in the portfolio value.
• A rolling three-year average rule is the percentage rate times the portfolio’s average value over the last three years. The rule helps to decrease volatility and can increase risk tolerance.
• A geometric smoothing rule is the weighted average of the prior year’s spending (adjusted for inflation) and the product of the percentage rate times the portfolio’s market value. This rule also increases risk tolerance but places more emphasis on the recent market value of the portfolio.
• Difference between endowments/foundations. A foundation may be the sole source of funding whereas endowments are usually a smaller part of overall funding. Foundations may have a limited time horizon whereas endowments are usually indefinite. Endowments do not have legally required spending levels.

Part A-

i. Most endowments and foundations, unless explicitly stated in vignette, are going to want to maintain REAL VALUE OF ASSETS. This means they must earn a return high enough to satisfy spending needs and inflation. The first two points in the vignette give you everything you need for the objective (maintain real value, long-term, fund 25% of annual op expenses)

ii. The institute will give you points for a geometric or arithmetic return (but you should know how to do the geometric return because it is technically correct).

Required return is going to be= spending rate * inflation rate * management expenses.

* remember- the correct inflation rate is that applicable to spending (this case higher education) not necessarily general inflation = (1+ spending rate)*(1+inflation rate)*(1+mgmt. expense rate)
* Know how to calculate your spending rate from the three spending rules

Part B-

Worth six points: one point for circling the correct answers in middle box, two points for ONE REASON stated in third column. ** Remember- graders are only going to look at your first response. Don’t waste your time putting down more than one response.

The guideline answer shows two possible responses, only one was asked for.

– For endowments, generally as funding increasesà risk tolerance increases because spending needs are lower proportion of total assets.

– As inflation increases, risk increases as well because it becomes harder to protect REAL VALUE of assets in portfolio and also satisfy spending needs

Part C-

Remember TUTLL, IPS constraints are just as important for institutionals as for individuals

Time- will generally be infinite for most institutional types or the vignette will say otherwise
Unique- usually explicit in case as well (endowments and foundations often have prohibitions against investing in ‘vice’ stocksà Socially-Responsible Investing)
Taxes- Endowments/Foundations are tax exempt, Banks and Insurance are Taxable
Liquidity- Annual spending needs for Endowment/Foundations, Very important for Banks/Insurance to fund claims and withdrawals.
Legal- UMIFA for Endowments/Foundations, Highly-regulated Banks/Insurance on the state level

Part D-

i. primary goal for endowment is usually spending with protection of real value- reducing portfolio risk will also reduce expected return and make it harder to cover spending and inflation

ii. LEARN THE SPENDING RULES! Three-year average rule will smooth needs thus lowering volatility

Part E-

Again, ONLY WRITE WHAT IS ASKED FOR. The questions asks for 3 factors (don’t write six and hope the grader will look for the best 3, they don’t do this)

For differences in risk tolerance, think about the IPS constraints that affect tolerance.

• Time – Longer or infinite horizons will have longer to make up portfolio shortfalls
• Liquidity – The need to fund a larger percentage of total institutional spending is an important one and makes for lower ability to tolerate risk. Spending rules that lower volatility (smoothing or the 3-yr average rule) will increase ability to tolerate risk.
• Legal – remember foundations must spend a certain percentage to maintain tax status while endowments do not have this requirement
• Additionally, other sources of funding and the yearly increase (inflationary or otherwise) in operating expenses are always important to needs

Guideline answer provided by Institute shows 7 possible answers, you only need 3

We’ll cover study session 14 in the CFA Level 3 curriculum next week. The readings start Risk Management, an extremely important topic in the Level 3 exam and definitely worth a couple of questions on the test.

‘til next time, happy studyin’
Joseph Hogue, CFA

# CFA Level 3 Review, Alternative Investments

Study session 13 in the CFA Level 3 curriculum includes three readings (31-33) on Alternative Investments and is worth between 5% and 15% of your total exam score.

Alternative Investments Portfolio Management
Remember the common features to alternative investments:
1)      Illiquidity and longer time horizon- investors demand a return premium
2)      Diversification from low correlation with traditional investments
3)      High due diligence costs because of complex structures and lack of transparency
4)      Difficulty in establishing a valid benchmark and performance appraisal
5)      Informationally less efficient with possibility of adding value through skill and information

Know the specific characteristics and limitations to each investment type within alternatives. Much of the material has been seen in the curriculum to the previous two exams so it should not be too difficult to pick up.

Real estate: Adds diversification and an inflation hedge but high transaction costs. REITs are highly liquid and more accessible but are correlated with stocks.
Private Equity/Venture Capital: illiquid and relatively high risk but high returns expected. May have lock-up periods or involve long time horizons. Remember the financing stages for private equity and characteristics of each. A few vocabulary here like clawback provision and carried interest.
Commodities: Understand the difference and characteristics of direct versus indirect investment. Direct investment entails carrying and storage costs while indirect investment in the companies may not provide sufficient exposure because of company hedging programs.
Hedge Funds: Understand the basics behind the different strategies (equity neutral, fixed income arbitrage, distressed securities, convertible arb, merger arb, hedged equity, global macro). Remember the advantages/disadvantages of funds of funds. Remember that a high water mark provision requires that incentive fees are only based on returns above the highest value over the life of the fund (i.e. once fees have been paid for achieving that level, the manager must exceed it to earn more incentive fees).

The Level 3 exam places some emphasis on the indexes as well, so remember the basics behind each index to alternative investments as well as strengths/weaknesses to each.

Swaps
You need to be able to work through a simple swap for the exam. Working through a couple of examples on flash cards will help and will allow you to review it quickly.

Example:  Find the price of a two long forward swaps to guarantee the cost of buying 100,000 barrels of oil in each of the next two years.
The forward price of oil for delivery in one year is \$20/barrel.
The forward price for delivery in two years is \$21/barrel.
The one-year zero coupon bond yields 6% while the two-year zero yields 6.5%

Present value of the cost per barrel would be: \$20/1.06 + \$21/1.0652 = \$37.383
The two-year swap price would be:  x/1.06 + x/1.0652 = \$37.383 à \$20.483

Rate swaps are a weighted average of implied forward interest rates. They are less risky relative to commodity swaps because of the fewer number of inputs. The market value is the difference in the present value of payments between the original and the new swap rates. The value of the swap is always zero at initiation and changes as the interest rate changes.

Commodity Swaps are a weighted average of the forward commodity price and is the difference in the present value of payments.

Commodity Forwards and Futures
The math can seem a little intimidating on commodity forwards but you have to be able to work through it because it does show up on the exam. Understand the difference between a commodity that can and cannot be stored.

The lease rate represents a return required to buy and lend a commodity. It is similar to a dividend yield but is not directly observable.
The convenience yield is the non-monetary benefits associated with holding a commodity but is only earned when the commodity is held by a commercial user.

Understand the concept behind the hedging strategies but the calculation is probably secondary to being able to work through the forwards calculation. A few vocabulary items are important like the crush and crack spread.

Study session 14 begins the readings on Risk Management, an extremely important topic in the Level 3 exam and definitely worth a couple of questions on the test.

‘til next time, happy studyin’
Joseph Hogue, CFA

# CFA Level 2 Review, Alternative Investments

Study session 13 in the CFA Level 2 curriculum includes four readings (38-39) on alternative investments. The material is quite a bit more detailed and quantitatively focused than that seen in the first exam and worth between 5% and 15% of your total exam score. Most of the readings are fairly conceptual with only some basic valuation calculations.

Private Real Estate Investments
Understand the forms of investment (direct, lending, and public securities) and how they differ. Understand the basics behind REITs and how they differ from normal stocks (tax advantaged structure).

The characteristics of the different ‘alternative’ investments are important throughout the readings. Understand that real estate is not homogeneous (each one differs in size, location, age, quality, etc.), are indivisible and may be prohibitively expensive for smaller investors, are management intensive, subject to depreciation, and have high transaction costs.

Understand the basics behind the different property types, i.e. residential, office, retail, industrial and how they differ. Pay attention to the income approach to valuation and be able to calculate NOI and capitalization rate. Understand that the cap rate is positively related to the discount rate and interest rates, but negatively related to the growth rate.

Publicly Traded Real Estate Securities
Here you will need to get more detail on REITs, the different types,  advantages and disadvantages to privately held real estate. REIT structure (upREITs versus DownREITs) is of secondary importance to basic investment characteristics.

Understand the basic economic drivers and factors for the group and each property type. The Institute does not expect you to become a REIT analyst or Donald Trump from the curriculum. Focus on the basics and don’t get bogged down in detail. Look for advantages/limitations as well as list material.

Pay attention to the NAV approach to valuation.

Pro forma cash NOI = NOI minus non-cash rents plus adjustments for impact of acquisitions
Estimated future expected cash NOI = pro forma NOI plus expected growth in NOI
Est. gross asset value =  estimated value of operating real estate plus BV of cash plus book value of land plus BV of receivables plus BV of prepaid and other assets
Net asset value = estimated gross asset value minus total debt minus other liabilities
NAVPS = NAV divided by shares outstanding

Understand that normal price multiples (P/E) are not appropriate for REITs and know the basic idea behind the FFO multiples.

Private Equity Valuation
Understand the differences between private equity and public equity and the various forms of PE (LBO and VC).

Beyond the vocabulary and general concepts, the NPV method of valuation is fairly testable. To be honest, this is one of the formulas/calculations that I skimmed when I was taking the test. Being that the entire topic area is worth about 10% of the exam and this PE valuation is such a small part of the topic, I didn’t really want to commit the time to get the lengthy process (especially when multiple rounds of financing are used). Unless it comes easily to you or you want to go into PE, I would focus on concepts and vocabulary.

Investing in Hedge Funds: A Survey
The differences between Hedge Funds and other investments is most important here, including fee structure, lock-up periods, and regulation. Understand the basic difference between the types of strategies as well as performance biases.

Self selection bias arises because losing funds simply do not report to a database, skewing average returns upwards.
Survivorship bias occurs because managers with poor performances drop out of the business and the results are removed from databases, overstating average returns.

Study session 14 in the CFA Level 2 curriculum begins the material on fixed income and includes some tough detail on term structure and valuation. Make sure you plan to spend some time on practice problems.

‘til next time, happy studyin’
Joseph Hogue, CFA

Last updated: October 27, 2017 at 3:22 am

# CFA Level 1 Review, Portfolio Management

Study session 12 in the CFA Level 1 curriculum includes four readings (42-45) on portfolio management and sets the basis for further material in the other two exams. While the topic area is only worth about 5% of your Level 1 test score, it makes up about 10% of the second exam and is the core focus on the third exam. The material here is pretty basic and easy to understand if you give it a little time and do the readings.

Portfolio Management: An Overview

The different types of clients, individual and institutional, are important here. Understand the basic return objectives and risk tolerance for individuals and the seven institutional clients (banks, pensions, insurance, endowments, foundations, investment companies, and sovereign wealth funds) as well as their time horizon, liquidity/spending needs and special circumstances for each.

Individual clients objectives and special constraints vary by individual.
Pension plans usually have long time horizons, high risk tolerance, varying income and liquidity needs.
Endowments and foundations usually have very long time horizons, high risk tolerance, with income needs based on that of college or foundation programs.
Banks have shorter time horizons, low risk tolerance, high income needs to pay interest and operational expenses.
Insurance companies have short horizons for P&C and long time horizons for Life companies, while the risk tolerance and income needs vary.

* Memorizing the needs is not nearly as important as knowing why they differ. You will need to understand this and be able to explain in on the Level 3 essay section, GUARANTEED.

The actual steps in the portfolio management process are of less importance than understanding individual sections in the process. Just remember that understanding the client’s needs through an IPS always comes first, followed by putting the portfolio together and then monitoring and rebalancing.

Target asset allocation is an important concept and you absolutely need to get the basics here to go into detail in Level 2. Weights are determined based on capital market expectations and the risk/return analysis of asset classes according to the needs of the specific client.

Understand the basics behind mutual funds, ETFs, hedge funds, and venture capital funds. Pay special attention to the differences between mutual funds and ETFs.

Portfolio Risk and Return (part 1 and 2)

These readings are more quantitatively focused and will set the stage for your quant material in the next exam. All the calculations can be done fairly easily on your calculator.

Understand the difference between arithmetic and geometric return. Geometric return measures the compound return and is appropriate when there are multiple periods. Arithmetic return is the average and is easier to compute and more commonly used.

Understand the IRR and how to work the cash flow functions on your calculator.

Remember, the asset class weights must sum to 1 for a portfolio return. Beyond that, it’s pretty easy. Just take the return of each asset times its weight and add them all up.

The calculations behind gross, net and real return are probably of lesser importance than how they differ. Understand what comes out of gross return (trading expenses, managerial and administrative expenses) to get net.

Variance and covariance, and correlations can seem overly lengthy and complex but you must know how to calculate them (despite the fact that your calculator can do it for you). Put them in some practice problems on flash cards and drill until its natural to run through the formulas.

Remember the three percentages to a normal distribution. +- 1 deviation holds 68% of observations, 95% within two deviations and 99% within three deviations.

The utility function is one of the few formulas in the curriculum that is pretty inconsequential in practical terms but seems to show up on exams because it’s easily testable. Just put it on a flash card and learn it.

Be able to calculate the capital allocation line and understand the idea behind indifference curves and the optimal portfolio. Understand the capital market line and how it relates to the CAL.

The capital asset pricing model will come into the curriculum several times and is the basis for many assumptions and valuation. At this point, just remember the basic formula and the assumptions underlying the model as well as limitations.

Basics of Portfolio Planning and Construction
Used to be, you didn’t start into the IPS until Level 2 and then really got into detail in Level 3. The Institute has moved it up to level 1 so that should give you an idea of its importance. We covered the basics of the IPS (Return Objective, Risk Tolerance, and 5 Constraints) in a previous post on Level 2 so click here for the summary.

Understand the criteria to specifying asset classes and how strategic asset allocation fits into portfolio construction. Understand the difference between SAA and tactical asset allocation. In TAA, the manager deviates from policy weights according to temporary changes in short-term capital market expectations but the long-term policy weights are constant.

Understand the difference and advantages/limitations between top-down and core-satellite.

Study session 13 in the CFA Level 1 curriculum begins the material on equity investments with three readings in equity market structure and efficiency.

‘til next time, happy studyin’
Joseph Hogue, CFA