#CFA: Revise entire CFA syllabus 6 days-Alt. Inv., Portfolio Mgt., Derivatives

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Tips-n-Tricks to crack entireCFA syllabus 6 daysPortfolio Management, Derivatives,Alternative Investments

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Tips and Tricks: Portfolio Management:Revise

Investment Policy Statement: Investment Policy Statement (IPS) is the document that guides and controls investment decision making

Investment Objectives: • Risk tolerance – • Return objectives – – Capital Preservation – – Capital Appreciation –– Current Income – Total Return

Constraints of an Investor: • Time horizon• Liquidity needs –• Taxes –• Legal & regulatory factors –• Unique needs and preferences

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Tips and Tricks: Portfolio Management:Revise Contd …

Willingness vs Ability to take risk:

Ability to take risk

High LowHigh High risk Tolerance Education required

Low Education required Low risk ToleranceWill

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to ta

ke ri

sk

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Characteristics of different types of clients

Mutual Fund vs. Exchange Traded Fund

Mutual funds vs. Separately Managed Accounts (SMA)

Mutual Funds vs. Hedge Funds

Mutual Funds vs. Buyout and Venture Capital Funds

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ASSET:

Expected return

Variance:

Expected return of a PORTFOLIO

1

)(;

)(1

2

11

2

T

RRs

T

RT

t

T

tt

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Covariance & correlation coefficient:

Covariance is a measure of how two variables move together

Correlation: measures the strength of the linear relationship between two variables

YX

YX

YXYX

YXEYX

)))(((),cov(

,

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Portfolio Risk (Variance):

Variance of Portfolio = wA2σA

2 + wB2σB

2 + 2 wAwB σAσBρAB

Risk Characteristics of an investor:

Risk Aversion

Risk Seeking

Risk Neutral

Introduction of Risk Free Asset:

Portfolio’s risk: Variance of Portfolio = wA2σA

2 + wB2σB

2 + 2 wAwB σAσBρAB

Variance of Portfolio = wA2σA

2 (a risk free asset )

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CML Vs. SML:

σp

E(Rp)

RFR

Lending Portfolio

Borrowing Portfolio

Market Portfolio

Efficient Frontier

CML

Systematic Risk

E(Rm)

SML

RFR

Return

Market Portfolio

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Portfolio Performance Evaluation:

1. Sharpe Ratio (Slope of the CAL)Greater the ratio, the better the portfolio

2. Treynor Ratio (Substitutes Beta Risk for Total Risk)Greater the ratio, the better the portfolio

3. M-Squared (Based on Total Risk)Greater the value, the better the portfolio

4. Jensen’s Alpha (Based on Systematic Risk)Greater the Alpha, the better the portfolio

fp

fp R-RRatio Sharpe

fp

fp R-R RatioTreynor

)()(2fm

p

mfp RRRRM

)]([ fmfpp RRRR

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Tips-n-Tricks : Portfolio Management : Do Not Forget

Don’t get confused between the different market lines! The CML uses Total Risk on the X-axis and SML uses Systematic Risk on the X-axis.

Remember that a risk free asset has a Beta of 0 and the market has a Beta of 1.

Don’t get confused between Market Risk Premium (Rm-Rf) and Equity Risk Premium which is Beta* (Rm-Rf)

If you were to decide which fund is performing better, the result using M-Squared and Sharpe Ratio will be exactly the same “ They use the same risk factor “ Total Risk

If you were to decide which fund is performing better, the result using Jensen’s Alpha and Treynor’s ratio will be exactly the same “ They use the same risk factor “ Systematic Risk (Beta)

Remember “ investors are NEVER compensated for taking on unsystematic risk “ the reason being is that they can be diversified away.

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Tips-n-Tricks : Derivatives : Revise

Futures & Forward• Comparison:

Forwards Futures

Private contracts Exchange-traded

Unique contacts Standardized contracts

Default risk Guaranteed by clearinghouse

Little or no regulation Regulated

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Tips-n-Tricks : Derivatives : Revise Contd…

Arbitrage• Second type of arbitrage:• Law of one price

Interest Rate Futures & Options• Interest Rate Swap• Forward Rate Agreements (FRA): payment to the long at settlement is:

(notional principal)* [{(floating rate-forward rate)*(days/360)}/{1+(floating rate)*(days/360)}]

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Tips-n-Tricks : Derivatives : Revise Contd …

American vs. European Options

Option Minimum Value Maximum Value

European call (c) ct ≥ Max(0,St-(X/(1+RFR)t) St

American Call (C) Ct ≥ Max(0, St-(X/(1+RFR)t) St

European put (p) pt ≥Max(0,(X/(1+RFR)t)-St) X/(1+RFR)t

American put (P) Pt ≥ Max(0, (X-St)) XWhere t is the time to expiration

Lower & UpperBounds for Options

Lower & UpperBounds for Options Put-Call ParityPut-Call Parity

Put-call parity holds that portfolio with identical payoffs must sell for the same price to prevent arbitrage, the put-call parity relationshipc + X/(1+RFR)T = S+p

Put-call parity holds that portfolio with identical payoffs must sell for the same price to prevent arbitrage, the put-call parity relationshipc + X/(1+RFR)T = S+p

If the asset has an underlying stream of cash flows, the minimum value for European Options change to:c0≥Max{0,[S0-PV(CF,0,T)]–(X/(1+r)T)}p0≥Max{0,(X/(1+r)T)- [S0-PV(CF,0,T)]}

If the asset has an underlying stream of cash flows, the minimum value for European Options change to:c0≥Max{0,[S0-PV(CF,0,T)]–(X/(1+r)T)}p0≥Max{0,(X/(1+r)T)- [S0-PV(CF,0,T)]}

If the asset has an underlying stream of cash flows, the put-call parity can change to:c0+(X/(1+r)T) = p0 + [S0PV(CF,0,T)]

If the asset has an underlying stream of cash flows, the put-call parity can change to:c0+(X/(1+r)T) = p0 + [S0PV(CF,0,T)]

Buyer of a call option - long position in Call

Writer of a call option - short position in Call

Buyer of a put option - long position in Put

Writer of a put option - short position in Put

Intrinsic value of a call option = Max [O, S - X]

Intrinsic value of a put option = Max [O, X - S]

Buyer of a call option - long position in Call

Writer of a call option - short position in Call

Buyer of a put option - long position in Put

Writer of a put option - short position in Put

Intrinsic value of a call option = Max [O, S - X]

Intrinsic value of a put option = Max [O, X - S]

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Tips-n-Tricks : Derivatives : Do Not Forget

Always remember, FRA payments are discounted using the FLOATING rate. Interest rate options and Swaps payments are NOT discounted.

Don’t get confused because of the name, a Eurodollar deposit is a Dollar denominated account operating ANYWHERE outside the United States.

Remember the shortcut: Because Eurodollar contracts are highly standardized, its structure works out in a way that if interest rates change by 1bp, the change in contract value is $25. So in your exam, if you see a question where there is a 3bps change in yield, the contract value changes by 3*25 = $75.

Don’t get confused between margins in Derivatives and Equity! In case your account balance drops below the maintenance margin, in Derivative, you need to deposit enough money to bring it back to the INITIAL margin.

Remember this to eliminate option in the exam: The Upper and Lower bounds for a European and American CALL Option are IDENTICAL. The Upper and Lower bounds for a European and American PUT Options are DIFFERENT.

Don’t forget the important characteristics of these two swaps: for a currency swap, there is an actual loan being made in the two currencies and the payments are NEVER netted. In an equity swap, since equity can have a negative return, it is possible that the fixed payer actually pays floating.

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Tips-n-Tricks : Alternative Investments : Revise

Characteristics

Fund of Funds• Leveraged Buyouts (LBOs)• Venture Capital: Stages of VC– Formative Stage– Later Stage:– Mezzanine

• Development Capital• Distressed Investing (or Vulture Investing)

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Tips-n-Tricks : Alternative Investments : Revise Contd …

Private Equity

• Leveraged Buyouts (LBOs)• Venture Capital: Stages of VC– Formative Stage– Later Stage:– Mezzanine

• Development Capital• Distressed Investing• Valuation Methods– Market or Comparable Approach– Discounted Cash Flow (DCF)– Asset – Based

Valuation of Real Estate Investments

Net Operating Income (NOI): Equals gross operating income less estimated vacancy.

Collections & other operating expenses, (including property taxes, but excluding income taxes). NOI does not include depreciation or financing costs.

Net Operating Income (NOI): Equals gross operating income less estimated vacancy.

Collections & other operating expenses, (including property taxes, but excluding income taxes). NOI does not include depreciation or financing costs.

Valuation methods: Cost method, sales comparison method & income method

Income method uses a discounted cash flow model similar to that for a perpetuity: Value = NOI / Market cap rate

Valuation methods: Cost method, sales comparison method & income method

Income method uses a discounted cash flow model similar to that for a perpetuity: Value = NOI / Market cap rate

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Hedge Funds

Types of Hedge Funds• Event-driven strategies• Relative value strategies• Macro• Equity hedge:

Risk• Liquidity• Potential for Mispricing• Settlement Errors• Counterparty Credit Risk• Short Covering• Margin Calls

Hedge Fund Biases and Fees:• Survivorship Bias:• Fee Structure & Gaming:

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Commodities :

Three sources of return for a commodity futures contract:• Roll Yield• Collateral Yield• Spot Price

Pricing of Commodities Contracts: Storage and interest costs are known as the cost of carry

Yield eConvenienc - Costs Storage)1(F frS

Contango Backwardation

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Tips-n-Tricks : Alternative Investments : Do Not Forget

NEVER consider depreciation and financing costs for calculating the NOI. Also, the only taxes relevant for this calculation are property taxes (not the investor’s tax).

Between MF’s and ETFs, ETF’s are clearly the best (due to in-kind creation and redemption). Hence, don’t waste too much time studying the disadvantages of ETFs.

Be sure to remember the advantages and disadvantages of High Watermark Provision and Fund of Funds. They are highly testable.

The Hedge Fund Return Reporting Biases are very important. Understand the biases through diagrams (stick figures for fund managers, squares for funds, and graph depicting fund performances).

Remember the three components of Total Return on a Commodities Investment = Collateral Yield +Price Return + Roll Yield

Unlike Equity Funds, a Commodity Index Strategy is NOT a passive strategy. The index comprises of not just Commodities but their Futures and Collateral. It is active because you need to roll over futures positions and reinvest in T.Bills (collateral) that have matured.

#CFA: Revise entire CFA syllabus 6 days-Alt. Inv., Portfolio Mgt., Derivatives

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Transcript of #CFA: Revise entire CFA syllabus 6 days-Alt. Inv., Portfolio Mgt., Derivatives