Page 354 2010 Kaplan, Inc.

FORMULAS
investment income tax (accrual taxes): FVIF
IT
= [1 + R(1 T
1
)]
N
deferred capital gains tax (MV = cost basis): FVIF
CGT
= [(1 + R)
N
(1 T
CG
) + T
CG
]
deferred capital gains tax (MV = cost basis): FVIF
CGBT
= [(1 + R)
N
(1 T
CG
)] + T
CG
B
wealth-based tax: FVIF
WT
= [(1 + R)(1 TW)]
N
return after realized taxes: R
ART
= R[1 (P
1
T
1
+ P
D
T
D
+ P
CG
T
CG
)]
effective capital gains tax rate:
T
ECG
= T
CG
(1 P
1
P
D
P
CG
) / (1 P
1
T
1
P
D
T
D
P
CG
T
CG
)
future value interest factor after all taxes:
FVIF
T
= [(1 + R
ART
)
N
(1 T
ECG
)] + T
ECG
(1 B)T
CG
accrual equivalent after-tax return:

R
FV
PV
AE
T
N
= 1
accrual equivalent tax rate:

T
R
R
AE
AE
= 1
future value interest factor for a tax-deferred account (TDA):
FVIF
TDA
= (1 + R)
N
(1 T
N
)
future value interest factor for a tax-exempt account: FVIF
TEA
= (1 + R)
N
human capital at time t, HC
I
j
t
=
( )
(
(

\
)

=
`

1
1
r
t j
t j
n
objective function for allocation of risky assets:
Max P D U FC HC P
death,t alive t 1 t 1 death,t
E 1 1 ( ) ( )( ) ( )

l
l
l

(( )( )( ) ( )

D U FC LIPO
expected estate
dead t 1

2010 Kaplan, Inc. Page 355
Book 1 Ethical and Professional Standards, Behavioral Finance, and Private Wealth Management
Formulas
relative after-tax value:
RV
r t
g ig
tax-free gift
tax-free gift
bequest
FV
FV
= =

( )

l
l
l
1 1
nn
e ie
n
e
r t T
RV
1 1 1 ( )

l
l
( )
=
taxable gift
taxable gift
beq
FV
FV
uuest
PV
PV
=

( )

l
l
l

( )

l
l
l
( )

l
l

1 1 1
1 1 1
T r t
r t
g g ig
n
e ie
n
TT
e
( )
RV
PV T T T r t
PV r t
g g e g ig
n
e ie
taxable gift
=

( )

( )

l
l
l
(
1 1 1
1 1 ))

l
l
( )
n
e
T 1
(donor pays gift taxes)
RV
FV
FV
r T
t g
n
charitable donation
charitable gif
bequest
= =

( )
1
ooi e ie
n
e
e ie
n
e
r t T
r t T
1 1 1
1 1 1
( )

l
l
( )
( )

l
l
( )
generation skipping:
FV
no skipping
= PV[(1 + r)
n1
(1 t)][(1 + r)
n2
(1 t)]
FV
skipping
= PV[(1 + r)
N
(1 T
e
) [N = n1 + n2]
double taxation: effective tax rates:
T
credit
= Max(T
residence
, T
source
); T
deduction
= T
residence
+ T
source
(1 T
residence
)
Page 56 2010 Kaplan, Inc.
Study Session 5
Cross-Reference to CFA Institute Assigned Reading #21 Linking Pension Liabilities to Assets
S
t
u
d
y

S
e
s
s
i
o
n

5
benet paid for a longer period of time. Thus, for deferreds, there is uncertainty in the
timing and amount of liability as well as longevity risk. For these reasons, the liability
noise associated with deferreds is larger and less easily hedged than that for retirees.
The liability noise arising from active participants is even greater than that from
deferreds. These participants are often many years from retirement and there is much
uncertainty regarding the plans future obligation.
In Figure 1, we summarize the exposures of a pension plan and the assets needed to
satisfy them. We assume that the accrued benets are not indexed to ination. If they
are indexed to ination, then real return bonds would be used. Recall that term structure
risk is the interest rate risk of parallel and nonparallel shifts in the yield curve.
For the Exam: Focus on the rst three plan segments (indicated with *), because they
are the pensions primary emphasis in the liability-relative portfolio.
Pension Liability Exposures Figure 1:
Pension Plan Segment
Market or
Non-Market Exposure
Risk Exposure
Liability Mimicking
Assets
*Inactive-accrued Market Term structure Nominal bonds
*Active-accrued Market Term structure Nominal bonds
*Active-future wage
growth
Market Term structure Nominal bonds
Market Ination Real return bonds
Market Economic growth Equities
Active-future service
rendered
Market
Similar to wage growth
but more uncertain
Not typically
funded
Active- future
participants
Market Very uncertain
Not typically
funded
Liability noise-
demographics
Non-market Plan demographics Not easily hedged
Liability noise-inactive Non-market
Model uncertainty &
longevity risk
Not easily hedged
or modeled
Liability noise-active Non-market
Model uncertainty &
longevity risk
Not easily hedged
or modeled
Page 244 2010 Kaplan, Inc.
FORMULAS
endowment spending rules:
spending S market value
t
= ( )
t 1
spending spending rate
market value market value m
t
t 1 t
=( )

2
aarket value
t 3
(
(

\
)

3
spending R spending 1 I 1 R S market value
t t 1 t 1 t 1
=( )( ) ( ) ( )( )

(( )
leverage-adjusted duration gap, LADG D
L
A
D
Assets Liabilities
=
(
(

\
)

asset beta, C C C
a d d e e
w w =
total asset beta, C C C
a,T
= w w
a o a o a p a p , , , ,
market volatility, o |o |
t t t
2
1
2 2
1 =

( )
factor model based market return, R F F
i i i i i
= o C C
, , 1 1 2 2
factor model based market variance, o o o o
i i
F
i
F
i i i
Cov F F
2
1
2 2
2
2 2
1 2 1 2
2
1 2
2 = ( ) C C C C
, , , , ,
,
covariance of two markets:
Cov i j Cov F
i j
F
i j
F
i j i j
, ( )
, , , , , , , ,
( ) = C C C C C C C C
1 1
2
2 2
2
1 2 2 1
1 2
o o
1 1 2
, F ( )
price of a stock at time 0, P
Div
R g
R
Div
P
g
i
i 0
1 1
0
=

= =

Grinold-Kroner expected return on equity,

R
Div
P
i g S
P
E
i
=
(
(

\
)

1
0
^ ^
expected bond return:

R
B
=real risk-free rate + inflation risk premium + default risk premium +
liquidity risk premium + maturity risk preemium + tax premium
ICAPM,

R R R R
i F i M F
=
( )
C
beta for stock i, C
i
=
( ) Cov i m
M
,
o
2
correlation of stock i with the market, e
o o
e o o
i,M i,M
=
( )
= =
Cov i m
Cov i m
i M
i M
,
( , )
2010 Kaplan, Inc. Page 245
Book 2 Institutional Investors, Capital Market Expectations, Economic Concepts, and Asset Allocation
Formulas
equity risk premium for market i, ERP
ERP
i i M i
M
M
=
(
(

\
)

e o
o
,
target interest rate to achieve neutral rate:
r r 0.5 GDP GDP 0.5 i i
target neutral expected trend expected t
=
( )

aarget
( )

l
l
l
stock value P
D
(1 k )
D
(1 k )
D
(1 k )
.....
D
(1
0
1
e
1
2
e
2
3
e
3
( ) =

kk )
e

stock value
D
k g
1
e
=

g = (retention rate)(ROE)
ROE = (net prot margin)(total asset turnover ratio)(nancial leverage)
FCFE = (net income + depreciation + new debt issues)
(capital spending + additions to working capital + principal repayments)
P
E
D E
k g
e
=

/
EPS = [(estimated sales per share)(EBITDA %) D A I](1 T)
index intrinsic value = (P/E)
1
(EPS
1
)

R
(intrinsic index value in one year beginning index
Index
=
value) expected dividend
beginning index value

U R A
P P P
2
= ( )
( )

. 0 005 o
RSF
R R
P MAR
P
=

o
return from a foreign asset is: R
$
= R
LC
+ S + (R
LC
)(S)
variance of the returns on the foreign asset in U.S. dollar terms:
o o o o o e
$
2
LC
2
S
2
LC S LC,S
= + + 2
contribution of currency risk = o o
$

LC
R w R w R
P
A B
B

=
o o o o o e
P A A B B A B A B A B
w w w w
2 2 2 2 2
2 =
,
2010 Kaplan, Inc. Page 227
FORMULAS
portfolio effective duration: D w D w D w D w D w D
p i
i
n
i n n
= =
=
`
1
1 1 2 2 3 3
...
dollar duration of a bond or portfolio:
DD = (modied or effective duration)(decimal change in interest rates)(price)
portfolio dollar duration:
DD DD DD DD DD DD
P i
i
n
n
= =
=
`
1
1 2 3
...
rebalancing ratio
old DD
new DD
=
R
P
= R
i
+ [(B / E) (R
i
c)]
leveraged portfolio duration: D
D I D B
E
p
i B
=

target dollar duration: DD

T
= DD
P
+ DD
Futures
dollar interest on a repo loan amount repo rate
repo ter
=( )( )
mm
360
(
(

\
)

dollar duration of a futures contract

conversio
DD
DD
f
CTD
( ) =
nn factor
number of contracts to adjust portfolio DD
DD DD
T P
=

DD
f
number of contracts for complete hedge
DD
=

p
f
DD
hedge ratio
DD
DD
conversion factor for the CTD yield b
P
CTD
= eeta
Page 228 2010 Kaplan, Inc.
Book 3 Fixed Income Portfolio Management, Fixed Income Derivatives, and Equity Portfolio Management
Formulas
OV = max [(strike value), 0]
OV = max [(actual spread strike spread) notional risk factor, 0]
payoff to a credit spread forward:
FV = (spread at maturity contract spread) notional risk factor
approximate forward premium or discount:
f
F S
S
c c
d,f
0
0
d f
=
( )
~

breakeven yield change:

%$
$
price
duration
y in basis points

= 100
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2010 Kaplan, Inc. Page 55
Study Session 16
Cross-Reference to CFA Institute Assigned Reading #45 Monitoring and Rebalancing
Constant-mix buys stocks as they fall and sells stocks as they rise ( concave strategy).
CPPI sells stocks as they fall and buys stocks as they rise (convex strategy).
A constant-mix strategy will outperform buy-and-hold and CPPI strategies in a
at but oscillating market (e.g., up-down oscillation). CPPI does poorly in a at,
oscillating market. In a at, oscillating market, CPPI sells on weakness only to have
the market rebound. Alternatively, it buys on strength only to see the market falter.
A constant-mix strategy will underperform comparable buy-and-hold and CPPI
strategies when there are no reversals (e.g., down-down oscillation). CPPI will do
at least as well as the oor (i.e., the strategy is protected on the downside). CPPI
outperforms the other strategies in a trending market (bull or bear).
The value of a constant-mix investors assets after several rebalancings will depend on
both the nal level of the stock market and also on the manner in which the stocks
moved period by period.
Cases in which the market ends up near its starting point are likely to favor
constant-mix strategies, while those in which the market ends up far from its
starting point are likely to favor CPPI.
Risk Tolerance
Buy-and-hold . The investors tolerance for risk is zero if the value of the investors
assets falls below the oor value; otherwise, risk tolerance increases proportionately
with wealth. That is, as stocks continually increase in value and become an
increasing proportion of the portfolio, the risk of the portfolio increases, but the
investor does nothing to reduce it.
Constant-mix . When equity is held at a constant proportion of the total portfolio
value, the investors relative risk tolerance remains constant. However, because the
absolute amount of equity increases as the portfolio increases in value, we say that
the investors absolute risk tolerance increases with (is positively related to) wealth.
CPPI . Investor risk tolerance is similar to that of the buy-and-hold methodology.
Investor risk tolerance drops to zero when total assets drop below the oor value.
However, CPPI assumes that investor risk tolerance is more dramatically affected
by changes in wealth levels than buy-and-hold (e.g., as stocks increase, CPPI
aggressively pursues more stocks; as stocks decrease, CPPI aggressively rids the
portfolio of stocks).
Risk and Return Consequences
Figure 6 summarizes the risk and return consequences of the strategies in up, down, and
at markets.
Page 80 2010 Kaplan, Inc.
Study Session 17
Cross-Reference to CFA Institute Assigned Reading #46 Evaluating Portfolio Performance
S
t
u
d
y

S
e
s
s
i
o
n

1
7
Advantages and Disadvantages of Benchmarks
There are seven primary types of benchmarks in use:
Absolute. 1.
Manager universes. 2.
Broad market indices. 3.
Style indices. 4.
Factor-model-based. 5.
Returns-based. 6.
Custom security-based. 7.
1. Absolute. An absolute benchmark is a return objective (e.g., aims to exceed a
minimum target return).
Advantage:
Simple and straightforward benchmark.
Disadvantage:
An absolute return objective is not an investable alternative and therefore does
not satisfy the benchmark validity criteria.
2. Manager universes. The median manager or fund from a broad universe of
managers or funds is used as the benchmark. The median manager is the fund that
falls at the middle when funds are ranked from highest to lowest by performance.
Advantage:
It is measurable.
Disadvantages:
Manager universes are subject to survivor bias, as fund sponsors will terminate
underperforming managers.
Fund sponsors who choose to employ manager universes have to rely on the
compilers representations that the universe has been accurately compiled.
Cannot be identied or specied in advance.
3. Broad market indices. There are several well known broad market indices that
are used as benchmarks [e.g., the S&P 500 for U.S. common stocks, the Morgan
Stanley Capital International (MSCI) Europe, Australasia and Far East (EAFE) for
non-U.S. developed market common stocks, etc.].
Advantages:
Well recognized, easy to understand, and widely available.
Unambiguous, generally investable, measurable, and may be specied in advance.
Disadvantage:
The managers style may deviate from the style reected in the index (e.g.,
assigning the S&P 500 to a small-capitalization U.S. growth stock manager).
2010 Kaplan, Inc. Page 81
Study Session 17
Cross-Reference to CFA Institute Assigned Reading #46 Evaluating Portfolio Performance
4. Style indices. Investment style indices represent specic portions of an asset
category. Four well-known U.S. common stock style indices are (1) large-
capitalization growth, (2) large-capitalization value, (3) small-capitalization growth,
and (4) small-capitalization value.
Advantage:
Widely available, widely understood, and widely accepted.
Disadvantages:
Some style indices can contain weightings in certain securities and sectors that
may be larger than considered prudent.
Differing denitions of investment style can produce quite different benchmark
returns.
5. Factor-model-based. Factor models involve relating a specied set of factor
exposures to the returns on an account. A well known one factor model is the
market model where the return on a portfolio is expressed as a linear function of the
return on a market index. A generalized factor model equation would be:
R a b F b F b F
P p K K

1 1 2 2
... F
where:
R the periodic return on
P
aan account
a the "zero factor" term, representing the exp
P
eected value of if all factor
values were zero
F factors
P
i
R
that have a systematic effect on the portfolios performa ance, i = 1 to K
b the sensitivity of the returns on the
i
aaccount to the returns generated from
factor i
error ter F mm; portfolio return not explained by the factor model
Some examples of factors are the market index, industry, growth characteristics, a
companys size, and nancial strength.
The benchmark portfolio (a.k.a. the normal portfolio) is the portfolio with exposures
to the systematic risk factors that are typical for the investment manager. The
managers past portfolios are used as a guide.
Advantage:
Helps fund sponsors better understand a managers investment style, by
capturing factor exposures that affect an accounts performance.
Disadvantages:
Factor-model-based benchmarks are not always intuitive to the fund sponsor or
even the investment manager.
Not always easy to obtain, potentially expensive to use, and can be ambiguous
as it is possible to construct multiple benchmarks with the same factor exposures
but not the same asset exposures as the manager.
Page 82 2010 Kaplan, Inc.
Study Session 17
Cross-Reference to CFA Institute Assigned Reading #46 Evaluating Portfolio Performance
S
t
u
d
y

S
e
s
s
i
o
n

1
7
It does not pass the validity criteria as the composition of a factor based
benchmark is not specied with respect to the constituent securities and their
weights. Also, the benchmark may not be investable.
6. Returns-based. Returns-based benchmarks are constructed using: (1) the managed
account returns over specied periods, and (2) corresponding returns on several style
indices for the same periods.
These return series are submitted to an allocation algorithm that solves for the
combination of investment style indices that most closely tracks the accounts
returns.
Advantages:
Generally easy to use and intuitive.
Unambiguous, measurable, and investable.
Useful where the only information available is account returns.
Disadvantages:
The style indices may not be precise matches to the components of the managed
portfolio, as the proper number and types of indices are difcult to determine.
A sufcient number of monthly returns would be needed to establish a
statistically reliable pattern of style exposures.
7. Custom security-based. Managers typically select the securities they feel represent
the best investment opportunities out of their universe of available securities. A
custom security-based benchmark is constructed from publicly traded assets selected
from the managers universe and weighted to reect the managers allocations and
rebalanced at the end of each evaluation period to reect the managers investment
process.
Advantages:
Meets all of the required benchmark properties and all of the benchmark validity
criteria.
Allows continual monitoring of investment processes.
Allows fund sponsors to effectively allocate risk across investment management
teams.
Disadvantages:
Can be expensive to construct and maintain.
A lack of transparency (e.g., hedge funds) can be a concern.
2010 Kaplan, Inc. Page 267
FORMULAS
CPPI strategies: $ in stock = m (TA F)
cash ow at the beginning of the evaluation period:
r
MV MV CF
MV CF
t
=
( )

1 0
0
cash ow at the end of the evaluation period:
r
MV CF MV
MV
t
=
( )
1 0
0
MWRR is the rate, R, that solves:
MV MV CF
1 0 i
=
=
`
( ) ( )
( )
1 1
1
R R
m L i
i
n
P = M + S + A
Sharpe ratio:
S
R R
P
P F
=

o
P
incremental return to the asset category level:
R w R R
AC i i F
i=1
n
= ( ) ( )
`
incremental return at the benchmark level:
R w w R R
B i
j = 1
m
i,j
i = 1
n
B,i,j i
= ( )
( )

( )
` `
return to the investment managers level:
R w w R R
IM i
j = 1
m
i,j
i = 1
n
i,j B,i
= ( )
( )

( )
` `

Page 268 2010 Kaplan, Inc.
Book 5 Execution, Monitoring, and Rebalancing; Evaluation and Attribution; and Global Investment Performance Standards (GIPS

)
Formulas
micro performance attribution:
R w w R R
V Pj Bj
j
S
Bj B
pure sector allocation
=
( )

( )
=
`
1


( )

( )
=
`
w w R R
Pj Bj
j
S
Pj Bj
allocation/selection interaction
1


( )
=
`
w R R
Bj
j 1
S
Pj Bj
within-sector selection

SML:

R R R R
A F A M F
=
( )
C
ex post alpha: o
A At A
R R =

information ratio:
IR
active return
active risk
R R
P
P B
R R
P B
= =

( )
o
Treynor measure:
T
R R
A
A
A
=

F
o
Sharpe ratio:
S
R R
A
A
F
A
=

o
M
2
measure:
M R +
R R
P
2
F
P F
P
M
=

(
(

\
)

o
o
purely domestic portfolio return: R
j
= CG
j
CF
j
global portfolio return: R CG CF C
j d j j j ,
=
domestic return on a global portfolio R w CG w
p,d j,p j,l
j
j,
= =
` pp j,l
j
j,p j
j
I w C
` `
currency effect for market C e CG I
j j j j
j = =
( )
1
market return for the portfolio in local currencies R w
p,l
= =
j j,p j,l
j
R
`
security selection effect:
R w R
SecSel,p j,p
j
SecSel,j
=
`
2010 Kaplan, Inc. Page 269
Book 5 Execution, Monitoring, and Rebalancing; Evaluation and Attribution; and Global Investment Performance Standards (GIPS

)
Formulas
global return decomposition:
R w R w R w I w C
w R w R
p,d j j,l
j
j
j
SecSel,j j j,l
j
j j
j
j j,l
j
j j,
=
=
` ` ` `
` pp,l j,b,l
j
j j,l
j
j j
j
R w I w C
( )

` ` `
where:
w R the portfolio market return in the local cu
j j,l
j
`
= rrrencies
w R R the portfolio security select
j j,p,l j,b,l
j

( )
=
`
iion effect in the local currencies
w I the portfolio
j j,l
j
`
= yyield in local currencies
w C the portfolio currency ef
j j
j
`
= ffect
benchmark domestic return:
R w R
b,d j,b j,b,d
j
=
( )( )
`
market allocation contribution (MAC) w w R
j,p j,b j,b,l
j
=
( )
`
currency allocation contribution = ( )
, , , ,
w C w C
j p j p j b j b
j

`
R benchmark domestic return market allocation contributio
p
= n n
currency allocation contribution security selection con

ttribution yield component

w R w w R
j,b j,b,d
j
j,p j,b j,

=
( )( )

( )
` bb,l
j
j,p j,p j,b j,b
j
j,p j,p,l j,b,l
j
j,p j,
w C w C w R R w I
`
` `

( )
( )
l l
j
`
two-period return to active management:
R R R R R
A,2 a,1 b,2 a,2 p,1
= ( )
( )
1 1
information ratio
=
SR
SR
S
Sharpe ratio =
R R
p F
p