READING 32 (INT’L EQUITY BENCHMARKS)

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

Why do we need float adjustments?

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

LOS32b. Discuss the trade-offs involved in constructing international indexes,

including (1) breadth versus investability, (2) liquidity and crossing opportunities
versus index reconstitution effects, (3) precise float adjustment versus
transactions costs from rebalancing, and (4) objectivity and transparency versus
judgment;

1. Breadth v Investability  Some international indexes including emerging market

indices include stocks that include illiquid and closely held small stocks and
investor should choose the index with less breadth and greater liquidity
2. Liquidity and crossing opportunities v index reconstitution effects  Crossing is
trading w/o broker. Popular indexes have greater index-level liquidity. But these
indices suffer from reconstitution (inclusion and deletion) effects. So index level
liquidity and crossing opportunities may have poorer performance because of
reconstitution effects.
3. Precise float adjustment v transaction costs from rebalancing  Some indexes
make precise float adjustments and revise these adjustments frequently impose
higher transaction costs on those benchmarking against them than indexes that use
float bands or broad categories. Float makes sense because transactions costs are
real expenses and what is to be gained by replicating the float of the market
exactly is not as clear.
4. Objectivity and transparency v judgment  Strict rules versus index committees
LOS32c. Discuss the effect that a country’s classification as either a developed
or an emerging market can have on market indexes and on investment in the
country’s capital markets.

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

capital markets
 Being a part of developed market index is highly desirable because far more
assets are committed to developed than to emerging markets.
 The inclusion of a country in an index has a real impact on the average company
size and average level of country development in that index.
 There’s no reason for developed, emerging markets segregation.
 The historical reason for managers defining themselves as emerging or developed
markets specialists is that they are not taking undue risk.
 They pursue this goal by investing only in developed markets believed to have
transparent accounting rules, liquid exchanges and stable currencies.
 But today it’s different.
READING 33 (CORPORATE GOVERNANCE)

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

The ways which management may not act in the firm’s best interest:
1. Insufficient effort; in wage negotiations, employment supervision, cutting costs
2. Extravagant investments; (oil industry) investment in noncore industries
3. Entrenchment strategies; taking actions that hurt shareholders as in creative
accounting to mask bad performance, taking too much or too little risk, resist
hostile takeovers, investing in activities that make them indispensable
4. Self-dealing; managers may increase their private benefits ranging from benign to
outright illegal activities easier to discover than insufficient effort, extravagant
investments or entrenchment strategies.

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

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

LOS33c. Explain the shortcomings of boards of directors as monitors of

management and state and discuss prescriptions for improving board oversight;

LOS33d. Explain investor activism in relation to corporate governance and

discuss the limitations of investor activism;

LOS33e. Critique the effectiveness of debt as a corporate governance

mechanism;

LOS33f. Explain the social responsibilities of the corporation in a “stakeholder

society” and evaluate the advantages and disadvantages of a corporate
governance structure based on stakeholder rather than shareholder interests;

LOS33g. Discuss the Cadbury Report recommendations for best practice in

maintaining an effective board of directors whose interests are aligned with those
of shareholders.
READING 34 (ALTERNATIVE INVESTMENTS
PORTFOLIO MANAGEMENT)

LOS34a. Characterize the common features of alternative investments and their

markets, and discuss how they may be grouped by the role they typically play in
a portfolio;

Common Features:
 Relative illiquidity
 Diversifying potential
 High due diligence costs: Due diligence takes time, average 3 months, and is a
limiting factor for smaller portfolios.
 Difficult performance appraisal (no valid benchmark)

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

Groups by the primary role they play in a portfolio:

 The investments that provide exposure to risk factors not easily accessible
through traditional stock and bond investments: Real estate, commodities
 Investments that provide specialized investment strategies run by an outside
manager: HFs and Managed Futures
 The investment that combine two: Distressed funds, PE

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

 Market opportunity
 Investment process
 Organization
 People
 Terms and structure
 Service providers
 Documents
 Write-up
LOS34c. Explain the special issues that alternative investments raise for
investment advisers of private wealth clients;
 Tax issues: these investments have distinct tax issues compared with traditional
assets.
 Determining suitability: Individual investors has multistage investment horizons
and that changes quickly compared with a pension fund
 Communication with client: it’s difficult to communicate with nonprofessional
investors on complex investments
 Decision risk
o Negatively skewed returns
o High kurtosis
 Concentrated equity position of the client in a closely held company

LOS34d. Distinguish among the principal classes of alternative investments,

including real estate, private equity, commodity investments, hedge funds,
managed futures, buy-out funds, infrastructure funds, and distressed securities;

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

LOS34e. Discuss the construction and interpretation of benchmarks and the

problem of benchmark bias in alternative investment groups;
Biases in Index Creation
Primary concern is that most data bases are self-reported; that is HF managers chooses
which databases to report to and provides the return data
The reasons for low correlations between “similar strategy” indices are size and age
restrictions indices impose and weighting schemes.
The differences among indices often reflect differences in the weights of different
strategy groups
Value weighting may result in a particular index taking on the return characteristics of
the best performing hedge funds in a particular time period: as top-performers grow and
poor ones shrink.
Equal-weighted indices may reflect potential diversification of hedge funds better than
value weighted indices
Survivorship Bias
Survivorship bias varies among HF strategies: minor for event-driven strategies, higher
for hedged equity and considerable for currency funds.
Survivorship bias may be reduced by conducting superior due diligence, and FOFs
mitigates that problem by screening managers.

Stale Price Bias

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

Backfill Bias (Inclusion Bias)

Similar to survivorship data as the missing data is filled at the discretion of the
component. Good data is provided by HFs.

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

LOS34f. evaluate and justify the return enhancement and/or risk diversification
effects of adding an alternative investment to a reference portfolio (for example, a
portfolio invested solely in common equity and bonds);
LOS34g. Evaluate the advantages and disadvantages of direct equity
investments in real estate;

REITS

Equity REITS: Mortgage REITS:

Own and manage properties More than 75% of assets in
mortgages
Advantages and Disadvantages of direct equity real-estate investing (pg268)

ADVANTAGES
Tax subsidies
More financial leverage for borrowers who
use mortgage loans
Investors have direct control over their
property
Geographic diversification is effective
when correlations are low(and also
disasters)
Returns have relatively low volatility
compared with public equities
DISADVANTAGES
Parcels are not easy to divide, block sale
increases risk
Cost of acquiring information is high
Brokers charge high commissions
Substantial operating and maintenance
costs
Risk of neighborhood deterioration
Tax benefits can be removed by politicians

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

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

Major buyers:
1. Angel investors
2. Venture Capitalists
3. Large companies

Stages:
 Early Stage
o Seed Stage The small amount of money provided by the entrepreneur to
get the idea off the ground
o Start-up  usually a pre-revenue stage that brings the entrepreneur’s idea
to commercialization
o First-Stage  additional funds, if the idea is sound but start-up funds have
run out
 Later Stage: occurs after revenue has started and funds are needed to expand sales
 Exit Stage: is the time when the venture capitalist realizes the value of the
investment. IPO, sale or merger
LOS34i. Compare and contrast venture capital funds to buyout funds;

The differences between buyout funds and VC funds:

 Buyout funds are highly leveraged: VC funds use no debt
 The cash flow to buyout fund investors come earlier and are often steadier than
those to VC fund investors: because buyouts purchase established companies and
earlier the investment the greater the risk and the potential
 The returns to VC fund investors are subject to greater error in measurement: less
uncertainty for buyout funds investing in established companies

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

1. Direct venture capital investment  convertible preferred rather than common

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

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

1. Limited Partnerships  Sponsor is “General Partner”

2. LLC  Sponsor is “Managing Director”. Provides more influence on the fund’s
operations than does a limited partnership interest, in particular, more control over
the raising of additional committed capital. The limited partners or shareholders
do not bear any liability beyond the amount of their investment.

The compensation to the fund manager of a private equity fund consists of a management
fee plus an incentive fee
1. The management fee is usually a percentage of limited partner commitments to
the fund. (If the investor has made a capital commitment of US$50 million but
actually invested US$10 million, the investor generally pays a management fee on
the US$50 million committed.)
 2. The fund manager’s incentive fee, the carried interest (incentive fee), is the
share of the private equity fund’s profits that the manager is due once the fund has
returned the outside investors’ capital. Carried interest is usually expressed as a
percentage (usually 20%) of the total profits of the fund.
3. In some funds, the carried interest is computed on only those profits that represent
a return in excess of a hurdle rate (the hurdle rate is also known as the preferred
return)
4. Claw-back provision

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

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

Investment Characteristics:
 Illiquidity  as convertible preferred shares does not trade in the secondary
market and investors are more restricted opportunities to withdraw funds
 Long-term commitments required
 Higher risks than seasoned public equity investments
 High expected IRR required
 Limited information

LOS34m. Compare and contrast indirect and direct commodity investment;

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

1. Direct Commodity Investments: cash market purchase, storage and carry costs or
exposure to spot market via futures
2. Indirect Commodity Investments: equity in companies specializing in commodity
production (but they do not provide effective exposure to commodity price
changes)
LOS34n. Explain the three components of return for a commodity futures
contract and the effect that an upward- or downward-sloping term structure of
futures prices will have on roll yield;

Commodity Index returns components

1. Price (spot) Return: when the spot price goes up, so does the futures prices, giving
rise to a positive (negative) return to a long futures
2. Collateral Return: is related to the assumption that when an investor invests in the
commodity futures index, the full value of the underlying futures contracts is
invested at a risk-free interest rate
3. Roll Return: arises from rolling long futures positions forward through time and
may capture a positive return when the term structure of futures prices is
downward sloping. The closer the futures contract is to maturity, the greater the
roll return/ yield is.

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

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

Commodity Index

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

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

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

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

Two factors determine whether a commodity is a good inflation hedge:

1. Storability: Good inflation hedge if it’s storable. Negative inflation hedge if it’s
not storable
2. Demand relative to economic activity: better inflation hedge when demand
increases with economic activity. Commodities that have constant demand
provide little inflation hedge.
LOS34p. Identify and explain the style classification of a hedge fund, given a
description of its investment strategy;

Prime Brokerage is an important revenue source for IBs

Arbitrage here is not “risk-free” but “low risk”

Types of HF investments:
 Equity Market Neutral: Combined long and short positions for over-undervalued
securities while neutralizing the portfolio’s exposure to market risk by combining
long and shirt positions. Constraint on shorting securities for some investors make
correction slower for overvalued securities
 Convertible arbitrage: Buy the convertible bond short the stock.
 Fixed income arbitrage
 Distressed securities
 Merger arbitrage: Long target, short acquirer
 Hedged equity (Equity L/S): Portfolios not structured to be market industry and sector
neutral. Identify over-undervalued securities.
 Global macro: They concentrate on major market trends rather than on individual
security opportunities
 Emerging markets
 Fund of Funds(FOF): For diversification, two layer of fees

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

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

Rationales for incentive fees:

1. Investor pays for the absolute returns not for easy “beta” exposure
2. HF contributes to controlling a portfolio’s downside risk, like a protective put, so
should earn a premium
LOS34r. Explain the purpose and special characteristics of fund-of-funds hedge
funds;
The purpose is to achieve diversification FOFs shorten the due diligence process to a
single manager.
Randomly selected five to seven HFs has a standard deviation similar to that of the
population from which it’s drawn. Correlation is around 0.90
Funds of funds: FOFs may provide a more accurate prediction of future fund returns than
that provided by the more generic indices. However classification and style drift are
issues with FOFs. As a result FOFs that change over time in response to rebalancing may
not fit well into strict asset allocation modeling.

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

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

Returns: Leverage is important. The calculation convention followed in the HF industry

is to “look through” the leverage as if the asset were fully paid.
Also rolling return method is used.

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

Performance Appraisal Measures:

Annual Sharpe ratio is commonly used (One year T-bill rate for risk-free rate).
But Sharpe ratio has limitations.
1. Time dependency higher for longer time periods
2. Assumes normality  inappropriate for skewed return distributions
3. Assumes liquidity  Illiquid holdings have upward SRs
4. Assumes uncorrelated returns Returns correlated across time will artificially
lower standard deviation (when market is trending). Serially correlated returns
also result when assets are illiquid and current prices are not available.
5. Stand-alone measure: Does not automatically consider diversification effects.
Sharpe ratio can be gamed; that is reported SR can be increased w/o the investment really
delivering higher risk-adjusted returns. It can be done by:
 Lengthening the measurement period, daily volatility is higher than the monthly
volatility.
 Compounding the monthly returns but calculating the standard deviation from the
(not compounded) monthly returns.
 Writing out-of-the money puts and calls.
 Smoothing of returns
 Getting rid of extreme returns

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

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

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

The advantage in distressed security investing:

1. Regulatory constraint or investment policy restrictions for companies in distressed
investing
2. Low analyst coverage
3. Skill in influencing management and skill in negotiation is important

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

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

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

3) Private Equity: This is an active approach in distressed investing with prepackaged

bankruptcy strategy. Buy the debt and become majority owner, involve in reorganization,
turn the company around, get the equity and sell it at profit.
LOS34v. Explain the importance of event risk, market liquidity risk, market risk,
and “J factor risk” for distressed securities investors.

 Event Risk: unexpected company-specific risk or situation-specific risk

 “Judge” factor risk  judge’s track record in adjudicating bankruptcies and
restructuring.
 Liquidity risk
 Market risk, the economy, interest rates, the state of the equity markets (not very
important)

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

Absolute priority rule is in effect under Chapter 11.

READING 36 (COMMODITY FORWARDS
AND FUTURES)

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

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

FORWARD PRICING

Forward Price  F0,T  S0e( r  )T

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

Cash and Carry Arbitrage Cash Flows

Transaction Time 0 Time T
Short forward @ F0,T 0 F0,T  ST
Buy e lT commodity and lend @  l  S 0 e  l T  ST
Borrow @ r  S 0 e  l T  S0 e( r  l )T
Total 0 F0,T  S0e( r l )T

Reverse Cash and Carry Arbitrage Cash Flows

Transaction Time 0 Time T
Long forward @ F0,T 0 ST  F0,T
Short e lT commodity units with lease rate @  l  S 0 e  l T  ST
Lend @ r  S 0 e  l T  S 0 e ( r  l ) T
Total 0 S0e( r  l )T  F0,T
NO-ARBITRAGE PRICING
S0e( r   c )T  F0,T  S0e( r   )T

FORWARD PRICE WITH A LEASE RATE

F0,T  S0e( r  )T

ANNUALIZED LEASE RATE

1
  r  ln( F0,T / S )
T
EFFECTIVE ANNUAL LEASE RATE

(1  r )
l  1
1
T
( F0,T / S )

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

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

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

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

Basis risk can also arise with financial futures

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

Stack and Roll Hedge Stacking futures contracts in the near-term contract and rolling
over into the new near-term contract. Why we use stack hedge:
1. Near term have high volume and more liquid, lower bid-ask spreads. Lower
transaction costs
2. Manager may wish to speculate the shape of the yield curve looks steep and then
flattens then you will have locked all your oil at the relatively cheap near-term
price and implicitly made gains from not having locked in the relatively high strip
prices.
READING 37 (RISK MANAGEMENT)

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

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

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

ERP is a centralized risk management system whose distinguishing feature is a firmwide

or across-enterprise perspective on risk. Overall risk will be less than the sum of
individual risks due to the correlations between the risk exposures

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

Financial Risk:
1. Market Risk
a. Interest rates
b. Stock prices
c. Exchange rates
d. Commodity prices
2. Credit Risk-The nature of credit risk has changed as the introduction of credit
instruments, without the underlying probability of default changing
3. Liquidity Risk, bid-ask spread / security prices

Non-Financial Risk:
1. Operational Risk
2. Model Risk
3. Settlement Risk: The possibility that one side of a position is paying while the
other side is defaulting. It is a problem in FX markets.
4. Regulatory Risk
5. Legal/Contract Risk
6. Tax Risk
 7. Accounting Risk
8. Sovereign and Political Risks (when a company invests overseas, goes hand in
hand w/ FX risk)
9. Other Risks (ESG Risk, Performance Netting Risk for HFs)

LOS37c. Evaluate the strengths and weaknesses of a company’s risk

management processes and the possible responses to a risk management
problem;

Centralized risk management puts the responsibility on a level closer to senior

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

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

financial risk factors;

Standard deviation,
Market risk had two dimensions:
1. The sensitivity of the assets to the factor (duration)
2. Changes in that sensitivity to that factor (convexity)
Power outage, sovereign risk.

LOS37f. Compare and contrast the analytical (variance–covariance), historical,

and Monte Carlo methods for estimating VAR and discuss the advantages and
disadvantages of each;

1) The Analytical or Variance-Covariance Method

Assumes portfolios are normally distributed.
Some approaches estimate VAR use zero expected value. This has several features:
 Offers slightly more aggressive results
 Avoids having to estimate expected return (because E(r) is zero)
 Makes easier to adjust the VAR for a different time period.
VAR   RP  ( z )( )VP

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

Disadvantages:
 Reliance of simplified assumptions such as normality. Real life returns show
negative skewness and leptokurtic. Also normality is not good for portfolios
contain options (limited downside and unlimited upside).
 The difficulty in estimating the correlations between individual assets in very
large portfolios

2) Historical Simulation Method

Use Historical returns and rank them then find the worst 5th return, this is the VAR.

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

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

Take the averages if Nth return is not a discrete number

3) Monte Carlo Simulation

Advantage:
 Any return distribution can be used. It does not require a normal distribution but
it’s common.

Disadvantage:
 The analyst must make thousands of assumptions about the returns distributions
for all inputs as well as their correlations.
LOS 37.g. Discuss the advantages and limitations of VAR and its extensions,
including cash flow at risk, earnings at risk, and tail value at risk;

The Advantages and Limitations of VAR

 Difficult to estimate and different estimation methods can give quite different
values
 Gives a false sense of security by giving the impression that risk is properly
measured and under control
 Underestimates the magnitude and the frequency of the worst returns although
this problem often derives from erroneous assumptions and models
 Difficult to obtain for complex organizations (such as banks)
 VAR fails to incorporate positive results into its risk profile, and such, it arguably
provides an incomplete picture of overall exposures
 Quantify the potential losses in simple terms and can be easily understood.
 Can be easily understood by senior management and quantifies the loss in simple
terms.
 It’s versatile as companies use it as a measure of their capital at risk.

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

Incremental VAR  The portfolio’s VAR while including a specified asset and the
portfolio’s VAR with that asset eliminated.
CFAR  The minimum cash flow loss
EAR  Minimum earnings loss
Those two are used for companies that generate cash flows or profits but cannot readily
valued publicly
TVAR  VAR+ the expected loss in excess of VAR when such excess loss occurs.
LOS37.h. Compare and contrast alternative types of stress testing and discuss
the advantages and disadvantages of each;

Scenario analysis:

 Stylized scenarios  it involves simulating a movement in at least one interest

rate, exchange rate, stock price, or commodity price relevant to the portfolio.
Some stylized scenarios are industry standards. One problem with stylized
scenario approach is that the shocks tend to be applied to variables in a sequential
fashion. In reality, these shocks happen at the same time.
 Actual extreme events The analyst measures the impact of major past events
on the portfolio value.
 Hypothetical events  that have never happened but might occur.

Stressing Models:

 Factor Push  to push the prices and risk factors of an underlying model in a
most disadvantageous way and work out the combined effect on the portfolio’s
value. (Disadvantage=enormous model risk in extreme risk climate)
 Maximum loss optimization  it tries to optimize mathematically the risk
variable that will produce the maximum loss.
 Worst-case scenario analysis
LOS37i. Evaluate the credit risk of an investment position, including forward
contract, swap, and option positions;

Two different time perspectives in credit risk:

1. Risk associated with immediate credit events  jump-to-default risk.
2. Risk associated with events that may happen later  potential credit risk

Cross-default provision  a creditor defaults on any outstanding credit obligations; the

borrower is in default on them all.

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

Option Pricing Theory and Credit Risk

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

The Credit Risk of Forward Contracts

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

Forward
Valuelong  SpotT 
(1  r )n
P0  $100
n 1
r  5%
F0  $100*(1.05)  $105
after 3 months :
P1  $102
$105
Value  $102   $0.7728
(1.05)0.75
The Credit Risk of Swaps
For interest and equity swaps the potential credit risk is largest during the middle period
of the swap’s tenor. As the counterparties perform sufficient credit research for each
other at the beginning
For FX swaps the greatest risk is between the midpoint and the end of the life of the
swap.

Valuemanager  PVinf lows  PVoutflows

Notional * ForwardRate Notional * SpotRate

Valuemanager  
RFRdomestic RFR foreign

The Credit Risk of Options

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

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

This is mainly related with Risk Budgeting. RB is about efficiently allocating risk
among the units, divisions, portfolio managers or individuals (traders).
The enterprise allocates risk capital before the fact in order to provide guidance on the
acceptable amount of risky activities that a given unit can undertake.
The sum of risk budgets for individual units will typically exceed the risk budget for the
organization as a whole because of the impacts of diversification.
RB is used to allocate funds to PMs based on their IRs.
LOS37.k Demonstrate the use of exposure limits, marking to market, collateral,
netting arrangements, credit standards, and credit derivatives to manage credit
risk;

Managing Credit Risk:

1. Reducing credit risk by limiting exposure is the primary means of managing
credit risk.
2. Reducing credit risk by Marking-to-Market (recalculate the forward or swap price
after negative value pays the positive value party. OTC options are not MTM
because their value is always positive to one side of the transaction)
3. Reducing credit risk with collateral
4. Reducing credit risk with netting. (It reduces the credit risk by reducing the
amount of money that must be paid)
o Payment netting
o Closeout netting(bankruptcy related)
o Cherry picking(bankruptcy related)
5. Reducing credit risk with Minimum credit standards and enhanced derivative
product companies (as some companies will not do business with an enterprise
unless its rating from these agencies meets a prescribed level of credit quality.
6. Transferring credit risk with credit derivatives (CDS, Total Return Swap, Credit
Spread Option, Credit Spread Forward)

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

 Sortino ratio  uses minimum return objective instead of RFR and downside
deviation instead of standard deviation.
 Sharpe Ratio  Sortino and Sharpe ratios can tell a more detailed story of risk-
adjusted return than either will in isolation, but SR is better grounded in financial
theory and analytically more tractable. Principal drawback to applying the Sharpe
is the assumption of normality in the excess return distribution. This is a problem
when the portfolio contains options and other instruments with non-symmetric
payoffs
 Risk Adjusted Return on Capital (RAROC)  expected return on an investment
divided by a measure of capital at risk.
 Return over Maximum Drawdown (RoMAD)  is simply the average return in a
given year that a portfolio generates, expressed as a percentage of this drawdown
figure. It is more intuitive than standard deviation as a measure of risk, because it
deals with more “concrete” numbers. However, like standard deviation, it
implicitly assumes that historical return pattern will continue.
 Rp
ROMAD 
Maximum Drawdown
Am I willing to accept an occasional drawdown of X percent in order to generate an
average return of Y percent? An investment with X=10% and Y=15% (RoMAD = 1.5)
would be more attractive than an investment with X=40% and Y=10% (RoMAD = 0.25)

LOS37.m. demonstrate the use of VAR and stress testing in setting capital
requirements.
1. Nominal (notional) position limits
2. VAR-based position limits
3. Maximum loss limits
4. Internal capital requirements
5. Regulatory capital requirements
READING 38 (RISK MANAGEMENT
APPLICATIONS OF FORWARD AND
FUTURES STRATEGIES)
LOS.38a. demonstrate the use of equity futures contracts to achieve a target
beta for a stock portfolio and calculate and interpret the number of futures
contracts required;

T S   S S  N f  f f (contractvalue)
So to adjust the beta,
   S  S 
Nf  T   
 f  f ( contractvalue ) 
 
To completely hedge the risk,
 S  S 
N f     
 f  f ( contractvalue ) 
 
LOS38b. Construct a synthetic stock index fund using cash and stock index
futures (equitizing cash);

Long stock + Short futures = Long risk-free bond

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

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

Return on long stock = St - S0

Add both you get:

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

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

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

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

Long stock - Short futures = Long risk-free bond

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

Starting Money = V

This money will grow to  V *(1  r )T and we’ll deliver it when the contact
expires.

V (1  r )T
So we need to buy
N  *
f futures
q* f
Round N, and the actual money invested to the index is:

N f *q* f
V *

(1  r )T

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

N *f * q
V
(1   )T

When rebalancing portfolio and adjustment of duration was asked at the same time;
1. First rebalance the portfolio and find synthetic positions or number of contracts to
adjust the share of stock and equity
2. Then find the number of contracts to adjust the beta of the stock portfolio and the
duration of the equity portfolio.
LOS38c. Create synthetic cash by selling stock index futures against a long
stock position;
Just the sign changes

V (1  r )T
N 
*
f
q* f

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

   S  S   0  1.1   $90,000,000 
Nf   T  Nf  
    f  
 0.96   $200,000 
 =-515.63
 f 

In order to change the allocation 50-50%,

Sell stock futures and buy bond futures,

 MDURT  MDURB  B   6.5  0   $90,000,000 

Nf  
     N f     = 772
 MDUR f   f b   7.2   $105, 250 
LOS38e. Demonstrate the use of futures to adjust the allocation of a portfolio
across equity sectors and to gain exposure to an asset class in advance of
actually committing funds to the asset class;

ADJUSTING THE ALLOCATION BETWEEN ONE BOND CLASS AND ANOTHER

$30 million bond portfolio

Duration of bonds= 6.5
Bond futures duration = 7.2
Contract price (bonds) = $105,250

2 goals:
 0  6.5   $10,000,000 
1) Move $10 million into cash = N f    =
 7.2   $105, 250 
2) Change the target duration for $20 million of the portfolio to 7.5 =
 7.5  6.5   $20,000,000 
Nf    
 7.2   $105, 250 

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

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

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

In both cases the future spot rate does not matter because the investor is hedged as long
as the basis doesn’t change.
LOS38g. Explain the limitations to hedging the exchange rate risk of a foreign
market portfolio and discuss two feasible strategies for managing such risk.

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

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

Two feasible strategies

1. Hedge foreign market risk only and earn foreign RFR but FX risk still exists
2. Hedge foreign market risk and foreign currency risk by forwards so earn domestic
RFR
READING 39 (RISK MANAGEMENT
APPLICATIONS OF OPTION STRATEGIES)
LOS39a. Determine and interpret the value at expiration, profit, maximum profit,
maximum loss, breakeven underlying price at expiration, and general shape of
the graph for the major option strategies (bull spread, bear spread, butterfly
spread, collar, straddle, box spread);

Money Spreads  Different exercise price, same expiration

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

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

Bear Spread: designed to make money when market drops. The maximum profit occurs
when both puts expire in the money. Two ways to design the strategy:
1. Buy a call and sell a call with the lower exercise price (the reverse of the bull
spread)
2. Sell a put and buy a put at the higher exercise price. (more intuitive way)

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

Also V0  c1  2c2  c3 is always a positive number. Because the bull spread we buy is
more expensive than the bull spread we sell.

 The investor believes that the underlying will be less volatile than the market
expects. If the investor buys the butterfly spread and the market is more volatile
than expected, the strategy is likely result in a loss.
 If you believe the market will be more volatile, sell the butterfly spread as selling
calls with the exercise prices of X1 and X3 and buying two calls with the exercise
prices of X2.
PUT-CALL PARITY

P0  S0  C0  Xe rT
Collars: Sell a call on a protective put with the same put price (to cover the cost of the
put). The call’s exercise price will be above the current price of the underlying.
When the premiums offset it is called zero-cost collar. The investor is giving up gains
above a certain level buy writing the call.
It is a modified version of a protective put and a covered call.
Asset managers often use them to guard against losses without having to pay cash up
front for the protection. They are virtually the same as bull spreads.
They perform based on the direction of the movement in the underlying.

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

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

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

The profit is:

  X 2  X 1  c1  c2  p2  p1
The payoff at the expiration is:
X 2  X1
The initial value:
c1  c2  p2  p1
As the strategy is risk free, the present value of the payoff at the expiration must be equal
to the initial value:
( X 2  X1 )
 c1  c2  p2  p1
(1  rfr ) n
LOS39b. Determine the effective annual rate for a given interest rate outcome
when a borrower (lender) manages the risk of an anticipated loan using an
interest rate call (put) option;

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

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

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

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

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

Loan Amount $40,000,000

Underlying 180-days LIBOR
Spread 200bps over LIBOR
Current LIBOR 5.5%
Today 14 April
Expiration 20 August (128 days later)
Exercise Rate 5.00%
Call Premium $100,000
Libor on August 20 8.00%

FV of call premium $100,000*[1+(5.5%+200bps)*128/360] = $102,667

Loan Proceeds (inflow) $40,000,000 - $102,667 = $39,897,333
Option Payoff $40,000,000*(8%-5%)*(180/360) = $600,000
Loan Interest $40,000,000*(8%+200bps)*(180/360) = $2,000,000
EAR [($40,000,000+$2,000,000-$600,000)/
$39,897,333]^(365/180)-1 = 7.79%

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

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

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

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

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

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

Assume you shorted a call option. There are various ways to hedge:
 Find the exact opposite trade (buy call) which is not easy
 Use put call parity c = p + S – X/(1+rfr)^T. This is a static hedge because you do
not need to change the position as time passes.
 Hedging with another derivative maybe other calls as, trading derivatives are
often easier and more cost effective than trading underlying (As we did in delta
hedge)

There are three complicating issued:

1. Delta is just an approximation
2. Delta Changes if anything else changes, such as the price of underlying and time.
3. The underlying units per option must be rounded off. This creates imprecision,

Two patterns become apparent for delta hedging:

1. The further away we move from the current price, the worse the delta-based
approximation
2. The effects are asymmetric. A given move in one direction does not have the
same effect on the option as the same move in opposite direction.
a. Especially for calls the delta underestimates the effects of increases and
overestimates the effects of decreased in the underlying

Delta = 1 if the option expires ITM

Delta = 0 if the option expires OTM
During its life delta will tend to be over 0.5 if the option is ITM and below 0.5 if the
option is OTM.
Largest moves occur before expiration for ATM options which delta’s move to 1.0 or to
0.
When gammas are large delta hedgers choose to also gamma hedge.
LOS39e. Identify the conditions in which a delta-hedged portfolio is affected by
the second-order gamma effect.

Gamma Hedging =Gamma is the options convexity. If the delta hedged position were
risk-free, its gamma would be zero. The larger the gamma, the more the delta-hedged
position deviates from being risk-free.
Dealers usually monitor their gammas and in some cases hedge their gammas by adding
other options to their positions such that the gammas offset.
Gamma is highest when option is ATM or close to expiration.
READING 40 (RISK MANAGEMENT
APPLICATIONS OF SWAP STRATEGIES)

LOS40a. Demonstrate how an interest rate swap can be used to convert a

floating-rate (fixed-rate) loan to a fixed-rate (floating-rate) loan

FROM BORROWERS PERSPECTIVE

If you pay floating interest, buy a pay fixed-receive floating swap
If you pay fixed interest, buy a pay floating-receive fixed swap

Pay fixed swap counterparty benefits from rising interest rates.

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

D pay floating  DFixed Leg  DFloating Leg

The duration of a floating rate bond is ½ of the length of payment interval:

 Semiannual (1/2)/2 = 0.25
 Quarterly (1/4)/2 = 0.125
 Monthly (1/12)/2= 0.042

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

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

So, for one year pay fixed-receive floating swap the duration is 0.125-0.75 = -0.625.
The buyer of this swap benefits from rising interest rates and falling market value.
LOS40c. Explain the impact to cash flow risk and market value risk when a
borrower converts a fixed-rate loan to a floating-rate loan;

The company which uses swaps to convert floating to fixed payments does not appear to
be exposed to the uncertainty of changing LIBOR, but we shall see that it is indeed
exposed.
Because the duration of floating rate only payments are roughly equal to the -0.125
and when the duration of the position when we combine this position to convert it to a
fixed position is 6 times as we effectively paying a fixed rate loan. The declining rates
and increasing market values will hurt fixed-rate borrower. The advantages and
disadvantages are:
 From cash flow perspective it is a hedge as we pay fixed. This is a hedge from
accounting and budgeting perspective
 From market value perspective it is highly speculative as the objective of the
corporation is maximizing shareholder value.
 Such a transaction despite stabilizing a company’s cash outflows, however,
increases the risk of the company’s market value.

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

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

$500, 000, 000(6.75)  NP ( MDURswap )  $500, 000, 000(3.5)

 MDURTARGET  MDURPORT 
NP  B *  
 MDURSWAP 

To reduce the duration:

1. We need to hold a position that moves directly with interest rates
2. The swap should be pay-fixed receive floating
3. This means negative swap duration

To reduce the duration:

1. We need to hold a position that moves inversely with interest rates
2. The swap should be pay floating-receive fixed
3. This means positive swap duration

Here the key point is when you select a swap with too small duration you get a very large
swap to execute.
LOS40e. Explain how a company can generate savings by issuing a loan or
bond in its own currency and using a currency swap to convert the obligation into
another currency;

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

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

LOS40g. Explain how equity swaps can be used to diversify a concentrated

equity portfolio, provide international diversification to a domestic portfolio, and
alter portfolio allocations to stocks and bonds
The most important issue is the CASH OUTFLOWS that will result in actual sale of
stock when the stock outperforms the market return. The diversification can be achieved
by selling stock return and buying index return in exchange.

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

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

LOS40h. Demonstrate the use of an interest rate swaption (1) to change the
payment pattern of an anticipated future loan and (2) to terminate a swap.
In using a swaption to terminate a current swap is set the exercise rate the same as the
fixed rate paid received on the swap so swap is terminated. The moneyness determines
whether the swaption will be exercised or not.
READING 41 (EXECUTION OF PORTFOLIO
DECISIONS)
LOS41a. Compare and contrast market orders to limit orders, including the price
and execution uncertainty of each
Market Orders  Price uncertainty, Execution certainty
Limit Orders  Price certainty, Execution uncertainty

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

Inside bid-ask spread (DIFFERENCE BETWEEN LOWEST ASK, HIGHEST BID) or

market bid-ask spread will be less than any individual dealers’ bid-ask spread if the
dealers’ best bid and best ask spreads are different.

Effective Spread is two times the deviation between the executed price and previously
quoted mid-point price. It is a better spread measure because:
 It captures both price improvement and,
 The tendency for large orders to move prices (market impact)

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

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

The quoted bid-ask spread is $0.06

The midquote is ($20.03+$19.97)/2 = $20.00
The effective spread is 2*($20.01-$20.00) = $0.02 so the effective spread is $0.04 less
than the quoted spread.
LOS41c. Compare and contrast alternative market structures and their relative
advantages
1. Quote-driven markets (Dealer Markets): Trading with dealers (Our Focus)
2. Order-driven markets: Trading with each other (no intermediation), not limited to
dealers. There might be more competition for orders, because a trader does not
have to transact with a dealer. A trader cannot choose with whom he or she trades
with.
a. Electronic Crossing Networks
i. They mainly serve institutional investors.
ii. The cost of trading low because commissions are low and traders
don’t pay dealers bid-ask spread.
iii. No order execution guarantee. Because liquidity is poor as there
may not be a dealer willing to maintain an inventory. Traders do
not know the size of the trade whether it is filled or not.
iv. Anonymity as trader do not know the counterparty’s identity and
trade size so the prices do not react to supply and demand
conditions so no price discovery
b. Auction Markets  Provide price discovery which results in less frequent
partial filling of orders than in electronic crossing networks.
c. Automated Auctions (Electronic Limit Order Markets)
i. Electronic Communication Networks (ECNs).
ii. They provide anonymity and computer based. They operate
continuously.
iii. There’s price discovery as auction markets. Also, it’s not
completely order or quote driven market.
iv. ECNs is a blend of order and quote driven markets as dealers,
traders and brokers trade at the same time.
3. Brokered markets: exist in countries where the underlying public markets are
relatively small or where it is difficult to find liquidity in size.
i. Brokered markets are mostly used for block transactions
ii. There is anonymity

LOS41d. Compare and contrast the roles of brokers and dealers

They have opposing interests.

Execution services secured through a broker include the following: representing the
order, finding the buyer, market information for the investor, discretion and secrecy,
escrow, and support of the market mechanism. A trader’s broker stands in an agency
relationship to the trader, in contrast to dealers.
Dealers provide bridge liquidity to buyers and sellers in that they take the other side of
the trade when no other liquidity is present. They have adverse selection risk (the risk of
trading with a more informed trader).
LOS41e. Explain the criteria of market quality and evaluate the quality of a
market when given a description of its characteristics

 The market has relatively low bid-ask spreads. Little price changes at high
volume orders
 The market is deep: Depth means that big trades tend not to cause large price
movements. Deep markets have high quoted depths.
 The market is resilient; fast correction of misvaluation.

Corporations benefit from liquidity as they attract more capital and the higher prices will
lower cost of capital. Investors pay premium for more liquid securities. Also:
 Many buyers and sellers
 Diversity of opinion, finding the other side of the trade with an opposite opinion
 Convenience: a readily accessible physical location or an easily mastered and
well-thought-out electronic platform attracts investor.
 Market Integrity, more fair and honest treatment more trading again.
 Pre-trade transparency v post-trade transparency
 Assurity of the contract

LOS41f. Review the components of execution costs, including explicit and

implicit costs, and evaluate a trade in terms of these costs

Explicit Costs
 Direct costs of trading, such as broker commission costs, taxes, stamp duties and
fees paid to exchanges

Implicit Costs
 The bid-ask spread
 Market Impact
 Missed trade opportunity costs: it arises from the failure to execute a trade in a
timely manner
 Delay costs: Inability to complete a trade due to its size and the liquidity of the
markets

VWAP  Volume weighted average price

It shows to identify when the trade is transacted at a higher or lower price than security’s
average trade price during the day. Sometimes it is less informative because:
1. For trades that represent a large fraction of total volume. You are the MARKET
2. Brokers have discretion to game the number.
HOW TO GAME THE PERFORMANCE AGAINST A BENCHMARK
NUMBER?
 If OPENING PRICE used and order is sell and market is up fill it immediately as
the price will be higher than VWAP, if market down wait for the next day. Do the
reverse for buy orders.
 If CLOSING PRICE is benchmark wait till closing to match the trade price
 If VWAP is benchmark, split the order and spread its execution throughout the
day so the transaction price is close to the market VWAP

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

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

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

Benchmark Price can be, opening, closing price and VWAP

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

LOS41g. Calculate, interpret, and explain the importance of implementation

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

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

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

Real Purchase Price=10.07

# of shares bought=700
Commissions and fees=$14
Last Closing Price=10.08

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

Paper Portfolio Return= $10,080-$10,000= $80.00

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

Paper Portfolio Return= $7,056-$7,063= -$7

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

$87/$10,000=0.87%

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

1. Commissions and fees are calculated naturally as 14/10,000 = 0.14%

2. Realized profit/loss reflects the difference between the execution price and the
relevant decision price (closing price of the previous day):

 10.07  10.05  700

   0.14%
 10.00  1, 000

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

 10.05  10.00  700

   0.35%
 10.00  1, 000

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

 10.08  10.00  300

   0.24%
 10.00  1, 000

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

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

LOS41i. Explain the use of econometric methods in pre-trade analysis to

estimate implicit transaction costs

The relationship between the variables and estimated costs can be non-linear. These
estimates can be used in two ways:
1. To form a pre-trade estimate of the cost of trading that can be juxtaposed against
the actual realized cost once trading is completed to assess execution quality.
2. to help the portfolio manager gauge the right trade size to order in the first place

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

1. Information-motivated traders  fast execution and block trades

2. Value-motivated traders  they trade infrequently, only motivated by value and
price. They use limit orders.
3. Liquidity-motivated traders  they trade to use liquidity to convert securities
to cash or reallocate their portfolio from cash. Profit is not the driver. They
execute trades within a day.
4. Passive traders  Passive investors and ETFs. They are more focused on trading
costs. No urgency in trades. Favor limit orders, portfolio trades and crossing
networks.

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

1. Liquidity-at-Any-Cost Trading Focus  these trades demand high liquidity on

short notice. An information trader or a MF that must liquidate its shares quickly
to satisfy redemptions in their fund.
2. Costs-Are-Not-Important Trading Focus  Market orders and the variations
of this type. Because they require little effort and risk taking by market makers,
they are inexpensive for brokers to execute and have been used to produce “soft
dollar” commissions in exchange for broker-supplied services. All trading
discretion s surrendered.
3. Need-Trustworthy-Agent Trading Focus  Brokers used. Immediate execution
is not of primary importance, so such orders are less useful for information-
motivated traders. Commissions may be high.
 4. Advertise-to-Draw Liquidity Trading Focus  There is public display the
trading interest in advance of the actual order.
5. Low-Cost-Whatever-the-Liquidity Trading Focus  Limit orders are the chief
example of this type of order. This order type is best suited to passive and value-
motivated trading situations. There’s execution uncertainty that could end up
“chasing the market”

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

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

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

Basic classes are:

1. Logical Participation Strategies
a. Simple Logical Participation Strategies
i. VWAP Strategy  The objective is to match or improve upon the
VWAP of the day
ii. TWAP Strategy  The objective is to match or beat time-weighted
average price
iii. In the % of Volume Strategy  the order is traded at 5-20% of
normal trading volume until the order is filled.
 b. Implementation Shortfall Strategies seek to minimize implementation
shortfall over time and they are “front-loaded” in the sense of attempting
to exploit market liquidity early in the trading day. Because sooner order
is made available to the market, better the opportunity for finding the other
side of the trade.
2. Opportunistic Strategies: Trade passively over time but increase trading when
liquidity is present.
3. Specialized Strategies: Include passive strategies and others.

LOS41m. Discuss and justify the factors that typically determine the selection of
a specific algorithmic trading strategy, including order size, average daily trading
volume, bid-ask spread, and the urgency of the order
Low UrgencyLow size of the order relative to the daily volumeVWAP
High UrgencyLow size of the order relative to the daily volumeImplementation Shortfall
Low UrgencyHigh size of the order relative to the daily volume and Large SpreadBroker/ Crossing Sys

LOS41n. Explain the meaning and criteria of best execution

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

Criteria of best execution (EXHIBIT 14):

-It cannot be known ex-ante
-It can be analyzed over time on an ex-post basis.
-It is tied to portfolio-decision value and cannot be evaluated independently

LOS41p. Discuss the role of ethics in trading

The code is self-enforcing: Any trader who does not adhere to it quickly finds that no one
is willing to deal with him