CFA Level 3 Exam 204 Questions with Answers 2023,100% CORRECT

CFA Level 3 Exam 204 Questions with Answers 2023 bounded rationality - CORRECT ANSWER individuals act as rationally as possible but are constrained by a lack of knowledge and cognitive ability satisfice - CORRECT ANSWER making a reasonable but not necessarily optimal decision the price is right - CORRECT ANSWER asset prices reflect and instantly adjust to all available information weak-form efficiency - CORRECT ANSWER prices inncoporate all past price and volume data semi-strong form efficient - CORRECT ANSWER prices reflect all public information strong-form efficient - CORRECT ANSWER all information reflected in prices. no one can consistently earn excess returns framing (consumption and savings) - CORRECT ANSWER the way income is framed affects whether it is saved or consumed self-control bias (consumption and savings) - CORRECT ANSWER favor current consumption rather than saving income for future goals mental accounting (consumption and savings) - CORRECT ANSWER assigning different portions of wealth to meet different goals sentiment premium (behavioral asset pricing) - CORRECT ANSWER added to discount rate; causes price deviation from fundamental values behavioral portfolio theory - CORRECT ANSWER investors structure their portfolios in layers according to their goals adaptive markets hypothesis - CORRECT ANSWER apply heuristics until they no longer work, then adjust them. must adapt to survive cognitive errors - CORRECT ANSWER result from incomplete information or inability to analyze emotional errors - CORRECT ANSWER spontaneous reactions that affect how individuals see information conservatism bias (cognitive) - CORRECT ANSWER emphasizing information used in original forecast over new data confirmation bias (cognitive) - CORRECT ANSWER seeking data to support beliefs; discounting contradictory facts representativeness bias (cognitive) - CORRECT ANSWER if-then stereotype heuristic used to classify new information base rate neglect (cognitive) - CORRECT ANSWER too little weight on the base rate sample size neglect (cognitive) - CORRECT ANSWER inferring too much from a small new sample of information control bias (cognitive) - CORRECT ANSWER individuals feel they have more control over outcomes than they actually have hindsight bias (cognitive) - CORRECT ANSWER perceiving actual outcomes as reasonable and expected anchoring and adjustment (cognitive) - CORRECT ANSWER fixating on a target number once investor has it in mind mental accounting (cognitive) - CORRECT ANSWER each goal, and corresponding wealth, is considered separately framing (cognitive) - CORRECT ANSWER viewing information differently depending on how it is received availability bias (cognitive) - CORRECT ANSWER future probabilities are impacted by memorable past events loss aversion (emotional) - CORRECT ANSWER placing more "value" on losses than on gains of the same magnitude myopic loss aversion (emotional) - CORRECT ANSWER if individuals systematically avoid equity to avoid potential short run declines in value (loss aversion), equity prices will be biased downward (and future returns upward) overconfidence (emotional) - CORRECT ANSWER illusion of having superior information or ability to interpret prediction overconfidence (emotional) - CORRECT ANSWER leads to setting confidence intervals too narrow certainty overconfidence (emotional) - CORRECT ANSWER overstated probabilities of success self-attribution bias (emotional) - CORRECT ANSWER self enhancing bias plus self protecting self enhancing bias (emotional) - CORRECT ANSWER individuals take all the credit for success self protecting bias (emotional) - CORRECT ANSWER placing the blame for failure on someone or something else self control bias (emotional) - CORRECT ANSWER suboptimal savings due to focus on short term over long term goals status quo bias (emotional) - CORRECT ANSWER individuals tendency to stay in their current investments endowment bias (emotional) - CORRECT ANSWER valuing an asset already held higher than if it were not already held regret aversion (emotional) - CORRECT ANSWER regret can arise from taking (commission bias) or not taking (omission bias) action goals-based investing - CORRECT ANSWER building a portfolio in layers, pyramiding up from key base goals behaviorally modified asset allocation - CORRECT ANSWER constructing a portfolio according to behavioral preferences standard of living risk - CORRECT ANSWER if low, greater ability to accommodate behavioral biases status quo bias (DC plan) - CORRECT ANSWER investors make no changes to their initial asset allocation naive diversification (DC plan) - CORRECT ANSWER 1/n allocation disposition effect (DC plan) - CORRECT ANSWER sell winners; hold losers home bias (DC plan) - CORRECT ANSWER placing a high proportion of assets in stocks of firms in their own currency mental accounting (DC plan) - CORRECT ANSWER each goal, and corresponding wealth, is considered separately gambler's fallacy (DC plan) - CORRECT ANSWER wrongly predicting reversal to the mean social proof bias (DC plan) - CORRECT ANSWER following the beliefs of a group momentum effect (market anomalies) - CORRECT ANSWER return pattern caused by investors following others' lead (Herding) financial bubbles and crashes (market anomalies) - CORRECT ANSWER unusual returns caused by irrational buying or selling value vs growth stocks (market anomalies) - CORRECT ANSWER value tends to outperform growth and the market in general IPS contraints (TTLLU) - CORRECT ANSWER taxes, time horizon, legal/regulatory, liquidity, unique annual accrual taxation (formula) - CORRECT ANSWER FVIF = [1+r(1-t)]^n deferred capital gains taxation (formula) - CORRECT ANSWER FVIF = (1+r)^n(1-t) + tB B = cost basis at start of period n annual wealth taxation (formula) - CORRECT ANSWER FVIF = [(1+r)(1-t)^n] accrual equivalent after tax return - CORRECT ANSWER return that produces the same terminal value as the taxable portfolio Rae (formula) - CORRECT ANSWER (FV/initial investment) ^1/n - 1 = r(1-T) tax drag increases as... - CORRECT ANSWER time horizon and returns increase tax deferred account (formula) - CORRECT ANSWER (1+r)^n(1-t) Prob(joint survival) formula - CORRECT ANSWER prob(husband survives) + prob(wife survives) - joint prob of survival (ph*pw) Core Capital (formula) - CORRECT ANSWER Summation of p(survival)(spending) / (1+r)^t FV tax free gift (formula) - CORRECT ANSWER PV[1+r(1-t)]^n PV = value of gift today r = pre-tax return if held by recipient t = tax rate if gifted (recipients rate) FV bequest (formula) - CORRECT ANSWER PV[1+r(1-t)^n(t-T) t = tax rate returns in testator's portfolio T = estate tax RV tax free gift - CORRECT ANSWER FV tax free gift / FV bequest RV taxable gift - CORRECT ANSWER FV taxable gift / FV bequest deduction method - CORRECT ANSWER tax paid to S reduces taxable income to R. Pay 30 to s and (100-30)*.4 to R, the least favorable method to the taxpayer. Total tax = 58 credit method - CORRECT ANSWER tax to S directly offsets the tax that would have been owed to R. Pay 30 to S and another 10 to R; total tax = 40 exemption method - CORRECT ANSWER income taxed in S is not taxed in R; pay 30 to S; total tax = 30 concentrated positions (3 techniques) - CORRECT ANSWER - sell the asset -- triggers a tax liability and loss of control - monetize the asset -- borrow against its value and use the loan proceeds for client objectives - hedge the asset value using derivatives to limit downside risk Hedging strategies for concentrated position - CORRECT ANSWER - short sale against the box -- borrow and short the stock. Uses short sale proceeds to meet needs of portfolio - Equity forward sale contract -- sell the stock forward. investor has a known sale price - Forward conversion with options -- selling calls and buying puts with the same strike price used to established a hedged ending value of the concentrated position - total return equity swap -- the investor enters a swap to pay the total return on a stock and receives LIBOR Modified hedging minimizes downside risk while retaining upside potential - CORRECT ANSWER - buy protective puts - prepaid variable forwards -- dealer pays the owner now--equivalent to borrowing. The loan will be repaid by delivering shares at a future date. Delivery of all shares on the repayment date if the price per share drops but delivery of a smaller number of shares if the price rises Tax optimization strategies - CORRECT ANSWER 1) Combining tax planning with investment strategy - index tracking with active tax management -- cash from a monetized position invested to track a broad market index - completeness portfolio -- select other portfolio assets such that total portfolio better approximates desired risk and return characteristics 2) Cross hedge -- use an imperfect hedge if an imperfect hedge doesnt exist or may trigger the tax liability 3) Exchange funds -- multiple investors contribute different positions and then each holds a pro rata position of the resulting portfolio with no taxes paid at initial contribution Private business position strategies (list) - CORRECT ANSWER 1) strategic buyers - take and buy and hold perspective 2) financial buyer or sponsor - restructures the business, add value, and resell the business 3) recapitalization - owner restructures the company balance sheet and directs the company to take actions beneficial to the owner, such as paying large dividends or buying some of the owner's shares 4) sale to other management of key employees - called a management buyout 5) divestiture, sale, or disposition of non-core business assets 6) sale or gift to family members 7) personal line of credit secured by company 8) IPO 9) Employee stock ownership plan - the owner sells stock to the ESOP Single investment in real estate strategies (list) - CORRECT ANSWER 1) mortgage financing - a non-recourse loan would allow the owner to default without risk to other assets 2) donor-advised fund or charitable trust - providing a tax deduction for and with conditions that meet other objectives of the owner 3) sale and leaseback Risk management for individuals - CORRECT ANSWER - economic balance sheet is superior to traditional for planning resource consumption. Total assets are expanded to include human capital and liabilities to include the PV of future expenses and bequests - market risk can be managed with traditional portfolio tools - idiosyncratic (non-market risks) can be managed with portfolio diversification and insurance -- life insurance can provide funds to meet expenses that would have been covered in the absence of premature death. Temporary insurance is generally less costly but permanent insurance continues for the lifetime of the insured -- annuities hedge the risk of the individual outliving their assets. Immediate annuities provide an immediate income stream while deferred annuities cost less. Fixed annuities provide an initially higher income stream while variable annuities may provide higher return over time and are morel likely to keep up with inflation. Foundations and endowments - CORRECT ANSWER asset only and can take higher risk if otherwise appropriate. Return is the compounded distribution, relevant inflation, and the expense rate. Higher beneficiary dependency on the portfolio reduces risk tolerance geometric spending rule - CORRECT ANSWER (R)(spending last pd)(1+ I last pd)+(1-R)(S)(mkt value last pd) DB portfolios - CORRECT ANSWER ALM and liability duration determines time horizon. Discount rate or a bit higher is the usual return objective. They are more conservative than most foundations and endowments and are managed solely for the participants' benefit and are generally untaxed. underfunding, financially weak sponsor, high + correlation of sponsor and portfolio results, and plan/workforce issues that increase liquidity needs or decrease time horizon Liability relative approach or liability mimicking - CORRECT ANSWER refinements on basic ALM and duration matching. if the liabilities can be broken down into categories use; traditional nominal bonds for FI, real rate bonds for inflation indexed future benefits, and equity for future benefits linked to future real wage growth. Risk due to liability noise cannot be eliminated (benefits for future new employees, deviations from actuarial assumptions) Insurance portfolios - CORRECT ANSWER are ALM and usually taxable to some degree. Conservative and fixed income oriented (with perhaps some equity in the surplus). The min. return is set by the crediting rate needed to meet liabilities to policyholders life insurers - CORRECT ANSWER may face disintermediation risk (customers may surrender policies in a rising rate environment) non-life insureres - CORRECT ANSWER more varied than life, less regulated, and often has more complex liquidity needs. Non-life can be exposed to inflation risk, and an underwriting/profitability/tax cycle. Banks - CORRECT ANSWER ALM, most regulated, and conservative. The securities portfolio is a residual use of funds; managed in order to control total balance sheet interest rate risk (duration) and provide liquidity while contributing to interest earnings and credit diversification Problems in forecasting (econ) - CORRECT ANSWER - limitations to using economic data - data measurement and biases - limitations of historical estimates - ex post data to determine ex ante risk and return - patterns - failing to account for conditioning information - misinterpretation of correlations - psychological traps - model and input uncertainty Var (analytical) - CORRECT ANSWER [R - z(std)]Vp Var (historical) - CORRECT ANSWER ranks past returns Var (Monte Carlo) - CORRECT ANSWER computer intensive but allows assumptions of any distributions and correlations Incremental Var (IVar) - CORRECT ANSWER the effect of an individual asset on the overall Var Cash flow at risk (CVar) - CORRECT ANSWER is Var applied to the company's cash flow Earnings at risk (Evar) - CORRECT ANSWER is analogous to CFAR only from an accountings earnings standpoint Tail value at risk (TVar) - CORRECT ANSWER Var plus the expected value in the lower tail of the distribution Credit Var - CORRECT ANSWER focuses on the upper tail of the returns Methods for managing market risk - CORRECT ANSWER position limits, liquidity limits, performance stopouts, and risk factor limits Risk budgeting - CORRECT ANSWER the process of determining which risks are acceptable and how total enterprise risk should be allocated across business units or portfolio managers measures to help control credit risk - CORRECT ANSWER limiting exposure to any single debtor, marking to market, assigning collateral to loans, payment netting agreements, setting credit standards, and using credit derivatives RoMAD (formula) - CORRECT ANSWER R/Max drawdown Sortino (formula) - CORRECT ANSWER R - MAR / downside deviation Changing portfolio duration with bond futures (formula) - CORRECT ANSWER # contracts = (yield beta)(MDt-MDp / MDf)(Vp/pf*multiplier) Changing portfolio beta with equity futures - CORRECT ANSWER # contracts = (Bt-Bp/ Bf)(Vp/pf*multiplier) Altering debt and equity allocations - CORRECT ANSWER equity to bonds: sell equity futures and buy bond futures bonds to equity: sell bond futures and buy equity futures synthetic positions are also based on the same formula: - V is replaced with FV of Vp - Vp(1+rp) - if betas are not given, it is presumed the desired change in beta is the same as the contact's beta syntehtic equity - CORRECT ANSWER buy contracts and hold the PV (discounted at rf periodic) of the full contract price x # of contracts in cash equivalents synthetic cash - CORRECT ANSWER sell contracts and hold sufficient shares that with dividends reinvested, shares can be delivered to close the contract position - multiplier x #shares x number of contracts / div yield periodic Call (interest rate option) - CORRECT ANSWER used to limit the cost of borrowing. If rates rise, call pays off, reducing effective loan rate. interest rate call payoff = (NP)[max(0, LIBOR - strike)(days/360)] Put (interest rate option) - CORRECT ANSWER used to maintain the return on an asset. If rates fall, the option pays off. interest rate put payoff = (NP)[max(0, strike rate - LIBOR)(d/360)] Cap - CORRECT ANSWER series of calls (caplets) Floor - CORRECT ANSWER series of puts (floorlets) interest rate collar - CORRECT ANSWER combination of cap and floor MD (pay float) - CORRECT ANSWER MDfixed - MDfloat 0 - to increase duration, receive fixed MD (pay fix) - CORRECT ANSWER MDfloat - MDfix 0 - to lower duration, pay fixed Currency Swap - CORRECT ANSWER the standard currency swap has two notional principals. The counterparties usually exchange the principals on the effective date and return them at maturity. Periodic interest rate payments are not usually netted Equity Swap - CORRECT ANSWER one counterparty makes payments based on an equity position. Counterparty makes payments based on another equity, a bond, or fixed payments Swaption - CORRECT ANSWER option on a swap Payer Swaption - CORRECT ANSWER gives the buyer the right to be the fixed-rate payer Receiver Swaption - CORRECT ANSWER gives the buyer the right to be the fixed-rate receiver Quote driven markets - CORRECT ANSWER traders transact with dealers who post buy and sell prices Order-driven markets - CORRECT ANSWER traders transact with traders Automated auctions - CORRECT ANSWER also known as electronic limit-order markets Brokered markets - CORRECT ANSWER brokers act as traders' agents to find counterparties Hybrid markets - CORRECT ANSWER combine quote-driven, order-driven, and broker markets Market quality - CORRECT ANSWER liquid market: - small bid-ask spreads - market depth - resilience transparent market: - investors can obtain pre-trade and post-trade information assurity of completion explicit execution costs - CORRECT ANSWER commissions, taxes stamp duties, and fees implicit execution costs - CORRECT ANSWER bid-ask spread, market of price impact costs, opportunity costs, and delay costs (aka slippage) Volume weighted average price (VWAP) - CORRECT ANSWER weighted average of execution prices during a day... advantages: - easily understood - simple to compute - can be applied quickly to enhance decisions - most appropriate for comparing small trades in non-trending markets disadvatanges: - not informative for trades that dominate trading volume - can be gamed by traders - does not evaluate delayed or unfilled orders - does not account for market movements or trade volume Implementation shortfall - CORRECT ANSWER measures transaction cost as the difference in performance of a hypothetical portfolio (trade is executed with no costs) and actual portfolio results. Total IS can be calculated as an amount. - for per share: divide by the number of shares in the initial order - for percentage or basis point divide by the market value of the initial order Implementation shortfall data required - CORRECT ANSWER - Decision price: the market price of the security when the order is initiated. If the market is closed, use the previous closing price - Execution price: the price or prices at which the order is executed - Revised benchmark price: this is the market price of the security if the order is not completed in a timely manner as defined by the user. if not otherwise stated, timely is within the trading day - Cancelation price: the market price of the security if the order is not fully executed and the remaining portion of the order is canceled Implementation shortfall component costs - CORRECT ANSWER - explicit costs = cost per share * # shares executed - missed trade = |CP-DP| x #shares canceled - delay = |BP* - DP| x #shares executed - Market impact = |EP-DP or BP*| x #shares executed at that EP * trading costs can be negative Fed Model (relative value) - CORRECT ANSWER S&P earnings yield / treasury yield - value 1 implies that equities are undervalued Yardeni model - CORRECT ANSWER E/P - [Yb-d(LTEG)] - if 0, market is undervalued Tobin's Q (mean reverting) - CORRECT ANSWER (MV of debt + MV equity) / replacement cost of total assets Equity Q (mean reverting) - CORRECT ANSWER MV of equity / replacement cost of assets - liabilities P/10-year MA(E) - CORRECT ANSWER current level of S&P 500 price index / average of previous 10 years' reported earnings (adjusted for inflation) Utility adjusted return (formula) - CORRECT ANSWER = Rp - .005 (A)(std^2) Roy's Safety First Measure (formula) - CORRECT ANSWER = (Rp - Rmar / std) Add investment to portfolio if... - CORRECT ANSWER Sharpe (investment) Sharpe (portfolio) x corr Specifying asset classes - CORRECT ANSWER - assets in a class have similar traits and stats - classes are not highly correlated - individual assets cannot fit more than one class - classes cover the majority of investible assets - classes contain sufficient liquid assets Rdc = ... - CORRECT ANSWER (1+Rfc)(1+Rdc) - 1 = Rfc + Rfx + (Rfc)(Rfx) Passive hedging - CORRECT ANSWER Rule based and typically matches the portfolio's currency exposure to that of the benchmark used to evaluate performance. Will require periodic rebalancing. Goal is to eliminate currency risk relative to benchmark Discretionary hedging - CORRECT ANSWER Allows manager to deviate modestly from passive hedging by a specified percentage. Goal is to reduce currency risk while allowing the manager to pursue modest incremental currency returns relative to the benchmark Active currency management - CORRECT ANSWER allows a manager to have greater deviations from passive hedging. The goal is adding value Currency overlay - CORRECT ANSWER is the outsourcing of currency management to another manager Factors that shift the strategic decision toward a benchmark neutral or fully hedged strategy - CORRECT ANSWER - short time horizon for portfolio objectives - high risk aversion - little weight given to the opportunity costs of missing positive currency returns - high short-term liquidity needs and income - significant foreign currency bond exposure - low hedging costs - clients who doubt the benefits of discretionary management Economic fundamental - CORRECT ANSWER Assumes that, in the long term, currency value will converge to fair value. Fundamental approach may assume purchasing power parity. Carry trade - CORRECT ANSWER Involves borrowing in one currency where interest rates are low and then using the proceeds to invest in another currency where interest rates are high Volatility trading (currency) - CORRECT ANSWER profit from predicting changes in currency volatility. If volatility is expected to increase, purchase an at-the-money call and put (long straddle). Sell volatility by selling both options (short straddle). Minimum variance hedge ratio - CORRECT ANSWER Regression of changes in the value of the portfolio to the past value of the hedging instrument to minimize tracking error. Hedge ratio is the beta of that regression - strong positive correlation between Rfx and Rfc increases the volatility of Rdc resulting in a hedge ratio of 1 Capitalization weighted index - CORRECT ANSWER The most common security weighting scheme in which constituents are held in proportion to their market capitalizations, calculated as price times available shares. Also known as market value, market cap, or cap weighting. - advantages: based on market price, float adjusted reflects what is currently available for investors to own, does not require rebalancing for splits / dividends - disadvantages: can lead to overconcentration in a few securities Price-weighted index - CORRECT ANSWER reflects owning one share of each stock. performance heavily influenced by the securities with the highest price - advantages: easy to construct - disadvantages: stocks that appreciate are more likely to split in price reducing the weight on the index Equal-weighted index - CORRECT ANSWER gives the same weight to the performance each index stock - advantage: places more emphasis on smaller cap stocks that may offer a return advantage - disadvantage: biased to the performance of smaller issuers, requires constant rebalancing Dollar duration (formula) - CORRECT ANSWER = effective duration * (.01)(Value) rebalancing ratio (formula) - CORRECT ANSWER target DD (dollar duration) / new DD (dollar duration) - if 1, buy Spread duration - CORRECT ANSWER Measures sensitivity of non-treasury issues to a change in their spread above treasuries of the same maturity Nominal spread - CORRECT ANSWER Spread between non-treasury and treasury of same maturity Zero Volatility Spread - CORRECT ANSWER spread over the treasury spot rate curve Option-adjusted spread - CORRECT ANSWER determined using a binomial interest rate tree Immunization - CORRECT ANSWER a low risk (ALM) strategy designed to achieve a target terminal value (FVL) at a specified date - matching the duration of assets and liabilities should produce offsetting effects between higher / lower reinvestment earnings versus loss / gain in price as interest rates increase / decrease - set initial PVA = PVL and continually rebalance assets to maintain the duration match -- cash flow match will meet the conditions of immunization, is more conservative, and will not require rebalancing; but it is more restrictive in asset selection and likely to be more expensive - multiple liabilities can be immunized by matching average duration of assets and liabilities -- to minimize yield curve risk, set the asset duration distribution somewhat wider than that of the liabilities distribution Contingent immunization - CORRECT ANSWER an active management strategy that starts with a positive surplus (S = PVA - PVL) - +S means that client will accept a minimum rate of return less than the immunization rate - Continually compare the PVA to the recomputed PVL. If successful, S will grow. If S reaches 0, portfolio must be immunized Combination matching - CORRECT ANSWER Creates a duration matched portfolio that is also cash flow matched during first few years Effect of leverage on return (formula) - CORRECT ANSWER R + [(B/E) x (R-c)] Effect of leverage on duration (formula) - CORRECT ANSWER Hedging formula using duration - CORRECT ANSWER Types of credit risk - CORRECT ANSWER - default risk - credit spread risk - downgrade risk Credit forwards - CORRECT ANSWER Forward contracts wherein the payment at settlement is a function of the credit spread over the benchmark at the time the contract matures. Credit swaps - CORRECT ANSWER provide credit risk transfer. credit default swaps provide protection against default on an underlying credit instrument Covered Interest Rate Parity (formula) - CORRECT ANSWER Forward premium for currency - CORRECT ANSWER differential between the interest rates of countries = (F - S0 / S0) = cd - cf Forward hedge - CORRECT ANSWER sell the foreign currency at the current forward rate Proxy hedge - CORRECT ANSWER short second foreign currency that is correlated with the long foreign currency Cross hedge - CORRECT ANSWER Contract to deliver the original foreign currency for a third currency Breakeven yield change (formula) - CORRECT ANSWER duration of an option (formula) - CORRECT ANSWER Approaches to creating an indexed portfolio - CORRECT ANSWER full replication, stratified sampling, optimization (Factor Model) Return-based style analysis (formula) - CORRECT ANSWER Ri,t = (b1R1 + b2Rb...) + e Holdings-based style analysis - CORRECT ANSWER evaluate the individual securities in the manager's portfolio Information ratio (formula) - CORRECT ANSWER Active return / Active risk = Rp-Rb/std = IC(IB^.5) Utility of active return - CORRECT ANSWER - same as Utility formula! Managers true active return (formula) - CORRECT ANSWER managers total return - managers normal portfolio return Managers misfit active return (formula) - CORRECT ANSWER managers normal portfolio return - investors benchmark return Total active risk (formula) - CORRECT ANSWER = SQRT [ (True Active Return)^2 + (Misfit Active Return)^2] Alternative investments (characteristics) - CORRECT ANSWER - low correlation to traditional investments - lack information transparency and have higher due diligence costs - are less liquid - lack investable benchmarks - lack inherent asset class characteristics and instead reflect manager skill - are infrequently traded and/or use appraisal pricing; leading to artificially low, reported standard deviation Real estate (issues) - CORRECT ANSWER inherent asset class characteristics with low correlation and good diversification. diversified, direct investment in properties requires larger amounts of funds. REITS are liquid, with investible benchmarks, but REITS are more like equity. CREFS are classified as indirect but provide true RE exposure. Unsmoothed CRED data provides true measures of RE characteristics. PE - CORRECT ANSWER offers higher return and risk VC - CORRECT ANSWER typically high risk with long time horizons. Buyout investments are somewhat less risky with somewhat shorter time horizons, but are generally leveraged Commodities - CORRECT ANSWER inherent asset class characteristics with low return and risk and good diversification. There are liquid investible benchmarks. A fully collateralized long position in commodity futures earns the RF rate, roll return, and change in spot price. Storable commodities linked to economic activity have provided desirable positive correlation to inflation Hedge funds - CORRECT ANSWER appear to offer positive value added and good diversification but there are significant challenges in interpreting the data (self-reporting, survivorship bias, skewed returns), and with significant due diligence issues. Return is based largely on manager skill. Benchmarks are more akin to manager universes and are not investible. Roll yield (formula) - CORRECT ANSWER delta futures - delta spot Centralized risk management system - CORRECT ANSWER provides a better view of how business units are correlated than decentralized Financial risks - CORRECT ANSWER - market risk - liquidity risk - credit risk - sovereign risk Non-financial risks - CORRECT ANSWER - settlement risk - operational risk - model risk - regulatory risk Var - CORRECT ANSWER estimate of the minimum expected loss over a set time period at a desired level of significance Advantages of Implementation Shortfall - CORRECT ANSWER - portfolio managers can see the cost of implementing their ideas - demonstrates the tradeoff between quick execution and market impact - decomposes and identifies costs - can be used to minimize trading costs and maximize performance - not subject to gaming Disadvantages of implementation shortfall - CORRECT ANSWER - may be unfamiliar to traders - requires considerable data and analysis Major trader types - CORRECT ANSWER Information motivated = time sensitive information, prefer market orders Value motivated = security misvaluations, price preferred through limit orders Liquidity motivated = Reallocation and liquidity, time concerned and prefer market orders Passive = reallocation and liquidity, price concerned and prefer limit orders Trading Tactics - CORRECT ANSWER Algorythmic trading - CORRECT ANSWER form of automated trading. motivation is to execute orders with minimal risk and costs. classified into 1) logical participation 2) opportunistic 3) specialized strategies 2 types of logical participation strategies - CORRECT ANSWER 1) Simple logical participation strategies - trade with market flow to minimize impact - break the trade into small pieces that are each a small part of trading volume, minimizing market impact costs - VWAP - order is broken up over the course of the day to match the day's VWAP -- low urgency - time weighted average price strategy, trading is spread out evenly over the whole day to equal a TWAP benchmark 2) implementation shortfall strategies focus on trading early to minimize opportunity costs. Typicall execute the order quickly -- high urgency Calendar rebalancing - CORRECT ANSWER benefit: provides discipline without constant monitoring drawback: portfolio could stray considerably between rebalancing dates Percentage of portfolio rebalancing - CORRECT ANSWER benefit: minimizes degree of corridor violations drawback: must constantly monitor portfolio Corridor width - CORRECT ANSWER - increases with higher transaction costs. the more expensive it is to trade, the less frequently you should trade, and the wider the corridor should be - increases with correlation. the more highly correlated the assets, the less frequently the portfolio will require rebalancing, and the wider the portfolios - decreases with volatility. the greater the volatility, the narrower the corridor should be. Impact of strategies on risk and return - CORRECT ANSWER Treynor Measure - CORRECT ANSWER excess return over the risk free rate earned per unit of systematic risk (beta) Sharpe Ratio - CORRECT ANSWER excess return per unit of total risk (standard deviation) Ex Post Alpha - CORRECT ANSWER Actual return - predicted return for a period M squared - CORRECT ANSWER Compares risk adjusted portfolio return to the market return M^2 = Rf + [Rp-Rb/stdp]stdm Valid Benchmark charactersitics - CORRECT ANSWER SMAURAI: specified, appropriate, measurable, unambiguous, reflect current investment options, accountable, investable Common benchmarks - CORRECT ANSWER absolute return, manager universes, broad market indexes, style indexes, factor model based, returns based, custom security based