CFAL3 FinQuiz

2018 Study Session # 1, Reading # 1
“CODE OF ETHICS AND STANDARDS

OF PROFESSIONAL CONDUCT”
M&C = Members & Candidates CFAI = CFA Institute
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COE = Code of Ethics PCP = Professional Conduct
SOPC = Standards of Program
Professional conduct CFAI PCP ⇒ covered by CFAI Bylaws & Rules for Procedures Related to DRC = Disciplinary Review
BOG=Board of Governors Professional Conduct. Committee
PDP=Professional Development PCP is based on principles of fairness to M&C& confidentiality of PCS = Professional Conduct
Program proceedings. Statement
DRC of CFAI BOG ⇒ responsible for PCP & enforcement of code & standards.
Circumstances Which Can Prompt Inquiry
Self disclosure by member/candidate on PCS which

comprehensively questions professional conduct such as
involvement in civil litigation, criminal investigation or any complaint
(written) against the member/candidate etc.
Written complaints about member/candidate received by professional

conduct staff.
Evidence of misconduct by member/candidate received by professional
conduct staff through public source.
A report by CFA proctor of a possible violation during examinations.
CFAI designated officer conducts inquiries.
Professional conduct staff (in writing) may request explanation from subject
member/candidate & may:
Interview the subject member/candidate.
Interview the complainant / third party.
Collect relevant documents& records.
Designated officer may decide:
That disciplinary sanctions are not required.
To issue a cautionary letter.
To discipline the member/candidate.
If disciplinary sanction is proposed, the subject member/candidate may
accept the sanction.
If sanction is rejected ⇒ matter may be referred to CFAI panel for hearing.
Sanctions may include.
Condemnation by member’s peers.
Suspension of candidate’s continued participation in CFAI program.
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Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients, prospective clients,
employers, employees, colleagues’ in the investment profession, and other participants in the global capital markets.
Place the integrity of the investment profession and the interests of clients above their own personal interests.
Use reasonable care and exercise independent professional judgment when conducting investment analysis, making investment
recommendations, taking investment actions, and engaging in other professional activities.
Practice and encourage others to practice in a professional and ethical manner that will reflect credit on themselves and the
profession.
Promote the integrity of and uphold the rules governing capital markets.
Maintain and improve their professional competence and strive to maintain and improve the competence of other investment
professionals.
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Standards of Professional Conduct
1. Professionalism 2. Integrity of Capital Markets 3. Duties to Clients 4. Duties to Employers 5. Investment Analysis,
Recommendations& Actions
6. Conflicts of Interest 7. Responsibilities as a CFAI Member or CFAI Candidate
Los1.c 1. Professionalism
A. Knowledge of Law B. Independence & Objectivity C. Misrepresentation D. Misconduct
2. Integrity of Capital Markets
A. Material Non-Public Information B. Market Manipulation
3. Duties to Clients
A. Loyalty, B. Fair Dealing C. Suitability D. Performance E. Preservation of

Prudence, and Care Presentation Confidentiality
4. Duties to Employers
A. Loyalty B. Additional Compensation C. Responsibility of

Arrangements Supervisors
5. Investment Analysis, Recommendations& Actions
A. Diligence & Reasonable B. Communication with C. Record Retention

Basis Clients & prospective
Clients
6. Conflicts of Interest
A. Disclosure of conflicts B. Priority of Transactions C. Referral Fees
7. Responsibilities as a CFAI Member or CFAI Candidate
A. Conduct as Members and Candidates in B. Reference to CFA Institute, the CFA

the CFA Program Designation, and the CFA Program

2018, Study Session # 1, Reading # 2
M&C = Members & CFAI = CFA Institute
Candidates
COE = Code of Ethics
“GUIDANCE FOR STANDARDS I-VII” PCP = Professional
Conduct Program
SOPC = Standards of DRC = Disciplinary
Professional conduct Review Committee
1. Professionalism
BOG=Board of PCS = Professional
Governors Conduct Statement
PDP=Professional 1 A. Knowledge of Law
Development
Program M&C must understand & comply with all applicable laws, rules& regulations (including COE & SOPC).
These rules & regulations pertain to any govt, regulatory organization, licensing agency or
professional association governing their professional activities.
Must comply with more strict law in case of conflict.
M&C must not knowingly participate or assist & must dissociate from any violation of laws.
Guidance ⇒ Code & Standards VS Local Law
Members must know laws & regulations related to their professional activity in all countries where
they conduct business.
Adhere to more strict rule while deciding b/w local laws & Codes & Standards of CFAI.
Must comply with local laws related to professional activity.
Never violate Codes & Standards even if activity is otherwise legal.
Guidance ⇒ Participation in or Association with Violation by Others
Members must dissociate or separate themselves from any ongoing client or employee activity
which is illegal or unethical.
In extreme case they may have to leave the employer.
May, at first, confront the individual involved.
Approach supervisor or compliance department.
Inaction with continued association may be construed as knowing participation.
Recommended Procedures for Compliance-Members
Members must keep themselves updated with applicable laws, rules & regulations.
Compliance laws must be reviewed on an ongoing basis in order to ensure that they address
prevailing laws, CFAI standards & regulations.
Members should maintain current reference material for employees in order to keep them up-to-
date on laws, rules & regulations.
In doubt, members should seek advice of counsel or their compliance department.
Members must document any violation when they disassociate from any prohibited activity.
Members must encourage their employers to end such activity.
Under some circumstances, it may be advisable or otherwise required by the law to report violations
to governmental authorities.
Standards (CFAI) do not require members to report violations to governmental authorities.
CFAI encourages members, clients & public to submit written report against a CFA member or
candidate involved in violation of the CFA Code & Standards
Recommended Procedure for Compliance-Firms
Members should encourage their firms to:

Develop and/or adopt a code of ethics.
Highlight applicable laws and regulations to employees.
Establish written procedures for reporting suspected violation of laws, regulations or company
policies.
Members incharge of supervision, creation and maintenance of investment services should:
Be aware of and comply with regulations and laws in their country of origin.
They must be aware of and comply with regulations of countries where products/services will
be sold.

1 B. Independence & Objectivity
M&C must use reasonable care & judgment to achieve & maintain independence &
objectivity in professional activities.
Do not accept any gift, or any type of consideration that may compromise their own or
another’s independence & objectivity.
Guidance
Investment process must not be influenced by any external sources.

Modest gifts by clients are permitted.
Allocation of shares in oversubscribed IPO to personal accounts is not permitted.
Distinguish b/w gifts from clients & entities seeking influence to the detriment of the client.
Gifts must be disclosed to the member’s employer either prior to acceptance or
subsequently.
Guidance-Investment Banking Relationships
Do not get pressurized from sell-side analyst to issue favorable research on current or
prospective investment-banking client.
Disclose conflicts and manage these appropriately while working with investment bankers
in “road shows”.
Ensure effective “firewalls” b/w research/investment management & investment banking
activities.
Guidance-Public Companies
Do not limit research to discussions with company management.

Use sources like:
Suppliers
Customers
Competitors
Analyst must not be pressured to issue favorable research by the companies they follow.
Guidance-Buy Side Clients
Responsibility of portfolio managers to respect and foster intellectual honesty of sell side
research.
Portfolio managers must not pressurize sell side analysts.
They may have large positions in particular securities. Rating downgrade may
adversely affect portfolio performance.
Guidance-Fund Manager Relationships
Members responsible for selecting outside managers should not accept gifts,
entertainment or travel that might be perceived to impair member’s independence and/or
objectivity.
Guidance-Credit Rating Agency
Members employed by credit rating agencies make sure they prevent undue influence by
security issuing firms.
Members using credit ratings must be aware of potential conflicts of interest& therefore
may consider independent validation of the rating granted.

Guidance-Issuer Paid Research
Analyst’s compensation for such researches should be limited.

Preference is flat fee.
No reward must be attached with report’s recommendation.
Guidance-Travel
Best practice ⇒ analysts pay their own commercial travel while attending
information events or tours sponsored by the firm being analyzed.
Recommended Procedures for Compliance
Protect the integrity of opinions (unbiased opinion of the analyst) & design proper compensation systems.
Create a restricted list (remove the controversial company from research universe).
Restrict special cost arrangements (limit the use of corporate aircraft to situations in which commercial
transportation is not available).
M&C should pay for commercial transportations & hotel charges.
Limit the acceptance of gratuities and/or gifts to token items only.
Develop formal policies related to employee purchases of equity or equity related IPOs (strict limits on private
placements).
Effective supervisory & review procedures.
Ensure that research analysts are not supervised or controlled by any department that could compromise the
independence of analyst.
Appoint a senior officer with oversight responsibilities for compliance with firm’s COE & all regulations
concerning its business.
1 C. Misrepresentation
M&C must not knowingly make any misrepresentations relating to investment

analysis, recommendation, actions or other professional activities.
Guidance
Misrepresentation causes mistrust.

Do not give false impressions in oral, written& electronic communication.
Misrepresentation includes.
Guaranteeing investment performance.
Plagiarism.
Plagiarism ⇒ using someone else’s work without giving him credit.
Misrepresentation also includes deliberately omitting information that could
affect investment decision.
Models and analysis developed by others at firm are the property of firm-
members can use them without attributing to developers.
A report written by another analyst employed by the firm cannot be released as
another analyst’s work.
Recommended Procedure for Compliance
Firms should provide employees who deal with clients a written list of firm’s
available services and its qualifications.
Employee qualification should be accurately presented as well.
To avoid plagiarism, firm must keep record of all sources and cite them.
Generally understandable and factual information need not to be cited.
Members should encourage firms to establish procedures for verifying
marketing claims of third parties whose information the firm provides to
clients.

1 D. Misconduct
M&C must not involve in dishonesty, fraud, deceit or commit any act that reflects adversely on
their professional reputations, integrity or competence.
Guidance
CFAI discourages unethical behavior in all aspects of members’ and candidates’ lives.
Do not abuse CFAI PCP by seeking enforcement of this standard to settle personal, political or
other disputes not related to professional ethics.
Firms are encouraged to adopt these policies and procedures to:

Develop and adopt a code of ethics and make clear that unethical behavior will not be tolerated.
Give employees a list of potential violations and sanctions including dismissal.
Check references of potential employees.
2. INTEGRITY OF CAPITAL MARKETS
2 A. Material Non-Public Information
M&C must not act or cause others to act on the

information that is material nonpublic (affect the value of
investments).
Guidance
Material information ⇒ if disclosure would impact price of security.

If reasonable investor would want the information before making an investment
decision.
Nonpublic information ⇒ non-available to the marketplace.
Analyst conference call is not public disclosure.
Selective disclosure causes insider trading.
Prohibition against acting on material non public information extends to securities,
swaps, and option contracts.
Guidance-Mosaic Theory
No prohibition on reaching an investment decision through public and non-material

nonpublic information.
Make reasonable efforts to achieve public dissemination of information.

Encourage firms to adopt procedures to prevent misuse of material nonpublic information.
Use a “firewall” within the firm with
Substantial control of relevant interdepartmental communication  through a clearance
like compliance/legal department.
Review employee trades maintain watch, rumor, and restricted lists.
Monitor & prohibit proprietary trading-if a firm is in possession of material non-public
information.
Prohibiting all proprietary trading may send a signal to the market firm should take the contra
side of only unsolicited customers trade.

2B. MARKET MANIPULATIONS
M&C must not engage in practices that mislead

market participants (distort prices or artificially
inflate trading volume).
Guidance
Spreading false rumors is prohibited (which can distort market).

Standard applies to transactions that deceive market.
By distorting the price-setting mechanism of financial investments.
Securing a controlling position to manipulate the price of a related derivative or
the asset.
3. DUTIES TO CLIENTS
3 A. Loyalty, Prudence & Care
M&C:
Have a duty of loyalty to clients & must act with reasonable care & exercise prudent judgment.
Must act for the benefits of clients & place clients’ interests above employers’ or their own interests.
Guidance
M&C must exercise same level of prudence, judgment & care as in management & disposition of their own interests in similar
circumstances.
M&C should manage pool of assets in accordance with the terms of governing documents (e.g. trust documents).
Determine the identity of “client’” to whom duty of loyalty is owed. (May be an individual or plan beneficiaries in case of
pension plan or trust).
M&C must follow any guidelines set by their clients for the management of their assets.
Investment decisions are judged in the context of total portfolio rather than individual investments.
Conflict arises when “soft dollars” are not used for the benefit of clients.
Cost-benefit analysis may show that voting all proxies may not a beneficial strategy for clients.
Recommended Procedures of Compliance
M&C with control of client assets should submit to each client, at least quarterly, a statement showing funds & securities.
In doubt, M&C should disclose the questionable matter in writing to client & obtain client approval.
M&C should address & encourage their firms to address the following regarding duties to client;
Follow all applicable rules & laws.
Establish the investment objectives of the clients.
Consider all the information when taking actions.
Diversify investments to reduce risk of loss.
Carry out regular reviews.
Deal fairly with all clients with respect to investment actions.
Disclose conflict of interest & compensation arrangements.
Maintain confidentiality & seek best execution.

3B. Fair Dealing
M&C must deal fairly & objectively with clients (when providing investment analysis,
making recommendations, taking action or engaging in other professional activities).
Guidance
No discrimination among clients while disseminating recommendations or taking investment decision.

Fairly does not mean equally ⇒ difference in timings of emails & fax received by clients are normal
course of business.
Different services levels are okay as far as they do not adversely affect any client.
Disclose different levels of services to all clients and prospects.
Premium services should be available to all those who are willing to pay for them.
Guidance-Investment Recommendation
All clients must be given fair opportunity to act upon every recommendation.
Clients unaware of the change in recommendation  should be advised before the order is
accepted.
Guidance-Investment Actions
Clients must be treated fairly in the light of their investment objectives and circumstances.
Both institutional and individual clients must be treated in a fair & impartial manner.
Member/candidates should not take advantage of their position to disadvantage clients
(e.g., in IPOs).
Firms are encouraged to establish compliance procedures to treat customers & clients fairly.
Communicate recommendations simultaneously within the firm & to customers.
M&C should consider the following:
Limit the no. of people who are aware that a recommendation is going to be disseminated.
Shorten the time frame b/w decision & dissemination.
Publish guidelines for pre-dissemination behavior.
Simultaneous dissemination (treat all clients fairly).
Maintain a list of clients & their holdings.
Develop & document trade allocation procedures.
Disclose trade allocation procedures (must be fair & equitable).
Establish systematic account review (no preferential treatment to any client or customer).
Disclose level of services (different levels of services are possible for same or different fees).
3 C. SUITABILITY
2. M&C are in advisory relationship 1. When M&C are responsible for a portfolio
with a specific mandate, strategy or style,
they must take actions according to the
Make inquiry into Determine Judge the objectives & constraints of the portfolio.
client’s investment investment’s investment
experience, risk & suitability with suitability in the
return objectives, reference to context of client’s
financial client’s objective & total portfolio.
constraints & constraints &
reassess & update mandate.
this information
regularly.

Guidance
Develop IPS at beginning of the relationship.

Consider client’s needs, circumstances & risk tolerance.
Consider whether use of leverage is suitable for the client or not.
Make sure to abide by the stated mandate.
Develop written IPS of each client & take the following into consideration:
Client identification.
Investor objectives.
Investor constraints.
Performance measurement benchmark
Objectives & constraints should be maintained & reviewed periodically to reflect any changes in
clients’ circumstances.
Suitability test policies.
3 D. Performance Presentations
M&C must communicate fair, accurate & complete investment performance information.
Guidance
Members must avoid misstating performance or misleading clients about investment performance
of themselves or their firms.
Members should not misrepresent past performance or reasonably expected performance.
Members should not state or imply the ability to achieve a rate similar to that achieved in the past.
Indicate if presentation has offered limited information.
Brief presentations should be supplemented with information that detailed report is available on
request.
Apply GIPS standards.

Consider the knowledge of audience to whom performance presentation is addressed.
Performance of composite rather than single account.
Include performance history of terminated accounts.
Disclosures that fully explain the performance results should be reported.
Maintain data & record used to calculate the performance being presented.
3 E. Preservation of Confidentiality
M&C must keep information about current, former &

prospective clients confidential unless:
Information concerns illegal activity.
Disclosure is required by law.
Client or prospective client permits disclosure.

Guidance
If a client is involved in illegal activitiesmembers may have an obligation

to report to the authorities.
This standard extends to former clients as well.
Standards do not prevent members from cooperating with CFA PCP
investigation.
Avoid disclosing information received from client except to the authorized

colleagues working for the same client.
Follow firm’s procedures for storing electronic data.
Recommend adoption of such procedures if they are not in place.
4. Duties to Employers
A. Loyalty
M&C:
Must act for the benefit of their employer.
Not deprive employer of the advantage of their skills &abilities, divulge confidential
information or otherwise cause harm to their employer.
Guidance
Do not indulge in the activities that may injure the firm deprive it of profit or
advantage of employee’s abilities & skills.
Though clients’ interests have priority than firm’s interests but consider the effects
of actions on the firm’s integrity and sustainability.
A careful balance b/w managing interests of employer & family manage such
obligations with work obligations.
Guidance-Employer Responsibility
Should not have incentive or compensation system that encourages unethical

behavior.
Members are encouraged to give their employers a copy of Code & Standards.
Guidance-Independent Practice
Independent practice for compensation is allowed.

Provide employer notification fully describing all aspects of service.
Compensation details
Duration
Nature of activities
Employer’s consent is required.

Guidance-Leaving an Employer
Continue to act in employer’s best interest until resignation is effective.

Activities that may constitute a violation include:
Misappropriation of trade secrets
Misuse of confidential information
Soliciting employer’s client prior to leaving
Self-dealing
Misappropriation of client lists.
Employer records on home computers, PDA, cell phones or any other medium
are property of firm.
After leaving the organization, simple knowledge of names and existence of
former clients is not confidential.
Member/candidate can use the experience or knowledge gained with former
employer at any other organization.
Guidance Whistle-blowing
In exceptional cases, duty to the employer may be violated in order to protect

a client for upholding the integrity of capital markets.
Whistle- blowing cannot be done for personal gains.
Guidance-Nature of Employment
If members/candidates are independent contractors, they still have duty to abide

by the terms of the agreement.
Recommended Procedures for compliance
Competition policy (employer restrictions on offering similar services outside

the firm).
Termination policy (how termination is disclosed to clients & staff).
Incident-reporting procedures.
Employee classification (e.g. full time, part time).
4 B. Additional Compensation Arrangements
M&C must not accept gifts, benefits, compensation, or consideration that competes
with or might reasonably be expected to create a conflict of interest with their
employer’s interest unless they obtain written consent from all parties involved.
Guidance
Compensation includes both direct & indirect form.

Additional benefits are also included.
Written consent from employer also includes email communication.
Immediately report to employer in written format detailing any

proposed compensation and services.
Performance incentives should be verified by the offering party.

4 C. Responsibility of Supervisors
M&C must make efforts to detect & prevent violations of applicable

laws, rules & regulations and Code & Standards by any one subject to
their supervision or authority.
Guidance
Members must take steps to prevent subordinates from violating

laws, rules, regulations or code & standards.
Make reasonable efforts to detect violations.
Members with supervisory responsibility must ensure that policies
regarding investment or non-investment behavior are enforced
equally.
Guidance-Compliance Procedures
Members with supervisory responsibility must bring an inadequate

compliance system to the firm’s attention and recommend
corrective action.
While investigating a violation it is appropriate to limit suspected
employee’s activities.
Unless adequate procedures are adopted by the firm, a member
must decline in writing from accepting supervisory responsibility.
M&C should recommend their employers to adopt a COE.

Separate the COE from compliance procedures.
Adequate compliance procedures:
Clearly written & accessible manual.
Designate a compliance officer to implement compliance procedures.
Implement system of checks & balances.
Describe the hierarchy of supervision.
Outline scope of procedures & permissible conduct.
Once a compliance program is in place, a supervisor should:
Disseminate program contents to appropriate personnel & educate them regarding
compliance procedures.
Professional conduct evaluation as part of employee’s performance review.
Review employee’s actions & identify violation.
Once a violation is discovered, supervisor should respond promptly, conduct thorough
investigation & increase supervision.

5. Investment Analysis, Recommendations and Actions
5 A. Diligence & Reasonable Basis
1. M&C must exercise diligence, 2. M&C must have a reasonable &

independence & thoroughness in adequate basis for investment
investment analysis, analysis, recommendation or action
recommendations & actions. (supported by research &
investigation).
Guidance-Reasonable Basis
Level of research for due diligence depends on product/service offered.

Prior to making recommendation or investment action consider;
Firm’s financial results, operating history & business cycles stage.
Mutual fund’s fee & past performance.
Limitation of any quantitative methods used.
Appropriateness of peer group comparisons.
Guidance-Using Secondary or Third-Party Research
To periodically review quality of third party research use the following:

Review assumptions used.
How rigorous was the analysis.
How timely the research is.
Evaluate objectivity & independence of recommendations.
Guidance-Quantitative Research
Able to explain the nature of quantitative methods used.

Consider scenarios which are not typically used to assess downside risk.
Ensure that both positive & negative results have been used.
Guidance-External Advisers
Ensure advisors have adequate compliance and internal controls.

They present correct return information.
Do not deviate from stated strategies.
Guidance-Group Research & Decision Making
If the group research has a reasonable basis, do not refuse to

be identified with the report merely on the basis of
disagreement with the consensus view.
Policy requiring that research reports, credit ratings & investment recommendations have a reasonable & adequate basis.
Develop written guidance for analysts, supervisory analysts & review committees.
Develop measureable criteria for research report quality assessment.
Written guidance for computer-based models used in developing rating & evaluating financial instruments.
Develop measurable criteria for assessing outside providers.
Standardized criteria for evaluating the adequacy of external advisers.

5 B. Communication with Clients and Prospective Clients
M&C must:
Disclose to clients & prospective clients the basic format & general principal of
investment process& disclose any change that materially affects that process.
Identify important factors (related to investments) & communicate with clients &
prospective clients.
Distinguish b/w fact & opinion (in investment analysis& recommendations).
Guidance
Always include basic characteristics of security identified.

Distinguish b/w facts and opinions.
Illustrate investment decision making process utilized.
All means of communication should be included not only the research reports.
Communicate any specific risk factors associated with securities.
Clearly communicate potential gains & losses.
Failing to illustrate model’s limitations may be considered as violation.
Able to supply additional information if requested maintain

relevant information.
5 C. Record Retention
M&C must develop & maintain appropriate records that support investment analysis,
recommendations, actions & other investment related communications with clients&
prospective clients.
Guidance
Maintain records that support conclusion or any investment action.

Such records are property of the firm.
If regulatory requirements do not recommend, keep records for 7
years.
Members who change firms must recreate analysis related
documentation – not rely on memory or material created at previous
firms.
Record-keeping is generally firm’s

responsibility.

6. Conflicts of Interest
6 A. Disclosures of Conflicts
M&C must:
Make full & fair disclosure of all matters that impair independence & objectivity or interfere
with respective duties to clients, prospective clients & employers.
Disclosures should be prominent, delivered in plain language & communicate information
effectively.
Guidance-Disclosure to Clients
Disclose all potentially conflicting areas to existing and prospective clients to let them judge
any potential bias themselves.
If servicing as a board member disclose.
Disclosure of broker/dealer market making activities is included.
Disclosure of holdings in companies that member recommends or clients hold.
Members’ compensation structure, if perceived to gain any client must be disclosed.
Members working in advisory capacity.
Update disclosure in case of significant change in compensation structure.
Guidance –Disclosure of Conflicts to Employers
Give employers enough information to judge the impact of conflict.

Take reasonable steps to avoid conflict  report promptly if they occur.
Special compensation arrangements (bonus, commission etc.) should be disclosed.
6 B. Priority of Transaction
Investment transaction priority flow:

Clients
⇓
Employers
⇓
Employees
Guidance
Prioritize client’s transactions over personal transactions& made on behalf of the member’s firm.
Personal transactions may be undertaken after clients and member’s employers have been given
adequate opportunity.
Personal transaction – member is a “beneficial owner”.
Family member accounts should not be disadvantaged to client accounts.
Information about pending trades should not be acted upon for personal gains.

Limited participation in equity IPOs by investment personnel.

Restrictions on private placements for investment personnel.
Establish blackout/restricted periods for investment personnel.
Reporting requirements for investment personnel.
Disclosure of holdings in which the employee has a beneficial interest.
Provide duplicate confirmations of transaction.
Preclearance procedures.
Disclosure of policies regarding personal investing.
6 C. Referral Fees
M&C must disclose to employer, clients & prospective clients, as appropriate, any
compensation, consideration or benefit received from or paid to others for
recommendation of products& services.
Guidance
Must inform employers, clients and prospects of benefits received for referral of
customers and clients.
All types of consideration must be disclosed.
Encourage firms to adopt clear procedures regarding compensation for referrals.

M&C should update the employer (at least quarterly) regarding nature and value
of referral compensation received. The clients should also be notified about
approved referral fee programs.

7. Responsibilities as a CFAI Member or CFAI Candidate
7 A. Conduct as Members and Candidates in the CFA Program
M&C must not:

Engage in any conduct that compromise reputation or
integrity of CFAI or CFA designation.
Violate integrity, validity or security or the CFA
examinations.
Guidance
Must not engage in any activity that undermines the integrity of CFA charter.
Standard applies to:
Cheating in CFA or any exam.
Revealing anything about the contents & topics of exam.
Not following exam related rules & polices of CFA program.
Disclosing confidential exam related information to candidates or to public.
Improperly using the designation.
Misrepresenting information on PCS or CFAI PDP.
Members can express their opinion regarding the CFA exam or program but without disclosing
actual exam specific information.
Members voluntarily participating in the administration of the CFA exam must not solicit or
reveal information about:
Exam questions
Grading process
Scoring of questions
7 B. Reference to CFA Institute, the CFA Designation, and the CFA Program
M&C must not misrepresent or exaggerate the meaning or implication of

membership in CFA institute, holding the CFA designation or candidacy in CFA
program.
Guidance
Do not over-promise individual competence.

Do not over promise future investment result.
Sign PCS annually.
Pay CFAI membership dues annually.
Do not misrepresent or exaggerate the meaning of the designation.
No partial designation exists.
Acceptable to state candidate successfully completed the program in 3 years ⇒claiming
superior ability is not permitted.
In written/oral communications.
The chartered financial analyst and CFA marks must be used as adjectives or after the
charterholder’s name.
Prohibited to be used as nouns.

Application of the
Code & Standards
FinQuiz Team recommends reading

‘Application of the Code & Standards’
directly from the CFA Institute’s curriculum.

“ASSET MANAGER CODE OF PROFESSIONAL CONDUCT”
THE ASSET MANAGER CODE
There are six risk components to the asset manager code.

Ethical responsibilities related to six components are:
Always act ethically & professionally.
Act independently & objectively.
Perform actions using skill, diligence & competence.
Act in best interest of the client.
Communicate with clients on a regular & accurate manner.
Legal & regulatory compliance.
PREVENTING VIOLATIONS
Loyalty to Clients Investment Process & Actions
Put the client’s interest before your own. Take actions that would not cause any harm to the client.
Maintain confidentiality. Never engage in market manipulation of security prices.
Do not accept any gift that affects your judgment& Fair dealing with all clients.
objectivity. Thoroughly investigate & research different investment
Design salary arrangements that align the interests of the options.
client with those of the manager.
Trading Risk Management, Compliance & Support
Do not trade or cause others to trade on insider information. Develop policies & procedures for complying with codes &
Seek best execution for all trades & equitable allocation standards & regulatory requirements.
among clients. Appoint a compliance officer & establish a firm wide system
Use soft $ commission to provide products & services that for identifying & measuring manager’s risk position.
aids the portfolio manager in investment decision making Complete & accurate portfolio information disseminated to
process. clients.
Place client’s trades before your own. Maintain records.
Contingency plan in the event of a natural disaster.
Performance & Valuation Disclosure
Report investment results in an accurate manner without Disclose the following to the client:
misrepresentation. Use fair MV. Any information needed to make an informed decision
Guideline ⇒ follows GIPS. regarding the investment manager or the organization.
In order to avoid conflict of interest, transfer the Potential conflict of interest.
responsibility of valuing asset accounts to an independent Any regulatory or disciplinary action taken against the
third party. manager or its personnel.
The investment decision-making process & fee
schedule.
Discussion about soft $ commission.
Trade allocation procedures & firm-wide risk
management processes.

“THE BEHAVIORAL FINANCE PERSPECTIVE”

REM = Rational Economic Man
1. INTRODUCTION
2. BEHAVIORAL VERSUS TRADITIONAL PERSPECTIVES
Traditional VS Behavioral Finance
Traditional Finance Behavioral Finance
Grounded in neoclassical economics. Grounded in psychology.

Individuals are assumed to be Based on observed financial behavior
rational, risk averse & utility rather than idealized financial
maximizers. behavior.
Traditional finance believes in EMH.
Classification
Behavioral Finance Micro Behavioral Finance Macro
Describe decision making process of Consider anomalies that distinguish

individuals. market from efficient markets.
Cognitive errors & emotional biases.
2.1 Traditional Finance Perspectives on Individual Behavior
Traditional finance assumes:

Investors are risk averse & self interested.
Investors make decisions based on utility theory &
revise expectations consistent with Bayes’ formula.
Efficient Markets.
2.1.1 Utility Theory and Bayes’ Formula
People maximize the PV of expected utility subject to their budget constraints.

Expected utility = weighted sum of the utility values of outcomes × Probabilities.
A rational investor make decision based on following axioms of utility theory:
Completeness ⇒ an individual has well defined preferences & can decide b/w two alternatives.
Transitivity ⇒ as an individual decides according to completeness axiom, an individual decides consistently.
Independence⇒ assumes preference order of two choices combined with third choice maintains the same preference order.
Continuity ⇒Indifferent curves (IC) are smooth & unbroken (continuous).
Bayes’ formula:
New information is assumed to update beliefs about probabilities according to Bayes’ formula.
Application of conditional probability.
Assumes that events are mutually exclusive & exhaustive with known probabilities.
⁄ =
⁄

Where P (A/B) & (P (B/A)) = conditional probability of event A, (B) given B, (A).
P (B) = prior probability of event B.
P (A) = prior probability of event A.

2.1.2 Rational Economic Man
REM:
Maximize utility given budget constraints & available information.
Selfishly seek the personal utility maximizing decision.
Tries to minimize economic cost.
Govern by perfect rationality, perfect self-interest & perfect
information principles.
2.1.3 Perfect Rationality, Self-Interest, & Information
Prefect rationality ⇒ REM is a rational thinker (ability to reason & make

beneficial judgments).
Prefect self interest ⇒ REM is perfectly selfish.
Perfect information ⇒ REM has perfect knowledge of every subject.
2.1.4 Risk Aversion
Risk Attitudes
Risk Averse Risk Neutral Risk Seeking
Investors who prefer a certain Investors are indifferent b/w a Investors who prefer to invest in
alternative over an uncertain one certain & uncertain alternative. uncertain alternatives.
(same expected value). Constant marginal utility of wealth. Increasing marginal utility of wealth
Diminishing marginal utility of Linear utility function. (convex function).
wealth (concave utility function).
Expected utility theory assumes that investors are risk averse

(utility functions are concave & diminishing marginal utility of
wealth).
Certainty equivalent ⇒ max sum of money a person would pay
to participate or minimum amount of money a person would
accept to not participate in an event with uncertain outcome.
2.2 Behavioral Finance Perspectives on Individual Behavior
Behavioral finance challenges assumptions of traditional finance

on the following grounds:
Investors may be unable to make decisions based on utility
theory & revise expectations consistent with the Bayes’
formula.
Perfect rationality, self interest & prefect information
principles’ violation.
2.2.1 Challenges to Rational Economic Man
Bounded rationality ⇒ individual’s choices are subject to

knowledge & cognitive limitations.
REM ignores the fact that people can have difficulty prioritizing
short term v/s long term goals.

2.2.2 Utility Maximization and Counterpoint
An IC depicts all possible combination of two goods amongst which an individual is indifferent.
For perfect substitutes (complements), the IC is a line with constant slope (L-shaped).
IC analysis fails to consider exogenous factors (e.g. risk aversion, individual’s circumstances etc).
2.2.3 Attitudes toward Risk
Risk evaluation depends on the:

Wealth level
Circumstances of the decision maker.
Double inflection utility function ⇒ utility function that changes based on level of
wealth.
Investors are risk averse at & income levels.
Investors are risk seeking at moderate income levels.
Prospect theory ⇒ Shape of a decision maker’s value function differs for G&L.
Value function is normally concave for gains, convex for losses & steeper for
losses than for gains.
2.3 Neuro-economics
Explain how humans make economic decisions under uncertainty.

Neuro-economics explains:
Overconfidence & market overreaction.
A panicked rather than analytical response after falling market.
3. DECISION MAKING
Prospect theory & bounded rationality are based on how people do behave & make
decisions(behavioral finance based).
Expected utility & decision theories are based on how people should& make decisions
(traditional finance based).
3.1 Decision Theory
Indentify values, probabilities & other uncertainties relevant to a decision & using that
information to arrive at a theoretically optimal decision.
Based on expected value & traditional finance assumptions.
Expected utility can vary from person to person (based on the worth assigned by the
decision maker).
Expected value is same for every one (based on price).
3.2 Bounded Rationality
Subjective expected utility theory ⇒ probability distributions of all relevant variables can be provided by the decision makers.
Bounded rationality & satisfice ⇒ situation where people gather some available information, use heuristics to analyze the
information & stop at a satisfactory decision.
Satisficing ⇒ finding an acceptable solution as opposed to optimizing.
Investor takes steps to achieve intermediate goals, as long as they advance the investor towards the desired goals.

3.3 Prospect Theory
Investors analyze risk relative to possible gains & losses rather than relative to expected return.
Investors are more concerned with the change in wealth & place greater value on a loss than on a
gain of same amount.
Phases to Making a Choice
Editing Phase 3.3.1 Evaluation Phase
Prospects are framed as gains or losses People compute a value function based on potential outcomes
using heuristics. & their probabilities.

= +
Where
, = Potential outcomes
Steps in Editing , = Probabilities
W = Probability weighting function.
Codification V = Function that assigns a value to an outcome.
The value function states:
People overreact (underreact) small (mid-sized & large)
Investors identify & code outcomes as probabilities events.
gains or losses & assign a probability to People are loss averse.
each. Preferences are determined by attitudes towards gains &
losses.
Combination
Investor combines those outcomes with

identical value.
Segregation
The riskless component of any prospect

is separated from its risky component.
Cancellation
Identical outcomes b/w choices can be

eliminated.
Simplification
Investors will tend not to think in precise

numbers (rounded off the prospects).
Detection of Dominance
Investor will eliminate any choice that is

strictly dominated by another.
Isolation effect⇒ investors focus on one factor or

outcome while eliminating or ignoring others.

4. PERSPECTIVES ON MARKET BEHAVIOR AND PORTFOLIO CONSTRUCTION
4.1 Traditional Perspectives on Market Behavior
Traditional finance assumes EMH
4.1.1 Review of the Efficient Market Hypothesis
EMH assumes:
Market participants are REM.
Population updates its expectations as new
relevant information appears.
Relevant information is freely available to
all participants.
Forms of Market Efficiency
Weak Form Semi-Strong Form Strong Form
Consistently excess return is not All publically available information All public & private information is
possible using technical analysis. is fully reflected in securities prices. fully reflected in securities prices.
Reflect all historical price &volume Excess return on continuous basis is Even insiders are unable to
data. not possible using technical & generate excess return on
fundamental analysis. consistent basis.
Grossman-Stiglitz paradox ⇒prices must offer returns to

information acquisition otherwise the market can’t be
efficient.
4.1.2 Studies in Support of the EMH
4.1.2.1 Support for the Weak Form of the EMH 4.1.2.2 Support for the Semi-Strong Form of the EMH
Test whether security prices are serially correlated or Event studies.

whether they are random. Announcement of the event (not event itself) appear
Studies conclude that security prices are random, to be reflected in prices.
(support weak form of the EMH).
4.1.3 Studies Challenging the EMH: Anomalies
4.1.3.1 Fundamental Anomalies 4.1.3.2 Technical
Investor generates excess return based on some Moving average ⇒ if the short (long) moving
fundamental characteristics of the firm. avg prices rise above the long (short) avg prices,
Small cap firms appear to outperform this is an indication of strength (weakness).
large cap firms. Resistance level ⇒ price will climb to the
Value stocks appear to outperform growth resistance level & then reverse direction (act
stocks. like a ceiling).
Support level ⇒ floor price (price will move
upward after support level reached).

4.1.3 Studies Challenging the EMH: Anomalies
4.1.3.3 Calendar Anomalies 4.1.3.4 Anomalies: Conclusion
January effect ⇒ stocks deliver abnormally Markets are neither perfectly efficient not
returns during the month of January. completely anomalous.
Turn-of-the month effect ⇒ stocks earn
returns on the last day & 1st four days of each
month.
4.1.3.5 Limits to Arbitrage
Uncertain need for liquidity limits the ability of

arbitrage to force prices to their intrinsic values.
Implicit in the limit to the arbitrage idea is that the
EMH does not hold.
4.2 Traditional Perspectives on Portfolio Construction
Rational portfolio:
Meets investor’s objective & constraints.
Choose from mean-variance efficient portfolios.
4.3 Alternative Models of Market Behaviorand Portfolio

Construction
4.3.1 A Behavioral Approach to Consumption and Savings
Behavioral life-cycle theory incorporates:

Self control bias ⇒ short-term satisfaction to the detriment of long-term goals.
Mental accounting ⇒ people ignore the fact that wealth is fungible (interchangeable) & assign different
portions of their wealth to meet different goals.
Framing bias ⇒results in different responses based on how questions are asked (framed).
4.3.2 A Behavioral Approach toAsset Pricing
Behavioral assets pricing model adds a sentiment premium (stochastic discount factor) to discount rate.
Required return on an asset = Rf + fundamental risk premium + sentiment premium.
Sentiment premium ⇒ based on analysts’ forecasts.
The dispersion of analysts’ forecasts, the sentiment premium, the discount rate & the
perceived value of the assets.
4.3.3 Behavioral PortfolioTheory
Uses of probability-weighting function rather than the real probability distribution.

Investor’s structure their portfolio in layers & composition of each layer is
determined by interaction of following five factors.
The importance of the goals.
Required return.
The investor’s utility function.
Access to information.
Loss aversion.
Optimal portfolio ⇒combination of riskless & highly speculative assets (may not be
mean-variance efficient).

4.3.4 Adaptive Markets Hypothesis
Revised version of the EMH that considers bounded rationality, Satisficing&

evolutionary principles.
The competition & adaptable the participants, the likelihood of not
surviving.
Five implications:
Risk premiums change over time.
Active management can add value.
Consistent outperformance is impossible.
Investors must adapt to survive.
Survival is the essential objective.

“THE BEHAVIORAL BIASES OF INDIVIDUALS”

FMP= Financial Market
Participants
2. CATEGORIZATIONS OF BEHAVIORAL BIASES
Behavioral Biases
Cognitive Errors Emotional Biases
Mechanical or physical limitations Stem from impulse or intuition.

(statistical, informational processing Emotional biases are difficult to
or memory errors). correct.
More easy to correct than emotional Result of attitude & feelings.
biases (moderated). Can be adapted not moderated
(decisions are made that adjust for it
rather than reduce or eliminate it).
3. COGNITIVE ERRORS
Belief Perseverance Biases Processing Errors
The tendency to cling to one’s Describe irrational or illogical

previously held beliefs irrationally or information processing in financial
illogically. decision making.
Closely related to cognitive
dissonance ⇒ a conflict b/w beliefs or
opinions & reality.
To resolve this dissonance people may
seek only selective exposure, selective
perception & selective retention.
3.1.1 Conservatism Bias
Definition Consequences
People place more emphasis on Slow to react new information.

information they used to form their Tendency to hold winners or losers
original forecast than on new too long.
information. Cognitive cost ⇒efforts required to
In Bayesian term⇒ people analyze new information.
overweight the base rates & under Cognitive cost of new information,
react to new information. underweight new information.
Guidance for Overcoming
Look carefully at new information

to determine its value.
Seek professional advice.

3.1.2 Confirmation Bias
Definition Consequences
People tend to look for & notice what Consider only the +ve information &
confirms their beliefs & undervalue ignore –ve information.
the contradict views. May be incorrect screening criteria.
It is a natural response to cognitive Under-diversified portfolios.
dissonance. Employees may overweight
employer’s stocks.
Guidance for Overcoming
One should seek out information

that challenges one’s beliefs.
Get corroborating support.
Do additional research.
3.1.3 Representativeness Bias
Definition Types
If-then heuristic where individuals i) Base-Rate Neglect

classify information into subjective
categories using heuristics.
Too little weight to the base rate
In Bayesian terms, investors tend to
underweight the base rates &
overweight the new information.
ii) Sample Size Neglect
Consequences Incorrect assumption ⇒ small sample

sizes are representative of population.
Too much weight to new information.
Emphasis is on new information.
Use simple classification rather than
deal with the mental stress of
updating beliefs given complex data Guidance for Overcoming
(low cognitive cost).
Under reliance on recent performance that
results in excessive trading & return.
Use a periodic table of investment returns that
ensure diversification over return chasing.
3.1.4 Illusion of Control Bias
Definition Consequences Guidance for Overcoming
Bias in which people tend to believe Excessive trading & inferior Investors should recognize that
that they can control outcomes, when performance. investing is a probabilistic activity.
infact they can’t. Less diversified portfolio. Seek contrary viewpoints.
Subjective probability of personal Keep records including reminders
success is. outlining the rationale behind each
trade.

3.1.5 Hindsight Bias
Individuals perceive outcomes (past Excessive risk because of false sense Carefully record & examine
events) as reasonable & expected. of confidence. investment decision.
People overweigh their predictions Unfair assessment of money Markets move in cycles so
because they are biased by the managers & security performance. expectations must be managed.
knowledge of what actually Investment managers must be
happened. evaluated relative to appropriate
benchmarks.
3.2 Information-Processing Biases
3.2.1 Anchoring and Adjustment Bias
Individual seem to be anchored to a Investors tend to remain focused on & Less weight to historical information.
value or number & then adjust the stay close to their original forecasts. Look at the basis for any
number to reflect new information. recommendations.
3.2.2 Mental Accounting Bias
Individual place each goal & the Layered pyramid format portfolios Create a portfolio strategy taking all
wealth, that will be used to meet each ignoring correlations among assets. assets into consideration.
goal, into a separate mental account. Consider income & capital gains Total return consideration.
separately.
Too much risk in search of
potential current income.
3.2.3 Framing Bias
Bias in which a person answers a More risk averse when presented Investors should focus on expected
question differently based on the way with a gain frame & more risk seeking return & risk rather than on gain or
in which it is asked. when presented with a loss frame losses.
Narrow framing ⇒ investors use too (sub optimal portfolios). When interpreting investment
narrow a frame of reference. Excessive trading. situations, investor should be neutral
& open minded.

3.2.4 Availability Bias
Bias in which people estimate the Advertisement based investment Follow a long-term strategic
probability of an outcome based on selection (retrievability). approach.
how easily the outcome comes to Limiting investment opportunity set Construct a suitable portfolio through
mind. (familiar categorizations). developing an IPS rather than relying
Easily recalled outcomes are Fail to diversify (narrow range of on more readily available information.
perceived as being more likely. experiences) & an appropriate asset
allocation (resonance).
Sources of Availability Bias
Retrievability Categorization Narrow Range of Experience
Refers to how easily an idea is Individual categorize information using Limited experience of investor will lead
recalled. classification they are most familiar with. to narrow focus to frame information.
The easier to retrieve a memory, the
more likely the individuals will use it
to classify new information. Resonance
Individuals tend to estimate other’s

choices using their own choices.
3.3 Cognitive Errors: Conclusion
Systematic process to describe problems & objectives, to document

decisions & the reasoning behind them& to compare the actual
outcomes with expected results will help to reduce cognitive errors.

4. EMOTIONAL BIASES
Harder to correct for than cognitive errors.

Recognize these biases & adapt to them.
4.1 Loss-Aversion Bias
Individuals focus on potential gains & Hold investments in a loss (gain) position longer (shorter) than justified Disciplined approach of investment
losses relative to risk rather than by fundamental analysis. based on fundamentals.
returns relative to risk. Limited upside potential. Base investment decisions on
Disposition effect ⇒ holding losing Excessive trading & riskier portfolio holdings. expectations rather than past
positions too long & selling gaining Framing & loss aversion biases may affect FMPs simultaneously. performance.
positions too quickly. House money effect ⇒ investors view profits as belonging to someone
else & become less risk averse when investing it.
Myopic loss aversion ⇒ investors overemphasize short-term gains &
losses & weight losses more heavily than gains.
Combine aspects of time horizon based framing, mental
accounting & loss aversion.
Higher than theoretically justified short-term equity risk premium.
If frequency of evaluation is , the probability of observing a loss
is .
4.2 Overconfidence Bias
Definition Types
People feel they know more than they i) Prediction Overconfidence

do because they feel they have more
or better information or better at
Too narrow confidence intervals.
interpreting information.
Poorly diversified portfolios.
ii) Certainty Overconfidence
Assign too high probabilities to outcomes.

Excessive trading.
Self-attribution bias ⇒combination of self enhancing bias (propensity

to claim too much credit for success) & self-protection bias (place
failure blame to someone or something else).
Overconfidence Bias
Consequences Guidelines to Overcome
Underestimate risk & overestimate Review trading records & calculate

expected returns. portfolio performance.
Excessive trading & poor Investors should be objective.
diversification.
Return than market.

4.3 Self-Control Bias
Individuals fail to balance the need for Insufficient savings for the future. Proper investment plan should be in
immediate satisfaction with long-term Accept too much risk by putting place.
goals. capital base at risk. Budgets help deter the propensity to
Suboptimal saving-consumption Asset allocation imbalance problem. over consume.
patterns.
Hyperbolic discounting ⇒ human
tendency to prefer small payoff now
compared to larger payoffs in the
future.
4.4 Status Quo Bias
Individual’s tendency to stay in their Portfolio risk characteristics may Education about risk, return &
current allocation rather than make differ from investors’ circumstances. diversification.
value enhancing changes. Fail to explore other opportunities. Proper asset allocation.
Outcome of the bias may be similar to One of the more difficult biases to
endowment & regret aversion bias mitigate.
but reasons differ among these
biases.
4.5 Endowment Bias
Bias in which people value an asset more Fail to replace certain assets when it is Inherited cash should be carefully
when they hold the rights to it than necessary. invested.
when they don’t. Inappropriate asset allocation. Research familiar as well as unfamiliar
Investors hold familiar assets. assets the investor may not hold.
Familiar assets can be replaced
gradually rather all at once.
4.6 Regret-Aversion Bias
Regret can arise from taking or not Too conservative attitude ⇒ long Education is primary mitigation tool.
taking action. term under performance & potential Efficient frontier research & proper
Error of commission ⇒ investor feel failure to reach investment goals. asset allocation.
regret from taking an action. Herding behavior.
Error of omission ⇒ investor feels
regret for not taking action.
Regret aversion can initiate herding
behavior (invest in similar fashion & in
the same stocks as others).
4.7 Emotional Biases: Conclusion
Focus should be on cognitive aspects of the biases than trying to alter an emotional response.
Education about portfolio theory can be helpful.

5. INVESTMENT POLICY ANDASSET ALLOCATION
Two approaches to incorporate behavioral finance considerations into

an IPS are:
Approaches
Goal-Based Investing Approach 5.1 Behaviorally Modified Asset Allocation
Identify an investor’s specific goals & associated risk tolerance. Standard asset allocation program ⇒ rational portfolio allocation
Investors are assumed to be loss averse rather than risk averse. (ignores behavioral biases).
More attractive approach for investors⇒ focused on wealth Investor’s interest ⇒ asset allocation that suits the investor’s
preservation. psychological preferences.
Riskier than appropriate asset allocation. In creating a modified portfolio:
Diversification but not efficient portfolios from a traditional finance Distinguish b/w emotional & cognitive biases.
perspective. Consider investor’s wealth level.
Risk may better understand but correlations among investments If a bias is adapted, the resulting portfolio represents an alteration
are not considered. of rational portfolio.
When a bias is moderated ⇒ resulting portfolio is similar to
rational portfolio.
5.1.1 Guidelines for Determining a Behaviorally Modified Asset Allocation
Two Guidelines
Guideline1 Guideline2
Decision to moderate or adapt biases Decision to moderate or adapt biases

depends on client’s level of wealth. depends on the type of behavioral
Wealthier the client, more likely it is bias.
to adapt the biases. Cognitive errors ⇒ moderated.
Emotional biases ⇒ adapted.
Wealth is determined based on level of assets & lifestyle.

Standard of living risk ⇒ risk that a specified life style may
not be sustainable.
5.1.2 How Much to Moderate or Adapt
To modify an allocation, no of asset classes used in the

allocation is important consideration.
Least (most) adjustment to the rational portfolio ⇒ low (high)
wealth level client with cognitive bias (emotional bias).
Middle of the road ⇒ high (low) wealth with cognitive
(emotional) biases (need to both adapt & moderate behavioral
biases).
Market participants may move up or down on efficient frontier
after considering client’s behavioral make up.

“BEHAVIORAL FINANCE AND INVESTMENT PROCESSES”

2. THE USES AND LIMITATIONS OFCLASSIFYING INVESTORS INTO TYPES
2.1 General Discussion of Investor Types
Models of Investor Psychographics
2.1.1 Barnewall Two-Way Model 2.1.2 Bailard, Biehl, and Kaiser Five-Way Model
(classify five investor personalities along two axes)
Passive Investors Active Investors
Confident axis Careful-impetuous axis

Investors who have become Risk own capital to gain
wealthy passively. wealth.
How confidently investor Whether then investor is
Risk averse and have a Prefer to maintain control of
approaches life. methodical, careful &
greater need for security. own investments.
Emotional choices. analytical in his approach to
Risk tolerance.
life.
Method of action can range
Five Investor Personality Types from carful to impetuous.
The Adventurer The Celebrity
Might hold highly concentrated portfolios. Like to be the center of attention.

Willing to take chances & likes to make own decisions. Might have opinions but recognizes limitations.
Advisors find them difficult to work with. Willing to seek & take advice about investing.
The Individualist The Guardian
Confident & careful. Cautious & concerned about the future.

Listen & process information rationally. Concerned about protecting their assets.
Likes to make own decisions after careful analysis. Seek advice of someone they perceive as more
knowledgeable.
The Straight Arrow
Sensible & secure.

Willing to take risk for expected return.
2.1.3 Behavioral Finance and Investment Processes Behavioral Investor Types
Two Methods
Bottom-Up Approach Top-Down Approach
Test for all behavioral biases in the client. Called behavioral alpha approach.
Create an appropriate IPS & behaviorally Simple & more efficient than a bottom-up approach.
modified asset allocation. Determine type of bias in the client & how to correct for
May be time consuming or complex. or adapt to the biases.

BF = Behavioral Finance BB = Behavioral Biases
Step in Top-Down Approach
Step 1 ⇒ interview the client & identify active or passive traits & risk tolerance.
Step 2 ⇒ the investor on the active/passive & risk tolerance scale.
Step 3 ⇒ tests for behavioral biases.
Step 4 ⇒ Classify investor into a behavioral investor type.
Passive Preserver (PP)
Low risk tolerance & are subject to emotional biases.

Emphasis on financial security & preserving wealth.
Most common emotional biases to PPs:
Endowment, loss aversion, status quo & regret aversion.
Cognitive errors:
Anchoring & adjustment & mental accounting.
Advising Passive Preserver
Difficult to advice (driven mainly by emotion).

Receptive to “big picture” advice.
Friendly Follower (FF)
Passive investors with low to medium risk tolerance.

Cognitive biases.
Prefer popular investments.
Overestimate risk tolerance.
Influenced by availability, hindsight, framing & regret aversion biases.
Advising Friendly Followers
Difficult to advise (overestimate their risk tolerance).

Education is usually the best course of action (cognitive errors).
Independent Individualist
Active investor with medium to high risk tolerance.

Strong willed & independent thinker (maintain their opinions).
Most likely to be contrarian & typically subject to cognitive errors.
Advising Independent Individualists
Difficult to advice but usually willing to listen to sound advice.

Regular educational discussion is effective
Active Accumulator
Active investor with high risk tolerance.

Most aggressive investors & primarily subject to emotional
biases.
Quick decision makers with risky investments.

Advising Active Accumulator
Most difficult client to advise (like control).

May lack self control.
Best approach to deal ⇒ take control of the situation.
2.2 Limitations of Classifying Investors into Various Types
Individuals may simultaneously display both emotional & cognitive biases.

Might display traits of more than one behavioral investor type.
As investors age, they will most likely go through behavioral changes.
Two individuals with same behavioral investor type are likely to require unique
treatment.
Individuals, tend to act irrationally at unpredictable time.
3. HOW BEHAVIORAL FACTORS AFFECT ADVISER- CLIENT RELATIONS
Goal of the client/adviser relationship ⇒ construct a portfolio with

which a client is comfortable.
Portfolio should serve the client’s longer term goals.
BF can enhance the following important areas of every successful
advisory relationship.
3.1 Formulating Financial Goals
BF helps adviser to understand the reasons for the client’s goals.
3.2 Maintaining a Consistent Approach
BF adds structure & professionalism to the relationship.
3.3 Investing as the Client Expects
Area that can be most enhanced by incorporating BF

Adviser is fully awared of what actions to perform &
what information to provide.
3.4 Ensuring Mutual Benefits
Incorporating BF into client/adviser relationship act as a

closer bond b/w them.
3.5 Limitations of Traditional Risk Tolerance Questionnaires
Risk tolerance questionnaires:

Ignore behavioral issues.
Can generate different results when applied repeatedly.
May not be revised.
Adviser may interpret the results of such questionnaire too literally.
May work better for institutional investors.

4. HOW BEHAVIORAL FACTORS AFFECTPORTFOLIO CONSTRUCTION
BB affects how investors construct

portfolio from the securities available
to them.
4.1 Inertia and Default
In most DC plans members show inertia & do not ∆ their asset

allocation.
Target date funds ⇒ fund that automatically switch from risky
assets to fixed income assets as the plan member nears the
intended retirement date.
Standardized strategy (one size fits all solution).
4.2 Naive Diversification
Allocating an equal proportion of assets to each fund

alternative.
Also called 1/n naïve diversification strategy & often used by
DC plans.
Conditional 1/n strategy ⇒ allocation equally among chosen
subset of funds.
Such strategies minimize future regret from one asset class
beating the other.
4.3 Company Stock: Investing in the Familiar
Reasons why employees have a tendency to invest in their

company’s stocks:
Familiarity bias.
Overconfidence.
Naively extrapolate past returns.
Framing.
Loyalty effect & financial incentives.
4.4 Excessive Trading
Investors with retail accounts appear to be more active trades

(overconfidence which leads to excessive trading).
Disposition effect⇒ selling winners too soon & holding losers
too long.
4.5 Home Bias
Proportion of assets in the stocks of firms listed in home

country.
Closely related to familiarity.

5. BEHAVIORAL FINANCE AND ANALYST FORECASTS
5.1 Overconfidence in Forecasting Skills
Undue faith in forecasting ability.

Several behavioral biases that contribute to overconfidence:
Illusion of knowledge bias.
Self attribution bias.
Representativeness bias
Availability bias.
Hindsight bias.
5.1.1 Remedial Actions for Overconfidence and Related Biases
Self calibration ⇒ process of remembering previous forecasts

more accurately.
Well structured feedback, unambiguous forecasts &
systematic review process can reduce hindsight bias.
Counter arguments, appraisal by colleagues, superiors as well
as self appraisal can help to control overconfidence.
Incorporate additional information with a Bayesian approach.
5.2 Influence of Company's Management on Analysis
The way a company’s management frames information can

influence how analysts interpret it & include it in their forecasts.
Three cognitive biases frequently seen when management
reports company results:
Framing
Anchoring & adjustment
Availability
Analysts should also look for self attribution bias that arises from
the impact of incentive compensation on company reporting.
5.3 Analyst Biases in Conducting Research
Biases are usually related to analysts collecting too much information

some biases are:
Illusion of knowledge & control.
Representativeness bias.
Confirmation bias.
Gambler’s fallacy⇒thinking that there will be a reversal to long-term
mean more frequently than actually happens.
Hot hand fallacy ⇒ wrongly project continuation of a recent trend.
Endowment bias.
5.3.1 Remedial Actions for Analyst Biases in Conducting Research
Focus on more objective data.

Collect information in a symmetric way.
Assign probabilities to base rates.
Consider the search process, limits& context of information.
Prompt feedback & document decision making.

6. HOW BEHAVIORAL FACTORS AFFECTCOMMITTEE DECISION MAKING
In a group setting, the individual biases mentioned before can be

either diminished or amplified with additional biases being created.
Social proof bias ⇒ bias in which individuals are biased to follow the
beliefs of a group.
Typically a group will have more confidence in its decisions (leads to
overconfidence bias).
6.1 Investment Committee Dynamics
Committee decision can be improved by carefully analyzing

& learning from past decisions & good quality feedback.
Changing committee membership can be unhelpful.
6.2 Techniques for Structuring and Operating

Committees to Address Behavioral Factors
Committee should be made up of members from diverse

backgrounds.
Ensure professional respect & analysts self esteem.
Collect individual views in advance of discussion (can
suppressed privately held information).
7. HOW BEHAVIORAL FINANCEINFLUENCES MARKET BEHAVIOR
Anomalies are identified by persistent abnormal returns that

differ from zero & are predictable in direction.
Some apparent anomalies may be explained by:
Small sample involved.
Selection or survivorship bias.
Data mining.
7.2 Momentum
Momentum effect ⇒ pattern of returns that is correlated

with the recent past.
Return are +vely correlated in short term (up to 2 years) &
-vely correlated in long term (revert to the mean).
Several forms of Biases.
Herding
Availability bias (extrapolate trends).
Hindsight bias (trend chasing effect).
Disposition effect (mean reversion at longer periods
of three to five years).

7.3 Bubbles and Crashes
Bubble & crashes ⇒ respectively periods of unusual +ve or –ve return.

Bubbles typically develop more slowly relative to crashes (due to
difference in behavioral factor involved).
A no. of cognitive & emotional biases during such periods are:
Overconfidence.
Confirmation & self attribution bias.
Hindsight.
Illusion of knowledge.
Disposition effect.
Anchoring.
7.4 Value and Growth
Studies have identified that the value stocks have outperformed relative
to growth stocks.
Halo affect ⇒ investor transfers favorable company attribute into thinking
that the stock is a good buy.
Behavioral explanations present the anomalies as mispricing rather than
risk.
Overconfidence in predicting growth rates (growth stocks over valuation).
Home bias anomaly ⇒ investors favor investing in domestic country as
compared to foreign countries.

“MANAGING INDIVIDUAL INVESTOR PORTFOLIOS”

SAA = Strategic Asset Allocation
CF = Cash Flow
MCS = Monte Carlo Simulation
3. INVESTOR CHARACTERISTICS
3.1 Situational Profiling
Categorizing individual investors based on their situational

characteristics.
Investor’s basic philosophy & preferences that facilitate the
discussion of investment risk with the investors.
Approaches of Situational Profiling
3.1.1 Source of Wealth 3.1.2 Measure of Wealth
Manner of acquiring wealth offers insight into an investor’s If investor perceives his holdings as small (large), may
risk attitude. demonstrate a low (high) tolerance for portfolio volatility.
Active investors (e.g. successful entrepreneurs) exhibit a Low return (high return) portfolio as compared to lifestyle is
higher level of risk tolerance. considered small (large).
Reluctant to cede control to a third party.
Passive recipients of wealth (e.g. inherited wealth) may be
associated with reduced willingness to assume risk.
3.1.3 Stage of Life
i) Foundation Phase ii) Accumulation Phase
Individual’s base establishment Income accelerates & gradually

phase. reaches its peak.
Long-time horizon & above avg. Risk tolerance, wealth &
risk tolerance. long-term time horizon.
Very few investable assets.
iii) Maintenance Phase iv) Distribution Phase
Individual moves into the later Accumulated wealth is

years of life. transferred to other persons or
Risk tolerance & time horizon. entities.
Goal ⇒ preserving wealth. Tax constraints & transfer
strategies often become
important consideration.

3.2 Psychological Profiling
3.2.1 Traditional Finance 3.2.2 Behavioral Finance
Investors are risk averse. Individual investors are:

Investors hold rational Loss averse.
expectations. Hold biased expectation.
Evaluate investments in portfolio Portfolio construction
context. through pyramiding.
Economic considerations. Economic & subjective
considerations.
3.2.3 Personality Typing
Cautious Investors Methodical Investors
Risk averse to potential losses. Undertake research on trading strategies.

Strong need for financial security. No emotional attachments to investment
Prefer low turnover & low volatility. positions.
Often missed opportunities due to over Conservative investors.
analysis.
Spontaneous Investors Individualistic Investors
Highest portfolio turnover ratio& below avg. Place a great deal of faith in handwork.
return. Not afraid to exhibit investment independence
Quick to make investment decisions. in taking a course of action.
More concerned with missing an investment
trend.
4. INVESTMENT POLICY STATEMENT
A well constructed IPS:

Presents the investor’s financial objectives & constraints.
Sets operational guidelines for constructing a portfolio.
Establish basis for portfolio monitoring & review.
Is portable & easily understandable.
Document that protects both the advisor & the individual
investor.

4.1 Setting Return and Risk Objectives
Required Return Desired Return
Return level necessary to achieve the Return level associated with investor’s secondary
investor’s primary or critical long-term goals.
objectives.
Total return approach should be followed.
Generally driven by annual spending & long-
term saving goals.
When an investor’s return objectives are inconsistent with his risk tolerance, a
resolution is required.
If portfolio’s expected return> investor’s return objective then:
Assume less risk to protect the surplus.
Use the surplus for assuming greater risk.
All CFs should be treated the same way (e.g. all should be after-tax).
Determine the amount of investable assets:
If any cash outflow in six months ⇒ PV of outflow should be subtracted
from the investable assets.
If inflows> expenses, the additional should be added to investable assets.
4.1.2 Risk Objective
Ability to Take Risk Willingness to Take Risk
Subject to quantitative measurement. Subjective assessment.

Determine the investor’s short-term & long- Psychological profiling provides useful
term financial needs & goals. estimates of an individual’s willingness to take
Determine the importance of these goals. risk.
Determine the investment shortfall that Important considerations are:
investor’s portfolio can bear. Personality type.
Important considerations are: Portfolio holdings.
Liquidity needs. Implicit or explicit statements.
Time horizon.
Portfolio size.
Goals.
State whether the client’s ability & willingness is below avg.,

“avg.” or “above avg.”.
Overall risk tolerance ⇒ lesser of the two if they are in conflict.
4.2 Constraints
4.2.1 Liquidity
Portfolio’s ability to efficiently meet an investor’s anticipated &

unanticipated demands for cash distributions.
the liquidity needs,the investor’s ability to bear risk.

Reasons for Liquidity Requirements
Ongoing Expenses Emergency Reserves
One of the portfolio’s highest priorities. Precaution against unanticipated events.

Should be met with liquid investments due to Reserve size ⇒ 3 months to more than 1 year
short time horizon. of the client’s anticipated expenses.
Negative Liquidity Events
For example a significant charitable gift, home repairs etc.

As time horizon to such events, liquidity needs.
Transaction costs & price volatility are two characteristics that
determine a portfolio’s liquidity.
IPS should specifically identify significant illiquid holdings (e.g.
home or primary residence).
Sometimes the home is treated as a long term investment
used to meet long-term housing needs or estate planning
goals.
4.2.2 Time Horizon
Long-term time horizon if > 15 or 20 years.

Short-term time horizon if < 3 years.
Intermediate to long term if 3-15 years.
Time horizon can be a single stage or multistage.
A shift from one stage to another stage occurs when client’s
objectives & constraints change.
4.2.3 Taxes
Widely recognized categories of taxes are:

Income tax.
Gains tax.
Wealth transfer tax.
Property tax.
Different tax strategies to minimize the impact of taxes includes:
Tax deferral.
Tax avoidance.
Tax reduction.
4.2.4 Legal and Regulatory Environment
Frequently involve taxation & the transfer of personal property

ownership.
Prudent investor rule may apply if manager is acting in a
fiduciary capacity.

The Personal Trust
Established by the grantor.

Funded when grantor transfers legal ownership of designated
assets to the trust.
Two types.
Revocable trust ⇒ grantor retains control over assets & is
responsible for any tax liability.
Irrevocable trust ⇒ trust is responsible for tax liability &
terms of the trust are fixed.
4.2.5 Unique Circumstances
Might include guidelines for social or special purpose investing.

List of assets held outside the investment portfolio.
Some examples are:
Concentrated position in low basis stock.
Significant amount of assets for charity purpose.
Significant unusual expenditure.
5. AN INTRODUCTION TO ASSET ALLOCATION
5.1 Asset Allocation Concepts
Process of elimination is used to arrive at appropriate SAA.

Process of selecting most satisfactory allocation consists of the
following steps:
Determine the allocations that meet the investor’s return
requirement.
Eliminate allocations that fail to meet risk objectives.
Eliminate asset allocations that fail to satisfy the investor’s stated
constraints.
Evaluate the expected risk adjusted performance & diversification
attributes.
5.2 Monte Carlo Simulation (MCS) in Personal Retirement Planning
MCS is generally superior to deterministic approach because:

It incorporates path dependency effect & assumptions variability.
It generates probability distribution of final value rather than a
single point estimate.
It allows projections of best & worst case scenarios.
It can capture the variety of portfolio changes.
MCS users should:
Choose a simulation that simulates the performance of specific
investments & takes into account the tax consequences.
Be aware that simulation is input dependent.
Drawbacks:
Can be biased by the perceptions of the analyst.
Actual results may differ from simulated results.

“TAXES AND PRIVATE WEALTH MANAGEMENT

IN A GLOBAL CONTEXT”
TDA = Tax Deferred Accounts LIFO = Lowest in, First Out HIFO = Highest in, First Out
SD = Standard Deviation
2. OVERVIEW OF GLOBAL INCOME TAXSTRUCTURES
Sources of Govt. Tax Revenue
Taxes on Income Wealth-Based Taxes Taxes on Consumption
Taxes on ordinary & Taxes on the holding of Sales tax.

investment income certain types of property. Value added taxes.
Wealth transfer taxes.
2.1 International Comparisons of Income Taxation
2.2 Common Elements
Types of tax structures:

Progressive tax rate structure ⇒tax rate as income.
Flat tax rate structure ⇒ all taxable income is taxed at the
same rate.
Marginal tax rate ⇒ rate paid on the next $ of income earned.
2.3 General Income Tax Regimes
Classification of Income Tax Regime

Regime l-Common 2 – Heavy 3 – Heavy 4- Heavy 5 – Light Capital 6 – Flat and Light 7 - Flat and Heavy
Progressive Dividend Tax Capital Gain Tax Interest Tax Gain Tax
Ordinary Tax Progressive Progressive Progressive Progressive Progressive Flat Flat
Rate Structure
Interest Some interest Some interest Some interest Taxed at Taxed at Some interest taxed Some interest taxed
Income taxed at taxed at taxed at ordinary rates ordinary rates at favorable rates at favorable rates or
favorable rates favorable rates favorable rates or exempt exempt
or exempt or exempt or exempt
Dividends Some dividends Taxed at Some dividends Some dividends Taxed at Some dividends Taxed at ordinary
taxed at ordinary rates taxed at taxed at ordinary rates taxed at favorable rates
favorable rates favorable rates favorable rates rates or exempt
or exempt or exempt or exempt
Capital Gains Some capital Some capital Taxed at Some capital Some capital Some capital gains Taxed at ordinary
gains taxed gains taxed ordinary rates gains taxed gains taxed taxed favorably or rates
favorably or favorably or favorably or favorably or exempt
exempt exempt exempt exempt
Reference: Level III Curriculum, Volume 2, Reading 9.

2.4 Other Considerations
Some countries permit TDA that:

Defer taxation on investment returns.
May permit a deduction for contributions.
May occasionally permit tax-free distributions.
3. AFTER-TAX ACCUMULATIONS AND RETURNS FOR TAXABLE ACCOUNTS
3.1 Simple Tax Environments
3.1.1 Return Based Taxes: Accrual Taxes on Interest and Dividend
Accrual taxes ⇒ levied & paid on a periodic basis, usually annually.

= 1 + 1 −
Where
= Future value interest factor after investment tax.
r = before tax return
= tax on investment income.
n = no. of periods.
Tax drag $ = returns without tax - returns with tax.
$
% =

Important considerations:
Tax drag > tax rate.
Tax drag $ & % has a direct relation with investment horizon & investment
return.
3.1.2 Returns-Based Taxes: Deferred Capital Gains
Tax on an investment’s returns is deferred until the end of investment horizon.

= 1 + 1 − +
2nd term-returns the tax associated with the initial investment.
Important consideration:
Tax drag% = tax rate.
Value of a capital gain tax deferral has a direct relation with investment return &
time horizon.
3.1.3 Cost Basis
Cost basis ⇒ amount that was paid to acquire an asset.

Cost basis has inverse relation with taxable gains.
= 1 + 1 − + ×
Lower the base, lower the future accumulation.
3.1.4 Wealth-Based Taxes
Wealth tax rate tends to be much lower than income tax rates (applied to the entire capital base).
= 1 + 1 −
Important consideration:
Tax drag > tax rate.
Tax drag as returns.
Tax drag as investment horizon.

3.2 Blended Taxing Environments
Investment returns may simultaneously include interest, dividend, realized &

unrealized capital gains.
Realized tax rate ⇒ applicable to interest, dividend & realized capital gains.
Realized tax rate = + +
=
1 −
To incorporate deferred capital gain taxes:

=

= 1 + 1 − + − 1 −
3.3 Accrual Equivalent Returns and Tax Rates
Accrual equivalent after-tax return ⇒ tax free return

that produces the same after tax accumulations as the
taxable portfolio.
Tax drag = taxable return – accrual equivalent return.
3.3.1 Calculating Accrual Equivalent Returns
!

= −1

Incorporates the impact of deferred taxes on
realized gains as well as taxes that accrue
annually.
RAE approaches to pretax return as:
Time horizon increases.
More returns are deferred.
3.3.2 Calculating Accrual Equivalent Tax Rates

= 1 −

can be used to measure the tax efficiency of

different asset classes or management styles.
Can be used to assess the impact of future tax law
changes.
4. TYPES OF INVESTMENT ACCOUNTS
Future accumulation depends heavily on the type of account in which assets are
held.
Most of investment accounts can be classified into three categories:
Taxable accounts.
Front-end loaded tax benefits or tax deferred accounts.
Back-end loaded tax benefits or tax exempt accounts.

4.1 Tax-Deferred Accounts
" = 1 + 1 −
Assets held in a TDA accumulate on a tax-
deferred basis, assuming cost basis equal to zero.
4.2 Tax-Exempt Accounts
# = 1 +
Contributions are made after tax.
Difference with TDA:
The taxing authority owns of the principal
value of a TDA.
Assets in TDA have built in tax liability.
4.3 After-Tax Asset Allocation
Allocation on an after-tax basis can be difficult

because:
After-tax value is time horizon dependent which
is difficult to estimate & may ∆ over time.
Improving client awareness on after tax basis can
be challenging.
4.4 Choosing Among Account Types
Contributions to TDAs are tax deductible whereas

contributions to tax exempt accounts generally are not.
If > $then value of TDA < value of tax exempt
account & vice versa.
Where $ is applicable to tax exempt account at time 0.
5. TAXES AND INVESTMENT RISK
If investment returns are subject to tax, govt. shares

risk & return with the investor.
SD of after tax return for a taxable account is:
% 1 −
6. IMPLICATIONS FOR WEALTH MANAGEMENT
Tax alpha ⇒ value created (tax savings) by using

investment techniques.

6.1 Assets Location
A well-designed portfolio prescribes a proper asset allocation & asset location.

Company should place heavily taxed assets within the pension fund & locate more lightly taxed
securities outside the fund.
Place tax-free municipal bonds in a taxable accounts & more heavily taxed stocks in a TDA.
6.2 Trading Behavior
Trader Active Investor
Trades frequently. Trades less frequently.

Accumulates the least amount of wealth. Longer term gains & more favorable tax
Recognizes all portfolio returns in the form of treatment.
annually taxed short term gains.
Passive Investor Exempt Investor
Passively buys & holds stocks. No capital gains tax liability.

More accumulation than active investors Accumulates the highest amount of wealth.
Follow buy & hold strategy.
6.3 Tax Loss Harvesting
Tax loss harvesting ⇒ process of reducing the current year’s tax obligation
through realizing a loss to offset a gain.
May be subject to limitations.
At a minimum, tax loss harvesting in current period can create time value of
money through reinvestment of tax savings.
HIFO ⇒ sell the highest cost basis lots first.
Suitable when tax rates are expected to.
LIFO ⇒ liquidate low basis stock first.
Suitable if current tax rate is temporarily low.
6.4 Holding Period Management
Strategies to reduce taxes by varying the holding period depending on the magnitude of gain from waiting.
Usually &'
( >
( , in order to produce same after tax results
&'
( must be >
( .
6.5 After-Tax Mean-Variance Optimization
In developing an after-tax MVO model consider:

Accrual equivalent return instead of pretax return.
After-tax SD instead of pretax SD.
Optimization process must include some constraints (e.g. limited amount to TDA
account).

B.S = Balance Sheet
CF= Cash flow “ESTATEPLANNING IN A GLOBAL CONTEXT”
2. DOMESTIC ESTATE PLANNING: SOME BASIC CONCEPTS
2.1 Estates, Wills, and Probate
Estate ⇒ all of the property a person owns or controls.

Estate planning ⇒ process of preparing for the disposition of one’s estate.
Will or testament ⇒ rights other will have over one’s property after death.
Testator ⇒ person whose property is disposed of according to the will.
Probate ⇒ legal process to confirm validity of a will.
Individuals wish to avoid probate because of the associated sizeable court fees
& other issues.
2.2 Legal Systems, Forced Heir ship, and Marital Property Regimes
Legal System
Civil Law Common Law
Developed primarily through Developed primarily through

legislative statutes or executive decisions of courts.
action. Trace their heritage to Britain.
May not recognize trust.
Forced heirship rules ⇒ children have a right to a portion of a parent’s estate.

Wealthy individuals might try to avoid forced heir ship rules (through
gifting assets or moving them into a trust).
Claw back provisions are used to prevent this practice.
Community property rights regimes ⇒ each spouse is entitled to one-half of the
estate earned during the marriage.
Separate property regimes ⇒ each spouse owns & controls his/her property,
separate from the other.
2.3 Income, Wealth, and Wealth Transfer Taxes
Taxes are levied in one of the four general ways:

Income tax.
Tax on spending.
Wealth tax.
Tax on wealth transfer.
Gift taxes or lifetime gratuitous transfers⇒ apply to lifetime gifts.
Testamentary gratuitous transfer ⇒ transferring assets upon one’s death.

3. CORE CAPITAL AND EXCESS CAPITAL
Life B.S ⇒ comprehensive accounting of an investor’s explicit & implied assets &
liabilities.
Implied assets ⇒ PV of one’s employment capital & expected pension benefits.
Implied liabilities ⇒capitalized value of the investor’s desired spending goals.
Core capital ⇒ amount of capital to fund spending, to maintain a give lifestyle,
fund goals & adequate reserves for unexpected commitments.
Excess capital ⇒ capital that can be transferred to others without jeopardizing
the investor’s lifestyle.
3.1 Estimating Core Capital with Mortality Tables
Core capital can be estimated in the following ways:

Forecast nominal (real) spending needs & discount these using
nominal (real) discount rates.
Spending needs can be forecasted by multiplying each CF with survival
probability.

= ℎ
+

−
ℎ
× (

).
PV of the spending needs is equal to:

×

=
1 +

Sum of each year’s PV of expected spending represents the investor’s
core capital.
3.1.1 Safety Reserve
PV of spending needs underestimates the true core capital needs

(no guarantee that capital markets will produce return>RF).
Solution ⇒incorporates a safety reserve.
Size of reserve can be based on a subjective assessment of
circumstances.
3.2 Estimating Core Capital with Monte Carlo Analysis
Estimate the size of a portfolio needed to generate sufficient

withdrawals to meet expenses (inflation adjusted).
Provides a range of possible outcomes & hence captures the risk
more appropriately.
Ruin probability of depleting one’s financial assets before death.
return improves sustainability & requires core capital to
generate same level of spending.

4. TRANSFERRING EXCESS CAPITAL
4.1 Lifetime Gifts and Testamentary Bequests
4.1.1 Tax-Free Gift
Tax reliefs may apply to gifts from donors.

Gifts can escape transfer tax by falling below periodic or lifetime allowances.
Appreciated assets can effectively be transferred, if subject to exclusions or tax reliefs.
Relative after-tax value of a tax-free gift:

1 + 1 −

= =
1 + 1 − 1 − !
where
! = estate tax if asset is bequeathed.
& = pretax return to the gift recipient & the estate making the gift.
! &! = effective tax rates on investment returns (both recipient & estate making the gift).
n = time until the donor’s death.

If pretax return & effective tax rates are equal, the relative value reduces to
೐
4.1.2 Taxable Gifts
Value can be added even when a lifetime gift is taxable.

After-tax future value of the gift:

1 + 1 − 1 − !
= =
1 + 1 − 1 − !
Assumes that gift tax is paid by the recipient rather than the donor.
If after tax returns gift = return of assets to be bequeathed, the value of a taxable gift reduced to
೒
೐
Another strategy ⇒ gift asset with E(R) to the 2nd generation.
4.1.3 Location of the Gift Tax Liability
If the tax liability is imposed on the donor’s taxable estate, the size of
the estate & hence the ultimate estate tax.
Relative after-tax value of the gift when the donor pays gift tax:

1 + 1 − 1 − ! + ! !
= =
1 + 1 − ! 1 − !
4.2 Generation Skipping
Transferring assets directly to the third generation or beyond may

reduce transfer taxes (avoid layer of double taxation).

where !is tax rate on 1st

=
భ
generation
Some jurisdictions discourage generation skipping transfer tax.
4.3 Spousal Exemptions
Allow decedents to make bequests & gifts to their spouses without

transfer tax liability.
It is advisable to transfer the exclusion amount to someone other than
the spouse ( the taxable value of the surviving spouse’s estate).

4.4 Valuation Discounts
Taxes might also be mitigated by transferring assets

that qualify for valuation discounts.
Valuation discounts can be:
Illiquidity discount.
Discount for lack of control.
4.5 Deemed Dispositions
Some counties treat bequests as deemed

disposition (as if the property were sold).
Tax is levied on the value of unrecognized gains.
4.6 Charitable Gratuitous Transfers
Two forms of tax relief:

Most donations are not subject to a gift transfer tax.
Most jurisdictions permit income tax deductions.
Non-profit making organizations may also be exempt from taxation.
Relative after-tax future value:
1 + + ! 1 + 1 − 1 − !

!"
!" = =
1 + 1 − 1 − !
Toi = tax rate on ordinary income
5. ESTATE PLANNING TOOLS
5.1 Trusts
An arrangement created by a settlor or granter who transfers assets to a trustee.

Trust document ⇒ document containing terms of the trust relationship.
Trusts can be used to reduce taxes, to protect assets & to retain control over assets even after transfer.
Categories of Trust
Revocable Trust Irrevocable Trust Fixed Trust Discretionary Trust
Settlor retain the rights & Settlor has no ability to Distributions to beneficiaries Trustee determines whether
responsible for tax payment. revoke the trust relationship. are prescribed in the trust & how much to distribute.
Creditor can claim trust Trust assets are protected document (amount & time).
assets. against creditors’ claims.
Trustee pays tax.
5.2 Foundations
Mostly act similar to trusts:

Allow settlor’s wishes to follow after settlor’s death.
Asset protection.
Tax minimization.

5.3 Life Insurance
Policy holder transfer premium to an insurer who has a contractual

obligation to pay death benefits to the beneficiary.
Death benefits & premium paid are tax exempt in most jurisdictions.
Also serve as a liquidity planning technique & offer asset protection.
Insurance policy can assign a discretionary trust (if beneficiaries are
unable to manage the assets themselves).
5.4 Companies and Controlled Foreign Corporations
Controlled foreign corporation (CFC) ⇒ a company located outside

a tax payer’s home country (tax payer has a controlling interest).
Benefits of placing income generating assets in CFC include:
Tax Deferrals.
Tax avoidance.
6. CROSS-BORDER ESTATE PLANNING
6.2 Tax System
Source jurisdiction or territorial tax system ⇒ country

that taxes income as a source within its borders.
Residence jurisdiction ⇒ taxes based on residency.
Tax System
6.2.1 Taxation of Income 6.2.2 Taxation of Wealth and Wealth Transfers
Individuals subject to residence Source principle ⇒ tax assets that are

jurisdiction are taxed on their economically sourced or transferred within a
worldwide income. particular country.
Residency tests may consider Residence principle ⇒ imposes transfer tax
subjective as well as objective on all assets transferred by donor.
standards.
6.2.3 Exit Taxation
Tax on unrealized gains accrued on assets leaving the jurisdiction.

May also include an income tax on income earned over a fixed
period after expatriation called “shadow period”.
6.3 Double Taxation
Residence-residence conflict ⇒ two countries may claim

residence of the same individual.
Source-source conflict ⇒ two counties may claim source
jurisdiction of the same asset.
Residence –source conflict is most common source of
double taxation.

6.3.1 Foreign Tax Credit Provisions
Residence-source conflict can be resolved using one or more of the following methods:
Credit method ⇒!!# = "# !#$% , !#%
Exemption method ⇒!&# = !#%
Deduction method ⇒!'# = !#$% + !#% − !#$% !#%
6.3.2 Double Taxation Treaties
Intended to facilitate international trade &

investment by eliminating double taxation.
DTTs typically do not resolve source-source conflict.
6.4 Transparency and Offshore Banking
Tax avoidance ⇒ legal tax minimizing or tax avoidance

strategies.
Tax evasion ⇒ illegal means to circumvent tax obligation.

“CONCENTRATED SINGLE-ASSET POSITIONS”

CP = Concentrated Position
1. INTRODUCTION
EM = Equity Monetization
Three major types of concentrated positions in a single asset:

Publicly traded stock.
Privately owned business.
Commercial or investment real estate.
Concentrated positions are often illiquid assets.
2. CONCENTRATED SINGLE-ASSET POSITIONS: OVERVIEW
No universally accepted threshold exists for concentrated position.

CP is often a long period held position with very low cost basis.
Publicly traded single-stock positions:
Ways an investor can end up owning a concentrated stock position:
Part of executive compensation.
Received a significant amount of stock in share-based sales
transaction.
Came from long term buy-end-hold investing strategy.
Privately owned business:
Usually private businesses with ownership transfer from one generation
to next.
Investment real estate.
Commercial or industrial real estate typically held for a long-term period.
2.1 Investment Risks of Concentrated Positions
2.1.1 Systematic Risk 2.1.2 Company-Specific Risk
Can’t be eliminated by holding a well- Non-systematic or idiosyncratic risk

diversified portfolio. to a particular company’s operations,
Multiple sources of systematic risk reputation & business environment.
e.g. business cycle, inflation etc. High level of company specific risk
exists in a CP.
the volatility with company
2.1.3 Property-Specific Risk specific risks of single-stock holdings,
the benefit of higher capital
Unsystematic risk of owning a particular accumulation.
piece of real estate

3. GENERAL PRINCIPLES OF MANAGING CONCENTRATED SINGLE-ASSET POSITIONS
3.1 Objectives in Dealing with Concentrated Positions
3.1.1 Typical Objectives 3.1.2 Client Objectives and Concerns
Reduce the risk of wealth Many objectives that the owner of

accumulation. the CP might wish to achieve
To generate liquidity to diversify & including:
satisfy spending needs. To maintain effective control.
To optimize tax efficiency. To enhance current income.
3.2 Considerations Affecting All Concentrated Positions
3.2.1 Tax Consequences of an Outright Sale 3.2.2 Liquidity
Significant taxable capital gains possible in CP is generally illiquid.

CP due to lower cost basis. Illiquidity generally acts as a
Primary objective ⇒ deferring or constraint with a CP.
eliminating C.G tax if possible.
3.3 Institutional and Capital Market Constraints
3.3.1 Margin-Lending Rules 3.3.2 Securities Laws and Regulations
If the purpose of the loan is to buy Company insiders & executives must
additional securities, the maximum often comply with these law’s
loan proceeds are usually quite
limited.
3.3.3 Contractual Restrictions and Employer Mandates 3.3.4 Capital Market Limitations
These generally restrict the flexibility of insider & Various characteristics of the
employees to either sell or hedge their shares & include underlying stock determine the
lockups or blackout periods feasibility of hedging different CPs &
degree of hedge.
3.4 Psychological Considerations2
3.4.1 Emotional Biases 3.4.2 Cognitive Biases
Following emotional biases can –vely affect the decision These include:
making of holders of CPs: Conservatism & confirmation bias.
Familiarity & overconfidence bias. Illusion of control, anchoring & adjustment.
Status quo bias. Availability heuristic.
Endowment effect.
Careful handling of client to overcome emotional
biases.

3.5 Goal-Based Planning in the Concentrated-Position Decision-Making Process
Goal based planning ⇒ one way to incorporate psychological considerations into

allocation & portfolio construction.
Personal risk bucket:
Goal is to protect from poverty or dramatic in life style.
Yield below market return but limit losses.
Market risk bucket:
Objective is to maintain current living standard.
Avg. risk adjusted market return (stock & bond portfolio).
Aspirational risk bucket:
Objective is to wealth substantially.
Above market expected return but with substantial risk of loss of capital.
Primary capital ⇒ minimum amount to maintain owner’s lifetime spending needs
(usually allocated to personal & market risk bucket).
Surplus capital ⇒ allocation to aspirational risk bucket.
3.6 Asset location and Wealth Transfers
Asset location decision ⇒ choice of where to place specific assets (different from
asset allocation decision).
Usually used to minimize transfer tax.
Wealth transfers
Early planning of wealth transfer enables the owner to shift future wealth with
little or no transfer tax.
Direct gifting is suitable before the concentrated position has appreciated
greatly.
Estate tax freeze ⇒ owners transfer a junior equity interest to the children that
will receive most or all of the future appreciation of the enterprise.
After significant appreciation, technique include:
Contribute the CP to an entity such as family limited partnership.
3.7 Concentrated Wealth Decision Making: A Five-Step Process
Five step process that best satisfy the objectives of holders of CPs.
Identify & establish objectives & constraints.
Identify tools that can satisfy these objectives.
Compare tax advantages & disadvantages.
Compare non-tax advantage & disadvantages.
Formulate & document an overall strategy.
4. MANAGING THE RISK OF CONCENTRATED SINGLE – STOCK POSITIONS
Diversification generally considered prudent to minimize risk from CPs.

Tools to mitigate the risks of concentrated position.
Outright sale ⇒ give funds but often incurs significant tax liabilities.
Monetization strategies ⇒ these provide owners with funds without
triggering a taxable event (e.g. loan against CPs).
Hedging the value of the concentrated asset through derivative.

4.1 Introduction to Key Tax Considerations
Internal inconsistency of tax codes provides an

opportunity for well diversified investors to reap
substantial tax savings.
4.2 Introduction to Key Non-Tax Considerations
Key non-tax considerations when deciding whether to use an

exchange traded or OTC derivative including:
Counterparty credit risk.
Ability to close out transaction prior to stated expiration.
Price discovery & transparency of fees.
Flexibility of terms.
Minimum size constraints.
4.3 Strategies
Three common strategies that investors use in the case of a CP in a

common stock.
Equity monetization.
Hedging.
Yields enhancement.
4.3.1 Equity Monetization
Equity monetization ⇒ transformation of a CP into cash usually in a

way to avoid current taxable event.
EM entails a two step process.
To remove a large position of risk inherent in the CP (hedging).
To borrow against the hedged positions.
4.3.1.1 Equity Monetization Tool Set
A Short sale against the box A total return equity SWAP
Shorting a security that is held long. Contract for a series of exchanges of the total return
Any future ∆ in stock price will have no effect on the on a specified asset in return for specified fixed or
investor’s economic position. floating payments.
Investor will earn money market return. Investor is fully hedged as in short sale strategy.
Least expensive technique. Money market rerun slightly less than what would be
on short sale strategy.
Forward conversion with options Equity forward sale contract
Synthetic short forward positions against the asset Private contract for the forward sale
held long. of an equity position.
Pay off of a short forward = pay off of a long put & a Money market returns
short call on same asset.
Money market return.

4.3.1.2 Tax Treatment of Equity Monetization Strategies
EM eliminates concentration risk & generates cash approximately equal to

outright sale.
Critical question ⇒ whether an EM strategy will be treated as a taxable
event for tax purpose in a particular country.
4.3.2 Lock-in Unrealized Gains: Hedging
4.3.2.1 Purchase of Puts 4.3.2.2 Cashless (Zero-Premium) Collars
Investors of CP can buy put option to These are used to:

Lock in floor price. Hedge price risk.
Retain unlimited upside. Retain certain degree of upside.
Defer CG tax. Defer CG tax.
Investor is fully protected against price risk. Structure ⇒ buy puts (at or out-of-the money) &
Long stock + long put position is extremely appealing sell calls with same maturity.
but costly. Strike price of calls is set at the level exactly to
Knock-out option ⇒ exotic option that can be amount required to pay for puts.
acquired only through OTC dealer (less expensive Investment risk is but not eliminated.
option).
4.3.2.3 Prepaid Variable Forwards 4.3.2.4 Choosing the Best Hedging Strategy
PVF ⇒ an agreement to sell a security at a specific time Tax characteristics of the shares that are being hedged
in the future with the number of shares to be delivered can help determine which strategy will deliver the
at maturity (varying with the underlying share price at optimal result for client.
maturity)
4.3.3 Yield Enhancement
Investors can enhance the yield of a CP while its volatility by writing

covered calls against some or all of the shares.
Premium income through selling call options.
Investors retain full downside exposure to the shares.
Most significant benefit of covered call writing ⇒ to psychologically
prepare the owner to dispose of those shares.
4.3.4 Other Tools: Tax-Optimized Equity Strategies
Combine investment & tax considerations in making investment decisions.

Index tracking strategy with active tax management ⇒ designed to track a
broad based market index on a pretax basis & outperform it on an after tax
basis.
Construction of completeness portfolios ⇒ builds a portfolio such that
combination of the two portfolio tracks the broadly diversified market
benchmark.

4.3.5 Other Tools: Cross Hedging
Cross hedging ⇒ using derivative on a substitute asset with an expected

high correlation with the investor’s concentrated position.
Investor is at least able to hedge market & industry risk (company specific
risk retains).
4.3.6 Exchange Funds
Exchange fund ⇒ partnership in which the partners have each contributed

their low basis CP to the fund.
Pro-rata holding of diversified pool of securities with minimum period of
7years.
Pro-rata ownership at redemption.
5. MANAGING THE RISK OF PRIVATE BUSINESS EQUITY
High percentage of private clients derives their wealth from the ownership
of a privately owned business.
Private business owners are often asset rich but relatively cash poor.
5.3 Monetization Strategies for Business Owners
5.3.1 Sale to Strategic Buyers 5.3.2 Sale to Financial Buyers
Strategic buyer ⇒ competitors or other companies These are private equity firms that typically raise
involved in the same or a similar industry as the funds from institutional investors.
seller. Pay price which is lower than strategic buyer’s
Highest price due to potential synergies. price.
5.3.3 Recapitalization 5.3.4 Sale to Management or Key Employees
Leveraged recapitalization ⇒ leveraging of a Employees or senior managers can acquire

company’s balance sheet. control of business through a management
Attractive for owners who would like to the risk of buyout.
their wealth concentration. Key risk ⇒ employees may not be successful
entrepreneurs.
Failed attempt to do an MBO has the potential
to –vely affect the dynamics of employer-
5.3.5 Divestiture (Sale or Disposition of Non-Core Assets) employee relationship
Divestiture ⇒ sale of non-core assets.

5.3.6Sale or Gift to Family Member or Next Generation
Owner continues to run business but generate liquidity
through divestiture.
Sell or transfer through a combination of tax
advantaged gifting strategies.
5.3.7 Personal Line of Credit Secured by Company Shares Transfer is typically made to family members or
members who actively involved in business.
Owner might consider arranging a personal loan

secured by his/her share in private company.
Key benefits ⇒ no immediate taxable event.

5.3 Monetization Strategies for Business Owners
5.3.8 Going Public through an Initial Public Offering 5.3.9 Employee Stock Ownership Plan
IPO is possible if the company is in an industry Sale of company’s shares to certain type of
deemed attractive by investors. pension plans.
Significant cost of going public but usually price of Leveraged ESOP ⇒ ESOP borrows funds to
the deal is very attractive. finance the purchase of the owner’s shares.
IPO is not a viable exit strategy if owner’s objective is
to exit from the company.
5.4 Considerations in Evaluating Different Strategies
Objective ⇒ to maximize the after-tax proceeds as opposed to simply

maximizing the sale price.
Different strategies may result in different values for the company that is
being sold or monetized.
Strategic buyers typically pay the highest price for a business.
6. MANAGING THE RISK OF INVESTMENT REAL ESTATE
Real estate owners are often exposed to significant degree of

concentration risk & illiquidity.
Various forms of debt & equity financing to facilitate monetization.
6.1 Monetization Strategies for Real Estate Owners
6.1.1 Mortgage Financing 6.1.2 Real Estate Monetization for the Charitably Inclined
Mortgage financing can be used to generate liquidity Asset location is also important for real estate.
to diversify asset portfolios (no taxable event). Many tools & techniques can be used by charitably
Non-recourse loan ⇒ lender’s only recourse upon an inclined clients under different tax regimes to monetize
event of default is to look to the property that was real estate.
mortgaged to lender.
6.1.3 Sale and Leaseback 6.1.4 Other Real Estate Monetization Techniques
Owner sells the property & then immediately leases Other monetization techniques include joint
it back from the buyer at a rental rate & lease term ventures, condominium structures etc.
that is acceptable to new owner. These techniques are out of the scope of this
Primary goal ⇒ free up the owner’s equity for other reading.
uses while retaining use of the facility.

“RISK MANAGEMENT FOR INDIVIDUALS”

HC = Human
Capital
1. INTRODUCTION FC = Financial
Capital
Overview of potential risks to indvs. & households
Indv. = Individual
Analysis of products & strategies to protect against those risks
Imp. = Importance
Selection of an appropriate product & strategy
B/S = Balance
sheet
Mortg. = Mortgage
2. HUMAN CAPITAL AND FINANCIAL CAPITAL Invst. = Investment
LI = Life Insurance
Adj. = adjustment
DVA = deferred
2. 1 Human Capital 2. 2 Financial Capital 2. 3 Net wealth variable annuity
IFA = Immediate
Fixed Annuity
Dominant asset on an indv.’s B/S. Pmt. = Payment
Value of an indv.’s HC today at Time 0: Net wealth = Net worth + claims to future Exp. = expense
೟ assets that can be used for consumption
o Simple Model = ∑

೟
(e.g. HC & PV of pension benefits)
(೟ ) ೟షభ (೟ )
o Expanded Model = ∑

(೑ )೟
Future payout on HC is uncertain as reality is more where Net worth = diff. b/w traditional
complicated than models. assets & liab.
Later in lifecycle as HC diminishes,
o Imp. of other risks ↑.
o Imp. ↑ for strategies that reduce invst. risks,
protect against LT health-care exp. & long-life
spending needs
2.2.1 2.2.2 2.2.6

Personal Investment Account
Assets Assets Type
2.2.3 2.2.4 2.2.5

Publicly Non-publicly Non-
Traded Traded Marketable
Marketable Assets
Marketable
Securities
Securities
Assets (e.g. automobile,
furniture, clothes, personal
residence) consumed/used
Varies materially
by an indv. Assets reflected on by countries but
Gen., not expected to traditional B/S. Gen. are of three
appreciate in value. Include money market types:
Often worth more to an indv. instruments, bonds, common i. Taxable
than their fair/mkt. value. and preferred equity. ii. Tax-deferred
[Mixed assets have both Their value and risk iii. Non-taxable
personal & invst. features characteristics are easier to
e.g. real estate, jewelry, estimate.
…continue
artwork etc.]
1
2.2.4 2.2.5
Non-publicly Traded Non-Marketable Assets
Marketable Securities
2.2.4.1 2.2.4.2 2.2.4.3 2.2.4.4 2.2.4.5

Real Estate Annuities Cash-value Life Business Assets Collectibles
Insurance
Among the largest A private defined- Combines life Indv’s (especially self- E.g. stamps,
assets owned by benefit pension insurance employed) significant paintings, wine,
indvs. guaranteed by an protection with portion of total wealth precious metals.
Mortg. pmts.→often insurance co. for some with some Value estimated through Value often set by
the largest fixed life/ over some type of cash recent sales of comparable auction/specialized
obligations of indvs. fixed period for accumulation businesses (multiple of NI dealers and involves
Mortg. loans → the beneficiary. vehicle. or EBITDA) ↑ transaction costs.
recourse or non- Value varies based on Also provide utility
recourse market conditions. for the owner.
Non-recourse loans
→riskier for lenders,
have ↑ interest rates
&/or ↑ borrower
credit standards.
2.2.5.1 2.2.5.2
Employer Pension Plans Government Pensions
(Vested)
Similar to employer pension plan but are

1) Employee-directed Saving Plan⇒ more secure and considered as bond-like
contribution amount & invst. controlled by However, country’s financial health, legal
indv. framework and political stability matters.
2) Traditional Pension Plan⇒ guarantee some
retirement benefits
Value estimated by determining
mortality wghtd. NPV = mNPV0 =
(೟ ) ೟
= ∑

()೟
Estimating pension discount rate is complex
and should consider plan’s funded status,
credit quality and additional credit support
2
3. A FRAMEWORK FOR INDIVIDUAL RISK MANAGEMENT
3.1 3.2 3.3 3.4

The Risk Management Financial Stages of Life The Indv. B/S Indv. Risk Exposures
Strategy for Indvs.
3.2.1
Education Phase
3.1.1. Step 1 3.3.1 3.3.2 3.3.3
Specify the objective Traditional B/S Economic Changes in Net
3.2.2 • Assets are (Holistic) B/S worth
Early Career netted against • Provides • Early in
3.1.2. Step 2 liab. indv’s overall Lifecycle→Tangible
Identify Risks • Includes financial assets dominate
3.2.3
recognizable condition indv.’s portf.
Career Development
3.1.3. Step 3 marketable based on his • Later in Lifecycle
Evaluate risks & assets & liab. holistic →Imp. of Non-
select appropriate 3.2.4 • Ignores HC wealth. traditional B/S
methods to Peak Accumulation and pension • Economic B/S items ↑.
manage the risks benefits. + PV of non- • In early retirement
marketable stage→Total
3.2.5 assets (HC, economic wealth is
Pre-retirement pensions) & dominated by
3.1.4. Step 4 liab. pension and real
Monitor outcomes (consumption estate.
& risk exposures & 3.2.6
Early Retirement
needs, • Volatility in invst
make suitable adj. bequests). portf. of Indv. with
in methods
↓ HC → ↑ impact on
3.2.7 variation in
Late Retirement expected
consumption.
3.4.1 3.4.2 3.4.3 3.4.4 3.4.5

Earning Risk Premature Death Longevity Risk Property Risk Liability Risk
• Major factors Risk • Risks associated with • Loss that a • Risk that an indv.
include health, • Death of an an extended person’s property may be legally
unemployment, indv. earlier retirement period. may be lost, stolen, liable for costs
underemployment than expected. • Significant impacts on damaged or associated with
• Self-employed or • ↓ HC and –vely indv’s lifestyle even destroyed. property
professionals are affect FC. when pension benefits • Direct damage/physical
also prone to • For young are substantial. loss⇒property’s $ injury.
earnings variability family the • To calculate the sum loss value • Major causes
• May ↓ HC & FC. effect can be needed at retirement, • Indirect involve
• Need to seek tragic. financial planners may loss⇒exps. automobile
additional training, • A risk to use: incurred for accidents;
education, skills. consumption i. Monte Carlo property homeowner’s
needs also Simulation repairment. property may
occur if non- ii. Mortality Table • Causes loss of FC cause injury to a
earning family (adj. for health • Also cause loss of visitor/tenant.
member dies. factors) HC specially when • May affect an
• Indv. concerned about property is used in indv’s FC &/or
outliving his money business to create HC.
intends to work income.
longer, has ↑ HC but at
possible exp. of less 3.4.6
desirable retirement Health Risk
stage. • Related to
illness or injury.
• Significant
implications to
HC and FC.
3
4. INSURANCE & ANNUITIES
4.1 4.2 4.3 4.4 4.5 4.6 4.7

Life Insurance Disability Income Property Health/Medical Liability Other Types Annuities
(LI) Insurance Insurance Insurance Insurance of Insurance
4.2 Disability Income Insurance

• To mitigate earning risk as a 4.4 Health/Medical Insurance 4.5 Liability 4.6 Other Types of
result of disability. • Highly dependent on countries Insurance Insurance
• Gen, insurance up to certain %. (some govts. fund health care) • If liability • Depending on the
• Other aspects include: • Two tiered System: Govt. coverage coverage in the indv. situation.
o Benefit period + upgraded coverage for more homeowner’s • Title insurance
o Elimination period pmt. and automobile (when purchasing a
o Rehabilitation clause • In U.S. 3 types of insurance insurance is less home, to make
o Waiver of premium approaches: than one think sure ownership of
o Option to purchase o Indemnity plan is appropriate. the property is not
additional rider o Preferred provider org. (PPO) • Personal in doubt)
o Non-cancelable & o Health maintenance org. umbrella policy • Service contracts
guaranteed renewable (HMO) (relatively (extended
o Non-cancelable policy • Comprehensive major medical inexpensive) → warranty) →when
o Inflation adj. insurance covers the vast majority pays claims if purchasing
of health care exp. liability limit of automobile, home
• Key terms of most health homeowner’s appliances,
insurance plan includes: or automobile sizeable products
• Deductibles policy is to avoid repair
• Coinsurance exceeded. cost.
• Copayments
• Max. out of pocket exp.
• Max. yearly benefit
On Next Page
• Max. lifetime benefit

• Preexisting conditions
• Preadmission certification
• 4.3.2 Automobile Insurance:

On Page 6
• 4.3.1 Homeowner’s Insurance:
• Risks related to homeownership and personal • Insurance rates are primarily based on vehicle
property & liability. value and driver’s age & driving record.
• Policies may be specified as “all risks”, include • Two parts of Coverage of damage
all risks except those specified as “named risks”. i. Collision Coverage (for damage from
• To settle claim policy may be Replacement cost accident)
(more expensive) or Actual Cash Value (cost less ii. Comprehensive Coverage (for damage from
dep.). other sources glass, breakage, hail, theft)
• If ↑ deductible, then ↓ Insurance premium • There may also be coverage available if vehicle is
• Mortgage lenders require enough insurance to damaged by uninsured/underinsured and
cover the outstanding mortgage amount. passengers’ medical coverage.
• Insurance co. want insurance at full value less • If repair cost > actual cash value insurance
land value and losses are reimbursed at ↓ rate if companies reimburse only the actual cash value.
home is underinsured. • Liability risks (body injury, property damage) is
• Homeowners’ liability risks are gen. addressed gen. covered within the policy.
within the insurance policy. • Indvs. can use other safe driving techniques such
• Homeowner can use other risk management as wearing seat belts, avoiding extreme weather,
techniques such as surveillance system, fire backup camera, lane-change warning system etc.
extinguishers, bank’s safe deposit box, installing
surge protectors etc.
4
4.1
Life Insurance (LI)
4.1.1 4.1.2 4.1.3 4.1.4 4.1.5

Uses of LI Types of LI Basic Elements of LI Policy How How Much LI
• Provides hedge 1. Temporary LI (TLI) • Term, type of policy LI is Does One
against earner’s • For certain specified time period • Amount. of benefits Price Need?
death. • Premium either remain level or ↑ over time. • Limitations (to withhold d • Vary from
• Imp. estate • Cost is less than PLI benefits) person to
planning 2. Permanent LI (PLI) • Contestability period person and
tool→provides • Life time coverage • Identity, policy owner based on the
immediate • Usually fixed policy premiums. • Beneficiaries no. of
illiquidity to • May have non-forfeiture clause (e.g. cash • Premium schedule dependents
beneficiary. surrender option, reduced paid up option, • Riders (if any) to the policy • Primary
• A tax-sheltered extended term option) • insurable interest purpose: to
saving tool. • Several types (e.g. whole LI, universal LI) • 4 primary parties: replace PV of
• As mortality risk Whole LI: Universal LI: i. insured future
↑, mortality • Remains in force for an • More flexible ii. policy owner earnings.
charge ↑. insured’s whole life. • Insured can pay iii. beneficiary • Other factors
• Cash value is associated ↑ ↓ premium iv. insurer include:
• Non-cancelability • More options for • documentation/proof of immediate
feature appeals investing the death financial exp.
younger indvs. cash value. & legacy
• Participating (benefits goals.
∆ due to co.’s profits)
or Non-participating
(fixed value).
Common features of TLI & PLI
• Non-cancelable
• Potential riders can be added (e.g. accidental
death & dismemberment AD&D, accelerated
death benefit, guaranteed insurability, waiver
of premium).
• Viatical settlement (option to sell the premium
to a 3rd party)
4.1.4.4
Consumer Comparisons of LI Costs
Two popular indexes for comparison are:
1) Net pmt. cost index 2) Surrender cost index
Calculation Comparison
(assuming 5% discount rate & 20-yr. period
4.1.4.1 4.1.4.2 4.1.4.3
Steps Net Pmt. Cost Index Surrender Cost Index
Mortality Calculation of the Net/Gross Premium Cash value & Policy
Assumes insured Assumes policy will be
Expectations • Net Premium of LI policy is the discounted Reserves
person will die at surrendered at period
• Are based value of future death benefits • In Whole LPs:
period end. end & policy owner
on historical • Gross premium adds a load to the net i. Premium →
will receive the
data & premium. stays constant
projected cash flow.
future • Level Term Policies: Premiums are ↑ in ii. Face value →
A Calculate FV of Same
expectations early yrs. and ↓ in later yrs. stays constant
Annuity Due of
• Actuaries • Annually Renewable Policies: consumers iii. Cash value → ↑
Premium
make adj. to have advantage of ‘loss leader’ but health iv. Insurance
value → ↓ B Calculate FV of Same
general issue or accident can make indv.
ordinary annuity of
mortality uninsurable. • Cash value can be
projected annual
table based • Two groups of Life Insurers: 1) withdrawn
dividends
on factors i. Stock Companies. when policy
C 20-yr. Insurance 20-yr. Insurance Cost =
(e.g. health • Owned by shareholders terminate or 2)
history, can be borrowed Cost = A-B A-B-20 yr. projected
• Have a profit motive Cash Value
smoking, • Add projected profit as a part of load as a loan.
excess • Life insurers are D Interest adj. cost Same
in pricing policies per yr. = Calculate
weight etc.) ii. Mutual Companies required by
• Large regulators to Pmts. for 20-yr.
• Owned by policy owners annuity due with FV
policies may • No profit motive maintain policy
require reserves. equal to C.
• Charge a gross premium, which is E Divide D by # of Same
physical ↑ than net premium + expenses.
examination thousand dollars of
This extra amount is paid back to face value.
. policy owner as a policy dividend.
5
4.7 Annuities
4.7.1 Parties to 4.7.2 4.7.3 Advantages & 4.7.4 Payout Methods 4.7.5 Annuity 4.7.6
an Annuity Classification Disadvantages of • Gen. similar for fixed or Benefit Taxation Appropriateness
Contract of Annuities Fixed & Variable variable annuities • Can offer of Annuities
Four primary Annuities • Life Annuity: Pmt. For attractive tax • Annual
parties: Imp. considerations annuitant’s entire life and benefits (e.g. benefit pmt.
i. Insurer when selecting cease at his death. in U.S. offer can be
ii. Annuitant fixed/variable • Period-certain Annuity: Pmts. tax deferred decomposed
iii. Contact annuities. for certain # of periods without growth). into i) interest
owner regard to lifespan. • Actual tax ii) return of
iv. Beneficiary • Life Annuity with period method varies premium iii)
certain: Pmts. for annuitant’s by countries. mortality
entire life but guaranteed min. credit.
# of yrs. even if he dies. • How much
• Life Annuity with refund: annuitize
similar to life annuity with →depends on
period certain but guaranteed indv’s
pmt. = initial invst. – fees preference for
• Joint Life Annuity: Pmt. wealth max. &
Continue until two/more longevity risk
members are no longer living. aversion.
• Payout methods are not
mutually exclusive and
frequencies may vary (e.g.
monthly, quarterly etc.)
4.7.3.1 Volatility of 4.7.3.2 Flexibility 4.7.3.3 Future Market 4.7.3.4 Fees 4.7.3.5 Inflation
Benefit Amount • IFA (gen. irrevocable) Expectations Variable Annuities: Concerns
• Retirees seeking ↑ offer guarantee of Fixed Annuities: (bond-like • ↑ fees • Inflation can
level of assurance of income for life. assets) • opaque pricing affect real
benefit payouts • Variable annuities • have interest rate risk cause reduced income of fixed
select fixed annuity (market • Annuitant receives only price annuities
or variable annuity performance based) market return on invst. competition. • No. of variable
that limits ∆ in provide guaranteed • no mortality credit Fixed Annuities: annuities and
benefit over time. income and flexibility Variable Annuities: • ↓ fees riders of fixed
• Risk tolerant retirees to access the funds. • possibility of ↑ future • much easier to annuities allow
→ opt. for variable pmts. in up market compare ↑ ↓in pmts.
annuity. • ↑ market risk and have due to ∆in
mortality credit inflation.
6
4.7.2.1 Deferred Variable Annuities (DVA)

• Similar to mutual funds
• Indvs. can choose from a menu of potential invst. options.
• Compared with mutual funds DVA are ↑expensive and have ↓ invst.
options.
• May include a death benefit (valuable to beneficiary when
contract value < initial invst.)
• Indv. have the right to exit (sell) the contract
• DVA does not guarantee lifetime income unless the indv. 1)add
contract rider → guaranteed min. pmt or 2) annuitize the contract
by converting DVA into immediate payout annuity (few investors
choose to annuitize).
4.7.2 Classification of Annuities

• Two most critical dimensions 4.7.2.2 Deferred Fixed Annuities (DFA)
to classify are: • Fixed annuity payout that begins at some future date.
1. Deferred vs immediate • Less costly for young indvs.
2. Fixed vs variable • Prior to annuitization, investor can cash out and receive eco. value
• Joint life annuity (based on less surrender charges.
expected life span of two • After retirement indv. has 2 options
annuitants) i. Cash out
ii. Begin fund withdrawal
• Most deferred fixed annuities are eventually annuitized
4.7.2.3 Immediate Variable Annuities (IVA)

• Lump sum is exchanged for an annuity (income for life)
• Pmt. varies based on the portfolio performance.
• Income floor feature can be added for protection in down market.
4.7.2.4 Immediate Fixed Annuities (IFA)

• Indvs. trade a sum of money today for promised life long income
benefit.

• Income yield (payout) =

• Payouts are ↑, when expected remaining longevity is shorter (i.e.
payout is ↑ for 85-yr.old compared to 65-yr. old).
• For same age, male has ↑ payout than female.
• Annuity pricing is affected by mortality and expected return
insurance co. earn on premium.
• Payout will be ↓ if current bond yields are ↓and life expectancy is ↑
4.7.2.5 Advanced Life Deferred Annuities (ALDA)

• Hybrid of deferred fixed (DFA) and immediate fixed annuity (IFA).
• Refereed to pure longevity insurance.
• Permanent exchange of lump sum for income (like IFA) but pmt.
begin immediately (unlike IPA).
• Cost ↓ than regular immediate life annuity bcz. fewer pmts. that
begin far in the future.
7
5. IMPLEMENTAION OF RISK MANAGEMENT FOR INDIVIDUALS
5.1 Determining the 5.2 Analyzing an 5.3 The Effect of 5.4 Asset
Optimal Risk Insurance Program Human Capital (HC) on Allocation & Risk
Management Strategy Asset Allocation Policy Reduction Policy
• Depends on household’s i. Current Insurance • Indv’s. total economic wealth affects • Mainly to smooth spending over
risk tolerance Plan portfolio construction through: time.
• 3 approaches to loss ii. Program Review a. Asset allocation • Invst. risk, property risk & HC risk
control iii. Recommendations b. Underlying asset classes can be either idiosyncratic or
i. Risk avoidance • Gen. HC is bond-like systematic.
(remove loss event • No hedging benefits → if asset • Idiosyncratic risks include:
possibility) performance is correlated with indv’s o Specific occupation risk
ii. Loss prevention earnings o Longevity risk
(taking actions to ↓ • Within occupation each indv. has o Pre-mature death risk
probability of loss different HC risks (job loss impact on o Long-term illness
event) long-term HC, Health shock etc.). o Property loss
iii. Loss reduction (↓ • Overall riskiness of HC is ↓ if: • Idiosyncratic HC risks can be
the size of loss) o both spouses are employed reduced through invst. portfolio
• Indvs. can manage risk (unless their HC is highly strategies & insurance products.
through techniques of: correlated). • Systematic risks include:
i. Risk transfer o non-working spouse can rejoin o Overall market
(insurance/ non- work force. performance
insurance transfers) • Overall riskiness of HC is ↑: o Economic condition
ii. Risk retention o if HC is tied to specific o Overall longevity due to
• Systematic risk mgmt. geographic location. healthcare
approach →consider the o if HC is vulnerable to improvements
optimal strategy for each disability/premature risk • Systematic risks affect all
risk exposure o if HC is very employer-specific. households.
o for Professions with ↑ income
variance
• Optimal invst. policy→forms a target
mix of risky vs. risk-free assets, based
on risk-tolerance & adj. for ∆ in assets
values over time:
8
“MANAGING, INSTITUTIONAL INVESTOR PORTFOLIOS”

FS = Funded Status IR = Interest Rates
PBO = Projected Benefit Obligation
DB = Defined Benefit FI = Fixed Income
ABO = Accumulated Benefit Obligation
DC = Defined Contribution ALM = Asset Liability Management
2. PENSION FUNDS
Types of Pension Plans
DB Plan DC Plan Hybrid Plans
Plan sponsor’s obligation in terms of the Sponsor’s obligation is to contribute to the Cash balance plan ⇒ DB plan whose benefits
benefit to plan participants. pension fund. are displayed in individual record keeping
Investment risk is borne by plan sponsor. Participants bear the investment risk. accounts.
Early termination risk. Can be sponsor directed or participant
directed.
2.1 Defined-Benefit Plans: Background and Investment Setting
Pension plan’s performance should be judged relative to the adequacy of its assets with respect to funding pension liabilities.
If plan’s assets are > < PV of plan’s liabilities, the plan is over (under)funded.
Three basic liability concepts:
ABO ⇒ PV of pension benefits assuming immediate plan termination.
PBO ⇒ PV of pension benefits under going concern assumption.
Total future liability ⇒ PV of accumulated & projected future service benefits.
the no. of retired lives, the pension fund’s liquidity requirements.
the % of retirees, shorter the duration of pension liabilities.
2.1.1 Risk Objectives
Direct relationship b/w FS & sponsor’s investment risk.

correlation b/w the sponsor’s operating results & pension asset returns, ability to tolerate risk.
Older the workforce, the risk tolerance.
ALM approach is more suitable for DB pension plan.
Surplus volatility & shortfall risk are important considerations.
2.1.2 Return Objectives
Return requirement begins with the discount rate used to calculate the PV of plan liabilities.
A realistic return objective is to minimize the amount of future pension contributions.
A well funded plan can be in a position to generate pension income.
2.1.3 Liquidity Requirement
Liquidity requirement = benefit payment-pension contribution.

the retirees, the liquidity requirement.
Inverse relationship with contributions.
Younger the workforce, the liquidity requirement.

2.1.4 Time Horizon
Investment time horizon for a DB plan depends on:

The proportion of active & the age of workforce.
Whether the plan is a going concern or plan
termination is expected.
2.1.5 Tax Concerns
DB pension plans are usually tax-exempt.
2.1.6 Legal and Regulatory Factors
Pension plans are governed by laws & regulations.

ERISA act 1974 governs U.S. pension plans.
Smaller plans may face human & financial resources constraints.

Self imposed constraints against investing in certain industries.
2.1.8 Corporate Risk Management and the Investment of DB Pension Assets
Two important concerns:

the correlation b/w sponsor operating results & pension asset
returns (lower risk tolerance).
Coordinating pension investments with pension liabilities.
2.2 Defined-Contribution Plans: Background and Investment Setting
Principal issues for participant-directed DC plans are:

Diversification (sponsor must offer a list of investment options).
Company stocks holdings.
2.2.1 The Objectives and Constraints Framework
Participants are responsible for choosing a risk & return objective.

IPS describes the strategies & alternatives available to the participants.
2.3 Hybrid and Other Plans
Cash Balance Plans Pension Equity Plans
DB plan where the employer bears the DC plans that invest all or the majority of plan
investment risk. assets in employer stock.
Personalized statement with account Important concern ⇒ adequate
balance. diversification.

3. FOUNDATIONS AND ENDOWMENTS
Foundations Endowments
Grant-making institutions funded by Long term funds generally owned by

gifts & investment assets. operating non-profit institutions
3.1 Foundations: Background and Investment Setting
Types of foundations are:

Independent foundations.
Company sponsored foundations.
Operating foundations.
Community foundations.
Foundations can vary widely in time horizons & their investment goals.
Private foundations are subject to payout requirement.
Foundations can be more aggressive because of no contractual liability as

in pension fund.
Return > than needed to maintain purchasing power is acceptable.
Foundations vary in their return objectives because:

Some are short term while others are long term in their nature.
Minimum return requirement should cover the spending needs,
inflation & management expenses.
3.1.3 Liquidity Requirements
Anticipated or unanticipated cash needed in excess of contributions made

to the foundation.
Smoothing rule is used to avoid large fluctuations in operating budget.
Anticipated needs are captured by the spending rate.
Cash reserve for contingencies by some private foundations.
3.1.4 Time Horizon
Usually longer time horizon.

Greater ability to bear risk.
3.1.5 Tax Concerns
Not-for-charitable purposes income is taxed at regular corporate tax rates.

Private foundation pays a 2% tax on its net investment (may reduced to 1%).

Variety of legal & regulatory constraints (vary by

country & sometimes by type of foundation).
Single stock position restricted by the donor

from diversifying.
3.2 Endowments: Background and Investment Setting
Fund established to provide budgetary support for

universities, colleges, hospitals etc.
Not subject to legally required spending level.
Spending Rule
Simple Spending Rule Rolling Three-Year Average
௧ = × ௧ିଵ ௧ =

× 1⁄3[ ௧ିଵ +
௧ିଶ + ௧ିଷ ]
Problem ⇒ place equal weights to all three years.
Geometric Smoothing Rule
௧ = ℎ × ሺ௧ିଵሻ × 1 + ௧ିଵ +

1 − ℎ × ௧ିଵ
Place more emphasis on recent MV & less on past values.
Depends on the endowment’s role in the operating budget & institution’s

ability to in spending:
Lower the need for endowment contribution, the risk tolerance.
the correlation b/w donor’s base & endowment, the risk tolerance.
Large fixed expenditures can reduce risk tolerance.
Sum of spending rate, the expected inflation rate & management fee can
serve as starting points for appropriate return objective.
The relevant inflation rate may differ from that of the general economy.
Long-term average spending rate must be < than the long term expected real
return to preserve purchasing power.

Perpetual nature & measured spending of true endowments limit their need
for liquidity.
Cash needs (to make spending distributions, to meet capital commitments &
to facilitate portfolio rebalancing transactions).
3.2.4 Time Horizon
Long term & multistage (in some cases)
3.2.5 Tax Concerns
Not a major concern (usually tax exempt)
3.2.6 Legal and & regulatory Factors
UMIFA is the primary governing legislation for endowments in U.S.
Socially responsible investing may become constraints (e.g. child

labor, gambling etc.).
4. THE INSURANCE INDUSTRY
Insurance industry has two broad categories:

Life insurance.
Casualty insurance.
Insurance companies are established either stock companies or mutual.
4.1 life Insurance Companies: Background and Investment Setting
Duration management is a major concern in investment setting.

Risk of disintermediation becomes acute when IR are high:
One type of disintermediation occurs when policyholders borrow against
cash value in insurance at below market policy loan rates.
Other type ⇒ policyholders surrender their cash value of insurance to
reinvest at higher rates.
Some new insurance products are:
Universal life ⇒ provides premium flexibility & adjustable death
benefits.
Unit-linked life insurance:
Type of ordinary life insurance.
Death benefits & cash values are linked to investment
performance.
Variable universal life ⇒ combines features of above two.

Primary investment objective ⇒ to fund future policyholders’ benefits &

claims.
Insurance regulators have been moving towards risk-based capital to
ensure adequate surplus.
ALM approach is useful to control IR risk & liquidity for a life insurance
company.
Aspects of IR risk.
Valuation concerns.
Reinvestment risk.
Credit risk & CF volatility are other risk objectives.
Specified primarily by the rates that actuaries use to determine

policyholder reserves (minimum return requirement).
Desired net interest spread ⇒ diff. b/w interest earned & interest credited
to policyholders.
Surplus growth is another return objective.
Segmentation has promoted sub-portfolio return objectives.
A major concern in periods of sharply rising IR.

In assessing liquidity needs, insurers must address the following.
Disintermediation.
Asset marketability risk.
4.1.4 Time Horizon
Traditionally, life insurance companies were considered long

term investors.
ALM has tended to shorten the time horizon.
4.1.5 Tax Concerns
Insurance companies are taxable investors so focus should be on after tax returns.
Income can be viewed into two parts for tax purposes:
Portion related to the rate necessary to fund reserve is not taxed.
Surplus is taxed.
Important concepts related to regulatory concerns include:

Eligible investments.
Prudent investor rule.
Valuation methods.
Company’s size & the sufficiency of its surplus position are

among the considerations influencing portfolio policy.

4.2 Non-Life Insurance Companies: Background and Investment Setting
These include health, property, liability, marine, surety insurance.

Investment policies differ significantly from life insurance.
Characteristics of non-life insurance industry:
Cyclical in nature.
Long tail nature of liabilities.
Underwriting cycle.
Business cycle.
Ability to meet policyholder’s claims is a dominant consideration.

Inflation must be considered due to replacement cost or current
cost coverage.
The ratio of premium income to total surplus should be maintained
b/w +2 to 1 to 3 to 1.
Volatile stock market conditions lower the % of surplus invested in
equities.
Factors influencing return objective include:

Competitive policy pricing ⇒ low premium rates, desired
return objectives.
Profitability ⇒ investment income & the portfolio returns are
primary determinants.
Growth of surplus ⇒ provides opportunity to expand the
volume of insurance.
Tax considerations ⇒ flexibility to shift b/w taxable & tax
exempt bonds.
Total return management.
Important consideration due to uncertainty of the CF.

Casualty Company needs to manage the marketability schedule.
4.2.4 Time Horizon
Duration of causality liabilities are typically than life insurance

liabilities.
Under writing cycle affect the mix of taxable & tax exempt bond
holdings.
Long-term equity investor status has been modified due to
turnover in stocks portfolio.
4.2.5 Tax Concerns
Tax is an important consideration:

Asset allocation b/w taxable& tax exempt
bonds.
Subject to tax code modification.

No asset valuation reserve requirement.

Subject to risk-based capital requirement.
Eligible asset classes & quality standard for each
class are subject to regulations.
4.2.7 Determination of Portfolio Policies
In determining investment policy, limited

investment risk tolerance & difficulty in forecasting
CF are important considerations.
5. BANKS AND OTHERINSTITUTIONAL INVESTORS
5.1 Banks: Background and Investment Setting
Portfolio of investment securities ⇒ residual use of funds after loan demand has been met.
Play a key role in managing bank’s risk & liquidity positions.
Profitability measures:
Net interest margin ⇒ net interest income/average earning assets.
Interest spread ⇒ interest yield –interest cost of liabilities.
Risk measures:
Leverage-adjusted duration gap ⇒஺ − × ௅
where
஺ = duration of assets.
௅ = duration of liabilities.

=

For a +ve (-ve) IR shock: the MV of net worth () for a bank with +ve (-ve) gap.
Value at risk ⇒minimum value of losses expected over a specified time period at a
given level of probability.
Securities Portfolio’s Objectives
Adjustment mechanism for IR risk.

To assure adequate liquidity.
To produce income.
To modify & diversify overall credit risk.
To meet other needs e.g. pledging requirement.
Portfolio’s Objectives
5.1.1 Risk Objectives 5.1.2 Return Objectives
ALM considerations. +ve return on invested capital.

Below-avg. risk tolerance. Positive spread over the cost of funds.

Portfolio’s Constraints
5.1.3 Liquidity Requirements 5.1.4 Time Horizon
Determined by: Liability structure reflects an overall

Net outflow of deposits. shorter maturity than its loan
Demand for loans. portfolio.
Time horizon is usually
intermediate term.
5.1.5 Tax Concerns 5.1.6 Legal & Regulatory Factors
Fully taxable Restrictions on bankholding of

common shares & below
investment grade bonds.
Risk based capital regulations.
Factors such as loan concentration & community

needs are important considerations.
5.2 Other Institutional Investors: Investment Intermediaries
Investment companies serve as financial intermediate.

Pooled investor funds usually invested in equity & F.I markets.
Commodity pools ⇒ invest in futures rather than equity & F.I markets.
Hedge funds ⇒ market to other institutional investors & high net-worth
individuals & subject to fewer regulations.
Non-financial corporation⇒ major investor in money markets.


“CAPITAL MARKET EXPECTATIONS”
CMEs = Capital Market Expectations AM = Arithmetic Mean IR = Interest Rates
E(R) = Expected Return GM = G eometric Mean YC = Yield Curve

2. ORGANIZING THE TASK: FRAMEWORK AND CHALLENGES
2.1 A Framework for Developing Capital Market Expectations
 CMEs ⇒β research (related to systematic risk).

 CMEs:
 Macro expectations ⇒ regarding asset classes.
 Micro expectations ⇒regarding individual assets.
 Process to formulate C MEs:
 Specify CMEs needed according to i nvestor’s tax status, allowable asset
classes & time horizon.
 Research historical records.
 Identify the valuation model & its requirements.
 Collect the best data possible.
 Use experience & j udgment to interpret current i nvestment c onditions.
 Formulate CMEs & document c onclusions.
 Monitor actual outcomes & c ompare them to expectations & refine the
process, if needed.
 Good forecasts are unbiased, objective, well researched & efficient.
2.2 Challenges in Forecasting
 Poor forecasts can r esult i n inappropriate asset allocation.

 Some problems in the use of data & a nalyst mistakes & biases are as follows:
2.2.1 Limitations of Economic Data
 Time lag b/w c ollection & distribution of data.

 Revisions are s ubstantial.
 Data definitions & methodology Δ over time.
 Data indices are often rebased over time.
2.2.2 Data Measurement Errors and Biases
Transcription Errors Survivorship Bias Appraisal (Smoothed/Data)
 Errors in gathering & recording  Data of s urviving entities only.  Appraisal data are used in lieu of
data.  Return s eries c onvey a n overly market price data for illiquid
 More problematic if biased i n a optimistic picture. assets.
certain direction.  â C orrelation & SD of the asset.
 Potential s olution ⇒ rescale the
data without effecting mean
return.



2.2.3 The Limitations of Historical Estimates
 Past can not be simply extrapolated to produce

future results.
 Regime changes ⇒Δ i n the technological, political
legal & regulatory environment ( on stationary
data).
 Statistical tools should be used to identify regime Δ
or turning points.
Long Data Series
Statistical Necessity (Advantages) Problems
 á precisions when population parameters  Data may no longer be relevant.
are estimated.  Time series of required length may not be
 Parameters ( e.g. return, SD etc.) are l ess available.
sensitive to time span.  Asynchronous data if frequency is á.
 Shorter time series of data should be used:

 if data is non-‐stationary.
 If regime Δ is detected statistically.
2.2.4 Ex Post Risk Can B e a Biased Measure of Ex Ante Risk
 Ex post data ⇒ after the fact, ex a nte data ⇒ before the
fact.
 Looking backward, a nalysts are likely to underestimate ex
ante risk & overestimate ex ante a nticipated returns.
2.2.5 Biases in Analysts' Methods
Data-‐Mining Bias Time-‐Period Bias
 Repeatedly s earching a dataset until the  Results from the time span of the data
analyst finds s ome statistically significant chosen.
pattern.
 To avoid the bias:
 Find economic basis for the variable.
 Test the discovered relationship with
out-‐of-‐sample data.
2.2.6 The Failure to Account for Conditioning Information
 Relationship b/w s ecurity r eturns & economic variables

is not c onstant overtime.
 Analysts s hould account for expected market conditions
in their forecasts.



2.2.7 Misinterpretation of C orrelations
 Analyst s hould take care in i nterpreting c orrelations because:

 Correlation may be s purious.
 Endogenous variable may be unable to explain exogenous variable.
 Correlation statistic miss nonlinear relationship b/w two variables.
 Multiple regressions (alternative to c orrelation) are used to uncover
predictive relationship.
 Partial correlation is used for desired analysis.
2.2.8 Psychological Traps
Anchoring Trap Status Quo Trap
st
 Disproportionate weight to the 1  Predict no c hange from the recent past.
information.  To avoid cognitive c ost or regret.
 Solution ⇒ avoid premature c onclusion.  Solution ⇒ rational analysis within a decision-‐
making process.
Confirming Evidence Trap Overconfidence Trap
 Greater weight to information that s upports  Overestimate the accuracy of forecasts.
an existing or preferred view.  Too narrow a range of scenarios in
 To ensure objectivity: forecasting.
 Give equal scrutiny to all evidences.  Solution ⇒ wider the range of possibilities.
 Seek out opposing opinions.
 Be honest a bout your motives.
Prudence Trap Recallability Trap
 Overly conservative forecasts.  Too many weights to the events that l eave a
 Stay close to the crowd (herding behavior). strong impression on a person’s memory.
 Solution ⇒ wider the range of forecasted  Solution ⇒ c onclusions on objective data.
values.
2.2.9 Model Uncertainty
 Model uncertainty ⇒ uncertainty concerning whether a selected model is

correct.
 Input uncertainty ⇒ uncertainty concerning w hether the inputs are c orrect.
 Some analysts believe that market anomalies are r esults of different
valuation models.



3. TOOLS FOR FORMULATING C APITALMARKET EXPECTATIONS
3.1 Formal Tools
Tools that are accepted within the investment community.
3.1.1 Statistical Methods
3.1.1.1 Historical Statistical Approach: Sample Estimators 3.1.1.2 Shrinkage Estimators
 Analyst use historical data for forecasting.  Weighted Avg. of a historical estimate of a parameter & some other
 Project the historical mean, SD & c orrelations for a data s et into the parameters estimate.
future.  â i mpact of historical extreme values.
 Decision point relates to the c hoice b/w AM & GM.  Applied to mean return & covariance.
 AM best represents the mean return i n a single period.  á efficiency of covariance if plausible target is s elected.
 GM repents the multi period growth.
 For a risky variable G M<AM.
3.1.1.3 Time-‐Series Estimators 3.1.1.4 Multifactor Models
 Forecasting a variable using previous values of itself or other variables.  Explains the r eturn to a n asset i n terms of the values of a s et of risk
 Variance clustering ⇒ high (low) v olatility tend to follow high (low) factors.
volatility.  Useful for modeling asset r eturn & c ovariance’s.
 J.P Morgan developed a model to measure c urrent period volatility:  Models usefulness:
𝜎"# = 𝜃𝜎"'( #
+ (1 − 𝜃)𝜖"#  When factors are well chosen, the model may filter out noise.
where  Common s et of factors simplify the task of estimating c ovariance.
𝜃 = rate of decay (between 0-‐1)  Verify covariance c onsistency.
3.1.2 Discounted Cash flow Models
 DCF model ⇒ asset’s value is the present value of

future CF.
 Advantage⇒forward l ooking.
 Disadvantages ⇒ does not address c urrent s upply &
demand c ondition, therefore not s uitable for short-‐
term expectations.



Discounted CF Models
3.1.2.1 Equity Markets Fixed-‐Income Markets
Gordon Growth Model

 YTM of a reference bond in a s egment
is used as expected return for the
 𝐸(𝑅1 ) =
23
+ 𝑔 segment.
45
23  Problem ⇒ YTM assumes
where = Dividend yield
45 reinvestment at YTM.
g = growth (capital gains)  Solution ⇒ use YTM of a zero c oupon
 When applied at entire market level. bond.
g = nominal G DP growth + excess
corporate growth.

Grinold-‐Kroner Model Fed Model
 E(Re) ≈ D1/Po -‐‑ ΔS + I + g + Δ P/E Stock market is overvalued

where (undervalued) if market’s E/P <(>) 10
-‐ΔS = repurchase yield year treasury bond yield.
i = expected inflation rate
g = expected r eal total earning growth
ΔP/E = per period change in P/E
multiple.
 Three c omponents:
 Expected income return: D/P -‐ΔS
 Expected nominal earning
growth = i+g expected capital
gains.
 Expected repricing return Δ P/E
expected capital gains.
3.1.3 The Risk Premium Approach
3.1.3.2 Fixed-‐Income Premiums 3.1.3.3 The Equity Risk Premium
𝐸(𝑅7 ) = Real R f rate + inflation premium + default risk  Equity risk premium ⇒ compensation required for the
premium + illiquidity premium + maturity premium + tax additional risk of equity.
premium.  Bond yield plus risk premium a pproach ⇒ 𝐸(𝑅1 ) = YTM on
long-‐term govt bond + equity risk premium.
3.1.4 Financial Market Equilibrium Models
Describe relationship b/w E(R) & risk in which

supply & demand are in balance.



Equilibrium Models
The ICAPM Approach Singer-‐Terhaar Approach
 If PPP holds:  Account for two market i mperfections.

𝐸(𝑅8 ) = 𝑅9 + 𝛽8 ;𝐸(𝑅< ) − 𝑅9 =  Illiquidity
where  Market segmentation.
𝐸(𝑅< ) = return on global i nvestable market.  Illiquidity premiums can be estimated through
𝛽8 = asset’s s ensitivity to the return on the investment’s multi period sharpe ratio(MPSR)
world market portfolio.  Investment’s MPSR s hould a t least be as
 Asset class’s risk premium high as MPSR.
𝑅𝑃<  Steps of singer-‐Terhaar approach:
𝑅48 = 𝜎8 𝜌8,< @ B
𝜎<  Estimate perfectly integrated &
segmented risk premiums.
 Add the illiquidity premiums.
 Estimate the degree of market
integration.
 Take w eighted Avg. of completely
integrated & s egmented market.
 Calculate the expected returns ⇒ 𝑅9 + 𝑅C .

3.2 Survey a nd Panel Methods
 Survey method ⇒ asking a group of experts for their

expectations & using the responses in C ME.
 Panel method ⇒ group pooled is fairly constant over time.
 Equity risk premium expectations of practitioners are
consistently more optimistic than that of a cademics.
3.3 Judgment
 Economic & psychological insights to improve forecasts.

 Investors may use c hecklists.

4. ECONOMIC ANALYSIS
 Assets with l ower ( higher) expected payoffs during business

cycle ⇒ higher (lower) risk premiums.
 Points of inflection in economic activity provide unique
investment opportunities.
 Economic growth has two c omponents:
 Trend growth ( use in l ong tem C ME).
 Cyclical growth (important for short-‐term C ME).



4.1 Business Cycle Analysis
 Two cycles:
 Inventory cycle (2-‐4 years).
 Business cycle (9-‐11 years).
 Chief measures of economic activity:
 GDP
 Output Gap ⇒ difference b/w actual GDP & trend.
 Recession ⇒ two s uccessive quarterly â in GDP.
4.1.1 The Inventory Cycle
 Usually judged through inventory/sales ratio:

 When this ratio has moved down ( up) ⇒ economy is
likely to be strong (weak) in the next few months.
 Overall this indicator has been trending down ⇒
improved techniques.
4.1.2 The B usiness Cycle
Initial Recovery Early Upswing
 Economy picks up from r ecession.  Economy gains momentum.

 Business c onfidenceá.  á c onsumer c onfidence.
 âinflation.  Short term rates & l ong term bond yield areá.
 Bond yieldâ.  Stocks are trendingá.
 Stock pricesá.
Late Upswing Slowdown
 Economy is i n the danger of overheating.  Confidence start wavering.

 áconfidence, â unemployment.  Inflation c ontinues to rise.
 Interest rates & bond yields areá.  Short term IR are high & bond yield curve
 Equities are volatile. inverts.
 Stock market mayâ.
Recession
 Inventories pull back.

 á unemployment, â inflation &â confidence.
 Short term IR & bond yieldsâ.
 Stock markets start to rise in the later stage.



4.1.3 Inflation a nd Deflation in the Business Cycle
 Inflation tends to rise in later s tages of cycle & to â during r ecession &
early stages of recovery.
 Three principles of central banks to deal with inflation:
i) Decision making must be independent of political influence.
ii) Inflation target.
iii) Use monetary policy to c ontrol economic growth (inflation).
 Deflation is a threat:
 It tends to undermine debt-‐financed investments.
 Central bank is unable to stimulate economy by further â IR
(already in bottom).
 Bonds outperform during recession.
 Rising inflation is good for equities unless the c entral bank tends to áIR.
4.1.4 Market Expectations a nd the B usiness Cycle
Business cycle phases are difficult to identify & predict

(CME difficult to form).
4.1.5 Evaluating Factors that Affect the Business Cycle
 Business cycle a nalysis should be focused on:

 Consumer spending ( major part of GDP).
 Business (small part of GDP but more volatile)
 Foreign trade.
 Govt. activity ( monetary policy & fiscal policy).
The Taylor Rule
 Links b/w target s hort-‐term IR to the rate of economic growth & inflation.
 Prescriptive tool & fairly accurate at predicting central bank action.
 𝑟"EFG1" = 𝑅𝑛𝑒𝑢𝑡𝑟𝑎𝑙 + 0.5 ;𝐺𝐷𝑃9SF1TEU"1V − 𝐺𝐷𝑃"F1WV = +
0.5;𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛9SF1TEU"1V 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛"EFG1" =
 When IR are at zero, further monetary s timulus requires new type of
measures:
 More cash into the banking system.
 Currency devaluations.
 Low short term IR for an extended period.
 Buy asset directly from the private sector.
4.1.5.4 Fiscal Policy
 Govt.á(â) spending or â(á) taxes to s timulate (slow) the economy.
 Two important points should be kept i n mind:
 It is Δ in deficit that matters not the level of deficit.
 Only deliberate c hanges in fiscal policy matters.



The Yield Curve
 Expansionary fiscal & monetary policy ⇒ steeply upward

sloping Y.C.
 Restrictive monetary & fiscal policy ⇒ inverted Y.C.
 Expansionary monetary & restrictive fiscal policy ⇒
moderately upward sloping Y.C.
 Expansionary fiscal & restrictive monetary policy⇒ flat Y.C.
4.2 Economic Growth Trends
 Long term growth path G DP.

 Shocks in trends are difficult to forecast.
 á trend rate, á equity returns.
4.2.1 Consumer Impacts: Consumption and Demand
 Consumer spending is quite s table over business cycle.

 Permanent income hypothesis ⇒ consumer spending
behavior is largely determined by long run income
expectations.
4.2.2 A Decomposition of GDP Growth a nd Its Use i n Forecasting
 Aggregate trend growth is the sum of the following:

 Changes in employment
 Growth in potential labor force size.
 Growth in actual labor force participation rate.
 Changes in labor productivity:
 Growth from capital inputs.
 Growth in total factor productivity.
 If investment is growing faster than returns, r eturns on
invested capital are driven down.
4.2.3 G overnment Structural Policies
 Policies that affect the limits of economic growth & incentives
with in a private s ector.
 Elements of structural policy:
 Sound fiscal policy ⇒ stimulate economy through
budget deficits however c ountries with regular large
deficits tend to face three problems:
 It brings current A/C deficit.
 á inflation
 Take r esources from private s ector.
 Low government i ntervention.
 Competition within the private s ector is encouraged.
 Sound tax policies.



4.3 Exogenous Shocks
 Unanticipated events that occur outside the normal c ourse of

an economy.
 These shocks usually produce a negative impact on the
economy & are built into prices.
Types of Economic Shocks
4.3.1Oil Shocks 4.3.2Financial Crises
 á oil prices, á inflation, âgrowth.  Affect growth through bank leading
 â oil prices, â inflation, ágrowth. or investor confidence.
 Significant â oil prices, overheated  More dangerous in low IR
economy, á inflation. environment.
4.4 International Interactions
4.4.1 Macroeconomic Linkages 4.4.2 Interest Rate/Exchange Rate Linkages
 Business cycle in one c ountry can affect that  Some countries unilaterally peg their
in others. currencies to one of the major currencies.
 Even economies of developed c ountries are  Pegging strategy has two benefits:
not perfectly integrated.  Currency v olatility is reduced.
 Inflation can be brought under c ontrol.
4.4.3 Emerging Markets
4.4.3.1 Essential Differences between Emerging and Major Economies 4.4.3.2 C ountry Risk Analysis
Techniques
 Emerging c ountries:  Emerging bond investors ⇒ focus on default risk.

 Rely heavily on foreign capital.  Emerging stock investors ⇒ evaluate growth prospects.
 Have v olatile political & social environment.  Investors should ask the following questions before
 Need major structural reforms. investing i n EM:
 Rely on commodities.  How sound is fiscal & monetary policy?
[8UTE\ V198T8"
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]24
4% 𝑖𝑠 𝑎𝑝𝑝𝑟𝑜𝑝𝑟𝑖𝑎𝑡𝑒).
 What are the economic growth prospects of the
economy? (growth rate > 4% is appropriate).
 Is the currency c ompetitive, & are external accounts under
control? ( deficit > 4% of G DP is uncompetitive).
 Is external debt under control? (ratio of foreign debt to GDP
> 50% is dangerous) a nd (ratio of debt to c urrent A/C
receipt > 200% is dangerous).
F1U1Fd1U
 Is liquidity plentiful? c <
UeSF" "1F< V17"
100 % 𝑖𝑠 𝑑𝑎𝑛𝑔𝑒𝑟𝑜𝑢𝑠g.

 Is the political situation supportive of the required policies?



4.5 Economic Forecasting

Approach of Economic Forecasting

Econometric Models Leading Indicators Checklists

Formals & mathematical a pproach to Variables found to lead the turns in the Subjective integration of the answers to
forecasting. business c ycle (economy). a set of questions.

4.5.1 Econometric Modeling
Definition Benefit Limitations
Application of quantitative modeling &  Can be r eused.  Complex & time taking.
analysis.  Prices quantitative forecasts.  Variables may also be measured with
error.

4.5.2 Economic Indicators

Definition Advantages Disadvantages

Contain information on an economy’s  Available from outside parties.  Not consistently accurate.
recent past activity or its current or  Easy to understand & interpret.  Forecasts can be misleading.
future positions in business cycle.  Adapted for s pecific purposes.
 Verified by academic r esearch.

4.5.3 Checklist Approach


A list of questions that should indicate  Flexible  Require s ubjective judgment.
the future growth of the economy.  Simple  Time intensive to create.

4.6Using Economic Information in Forecasting Asset Class R eturns
4.6.1 Cash and Equivalents
 Short term debt with maturity of a y ear or less.

 Longer maturity & less credit worthy i nstruments have á
expected return & risk.
 In order to outperform, manager must be able to forecast
future rates better than other managers.



4.6.2 Nominal Default-‐Free Bonds
 Default free bonds issued by G ovt. in developed countries.

 Yield on these bonds:
 Real yield
 Expected inflation
 Stronger economic growth ⇒á bond yields (ádemand for capital &á inflation).
 Changes in s hort term IR have less predictable effects on bond yield.
 á in short term rates ⇒á longer term bond’s yield (but if economy slows as result of
á in IR then yield â).
4.6.3 Defaultable Debt
 Debt with credit risk ( particularly corporate debt).

 During recession ( expansion) spreads tend to widen (narrow).
4.6.4 Emerging Market Bonds
 Debt of non-‐developed countries.

 Emerging c ountries usually borrow in foreign currency, so the
risk of default is higher.
4.6.5 Inflation-‐Indexed B onds
 Yield on inflation indexed bonds c hanges over time with three
economic factors:
 Strong economy (á r eal yields), real yields on TIPS will be
higher.
 Supply & demand may also effect yields on TIPS.
 Yields fall if inflation accelerates.
4.6.6 Common Shares
4.6.6.1 Economic Factors Affecting Earnings 4.6.6.2 The P/E Ratio a nd the Business Cycle 4.6.6.3 Emerging Market Equities
 á the trend growth rate, á the avg.  A P/E rate tends to be á during early Equity risk premiums for
earnings growth. stages of a recovery. emerging markets are on average
 Defensive stocks receive á market  Molodovsky effect ⇒ P/Es of cyclical higher & more v olatile than
valuation while c yclical stocks receive â companies may be á than their own developed markets.
valuation during recession. historical means during downturns
(investors anticipate the s harp future
earnings).
 á Inflation rates tend to depress P/E
ratios.
4.6.7 R eal Estate
 Determinants of real estate returns ⇒

consumption growth, real IR, term structure of IR
& unexpected inflation.
 Low IR are positive for r eal estate valuation.



4.6.8 Currencies
á i mports, â economic growth &â

IR, c urrency will depreciate.
4.6.9 Approaches to Forecasting Exchange Rates
4.6.9.1 Purchasing Power Parity 4.6.9.2 R elative Economic Strength
 Exchange rate differential = i nflation differential.  Focus on investment flows rather than trade flows.
 Does not hold in short or medium term.  Strong economic growth, á c urrency demand,
currency appreciation.
 á s hort-‐term deposit rates, á capital moves in to the
country, currency a ppreciation.
 This approach tells nothing about level of exchange
rates.
4.6.9.3 Capital Flows 4.6.9.4 Savings-‐Investment Imbalances
 Particularly equity investment & foreign direct  During expansion, if domestic savings are <
investment (FDI). investments, then foreign borrowings (appreciate
 á FDI inflows, c urrency tends to appreciate. domestic currency to attract foreign capital).
 Capital flows may reverse the usual relationship b/w IR  If investments < savings, then currency will deprecate.
& currency.
4.6.10 G overnment Intervention
 Govt. faces three c hallenges when they try to i nfluence

exchange rates:
 Foreign exchange trading value > foreign exchange
reserves.
 Exchange rates are determined by fundamentals (Govt.
is just a nother player).
 Foreign exchange trends c ontrol is not encouraging in
the absence of capital control.

EY = Earning Yield
TFP = Total Factor Productivity
DCF = Discounted Cash Flow
“EQUITY MARKET VALUATION”
CPI = Consumer Price Index
2. ESTIMATING A JUSTIFIED P/E RATIO
2.1 Neoclassical Approach to Growth Accounting
Growth accounting ⇒ to measure the contribution of different factors to economic growth & to compute the rate of an
economy’s technological progress.
Cobb-Douglas production function ⇒uses country’s labor input& capital stock to estimate the total real economic output.
=
where
Y = total real economic output
A = TFP
k = Capital stocks
L = Labor Input
α = output elasticity of K (0<α<1)
β = output elasticity of L (α +β=1)
If we assume constant returns to scale, we can derive following expression from above equation:
∆ ∆ ∆ ∆
≈ + + 1 −

Each of the inputs as well as the output is now stated in terms of growth.
% ∆ in capital &labor can be obtained from national accounts.
Growth in TFP is determined using other inputs & is called Solow residual:

= % ∆ − %∆ − 1 − ∆% ∆
Factors that contribute to TFP growth:
Changing technology
Changing trade restriction.
Changing laws.
Changing division of labor.
Changing natural resources.
2.4 Equity Market Valuation
DDM can be used to estimate value of an equity market index.

Assumption ⇒ growth in corporate earnings & dividends is
the same as the growth rate in GDP.
H-model ⇒ valuation model that assumes that dividend growth
rates are expected to decline in a linear fashion (from super-
normal to the long term sustainable growth).

= 1 + + −
− 2
Growth rates & & discount rate ( r) are in real term
(preferred by economists).
H-model involves an approximation to the value estimate.
Justified P/E
Investment attraction of a market index can be evaluated through P/E ratio.

Justified =

( )

Ratio is warranted by fundamentals.
Criticisms
Inaccurate input data (particularly in developing markets).
Difference b/w corporate & GDP growth rates.
Hyperinflation, currency instability can diminish the accuracy & reliability of the model.

3. TOP-DOWN AND BOTTOM-UP FORECASTING
Top-Down Forecasting Bottom-Up Forecasting
Macroeconomic projections to produce return Starts with microeconomic outlook.

expectations for large composites. Individual security ⇒ market sectors⇒ equity
Further refined into return expectations for market.
various market sectors & industry groups.
Information can be distilled into projected
returns for individual securities.
3.1 Portfolio Suitability of Each Forecasting Type
Tactical asset allocation ⇒ top-down forecast

may not need to be focused.
Individual security return focus ⇒
macroeconomic study may be unnecessary.
3.2 Using Both Forecasting Types
Fundamental security analysis ⇒ tries to use both top-down &

bottom-up forecasting.
Top-down & bottom up forecasts can provide significantly
different results.
Most often, the aggregate market consensus will tend to be
more accurate than the individual forecasts.
3.3 Top-Down and Bottom-Up Forecasting of Market Earnings per Share
Bottom-up Earnings Estimate Top-Down Earnings Estimate
Adds up the individual estimates of the Relies on forecasts of various macroeconomic

companies in the index. variables.
Apply model that fits these forecasts.
4. RELATIVE VALUE MODELS
4.1 Earnings-Based Models
1. The Fed Model
Hypothesizes that yield on long terms U.S treasury securities

should be equal to the S&P 500 earnings yield.
If EY > (<) bond yield, stocks are undervalued (overvalued).

Benefits &Criticisms of Fed Model
Benefits Criticisms
Model typically makes use of expected earnings as an input, Ignores equity risk premium.
which is consistent with DCF analysis. Ignores growth in earnings.
When IR, it does correctly suggest that equities become Compares a real variable (index level) to a nominal variable.
more attractive as an asset class.
2. Yardeni Model
Stated as justified earnings yield on equities:

= − ×

where
LTEG = 5 year earnings growth forecast for the S&P 500
= Moody’s A-rated corporate bond yield (as required return)
d = weighting factor
Model captures default risk premium but not equity risk
premium.
5 year growth forecast may not be sustainable in the long run.
3.10-Year Moving Average Price
=
'"()! *+ ,-! & . /#01! 023!4

!"# $% (&) %56.*+ /#!50*)7 !"# ᇲ 7 #!/*#,!3 !"#20267
Many analysts believe that this ratio is mean reverting.
Both numerator & denominator is inflation adjusted through CPI.
10 year moving avg. accounts for business cycle effects on
earnings.
4.2 Asset-Based Models
Tobin’s q Ratio Equity q Ratio
$' *+ " 1*8/"2 %66#!6",! $'*+ !:)0,

9!/("1!8!2, 1*7, *+ 0,7 "77!,7 $"#;!, '"()! *+ +0#8ᇲ 7 2!, <*#,-
Theoretical value of ratio is 1.0 Expected value of ratio is 1.0.
Ratio > (<) 1.0, firm’s stock is presumed to be overpriced Measure differs from P/B ratio because net worth is based on
(underpriced). replacement cost rather than BV of equity.
Limitation ⇒ replacement cost is difficult to determine.
Ratio is mean reverting.

2018, Study S ession # 8, Reading # 16

“INTRODUCTION TO ASSET ALLOCATION”

Invst. = Investment
SAA = strategic asset
2. ASSET ALLOCATION: IMPORTANCE IN INVESTMENT MANAGEMENT
allocation
MVO = mean variance

optimization
A&L = assets &
liabilities

3. THE INVESTMENT GOVERNANCE BACKGROUND TO ASSET ALLOCATION

Investment Governance: a structure to attain asset owner’s
investment r elated objectives within his risk tolerance & c onstraints

3.1 3.2 Articulating 3.3 Allocation 3.4 3.5 Asset 3.6 3.7 The
Governance Investment of Rights & Investment Allocation & Reporting Governance
Structures Objectives Responsibilities Policy Rebalancing Framework Audit
Statement
policy
A typical governance Typically, • Invst. c ommittee, grant

structural has three levels: settled at the approval of asset An effective The
1. Invt. Committee: committee level. allocation decision. framework governance
enables:
2. Invt. Staff: • Rebalancing can be rd
auditors (3
rd
3. 3 -‐party resources: performed by i nvst. • overseers to party) examine
Governance structure committee, staff or assess program’s
the documents,
performs six tasks. external c onsultant. progress quickly
i. Articulate s hort & & clearly. assess firm’s
long-‐term objectives • advisors to execution
ii. Allocate rights & duties A typical IPS includes: comply with the capacity &
iii. Specify IPS r elated Identify primary • Introduction guidelines. portfolios’
methods objective and return • Invst. objective statement performances.
iv. Specify SAA r elated Invst. c onstraints
requirement within •
methods • Statement of decision, rights &
investor’s resource
v. Establish a reporting duties
framework constraints and risk
tolerance.
• Invst. guidelines
vi. Periodic g overnance a udit.
• Frequency & nature of reporting



4. THE ECONOMIC BALANCE SHEET & ASSET ALLOCATION
• Asset allocation s hould c onsider i nvestor’s economic balance sheet -‐

full range of assets a nd liabilities (A&L).
• An economic balance s heet includes financial (A&L) a nd extended
(A&L).
Investor Extended Assets include: Extended
Type Liabilities include:
Individuals Human capital, PV of PV of future
pension income, PV of consumption
expected inheritance etc.
Institutions Resources, PV of future PV of prospective
intellectual property payouts
royalties etc.

5. APPROACHES TO ASSET ALLOCATION

1. Asset-‐only approaches focus only on the asset-‐side of investor’s
balance-‐sheet such as MVO.
2. Liability-‐relative approaches are intended to fund liabilities such as
surplus-‐optimization, liability-‐hedging portfolio c onstruction etc.
3. 3.1.3 Forward
Goal-‐based approaches, Rate Pfarity
primarily or individuals or families, involve
specifying asset allocation to s ub-‐portfolios.

5.1 Relevant 5.2 Relevant 5.3 Modeling
Risk Concepts
Objectives Asset Class Risks
Primary risk measures for: Three ‘super classes’ for assets

 Asset-‐only investors: v olatility, i. capital assets
semi-‐variance, VaR, etc. ii. consumable/transferable assets
 Liability-‐relative approaches: iii. store of value assets
shortfall risk Modern four types of asset classes in practice:
 Goal-‐based approach: failure 1. Global public equity
to attain agreed-‐on s ub goals 2. Global private equity
3. Global fixed income
4. Real-‐assets
Five criteria for effectively s pecifying asset

classes are:
1. Homogenous assets within a n asset class:
2. Mutually exclusive asset classes:
3. Diversifying asset classes:
4. Asset classes as a group s hould c omprise
the majority of w orld investable w ealth:
5. Capacity to absorb a significant proportion
of investor’s portfolio without s eriously
affecting liquidity of portfolio:



6. STRATEGIC ASSET ALLOCATION
6.1 6.2 6.3

Asset-‐only Liability-‐relative Goal-‐based
• focuses on portfolios with the • uses economic and fundamental • uses economic & fundamental factors to link A&L
highest sharpe ratio. factors to link liabilities and assets. • helps investors holding optimal portfolios by
• It is r ecommended to allocate in • Fixed income assets play key role usefully systemizing ‘mental accounting’
global market-‐value w eighted for this approach. • goals can be classified into various dimensions.
portfolio’ (GMP) as a baseline. • Liability Glide Paths, a technique Two of those classifications are:
GMP allocation has two phases. typically, where allocation Classification 1
Phase 1: Allocate assets in the same gradually shifts from return-‐ 1) Personal goals 2) Dynastic goals
proportion as i n the GMP. seeking assets to liability hedging 3) Philanthropic goals
Phase 2: Sub-‐divide broad asset classes assets. Classification 2
into r egional, country & security • Risk-‐factors (duration, inflation, 1. Personal risk bucket-‐ (safe heaven investing)
weights and alter/tilt with regards to credit risk) based modelling can 2. Market risk bucket-‐ (investing in avg risk-‐adjusted
asset-‐owner’s c oncerns. improve performance of liability market returns)
hedging assets 3. Aspirational risk bucket-‐ (risky investing)
Drawbacks:
• Sub-‐portfolios add c omplexity
• Goals may be ambiguous or may ∆ overtime.

7. IMPLEMENTATION CHOICES
7.1 7.2 7.3

Passive/Active Management Passive/Active Management Risk Budgeting Perspective in
of Asset Class Weights of Allocation to Asset Classes Allocation & Implementation
Strategic Asset Allocation (SAA)-‐ Risk Budgeting: budget for risk taking (in
incorporates i nvestor’s long-‐term, 1. Passive m anagement approach does absolute/relative terms expressed in $ or %)
equilibrium market expectations. not respond to ∆ in market Risk budgeting approach to asset allocation
Tactical Asset Allocation (TAA)-‐ expectations or to info. on individual purely focuses on risk, regardless of asset
deliberate temporary tilts away investments. returns,
from the SAA. 2. Active m anagement approach reacts Active Risk Budgeting quantifies investor’s
• TAA, exploits short-‐term capital to ∆ in capital market expectations or capacity to take benchmark-‐relative.
market opportunities individual investment insights.
• Costs are main hurdle for an 3. Blend of active & p assive investing Two levels of active risk budgeting:
effective TAA. At the level of Active risk r elative to
Dynamic Asset Allocation (DAA)-‐ Factors that influence active/passive 1) Overall asset SAA benchmark
deviations from SAA, usually driven investing: allocation
by long-‐term valuation models or • Investment availability: 2) Individual asset Asset Class Benchmark
economic views. • Scalability of active strategies: allocation
• Feasibility of investing passively along
with asset-‐owner’s specific
constraints:
• Belief regarding market informational
efficiency:
• Incremental benefits relative to
incremental costs & risk c hoices:
• Tax Status



8. REBALANCING STRATEGIC CONSIDERATIONS

Rebalancing: aligning portfolio’s weights
with the i nvestor’s target allocation.

8.1 8.2
A Framing for Strategic Considerations
Rebalancing for R ebalancing

• Calendar rebalancing: rebalancing a Factors that suggest tighter rebalancing
portfolio to target weights on include:
periodic basis. • More risk averse investors
• Percent-‐range rebalancing involves • Less c orrelated assets
setting r ebalancing threshold or • Belief in mean variance or mean
trigger points as % of portfolio’s reversion
value, around the target allocation. Factors that suggest wider rebalancing
range l include:
• Higher transaction c osts
• Higher taxes
• Illiquid assets
• Belief in momentum and trend

“PRINCIPLES OF ASSET ALLOCATION”

S.D = standard
deviation 1. INTRODUCTION
Two separate decisions for a diversified multi-asset class portfolio includes:

• Asset allocation decision – translating the client’s goals & constraints into an appropriate portfolio.
• Implementation decision – determining specific investments
2. DEVELOPING ASSET-ONLY ASSET ALLOCATION
2.1 2.2 2.3 2.4 2.5 2.6 2.7

MVO Monte Carlo Criticisms Addressing the Allocating to Risk Factor-
Overview Simulation of MVO Criticisms of MVO Less Liquid Budgeting Based Asset
Asset Classes Allocation
• MVO requires 3 inputs: i) returns, • outcomes are sensitive to Including less liquid asset focuses on
ii) risks and iii) related assets’ small ∆ in inputs. classes in the optimization to an
pairwise correlations. • highly concentrated asset optimization is opportunity set
• Risk-adjusted exp. return = Um= E classes. challenging as indexes consisting of
(Rm) – 0.005 σ2m • focuses on the mean and fail to gauge aggregate
investment factors
• Common Constraints are ’budget variance of returns only. performance of asset
constraint’ & ‘no negative or short • may fail to properly diversify class: the characteristics (fundamental or
position’. the sources of risk. of assets differ structural)
• To estimate risk aversion, • does not consider the significantly because of
determine investor’s risk economic exposures of idiosyncratic (co. specific)
preference & risk capacity liabilities. risk.
• ‘Global min. variance portfolio’, • not useful for multi-period
has the lowest risk & is located at objectives.
the far left of the efficient frontier. • does not take into account
• ‘Max. expected return portfolio’ is trading/rebalancing costs and
the portfolio at the far right of the taxes.
frontier. If no constraints, the
max. exp. return portfolio
allocates 100% in the single asset
with the highest expected return.
• MVO is a single-period framework
Continued on Page 2
• is a statistical tool • finding optimal risk budget to maximize

• generates a no. of strategic asset return per unit of risk.
allocations using random scenarios Some key computations for risk budgeting:
for variables such as: returns, Marginal contribution to risk (௜ ) =
inflation, time frame etc. (Beta of Asset Class i relative to
• delivers more realistic outcome Portfolio) x (Portfolio S.D)
• helps to evaluate the strategic asset Absolute contribution to risk (௜ ) =
allocation for multi-period time ℎ ௜ x ௜
horizon. Portfolio S.D = Sum of ACTR = ∑௡௜
• incorporates effectively the effects % contribution to total S.D =
೔
of ∆ in financial markets, trading or

.
rebalancing costs & taxes.
Ratio of excess return to MCTR =
• complements MVO by tackling the
೑
limitations of MVO.


2.4.1 2.4.2 2.4.3 2.4.4 2.4.5

Reverse Black-Litterman Adding Constraints beyond Resampled Other Non-Normal
Optimization Model the Budget Constraints: MVO Optimization Approaches:
• technique for reverse combines • to incorporate real- combines MVO with More sophisticated
engineering the expected investor’s world constraints Monte-Carlo techniques are trying
returns implicit in a expected returns into the optimization simulation and to overcome MVO
diversified portfolio. forecasts with process challenges by
addresses the issues
• works opposite to MVO • to overcome MVO
reverse-optimized of input uncertainty, incorporating non-
• inputs are: optimal asset problems regarding
returns and makes input quality, input estimation error, and normal return
allocation weights (derived
from the optimization MVO process sensitivity, diversification distribution & by
process), covariances & , more useful. concentrated associated with using other risk
• outputs are: expected allocations. traditional MVO. measures such as
returns. value-at-risk etc.
3. DEVELOPING LIABILITY-RELATIVE ASSET ALLOCATION
3.1 3.2 3.3 3.4

Characterizing Approaches to Liability- Examining the Robustness of Factor-Modeling in
the Liabilities relative Asset Allocation Asset Allocation Alternatives Liability Relative
Approaches:
3.2.2 3.2.3 3.2.4

3.2.1 Hedging/Return- Integrated Comparing
Surplus Seeking Portfolio Asset-liability the
Optimization Approach Approach:
Fixed vs. contingent Approaches:
cash flows
Legal vs. quasi-
liabilities
Duration and ௠஺௅ெ
• Two-portfolio • jointly
= ௌ,௠ − 0.005 ଶ ௦,௠ approach: hedging optimizes asset Liability cash flows
convexity of liability
Steps for surplus optimization and liability typically count on
cash flows portfolio & surplus
Select asset classes & the decisions. multiple factors or
Value of liability portfolio.
relative to the size of time period • Useful for uncertainties.
Estimate E(R) & S.D • several variants of banks, long- The two primary
the sponsoring
Add investor constraints. two-portfolio short hedge factors are inflation
organization
Estimate the correlation approach when funds, & future economic
Factors driving future
matrix and volatilities for there is no +ve insurance or conditions.
liability cash flows
(inflation, discount asset classes & liabilities. surplus reinsurance
rate, economic Compute surplus efficient companies etc.
changes, risk frontier
premium) Select the desired portfolio ‘What if’ sensitivity
Timings mix analysis
Considerations Scenario analysis
Regulations affecting simulation analysis
Surplus Optimization Hedging/Return- Integrated Asset-
liability cash flow seeking Portfolio Liability Portfolio
calculations Simple, ext. of asset- Simple, separating Complex
only MVO assets in two buckets
Linear correlation Linear/non-linear Linear/non-linear
correlation correlation
All levels of risk, Conservative level of All levels of risk
Assumptions similar Can be constructed Can be constructed
to Markowitz model. using a factor model using a factor model
Any funded ratio +ve funded ratio for Any funded ratio
basic approach
Single period Single Period Multiple Period

4. DEVELOPING GOALS-BASED ASSET
4.1
The Goals- 4.2 4.3 4.4 4.5 4.6 4.7
Based Asset Describing Constructing The Overall Revisiting Periodically Issues related
Allocation Client Goals Sub-Portfolios Portfolio the Module Revisiting the to the Goals-
Process Overall Asset Based Asset
Allocation Allocation
Process in Detail:
Two essential parts of this Distinguish b/w cash flow The overall asset
process are: based-goals (for which allocation is aggregation
1. creating portfolio module cash flows are defined) of individual exposures Time horizons are Managing more
2. matching each goal with and labeled goals (for generally rolling than one policy for
suitable sub-portfolios. which investor is unclear concepts each client,
Advisors usually apply pre- about the need). Portfolios, Handling portfolios
established models that Because of constraints, the typically, on day-to-day
best serve the purpose. resultant frontier is not outperform the Satisfying
Different modules therefore, following concerns discount rate and regulatory
The advisor estimates the are crucial.
represent different resultant requirements of
amount allocated for each i. Liquidity concerns
features e.g. implied excessive assets treating all clients
goal and the asset ii. Non-normal return
risk/return tradeoffs, need rebalancing equivalently
allocation that will apply to distribution
liquidity concerns, that sum and then selects
eligibility of some asset- iii. Include drawdown
the suitable module controls
classes or strategies.
Regularly revise: modules &
investor constraints
5.
HEURISTICS AND OTHER
APPROACHES TO ASSET ALLOCATION
Some other offhand techniques for asset allocation

120 minus your age rule
120 minus age = equity allocation
60/40 stock/bond heuristic
Endowment Model or Yale model
allocates large portion to non-traditional
investments (private equity, real-estate)
Risk Parity (each asset class should contribute evenly to the overall
portfolio risk). Mathematically:
1
௜ × ௜ , ௉ = ௉ଶ

The 1/N rule involves allocating equal % to each of (N) asset classes.
6. PORTFOLIO
REBALANCING IN
PRACTICE
Factors & their relation Effect on optimal width of corridor

with corridor width (all else equal)
Transaction costs +ve ↑ transsaction cost, wider the corridor
Risk tolerance +ve ↑ risk tolerance, wider the corridor
Correlation with the rest of ↑ correlation, wider the corridor

the portfolio +ve
Volatility of the rest of the ↑ volatility, narrower the corridor
portfolio -ve


“ASSET ALLOCATION WITH REAL WORLD CONSTRAINTS”

2. ASSET ALLOCATION: IMPORTANCE IN INVESTMENT MANAGEMENT

2.1 2.2 2.3 2.4
Asset Size Liquidity Time Horizon Regulatory & Other
External Constraints

Limited no. of potential asset classes for asset • Two dimensions of • As time passes,
owners with: liquidity are investor’s characteristics of asset-‐
• too large portfolios due to lack of availability of liquidity needs and owner’s:
investment v ehicles. liquidity features of • Human capital changes
• too s mall portfolios because s ome investments asset classes. • Liabilities changes
require a minimum amount.
Managing a large asset pool requires: engagement
of no. of asset-‐managers a nd supervision of their
performances.
Investment managers generally have decreasing
return to scale due to: large trade sizes, greater
price impacts, forced pursuit of investments outside
their expertise and slow decision-‐making.
Asset owners have increasing return to scale due to:
cost savings related to internal management and
ability to allocate to asset classes unavailable to
small funds (for example private equity).
Owners of very large portfolios g enerally invest
passively in developed market equities and allocate
assets to private equity, hedge funds and
infrastructure where having large size of investment
is an a dvantage.

2.4.1 2.4.2 2.4.3 2.4.4
Insurance Companies Pension Funds Endowments & Sovereign
Foundations Wealth Funds

Major c oncerns for Insurance Asset allocation for General features include: Asset allocation of
co. are: pension funds are • Long-‐term time-‐horizon endowments a nd
• matching assets to the subject to constraints • no obligations foundations is influenced by:
projected cash flows of the such as: • in addition to c ommon • Tax Incentives: tax
risks being underwritten. • limiting allocation to benefits tied to certain
constraints, these funds
• Paying claims to policyholders certain asset classes are subject to broad minimum spending rules
• maintaining co.’s financial • tax rules, public scrutiny and or relaxed spending
strength • other accounting, constraints such as requirements for
Factors that directly affect the reporting a nd adopting lower risk asset investing i n s ocially
insurance businesses are: funding restraints. allocation, cultural, responsible stocks.
• Risk-‐based capital measures religious factors, ESG • Credit Considerations:
• Yield (environmental, s ocial & Lenders often place
• Liquidity governance) covenants to maintain
• forced liquidation of assets considerations certain min. liquidity and
balance sheet ratios.



3. ASSET ALLOCATION FOR TAXABLE INVESTORS

Some factors that affect the tax efficiency of asset r eturns include:
• Contribution of interest,
• Dividends
• Realized or unrealized capital gains
• Jurisdictional rules (regarding how returns of certain assets are taxed)
Some commonalities across many j urisdictions regarding how investment r eturns are taxed are:
• Interest income is taxed at progressively higher income tax rates in many c ountries.
• Lower tax rate for dividend income a nd capital gains compared to interest income and earned income.
• Capital losses usually offset capital gains.
• Entities and accounts can be s ubject to different tax rules (tax-‐deferred, tax exempt, taxable accounts),
3.1 3.2 3.3

After-‐tax Portfolio Taxes & Portfolio Strategies to
Optimization Rebalancing reduce Tax Impact

• When cost basis of assets is <(>) its market The equivalent rebalancing To r educe tax c ost other
value, taxable assets have unrealized capital range for the taxable strategies include:
gains (losses) a nd embedded tax liability investor is derived by Ø Tax-‐loss h arvesting-‐
(asset) is formed. adjusting the pre-‐tax Ø Strategic tax location. Two
• Three ways to adjust the c urrent market value deviation by the tax rate. types of account that offer
to reflect embedded tax liability or assets are: After-‐tax rebalancing range tax benefits are:
1. Subtract the value of the embedded ,-./ 012 i. Tax-‐exempt accounts
capital gain tax from the market value as
= Rat =
34#"5

ii. Tax-‐deferred accounts
if it were sold today.
2. Assume the asset is s old in the future and
discount the tax liability to its PV using
the asset’s a fter tax return as the discount
rate.
3. Assume the asset is s old in the future and
discount the tax liability to its PV using
the asset’s a fter tax risk-‐free rate.
• Expected after tax standard deviation = 𝜎"# =
𝜎&# (1 − 𝑡)

4.REVISING THE STRATEGIC
ASSET ALLOCATION
The circumstances that may initiate a s pecial

review of asset allocation policy are:
• Change in goals
• Change in Constraints
• Change in Beliefs



5. SHORT-‐TERM SHIFTS
IN ASSET ALLOCATION
Characteristics of TAA are as follows:

• capturing temporary return opportunities regarding financial or economic market
conditions.
• Assumes that investment r eturns are predictable in the short-‐run.
• Finding c yclical variations within a s ecular trend or short-‐term price changes in capital
markets.
• Short-‐term adjustments to broad asset-‐classes, sectors or risk factor premiums
Common risk c onstraints:
• acceptable range around each asset class policy w eights
• predicted tracking error budget v ersus range of targeted risk
TAA Evaluation: c omparison of TAA a nd SAA with respect to
i. Sharpe ratios
ii. information ratio or t-‐statistic of excess return
iii. realized risk a nd return of TAA portfolio and the realized risk and return of
portfolios along the SAA’s efficient frontier.
iv. performance difference using the attribution a nalysis
TAA Drawbacks:
• Higher trading c osts a nd higher taxes (for taxable investors).
• Higher concentrated asset class risk
5.1 5.2
Discretionary Systematic
TAA TAA
Discretionary TAA typically focuses on: Systematic TAA captures asset class a nomalies that
• asymmetric return distribution have shown predictability and persistence historically.
• skilled managers
• temporary market movements 1. Valuation signals: Different asset classes have their
Short-‐term forecasts require number of i nputs that own value signals.
provide relevant information a bout: Equity Classes: Valuation ratios for equities
1. Current a nd expected political, economic and include: dividend yield, cash flow yield and
financial market c onditions: Valuation measures Shiller’s earning yield
(such as P/E, P/BV, Div. yield), term & credit Fixed Income: yield-‐to-‐maturity a nd term
spreads, c entral bank policy, G DP growth, earnings premiums (yield in excess of the risk-‐free rate).
expectations, inflation expectations, leading Commodities: c omparing roll yields ( +ve is
economic indicators. backwardation, -‐ve is c ontango)
2. Economic s entiment indicators: Consumer Currencies: comparing s hort-‐term interest rate
spending, level of optimism regarding economy a nd gaps to determine w hich currency to overweight
personal finances. or underweight.
3. Market sentiment: Sentiments of financial market 2. Trend Signals:
participants. Three k ey indicators are: Most recent 12-‐month trend-‐
o Margin Borrowing: Higher prices boost Moving average cross-‐over
confidence and trigger more buying on
margin that in turn s pur higher prices.
o Short interest-‐ indicates current & future
bearish s entiment
o Volatility Index: (fear index), indicates
market expectations of near-‐term v olatility.



6. DEALING WITH BEHAVIORAL
BIASES IN ASSET ALLOCATION

6.1 Loss 6.2 Illusion of 6.3 Mental 6.4 6.5 6.6
Aversion Control: Accounting Representative Framing Bias Availability Bias
Bias

suggests that losses are
• significantly more powerful • investors categorize assets • a person’s response is
than gains and liabilities into arbitrary dependent on how the question
• investor’s fail to maintain their groups. is framed.
asset allocation when returns • Goal-‐based investing • In asset allocation, i nvestor’s
are –ve. incorporates mental choice is dependent on how the
• Goal-‐based investing alleviates accounting by linking each investment’s risk and return are
loss-‐aversion bias by: goal with a separate sub-‐ presented,
portfolio. • Some portfolio risk measures
o Funding high priority goals
with less risky assets: • Associated issues include: other than variance are VaR,
o Framing risk in terms of Concentrated stock positions CVaR, Shortfall probability
shortfall probability: & Endowment Effect. • The best approach to scale down
• In i nstitutional investors, loss • Assign concentrated assets to the effects of framing bias is to
aversion can be observed in meet l ess i mportant goals. provide a full range of pertinent
the form of herding behavior. information.

• individuals overestimate their ability to c ontrol • tendency to give more • people give more i mportance to
events weight to recent events as easily recalled info.
• Some common behaviors attributed to this bias compared to l ong-‐term • In asset allocation, two biases
are: events stem from availability biases are
Ø Alpha-‐s eeking behaviors, frequent trading a nd • Objective asset allocation familiarity bias and home bias
tactical allocation shifts, policy with pre-‐specified To mitigate the effects:
Ø Institutional i nvestors w ho believe that their allowable ranges and s trong • use the global portfolio as a
internal resources are s uperior, governance framework can starting point a nd properly
Ø Excessive use of leverage or s hort selling help overcome the bias. evaluate all deviations
Ø Concentrated stock positions • avoid c omparison of investment
• To alleviate the bias, use global market portfolio returns or allocation decisions
as a starting point in developing the portfolio. with others.

Six important features of effective investment

governance a re:
1. Clearly stated long-‐term and short-‐term investment
objectives.
2. Allocation of rights a nd duties in the governance hierarchy
based on their knowledge, expertise a nd designation.
3. Articulate procedures for developing a nd approving the IPS.
4. Articulate procedures for developing a nd approving the
strategic asset allocation.
5. A reporting framework to monitor the performance for
attaining the goals a nd objectives.
6. Periodic g overnance a udits.


“CURRENCY MANAGEMENT: AN INTRODUCTION”
FC = Foreign currency
3. CURRENCY RISK AND PORTFOLIO RETURN AND RISK
DC = Domestic Currency
HR = Hedge Ratio
FI = Fixed Income 3.1 Return Decomposition
Domestic asset⇒ asset that trades in the investor’s domestic currency.

Foreign asset ⇒ assets denominated in currencies other than the investor’s
home currency.
FC return ⇒ return of the foreign asset measured in foreign currency terms.
DC return ⇒ FC return + % movement in spot exchange rate
⇒஽஼ = 1 + ி஼ 1 + ி௑ − 1
where
ி௑⇒ % ∆ in FC against DC.
⇒ The same formula is applicable to multi-currency portfolio of foreign assets.
⇒ Portfolio managers would need to account for the correlations (e.g. b/w
exchange rate movement, FC asset returns etc.) when forming expectations
about future asset price & exchange rate movement.
3.2 Volatility Decomposition
Above formula can be rearranged as:

஽஼ = ி஼ + ி௑ + ி஼ ி௑
Variance of the DC returns for the overall foreign asset portfolio:
ଶ ଵ ଵ + ଶ ଶ ≈ ଵଶ ଶ ଵ + ଶଶ ଶଶ + 2ଵ ଶଵଶଵ, ଶ
-ve correlation b/w variables will overall portfolio’s risk through
diversification.
Overall portfolio’s risk also depends on the ௜ used.
4. CURRENCY MANAGEMENT: STRATEGIC DECISIONS
Various approaches to currency management are in place ranging from currency

risk avoidance to actively seeking FX risk.
Well-developed set of financial products & portfolio management technique are
available to manage currency risk.
4.1 The Investment Policy Statement
IPS mandates the degree of discretionary currency management that will be

allowed in the portfolio.
4.2 The Portfolio Optimization Problem
Optimization of multi-currency portfolio ⇒ selecting portfolio weights that

locate the portfolio on the efficient frontier of the trade-off b/w risk & expected
return defined in terms of the investor’s DC.
Portfolio managers usually handle asset allocation with currency risk as a two
step process:
Portfolio optimization over fully hedged return.
Selection of active currency exposure.

4.3 Choice of Currency Exposures
4.3.1 Diversification Considerations
Many investment practitioners believe that in the long run, currencies have
“mean reversion” feature (i.e. un-hedged currency exposure addition does not
affect long-run expected portfolio return).
Correlation b/w FC return & FC asset return tends to be for fixed income
portfolios than for equity portfolios.
Intuitive sense ⇒ bonds & currencies react strongly to movements in
interest rates.
4.3.2 Cost Considerations
Optimal hedging decision⇒ to balance the hedging benefits against hedging

costs.
Two forms of hedging costs include trading costs & opportunity costs.
4.4 Locating the Portfolio along the Currency Risk Spectrum
4.4.1 Passive Hedging 4.4.2 Discretionary Hedging
Goal is to keep portfolio’s currency exposure close to the “Neutral” benchmark exists as in passive hedging
benchmark portfolio. however manager has some limited discretion.
Rules based approach that removes almost all discretion Discretion is usually defined in terms of FC market value.
of portfolio manager.
4.4.3 Active Currency Management 4.4.4 Currency Overlay
Extension of discretionary hedging. Currency overlay program ⇒ outsourcing currency risk

No allowance for unlimited speculation. management task to a firm specialized in FX
Discretionary hedger usually protects the portfolio from management.
currency risk while active currency manager is supposed Currency managers are allowed to take directional views
to take currency risk for profit. on future currency movements.
One approach may be to separate the hedging & alpha
function (through overlay) mandates of the portfolio.
5. CURRENCY MANAGEMENT: TACTICAL DECISIONS
Tactical currency decision⇒ involves active currency management.

There is no simple formula, model or approach that will allow market
participants to precisely forecast exchange rates.

5.1 Active Currency Management Based on Economic Fundamentals
Developing a view about future exchange rate movements based on the underlying fundamentals.
Assumptions ⇒ In free markets, exchange rates are determined by logical economic relationships.
Model indicates that base currency’s real exchange rate should appreciate, if there is an upward
movement in:
Long run real exchange rate.
Real or nominal interest rates.
Expected foreign inflation.
The foreign risk premium.
Challenges ⇒ to model movements in real exchange rates & changes in other variables overtime.
5.2 Active Currency Management Based on Technical Analysis
Based on three broad themes:

First ⇒historical price data can be helpful in projecting future price movements.
Second ⇒ historical patterns in the price data have a tendency to repeat.
Third ⇒ technical analysis does not attempt to determine where market prices should
trade but where they will trade.
Technicians try to identify when markets have become overbought or oversold to identify
reversal or correction.
Many FX active managers use technical analysis to form a market opinion or to time
positions, entry & exit points.
5.3 Active Currency Management Based on the Carry Trade
Carry trade ⇒ strategy of borrowing in low-yield currencies & investing in high yield
currencies.
Forward rate bias ⇒ forward rates are biased predicator of future spot rate.
Forward premium (discount) overstates the amount of appreciation (depreciation).
Trading the forward rate bias ⇒ buying (selling) currencies selling at a forward
discount (premium).
The Carry Trade: A Summary

Buy/Invest Sell/Borrow
Implementing the carry High-yield currency Low-yield currency
trade
Trading the forward Forward discount Forward premium
rate bias currency currency
5.4 Active Currency Management Based on Volatility Trading
Trading style is unique to option markets & is known as volatility trading.

Volatility trade can be implemented through straddle.
Straddle ⇒ combination of both at-the-money put & call
Profitable in more volatile markets.
Strangle ⇒ buying out-of-the money put & call.
Cheaper to take positions.
Volatility overlay programs, for actively trading the portfolio’s exposures to
movement in currencies’ implied volatility, are also available.

6. TOOLS OF CURRENCY MANAGEMENT
6.1 Forward Contracts
Future or forward contracts on currencies can be used to obtain full currency

hedge.
Institutional investors prefer forwards over futures based on the following reasons:
Due to standardization, futures contracts may not correspond to the portfolio’s
investment parameters.
Futures contracts may not be available in currency pairs required for hedging.
Futures contracts require upfront margin.
6.1.1 Hedge Ratios with Forward Contracts 6.1.2 Roll Yield
Actual HR may drift away from desired HR as Forward contracts are priced at spot rate adjusted for the no. of forward points at the
market conditions change. maturity.
Static hedge ⇒ avoid transaction cost but Forward points may be at premium or discount (+ve or –ve roll yield) depending upon
accumulate unwanted currency risk. buying /selling in the market.
Dynamic hedge ⇒ rebalance the portfolio The Carry Trade and Roll Yield
periodically to manage the currency risk. Buy/Invest Sell/Borrow
Actual HR remains close to target HR. Implementing the High-yield currency Low-yield
Risk aversion, frequency to hedge. carry trade currency Earning a
Trading the forward Forward discount Forward positive roll
rate bias currency premium yields
currency
6.2 Currency Options
Forward contracts hold opportunity cost if future currency moves are in portfolio’s favor.
Options remove this cost by providing right but not obligation to buy FX at agreed upon
price in future.
Protective put ⇒ matching a long position in the underlying with a put option.
Option cost is the premium paid to enter into an option (based on its intrinsic value & time
value).
6.3 Strategies to Reduce Hedging Costs and Modify a Portfolio's Risk Profile
Cost-reduction measures, invariably involve some combination of less downside protection &/or less
upside potential for hedge.
Hedge ratio may drift from 100% to some directional positions in order to reduce cost.
Select Currency Management Strategies

Forward Contracts Over-/ under-hedging Profit from market view
Option Contracts OTM options Cheaper than ATM
Risk reversals Write options to earn premiums
Put/call spreads Write options to earn premiums
Seagull spreads Write options to earn premiums
Exotic Options Knock-in/out features Reduced downside/upside exposure
Digital options Extreme payoff strategies

6.3.1 Over-/Under-Hedging Using Forward Contracts
Manager can add incremental value based on market view (subject to IPS
permission).
If base currency is likely to depreciate (appreciate) then over (under) hedging might
be implemented.
Variant of this approach ⇒() the hedge ratio if base currency depreciates
(appreciates).
Form of delta hedging.
6.3.2 Protective Put Using OTM Options
To reduce cost of using options, accept some downside risk by using an OTM
option (e.g. 25 or 10 delta option).
It is rational to have a cheaper insurance policy & accept responsibility for minor
events.
6.3.3 Risk Reversal (or Collar)
Writing options to earn income that can be used to offset the cost of buying put
options.
Cheap downside protection compared to protective put ⇒ buy an OTM put & write
an OTM call option.
Risk reversal ⇒ long call & short put in FX markets.
6.3.4 Put Spread
Put spread is used to upfront cost of buying a protective put.

Put spread ⇒ buying put + writing put.
6.3.5 Seagull Spread
Seagull spread ⇒ long protective put & write both a call & a deep
OTM put.
6.3.6 Exotic Options
Usually used by currency overlay managers.

Vanilla options ⇒ European style put & calls options.
Exotic options ⇒ options that are not vanilla.
Option with knock-in (knock-out) features ⇒ vanilla
Option that is created (ceases to exist) when spot rate touches
some pre-specified level.
6.4 Hedging Multiple Foreign Currencies
Very similar to hedging single currency but must consider correlation

b/w various foreign currency risk exposures.

6.4.1 Cross Hedges and Macro Hedges
Cross (proxy) hedge ⇒position in one asset is used to hedge the risk exposures of a
different asset.
Macro hedges are some types of cross hedges.
Reason ⇒ entire portfolio is the focal point.
6.4.2 Minimum-Variance Hedge Ratio
A mathematical approach to determine the optimal cross-hedging ratio.

Minimum variance hedge ratio typically applies only for indirect hedges based on
cross hedging.
6.4.3 Basis Risk
Basis risk ⇒ risk to portfolio when a direct currency hedge is replaced with indirect
hedge.
All cross hedgers & macro hedges will have to be carefully monitored & rebalanced
to account for the drift in correlation.
7. CURRENCY MANAGEMENT FOR EMERGING MARKETCURRENCIES
7.1 Special Considerations in Managing Emerging Market Currency Exposures
Two important considerations:

Higher trading costs than the major currencies.
Chances of extreme market events & severe illiquidity.
Higher costs would especially be the case for crosses in currency pairs.
When trades in these less liquid currencies get crowded, liquidity becomes an
issue.
Forward contract based hedging strategies also affect from currency crises.
7.2 Non-Deliverable Forwards
Non-deliverable forwards ⇒ similar to regulated forward contract but these are

cash settled.
NDF has lower credit risk than outright forward (as principal sums in the NDF don’t
move).

“MARKET INDEXES AND BENCHMARKS”
1. INTRODUCTION
Oxford English dictionary ⇒ Benchmark ⇒ a standard or point of reference

against which things may be compared.
Investment context ⇒ a standard for evaluating the performance of an
investment portfolio.
Benchmarks communicate information about an investment manager’s
investment universe & investment discipline.
Market indexes can be used as benchmarks.
2. DISTINGUISHING BETWEEN A BENCHMARK AND A MARKET INDEX
Market index ⇒it represents the performance of a specified security market,

segment or asset class.
The constituents of indexes are selected for their appropriateness in
representing the targeted market, segment or asset class.
Market indexes are often used as benchmark by passive managers.
Active managers usually follow investment disciplines that cannot be
adequately described by a security market index.
Benchmarks must be appropriate for the specific investor whereas market
indexes have broad appeal.
Valid benchmark should be unambiguous, investable, measureable, appropriate,
reflective of current investment opinions, specified in advance & accountable.
3. BENCHMARK USES AND TYPES
3.1 Benchmarks: Investment Uses
Benchmarks uses include the following:

Convey the sponsor’s expectations to the manager as to how the fund assets
will be invested & their expected risk & return.
Reference points for segments of the sponsor’s portfolio.
Communicate to the board & external consultants the mangers’ area of
expertise.
Identification & evaluation of the current portfolio’s risk exposures.
Attribution & appraisal of past performance.
Manager appraisal & selection.
Benchmarks are also used to market investment products to potential investors.
Demonstration of compliance with regulation, laws & standards.

3.2 Types of Benchmarks
Absolute Return Benchmark Manager Universes (Peer Groups)
Minimum target return that the manger is expected to beat Broad group of managers with similar investment disciplines.
(e.g. 9%). Allow performance comparisons with other managers.
Market neutral long-short funds are another example. Managers typically try to beat the median manager’s return.
Broad Market Indexes Factor-Model-Based Benchmarks
These indexes measure broad asset class performance. These are constructed by examining the portfolio’s sensitivity
Style indexes can be generated from market indexes by more to a set of factors.
narrowly defining investment styles. Simplest form ⇒ market model.
Returns-Based Benchmarks Custom Security-Based (Strategy)
Similar to factor-model-based benchmarks in that portfolio These are built to accurately reflect the investment discipline
returns are related to a set of factors. of a particular investment manager.
Factors include the return for various style indexes (e.g. small Developed through discussions & past exposure analysis.
cap value, large cap growth etc.).
Liability-Based Benchmarks
These benchmarks are used by investors who invest to meet a stream of liabilities.
Duration profile & other key characteristics are usually matched & weights are
determined to closely track the returns to the liabilities.
4. MARKET INDEXES USES AND CONSTRUCTION
Indexes represent the performance of securities in a market.

Indexes played a key role in modern portfolio theory & are
popular due to the success of low cost index funds.
4.1 Use of Market Indexes
Asset allocation proxy ⇒ provides the investor a tool to measure asset class ex-ante return, risk &
correlations.
Investment management mandates ⇒ communicate the expectation of the asset owner to the portfolio
manager.
Performance benchmark ⇒ indexes are often used as ex-post performance benchmarks & represent
market return.
Portfolio analysis ⇒ indexes can be used for detailed portfolio analysis in addition to benchmarking the
manger’s performance.
Gauge of market sentiment ⇒ The most common use of indexes is to gauge the market sentiment.
Basis for investment vehicles e.g. index mutual funds, ETFs & derivatives.

4.2 Index Construction
Inclusion Criteria Weighting Methodology Maintenance Rules
Define Eligible Securities
The starting universe of securities must first be identified.

To improve the investability of the index, various eligibility rules
are applied.
Index Weighting
Market Cap Weighting Price Weighting
Most common weighting scheme. Under this scheme constituents are weighted in proportion to
Constituents are held in proportion to their market cap. their prices.
The performance of a value-weighted index represents the Index value = Avg. of the constituent prices.
performance of a portfolio that holds all the outstanding value Performance of this index can be matched by constructing a
of each index security. portfolio that holds one unit of each index security.
Usually such index is adjusted for free float (amount of shares
available to the public).
Equal Weighting Fundamental Weighting
Equal weights to all constituents at specified rebalancing Company’s characteristics e.g. sales, cash flows, book value
times. are used to weight securities rather than market value under
It represents the performance of a portfolio that invests the this weighting scheme.
same amount of wealth in each index security. Performance according to valuation metrics.
Must be rebalanced periodically.
Determine Index Maintenance Rules
Variety of rules must be chosen by an index constructor to provide

for ongoing maintenance of an index (e.g. outstanding shares may
change due to buy backs spin-off etc.).

4.3 Index Construction Tradeoffs
Completeness v/s Investability Reconstitution and rebalancing frequency vs. Turnover
There must be tradeoff b/w completeness & investability. Reconstitution ⇒ the process of adding & dropping securities
Index designers must decide how broad their indexes can be from an index.
while maintaining investability. Rebalancing ⇒ readjustment in the weights of existing
Investability is not the same as liquidity. securities.
Investability is an important concern when manager faces Index designers must decide how often to reconstitute &
frequent & uncertain withdrawals. rebalance their indexes while maintaining tolerable turnover.
Objective and transparent rules vs. Judgment
Index reconstitution ⇒ passive managers’ returns (they have

to buy added securities at higher price & vice versa).
Transparent & objective index ⇒ allow investors to readily
predict the changes in index constituents that might occur.
Index designers may exercise some degree of judgment in
applying their methodologies.
5. INDEX WEIGHTING SCHEMES: ADVANTAGES AND DISADVANTAGES
5.1 Capitalization-Weighted Indexes
Advantages Disadvantages
Objective way of measuring the relative importance of the Overly influenced by overpriced securities.
constituents. Larger issues weighted most heavily.
Best representative of a typical investor’s opportunity set. May be not suitable for active managers & institutional
Less rebalancing required. investors.
5.2 Price-Weighted Indexes
Simple to construct. Overly influenced by highest priced securities.

Long historical track record. Downward bias due to stock-splits.
It does no describe how most investors form portfolios.

5.3 Equal-Weighted Indexes
More diversified. Small issuer bias.

This index may better represent “how Frequent rebalancing & high
the market did” based on average transaction costs.
returns. Liquidity issues.
5.4 Fundamental-Weighted Indexes
It addresses the problem of overweighting the overvalued Rely on subjective judgment of constructor.
issues & underweighting the undervalued issues as the case May be less diversified if valuation screen is restrictive.
with market-cap based index through valuation matrices. Liquidity issues.
Represents an issuer’s importance in economy (less subject to May not serve as valid benchmarks, tilted towards small-cap
bubbles). value stocks.
May not suitable for large-cap or growth preference.
5.5 Choosing an Equity Index Weighting Scheme When an Index Is Used as a Benchmark
Float adjusted indexes are considered the best for use as benchmarks because they
are most easily mimicked with the least amount of tracking risk and lower cost.
Non-cap weighted indexes ⇒ often used to seek returns in excess of cap-weighted
index’s return.
5.6 Market Indexes as Benchmarks
Float-adjusted indexes generally fulfill most validity criteria because they are easily
measureable, unambiguous, specified in advance generally investable.
Limitation of cap-weight, float-adjusted indexes:
May not compatible with a manager’s investment approach.
Construction rules may be less transparent.

“EQUITY PORTFOLIO MANAGEMENT”

SD = Standard Deviation 1. INTRODUCTION L/S = Long-Short
ER = Equity Research IR = Information Ratio
MF = Mutual Fund CSP = Core-Satellite Portfolio
Decision of how to invest in competing equity investments
IT = Information Technology
ranks second compared to how much to allocate to equities.
2. THE ROLE OF THE EQUITY PORTFOLIO
As an investor’s domestic market‘s global weight increases, so does his domestic market focus.
Investing across countries provides diversification because no one market fully captures all global
economic factors & no exact home-market equivalent.
Equities provide inflation hedge (certain limitations, taxes are not inflation hedged so reduce after
tax real return, price competition may limit price due to inflation).
Equities play growth role in portfolio.
For the above reasons investors are equity biased in their asset allocation.
Both domestic & international equities play an important role in individual/institutional portfolios.
3. APPROACHES TO EQUITY INVESTMENT
Passive Management Active Management Semi Active Management
Investor does not reflect his expectations in Seeks to outperform benchmark More concerned about tracking risk
security selection. through security selection. while trying to beat benchmark.
Dominant passive approach is indexing.
Indexed portfolios are passive in
implementation.
Information ratio ⇒ mean active return / tracking risk

(efficiency with which tracking risk deliver active return).
Efficient markets favor indexing.
Information ratio is higher in enhanced indexing.
Client constraints should also be considered when selecting an appropriate approach.
4. PASSIVE EQUITY INVESTING
Historically before cost avg. active return is approximately equal to index

return (active investment underperform after-cost basis).
Passive investing has tax benefit than active investing (low turnover).
Indexing is appropriate in large cap equity market (informationally efficient),
small cap (heavy transaction cost) & unfamiliar overseas markets.
4.1 Equity Indices
Indexes are used to;

Create index fund.
As benchmark.
To perform technical analysis &β calculation.
Explain factors that influence share prices.
Boundaries of index universe, criteria for inclusion, weighting schemes & how
returns are calculated, determine stock index’s characteristics.

4.1.1 Index Weighting Choices
Price Weighted Value Weighted Equal Weighted
Weighted according to absolute share Weighted according to market cap. Each index stock weighted equally.
price. Performance can be matched by Performance can be matched through
Index = sum of price / adjusted no. of investing same proportion as each equal $ investment in each index
shares. index component in index. component.
Index performance can be matched by Self corrects for stock splits & reverse Must be rebalanced periodically.
buying one share of each index stock splits etc.
component. Float weighted index ⇒ subcategory
Simple to construct & can go back far ⇒ consider investable MV of equity.
into the past. Weight of stock in float adjusted index
= market cap weights× adjustment
factor.
Float weighted return represents
return to avg. dollar invested
passively.
Float weighting considered best index
(representative & minimum tracking
error).
Weighting Scheme Biases
Price Weighted Value Weighted Equal Weighted
Biased towards the highest-priced Biased towards large market cap Small company bias.
stock. (mature & overvalued companies) Rebalanced periodically (high
Absolute share price level is arbitrary Less diversified. transaction cost).
(can change through splits, stock Not suitable due to regulatory Illiquid index components.
dividends etc.) restriction (e.g. maximum holdings).
4.1.2 Equity Indices: Composition & Characteristics of Major Indices
Price weighted & equal weighted indexes are very few in numbers these days.
Indices
Committee-determined indices Algorithm (formula based)
Low turnover (low transaction cost & tax). High cost & taxes.
Not reconstituted regularly and may drift Reconstituted regularly (no drift).
away from intended segment.
Fund must evaluate tradeoff b/w transaction cost & difference in return premiums.

4.2 Passive Investment Vehicles
4.2.1 Investment in indexed Long position in cash & long Long position in cash & long
portfolio position in futures position in Swap
Indexed mutual funds ETFs Separate or pooled accounts
Difference b/w Indexed Mutual Funds & ETFs
Mutual Funds Exchange Traded Funds

Trading frequency Trade at NAV once at market close Trade in public market anytime during trading day
Index licensing fee Lower Higher
Tax efficiency Lower Higher
Cost of providing liquidity Yes No, due to in-kind creation/redemption
Shareholder accounting expense Yes No fund level shareholder accounting
Separate or Pooled Accounts
Indexed institutional portfolios (separate or pooled) are cost efficient than MF & ETFs.
In some cases securities lending revenue can equal or exceed total portfolio management
& custody expense.
Indexing a Portfolio
Full Replication Stratified Sampling Optimization
Suitable when securities in index are less Divide index along a no. of dimensions Use multifactor risk model against which
than 1000 & liquid. /cells (industry value, growth etc.). index & individual securities risk
Minimum tracking risk. Place each stock into a cell & match cell exposures are measured & minimize the
Full replication based on value/float weight into portfolio as cell weights in tracking error.
weighted index, is self rebalancing, the index. Optimization considers covariance
trading required only for reinvestment Greater the no. of cells lesser the among factors (advantage).
of dividends & to reflect changes in tracking error. Three disadvantages:
index composition. Stratified sampling can be used to create Risks change over time & model is
Return of full replicated fund is less than index fund from non-diversified index. based on historical data.
return on index (administrative cost, Sampling error.
transaction cost, cash drag). Requires periodic rebalancing.
Optimization produces lower tracking
error than stratified sampling when
used in combination with full
replication.
4.2.2 Equity Index Futures
Exchange of future for physicals ⇒ exchange the stock basket for future contract on index (reduce transaction cost).
Facilitate risk management transaction.
Rolling costs (futures position must be rolled over).
Shorting on Basket trades impeded due to Uptick rule (i.e. no short sale on down tick relative to last trade at a different price).
ETFs are better risk management & hedging tools (no uptick rule, lack of expiration date).

4.2.3 Equity Total Return Swaps
Motivated by different tax treatment of shareholders in different

countries or to acquire exposure to an asset class for strategic/tactical
asset allocation (less cost of rebalancing).
5. ACTIVE EQUITY INVESTING
To outperform benchmark within risk & other constraints.

Range of products from active to passive to satisfy investors’ needs.
5.1 Equity Styles
Value Growth Market oriented
Focus is low share price High earning growth Intermediate grouping for
relative to earnings or BV. companies are key investments (neither value
considerations. nor growth).
Market cap frequently specified in describing investor’s style.

Styles play a role in risk management & performance evaluation.
5.1.1 Value Investment Styles
Focus on cheap stocks relative to earnings or BV.

Possible arguments:
Earnings have mean reverting tendency so earnings will
causing in multiples & stock prices.
Growth investing contains risk of contraction in earnings &
multiples.
Main risks
Misinterpreting a stock’s cheapness.
Undervaluation may not correct with in investment horizon.
Three substyles
Low P/E ⇒ Invest in stocks with low price hoping industry &
stock will recover & P/E will improve.
Contrarian⇒ investment in very depressed industries usually
P/B < 1.
Yield investor ⇒ focus on high current & future dividend yield
(component of total return).
5.1.2 Growth Investment Styles
Focus on future EPS growth rate & major risk is that growth will not
take place & price will.
Substyles
Consistent growth ⇒ invest in companies with long growth
history.
Earning momentum ⇒ higher quarterly year-over-year
earnings growth but less sustainable.
Growth investors do better in economic contraction than economic
expansion.

5.1.3 Other Active Management Styles
Market oriented investor buys stocks below its perceived intrinsic value irrespective of where it falls (growth / value).
Drawback ⇒ if portfolio achieves market like return, indexing or enhanced indexing presents a lower cost alternative.
Substyles
Market oriented with value biased (hold well diversified portfolios).
Market oriented with growth biased (hold well diversified portfolios).
Growth-at-reasonable price ⇒ investor favors companies with above avg. growth with conservative valuation
(portfolios are less diversified than other growth investors).
Style rotators ⇒ invest in most favored near term style.
Market Capitalization
Small Cap Mid Cap Large Cap
Opportunity for mispriced Less well researched More financial stability.

stocks (less research). than large cap Add value through
Better growth prospects. (opportunities exist). superior analysis.
Micro cap ⇒ smallest part Less volatile than small
of small cap. cap.
5.1.4 Techniques for Identifying Investment Styles
Return based style analysis Holding based style analysis
Regress portfolio return on return series of set Categorize individual securities by their
of indices. characteristics & draw overall style conclusion.
Indices should be Value-oriented portfolio has clear bias towards
Mutually exclusive & exhaustive. low P/E, P/B& high dividend yield (vice versa
Not be highly correlated. for growth) & market oriented has valuation
βs on indices are nonnegative & sum to 1. close to market avg.
Normal benchmark ⇒ benchmark with same Greater earning variability ⇒ value oriented
systematic risk exposure as manager’s portfolio⇒ larger weight in utilities & finance
portfolio. sector.
R2 determine style fit & 1-style fit = selection. Growth portfolios ⇒ health care & IT weights
Error term in regression equation reflects style are higher.
return.
Two approaches to style analysis: Advantages and Disadvantages
Returns-based style Characterizes entire portfolio. May be ineffective in characterizing current style.
analysis Facilitates comparisons of portfolios. Error in specifying indices in the model may lead to inaccurate
Aggregate the effects of the investment process. conclusions.
Different models usually give broadly similar results and
portfolio characterizations.
Clear theoretical basis for portfolio categorization.
Requires minimal information.
Can be executed quickly.
Cost effective.
Holding-based style Characterizes each position. Does not reflect the way many portfolio managers approach
analysis Facilitates comparisons of individual positions. security selection.
In looking at present, may capture changes in style more quickly Requires specification of classification attributes for style;
than returns-based analysis. different specifications may give different results
More data intensive than returns-based analysis.

5.1.5 Equity Style Indices
Style indices construction uses multiple variables (price, earnings, book value etc).
Index publishers capture licensing fees from ETF & other investment products.
All style indices use holding-based style analysis.
Overlap ⇒ some securities may be assigned in part to both value & growth.
No overlap ⇒ security is assigned to either value, growth or market oriented.
Buffering ⇒ rules for maintaining the previous stock assignment when stock has not clearly
moved to a new style.
Buffering reduces turnover & transaction expenses.
Index publisher uses growth & value as categories (no overlap) or as quantities (with overlap).
5.1.6 The Style Box
Style box is used for looking at a style.

Style box used by Morningstar divides fund portfolio by market cap (large, mid, small)& style
(value, core & growth).
Categorizing a stock by size is relatively standard technique but techniques used in styles are
diverse across firms.
5.1.7 Style Drift
Inconsistency or straying from stated style.

Two consequences
Investor may lose exposure to desired style.
Manager is operating outside area of expertise.
5.2 Socially Responsible Investing
Consider ethics, social & religious concerns while taking investment decisions.
Negative stocks screens ⇒ reduce investment universe.
Positive SRI Screens ⇒identify companies with ethically desirable characteristics.
SRI often exhibits style bias towards growth investing & market cap bias towards small
cap stocks.
Two benefits of being aware of these biases.
Portfolio manager tries to minimize their biases if inconsistent with client’s
objective & constraints.
Manager can chose appropriate benchmark.
Progress towards style bias issue can be identified & measured through return-based
style analysis.
5.3 Long-Short investing
Style investing focuses on portfolio characteristics while L/S investing

focuses on constraints (short selling).
Long only strategy can hold single alpha while L/S market neutral (zero β)
holds two alphas.
Portable alpha ⇒ added a variety of systematic risk exposures.
Pair trade ⇒ long / short in two single industry firms’ stocks by equal
currency amounts (almost zero β, only firm specific risk).
Leverage used in L/S strategy magnifies risk & return.
If the price of short position tends to rise, loss can be unlimited.

5.3.1 Price Inefficiency on the Short Side
Four pricing inefficiencies exist on short side (can cause higher short side
alpha than long side).
Short positions difficult to obtain (e.g. find lender).
Management manipulations & window dressing (stock is more likely
to be overvalued rather than undervalued).
More frequent issuance of “buy” recommendations due to greater
commissions & potential buyers > sellers & short sellers.
Fear of management lawsuits & business lost prevent analyst from sell
recommendations [against standard I (B)].
5.3.2 Equitizing a Market-Neutral Long-Short Portfolio
Equitizing⇒ market exposure through futures& Swaps.

Notional value of futures= value of cash position from short position.
Rate of return on total portfolio is sum of;
G/L on L/S securities position.
G/L on long futures position.
Interest earned on cash position.
All above divided by portfolio equity.
ETF is an alternative to futures & cost effective way of equitizing & de-equitizing.
Market neutral L/S should be benchmarked against RFR & equitizing should be
benchmarked against relative index.
5.3.3 The Long-Only Constraint
L/S strategies have advantage of “allowing action on negative

insights” over long only portfolio.
Investor’s opportunity set is not symmetric for long only portfolio
(can not take short position).
5.3.4 Short Extension Strategies
Modify long-only strategy by specifying a stated level of short selling.

Generally designed to have market β of 1.
More efficient use of negative information.
In 130/30 strategy, L/S portfolio decision are coordinated (consider single portfolio) while in
100/0 & 30/30 they are not (consider two portfolios).
Several advantages of short extension.
No need for liquid futures a swap market as in equitizing market natural L/S.
Manager’s investment insight as compared to long only.
Disadvantage
Market return & alpha from same source (less flexible than equitizing market neural L/S).
Market neutral L/S is considered part of alternative investments.
5.4 Sell Disciplines/Trading
Strategy of Substitution Deteriorating Fundamentals Rule Driven
Replace existing holding with better Reduce or eliminate a position if Valuation level (e.g. if P/E reaches
opportunity by considering transaction company’s business prospects are historical avg.).
cost & taxes. expected to deteriorate. Down-from-cost.
Also known as opportunity cost sell Up-from-cost.
discipline. Target price sell discipline.
These sell disciplines are not mutually exclusive.

6. SEMIACTIVE EQUITY INVESTING
Designed to outperform benchmark while carefully

managing portfolio risk exposure.
Highest IR as compared to indexing & active
management.
Basic Forms
Derivative-Based Stock Based
Achieve desired equity exposure through derivatives& enhanced Identify overvalued & undervalued stocks & outperform through stock
return through something other than equity investments. selection.
Most common strategy ⇒ equitize a cash portfolio & add value Risk is controlled through factor exposure & industry concentration.
through duration management. If manager has no opinion on stock, hold it at benchmark weight.
Low investment breadth. Limitations
Straight forward strategy. Positive alpha may disappear as other mangers try to exploit it.
Quantitative & mathematical models, based on historical data,
will not work if economy changes.
Fundamental Law of Active Management
IR ≈ IC √Breadth
Where IC = information coefficient (effectiveness of
investment insight).
Breadth = no. of independent active investment
decisions.
Higher the ratio, the better it is.
7. MANAGING A PORTFOLIO OF MANAGERS
When investing a pool of assets, determine overall asset allocation i.e. which classes to
use & how to invest within each asset class.
Allocation should maximize expected total return at a given level to total risk.
(
ℎ ) ஺ = ஺ −⋌஺ ஺ଶ
Where
஺ = expected utility of active return of manager mix.
஺ = expected active return.
⋌஺ = active risk aversion.
஺ଶ = variance of active return.
How much active risk an investor assumes determines mix of managers.
Investors are more averse to active risk than total risk, because;
They believe that successful active management is possible & that they have the
skill to select outperforming managers.
Answerable to someone i.e. institutional conservatism, where overall performance
is judged relative to benchmark, which is difficult to outperform.
More active risk less manager diversification on efficient frontier (active risk
limitation by institutional investors).
= ∑௡௜ୀଵ ℎ஺௜ ஺௜
Where
ℎ஺௜ = weight assigned to ith manager.
஺௜ = active return of ith manager.
Portfolio active risk (active returns are uncorrelated);∑௡௜ୀଵ ℎ஺௜
ଶ
஺௜
ଶ
if returns are
correlated include covariance term under square root sign.

7.1 Core-Satellite
Core-satellite portfolio ⇒ consists of a core holding (index & semi active) &
satellite (active managers).
CSP is a result of optimization applied to a group of equity mangers or some
other heuristic.
Objective is to achieve passive as well as active exposure.
Core should closely resemble investor’s benchmark while satellite portfolios
may have different benchmarks.
Decomposition of Active Return
True Active Return Misfit Active Return
Manager’s return-manager’s normal Manager’s normal benchmark-

benchmark. investor’s benchmark.
Decomposition of Active Risk
True Active Risk Misfit Active Risk
SD of true active return. SD of misfit active return.
Total active risk = ! ᇱ "ଶ + ! ᇱ "ଶ #
Most accurate risk-adjusted performance measure is;

=

Two main uses of true / misfit distinction.
Performance appraisal.
Optimization (allow optimal level of “misfit” risk).
7.2 Completeness Fund
Active managers’ portfolios have number of risk exposures or biases in CSP.

Bottom-up stock picker’s portfolios reflect industry concentrations.
Completeness fund ⇒ when added to active managers’ positions, establishes an overall
portfolio with same risk exposure as investor’s overall equity benchmark.
Value added through stock selection.
Can be managed passively or semi actively &re-estimated periodically.
Drawback ⇒eliminates misfit risk where non-zero misfit risk may be optimal, hence
losing part of true active return.
7.3 Other Approaches: Alpha & Beta Separation
Long active equity portfolio ⇒ provides both α&β exposure.

Market neutral L/S ⇒ can better manage α&β (can use portable α in asset class outside
β asset class).
Risks to market neutral L/S ⇒ short positions are difficult to construct or portfolio may
not really be market neutral.
Portable alpha can be used even without investing on a L/S basis e.g.
' [ long on S & P 500 future]
Long on Japanese manager portfolio !TOPIX index"
∝ $ &
% ℎ on TOPIX future

8. IDENTIFYTING, SELECTING, AND CONTRACTING WITH EQUITY PORTFOLIO MANAGERS
When funds are delegated to outside management a

consultant is required for investment manager search.
8.1 Developing a Universe of Suitable Manager Candidates
Consultants use research staff to determine which

managers are talented & truly add value.
Use both qualitative (people, investment philosophy
etc.) & quantitative (comparison with peers, style
orientation etc.) factors.
8.2 The Predictive Power of Past Performance
Legally “past performance is no guarantee of future

result”.
Past performance must be examined (e.g. active
manager exhibiting consistent underperformance
from benchmark not likely to be selected).
8.3 Fee Structures
Ad Valorem Fees Performance-Based Fees
Calculated by multiplying a % by value of assets managed. Base fee plus sharing %.

Advantage ⇒ simple & predictable. Fee cap ⇒ upper limit to total fee (limit manager from high risk).
Also called assets under management fees. High water mark ⇒ provision requiring cumulatively generated
outperformance since last performance-based fee paid.
Symmetric incentives fees ⇒ reduce (poor performance) as well as
increase (good performance) compensation (better align manager &
plan sponsor interest). manager’s revenue volatility.
One-sided performance based fee ⇒ conveys a call option to
investment manager & value is determined through option pricing
model.

8.4 The Equity Manager Questionnaire
Five Sections
First Section Second Section
Organization / people. Philosophy / process.

Questions include vision of firm, competitive advantage, role of Questions about how equity portfolio will be managed (e.g. research
portfolio managers, length of time the team has together etc. process, risk management function, stock selection process etc.).
Third Section Fourth Section
Focus is on research process, how it is conducted and communicated Performance.

etc. Appropriate benchmark & level of appropriate excess return.
Allocation of resources within organization (investment in technology, Firms submit monthly or quarterly returns & holdings for evaluators.
portfolio construction etc.).
Fifth Section
Fees.
Type of fees (ad valorem or performance based) & terms& conditions
related to fees.
9. STRUCTURING EQUITY RESEARCH AND SECURITY SELECTION
ER is a necessary component of active & semi active

investing.
9.1 Top-Down versus Bottom-Up Approaches
Top-Down Bottom-Up
Focuses on macroeconomic factors. Focuses on company-specific fundamentals.

Build portfolio of individual stocks with
macro insights.
9.2 Buy-Side versus Sell-Side Research
Buy-Side Sell-Side
Research with intent of building a portfolio Independent researchers (who sell their
(investment management firms). work) or investment banks / brokerage to
Decisions are made through committee generate business.
structure (analyst prepares report, presents Analysts work either in teams or themselves
to committee that reviews & decides upon & produce reports on companies &
the conclusion). industries.

9.3 Industry Classification
Equity research departments organized along

industry or sector lines.
Company is categorized into sector, industry group,
industry & sub-industry.

“ALTERNATIVE INVESTMENTS PORTFOLIO MANAGEMENT”

AI = Alternative Investments GP = General Partner
HF = Hedge Funds 1. INTRODUCTION FOF = Fund of Funds
MF = Managed Futures AM = Arithmetic Mean
PE = Private Equity GM = Geometric Mean
High net-worth individuals & institutional investors invest in alternative classes
PS = Preferred stock CY = Convenience Yield
RE = Real Estate for risk reduction & to apply active management skills or both. HWM = High Water Mark
CREFS = Commingled Real Estate There are six diverse groups of alternative investments (real estate, private MVO = Mean Variance
Funds equity, commodities, hedge funds, managed futures & distressed securities). Optimization
REITS = Real Estate Investment Due diligence ⇒ investigation into details of potential investment. SD = Standard Deviation
Trusts DD = Downside Deviation
PIPE = Private Investment in Public VC = Venture Capital
Entity
2. ALTERNATIVE INVESTMENTS: DEFINITIONS, SIMILARITIES, AND CONTRASTS
Alternative investments⇒ comprise group of investments with risk & return characteristics
that differ markedly from those of traditional stocks & bonds investments.
Features of alternative investments:
Illiquidity (require liquidity premiums).
Diversification (relative to stocks & bonds).
Higher due diligence costs (complex securities).
Performance appraisal is difficult.
Less informational efficiency (greater scope for active management).
Investment Universe
Traditional Alternative Modern Alternative Traditional Investments

Investments Investments
Private Equity Hedge Funds Stocks

Commodities Managed Futures Bonds
Real Estate Distressed Securities
Modern alternative investments are more akin to investments or trading strategies than to
asset classes.
AI role in portfolio:
Exposure to risk factors not accessible through stocks & bonds (real estate & long only
commodities).
Exposure to specialized investment strategies (hedge funds & managed futures).
Investments that combine features of prior two groups (private equity & distressed
securities).
Illiquidity of AI is a major concern for short term investors.
AI are not suitable for smaller portfolios due to due diligence costs.
Active Manager Selection Process
Market Opportunity Investment Process
Type of market opportunity. Identify group of managers that seek to exploit these
Reasons for opportunity (regulatory structure or inefficiencies.
behavioral bias). Competitive advantage of managers.
Usually history of past active return is meaningless.

Active Manager Selection Process
Organization People
Is the firm well organized & stable? Consider trustworthiness of people.

Compensation, turnover & succession plan. Speak at length of principal face to face.
Reference checks.
Terms & Structure Service Providers
Check whether fund or account structured Verify lawyers, auditors, prime brokers, lenders
appropriately to the opportunity etc.
Documents Write-Up
Read prospectus & private placement Produce a formal manager

memorandum. recommendation.
Hire lawyers if we do not understand It ensures organized thoughts, informs
everything. others & formally documents the process.
Due Diligence Questions Unique to Individual Clients
Tax Issues Determining Suitability
Advisers frequently dealing with structures that Complex for individual due to multi stage
have distinct tax issues. time horizon & liquidity needs.
Distinct emotional & financial needs.
Communication with Client Decision Risk
Advisors face communication problem Risk of changing strategies at a point of

(complex investment, non professional maximum loss.
investors). Issue relates to downside risk at all points
within a time horizon & investor’s reaction
to it.
Negative skewness, kurtosis, decision
risk.
Concentrated Equity
Concentrated equity position should be

considered while investing in private equity.
Home value must be considered while
investing in real estate.

3. REAL ESTATE
3.1 The Real Estate Market
Our focus is equity investment in real estate.

Potential return enhancement & risk diversification benefit.
3.1.1 Types of Real Estate Investments
Real estate management & development subsector REITS
Companies holding RE ownership, development or Publicly traded equities representing RE properties & /
management. or RE debt investments.
According to GICS & FTSE industry classification REITS returns are dependent on underlying RE holdings.
benchmarks.
Equity REITS Mortgage REITS Hybrid REITS
Own & manage mortgage More than 75% of the assets Mix of the equity &
properties. are mortgages. mortgage REITS
Rental income + capital Interest income + capital
appreciation. appreciation.
CREFS Infrastructure Funds Separately Managed Accounts
Professionally managed vehicles Private investments in public projects (e.g. roads Often offered by the CREFs
investments in RE. schools etc.). sponsoring advisors.
Investments in RE can be open-end Usually investment through consortium of private Important alternative to CREFs.
& closed-end CREFs funds. companies.
Closed end funds use leverage & Govt. leases the project& pay annual fees (avoid
have return objectives. debt & tax).
Consortium often sells its equity portion to
investors through a variety of structures.
3.1.2 Size of the Real Estate Market
RE represents one third to one half of

the world’s wealth (figures are hard
to document).

3.2 Benchmarks and Historical Performance
3.2.1 Benchmarks
NCREIF NAREIT
To measure performance of direct real estate. Benchmark for indirect investments in RE.
Quarterly benchmark for RE (sample of commercial Market-cap-weighted index of all REITS (real time).
properties). NAREIT also computes monthly.
Value weighted index. Equity REITs index.
Subsidies by RE sectors & geographical region. Mortgage REITs index.
Property appraisal determines values in the index Hybrid REITs index.
(conducted infrequently & remain unchanged).
Index is smoothed & underestimates volatility &
correlation.
Methods developed to unsmooth the index.
Significant measurement issues are associated with

direct & indirect investments.
3.2.2 Historical Performance
Over the period of 1990-2004, both direct & indirect RE investments produced better
risk adjusted performance than traditional investments.
NAREITs index hedged = long on equity REITS index & short on equity index.
NCREIF index represents non-leveraged investments & representative of the
performance of private RE funds.
Direct & securitized RE investment performance differ significantly.
3.2.3 Interpretation Issues
NCREIF is not an investable index

(performance appraisal is difficult).
3.3 Real Estate: Investment Characteristics and Roles
In a strategic asset allocation, advisors do not include

client’s residencies as marketable assets.
3.3.1 Investment Characteristics
RE is an asset (has intrinsic value) & holds a substantial income component (commercial RE).
Characteristics of physical RE market:
Illiquid & large lot sizes.
High transaction costs.
Heterogeneity & immobility.
Low information transparency (better risk adjusted returns for efficient, high quality
information investors).
Demographics, market, economic & idiosyncratic factors affect RE.
Complete RE diversification can be achieved only by investing internationally.

Direct Equity RE Investing
Tax subsidies. Not easy to divide into small pieces & may involve large idiosyncratic
More financial leverage. risk.
Direct control over property. Cost of acquiring information is .
Geographical diversifications reduce catastrophic risks (e.g. risk of High commissions & substantial operating & maintenance costs.
floods). Risk of neighborhood deterioration.
On average, RE returns are less volatile than returns to equities. Income tax benefits may be subject to political risk.
3.3.2 Roles in the Portfolio
RE markets follow economic cycles.

Tactical asset allocation⇒ good forecasting of economic
cycles results in improved dynamic strategies.
The Role of Real Estate as a Diversifier
Add value through active management.

Low correlation with stocks & bonds.
Good income enhancer.
REITS provide some diversification benefits relative to traditional investments portfolio but no
benefits to a portfolio consisting of stocks, bonds, hedge funds & commodities.
Direct RE investment provides more diversification benefits than indirect investments.
Diversification within Real Estate Itself
Different RE sectors differ with reference to risk & return.

Apartment sector of commercial RE yielded better results than
simply diversifying across all sectors.
Direct RE investment may provide inflation hedge to some degree.
Direct market exhibits a high degree of return persistence.
Investment in Real Estate Worldwide
Investors may benefit from including domestic & international

investments in RE in their portfolios.
3.3.3 Other Issues
Investment specific points (e.g. valuation methods, tax issues etc)

should also be considered in addition to due diligence process
discussed previously.

4. PRIVATE EQUITY AND VENTURE CAPITAL
PE ⇒ security by which equity capital is raised via private placement

rather than through public offering.
PE investments can be made directly (face to face) or through PE
funds.
PE funds ⇒ pooled investments in highly illiquid assets.
Fields of PE
Venture Capital Buyout PIPE
Investment in a risky company Taking a publicly owned Large investments in a public

that starts out as private & may company private. company usually at a price less
eventually become publicly Private purchase of a division of than the current MV.
owned. public company.
Buyout of private companies.
Capacity issues in PE ⇒ limited supply of winning ideas for

product/services & entrepreneurial &/or managerial skills.
PE investment involves distinct knowledge & experience (particularly
direct P/E investments).
4.1 The Private Equity Market
Why market opportunities arise in VC investments:

To meet capital needs.
Lack of managerial skills & experience.
Diversification of wealth.
Formative stage companies ⇒ raise capital through marketing of an effective business plan.
Private placement memorandum ⇒ a document that is used to raise funds through an agent.

Venture Capital
Demand Supply
Formative-stage companies ⇒ ranges from Angel investors

newly to young companies.
Expansion-stage companies ⇒ ranges from
Seed & early stage investors.
young to established companies (preparing
Relatively small but risky investment.
for IPO).
Usually the 1st outside investors.
Financing Stages
Venture Capital
Early-Stage Later-Stage Pools of capital managed by specialists

(venture capitalists).
Board representations & provide
Seed Stage ⇒ small amount Fund for sales (generally for
significant expertise in addition to
of financing to form a promising companies).
capital.
company & to prove a
VC trusts ⇒ exchange traded, closed-end
successful idea.
vehicles.
Start-up ⇒ pre-revenue
stage to bring the product or
idea to commercialization.
Large Companies
First stage ⇒ additional
funds if company has
exhausted its seed & start up Corporate venturing ⇒ major
financing. companies’ investment in promising
young companies in the same or related
Exit from PE is often difficult industry.
& in following ways. Strategic partners ⇒ investors of
IPO corporate venturing.
Merger with or
acquisition by another
company.
PE Funds
VC Funds Buyout Funds
Relatively small in size than buyout funds

Mega-Cap Middle-Cap
Take public companies private. Purchase private companies

with small revenues & profits.
Dividend recapitalization ⇒ issuance of debt to

finance a special dividend to owners.

4.1.1 Types of Private Equity Investment
Direct VC Investment Indirect Investment (through PE funds)
Structured as convertible preferred Investment through VC & buyout funds.

stock rather than common stock.
Shares of later rounds of financing are
more valuable than earlier round PE Fund Structure
shares.
Limited Partnership Limited Liability Companies
Run by the GP (may be an individual or Hybrid of corporate & partnership form.

corporation). Preferred form when raising funds from
GP also commits its own capital (better small group of knowledgeable investors.
alignment of interests). Run by a managing director.
PE FOF ⇒ invests in other PE funds (double fees structure).
Fund Manager Compensation
Management Fee Carried Interest
Often in the range of 1.5% - 2.5%. Fund manager’s share of fund’s profit.
Usually a % of limited partners’ commitments Sometimes carried interest is paid only if
to the fund. profit exceeds hurdle rate.
Claw back provision ⇒ fund manager will
return money to investors if investors have
not received their capital & share of profit.
4.1.2 Size of the Private Equity Market
As of early 2006, approximately 200 billion U.S. $ was invested in

PE VC & buyout funds worldwide.
Infrequent market pricing of PE poses a challenge to index

construction.
IRR is used to measure performance of PE investment.
4.2.1 Benchmarks
Major benchmarks for VC & buyout funds ⇒ Cambridge

associates & Thomson venture economics.
Custom benchmarks are also used.
PE returns have low correlation with publicly traded securities.

Correlation & return may suffer from stale price bias.

IRR calculation based on appraised value may.

Use stale data (slow to adjust new circumstances).
Focus on company-specific events.
Have no generally accepted standards for
appraisals.
Erroneous returns (due to all above factors).
4.3 Private Equity: Investment Characteristics and Roles
PE plays a growth role in portfolios.

Investment via buyout funds involves less risk & earlier
returns.
Investment characteristics of PE
Illiquidity ⇒ PE investments are illiquid & convertible PS investments don’t trade in
a secondary market.
Long-term commitments required.
Higher risk than seasoned public equity investments.
High expected IRR required (for the risk & illiquidity).
Limited information (in case of VC investments).
Difference b/w VC & buyout funds.
Buyout funds use more leverage than VC funds.
CFs to buyout fund investors come earlier & often steadier than those to VC fund
investors.
VC fund investors are subject to greater error in return measurement.
Moderately high average correlation b/w private & public equity returns has an economic
explanation (some economic & industry exposure in both).
PE has more company specific risk, so correlation is not extremely.
Issues that must be considered when investing in PE:
Sufficient diversification.
Liquidity of the position.
Cash requirement for future capital calls.
Appropriate diversification strategy.
Indirect PE investment in secondary market can be made through purchase from limited
partners seeking liquidity.

4.3.3 Other Issues
Due Diligence
Portfolio Company PE Fund
Due diligence includes:

Evaluation of Prospects for Market Success
Managers experience, capabilities & commitment.
Fund’s GIPS compliance.
Markets, competition & sales prospects. Fund selection is largely dependent on capabilities
Management’s commitment. of general manager’s management team.
Management’s experience & capabilities.
% ownership.
Compensation incentives.
Cash invested.
Identity of current investors.
Opinion of customers.
Operational Review
Employment contracts.
Intellectual property.
Expert validation of technology.
Financial/Legal Review
Examination of financial statements.

Potential for dilution of interest.
5. COMMODITY INVESTMENTS
Commodity ⇒ tangible asset that is relatively homogenous in

nature (standardized futures contracts available).
Investment in commodities via cash & the derivatives markets
constitutes alternative investing.
5.1 The Commodity Market
Direct commodity exposure through:

Cash market.
Future/forward/option market.
To transfer commodity risk.
To improve the functioning of spot &
forward markets
Commodity futures may be cash or delivery settled.

5.1.1 Types of Commodity Investments
Direct Commodity Investment Indirect Commodity Investment
Purchase of commodity in cash or Indirect claims on commodities (e.g. investment

derivative market. in companies specialized in commodity
production).
Poor commodity exposure if commodity linked
companies hedge their commodity exposure.
Small investors can take commodity exposure
through mutual funds & ETFs.
5.1.2 Size of the Commodity Market
Commodity futures were estimated at U.S. $

350 billion as of the 4th quarter of 2005 (in
U.S. only).
Performance evaluation of commodity

investments⇒ through commodity indices
5.2.1 Benchmarks
Long position on commodities & long futures produce similar return if futures are fully margined.
Major commodity indices contain different groups of underlying assets e.g. energy, metals etc.
Market-cap weighting scheme is not suitable for commodity futures indices (every long futures position has a
corresponding short position).
Rj / CRB index ⇒ four sectors with fixed unequal weights.
GSCI index ⇒world-production weighting scheme.
AM or GM to calculate index return from the component return.
Two version of indices:
Total return version ⇒ assumes that capital sufficient to purchase basket of commodities is invested at Rf.
Spot version⇒ tracks only futures price movement.
Different commodity indices produce different results due to difference in composition & weights.
Correlation of commodity indices with traditional asset classes is low (risk diversification benefit).
GSCI sector sub-indices indicate considerable risk & return difference among them.
Recent Performance (2000-2004)
Commodity indices outperformed U.S. & world

equities but not bonds (correlations remain
same but return ∆ with respect to equity).

Commodity Index Return Components
Spot or Price Return Collateral Return Roll Return
∆ in spot price of the underlying commodity Risk free return from the assumption that Yield arises from rolling long futures
futures contract is 100% margined. positions.
over a specified time period.
Monthly roll return=∆ in future price over
the month-∆ in spot price over the month.
Closer the futures contract to maturity
& the CY, roll yield.
Commodities are a distinct asset class if commodity

indices are used as benchmark.
If commodities don’t receive separate treatment ⇒
customized benchmark.
5.3 Commodities: Investment Characteristics and Roles
To take passive commodity exposure ⇒ futures index

investment ⇒ index should be liquid.
Commodities:
Are used to manage portfolio risk.
Provide inflation hedge.
Special Risk Characteristics
During financial & economic crisis, commodity prices

tend to (provide diversification benefits).
Determinants of commodity returns:
Economic cycle-related demand & supply.
Convenience yield.
Real options under uncertainty.
Reasons for including commodity in a portfolio:
Related to economic fundamentals.
Provide inflation hedge.
Commodities as an Inflation Hedge
Storable commodities (e.g. energy) have superior inflation

hedging properties.

Commodities are considered as a portfolio risk diversifier & provide

inflation hedge.
Investors with liabilities indexed to inflation, commodities provide
better risk-return trade-off.
Irrespective of passive long-only commodity exposures, commodities
also offer potential for active management (both, long & short
position).
Commodity active management can be done through separately
managed account or private commodity pool.
6. HEDGE FUNDS
HF are loosely regulated pooled investment vehicles with no universally

accepted definition.
Each HF strategy is used to exploit certain market opportunities.
6.1 The Hedge Fund Market
As no. of similar strategy HF, their return.

HF are absolute return vehicles, but some institutional investors require
relative performance evaluation.
6.1.1 Types of Hedge Fund Investments
Equity Market Neutral Convertible Arbitrage
Identify overvalued & undervalued equity Exploit price anomalies in corporate convertible
securities. securities.
Neutralize portfolio’s exposure to market risk Examples ⇒ buying the convertible bond &
(through long & short positions). shorting the associated stock.
Fixed Income Arbitrage Distressed Securities
Through identifying misvalued securities. Debt & equity investment in companies that are in
Credit quality or term structures of IR are key or near bankruptcy.
considerations. Illiquid securities ⇒ short sales are difficult (mainly
long position).
Merger Arbitrage Hedged Equity
To capture price spread (diff b/w current price & Portfolios not structured to market, industry sector
price after take over). or $ neutral.
Example ⇒ post merger long position on target & Try to identify misvalued securities.
short on acquirer.

6.1.1 Types of Hedge Fund Investments
Global Macro Fund of funds Emerging Markets
To take advantage of systematic moves Fund that invests in a no. of underlying Funds with less mature &emerging
in financial & non-financial markets. HF. market focus.
Concentrate on market trends (macro Diversification. Usually long position because short
focus). Two layers of fees. selling is not allowed.
Sometimes managed futures are
classified under it.
Groups of HF Strategies
Relative Value Event Driven
Exploit valuation discrepancies. To create value through corporate

Through long/short positions. transactions.
Examples ⇒ equity market neutral Examples ⇒ merger arbitrage,
convertible arbitrage. distressed securities.
Equity Hedge Short Selling Global Asset Allocator
Long/short equity position. Short equities with the expectation of Opportunistically long/short positions
Varying degree of equity market market. on financial/nonfinancial assets.
exposure & leverage.
Compensation Structure of HF
Management or AUM fees ⇒ generally ranges from 1% to 2% of asset under management (AUM).
Incentive fee ⇒ % of profits specified by the terms of the investment.
HWM provision ⇒ NAV level that a fund must exceed before performance fees are paid to HF manager.
Purpose of HWM provision ⇒ incentive fees is paid only once for the same gain.
If two funds are of similar size & strategy, it is expected that fund with lower management fee will deliver superior
performance.
Funds with lock up periods specify exit windows (rationale ⇒ avoid unwinding positions unfavorably).
FOF usually do not impose lock up periods ⇒ require additional liquidity & expected return.
HF do not provide sufficient means for monitoring & rebalancing.

Research has also focused on developing indices for strategies
( misfit risk if reference benchmark is not a complete tracking
portfolio).

6.2.1 Benchmarks
Monthly Benchmarks Daily Benchmarks
CISDM of the university of Massachusetts. Dow Jones hedge fund strategy

Credit Suisse/ Tremont. benchmarks.
ECAM advisor. HFR hedge fund indices.
Hedge fund intelligence Ltd. MSCI hedge invest index.
Hedge fund net. Standard & poor’s hedge fund indices.
HFR.
MSCI
Comparison of Major Manager-Based Hedge Fund Indices
Determine whether HF indices are investable & list the actual funds used in
benchmark construction.
Daily indices are generally constructed from managed accounts of an asset
manager rather than from the funds themselves.
Difference in construction of the manager-based HF indices include:
Selection criteria difference.
Different style classification.
Different weighting & rebalancing schemes.
Investability.
Alpha Determination and Absolute-Return Investing
HF are often promoted as absolute return vehicles (no direct

benchmark), so alpha determination is difficult.
Problems in alpha determination:
Difference in selected benchmark.
Investible benchmark is required.
Consider all sources of systematic risk.
During periods of 1990-2004 HF outperform equities & bonds on a risk adjusted basis.
During period of 2000-2004, HF outperforms U.S. & world equities but not bonds.
Equity market neutral & managed futures are considered risk diversifiers (low
correlation with equity market).
Equity hedge funds are considered return enhancers (correlation with equity
markets).
There is a difference in correlations among HF strategies due to difference in
sensitivities to various market factors.
Diff. in HF indices returns due to diff. in HF strategy weights.

Biases in Index Creation
Most HF databases are self reported.

Low correlation among similar strategy indices
is because of:
Size & age restriction.
Diff in weighting schemes.
Weighting Schemes
Value weighting Equal weighting
Momentum effect (popularity bias). Provide diversification benefits.

Index is difficult to track. Rebalancing cost.
Creating a single, all encompassing HF index does

not appear to be feasible.
HF investors also use custom or negotiated
benchmarks.
Relevance of Past Data on Performance
Research shows that volatility of returns

persist through time than the level of returns.
Composition of HF indices also change which
will cause more severe problems for value-
weighted indices than equal weighted.
Biases
Survivorship Bias Stale Price Bias
Only surviving managers (good track record) Lack of security trading may lead to stale price
remain in HF data base. bias.
Overestimation of historical return. SD may or & measured correlations may
Survivorship bias can be through superior .
due diligence. Very little evidence of the presence of this bias
FOFs have screened funds (reduce survivorship in HF.
bias).
Backfill (Inclusion Bias)
Filling of missing past data when a component

joins the index.
Makes results look too good.

6.3 Hedge Funds: Investment Characteristics and Roles
HF are skill-based investment strategies (return through

competitive advantages in information or its interpretation).
Significant market opportunities are required to utilize these
strategies.
HF strategies may be used as return enhancer or risk diversifier.

Analysis of underlying factors used in trading strategies is
important when deciding which HF to include in a portfolio.
6.3.2 Roles in the portfolio
FOF are popular investment vehicles at entry level (provide

diversification, due diligence, two layers of fees).
The Role of Hedge Funds as a Diversifier
Asset allocations produced by MVO are:

Sensitive to errors in return estimates.
Not suitable for HF strategies due to option-like
characteristics of HF strategies.
Historical Performance
Inclusion of HF in portfolio resulted in a mean-variance

improvement (due to its lower skewness & high kurtosis).
Techniques for neutralizing –ve skewness:
Adopt a mean-variance, skewness & kurtosis aware
approach.
Invest in managed futures.
6.3.3 Other Issues
Fund-specific factors
Young funds outperform old funds on total return basis.
Small funds outperform large funds.
Return of FOFs are close to returns of HF indices.

Relationship b/w Fund Factors & HF Return
Performance Fees & Lock-Up Impact Funds of Funds
Funds with quarterly lock-up have returns Less direct impact of survivorship bias.
than with monthly lock-up funds. Classification & style drift (not fit into strict
Funds dissolved during severe drawdown, asset allocation).
rather than not to earn incentive fees.
Effect of Fund Size Age (vintage) Effects
Funds with large asset base attract talented Comparison is difficult among funds with
people, receive more attention of their prime different lengths of track record.
brokers than small fund. Performance of median manger of same
Historically, large funds earns lower mean vintage can be revealing.
return than small funds.
Evaluate the effect of fund size on a case-by-
case basis.
Hedge Fund Due Diligence
Hedge funds rarely disclose their existing portfolio position

(provide annual audited reports & performance review).
Possible concerns:
Authenticity of performance is doubtful without
position report.
Risk management is difficult without disclosure of
portfolio positions.
Certain due diligence check points are available as a guide
for investors.
6.4 Performance Evaluation Concerns
Typically HF performance evaluation & reporting is monthly.

Monthly holding period return =

this return
.
can be compounded annually or quarterly.
HF industry looks through the leverage as if the asset were fully paid (affect the weight of
asset in the portfolio, not the returns on the individual asset).
Rolling return to HF
, = ( + + + ⋯ + )⁄
Reflect return consistency & identify cyclicality in the return.

Volatility &Downside Volatility
SD:
SD of monthly return as measure of risk in HF:

= ℎ × √12
Assumption ⇒ returns are normally distributed (not
suitable for HF, because of excess kurtosis & negative
skewness).
SD penalizes high positive returns.
Downside deviation:
Deviation from a specified threshold (only –ve deviations
are considered in calculation).
DD distinguish b/w good& bad volatility.
=
∑ ೔ ∗ , మ

Drawdown:
Diff. b/w HWM & subsequent low.
Max drawdown ⇒ largest diff. b/w HWM & subsequent
low.
Performance Appraisal Measures
ℎ =
!"#$%&'( #' )* '"!"#$%&'( +*+
!"#$%&'( ,-
Limitations of Sharpe ratio:
Time dependent ⇒ proportionally with square root of time.
Not suitable when asymmetrical return distribution.
Illiquid holdings ⇒ sharpe ratio will biased upward.
Serially correlated return ⇒sharpe ratio is overestimated.
Ratio ignores correlations with other assets in the portfolio.
Ratio has no predictive ability for HF.
Sharpe ratio can be gamed through:
Lengthening the measurement interval.
Compounding the monthly return but calculating the SD from (not compounded)
monthly return.
Writing out-of-money puts & calls on portfolio.
Smoothing & getting rid of extreme returns.
Sortino ratio ⇒replaces SD in sharpe ratio with downside deviation.
=
!"#$%&'( #' )* '"!"#$%&'( +*+
-)./%(' (%0#%)
− − = ×
1)/%%0' '" 2)3/ !05 612)3 '"
4'5#%0' '"/ 2)3/ !05 ().2)3 '"
the ratio, the better it is
Correlations
Most meaningful when returns are

normally distributed.
Skewness & Kurtosis
Skewness ⇒ measures asymmetry in return distribution.

Kurtosis ⇒ measures how return are cluster near the
mean or away from the mean.

Consistency
More relevant when comparing funds of the same

style or strategy.
A fund is considered consistent if it has greater % of
+ve return & less % of –ve return than the benchmark
in all market conditions.
7. MANAGED FUTURES
Actively managed private pooled investment vehicles that invest cash,

spot & derivative markets & use leverage.
Difference b/w HF & MF.
MF trade exclusively in derivative markets while HF tends to be
more active in spot market.
MFs are macro focused while HFs are mainly micro focused.
7.1 The Managed Futures Market
MF are skill-based absolute-return strategies.

MF programs are available in separately managed
accounts & private & publicly traded commodity
funds.
Trading Strategies of MF
Systematic trading strategies Discretionary trading strategies
Rule-based trading model. Trade financial, currency & commodity derivatives.

Most systematic CTAs invest in trend following Involve portfolio manager’s judgment.
programs.
7.2.1 Benchmarks
Investable benchmark exists for active derivative strategies

Mount Lucas is a trading rule based index for active momentum strategy.
CISDM CTA ($ weighted & equal weighted) indices are available for
systematic v/s discretionary strategies.
Over the period of 1990-2004, MF outperforms the equity but

underperforms the bonds.
Correlation of MF with equity is slightly –ve but correlations with bonds
is lower positive.
Results for a more recent period (200-2004) are qualitatively similar.

Survivorship bias in MF can result in returns.

Investment results can be significantly different if
investors are able to forecast surviving managers.
7.3 Managed Futures: Investment Characteristics and Roles
Long-term passively managed unlevered futures position ⇒ earns Rf-

management fee &transaction costs.
To earn more than Rf, sufficient no. of hedgers should be there who
systematically earn less than Rf.
Arbitrage is possible when derivative relationships are out of equilibrium.
Managed derivative strategies follow momentum strategies (positive
skewness to managed fund returns).
Managed futures strategies are lower cost strategies than cash market
strategies.
Provide investors with exposure to unique sources of return.
Short positions can easily be taken in futures.
For the period of 1990-2004, managed futures would have been a valuable
addition to stock/bond/hedge fund portfolio.
For 2000-2004 the results are qualitatively similar.
7.3.3 Other Issues
There is some evidence of performance persistence in MF.

Performance measurement CTAs β with respect to an index of CTAs is a good
predictor of future relative return.
MF uses same due diligence process as in HF (because of leverage & use of
derivatives).
8. DISTRESSED SECURITIES
Distressed securities ⇒ securities of companies that are in financial distress

or near bankruptcy.
Due to IPS or regulatory restrictions, many investors are unable to hold
investment-grade securities.
Provide opportunities to knowledgeable investors which are mostly HF & PE
funds.

8.1 The Distressed Securities Market
8.1.1 Types of Distressed Securities Investments
Hedge Fund Structure Private Equity Fund Structure
Dominant type. Closed-end with a fixed term.

New capital inflows can be taken on a Suitable when assets are highly illiquid or
continuing basis. difficult to value.
AUM fee & incentive structure. NAV fee structure may be problematic
More liquidity than other structure. (assets are difficult to value).
Hybrid Structures
Mix of HF & PE Fund Structures
8.2.1 Benchmarks
A distressed security investing is often classified as

a sub-style of event-driven HF strategy.
All major HF indices have a sub-index for distressed
securities.
Return distribution for distressed securities is distinctly non-normal & can be quite
rewarding.
Significant downside risk is present in distressed securities (negative skewness & excess
kurtosis) so Sharpe ratio is not a suitable measure.
For the period of 1990-2004, distressed securities outperformed all stocks & bonds
investments.
Distressed securities strategy outperforms when economy is not doing well.
Distressed bonds ⇒ highest credit-risk segment of

the high-yield bond market
8.3 Distressed Securities: Investment Characteristics and Roles
Fallen angels ⇒ debt that has crossed the threshold from investment grade
to high yield.
In a reorganization process, old equity may be wiped out & new shares are
issued to creditors & sold to public.
Special skills & deep experience of credit & business valuation is required in
distressed securities.

8.3.2 Role in the Portfolio
Long-Only Value Investing Distressed Debt Arbitrage
Investment in perceived undervalued Long on debt & short on equity of

distressed securities. bankrupt companies.
Orphan equity investing ⇒ investment In case of, equity will more
in newly issued equity of a company (because of residual claim).
emerging from reorganization. In case of, debt will more (senior
claim).
Private Equity
Active approach that involves corporate activism.

Investors become creditors & influence the reorganization process to the value of a troubled company.
Variation of the active approach ⇒ prepackaged bankruptcy (converting distressed debt to private equity).
After restoring, the company can be sold to private or public investors.
Vulture investor⇒ proactive or aggressive investor trying to protect & the value of his claims.
Distressed securities strategies may entail one or more of the following risks.
Event risk ⇒ company specific, low correlation with stock market.
Market liquidity risk ⇒ liquidity is very much low & can be highly cyclical in nature.
Market risk ⇒ not as important as liquidity risk.
J factor risk ⇒ due to involvement of judges in bankruptcy process.
Stale pricing makes the distressed securities appear less risky (Sharpe ratio).
Distressed securities investing require sources of distress &legal, financial & operational analysis.

“RISK MANAGEMENT”
RG = Risk Governance VAR = Value at Risk
ERM = Enterprise Risk 1. INTRODUCTION EAR = Earning at Risk
Management CR = Credit Risk
CG = Corporate Governance IR = Information Ratios
Identification, measurement & control of risk are key to the investment process.
DB = Defined Benefit RAROC = Risk-Adjusted Return on
ESG = Environmental, Social Risk management framework is applicable to the management of both Capital
Governance enterprise & portfolio risk.
Identify which risks are worth taking on a regular or occasional basis & which
should be avoided altogether
2. RISK MANAGEMENT AS A PROCESS
Risk management ⇒ a continuous process involving the identification of exposures to risk, establishing appropriate
ranges for exposures, measurement of these exposures & the execution of appropriate adjustments when required.
Risk management is a continuous processes (subject to evaluation & revisions) not just an activity.
Risk management process of a hypothetical business enterprise:
Nonfinancial Risk The Company Financial Risk
Set Policies &

Procedures
Information/Data Define Risk Information/Data

Tolerance
Derivatives
Identify Risks Execute Risk Mgmt.
Transactions
Measure Risks Non-Derivatives

Identify Appropriate
Transactions
Adjust Level
of Risk
Price Transactions
Execute Transactions
Measure Risks Identify Source(s) of

Uncertainty
Select Appropriate
Model
Determine Market Determine Model

Price or Value Price or Value
Compare
Attractively Priced Not Attractively Priced
Execute Transaction Seek Alternative

Transaction

2. RISK MANAGEMENT AS A PROCESS
Risk management process to portfolio management:

Companies hedge risk that arises from areas in which they have
no expertise or comparative advantage &hedge tactically where
they have an edge (e.g. primary line of business).
Risk management involves risk modification.
3. RISK GOVERNANCE
RG ⇒process of setting overall policies & standards for risk

management is called RG
RG is of good quality if it is transparent, effective, efficient &
accountable.
Risk Governance Structure
Centralized Decentralized
Single risk management group to Risk management by individual

monitor & control risk. business unit managers.
Also called ERM or firm wide risk
management.
Benefit
Benefits People closer to actual risk taking

are allowed to manage it
Economies of scale.
Allows a company to recognize
the offsetting nature of distinct
exposures. Effective RG is possible only if the organization has effective CG.
Enterprise-level risk estimates Steps in effective ERM system:
may be than individual units Identify individual risk factors.
(risk-mitigating benefits of Quantify exposure in monetary terms.
diversification). Use these inputs in a risk estimation model (e.g. VAR).
Consider each risk factor to Identify overall risk exposures & contribution of each risk factor to
which a firm is exposed (in overall risk.
isolation & in terms of any Process of risk reporting to senior management.
interplay). Monitor compliance with policies & risk limits.
Effective ERM systems have centralized data warehouses, which may
require a significant & continuing investment.

4. IDENTIFYING RISKS
Effective risk management requires the separation of risk exposures into

specific categories that reflect their distinguishing characteristics.
Financial risk ⇒ risk derived from events in the external financial markets.
Nonfinancial risk ⇒ all other forms of risk.
Taxes Accounting
Legal Liquidity Risk
Regulations Nonfinancial Risks The Company Financial Risks Credit Risk
Settlement Market Risk (interest rate, exchange rate,

equity prices & commodity prices risk)
Model Operations
4.1 Market Risk
Market risk ⇒ risk associated with IR, exchange rates, stock prices & commodity prices.
Market risk is linked to supply & demand in various marketplaces.
DB plan measures market exposure in asset/liability management context.
4.2 Credit Risk
Credit risk ⇒ risk of loss caused by counterparty’s failure to make a promised payment.
Development of credit derivatives has blurred the lines b/w credit risk & market risk.
Before OTC credit derivative recognition, bond portfolio managers & bank officers were
the primary credit risk managers.
4.3 Liquidity Risk
Liquidity risk ⇒ risk of concession in financial instruments price because of the market’s
potential inability to efficiently accommodate the desired trading size.
In case of short squeezing, liquidity may completely dry up in the market.
For illiquid underlying, derivatives market may also be illiquid.
Size of the bid-ask spread is an imprecise measure of liquidity risk (because it is suitable
only for small trade size).
Complex liquidity measures are available to address the issue of trading volume.
Liquidity risk is difficult to observe & quantify.

4.4 Operational Risk
Operational risk ⇒ risk of loss in a company’s internal (systems & procedures) or from
external events.
The risk can arise from:
Human errors (unintentional errors or willful misconduct).
Computer breakdown (hardware, software problems).
Act of God (only cash compensation for losses can be covered through insurance).
Rogue trader ⇒ trader that assumes irresponsibly level of risk or engaged in
unauthorized transactions or some combination of both.
Companies manage operational risk by monitoring their systems, taking preventive
actions & having a plan in place to respond if such events occur.
4.5 Model Risk
Model risk ⇒ risk that model is incorrect or misapplied (often valuation models).
Inappropriate model ⇒ chances of loss & control over risk is impaired.
Investors must scrutinize & validate all models they use.
4.6 Settlement (Herstatt) Risk
Settlement risk ⇒ risk that one party could be in process of paying the counterparty
while the counterparty is announcing bankruptcy.
Transactions b/w exchange members & clearing house removes settlement risk
Netting arrangement reduces settlement risk.
Transactions with foreign exchange component:
Do not lend themselves to netting.
Parties are unaware of each other.
The risk is called Herstatt risk (bank Herstatt default).
Risk can be mitigated through continuously linked settlement (simultaneous
payments).
4.7 Regulatory Risk
Risk associated with the uncertainty of how a transaction will be regulated or potential
for regulation change.
Regulation is a source of uncertainty (risk that existing regulatory regime will ∆ or
unregulated market will become regulated).
Regulatory risk is difficult to estimate due to ∆ in political parties & regulatory
personnel.
Equivalent combinations of cash & derivative securities are not regulated in the same
way or by the same regulator.
4.8 Legal/Contract Risk
Legal/contract risk ⇒ possibility of loss arising from failure of legal system to enforce a
contract in which an enterprise has a financial stake.
Dealers should be very careful when writing contracts with their counterparties (due to
their advisory nature).
Contract law is often federally or nationally governed.
4.9 Tax Risk
Uncertainty associated with tax laws.

Tax policy often fails to keep pace with innovations in financial instruments.
Equivalent combination of financial instruments may be subject to different tax treatments.

4.10 Accounting Risk
Uncertainty about transaction recording & potential for accounting rules & regulations to∆.
Historically accounting standards varied from country to country (more disclosure
requirements in some countries than others).
Accounting risk can be reduced by hiring personnel with latest accounting knowledge
(accounting risk will always remain).
4.11 Sovereign and Political Risks
Sovereign risk;
Form of credit risk involving sovereign nation’s borrowing.
Current credit risk & potential credit risk.
Its magnitude involves likelihood of default & the estimated recovery rate.
Willingness & ability to repay.
Political risk ⇒ risk of ∆ in the political environment.
4.12 Other Risks
ESG Risk Performance Netting Risk
Environmental risk ⇒ leads to variety of –ve financial & other Performance netting risk;
consequences. Applies to firms that fund more than one strategy.
Social risk ⇒ risk regarding policies & practices of human Firm will receive fee only if net +ve performance.
resources, contractual arrangements & work-place. Firm will pay its portfolio managers on the basis of
Governance risk ⇒ flaws in CG policies & procedures. individual performance.
Asymmetric incentive fee arrangements with portfolio
managers.
Firms may have to pay its portfolio managers when firm’s
revenue is zero.
Settlement Netting Risk
Risk of netting arrangement on profitable transactions for the

benefit of creditors challenged by liquidator of counterparty in
default.
Risk is mitigated by netting agreements that can survive legal
challenge.
5. MEASURING RISK
5.1 Measuring Market Risk
Exposure of actively traded financial instrument prices to ∆ in IR, exchange rates, equity prices & commodity
prices.
Volatility (S.D) is a statistical tool to describe market risk.
Adequate description of portfolio risk.
Suitable for instruments with linear payoffs.
Portfolio’s exposure to losses due to market risk:
Primary or 1st order measures of risk ⇒ adverse movement in a key variable (linear).
2nd order measures ⇒∆ in sensitivities (curvature).
Examples of primary risk measures are β (for stocks), duration (for bonds) & delta, vega & theta (for options).
Examples of 2nd order measures are convexity & Gamma.

5.2 Value at Risk
VAR:
Probability-based measure of loss potential for a company, fund, portfolio, strategy
or transactions.
Expressed either in % or in units of currency.
Easily & widely used to measure loss from market risk but can also be used to
measure credit risk & other exposures (subject to greater complexity).
Can be described as a minimum or maximum VAR.
VAR implication:
It measures minimum loss.
The probability, the VAR in magnitude.
VAR has a time element (the period, the VAR).
5.2.1 Elements of Measuring Value at Risk
Establishing an appropriate VAR measure requires

a no. of decisions about the calculation structure.
Three Important Decisions in VAR
Picking a Probability Level Choosing the Time Period Selecting a Specific Approach
The probability, more conservative the VAR magnitude is directly related to time Three standardized methods for estimating
VAR estimate is. interval selected. VARs (discussed below).
Linear risk characteristic portfolios, two Relationship is nonlinear.
probability levels (e.g. 5% & 1%) will
provide identical information.
Optionality or nonlinear risks, select the
more conservative probability threshold.
5.2.2 The Analytical or Variance-Covariance Method
Assumptions ⇒ portfolio returns are normally distributed.

Standard normal distribution ⇒ expected value of zero & a SD of 1.
Conversion of a nonstandard normal distribution to a standard normal distribution:

−

= ^ −
Estimation of expected returns& SD of returns is key to using analytical method.
If we are comfortable with normal distribution assumption & accuracy of our estimates, we can confidently use the
analytical method for a different time period by adjusting the avg returns & SD accordingly (e.g. annual VAR can be
converted to daily VAR by dividing avg return & SD to 250 (trading days)).
VAR (usually daily VAR) can also be estimated by assuming an expected return of zero. Two advantages:
No need to estimate E(R) which is harder to estimate than volatility.
Easier to adjust VAR for a different time period(. . = √250).
Advantage/Disadvantage of Analytical Method
Advantage Disadvantage
Simple method Normal distribution assumption often

does not hold (e.g.in options).

5.2.3 The Historical Method
Collect the historical return & identify the return below which 5% or 1% of returns fall.
No constraint to use normal distribution.
If different portfolio composition, than what actually had in the past to calculate historical
VAR, it is more appropriate to call the method a historical simulation.
Advantage ⇒ non parametric.
Disadvantage ⇒ relies completely on past data (also a problem with other methods but
not so acute).
5.2.4 The Monte Carlo Simulation Method
MCS produce random portfolio returns that are assembled into a summary distribution
from which we can determine at which level the lower 5% (or 1%) of return outcomes
occur.
MCS does not require a normal distribution.
MCS is a more flexible approach & even suitable for portfolios containing options.
As sample size sample VAR converge to population VAR.
MCS require extensive commitments of computer resources.
5.2.5 Surplus at Risk": VAR as It Applies to Pension Fund Portfolios
Pension fund managers apply VAR methodologies to the

surplus (rather than their asset portfolio).
Managers express their liability portfolio as a set of short
securities & calculate VAR on net position (any VAR
methodology can apply).
5.3 The Advantages and Limitations of VAR
VAR’s Imperfections VAR’s Attractions
Can be difficult to estimate. Quantify loss in simple terms.

Different estimation methods can provide different Easily understood by senior management.
results. May be a requirement of regulatory body.
If assumptions are not accurate, VAR often VAR is a versatile measure.
underestimates magnitude or frequency of worst VAR is often paired with stress testing.
returns. VAR results are input dependent.
Portfolio VAR is not simply the sum of individual
position’s VAR.
VAR provides an incomplete picture of overall exposure
(ignore +ve results).
Back testing should be applied to check method’s
accuracy.
VAR estimate is not suitable for organization with
complex structure.

5.4 Extensions and Supplements to VAR
Incremental VAR ⇒ effect on portfolio VAR by including & excluding

an asset.
Provide extremely limited picture of the asset’s or portfolio’s
contribution to risk.
Cash flow at risk & EAR ⇒ with a given probability & over a specified
time period, the minimum CF (earnings) that we expect to be
exceeded.
Useful for companies that generate CF or earnings but not
readily valued in a publicly traded market.
Tail VAR ⇒VAR plus the expected loss in excess of VAR, when such
additional loss occurs.
5.5 Stress Testing
Stress testing is used to supplement VAR as a risk measure.

VAR assumes potential losses under normal market conditions while
stress testing identifies additional losses due to unusual circumstances.
Approaches in Stress Testing
5.5.1 Scenario Analysis 5.5.2 Stressing Models
Evaluating a portfolio under different scenarios. Use an existing model & apply shocks to the model inputs in some
Effect of large movements in a key variable on portfolio’s value. mechanical way.
Stylized scenarios ⇒ simulating a movement in at least one primary market Range of possibilities rather than a single set of scenarios.
force (e.g. IR, exchange rate etc.). Computationally demanding.
Problem ⇒it assumes that shocks tend to be applied to variables in a Factor push ⇒ push risk factors & prices of a model in most disadvantageous
sequential fashion (in reality, shocks often happen simultaneously). way & to work out the combined effect on the portfolio value.
Actual extreme events ⇒ put the portfolio through price movements Model risk is present.
resulting from the events that occurred in the past. Max. Loss optimizations ⇒ mathematically optimizing the risk variable that
Hypothetical events⇒ that have never happened in the markets (difficult to will produce the maximum loss.
analyze & confusing outcomes). Worst-case scenario analysis ⇒ examines the expected worst case.
When a series of appropriate scenarios is established, the next step is to
apply them to the portfolio (consider assets’ sensitivities to the underlying
risk factors).
5.6 Measuring Credit Risk
Credit risk ⇒ risk that the party owing money to another will be unable to meet its obligation.
CR has two dimensions:
Probability of default.
Amount of loss.
Empirical data set on credit losses is quite limited with respect to time perspective, credit losses can be current or potential credit losses.
Cross-default provision ⇒ borrower’s default on any outstanding credit obligation is considered default on all outstanding credit obligations.
Credit or default VAR ⇒ reflects the probability of minimum loss during a certain time period.
Credit VAR can’t be separated from market VAR & focus on upper tail of the distribution of market returns.
More accurate measures of default probability & recovery rate ⇒& more accurate credit VAR.
Estimating credit VAR is complicated because:
Credit events are rare & harder to estimate.
CR is less easily aggregated than market risk.
Correlations b/w CR of counterparties must be considered.

5.6.1 Option-Pricing Theory and Credit Risk
A bond with CR can be viewed as:

Default free bond plus.
Short put option written by bondholders for shareholders (this put option reflects
shareholders right of limited liability).
Traditional put-call parity with a little bit changes
5.6.1option-Pricing can be
Theory used
and to draw
Credit Risk value of implicit put option.
Value of put option is the difference b/w default-free bond & bond subject to default.
5.6.2 The Credit Risk of Forward Contracts
Each party assumes the other’s CR.

No current CR exists prior to expiration (no payments are due).
If the counterparty with –ve value declares bankruptcy before the contract expiration, the claim of
non-defaulting counterparty is market value of forward contract at the time of bankruptcy.
5.6.3 The Credit Risk of Swaps
CR is present at a series of points during the contract’s life.

MV of contract can be calculated at any time to reflect potential CR.
CR of IR & equity swaps is largest during the middle of a swap’s life.
In case of currency swaps, the CR is greatest b/w a midpoint to the end of the
swap’s life.
5.6.4 The Credit Risk of options
Options have unilateral CR (after paying premium credit risk accrues entirely to
the buyer).
European options ⇒ no current CR until expiration ⇒ significant potential CR.
American option ⇒ current CR if holders decide to exercise option early.
Credit risk on derivative transaction tends to be quite small relative to that on
loan.
5.7 Liquidity Risk
Cost of an illiquid instrument can be measured through bid-ask spread.

Instruments that trade very infrequently at any price give illusion of volatility).
Practitioners often liquidity-adjust the VAR estimates.
5.8 Measuring Non-Financial Risks
These risks are very difficult to measure ⇒ usually lack of observable distribution
of losses related to these factors.
Techniques like extreme value theory is used if possible to model sources of risk
but these techniques are input dependent.
5.8.1 Operational Risk
Well publicized losses at financial institutions (e.g. rogue employees

theft) have put operational risk justifiable into the forefront.
Banks can measure their operational risk through Basel II.

6. MANAGING RISK
Key components:
Effective risk governance model.
Systems & technology to provide timely& accurate risk information to decision
makers.
Trained personnel to evaluate risk information.
Risk management is just a good common business sense.
6.1 Managing Market Risk
ERM system identifies appropriate risk tolerance levels.

Taking too little risk is as much problematic as taking
too much risk (e.g. possible rewards).
6.1.1 Risk Budgeting
Risk budgeting ⇒ efficient allocation of capital risk across various

units of an organization or portfolio managers.
Risk Budgeting
Organization Perspective Portfolio Management Context
Allocation of an acceptable level of risk to Asset class correlation adjusted IR can

various departments of an organization. determine the optimal tracking risk
In addition to VAR, risk can also be allocated allocation.
based on individual transaction size, amount Investment manager’s allocation is positively
of working capital needed etc. related to his correlation adjusted IR.
If correlation among departments is < 1, the Risk budget allocation should be measured in
sum of risk budgets for individual units > relation to risk to surplus (assets – liabilities).
than organizational risk budget.
6.2 Managing Credit Risk
Estimating default probability is difficult.

Credit risk is not symmetric & normally distributed (downside
only) thus not easily measured & controlled using SD & VAR.
6.2.1 Reducing Credit Risk by Limiting Exposure
Not lend too much money to one entity.

Not engage in too many derivative transactions with one
counterparty.
6.2.2 Reducing Credit Risk by Marking to Market
Credit risk can be reduced through marking to market an OTC

derivative contract.
OTC options are not marked to market (one sided +ve value).
Credit risk of option is normally handled by collateral.

6.2.3 Reducing Credit Risk with Collateral
Collateral posting is widely accepted as credit

exposure mitigant.
Collateral requirements are based on market
values & participants credit ratings.
6.2.4 Reducing Credit Risk with Netting
Payment netting credit risk by the amount of money that must be

paid.
Netting in the event surrounding a bankruptcy is referred to as closeout
netting.
Cherry picking ⇒ bankrupt company attempting to enforce contracts that
are favorable to it while walking away from those that are unprofitable.
6.2.5 Reducing Credit Risk with Minimum Credit Standards and Enhanced Derivative Product Companies
Companies will not do business with an organization of low credit quality.

EDPCs are SPVs, which are used by banks to control their exposure to
rating downgrades.
6.2.6 Transferring Credit Risk with Credit Derivatives
Credit default swap ⇒ protection buyer pays the protection seller in

return for the right to receive a payment from the seller in case of specific
credit event.
Total return swap ⇒ protection buyer pays the total return in return for
floating rate payments.
Protection seller exposed to credit & IR risk.
Credit spread option ⇒ yield spread of a reference obligation & over a
referenced benchmark.
Credit spread forward ⇒forward contract on yield spread.
Credit derivatives are used to eliminate as well as to assume credit risk.
6.3 Performance Evaluation
Risk adjusted performance is a critically important capital allocation tool

(homogenous units of exposure assumption) as measured against sensible
benchmarks.
Methodologies for Risk-Adjusted Performance
Sharpe Ratio RAROC

This ratio measures excess mean return over

Rf per unit of total risk.
Capital at risk can be calculated in a variety of
SD assumes normal distribution therefore it
ways & can take a no. of different forms.
is not suitable for portfolios containing
options.

Methodologies for Risk-Adjusted Performance
Return over Maximum Drawdown Sortino Ratio
Max drawdown ⇒ largest difference b/w a Portfolio managers should not be penalized
high watermark & subsequent low. for +ve volatility (as in Sharpe ratio).

= Downside deviation ⇒ rate of return
%

the ratio, the better it is. volatility below the minimum acceptable
return (MAR).
(

)
=

If MAR is Rf then the only difference b/w
Sharpe ratio & Sortino ratio is due to
denominator.
If non-normal distribution = Sharpe ratio &
Sortino ratio behave much in similar way.
Sharpe ratio is preferred in finance theory.
6.4 Capital Allocation
In addition to capital preservation, risk management has

become a vital component for risk taking enterprises.
Risk management is a vital input into a capital allocation process.
Most effective approach to capital allocation ⇒ appropriate
combination of these methodologies:
Methodologies for Capital Allocation
1. Nominal, Notional, or Monetary Position Limits 2. VAR-Based Position Limits
Capital that a portfolio or business unit can use in a specified activity. In notional limits a VAR limit serves as a proxy for capital allocation.
Advantages: Advantage ⇒ appropriate for risk control process.
Easy to understand & calculate. Problem ⇒ dependent on VAR’s effectiveness.
Nominal position can be taken by using other assets (e.g.
derivatives).
Disadvantages:
Ignore effects of correlation & offsetting risks. 4. Internal Capital Requirements
Not suitable in risk-control perspective.
Capital, the management believes to be appropriate for the firm.
If regulatory capital requirement is, overrule internal requirements.
3. Maximum Loss Limits Traditionally, capital ratio was used to specify internal capital
requirements.
Modern approach ⇒ firm will be insolvent if in asset is > than value
Determine a maximum loss limit. of capital.
Max loss limit should be determined carefully (preserve capital & not VAR based capital requirement has an advantage over regulatory
constrained in meeting investment objectives). capital requirement ⇒ it considers correlations.
5. Regulatory Capital Requirements
May be inconsistent with rational capital allocation scheme.

Part of overall allocation process whenever demanded by overall
allocation process.

6.5 Psychological and Behavioral Considerations
Behavioral aspects have two implications of risk management:

At different points in portfolio management cycle, risk
takers may behave differently.
Risk management can be better implemented if these
dynamics could be modeled.

“RISK MANAGEMENT APPLICATIONS OF

FORWARD AND FUTURES STRATEGIES”
FP = Futures Price
FC = Futures Contracts 1. INTRODUCTION
Companies should take risk in those areas in which business has expertise &
avoid risks in areas not related to their primary lines of business.
Risk management is about managing risk not necessarily only hedging risk
2. OPTIONAL SEGMENT
3. STRATEGIES AND APPLICATIONS FORMANAGING EQUITY MARKET RISK
Stock markets are more volatile & liquid than bond markets.
Index futures contracts are used to manage risk arising from stock market
volatility.
3.1 Measuring and Managing the Risk of Equities
Index futures are used to manage the risk of diversified equity portfolios.
Broad market movements’ exposure is called systematic risk while risk associated
with a specific company is known as non-systematic risk.
β plays a critical role in stock risk management but it is subject to systematic risk only.
$β of stock portfolio = ௉ × MV of the stock portfolio.
Futures $ β = ௙ × future price.
β of futures contract can be different from 1.
Following relationship holds to achieve target level of β:
் = ௌ + ௙ ௙
where
் = Target β
ௌ = Current portfolio β
S = Stock portfolio value
F = Actual futures price = quoted FP× multiplier

ℎ

௙ = ×

To () β, futures contracts must be bought (sold).
Index futures should be representative of portfolio investment style.
3.2 Managing the Risk of an Equity Portfolio
Scaling β up or down with futures contract can magnify both, gain or loss.
ௌ are difficult to measure.
Diff. b/w effective β& target β can be due to:
Rounding off of FC.
Expected value of β may not be equal to observed actual value of β.

3.3 Creating Equity out of Cash
Synthetic cash (long Rf bonds) = long stock + short futures.

Synthetic stock (long stock) = long Rf bond + long futures.
Advantages of synthetic equity position:
Lower transaction costs.
Higher liquidity.
3.3.1 Creating a Synthetic Index Fund
Steps to create synthetic index fund:

Calculate no. of futures contracts to represent the ending cash value:
1 ்
௙∗ = × +
×
where
V = Portfolio value
q = Multiplier
f = Futures price
Round the no. of FC to the nearest whole number & estimate the
amount of cash that needs to be equitized.
௙∗ × ×
∗ =
1 +
்
The amount of treasuries equitized will grow at Rf.
The amount of stocks that will be purchased at the start of contract:
∗ ×
! "
ℎ = ௙
1 + #்
where
# = dividend yield
At the end of investment horizon:
$ℎ " ! − ௙∗ = ௙∗ × × (் − )
where
் = Index value at time T.
Issues:
Index used to create synthetic equity position is price only therefore it
ignores dividend portion.
Futures expiration date may be different than horizon date.
3.3.2 Equitizing Cash
Cash is converted into equity position using FC

while maintaining the liquidity provided by cash.
Issue ⇒ investors have no control over the
pricing of futures.
3.4 Creating Cash out of Equity
Synthetic cash (long Rf bond) = long stock + short futures.

Steps:
Calculate the no. of FC needed to short (Nf).
Determine the actual amount of synthetic cash created (V).
Settle the short position by selling the equity position
(management will be left with synthetic cash).

Advantages & Limitation of Using Derivatives
Advantages Limitation
Liquidity & transaction costs. Liquidity problem exists in longer maturity

Provide better timing & allocation derivatives.
strategies.
Derivatives have less disruption &
provides a quicker way to execute
transactions.
Derivatives require less capital to trade &
provide ease to alter risk exposure.
4. ASSET ALLOCATION WITH FUTURES
Asset allocation can be effectively altered through FC.

Portfolio performance significantly depends on asset class allocation.
Duration of portfolio through FC does not liquidity of position.
Reasons of imperfect hedge:
Exact hedging is not possible.
Rounded off FC.
β & duration is difficult to measures (expected value may not be
equal to the observed actual values).
Basis risk.
FCs are based on price only indexes.
4.2 Pre-Investing in an Asset Class
Pre-investing ⇒ strategy in which futures contracts convert a yet-to-

receive cash into desired synthetic equity or bond exposure.
Useful when attractive investment opportunities are available & investors
might not have cash at that time.
Investor will take long position in futures & close out the position in futures
when cash is received & invest that cash in the underlying.
Risk ⇒ leveraged futures position can magnify losses in case of adverse
market movements.
5. STRATEGIES AND APPLICATIONS FORMANAGING FOREIGN CURRENCY RISK
Companies dealing in foreign currency are exposed to:

Exchange rate risk.
Future business related risks.
Types of Foreign Exchange Rate Risk
Transaction Exposure Translation Exposure Economic Exposure
Foreign currency receipts become less valuable Risk faced by multinational Risk faced by importer or exporter.
in terms of domestic currency if foreign currency companies if foreign currency When foreign currency appreciates
depreciates. depreciates (assets will face in (depreciates) exporter (importer) faces currency
In case of purchases, currency loss is incurred domestic value). risk.
when foreign currency appreciates.

5.1 Managing the Risk of a Foreign Currency Receipt
If foreign currency receipts ⇒ sell forward contract to

hedge currency risk.
If foreign currency payments ⇒ buy forward contract to
hedge currency risk.
Equity risk of foreign investment can be hedged by
selling futures contracts on foreign market index.
Foreign exchange risk can be hedged through forward
contracts on the foreign currency.
5.3 Managing the Risk of a Foreign-Market Asset Portfolio
Investors can:
Hedge foreign equity market return & leave the
currency risk unhedged.
Hedge (remain unhedged) both equity market
return & currency risk.
It is not possible to remain unhedged in local equity
market & hedge currency risk.
Hedging market risk ⇒ generates foreign Rf rate.
Hedging both risks (market & exchange rate) ⇒
generates domestic Rf rate.
These strategies are useful only in the short-run.
6. FUTURES OR FORWARDS?
Preferred instruments in different situations:

Specific dates risk ⇒ use forward contracts.
When transaction costs are a concern & not a perfect
hedge is required ⇒ use futures contracts.
Flexibility with respect to horizon date ⇒ use futures
contracts.
Usually equity risk is managed through equity index
futures.
Usually forward contracts are used to hedge exchange
rate risk.
Future & Forwards v/s Options
Many organizations are not permitted to use fully

leveraged position (e.g. forwards or futures) so they use
options.
Option loss is limited to option premium (non linear
payoffs).

“RISK MANAGEMENT APPLICATIONS OF OPTION STRATEGIES”

IR = Interest Rate
NP = Notional Principal
2.2 Risk Management Strategies with Options and the Underlying
An investor can exposure without selling the underlying

through:
Covered call.
Protective put.
2.2.1 Covered Calls
Long stock + short call.

Appropriate when stock price neither nor in the near future.
Limited upside potential & downside protection.
Reduces both overall risk & the expected return.
= − 0, −

= − +
= −

= −
the X, lower the option premium.
2.2.2 Protective Puts
Long stock + long put.

Provide protection against in value (similar to insurance).
Requires upfront option cost.
Appropriate when an investor expects a in value of the stock in
the near future.
= + 0, −
Profit = − − &
= ∞.
Max loss = + − .
Break even = +
2.3 Money Spreads
Spread ⇒ strategy that involves buying one option & selling

another identical option but either with different X or different
time to expiration.
Time spread ⇒ different time to expiration.
Money spread ⇒ different exercise price.

2.3.1 Bull Spreads
Buying a call with a lower X & selling another with X.

Rationale ⇒when investor expects an in stock price in the near
future.
Similar to covered call it provides protection against downside risk
& limited upside potential.
= −
Where & are option premiums for the lower X & higher X
respectively.
=Value of long call-value of short call.
Profit = = +
Max profit = − − +
Max loss = −
Breakeven = + −
Bull Put Spread
Buys a put with a lower X & sells an identical put with a higher X.
Cash inflows at initiation of the position.
Identical to the sale of bear put spread.
Profit occurs when both put options expire out-of-the money.
2.3.2 Bear Spreads
Bear Put Spread
Long position in a put with X & short position in a put with a X.
Rationale⇒ investor expects that stock price will in the future.
= −
Where
P2 = put premium on higher X.
= value of long put-value of short put.
Profit = − +
Max profit = − − +
Max loss = −
Breakeven = − +
Bear Call Spread
Investor sells a call with a lower X & buys an otherwise identical call
with a higher X.
Investor will earn net premium when both call options expire out-
of-the money.
Identical to the sale of a bull call spread.

2.3.3 Butterfly Spreads
Long Butterfly Spread
Long bull call spread + short bull call spread.

Require cash outlay at initiation because bull spread purchased by an investor is expensive
than a bull spread sold.
Rationale ⇒ useful when investor expects that the volatility of underlying will be low
relative to market expectations.
= 0, − − 20, − + 0, −

= − + 2 −

= − − + 2 −
= − 2 +
Two breakeven points.
+ − 2 +
2 + − + 2 −
Short Butterfly Spread
Selling the calls with && buying two calls with

Rationale ⇒ preferable when investor expects that the volatility of the underlying will be
relatively high compared to market expectations.
Long Butterfly Spread (using puts)
Long bear put spread + short bear put spread.

Cost of < <
Long Butterfly Spread (using puts)
Selling the puts with && buying two puts with

Max profit = + − 2
If correctly priced, butterfly spread using calls will
provide the same result as butterfly using puts.
2.4 Combinations of calls and Puts
2.4.1 Collars
Strategy in which cost of buying put option can be reduced by selling a call option.
Provide downside protection at the expense of giving up upside potential.
Zero cost collar ⇒ call option premium is equal to put option premium.
Put X & call X results is in both the upside & downside potential.
Quite similar to bull spread with respect to cap on gains & a floor on loss but no
underlying holdings in bull spread.
=
= + 0, − − 0, −

= −

= −
= −
Breakeven =
Collars are also known as range forwards & risk reversals.

2.4.2 Straddle
Long Straddle
Buying at-the-money put & a call with same X on same underlying &
expiration.
Rationale ⇒ investor expects volatility than what market expects.
Costly strategy.
= 0, − + 0, −

= − −

= ∞ & max = +
Breakeven ± +
Short Straddle
Selling a put & a call with same X on the same underlying with the same
expiration.
Preferable when neutral view about volatility.
Unlimited loss potential.
This strategy gains when both the options expire out-of-the money.
Variation of Straddle
Adding call (put) to a straddle is known as strap (strip).

Long strangle ⇒ variation of the straddle (buying put &
calls with different (X).
Short strangle ⇒ selling the put & call with different X.
2.4.3 Box Spread
Bull spread + bear spread
Long Box Spread
Long call with & short cal with + long put with & short put with.
If options are correctly priced, the box spread payoff is always RF (riskless strategy).
PV of the payoff discounted at RF should be equal to initial outlay.
= − + −
= −
Profit & Max profit = − − − + −
No breakeven & max loss.
Short box is also possible with opposite positions.
Benefits of box spread:
To exploit an arbitrage opportunity.
Does not require a volatility estimate.
Hold lower transaction costs.

3. INTEREST RATE OPTION STRATEGIES
IR call & put options are used to protect against IR.

IR call option pay-off = N.P × Max (0, underlying rate at expiration –exercise rate)
× Days in underlying rate/360.
180 day LIBOR can be used as the underlying rate & underlying days could
be 180, 182 183 etc.
Rate is determined on the day when option expires & payment is made m
days later.
IR put option pay-off =NP × Max (0, X –underlying rate at expiration) × days in
underlying rate/360.
3.1 Using Interest Rate Calls with Borrowing
Used by borrowers to manage IR risk on floating rate loans.

Consider the following factors:
Option expiration date is the same as when loan starts.
Option pay-offs must occur at the time when borrower makes IR payments
on loan.
3.2 Using Interest Rate Puts with Lending
Used by lender to manage IR risk on

floating rate loans.
3.3 Using an Interest Rate Cap with a Floating-Rate Loan
Interest rate cap ⇒combination of IR call options.

Each option in a cap is called a caplet.
Each caplet has same X but its own expiration date.
Cap seller makes payments if IR < strike rate.
Payoff is determined on its expiration date but made on the next payment date.
Cap pay-off = NP × (0, LIBOR on previous reset date – X) X days in settlement
period / 360.
Effective interest = interest due on the loan – caplet pay-off.
3.4 Using an Interest Rate Floor with a Floating-Rate Loan
Interest rate floor ⇒ combination of IR put options.

Floorlet pay-off = NP X (0,X –LIBOR on previous reset date) × days in settlement
period/360
Effective interest = interest received on the loan + floorlet pay-off.

3.5 Using an Interest Rate Collar with a Floating-Rate Loan
Combination of a long (short) position in a cap & a short (long) position in a floor.
The borrower (lender) can buy a cap (floor) to protect against rising (falling) IR &
sell the floor (cap) to finance the premium paid to buy a cap.
Initial cost of the hedge can be by call exercise rate &floor exercise rate.
Cost can also be by having NP for the cap & NP for the floor.
Borrower will benefit when IR & will be hurt when IR within the collar.
4. OPTION PORTFOLIORISK MANAGEMENT STRATEGIES
Dealers provide liquidity to the market & take risk by trading in options.
Dealers use different hedging strategies to avoid risk.
If a dealer has sold a call, he can hedge his/her risk by:
Buying an identical call option.
Buying a put with same X & expiration, buying the asset & selling a bond
(static hedge).
Using delta hedging.
Size of the long position in underlying to offset the risk associated
with short position in option = -1/ delta
Three complicating issues in delta hedging:
Delta is an approximate for small changes only.
Delta changes with the change in the price of the underlying & or
time.
Small amount of imprecision due to rounding the no. of units of
underlying.
4.1 Delta Hedging an Option over Time
Dynamic hedging ⇒ delta-hedged position needs to be rebalanced as underlying

price ∆ or with the passage of time.
Delta of in-the-money (out-of-the money) call option will () towards 1 (0)
near expiration.
Delta hedges are most difficult to maintain for-at-the-money options & /or near
expiration.
Hedging Using Non-Identical Option
= +
Where
& = quantity of each option that hedges the value of one of the options in a
portfolio.
& = Price of option 1&2.
Desired quantity of option 1 relative to option 2:
2 −∆

= = =
1 ∆

4.2 Gamma and the Risk of Delta
∆

=
∆

Larger the gamma, greater will be the risk.

Gamma is largest for at-the-money options & /or near expiration.
Gamma hedge ⇒ position in underlying + position in two options.
4.3 Vega and Volatility Risk
∆
! =
∆

At-the-money option has greater sensitivity to ∆ in volatility.
Volatility is unobservable, so it is difficult to estimate Vega.
Delta is required to manage Vega risk jointly with delta & gamma.
5. FINAL COMMENTS
Major difference b/w equity & bond option strategies are that
bond options must expire before the bond matures.
Bullish (bearish) investor buys puts (calls) on IR.
Bullish (bearish) equity or bond investors buy calls (puts).

“RISK MANAGEMENT APPLICATIONS OF SWAP STRATEGIES”

DCB = Dual Currency Bond
CF= Cash Flow
1. INTRODUCTION
SWAP ⇒ contractual agreements that are used to exchange a series of CF over a

specific period of time.
Swaps involve credit risk & have zero MV at initiation.
Swaps can be used to adjust the rate sensitivity of an asset or liability.
Types of Swaps
Interest Rate Swaps Currency Swaps
One party pays fixed IR & other pays One party makes payments in one currency
floating IR or both parties pay floating & other party makes payments in another
payments. currency.
Less credit risk relative to ordinary loans
(interest payments are netted).
Equity Swaps Commodity Swaps
Agreement in which at least one set of One set of payment is based on the course
payments is based on the return of a stock of a commodity price.
price or stock index.
2. STRATEGIES AND APPLICATIONS FORMANAGING INTEREST RATE RISK
2.1 Using Interest Rate Swaps to Convert a Floating-Rate Loan to a Fixed-Rate Loan (and Vice Versa)
Borrower will not be able to take advantage of falling IR as he/she is locked in to a synthetic fixed
rate loan through swap.
The NP on the swap is set equal to the face value of the loan.
Duration of floating rate bond ≈ amount of time remaining until the next coupon payment.
Durations of fixed rate bonds ≈ 75% of its maturity for this reading.
Receive (pay) fixed swaps () the duration of an existing position.
MV risk ⇒ uncertainty associated with MV of an asset or liability due to ∆ in IR.
CF risk ⇒ uncertainty associated with the size of the CFs.
When floating rate loan is converted to fixed rate loan CF risk & MV risk.
When fixed rate loan is converted to floating rate loan CF risk & MV risk.

2.2 Using Swaps to Adjust the Duration of a Fixed-Income Portfolio
Duration is affected by maturity & frequency of the swap.

Most preferred approach ⇒ use the swap with a maturity at least equal to the period
during which the duration adjustment is applied.
=

Where

= target market duration.
= current market duration of portfolio.
= market duration of a swap.
2.3 Using Swaps to Create and Manage the Risk of Structured Notes
2.3.1 Using Swaps to Create and Manage the Risk of Leveraged Floating Rate Notes
Leverage floater ⇒ type of leveraged structured note.

Coupon is a multiple of a specific market rate of interest e.g.

= 1.5 ×
No capital is needed ⇒ cost of buying a fixed rate bond will be financed by the
proceeds from issuing the structured note.
2.3.2 Using Swaps to Create and Manage the Risk of Inverse Floaters
Inverse floater is another type of structured note:

= −
To manage -ve interest payment risk (LIBOR>b), inverse floater issuers should buy an
IR cap with followings features:
Exercise rate of b.
NP = FV of loan.
Caplet expires on the IR reset dates of the swap.
Caplet payoff = (LIBOR-X) NP.
Limitation ⇒the lender would have to accept a lower rate (b) to avoid –ve IR
problem.
3. STRATEGIES AND APPLICATIONS FORMANAGING EXCHANGE RATE RISK
3.1 Converting a Loan in One Currency into a Loan in another Currency
Currency swaps ⇒ swaps used to transform a loan denominated in one currency into
a loan denominated in another currency.
Principal amounts are exchanged at the beginning & end of the life of the swap.
Firms use currency swap to exploit their comparative advantage in foreign
borrowings.
If a firm wants to issue debt in FC at a floating rate:
It could issue a fixed rate bond in domestic currency & enter into a swap with
the dealer in which the firm pays floating rate in FC against fixed rate domestic
currency payment by dealer.
Firm could issue a domestic currency floating rate bond & enter a floating for
floating swap as FC floating rate payer.

3.2 Converting Foreign Cash Receipts into Domestic Currency
Currency swaps can be used to convert the FC cash flows into

domestic CF (e.g. foreign subsidiary’s CF).
Credit risk is inherent in such transactions.
3.3 Using Currency Swaps to Create and Manage the Risk of a Dual-Currency Bond
Dual currency bond ⇒ interest is paid in one currency while the principal is paid in
another.
Synthetic dual-currency bond = ordinary bond in domestic currency +currency swap
with no principal payments.
Profitable if synthetic DCB is cheaper than the actual DCB.
Take a long position in synthetic bond+ short positions in actual DCB.
4. STRATEGIES AND APPLICATIONSFOR MANAGING EQUITY MARKET RISK
Equity swap ⇒ swap where one party is obligated to pay an equity index or on an
individual stock in exchange for a fixed rate, floating rate or the return on another
index.
Equity swaps can be used to:
Make necessary portfolio adjustments.
Exploit restrictions of short selling.
Lower transaction costs & to avoid losses.
To avoid risk associated with a concentrated position.
Limitation⇒ renewal required (limited swap life).
F.I Swap V/S Equity Swaps
Similarities Difference
Total return based payment. FI swaps ⇒ interest payment represents major portion
Total return is not known until the end of settlement of total return.
period. Equities ⇒ dividend represents small amount of capital
When capital gain is –ve, the overall payment will also gains.
be-ve.
Risk Inherent in Equity & F.I Swaps
Tracking Error Cash Flow Problem
Mismatch b/w performance of portfolio & indices that If FI payments > equity receipts, the investor faces the
are used as proxy & on which swap payments are based. CF problem.
In case of swapping stock return for index return, net
outflow may be required if stock outperforms the index.

5. STRATEGIES AND APPLICATIONSUSING SWAPTIONS
Swaption ⇒ an option to enter into a swap.

() exercise rate, the more expensive the receiver (payer) Swaption.
Method used to exercise a Swaption is predetermined by the parties.
Types of Swaption
Payer Swaption Receiver Swaption
Allows the holder to enter into a swap as fixed rate Allows the holder to enter into a swap as fixed rate
payer. receiver.
Similar to put option on a bond. Similar to call option on a bond.
5.1 Using an Interest Rate Swaption in Anticipation of a Future Borrowing
Swaption gives the flexibility to the buyer to enter into

a swap at an attractive rate (option is in-the-money).
5.2 Using an Interest Rate Swaption to Terminate a Swap
By Entering an Offsetting Swap By Buying a Swaption
Terminate an existing swap by entering into an If IR is expected to () a borrower should use
offsetting swap with a different counterparty. receiver (payer) Swaption to convert its pay fixed
Terminate an existing swap by entering into an (floating) position to a pay floating (fixed) position.
offsetting swap with the original counterparty.
5.3 Synthetically Removing (Adding) a Call Feature in Callable (Non-callable) Debt
5.3.1 Synthetically Removing the Call from Callable Debt
Receiver swaption is similar to call option on a bond.

Call option can synthetically be removed by selling receiver
swaption (also called monetizing a call).
Swaption will not cancel the bond’s call features & both options
will remain in place.
5.3.2 Synthetically Adding a Call to Non-callable Debt
Call option can synthetically be added to a non-callable bond by buying a receiver

swaption.
When rates, issuer starts receiving interest on receiver swaption & effectively cancel
out its current fixed rate obligation on a non-callable bond.
An investor can:
Synthetically add a call feature in a non-callable bond by selling a receiver swaption.
Remove a call feature in a callable bond by buying a receiver swaption.

Payer Swaptions (Add or Remove Put Options)
For Issuers For Investors
Add a put to an otherwise non-putable bond by selling a Synthetically add (remove) a put in (from) a non-putable
payer Swaption. (putable) bond by buying (selling) a payer Swaption.
Synthetically remove a put option from a putable bond
by buying a payer Swaption.
5.4 A Note on Forward Swaps
Forward Swaps V/S Swaptions
Forward Swaps Swaptions
Commitment to enter into a swap. Option to enter into a swap.

No upfront cash required at contract initiation. Upfront premium is paid by the buyer to the
seller.

“EXECUTION OF PORTFOLIO DECISIONS”

MV = Market Value IV = Intrinsic Value TMG = Trade Management Guidelines
2. THE CONTEXT OF TRADING: MARKET MICROSTRUCTURE
Market microstructure ⇒ process that affects how trades are executed.
2.1 Order Types
Market Order Limit Order
Requires prompt execution. Specific limit price for execution.

Price uncertainty. Execution uncertainty.
Additional Order Types
Market-Not-Held Order Market on Open Order
Variation of the market order. Executed at the opening of the market.

Not held means not to trade at any specific Market on close order ⇒ executed at market
price or time interval. close.
Participate (don’t Initiate) Order
To capture a better price, broker waits for &

responds to initiate more active trades.
Best Effort Order Undisclosed Limit Order/Reserve/ Hidden Iceberg Order
Gives the trader’s agent even more discretion Variation of a limit order.
to work the order. Instruction not to show more than some maximum
unfilled order quantity.
Types of Trades
Principal Trades Portfolio Trades
Broker commits capital for the prompt Order to trade a specific basket of securities.
execution of the trader’s order. Low cost strategy on a relative basis.
Suitable when order size is large & more urgent.

2.2 Types of Markets
2.2.1 Quote-Driven (Dealer) Markets 2.2.2 Order-Driven Markets
Trades are executed with a dealer. Public limit orders establish transaction prices.
Inside bid (ask) is the highest (lowest) bid (ask). Trade may be delayed or unexecuted (absence of
Closed-book market ⇒ where limit order book is a dealer).
not visible to the public. Traders can’t choose with whom they trade.
Dealer’s role:
Ensure market continuity.
Immediacy or bridge liquidity.
Suitable in markets requiring negotiation.
Some measures of trade costs:
Quoted bid-ask spread.
Effective spread.
Better representative of true cost
because it captures both price
improvement & market impact.
2.2.3 Brokered Markets 2.2.4 Hybrid Markets
Transactions take place through brokers away Combinations of the previously described market
from public markets. types.
These markets are suitable where: Example ⇒ NYSE (elements of batch auction,
Public markets are small. continuous auction & quote driven markets).
Illiquidity.
Block transactions take place.
Types of Order-Driven Markets
Electronic Crossing Networks Auction Markets
Buy & sell orders are batched & crossed at a Orders of multiple buyers compete for execution.
specific point in time. Provide price discovery.
Benefits. The problem of partial fill.
Avoid costs of dealers. Batch action markets ⇒ trade occurs at a single
Avoid market impact. price pre specified point in time.
Prevent information leakage. Continuous auction markets ⇒ trades occur at
Anonymity. any time during the day.
Low commissions.
Drawbacks:
Execution uncertainty.
No price discovery.
Electronic Limit-Order Markets
Computer based auctions that operate continuously within the day.

In contrast to crossing networks these:
Operate continuously.
Provide price discovery.
Like crossing networks, these:
Provide anonymity.
Are computer based.

2.3 The Roles of Brokers and Dealers
Brokers Dealers
Agent of the investor who works for commission. Adversarial relationship b/w the trader & a
Provides following services: dealer:
Represents the order. Difference in bid-ask spread preferences.
Find the opposite side of trade. Adverse selection risk ⇒ risk of trading with
Supply market information. a more informed trader.
Provide discretion & secrecy. Buy side traders are often strongly
Supporting investment services. influenced by sell side trade.
Supports the market mechanism.
2.4 Evaluating Market Quality
Liquidity Transparency
Characteristics of a liquid market: Pre-trade transparency ⇒ quick, easy,

Low bid-ask spread. inexpensive & accurate information about quotes
Market depth ⇒ big trades do not tend to & trades.
cause large price movements. Post trade transparency ⇒quick & accurate
Resilient market ⇒ small & quickly details on completed trades.
correctable discrepancies b/w MV & IV.
Factors that contribute to a liquid market:
Many buyers & sellers.
Different types of market participants.
Convenience.
Market integrity.
Liquidity advantages:
Less price impact.
Suitable for information motivated traders.
Easy capital raised by corporations.
Assurity of Completion
All parties to trades will honor their

commitments.
Clearing entities can help ensure assurity of
completion.

3. THE COSTS OF TRADING
3.1 Transaction Cost Components
Explicit Costs Implicit Costs
Direct costs of trading. Bid ask spread.

These include commission, taxes, stamp duties & Market impact ⇒effect of the trade on
fees paid to exchanges. transaction prices.
Missed trade opportunity costs ⇒arise from
failure to trade in a timely manner.
Delay costs ⇒ inability to trade immediately due
to size & liquidity.
Measurement of Costs
Implicit costs are measured against some price benchmark:

One benchmark is the time-of-trade mid quote.
Opening & closing prices (less satisfactory).
VWAP (when price information is lacking).
Most exact approach ⇒ implementation shortfall.
VWAP
Volume weighted Average price at which

the security traded during the day.
Easy to compute & understand. Ignores slippage & missed trade opportunity
Best for comparing smaller trades in non- costs.
trending markets. Subject to gaming by delaying trades.
Can be computed quickly. Can be misleading.
Not sensitive to trade size or market conditions.
Implementation Shortfall Approach
Definition Advantages/Disadvantages
Difference b/w money return on a paper portfolio & actual

portfolio’s return. Advantages Disadvantages
Decision price is used for paper portfolio.
Captures explicit & implicit elements of transaction costs.
Relate cost to the value of Require extensive data.
Four components:
ideas. Unfamiliar evaluation
Explicit costs.
Recognizes tradeoff b/w framework for traders.
Realized profit/loss.
immediacy & price.
Slippage cots.
Allows attribution of
Missed trade opportunity costs.
costs.
Implementation shortfall is adjusted for market movement
Not subject to gaming.
through market model.

3.2 Pre-trade Analysis: Econometric Models for Costs
Used to build reliable pre-trade estimates.

According to market microstructure theory, trading costs are non-linearly
related to these factors:
Stock liquidity characteristics
Risk
Trade size relative to available liquidity
Momentum
Trading style
Estimated cost function can be used:
To assess execution quality.
Appropriate trade size to order.
4. TYPES OF TRADERS ANDTHEIR PREFERRED ORDER TYPES
4.1 The Types of Traders
Information-Motivated Traders Value-Motivated Traders
Act on information that has limited value if Act on value judgments based on research.
delayed. Price focus & infrequent trading.
Focus on liquidity & speed of execution. Use limit orders.
Market orders & large block trades. Sometimes act as a dealer’s dealer.
Liquidity-Motivated Traders Passive Traders
Counterparties to more knowledgeable traders. Much more concerned with cost of trading.
Do not want to reap information advantage. Price preference.
Time preference. Use limit orders, portfolio trades & crossing
Use market, market not held, best efforts, networks.
participate, principal traders, portfolio trades & Avoid large as well as heavily concentrated
orders on ECNs & crossing networks. orders.
5. TRADE EXECUTION DECISIONS AND TACTICS
5.1 Decisions Related to the Handling of a Trade
Small, liquidity trades ⇒ executed via direct market access &

algorithmic trading.
Large information laden trades ⇒ executed via skills of senior
traders.

5.2 Objectives in Trading and Trading Tactics
5.2.1 Liquidity-at-Any-Cost Trading Focus 5.2.2 Costs-Are-Not-Important Trading
Used by information traders who trade in large Market orders.

block sizes & demand immediacy Ordinary spreads & commission for speed of
Attract high commission rate brokers. execution.
Use expensive methods for timely execution.
5.2.3 Need-Trustworthy-Agent Trading Focus 5.2.4 Advertise-to-Draw-Liquidity Trading Focus
To execute large orders in thinly traded issues. Used for IPOs, secondary offerings & sunshine
Use of skillful brokers by placing a best effort, traders.
market not held or participate order. Risk of front running.
Trader loses control of the trade. Little or no market impact if sufficient number of
traders.
5.2.5 Low-Cost-Whatever-the-Liquidity Trading Focus
Best suited for passive & value motivated investors.

Limit orders.
Traders may end up chasing the market.
5.3 Automated Trading
5.3.1 The Algorithmic Revolution 5.3.2 Classification of Algorithmic &Execution Systems
Logic behind algorithmic trading ⇒ break large Logical Participation Strategies

orders into smaller orders to moderate price
impact.
Constant monitoring required. Simple Logical Participation Implementation Shortfall Strategies
Meat-grinder effect ⇒ in order to get done, large
equity orders are broken up into smaller orders.
VWAP strategy, TWAP strategy Optimal trading strategy that
(order in proportion to time) & minimizes trading costs.
% of-volume strategy
Opportunistic Participation Strategies Specialized Strategies
Passive trading combined with the opportunistic These are:

seizing of liquidity. Hunter strategies.
Trading over time. Market on close algorithms.
Smart routing.
Other specialized strategies.

5.3.3 The Reasoning behind Logical Participation Algorithmic Strategies
Simple Logical Participation Strategies Implementation Shortfall Strategies
Breaking up the order into smaller sub-blocks To minimize market impact & missed trade
yields a lower average market or price impact. opportunity costs.
Trade heavily early in the trading day.
Use an objective function that minimizes
expected total cost & variance.
Ideal for small, highly urgent orders.
6. SERVING THE CLIENT'S INTERESTS
6.1 CFA Institute Trade Management Guidelines
Guidelines define best execution as:

To maximize the value of a client’s portfolio within stated objectives &
constraints.
Four characteristics of best execution:
Can’t be determined independently.
Can’t be known with certainty ex-ante.
Measured on ex-post basis.
Process, not an outcome.
TMG are divided into the three areas:
Processes.
Disclosures.
Record keeping
6.2 The Importance of an Ethical Focus
Over time markets become adversarial&

implicit costs.
Interest of clients must be honored &
fiduciary duties must be met appropriately
by traders.

“MONITORING AND REBALANCING”

2. MONITORING
Fiduciary must:
Act in a position of trust.
Assess portfolio suitability relative to client’s needs & circumstances.
Monitor investor related circumstances, market & economic changes
& portfolios.
2.1 Monitoring Changes in Investor Circumstances and Constraints
∆ in the needs, circumstances or objectives of private wealth clients

(institutional clients) are reviewed on a semiannual or quarterly basis
(annual basis).
More frequent reviews may be required on client’s request or unexpected
∆ in client circumstances.
2.1.1 Changes in Investor Circumstances and Wealth
May affect income, expenditure, risk, return &

retirement income.
2.1.2 Changing Liquidity Requirements
Portfolio managers:
Provide liquidity when requested by a client.
Monitor changes in liquidity requirement.
2.1.3 Changing Time Horizons
the time horizon, investment, allocation to bonds.

Perpetual life portfolios ⇒ few changes in time horizon, risk
budgets & asset allocation.
2.1.4 Tax Circumstances
Portfolio manager should:

Assess tax consequences of investment decisions.
Consider client’s current & future tax situation.
Assess tax efficiency.
2.1.5 Changes in Laws and Regulations
Managers must evaluate laws & regulations to

ensure compliance.
∆ in law affects current portfolio as well as range of
available investments.

2.2 Monitoring Market and Economic Changes
2.2.1 Changes in Asset Risk Attributes
A portfolio’s asset allocation may change due to ∆ in

mean return, volatility & correlation of assets.
2.2.2 Market Cycles
Major market swings provide extreme +ve or –ve

opportunities.
Investors tactically adjust asset allocations or
individual security holdings based on their opinions.
2.2.3 Central Bank Policy
Expansionary monetary policy ⇒ discount rates,

stock return.
Restrictive monitory policy ⇒discount rates,
bond return.
2.2.4 The Yield Curve and Inflation
Default RF yield curve reflects:

Expected inflation.
Maturity premium
Time preference for real consumption.
Maturity premiums are countercyclical.
Sharpe of the Y.C depends on the economic cycle stages.
Y.C provides information about future GDP growth.
2.3 Monitoring the Portfolio
Continuous process requiring a manager to assess:

Events & trends affecting asset classes & individual holdings.
∆in asset values creating deviation from the SAA.

3. REBALANCING THE PORTFOLIO
3.1 The Benefits and Costs of Rebalancing
3.1.1 Rebalancing Benefits 3.1.2 Rebalancing Costs
In PV of expected utility losses. Transaction costs (offset rebalancing

Controls the level of drift in overall benefits).
portfolio risk. Tax costs if investor is taxable.
Maintains desired systematic risk
exposure.
Removes overpriced assets with an
inferior returns prospect.
3.2 Rebalancing Disciplines
3.2.1 Calendar Rebalancing 3.2.2 Percentage-of-Portfolio Rebalancing
Periodic rebalancing to target weights (e.g. Rebalancing thresholds or trigger points

monthly). stated as % of portfolio value.
Rebalancing frequency may be timed to Require frequent monitoring.
match with portfolio reviews. Directly related to market performance.
Simplest approach. Tighter control on divergence from target
No continuous monitoring required. allocation.
Drawback:
If allocation is close to optimal
allocation rebalancing cost > benefits.
If allocation is far from the optimal,
level of market impact costs.
Key Determinants of the Optimal Corridor Width in a Percentage- of-Portfolio Rebalancing Program:
Factor Effect on Optimal Width of Corridor Intuition
Factors Positively Related to Optimal Corridor Width
Transaction costs The higher the transaction costs, Higher transaction costs set a high
the wider the optimal corridor hurdle for rebalancing costs to
overcome
Risk tolerance The higher the risk tolerance, the High risk tolerance implies lower
wider the optimal corridor sensitivity to divergences from
target allocations
Correlation with rest of portfolio The higher the correlation, the When asset classes move in
wider the optimal corridor synch, further divergence is less
likely
Factors Inversely Related to Optimal Corridor Width
Asset class volatility The higher the volatility of a given A given percentage move away
asset class, the narrower the from the target
optimal corridor Costly for a highly volatile asset
class, as further divergence
becomes more likely
Volatility of rest of portfolio The higher the volatility, the Makes large divergences from
narrower the optimal corridor strategic asset allocation more
likely
Reference: Volume 6, Exhibit 8, Reading 30.

3.2.3 Other Rebalancing Strategies
Calendar-And-Percentage-Of-Portfolio Rebalancing Equal Probability Rebalancing
Monitor the portfolio at specified intervals. Corridors are specified for each asset class.
Rebalance the portfolio under % principle. Rebalancing is triggered when any asset class
Avoid incurring rebalancing cost when the weight moves outside its corridor.
portfolio is nearly optimal. Equal probability of triggering rebalancing.
Ignores difference in transaction costs or asset
correlations.
Tactical Rebalancing
In trending markets less frequent rebalancing.

More frequent rebalancing when markets are
characterized by reversals.
3.2.4 Rebalancing to Target Weights versus Rebalancing to the Allowed Range
Rebalancing to an allowed range has the following advantages over

rebalancing to target weights:
Transaction costs.
Tactical adjustments are possible.
Better manage the weights of an illiquid assets.
Disadvantage:
Not perfectly align actual asset allocation with target proportions.
3.2.5 Setting optimal Thresholds
Optimal rebalancing strategy implies:

Maximize rebalancing benefits.
Transaction costs.
Challenges:
Rebalancing costs & benefits are difficult to measure.
Tax consequences.
Optimal strategy changes with the passage of time.

3.3 The Perold-Sharpe Analysis of Rebalancing Strategies
3.3.1 Buy-and-Hold Strategies 3.3.2 Constant-Mix Strategies
Passive do-nothing strategy. Reacts to market movements.

Floor = amount invested in T-bills. Target investment in stocks = m × portfolio value.
Risk tolerance is +ly related to wealth & stock returns. where
Special case of CPPI. 0<m<1
In trending market, this strategy outperforms m = target stock proportion.
constant mix strategy. () actual stock proportions to m when stock
This strategy remains neutral in flat & oscillating values are trending ().
market. Effectively maintains a portfolio’s systematic risk.
Portfolio value = investment in stocks +floor value. During strong bull & bear markets this strategy
Limited downside (floor) & unlimited upside potential. underperforms CPPI & buy & hold.
Target stock proportion = actual stock proportion Outperforms CPPI & buy & hold when equity returns
(m=1). are characterized by reversals.
3.3.3 A Constant-Proportion Strategy: CPPI 3.3.4 Linear, Concave, and Convex Investment Strategies
Dynamic strategy. Constant mix & CPPI strategies are non-linear whereas
Buy(sell) shares as stock prices (). buy & hold strategies are linear.
Target investment in stock = m ×(portfolio value- floor Constant-mix strategies (CPPI strategies) ⇒
value). relationship b/w portfolio & stock returns ⇒ concave
If m>1, strategy is known as CPPI. (convex).
Investment in RF assets is dynamic. Concave strategies provide liquidity to convex
Perform well in trending markets & poor in markets strategies.
characterized by reversals.
3.3.5 Summary of Strategies
Investor’s risk tolerance & asset class return expectations

are parameters for appropriate rebalancing strategies.
3.4 Execution Choices in Rebalancing
3.4.1 Cash Market Trades 3.4.2 Derivative Trades
Most direct means of portfolio rebalancing. Rebalancing through derivative instruments.

Benefits: Benefits:
Favorable tax considerations. Transaction costs & rapid execution.
Derivative markets may have liquidity Minimal impact of active manager’s strategies.
limitations. Drawbacks:
Derivative strategies are not available for all Exposure may be difficult to replicate.
asset class exposures. Liquidity limitations in individual markets.
Drawbacks:
More costly & execution delay.
May impair active manager trades.

“EVALUATING PORTFOLIO PERFORMANCE”

PE = Performance Evaluation
MCP = Manager Continuation Policies HF = Hedge Funds
CML = Capital Market Line YC = Yield Curve
1. INTRODUCTION
Performance Evaluation
Performance Measurement Performance Attribution Performance Appraisal
Calculating accounts’ Analyzing sources of return& Assessing whether the return

performance based on importance of those sources. was generated due to skills or
investment related∆. luck.
Assessing size & consistency
of accounts’ relative to
performance.
2. THE IMPORTANCE OFPERFORMANCE EVALUATION
2.1 The Fund Sponsor's Perspective
Fund sponsors ⇒ owners of large pools of investable assets.

PE is important because:
It provides an exhaustive quality control check of the fund & its
constituent parts.
It is a part of feedback of the investment management process.
It acts as a feedback & control mechanism.
2.2 The Investment Manager's Perspective
PE involves reporting investment returns along with the

return of some benchmark.
Measures the effectiveness of all aspects of the investment
processes.
3. THE THREE COMPONENTS OFPERFORMANCE EVALUATION
Account ⇒ one or more portfolios of securities managed by

one or more investment management organizations.

4. PERFORMANCE MEASUREMENT
4.1 Performance Measurement without Intra-period External Cash Flows
Rate of return on an account ⇒ % ∆ in the account’s MV over some

defined period of time after considering all external CF (contributions
& withdrawals).
If contribution is received at the start of the period:
− +
=
+
If contribution is received at the end of the evaluation period:
− −
=

In case of withdrawals, CF signs will change
4.2 Total Rate of Return
Measures the ∆ in the investor’s wealth due to both investment

income & capital gains.
Use of total return measure due to:
Allocation to equities.
Computing costs.
Institutional investors.
4.3 The Time-Weighted Rate of Return
Measures the compounded rate of growth over a stated evaluation

period of one unit of money initially invested in the account.
TWR is preferred when manager has no control over the deposits
& withdrawals made by clients.
Account needs to be valued whenever an external CF occurs.
= 1 + ,
1 + ,
× … × 1 + ,
− 1
Advantage/Disadvantage of TWR
Advantage Disadvantages
Not affected by external CF. Valuation required each time when an external
CF occurs.
Administratively more cumbersome, expensive
& potentially more error prone.
4.4 The Money-Weighted Rate of Return
Measures the compound growth rate in the value of all funds invested
in the account over the entire evaluation period.
Preferred method when manager has discretion over cash flows.
MWR is an IRR of an investment.

Advantage/Disadvantage of MWR
Advantage Disadvantages
A/C is valued at beginning & end of the evaluation Sensitive to size & timing of external CF.
period. Inappropriate when investor has no control
over external CF.
4.5 TWR versus MWR
When funds are contributed to an account prior to a period of strong

performance MWR > TWR.
MWR & TWR provide significantly different results if:
Large external CF occurs.
Account’s performance is highly volatile.
4.6 The Linked Internal Rate of Return
In LIRR, the TWR is approximated by calculating MWR over reasonably

frequent time intervals & then chain links over the entire evaluation
period.
Appropriate to use under normal conditions.
4.7 Annualized Return
Compounded avg annual return earned by account.

= 1 + ,
× 1 + ,
× … × 1 + ,
− 1
It is not advisable to calculate annualized returns when measurement
period < full year.
4.8 Data Quality Issues
Illiquid & infrequently priced assets with heavy external CF activity

generally not reliable in nature.
For thinly traded securities, usually matrix pricing approach is used.
A/C should be valued on the trade date rather than settlement date.
5. BENCHMARKS
5.1 Concept of a Benchmark
Components of portfolio return include:

Market (M).
Style (S) = manager’s benchmark-market index.
Active management (A) = manager’s portfolio-
benchmark.
Portfolio return:
P=M+S+A

5.2 Properties of a Valid Benchmark
A valid benchmark should have the following properties.

Unambiguous ⇒ clearly defined identities & weights.
Investable ⇒ passive investment alternative.
Measureable ⇒ return can be readily calculate.
Appropriate ⇒ consistent with manager’s style.
Reflective of current investment opinions.
Specified in advance ⇒ known to all interested parties at the
start of evaluation period.
Owned ⇒ manager should be aware & accept accountability.
5.3 Types of Benchmarks
Absolute
Advantage Disadvantage
Simple & straight forward Do not meet benchmark validity

criteria (not investable)
Manager’s Universes
Definition Advantage Disadvantage
Median manager or fund from a broad Measureable Suffers from survivorship bias.
universe of mangers or funds as a Except being measureable, it fails all the
benchmark. benchmark validity criteria.
Reliance on compilers.
Broad Market Indexes
Broad market indexes as Well recognized & easy to understand. Style drift
benchmark e.g. S&P 500. Widely available & unambiguous.
Measureable & investable.
Can be specified in advance.
Style Indexes
Using specific portion of asset Well known & easy to Larger than prudent weighting
category as benchmark understand. in certain securities.
Widely available. May be inconsistent with
manager’s investment process.

Factor Model Based
One or more systematic sources Facilitate manager & fund Difficult to obtain & expensive
of return to the returns on an sponsors to better understand to use.
account. manager’s investment style. Different benchmarks with the
Normal portfolio ⇒ portfolio same factor exposures can
which has exposures to sources generate different returns.
of systematic risk factors that is May not be investable.
typical for a manager.
Return Based Benchmarks
These benchmarks are constructed Intuitive & easy to use. May be inconsistent with
using the series of a manager & Unambiguous, measureable manager’s investment process.
investment style index’s return. investable & specified in Sufficient no. of observations
advance. required.
Useful when only the Not appropriate for managers
information regarding account who rotate among style
return is available. exposures.
Custom Security-Based
Reflect manager’s research Satisfy all of the benchmark Expensive to construct &
universe weighted in a particular validity criteria. maintain.
manner. Effective allocation of risk across Lack transparency.
all the investment managers.
Effective monitoring & control
of investment processes.
5.6 Tests of Benchmark Quality
Systematic Biases Tracking Error
Benchmark should have minimal systematic Volatility of account’s return relative to a good
biases relative to the account (Avg. historical β benchmark should be < than volatility of the
of A/C should be close to 1). account’s return relative to a market index.
Correlation b/w A&S should be zero.
Difference b/w (P-M) & S should be highly
correlated.

5.6Tests of Benchmark Quality
Risk Characteristics Coverage
A/C’s exposure to systematic risk should be Benchmark coverage:

ℎ

similar to those of benchmark.
Systematic bias if A/C’s risk characteristics are ℎ ℎ ℎ
always greater or always less than benchmark. ℎ
Low coverage indicates that the benchmark is
poor.
Turnover Positive Active Positions
% of the benchmark’s MV that is Large no. of +ve active positions ⇒ good custom
purchased/sold for the purpose of periodic security based benchmark has to be constructed.
rebalancing.
Passively managed portfolio ⇒low benchmark
turnover.
5.7 Hedge Funds and Hedge Fund Benchmarks
Long only benchmark is inappropriate to

evaluate HF performance due to short
positions.
Due to zero net position or –ve net position
traditional methods to calculate return does
not yield reliable results.
Hedge Fund Benchmarks
Following three are appropriate:

Value added return.
=
−
Construct separate long & short benchmarks.
Limitation ⇒ not appropriate if rapidly changing leveraged
positions.
Sharpe ratio.
Limitations ⇒ assume normal distribution.
6. PERFORMANCE ATTRIBUTION
Macro attribution ⇒ conducted at the fund sponsor level

(total fund performance).
Micro attribution ⇒ carried out at the investment
manager level (performance of individual portfolios).

6.1 Impact Equals Weight Times Return
Impact = weight × return.

Select superior performing assets.
Overweight superior performing assets relative to
benchmark.
6.2 Macro Attribution Overview
6.3 Macro Attribution Inputs
Policy Allocations Benchmark Portfolio Returns
Fund sponsor determines the broad allocation to the Fund sponsor selects:
fund & individual managers. Broad market indexes as benchmark for asset
Policy allocations depend on: category.
Fund sponsor’s risk tolerance & liabilities. Specific benchmark for manager’s style.
Sponsor’s long term expectations.
Fund Returns, Valuations, and External CF
Rate-of-Return Metric Value Metric
Computing fund return at individual manager level to Requires A/C valuation & external CF data to compute
evaluate decision regarding manager selection. accurate rate of return.
To evaluate the impact of the fund sponsor’s investment
decision-making on the fund’s performance.
6.4 Conducting a Macro Attribution Analysis
Six components of investment policy decision making with

increasing order of volatility & complexity.
Based on incremental return of each investment strategy &
contribution of each level to the overall return of the fund.
Macro Attribution Components
Net Contributions Risk-Free Asset
These include additions to the portfolio. Conservative strategy involving all fund’s assets invested
These CF are invested at zero rate of return. at RF.
∆ in the value of fund = total amount of net ∆In fund’s value = ending value under RF investment
contributions. strategy-beginning value.
Ending value = beginning value + net contributions.

Macro Attribution Components
Asset Category Benchmarks
Fund’s beginning value & external CF are invested Assume that the fund’s beg value & net external CF are
passively based on policy allocations. invested in manager’s benchmark.
Pure index fund approach. Pure index fund approach.
Return –metric perspective = ∑ × −
From a return-metric perspective

where
= return contribution of asset category = × × −
= return on ith asset category.

Value – metric perspective:
= weight of asset category i.
sum (each manger’s policy proportion of the total fund’s
beg value + net external CF)× (manager’s benchmark
return – return of the manager’s asset category).
Investment Managers Allocation Effects
Assumes that the fund sponsor has invested in each of Allocation effects incremental contribution= fund’s
the manager according to the manager’s policy ending value-value calculated at the investment
allocation. manager’s level.
Return to the investment managers level = sum (active Allocation effect results when fund sponsors slightly
managers’ return – their benchmark return). deviate from their policy allocation.
Return metric perspective:

= × × ‫ ܣ‬− ‫

ܤ‬

6.5 Micro Attribution Overview
Security-by-security analysis:

= ! " − "
× − #

Manager can add value by overweighting outperforming securities.
Limitation ⇒ as the no. of securities in a portfolio the impact of any individual security becomes insignificant.
Micro attribution using factor model of returns:
Allocating the value added return to various sources of systematic return.
Market model is a type of factor model.
6.6 Sector Weighting/Stock Selection Micro Attribution
Holding Based Attributions Transaction Based Attribution

= ∑

− ∑ Mostly used in actively managed accounts with high turnover.
Advantage ⇒ only holdings & their returns Three components:
are required to perform attribution analysis. Pure sector allocation:
ௌ
Limitation ⇒ ignores the impact of
෍൫ܹ௣௝ − ܹ஻௝ ൯ ൫‫ݎ‬஻௝ − ‫ݎ‬஻ ൯
transactions. ௝ୀଵ
Within sector selection:
ௌ
෍ ܹ஻௃ ൫‫ݎ‬௣௝ − ‫ݎ‬஻௝ ൯

௝ୀଵ
assumes same sector weight in portfolio as in benchmark.
Allocation selection interaction:
ௌ
෍൫ܹ௣௝ − ܹ஻௝ ൯ ൫‫ݎ‬௣௝ − ‫ݎ‬஻௝ ൯

௝ୀଵ

6.7 Fundamental Factor Model Micro Attribution
Combines economic sector factors with other fundamental factors.

Following are steps to perform fundamental factor model:
Identify the fundamental factors.
Determine the portfolio & benchmark sensitivity to the fundamental factors
at the beginning of evaluation period.
Specify a valid benchmark for portfolio to determine the performance of each
of the factors.
6.8 Fixed-Income Attribution
Major determinants of F.I account returns include:

∆ in general level of IR.
∆ in sector, credit quality, individual security differentials to the Y.C.
Factors That Contribute to Total Return of F.I Portfolio
External I.R Effect Management Effect
is estimated using a term structure Estimated by a series of repricing.

analysis. Four components:
Manager has no control over external IR management effect.
IR environment. Sector/quality effect.
External IR environment can be Security selection effect.
separated into expected & unexpected Trading actively.
return.
7. PERFORMANCE APPRAISAL
Performance appraisal ⇒evaluation of investment skill of managers & to make

decisions regarding retaining or modifying portion of investment program.
Level & magnitude of the value-added return should be used to determine
manager’s skill.
7.1 Risk-Adjusted Performance Appraisal Measures
Jensen’s Alpha Treynor Measure
=
Measures the excess of the portfolio’s return over ಷ
ಲ

that predicted by CAPM.
Represents the slope of the line b/w RF & the point
$ =
− ! + %
−
#
representing the avg return &β for the security.
Direct measure of performance.

7.1 Risk-Adjusted Performance Appraisal Measures
Sharpe Ratio M2
& =
ಲ ೑ Avg. incremental return over a market index of a
ಲ
hypothetical portfolio that is created by combining
Benchmark k is based on ex-post CML.
the account with borrowing or lending at Rf. so that
Like Treynor ratio, greater slope indicates a better
its SD is identical to the market index.
risk return trade off.
= + ' ( )*
ಲ ೑

ಲ
Information Ratio
+, =
ಲ ಳ

ಲಳ
+ve (-ve) IR indicates that the manager
outperforms (underperforms) the benchmark.
7.2 Quality Control Charts
Effective & useful way of presenting performance appraisal data.

Assumptions:
Null hypothesis ⇒ manager has no investment skill.
Value added returns are independent.
Manager’s investment process is consistent.
Confidence band ⇒indicates the range within which the
manager’s value added returns are expected to fall.
Confidence range is only for one time period.
7.3 Interpreting the Quality Control Chart
If value-added returns are distributed more or less randomly

around the horizontal line ⇒ deviations from the benchmark are
purely random.
We fail to reject the null hypothesis when investment results of a
manager fall within the confidence band.
8. THE PRACTICE OF PERFORMANCE EVALUATION
Sponsors use qualitative & quantitative factors to

evaluate investment managers.
8.1 Noisiness of Performance Data
Past performance is not a good evaluation tool.

Long evaluation period must be used to
determine truly superior performance.

8.2 Manager Continuation Policy
Hiring new managers & firing old managers involves a significant

cost in terms of money & time.
MCP ⇒ to the costs of manager’s turnover & to deal
appropriately with future poor performance.
MCP is used to minimize manager turnover & to consistently apply
procedures to overall managers.
MCP is a two part process.
Manager monitoring.
Manager reviews.
8.3 Manager Continuation Policy as a Filter
MCP can be used as a statistical filter to remove-ve value add

managers & retain +ve value added mangers.
Null hypothesis ⇒ manager has no investment skill.
Alternative hypothesis ⇒ managers are not zero value added
managers.
Type I error ⇒rejecting the null hypothesis when it is true.
Type II error ⇒ not rejecting the null when it is incorrect.
When the width of the confidence band is widened, type I error &
type II error.

“Global Investment Performance Standards”
History
In 1995, CFA Institute, formerly known as the In 1998, the proposed GIPS standards were The initial edition of the GIPS standards was
Association for Investment Management and posted on the CFA Institute website and designed to create a minimum global
Research (AIMR), sponsored and funded the circulated for comment to more than 4,000 investment performance standard that would:
Global Investment Performance Standards individuals who had expressed interest. The
Committee to develop global standards for result was the first Global Investment
calculating and presenting investment Performance Standards, published in April Permit and facilitate acceptance
performance, based on the existing AIMR 1999. and adoption in developing
Performance Presentation Standards (AIMR- markets
PPS®).
Give the global investment
management industry one
commonly accepted approach for
calculating and presenting
performance;
In 1999, the Global Investment Second edition of the GIPS In 2005, with the convergence of
Performance Standards standards was published in country-specific versions to the
Committee was replaced by the February 2005. GIPS standards and the need to Address liquid asset classes (equity,
Investment Performance Council reorganize the governance fixed income and cash).
(IPC) to further develop and structure to facilitate
promote the GIPS standards. involvement from GIPS country
sponsors, CFA Institute dissolved
the IPC and created the GIPS
Executive Committee and the
GIPS Council.
Why GIPS Are Needed?
Standardized Investment Global Passport Investor Confidence

Asset managers and both existing and Investment managers that adhere to investment
Performance prospective clients benefit from an established performance standards help assure investors
The growth in the types and number of financial global standard for calculating and presenting that the firm’s investment performance is
entities, the globalization of the investment investment performance. Performance complete and fairly presented. Both prospective
process, and the increased competition among standards that are accepted globally enable and existing clients of investment firms benefit
investment management firms demonstrate the investment firms to measure and present their from a global investment performance standard
need to standardize the calculation and investment performance so that investors can by having a greater degree of confidence in the
presentation of investment performance. readily compare investment performance among performance information presented to them.
firms.
Goals of the GIPS Executive Committee
To establish investment To obtain worldwide To promote the use of To encourage fair, global To foster the notion of
industry best practices for acceptance of a single accurate and consistent competition among industry “self-regulation”
calculating and presenting standard for the calculation investment performance investment firms without on a global basis.
investment performance and presentation of data creating barriers
that promote investor investment performance to entry
interests and instill based on the principles of
investor confidence fair representation and full
disclosure

Key Features
PROVISIONS OF THE GLOBAL INVESTMENT PERFORMANCE STANDARDS

The GIPS standards are ethical The GIPS standards require firms to Firms must comply with all
standards for investment performance include all actual, discretionary, fee- requirements of the GIPS standards,
presentation to ensure fair paying portfolios in at least one including any updates, Guidance
0. Fundamentalsand full1.disclosure
Input 7. Private
representation of 2. Calculation 3. Composite
composite defined by 4. investment 5. 6. Real Statements, 8. WRAP
interpretations, FEE/SMA
Questions
of Compliance
investment performance. Data
In order to Methodology Construction Disclosur
mandate, objective, Presentation
or strategy in order Equity
Estate & Answers Portfolios
(Q&As), and clarifications
claim compliance, firms must adhere to to prevent firms from cherry-picking published by CFA Institute and the GIPS
the requirements included in the GIPS their best performance. Executive Committee.
standards. 0. FUNDAMENTALS OF COMPLIANCE
Meeting the objectives of fair representation and The GIPS standards rely on the integrity of input data. The
full disclosure A.
is likely to require more than accuracy of input data is critical to the accuracy of the
B.
performance presentation. The underlying valuations of
simply adhering to the minimum requirements
Requirements
of the GIPS standards. Firms should also adhere portfolio holdings driveRecommendations
the portfolio’s performance. It is
to the recommendations to achieve best practice essential for these and other inputs to be accurate. The
in the calculation and presentation of GIPS standards require firms to adhere to certain
0.A.1FIRMS
performance. MUST comply with all the 0.A.9
calculation FIRMS MUST and
methodologies maketoevery
make reasonable
specific effort to provide a
REQUIREMENTS of the GIPS standards, COMPLIANT
disclosures along withPRESENTATION to all PROSPECTIVE CLIENTS. FIRMS
the firm’s performance.
including any updates, Guidance Statements, MUST NOT choose to whom they present a COMPLIANT PRESENTATION.
interpretations, Questions & Answers As long as a PROSPECTIVE CLIENT has received a COMPLIANT
(Q&As), and clarifications published by CFA PRESENTATION within the previous 12 months, the FIRM has met this
Institute and the GIPS Executive
Historical Performance Record
REQUIREMENT.
Committee,
0.A.10 FIRMS MUST provide a complete list of COMPOSITE
A firm is required to initially present,
0.A.2 FIRMS at a comply with all
MUST After a firm presents a minimumDESCRIPTIONS
applicable of five years ofto any PROSPECTIVE
Firms may link non-GIPS-compliant
CLIENT that makes such performance
a request.
minimum, five years of laws
annual
andinvestment GIPS-compliant
regulations regarding the calculation performance (orFIRMS
for theMUST
period to their GIPS-compliant
include terminated COMPOSITES on performance
the FIRM’S provided
list of
performance that is compliant with the GIPS
and presentation of performance.since the firm’s inception or theCOMPOSITE
composite DESCRIPTIONS that only
for atGIPS-compliant
least five years performance is
after the COMPOSITE
standards. If the firm or the composite has been inception date if the firm or the TERMINATION
composite has DATE. presented for periods after 1 January 2000 and
in existence less than five years, the firm must been in existence less than five years), the firm the firm discloses the periods of non-compliance.
0.A.3 FIRMS MUST NOT present performance
present performance since the firm’s inception or must present an additional year of performance Firms must not link non- GIPS-compliant
or performance-related information that 0.A.11ofFIRMS MUST provide a COMPLIANT PRESENTATION fororany
the composite inception date. each year, building up to a minimum 10 years performance for periods beginning on after 1
is false or misleading.
of GIPS-compliant performance.COMPOSITE listed on theJanuary FIRM’S2000
list oftoCOMPOSITE DESCRIPTIONS to
their GIPS-compliant
any PROSPECTIVE CLIENT that makes such a request.
performance.
0.A.4 The GIPS standards MUST be applied on
a FIRM-wide basis. Compliance 0.A.12 FIRMS MUST be defined as an investment firm, subsidiary, or
division held out to clients or PROSPECTIVE CLIENTS as a DISTINCT
0.A.5 FIRMS MUST document their policies BUSINESS ENTITY.
and procedures used in establishing and
maintaining compliance with the GIPS 0.A.13 For periods beginning on or after 1 January 2011, TOTAL FIRM
standards, including ensuring the existence ASSETS MUST be the aggregate FAIR VALUE of all discretionary and non-
and ownership of
Firms must take all stepsclient assets, and MUST Firms are strongly encouraged
discretionary assets managed
Firms by theto
may choose FIRM.
haveThis includes both fee-paying
an independent
apply to
necessary them consistently.
ensure that to perform periodic internal
and non-fee-paying PORTFOLIOS.
third-party verification that tests the
they0.A.6
have If
satisfied
the FIRM the not meet all the compliance checks.
alldoes construction of the firm’s composites as well as
requirements of the GIPS
REQUIREMENTS of the GIPS standards, the the firm’s policies and procedures as they
standards beforeNOT
claiming 0.A.14 TOTAL FIRM ASSETS MUST include assets assigned to a SUB-
FIRM MUST represent or state that it is relate to compliance with the GIPS standards.
compliance. ADVISOR provided the FIRM has discretion over the selection of the SUB-
“in compliance with the Global Investment ADVISOR.
Performance Standards except for...” or make
any other statements that may indicate partial
compliance with the GIPS standards. 0.A.15 Changes in a FIRM’S organization MUST NOT lead to alteration of
historical COMPOSITE performance.
The value of verification is widely In addition to verification, firms may The GIPS Executive Committee
0.A.7 Statements
recognized, and being referring
verified isto the calculation
also choose to have specifically focused strongly recommends that firms
methodology
considered as being
to be best “in accordance,”
practice. composite testing (performance be verified.
“in compliance,” or “consistent” withexamination)
the performed by an 0.A.16 When the FIRM jointly markets with other firms, the FIRM
Global Investment Performance claiming
independent third party verifier to compliance with the GIPS standards MUST be sure that it is
Standards, or similar statements, areprovide additional assuranceclearly defined and separate relative to other firms being marketed, and
regarding
prohibited. a particular composite. that it is clear which FIRM is claiming compliance.
0.A.8 Statements referring to the performance
of a single, existing client PORTFOLIO
as being “calculated in accordance with the Effective Date
Global Investment Performance
Standards” are prohibited, except when a
GIPS-compliant FIRM reports the
performance of an individual client’s
The effective date for the 2010 edition
PORTFOLIO of the
to that GIPS standards is
client. Compliant presentations that include performance for periods
1 January 2011.. that begin on or after 1 January 2011 must be prepared in
accordance with the 2010 edition of the GIPS standards.

PROVISIONS OF THE GLOBAL INVESTMENT PERFORMANCE STANDARDS
0. Fundamentals 1. Input 2. Calculation 3. Composite 4. 5. 6. Real 7. Private 8. WRAP FEE/SMA

of Compliance Data Methodology Construction Disclosur Presentation Estate Equity Portfolios
0. FUNDAMENTALS OF COMPLIANCE
A. B.
Requirements Recommendations
0.A.1FIRMS MUST comply with all the 0.A.9 FIRMS MUST make every reasonable effort to provide a
REQUIREMENTS of the GIPS standards, COMPLIANT PRESENTATION to all PROSPECTIVE CLIENTS. FIRMS
including any updates, Guidance Statements, MUST NOT choose to whom they present a COMPLIANT PRESENTATION.
interpretations, Questions & Answers As long as a PROSPECTIVE CLIENT has received a COMPLIANT
(Q&As), and clarifications published by CFA PRESENTATION within the previous 12 months, the FIRM has met this
Institute and the GIPS Executive REQUIREMENT.
Committee,
0.A.10 FIRMS MUST provide a complete list of COMPOSITE
0.A.2 FIRMS MUST comply with all applicable DESCRIPTIONS to any PROSPECTIVE CLIENT that makes such a request.
laws and regulations regarding the calculation FIRMS MUST include terminated COMPOSITES on the FIRM’S list of
and presentation of performance. COMPOSITE DESCRIPTIONS for at least five years after the COMPOSITE
TERMINATION DATE.
0.A.3 FIRMS MUST NOT present performance
or performance-related information that 0.A.11 FIRMS MUST provide a COMPLIANT PRESENTATION for any
is false or misleading. COMPOSITE listed on the FIRM’S list of COMPOSITE DESCRIPTIONS to
any PROSPECTIVE CLIENT that makes such a request.
0.A.4 The GIPS standards MUST be applied on
a FIRM-wide basis. 0.A.12 FIRMS MUST be defined as an investment firm, subsidiary, or
division held out to clients or PROSPECTIVE CLIENTS as a DISTINCT
0.A.5 FIRMS MUST document their policies BUSINESS ENTITY.
and procedures used in establishing and
maintaining compliance with the GIPS 0.A.13 For periods beginning on or after 1 January 2011, TOTAL FIRM
standards, including ensuring the existence ASSETS MUST be the aggregate FAIR VALUE of all discretionary and non-
and ownership of client assets, and MUST discretionary assets managed by the FIRM. This includes both fee-paying
apply them consistently. and non-fee-paying PORTFOLIOS.
0.A.6 If the FIRM does not meet all the 0.A.14 TOTAL FIRM ASSETS MUST include assets assigned to a SUB-
REQUIREMENTS of the GIPS standards, the ADVISOR provided the FIRM has discretion over the selection of the SUB-
FIRM MUST NOT represent or state that it is ADVISOR.
“in compliance with the Global Investment
Performance Standards except for...” or make
any other statements that may indicate partial 0.A.15 Changes in a FIRM’S organization MUST NOT lead to alteration of
compliance with the GIPS standards. historical COMPOSITE performance.
0.A.7 Statements referring to the calculation

methodology as being “in accordance,” 0.A.16 When the FIRM jointly markets with other firms, the FIRM
“in compliance,” or “consistent” with the claiming compliance with the GIPS standards MUST be sure that it is
Global Investment Performance clearly defined and separate relative to other firms being marketed, and
Standards, or similar statements, are that it is clear which FIRM is claiming compliance.
prohibited.
0.A.8 Statements referring to the performance

of a single, existing client PORTFOLIO
as being “calculated in accordance with the
Global Investment Performance
Standards” are prohibited, except when a
GIPS-compliant FIRM reports the
performance of an individual client’s
PORTFOLIO to that client.

B. Recommendations
0.B.1 FIRMS SHOULD comply with the 0.B.2 FIRMS SHOULD be 0.B.3 FIRMS SHOULD adopt the 0.B.4 FIRMS SHOULD
RECOMMENDATIONS of the GIPS standards, verified. broadest, most meaningful provide to each existing
including RECOMMENDATIONS in any definition of the FIRM. The scope client, on an annual basis, a
updates, Guidance Statements, interpretations, of this definition SHOULD include COMPLIANT
Questions & Answers (Q&As), and all geographical (country, PRESENTATION of the
clarifications published by CFA Institute and regional, etc.) offices operating COMPOSITE in which the
the GIPS Executive Committee. under the same brand name client’s PORTFOLIO is
regardless of the actual name of
included.
the individual investment
management company.
1. INPUT DATA
A. Requirements B.
Recommendations
1.A.1 All data and information necessary to support all 1.B.1 FIRMS SHOULD value PORTFOLIOS on the date of
items included in a COMPLIANT PRESENTATION MUST all EXTERNAL CASH FLOWS.
be captured and maintained.
1.A.2 For periods beginning on or after 1 January 2011, 1.B.2 Valuations SHOULD be obtained from a qualified
PORTFOLIOS MUST be valued in accordance with the independent third party.
definition of FAIR VALUE and the GIPS Valuation
Principles in Chapter II.
1.B.3 ACCRUAL ACCOUNTING SHOULD be used for
1.A.3 FIRMS MUST value PORTFOLIOS in accordance
dividends (as of the ex-dividend date).
with the COMPOSITE-specific valuation policy.
PORTFOLIOS MUST be valued:
1.B.4 FIRMS SHOULD accrue INVESTMENT

a. For periods beginning on or after 1 January 2001, at
MANAGEMENT FEES.
least monthly.
b. For periods beginning on or after 1 January 2010, on

the date of all LARGE CASH FLOWS. FIRMS MUST define
LARGE CASH FLOW for each COMPOSITE to determine
when PORTFOLIOS in that COMPOSITE MUST be valued.
c. No more frequently than required by the valuation policy.
1.A.4 For periods beginning on or after 1 January 2010,

FIRMS MUST value PORTFOLIOS
as of the calendar month end or the last business day of the
month.

FIRMS MUST use TRADE DATE ACCOUNTING.
1.A.6 ACCRUAL ACCOUNTING MUST be used for fixed-income

securities and all other investments that earn interest
income. The value of fixed-income securities MUST
include accrued income.

COMPOSITES MUST have consistent beginning and ending
annual valuation dates. Unless the COMPOSITE
is reported on a non-calendar fiscal year, the beginning and
ending valuation dates MUST be at calendar year end or on
the last business day of the year.

2. CALCULATION METHODOLOGY
A. Requirements B. Recommendations
2.A.1 TOTAL RETURNS MUST be used.

2.B.1 Returns SHOULD be calculated net of non-
reclaimable withholding taxes on dividends,
2.A.2 FIRMS MUST calculate TIME-WEIGHTED interest, and capital gains. Reclaimable withholding
RATES OF RETURN that adjust for EXTERNAL taxes SHOULD
CASH FLOWS. Both periodic and sub-period returns be accrued.
MUST be geometrically LINKED. EXTERNAL CASH
FLOWS MUST be treated according to the FIRM’S
COMPOSITE-specific policy. At a minimum: 2.B.2 For periods prior to 1 January 2010, FIRMS
SHOULD calculate COMPOSITE returns
a. For periods beginning on or after 1 January 2001, by asset-weighting the individual PORTFOLIO
FIRMS MUST calculate PORTFOLIO returns at least returns at least monthly.
monthly.
b. For periods beginning on or after 1 January 2005,

FIRMS MUST calculate PORTFOLIO returns that
adjust for daily-weighted EXTERNAL CASH FLOWS.
2.A.3 Returns from cash and cash equivalents held

in PORTFOLIOS MUST be included in all return
calculations.
2.A.4 All returns MUST be calculated after the

deduction of the actual TRADING EXPENSES
incurred during the period. FIRMS MUST NOT use
estimated TRADING EXPENSES.
2.A.5 If the actual TRADING EXPENSES cannot be

identified and segregated from a BUNDLED FEE:
a. When calculating GROSS-OF-FEES returns, returns MUST

be reduced by the entire BUNDLED FEE or the portion of the
BUNDLED FEE that includes the
TRADING EXPENSES. FIRMS MUST NOT use estimated
TRADING EXPENSES.
b. When calculating NET-OF-FEES returns, returns MUST be

reduced by the entire BUNDLED FEE or the portion of the
BUNDLED FEE that includes the
TRADING EXPENSES and the INVESTMENT MANAGEMENT
FEE. FIRMS MUST NOT
use estimated TRADING EXPENSES.
2.A.6 COMPOSITE returns MUST be calculated by asset-

weighting the individual PORTFOLIO returns using
beginning-of-period values or a method that reflects both
beginning-of-period values and EXTERNAL CASH FLOWS.
2.A.7 COMPOSITE returns MUST be calculated:
a. For periods beginning on or after 1 January 2006,

by asset-weighting the individual PORTFOLIO
returns at least quarterly.

by asset-weighting the individual PORTFOLIO
returns at least monthly.

3. COMPOSITE CONSTRUCTION
3.A.1 All actual, fee-paying, discretionary

PORTFOLIOS MUST be included in at least one 3.B.1 If the FIRM sets a minimum asset level for
COMPOSITE. Although non-fee-paying PORTFOLIOS to be included in a COMPOSITE, the
discretionary PORTFOLIOS may be included in a FIRM SHOULD NOT present a COMPLIANT
COMPOSITE (with appropriate disclosure), non- PRESENTATION of the COMPOSITE to a
discretionary PORTFOLIOS MUST NOT be included PROSPECTIVE CLIENT known not to meet the
in a FIRM’S COMPOSITES. COMPOSITE’S minimum asset level.
3.A.2 COMPOSITES MUST include only actual assets 3.B.2 To remove the effect of a SIGNIFICANT CASH
managed by the FIRM. FLOW, the FIRM SHOULD use a TEMPORARY NEW
ACCOUNT.
3.A.3 FIRMS MUST NOT LINK performance of

simulated or model PORTFOLIOS with actual
performance.
3.A.4 COMPOSITES MUST be defined according to

investment mandate, objective, or strategy.
COMPOSITES MUST include all PORTFOLIOS that
meet the COMPOSITE DEFINITION. Any change to a
COMPOSITE DEFINITION MUST NOT be applied
retroactively. The COMPOSITE DEFINITION MUST
be made available upon request.
3.A.5 COMPOSITES MUST include new PORTFOLIOS

on a timely and consistent basis after each
PORTFOLIO comes under management.
Claiming Compliance Statements
3.A.6 Terminated PORTFOLIOS MUST be included
in the historical performance of the COMPOSITE up
to the last full measurement period that each
PORTFOLIO was under management.
A Firm (not independently verified):

3.A.7 PORTFOLIOS MUST NOT be switched from
one COMPOSITE to another unless documented
“[Insert name of the firm] claims compliance with
changes to a PORTFOLIO’S investment mandate,
objective, or strategy or the redefinition of the the Global Investment Performance Standards
COMPOSITE makes it appropriate. The historical
performance of the PORTFOLIO MUST remain with (GIPS) and has prepared and presented this
the original COMPOSITE.. report in compliance with the GIPS standards.
[Insert name of the firm] has not been
3.A.8 For periods beginning on or after 1 January
independently verified.”
2010, a CARVE-OUT MUST NOT be included in a
COMPOSITE unless the CARVE-OUT is managed
separately with its own cash balance. A Firm (independently verified):
“[Insert name of the firm] claims compliance with

3.A.9 If the FIRM sets a minimum asset level for
PORTFOLIOS to be included in a COMPOSITE, the the Global Investment Performance Standards
FIRM MUST NOT include PORTFOLIOS below the (GIPS) and has prepared and presented this
minimum asset level in that COMPOSITE. Any
changes to a COMPOSITE-specific minimum asset report in compliance with the GIPS standards.
level MUST NOT be applied retroactively. [Insert name of the firm] has been independently
verified for the periods [insert dates]. The
3.A.10 FIRMS that wish to remove PORTFOLIOS
from COMPOSITES in cases of SIGNIFICANT verification report is/are available upon request.”
CASH FLOWS MUST define “significant” on an EX-
ANTE, COMPOSITE-specific basis and MUST
consistently follow the COMPOSITE-specific policy.

4. DISCLOSURE
4.A.1 Once a FIRM has met all the REQUIREMENTS 4.A.13 FIRMS MUST disclose the presence, use, and extent of
of the GIPS standards, the FIRM MUST disclose its leverage, derivatives, and short positions, if material, including
compliance with the GIPS standards using one of a description of the frequency of use and characteristics of the
the compliance statements (mentioned in the instruments sufficient to identify risks.
previous page). The claim of compliance MUST only
be used in a COMPLIANT PRESENTATION.
4.A.14 FIRMS MUST disclose all significant events that would
help a PROSPECTIVE CLIENT
4.A.2 FIRMS MUST disclose the definition of the interpret the COMPLIANT PRESENTATION.
FIRM used to determine TOTAL FIRM ASSETS and
FIRM-wide compliance.
4.A.15 For any performance presented for periods prior to 1
January 2000 that does not comply with the GIPS standards,
4.A.3 FIRMS MUST disclose the COMPOSITE FIRMS MUST disclose the periods of
DESCRIPTION. non-compliance.
4.A.4 FIRMS MUST disclose the BENCHMARK 4.A.16 If the FIRM is redefined, the FIRM MUST disclose the
DESCRIPTION. date of, description of, and reason for the redefinition.
4.A.5 When presenting GROSS-OF-FEES returns,

FIRMS MUST disclose if any other fees are deducted 4.A.17 If a COMPOSITE is redefined, the FIRM MUST disclose
in addition to the TRADING EXPENSES. the date of, description of, and reason for the redefinition.
4.A.6 When presenting NET-OF-FEES returns,

FIRMS MUST disclose: 4.A.18 FIRMS MUST disclose changes to the name of a
COMPOSITE.
a. If any other fees are deducted in addition to the
INVESTMENT MANAGEMENT 4.A.19 FIRMS MUST disclose the minimum asset level, if any,
FEES and TRADING EXPENSES; below which PORTFOLIOS are not included in a COMPOSITE.
FIRMS MUST also disclose any changes to the minimum asset
level.
b. If model or actual INVESTMENT MANAGEMENT
FEES are used; and
4.A.20 FIRMS MUST disclose relevant details of the treatment
of withholding taxes on dividends, interest income, and capital
c. If returns are net of any PERFORMANCE-BASED gains, if material. FIRMS MUST also disclose if BENCHMARK
FEES. returns are net of withholding taxes if this information is
available.
4.A.7 FIRMS MUST disclose the currency used to
express performance. 4.A.21 For periods beginning on or after 1 January 2011,
FIRMS MUST disclose and describe any known material
differences in exchange rates or valuation sources used among
4.A.8 FIRMS MUST disclose which measure of the PORTFOLIOS within a COMPOSITE, and between the
INTERNAL DISPERSION is presented. COMPOSITE
and the BENCHMARK.
4.A.9 FIRMS MUST disclose the FEE SCHEDULE

4.A.22 If the COMPLIANT PRESENTATION conforms with laws
appropriate to the COMPLIANT PRESENTATION.
and/or regulations that conflict with the REQUIREMENTS of
the GIPS standards, FIRMS MUST disclose this fact and disclose
4.A.10 FIRMS MUST disclose the COMPOSITE the manner in which the laws and/or regulations conflict with
CREATION DATE. the GIPS standards.
4.A.23 For periods prior to 1 January 2010, if CARVE-OUTS are

4.A.11 FIRMS MUST disclose that the FIRM’S list of included in a COMPOSITE,
COMPOSITE DESCRIPTIONS is available upon FIRMS MUST disclose the policy used to allocate cash to
request. CARVE-OUTS.
4.A.12 FIRMS MUST disclose that policies for 4.A.24 If a COMPOSITE contains PORTFOLIOS with BUNDLED
valuing PORTFOLIOS, calculating performance, FEES, FIRMS MUST disclose the
and preparing COMPLIANT PRESENTATIONS are types of fees that are included in the BUNDLED FEE.
available upon request.

FIRMS MUST disclose the use
of a SUB-ADVISOR and the periods a SUB-ADVISOR was used.

4.A.26 For periods prior to 1 January 2010, FIRMS 4.A.27 For periods beginning on or after 1 January
MUST disclose if any PORTFOLIOS were not valued 2011, FIRMS MUST disclose the use of subjective
at calendar month end or on the last business day of unobservable inputs for valuing PORTFOLIO
the month. investments (as described in the GIPS Valuation
Principles in Chapter II) if the PORTFOLIO
investments valued using subjective unobservable
4.A.28 For periods beginning on or after 1 January inputs are material to the COMPOSITE.
2011, FIRMS MUST disclose if the COMPOSITE’S
valuation hierarchy materially differs from the
RECOMMENDED hierarchy in the GIPS Valuation 4.A.29 If the FIRM determines no appropriate
Principles in Chapter II. BENCHMARK for the COMPOSITE exists, the
FIRM MUST disclose why no BENCHMARK is
presented.
4.A.30 If the FIRM changes the BENCHMARK, the
FIRM MUST disclose the date of,
description of, and reason for the change. 4.A.31 If a custom BENCHMARK or combination of
multiple BENCHMARKS is used, the FIRM
MUST disclose the BENCHMARK components,
4.A.32 If the FIRM has adopted a SIGNIFICANT weights, and rebalancing process.
CASH FLOW policy for a specific COMPOSITE,
the FIRM MUST disclose how the FIRM defines a
SIGNIFICANT CASH FLOW for that 4.A.33 FIRMS MUST disclose if the three-year
COMPOSITE and for which periods. annualized EX-POST STANDARD DEVIATION
of the COMPOSITE and/or BENCHMARK is not
presented because 36 monthly
4.A.34 If the FIRM determines that the three-year returns are not available.
annualized EX-POST STANDARD DEVIATION is not
relevant or appropriate, the FIRM MUST:
4.A.35 FIRMS MUST disclose if the performance
from a past firm or affiliation is LINKED
a. Describe why EX-POST STANDARD DEVIATION is to the performance of the FIRM.
not relevant or appropriate; and
b. Describe the additional risk measure presented

and why it was selected.
B. Recommendations
4.B.1 FIRMS SHOULD disclose material changes to 4.B.2 FIRMS SHOULD disclose material changes to
valuation policies and/or methodologies. calculation policies and/or methodologies.
4.B.3 FIRMS SHOULD disclose material differences 4.B.4 FIRMS SHOULD disclose the key assumptions
between the BENCHMARK and the COMPOSITE’S used to value PORTFOLIO investments.
investment mandate, objective, or strategy.
4.B.5 If a parent company contains multiple firms, 4.B.6 For periods prior to 1 January 2011, FIRMS
each FIRM within the parent company SHOULD SHOULD disclose the use of subjective
disclose a list of the other firms contained within unobservable inputs for valuing PORTFOLIO
the parent company. investments (as described in the GIPS Valuation
Principles in Chapter II) if the PORTFOLIO
investments valued using subjective unobservable
inputs are material to the COMPOSITE.
4.B.7 For periods prior to 1 January 2006, FIRMS 4.B.8 FIRMS SHOULD disclose if a COMPOSITE
SHOULD disclose the use of a SUBADVISOR contains PROPRIETARY ASSETS.
and the periods a SUB-ADVISOR was used.

5. PRESENTATION AND REPORTING
5.A.1 a At least five years of performance (or for the 5.A.3 FIRMS MUST NOT LINK non-GIPS-compliant performance
period since the FIRM’S inception or the COMPOSITE for periods beginning on or after 1 January 2000 to their GIPS-
INCEPTION DATE if the FIRM or the COMPOSITE has compliant performance. FIRMS may LINK non-GIPS-compliant
been in existence less than five years) that meets the performance to GIPS-compliant performance provided that
REQUIREMENTS of the GIPS standards. After a FIRM only GIPS-compliant performance is presented for periods
presents a minimum of five years of GIPS compliant beginning on or after 1 January 2000..
performance (or for the period since the FIRM’S
inception or the COMPOSITE INCEPTION DATE if the
FIRM or the COMPOSITE has been in existence less than 5.A.4 Returns for periods of less than one year MUST NOT be
five years), the FIRM MUST present an additional year of annualized.
performance each year, building up to a minimum of 10
years of GIPS compliant performance.
5.A.5 For periods beginning on or after 1 January 2006 and
ending prior to 1 January 2011, if a COMPOSITE includes
b. COMPOSITE returns for each annual period. CARVE-OUTS, the FIRM MUST present the percentage of
COMPOSITE returns MUST be clearly identified as COMPOSITE assets represented by CARVE-OUTS as of each
GROSS-OF-FEES or NET-OF-FEES. annual period end.
c. For COMPOSITES with a COMPOSITE INCEPTION DATE 5.A.6 If a COMPOSITE includes non-fee-paying PORTFOLIOS,
of 1 January 2011 or later, the FIRM MUST present the
when the initial period is less than a full year, returns percentage of COMPOSITE assets represented by non-fee-
from the COMPOSITE INCEPTION DATE through the paying PORTFOLIOS as of each annual period end.
initial annual period end.
5.A.7 If a COMPOSITE includes PORTFOLIOS with BUNDLED

d. For COMPOSITES with a COMPOSITE TERMINATION FEES, the FIRM MUST present the percentage of COMPOSITE
DATE of 1 January 2011 or assets represented by PORTFOLIOS with BUNDLED FEES as of
later, returns from the last annual period end through the each annual period end.
COMPOSITE TERMINATION DATE.
e. The TOTAL RETURN for the BENCHMARK for each 5.A.8 a. Performance of a past firm or affiliation MUST be
annual period. The BENCHMARK MUST reflect the LINKED to or used to represent the historical performance of a
investment mandate, objective, or strategy of new or acquiring FIRM if, on a COMPOSITE-specific basis:
the COMPOSITE.
f. The number of PORTFOLIOS in the COMPOSITE as i. Substantially all of the investment decision makers are
of each annual period end. If the COMPOSITE employed by the new or acquiring FIRM (e.g., research
contains five or fewer PORTFOLIOS at period end, department staff, portfolio managers, and other relevant staff);
the number of PORTFOLIOS is not REQUIRED.
g. COMPOSITE assets as of each annual period end. ii. The decision-making process remains substantially intact
and independent within the new or acquiring FIRM; and
h. Either TOTAL FIRM ASSETS or COMPOSITE

assets as a percentage of TOTAL FIRM ASSETS, as of
each annual period end. iii. The new or acquiring FIRM has records that document and
support the performance.
i. A measure of INTERNAL DISPERSION of
individual PORTFOLIO returns for each annual b. If a FIRM acquires another firm or affiliation, the FIRM has
period. If the COMPOSITE contains five or fewer one year to bring any non-compliant assets into compliance.
PORTFOLIOS for the full year, a measure of
INTERNAL DISPERSION is not REQUIRED.
5.A.2 For periods ending on or after 1 January 2011,

FIRMS MUST present, as of each annual period end:
a. The three-year annualized EX-POST STANDARD

DEVIATION (using monthly returns) of both the
COMPOSITE and the BENCHMARK; and
b. An additional three-year EX-POST risk measure for the BENCHMARK (if

available and appropriate) and the COMPOSITE, if the FIRM determines that
the three-year annualized EX-POST STANDARD DEVIATION is not relevant or
appropriate. The PERIODICITY of the COMPOSITE and the BENCHMARK MUST
be identical when calculating the EX-POST risk measure.

B. Recommendations 5.B.2 FIRMS SHOULD present the following items:
a. Cumulative returns of the COMPOSITE and the

5.B.1 FIRMS SHOULD present GROSS-OF-FEES BENCHMARK for all periods;
returns.
b. Equal-weighted mean and median COMPOSITE
returns;
5.B.3 For periods prior to 1 January 2011, FIRMS
SHOULD present the three-year annualized EX-
POST STANDARD DEVIATION (using monthly c. Quarterly and/or monthly returns; and
returns) of the COMPOSITE and the BENCHMARK
as of each annual period end.
d. Annualized COMPOSITE and BENCHMARK
returns for periods longer than 12 months.
5.B.5 For each period for which an annualized
return of the COMPOSITE and the BENCHMARK are
5.B.4 For each period for which an annualized EX-
presented, the corresponding annualized EX-POST
POST STANDARD DEVIATION of the COMPOSITE
STANDARD DEVIATION (using monthly returns) of
and the BENCHMARK are presented, the
the COMPOSITE and the BENCHMARK
corresponding annualized return of the
SHOULD also be presented.
COMPOSITE and the BENCHMARK SHOULD also be
presented.
5.B.7 FIRMS SHOULD present more than 10 years of
annual performance in the COMPLIANT
PRESENTATION. 5.B.6 FIRMS SHOULD present additional relevant
COMPOSITE-level EX-POST risk measures.
5.B.9 FIRMS SHOULD update COMPLIANT

5.B.8 FIRMS SHOULD comply with the GIPS
PRESENTATIONS quarterly.
standards for all historical periods.
6. REAL ESTATE
The following investment types are not considered REAL ESTATE and, therefore, MUST
follow Sections 0–5 in Chapter I:
Publicly traded REAL ESTATE securities;
Commercial mortgage-backed securities (CMBS); and
Private debt investments, including commercial and residential loans where the
expected return is solely related to contractual interest rates without any participation
in the economic performance of the underlying REAL ESTATE.
Input Data — Requirements (the

following provisions do not apply:
1.A.3.a, 1.A.3.b, and 1.A.4)
6.A.1 For periods beginning on or after 1 January 2011, 6.A.5 EXTERNAL VALUATIONS must be performed
REAL ESTATE investments MUST by an independent external
be valued in accordance with the definition of FAIR PROFESSIONALLY DESIGNATED, CERTIFIED, OR
VALUE and the GIPS Valuation LICENSED COMMERCIAL PROPERTY
Principles in Chapter II. VALUER/APPRAISER. In markets where these
professionals are not available, the FIRM MUST take
6.A.2 For periods beginning on or after 1 January 2008, necessary steps to ensure that only well-qualified
REAL ESTATE investments MUST independent property values or appraisers are
be valued at least quarterly. used.
6.A.3 For periods beginning on or after 1 January 2010, FIRMS

MUST value PORTFOLIOS
as of each quarter end or the last business day of each quarter.
at least once every 12 months unless client
agreements stipulate otherwise, in which case
6.A.4 REAL ESTATE investments MUST have an REAL ESTATE investments MUST have an
EXTERNAL VALUATION: EXTERNAL VALUATION at least once every 36
months or per the client agreement if the client
agreement requires
a. For periods prior to 1 January 2012, at least once
EXTERNAL VALUATIONS more frequently than
every 36 months.
every 36 months.

A. Requirements
Calculation Methodology —Requirements (the Disclosure — Requirements (the following

following provisions do not apply: 2.A.2.a, 2.A.4, provisions do not apply: 4.A.5, 4.A.6.a,
and 2.A.7) 4.A.15, 4.A.26, 4.A.33, and 4.A.34)
6.A.10 The following items MUST be disclosed in

6.A.6 FIRMS MUST calculate PORTFOLIO returns at each COMPLIANT PRESENTATION:
least quarterly.
a. The FIRM’S description of discretion;
6.A.7 All returns MUST be calculated after the
deduction of actual TRANSACTION EXPENSES
b. The INTERNAL VALUATION methodologies used
incurred during the period.
to value REAL ESTATE investments for the most
recent period;
6.A.8 For periods beginning on or after 1 January
2011, INCOME RETURNS and CAPITAL c. For periods beginning on or after 1 January 2011,
RETURNS (component returns) MUST be calculated material changes to valuation policies and/or
separately using geometrically LINKED TIME- methodologies;
WEIGHTED RATES OF RETURN..
d. For periods beginning on or after 1 January 2011,
6.A.9 COMPOSITE TIME-WEIGHTED RATES OF material differences between an EXTERNAL
RETURN, including component returns, VALUATION and the valuation used in performance
MUST be calculated by asset-weighting the reporting and the reason for the differences;
individual PORTFOLIO returns at
least quarterly. e. The frequency REAL ESTATE investments are
valued by an independent external
ROFESSIONALLY DESIGNATED, CERTIFIED, OR
LICENSED COMMERCIAL PROPERTY
Presentation and Reporting — Requirements (the VALUER/APPRAISER;
following provisions do not apply: 5.A.1.i, 5.A.2,
and 5.A.3) f. When component returns are calculated
separately using geometrically LINKED TIME-
WEIGHTED RATES OF RETURN; and
6.A.14 FIRMS MUST present component returns in
addition to TOTAL RETURNS.
COMPOSITE component returns MUST be clearly g. For periods prior to 1 January 2011, if component
identified as GROSS-OF-FEES or returns are adjusted such that the sum of the
NET-OF-FEES. INCOME RETURN and the CAPITAL RETURN equals
the TOTAL RETURN.
6.A.15 FIRMS MUST NOT LINK non-GIPS-compliant
performance for periods beginning 6.A.11 For any performance presented for periods
on or after 1 January 2006 to their GIPS-compliant prior to 1 January 2006 that does not comply with
performance. FIRMS may LINK non-GIPS-compliant the GIPS standards, FIRMS MUST disclose the
performance to their GIPS-compliant performance periods of noncompliance.
provided that only GIPS-compliant performance is
presented for periods beginning on or after 1
6.A.12 When presenting GROSS-OF-FEES returns,
January 2006.
FIRMS MUST disclose if any other fees are deducted
in addition to the TRANSACTION EXPENSES.
6.A.16 The following items MUST be presented in
each COMPLIANT PRESENTATION:
a. As a measure of INTERNAL DISPERSION, high 6.A.13 When presenting NET-OF-FEES returns,
and low annual TIME-WEIGHTED RATES OF FIRMS MUST disclose if any other fees are deducted
RETURN for the individual PORTFOLIOS in the in addition to the INVESTMENT MANAGEMENT
COMPOSITE. If the COMPOSITE contains five or FEES and TRANSACTION EXPENSES.
fewer PORTFOLIOS for the full year, a measure of
INTERNAL DISPERSION is not REQUIRED.
b. As of each annual period end, the percentage of
COMPOSITE assets valued using an EXTERNAL
VALUATION during the annual period.

A. Requirements
The following provisions are Presentation and Reporting - Requirements

additional REQUIREMENTS for REAL
ESTATE CLOSED-END FUND
COMPOSITES: 6.A.25 FIRMS MUST present, as of each annual
period end:
Calculation Methodology -
a. COMPOSITE SINCE INCEPTION PAID-IN

6.A.17 FIRMS MUST calculate annualized SINCE
CAPITAL;
INCEPTION INTERNAL RATES OF RETURN
(SI-IRR).
b. COMPOSITE SINCE INCEPTION DISTRIBUTIONS;
6.A.18 The SI-IRR MUST be calculated using
quarterly cash flows at a minimum.
c. COMPOSITE cumulative COMMITTED CAPITAL;
Composite Construction -
d. TOTAL VALUE to SINCE INCEPTION PAID-IN

6.A.19 COMPOSITES MUST be defined by CAPITAL (INVESTMENT MULTIPLE or TVPI);
VINTAGE YEAR and investment mandate,
objective, or strategy. The COMPOSITE
DEFINITION MUST remain consistent e. SINCE INCEPTION DISTRIBUTIONS to SINCE
throughout the life of the COMPOSITE. INCEPTION PAID-IN CAPITAL (REALIZATION
MULTIPLE or DPI);
Disclosure -
f. SINCE INCEPTION PAID-IN CAPITAL to
6.A.20 FIRMS MUST disclose the FINAL cumulative COMMITTED CAPITAL (PIC
LIQUIDATION DATE for liquidated COMPOSITES. MULTIPLE); and
6.A.21 FIRMS MUST disclose the frequency of cash g. RESIDUAL VALUE to SINCE INCEPTION PAID-IN
flows used in the SI-IRR calculation. CAPITAL (UNREALIZED MULTIPLE
or RVPI).
6.A.22 FIRMS MUST disclose the VINTAGE YEAR of

6.A.26 FIRMS MUST present the SI-IRR of the
the COMPOSITE and how the VINTAGE
BENCHMARK through each annual period end. The
YEAR is defined.
BENCHMARK MUST:
Presentation and Reporting - Requirements
a. Reflect the investment mandate, objective, or
6.A.23 The following items MUST be presented in strategy of the COMPOSITE;
each COMPLIANT PRESENTATION:
b. Be presented for the same time period as
a. FIRMS MUST present the NET-OF-FEES SI-IRR of the presented for the COMPOSITE; and
COMPOSITE through each annual period end. FIRMS
MUST initially present at least five years of
performance (or for the period since the FIRM’S c. Be the same VINTAGE YEAR as the COMPOSITE.
inception or the COMPOSITE INCEPTION DATE if the
FIRM or the COMPOSITE has been in existence less
than five years) that meets the REQUIREMENTS of the
GIPS standards. Each subsequent year, FIRMS MUST
present an additional year of performance.

when the initial period is less than a full year, FIRMS
MUST present the non-annualized NET-OF-FEES
SI-IRR through the initial annual period end.
c. For periods ending on or after 1 January 2011, FIRMS

MUST present the NETOF- FEES SI-IRR through the
COMPOSITE FINAL LIQUIDATION DATE.
6.A.24 If the GROSS-OF-FEES SI-IRR of the COMPOSITE

is presented in the COMPLIANT
PRESENTATION, FIRMS MUST present the GROSS-OF-
FEES SI-IRR of the COMPOSITE for
the same periods as the NET-OF-FEES SI-IRR is
presented.

B. Recommendations
Presentation and Reporting- Recommendations

Input Data- Recommendations (the (the following provisions do not apply: 5.B.3,
following provision does not apply: 1.B.1) 5.B.4, and 5.B.5)
6.B.1 For periods prior to 1 January 2012, REAL

ESTATE investments SHOULD be valued 6.B.6 FIRMS SHOULD present both GROSS-OF-FEES
by an independent external PROFESSIONALLY and NET-OF-FEES returns.
DESIGNATED, CERTIFIED, OR LICENSED
COMMERCIAL PROPERTY VALUER/APPRAISER at 6.B.7 FIRMS SHOULD present the percentage of the
least once every 12 months. total value of COMPOSITE assets that are not REAL
ESTATE as of each annual period end.
6.B.2 REAL ESTATE investments SHOULD be valued
as of the annual period end by an independent 6.B.8 FIRMS SHOULD present the component
external PROFESSIONALLY DESIGNATED, returns of the BENCHMARK, if available.
CERTIFIED, OR LICENSED COMMERCIAL
PROPERTY VALUER/APPRAISER.
The following provision is an additional
RECOMMENDATION for REAL ESTATE CLOSED-
END FUND COMPOSITES:
Disclosure - Recommendations
Calculation Methodology- Recommendations

6.B.3 FIRMS SHOULD disclose the basis of
accounting for the PORTFOLIOS in the
COMPOSITE (e.g., U.S. GAAP, IFRS). 6.B.9 The SI-IRR SHOULD be calculated using daily
cash flows.
6.B.4 FIRMS SHOULD explain and disclose material
differences between the valuation used in
performance reporting and the valuation used in
financial reporting as of each annual period end.
6.B.5 For periods prior to 1 January 2011, FIRMS

SHOULD disclose material changes to
valuation policies and/or methodologies.

7. PRIVATE EQUITY
Input Data — Requirements (the following Disclosure — Requirements (the following

provisions do not apply: 1.A.3.a, 1.A.3.b, and 1.A.4) provisions do not apply: 4.A.5, 4.A.6.a, 4.A.6.b,
4.A.8, 4.A.15, 4.A.26, 4.A.32, 4.A.33, and 4.A.34)
7. A.1 For periods ending on or after 1 January 2011,
PRIVATE EQUITY investments MUST be valued in 7. A.11 FIRMS MUST disclose the VINTAGE YEAR of
accordance with the definition of FAIR VALUE and the the COMPOSITE and how the VINTAGE
GIPS Valuation Principles in Chapter II. YEAR is defined.
7. A.2 PRIVATE EQUITY investments MUST be valued 7. A.12 FIRMS MUST disclose the FINAL
at least annually. LIQUIDATION DATE for liquidated COMPOSITES.
Calculation Methodology — Requirements (the 7. A.13 FIRMS MUST disclose the valuation
following provisions do not apply: 2.A.2, 2.A.4, methodologies used to value PRIVATE EQUITY
2.A.6, and 2.A.7) Investments for the most recent period.
7. A.3 FIRMS MUST calculate annualized SINCE 7. A.14 For periods ending on or after 1 January
INCEPTION INTERNAL RATES OF RETURN 2011, FIRMS MUST disclose material
(SI-IRR). changes to valuation policies and/or
methodologies.
7. A.4 For periods ending on or after 1 January
2011, the SI-IRR MUST be calculated using 7. A.15 If the FIRM adheres to any industry
daily cash flows. Stock DISTRIBUTIONS MUST valuation guidelines in addition to the GIPS
be included as cash flows and MUST be valued Valuation Principles, the FIRM MUST disclose which
at the time of DISTRIBUTION. guidelines have been applied.
7. A.5 All returns MUST be calculated after the 7. A.16 FIRMS MUST disclose the calculation
deduction of actual TRANSACTION EXPENSES methodology used for the BENCHMARK. If
incurred during the period. FIRMS present the PUBLIC MARKET EQUIVALENT
of a COMPOSITE as a BENCHMARK, FIRMS MUST
disclose the index used to calculate the PUBLIC
7. A.6 NET-OF-FEES returns MUST be net of MARKET EQUIVALENT.
actual INVESTMENT MANAGEMENT FEES
(including CARRIED INTEREST).
7. A.17 FIRMS MUST disclose the frequency of cash
flows used in the SI-IRR calculation if daily cash
7. A.7 For FUNDS OF FUNDS, all returns MUST flows are not used for periods prior to 1 January
be net of all underlying partnership and/or 2011.
fund fees and expenses, including CARRIED
INTEREST.
7. A.18 For GROSS-OF-FEES returns, FIRMS MUST
Composite Construction — Requirements disclose if any other fees are deducted in
addition to the TRANSACTION EXPENSES.
(the following provision does not apply:
3.A.10)
7. A.19 For NET-OF-FEES returns, FIRMS MUST
7. A.8 COMPOSITE DEFINITIONS MUST remain disclose if any other fees are deducted in addition
consistent throughout the life of the COMPOSITE. to the INVESTMENT MANAGEMENT FEES and
TRANSACTION EXPENSES.
7. A.9 PRIMARY FUNDS MUST be included in at
least one COMPOSITE defined by VINTAGE YEAR 7. A.20 For any performance presented for periods
and investment mandate, objective, or strategy. ending prior to 1 January 2006 that does not
comply with the GIPS standards, FIRMS MUST
disclose the periods of non-compliance.
7. A.10 FUNDS OF FUNDS MUST be included in at
least one COMPOSITE defined by VINTAGE YEAR of
the FUND OF FUNDS and/or investment mandate,
objective, or strategy.

Presentation and Reporting - Requirements (the

following provisions do not apply: 5.A.1.a, 5. A.1.b,
5.A.1.c, 5.A.1.d, 5.A.1.e, 5.A.1.i, 5.A.2, and 5.A.3)
7.A.21 The following items MUST be presented in 7. A.24 FIRMS MUST present the SI-IRR for the
each COMPLIANT PRESENTATION: BENCHMARK through each annual period end. The
BENCHMARK MUST:
a. FIRMS MUST present both the NET-OF-FEES and GROSS-
OF-FEES SI-IRR of the COMPOSITE through each annual a. Reflect the investment mandate, objective, or
period end. FIRMS MUST initially present at least five years strategy of the COMPOSITE;
of performance (or for the period since the FIRM’S inception
or the COMPOSITE INCEPTION DATE if the FIRM or the
COMPOSITE has been in existence less than five years) that b. Be presented for the same time periods as
meets the REQUIREMENTS of the GIPS standards. Each presented for the COMPOSITE; and
subsequent year, FIRMS MUST present an additional year of
performance. COMPOSITE returns MUST be clearly c. Be the same VINTAGE YEAR as the COMPOSITE.
identified as GROSS-OF-FEES or NET-OF-FEES.
b. For periods beginning on or after 1 January 2011, 7.A.25 For FUND OF FUNDS COMPOSITES, if the
when the initial period is COMPOSITE is defined only by investment
less than a full year, FIRMS MUST present the non- mandate, objective, or strategy and a BENCHMARK
annualized NET-OF-FEES and is presented for the underlying
GROSS-OF-FEES SI-IRR through the initial annual investments, the BENCHMARK MUST be the same
period end. VINTAGE YEAR and investment
mandate, objective, or strategy as the underlying
c. For periods ending on or after 1 January 2011, investments.
FIRMS MUST present the
NET-OF-FEES and GROSS-OF-FEES SI-IRR through 7.A.26 For periods ending on or after 1 January
the COMPOSITE FINAL 2011, for FUND OF FUNDS COMPOSITES,
LIQUIDATION DATE. FIRMS MUST present the percentage, if any, of
COMPOSITE assets that is invested
7. A.22 For periods ending on or after 1 January 2011, for FUND in DIRECT INVESTMENTS (rather than in fund
OF FUNDS COMPOSITES, investment vehicles) as of each
if the COMPOSITE is defined only by investment mandate, annual period end.
objective, or strategy,
FIRMS MUST also present the SI-IRR of the underlying 7.A.27 For periods ending on or after 1 January
investments aggregated by 2011, for PRIMARY FUND COMPOSITES,
VINTAGE YEAR as well as other measures as REQUIRED in FIRMS MUST present the percentage, if any, of
7.A.23. These measures COMPOSITE assets that is invested
MUST be presented gross of the FUND OF FUNDS INVESTMENT in fund investment vehicles (rather than in DIRECT
MANAGEMENT FEES INVESTMENTS) as of each
and MUST be presented as of the most recent annual period annual period end.
end.
7.A.28 FIRMS MUST NOT present non-GIPS-
7. A.23 FIRMS MUST present as of each annual compliant performance for periods ending
period end: on or after 1 January 2006. For periods ending prior
to 1 January 2006, FIRMS
a. COMPOSITE SINCE INCEPTION PAID-IN may present non-GIPS-compliant performance.
CAPITAL;
b. COMPOSITE SINCE INCEPTION DISTRIBUTIONS;
c. COMPOSITE cumulative COMMITTED CAPITAL;
d. TOTAL VALUE to SINCE INCEPTION PAID-IN

CAPITAL (INVESTMENT MULTIPLE or TVPI);
e. SINCE INCEPTION DISTRIBUTIONS to SINCE

INCEPTION PAID-IN CAPITAL (REALIZATION
MULTIPLE or DPI);
f. SINCE INCEPTION PAID-IN CAPITAL to

cumulative COMMITTED CAPITAL (PIC
MULTIPLE); and
g. RESIDUAL VALUE to SINCE INCEPTION PAID-IN

CAPITAL (UNREALIZED CAPITAL
or RVPI).

B. Recommendations
Input Data - Recommendations (the Presentation and Reporting - Recommendations

following provision does not apply: (the following provisions do not apply: 5.B.2,
5.B.3, 5.B.4, and 5.B.5)
7.B.1 PRIVATE EQUITY investments SHOULD be
valued at least quarterly. 7.B.5 For periods ending on or after 1 January 2011, for FUND
OF FUNDS COMPOSITES,
if the COMPOSITE is defined only by VINTAGE YEAR of the
Calculation Methodology - Recommendations (the FUND OF FUNDS, FIRMS
following provision does not apply: 2.B.2) SHOULD also present the SI-IRR of the underlying
investments aggregated by
7. B.2 For periods ending prior to 1 January 2011, investment mandate, objective, or strategy and other
the SI-IRR SHOULD be calculated using daily cash measures as listed in 7.A.23.
flows. These measures SHOULD be presented gross of the FUND OF
FUNDS INVESTMENT
MANAGEMENT FEES.
Composite Construction - Recommendations
(the following provision does not apply: 3.B.2)
7.B.6 For periods ending prior to 1 January 2011, for FUND
OF FUNDS COMPOSITES,
Disclosure - Recommendations FIRMS SHOULD present the percentage, if any, of COMPOSITE
assets that is invested
7.B.3 FIRMS SHOULD explain and disclose material in DIRECT INVESTMENTS (rather than in fund investment
differences between the valuations used in vehicles) as of each
performance reporting and the valuations used in annual period end.
financial reporting as of each annual period end.
7.B.7 For periods ending prior to 1 January 2011, for
7. B.4 For periods prior to 1 January 2011, FIRMS PRIMARY FUND COMPOSITES,
SHOULD disclose material changes to FIRMS SHOULD present the percentage, if any, of COMPOSITE
valuation policies and/or methodologies. assets that is invested
in fund investment vehicles (rather than in DIRECT
INVESTMENTS) as of each
annual period end.

8. WRAP FEE/SEPARATELY MANAGED ACCOUNT (SMA) PORTFOLIOS
A. Requirements
Composite Construction Disclosur

e
8.A.1 FIRMS MUST include the performance record of 8.A.2 For all WRAP FEE/SMA COMPLIANT
actual WRAP FEE/SMA PORTFOLIOS in PRESENTATIONS that include periods prior to the
appropriate COMPOSITES in accordance with the inclusion of an actual WRAP FEE/SMA PORTFOLIO
FIRM’S established PORTFOLIO inclusion policies. in the COMPOSITE, the FIRM MUST disclose, for
Once established, these COMPOSITES (containing each period presented, that the COMPOSITE does
actual WRAP FEE/SMA PORTFOLIOS) MUST be not contain actual WRAP FEE/SMA PORTFOLIOS.
used in the FIRM’S COMPLIANT PRESENTATIONS
presented to WRAP FEE/SMA PROSPECTIVE
CLIENTS. 8.A.3 For any performance presented for periods prior
to 1 January 2006 that does not comply with the
GIPS standards, FIRMS MUST disclose the periods
Presentation and Reporting of non-compliance.
8.A.4 When FIRMS present COMPOSITE performance to

an existing WRAP FEE/SMA sponsor that includes
8.A.5 When FIRMS present performance to a WRAP only that sponsor’s WRAP FEE/SMA PORTFOLIOS
FEE/SMA PROSPECTIVE CLIENT, the COMPOSITE (resulting in a “sponsor-specific COMPOSITE”):
presented MUST include the performance of all
actual WRAP FEE/SMA PORTFOLIOS, if any,
managed according to the COMPOSITE investment
8. A.4.a. FIRMS MUST disclose the name of the
mandate, objective, or strategy, regardless of the
WRAP FEE/SMA sponsor represented by
WRAP FEE/SMA sponsor (resulting in a “style-
the sponsor-specific COMPOSITE
defined COMPOSITE”).
8.A.6 When FIRMS present performance to a WRAP b. If the sponsor-specific COMPOSITE

FEE/SMA PROSPECTIVE CLIENT, performance COMPLIANT PRESENTATION is intended
MUST be presented net of the entire WRAP FEE. for the purpose of generating WRAP
FEE/SMA business and does not include
performance net of the entire WRAP FEE,
8.A.7 FIRMS MUST NOT LINK non-GIPS-compliant the COMPLIANT PRESENTATION MUST
performance for periods beginning on or after 1 disclose that the named sponsor-specific
January 2006 to their GIPS-compliant performance. COMPLIANT PRESENTATION is only for
FIRMS may LINK non-GIPS-compliant performance the use of the named WRAP FEE/SMA
to their GIPS-compliant performance provided that sponsor.
only GIPS-compliant performance is presented for
periods beginning on or after 1 January 2006.

II. GLOBAL INVESTMENT PERFORMANCE STANDARDS VALUATION PRINCIPLES
A. FAIR VALUE DEFINITION B. VALUATION REQUIREMENTS C. VALUATION RECOMMENDATIONS
FAIR VALUE is defined as the amount at which an 1. For periods beginning on or after 1 January 2011, PORTFOLIOS MUST be valued in
investment could be exchanged in a current arm’s length accordance with the definition of FAIR VALUE and the GIPS Valuation Principles in Chapter
transaction between willing parties in which the parties II (Provision 1.A.2).
each act knowledgeably and prudently. The valuation
MUST be determined using the objective, observable,
unadjusted quoted market price for an identical
investment in an active market on the measurement 2. FIRMS MUST value investments using objective, observable, unadjusted quoted market
date, if available. In the absence of an objective, prices for identical investments in active markets on the measurement date, if available.
observable, unadjusted quoted market price for an
identical investment in an active market on the
measurement date, the valuation MUST represent the 3. FIRMS MUST comply with all applicable laws and regulations regarding the calculation and
FIRM’S best estimate of the MARKET VALUE. FAIR presentation of performance (Provision 0.A.2). Accordingly, FIRMS MUST comply with
VALUE MUST include accrued income. applicable laws and regulations relating to valuation.
4. If the COMPLIANT PRESENTATION conforms with laws and/or regulations that conflict
ADDITIONAL PRIVATE EQUITY with the REQUIREMENTS of the GIPS standards, FIRMS MUST disclose this fact and
disclose the manner in which the laws and/or regulations conflict with the GIPS standards
VALUATION REQUIREMENTS:
(Provision 4.A.22). This includes any conflicts between laws and/or regulations and the
GIPS Valuation Principles.
17. The valuation methodology selected MUST be
the most appropriate for a particular
investment based on the nature, facts, and 5. FIRMS MUST document their policies and procedures used in establishing and maintaining
circumstances of the investment. compliance with the GIPS standards, including ensuring the existence and ownership of
client assets, and MUST apply them consistently (Provision 0.A.5). Accordingly, FIRMS
MUST document their valuation policies, procedures, methodologies, and hierarchy,
18. FIRMS MUST disclose the valuation including any changes, and MUST apply them consistently.
methodologies used to value PRIVATE
EQUITY investments for the most recent
6. FIRMS MUST disclose that policies for valuing PORTFOLIOS, calculating performance, and
period (Provision 7.A.13).
preparing COMPLIANT PRESENTATIONS are available upon request (Provision 4.A.12).
19. For periods ending on or after 1 January 2011,

FIRMS MUST disclose material changes to 7. For periods beginning on or after 1 January 2011, FIRMS MUST disclose the use of
valuation policies and/or methodologies subjective unobservable inputs for valuing PORTFOLIO investments (as described in the
(Provision 7.A.14). GIPS Valuation Principles in Chapter II) if the PORTFOLIO investments valued using
subjective unobservable inputs are material to the COMPOSITE (Provision 4.A.27).
20. If the FIRM adheres to any industry valuation
guidelines in addition to the GIPS Valuation 8. For periods beginning on or after 1 January 2011, FIRMS MUST disclose if the COMPOSITE’S
Principles, the FIRM MUST disclose which valuation hierarchy materially differs from the RECOMMENDED hierarchy in the GIPS
guidelines have been applied (Provision Valuation Principles in Chapter II (Provision 4.A.28).
7.A.15).
ADDITIONAL REAL ESTATE VALUATION REQUIREMENTS:
9. REAL ESTATE investments MUST have an EXTERNAL 10. The EXTERNAL VALUATION process MUST adhere to practices of the relevant valuation
VALUATION (Provision 6.A.4). governing and standard setting body.
11. The FIRM MUST NOT use EXTERNAL VALUATIONS 12. EXTERNAL VALUATIONS must be performed by an independent external
where the valuer’s or appraiser’s fee is contingent PROFESSIONALLY DESIGNATED, CERTIFIED, OR LICENSED COMMERCIAL PROPERTY
upon the investment’s appraised value. VALUER/APPRAISER. In markets where these professionals are not available, the FIRM
MUST take necessary steps to ensure that only well-qualified independent property
valuers or appraisers are used (Provision 6.A.5).
13. FIRMS MUST disclose the INTERNAL VALUATION
methodologies used to value REAL ESTATE
14. For periods beginning on or after 1 January 2011, FIRMS MUST disclose material changes
investments for the most recent period (Provision
to valuation policies and/or methodologies (Provision 6.A.10.c).
6.A.10.b).
15. For periods beginning on or after 1 January 2011, 16. FIRMS MUST present, as of each annual period end, the percentage of COMPOSITE assets
FIRMS MUST disclose material differences between valued using an EXTERNAL VALUATION during the annual period (Provision 6.A.16.b).
an EXTERNAL VALUATION and the valuation used in
performance reporting and the reason for the
differences (Provision 6.A.10.d).

C. VALUATION RECOMMENDATIONS
1. Valuation Hierarchy: FIRMS SHOULD incorporate the following

hierarchy into the policies and procedures for determining FAIR 2. FIRMS SHOULD disclose material changes to valuation policies
VALUE for PORTFOLIO investments on a COMPOSITE specific basis. and/or methodologies (Provision 4.B.1).
a. Investments MUST be valued using objective, observable,

unadjusted quoted market prices for identical investments in 3. FIRMS SHOULD disclose the key assumptions used to value
active markets on the measurement date, if available. If not PORTFOLIO investments (Provision 4.B.4).
available, then investments SHOULD be valued using
4. For periods prior to 1 January 2011, FIRMS SHOULD disclose the

b. Objective, observable quoted market prices for similar use of subjective unobservable inputs for valuing PORTFOLIO
investments in active markets. If not available or appropriate, investments (as described in the GIPS Valuation Principles in
then investments SHOULD be valued using Chapter II) if the PORTFOLIO investments valued using
subjective unobservable inputs are material to the COMPOSITE
c. Quoted prices for identical or similar investments in markets (Provision 4.B.6).
that are not active (markets in which there are few transactions
for the investment, the prices are not current, or price
quotations vary substantially over time and/or between market 5. Valuations SHOULD be obtained from a qualified independent
makers). If not available or appropriate, then investments third party (Provision 1.B.2).
SHOULD be valued based on
d. Market-based inputs, other than quoted prices, that are

observable for the investment. If not available or appropriate, ADDITIONAL PRIVATE EQUITY VALUATION
then investments SHOULD be valued based on RECOMMENDATIONS:
e. Subjective unobservable inputs for the investment where

10. FIRMS SHOULD explain and disclose material
markets are not active at the measurement date. Unobservable
differences between the valuations used in
inputs SHOULD only be used to measure FAIR VALUE to the
performance reporting and the valuations used in
extent that observable inputs and prices are not available or
financial reporting as of each annual period end
appropriate. Unobservable inputs reflect the FIRM’S own
(Provision 7.B.3).
assumptions about the assumptions that market participants
would use in pricing the investment and SHOULD be developed
based on the best information available under the
circumstances. 11. For periods prior to 1 January 2011, FIRMS
SHOULD disclose material changes to valuation
policies and/or methodologies (Provision 7.B.4).
12. The following considerations SHOULD be

incorporated into the valuation process:
ADDITIONAL REAL ESTATE VALUATION
RECOMMENDATIONS:
a. The quality and reliability of the data
used in each methodology;
6. Although appraisal standards may allow for a
range of estimated values, it is RECOMMENDED b. The comparability of enterprise or
that a single value be obtained from external transaction data;
valuers or appraisers because only one value is
used in performance reporting.
c. The stage of development of the
enterprise; and
7. It is RECOMMENDED that the external appraisal
firm be rotated every three to five years.
d. Any additional considerations unique
to the enterprise.
8. FIRMS SHOULD explain and disclose material
differences between the valuation used in
performance reporting and the valuation used in
financial reporting as of each annual period end
(Provision 6.B.4).
9. For periods prior to 1 January 2011, FIRMS

SHOULD disclose material changes to valuation
policies and/or methodologies (Provision 6.B.5).

III. GLOBAL INVESTMENT PERFORMANCE STANDARDS ADVERTISING GUIDELINES
A. PURPOSE OF THE GIPS ADVERTISING B. REQUIREMENTS OF THE GIPS

GUIDELINES ADVERTISING GUIDELINES
The GIPS Advertising Guidelines provide FIRMS with 2. How a PROSPECTIVE CLIENT can
options for advertising performance when mentioning the obtain a COMPLIANT
FIRM’S claim of compliance. The GIPS Advertising 1. The definition of the FIRM. PRESENTATION and/or the
Guidelines do not replace the GIPS standards, nor do they FIRM’S list of COMPOSITE
absolve FIRMS from presenting a COMPLIANT DESCRIPTIONS.
PRESENTATION as REQUIRED by the GIPS standards. 3. The GIPS compliance statement for
These guidelines only apply to FIRMS that already satisfy advertisements:
all the REQUIREMENTS of the GIPS standards on a FIRM- “[Insert name of FIRM] claims 4. The COMPOSITE DESCRIPTION.
wide basis and claim compliance with the GIPS standards compliance with the Global Investment
in an advertisement. FIRMS that choose to claim Performance Standards (GIPS®).”
6. Whether returns are presented
compliance in an advertisement MUST follow the GIPS
GROSS-OF-FEES and/or NET-OF-
Advertising Guidelines or include a COMPLIANT 5. COMPOSITE TOTAL RETURNS FEES.
PRESENTATION in the advertisement. according to one of the following:
a. One-, three-, and five-year 7. The TOTAL RETURN for the

annualized COMPOSITE returns BENCHMARK for the same
through the most recent period with periods for which the
Definition of Advertisement the period-end date clearly COMPOSITE return is presented.
For the purposes of these guidelines, an advertisement identified. If the COMPOSITE has FIRMS MUST present TOTAL
includes any materials that are distributed to or designed been in existence for less than five RETURNS for the same
for use in newspapers, magazines, FIRM brochures, years, FIRMS MUST also present the BENCHMARK as presented in the
letters, media, websites, or any other written or electronic annualized returns since the corresponding COMPLIANT
material addressed to more than one PROSPECTIVE COMPOSITE INCEPTION DATE. (For PRESENTATION.
CLIENT. Any written material, other than one-on-one example, if a COMPOSITE has been
presentations and individual client reporting, distributed in existence for four years, FIRMS 8. The BENCHMARK ESCRIPTION.
to maintain existing clients or solicit new clients for a MUST present one-, three-, and
FIRM is considered an advertisement. four-year annualized returns
9. If the FIRM determines no
through the most recent period.)
appropriate BENCHMARK for the
Returns for periods of less than one
Relationship of GIPS Advertising Guidelines to COMPOSITE exists, the FIRM
year MUST NOT be annualized.
Regulatory Requirements MUST disclose why no
FIRMS advertising performance MUST adhere to all BENCHMARK is presented.
applicable laws and regulations governing b. Period-to-date COMPOSITE returns
advertisements. FIRMS are encouraged to seek legal or in addition to one-, three-, and five-
year annualized COMPOSITE 10. The currency used to express
regulatory counsel because additional disclosures may be
returns through the same period of performance.
REQUIRED. In cases where applicable laws and/or
regulations conflict with the REQUIREMENTS of the GIPS time as presented in the
standards and/or the GIPS Advertising Guidelines, FIRMS corresponding COMPLIANT 11. The presence, use, and extent of
are REQUIRED to comply with the law or regulation. PRESENTATION with the period leverage, derivatives, and short
end date clearly identified. If the positions, if material, including a
The calculation and advertisement of pooled unitized COMPOSITE has been in existence description of the frequency of
investment vehicles, such as mutual funds and open- for less than five years, FIRMS use and characteristics of the
ended investment companies, are regulated in most MUST also present the annualized instruments sufficient to
markets. The GIPS Advertising Guidelines are not returns since the COMPOSITE identify risks.
intended to replace applicable laws and/or regulations INCEPTION DATE (For example, if a
when a FIRM is advertising performance solely for a COMPOSITE has been in existence 12. For any performance presented
pooled unitized investment vehicle. for four years, FIRMS MUST present in an advertisement for periods
one-, three-, and four-year prior to 1 January 2000 that
annualized returns in addition to does not comply with the GIPS
Other Information the period-to-date COMPOSITE standards, FIRMS MUST disclose
The advertisement may include other information beyond return.) Returns for periods of less
what is REQUIRED under the GIPS Advertising Guidelines the periods of noncompliance.
than one year MUST NOT be
provided the information is shown with equal or lesser annualized.
prominence relative to the information REQUIRED by the 13. If the advertisement conforms
GIPS Advertising Guidelines and the information does not with laws and/or regulations
conflict with the REQUIREMENTS of the GIPS standards c. Period-to-date COMPOSITE returns that conflict with the
and/or the GIPS Advertising Guidelines. FIRMS MUST in addition to five years of annual REQUIREMENTS of the GIPS
adhere to the principles of fair representation and full COMPOSITE returns (or for each standards and/or the GIPS
disclosure when advertising and MUST NOT present annual period since the COMPOSITE Advertising Guidelines, FIRMS
performance or performance-related information that is INCEPTION DATE if the MUST disclose this fact and
false or misleading. COMPOSITE has been in existence disclose the manner in which
for less than five years) with the the laws and/or regulations
period end date clearly identified. conflict with the GIPS standards
The annual returns MUST be and/or the GIPS Advertising
calculated through the same period Guidelines.
of time as presented in the
corresponding COMPLIANT
PRESENTATION.

A. SCOPE AND PURPOSE OF VERIFICATION
1. VERIFICATION MUST be performed by a 2. VERIFICATION assesses whether: 3. A single VERIFICATION REPORT is issued with respect
qualified independent third party. to the whole FIRM. VERIFICATION cannot be carried
a. The FIRM has complied with all out on a COMPOSITE and, accordingly, does not provide
the COMPOSITE construction assurance about the performance of any specific
REQUIREMENTS of the GIPS COMPOSITE. FIRMS MUST NOT state that a particular
4. The initial minimum period for which standards on a FIRM-wide COMPOSITE has been “verified” or make any claim to
VERIFICATION can be performed is one basis that effect.
year (or from FIRM inception date
through period end if less than one year) b. The FIRM’S policies and
of a FIRM’S presented performance. The 7. Sample PORTFOLIO Selection: Verifiers MUST subject the
procedures are designed to entire FIRM to testing when performing VERIFICATION
RECOMMENDED period over which calculate and present
VERIFICATION is performed is that part procedures unless reliance is placed on work performed by a
performance in compliance qualified and reputable independent third party or
of the FIRM’S performance for which with the GIPS standards.
compliance with the GIPS standards is appropriate alternative control procedures have been
claimed. performed by the verifier. Verifiers may use a sampling
methodology when performing such procedures. Verifiers
MUST consider the following criteria when selecting samples:
5. A VERIFICATION REPORT MUST opine 6. A principal verifier may accept the work of
that: another verifier as part of the basis for the a. Number of COMPOSITES at the FIRM;
principal verifier’s opinion. A principal
verifier may also choose to rely on the audit
a. The FIRM has complied with all and/ or internal control work of a qualified b. Number of PORTFOLIOS in each COMPOSITE;
the COMPOSITE construction and reputable independent third party. In
REQUIREMENTS of the GIPS addition, a principal verifier may choose to
standards on a FIRM-wide rely on the other audit and/or internal control
basis c. Type of COMPOSITE;
work performed by the VERIFICATION firm. If
reliance on another party’s work is planned,
b. The FIRM’S policies and the scope of work, including time period
covered, results of procedures performed, d. TOTAL FIRM ASSETS;
procedures are designed to
calculate and present qualifications, competency, objectivity, and
performance in compliance reputation of the other party, MUST be
with the GIPS standards. assessed by the principal verifier when e. Internal control structure at the FIRM (system
making the determination as to whether to of checks and balances in place);
place any reliance on such work. Reliance
considerations and conclusions MUST be
documented by the principal verifier. The f. Number of years being verified
8. After performing the VERIFICATION, the principal verifier MUST use professional
verifier may conclude that the FIRM is skepticism when deciding whether to place
not in compliance with the GIPS reliance on work performed by another g. Computer applications, software used in the
standards or that the records of the construction and maintenance of COMPOSITES,
independent third party.
FIRM cannot support a VERIFICATION. the use of external performance measurers,
In such situations, the verifier MUST and the method of calculating performance.
issue a statement to the FIRM clarifying
why a VERIFICATION REPORT could not
be issued. A VERIFICATION REPORT 9. The minimum VERIFICATION procedures
MUST NOT be issued when the verifier are described below in Section B. The
knows that the FIRM is not in VERIFICATION REPORT MUST state that
compliance with the GIPS standards or the VERIFICATION has been conducted in
the records of the FIRM cannot support accordance with these VERIFICATION
a VERIFICATION. procedures.

B. REQUIRED VERIFICATION PROCEDURES
1. Pre-VERIFICATION Procedures: 2. VERIFICATION Procedures:
a. Knowledge of the GIPS Standards: b. Knowledge of Regulations: a. Fundamentals of Compliance: b. Determination of

Verifiers MUST understand all the Verifiers MUST be Verifiers MUST perform Discretionary Status of
REQUIREMENTS and knowledgeable of applicable laws sufficient procedures to PORTFOLIOS: Verifiers MUST
RECOMMENDATIONS of the GIPS and regulations regarding the determine that: obtain a list of all
standards, including any updates, calculation and presentation of PORTFOLIOS. Verifiers MUST
Guidance Statements, performance and MUST consider i. The FIRM is, and has been, select PORTFOLIOS from this
interpretations, Questions & any differences between these appropriately defined; list and perform sufficient
Answers (Q&As), and clarifications laws and regulations and the procedures to determine that
published by CFA Institute and the GIPS standards. ii. The FIRM has defined and the FIRM’S classification of the
GIPS Executive Committee, which maintained COMPOSITES PORTFOLIOS as discretionary
are available on the GIPS standards in compliance with the or non-discretionary is
d. Knowledge of the FIRM’S Policies
website (www.gipsstandards.org) GIPS standards appropriate by referring to
and Procedures: Verifiers MUST
as well as in the GIPS Handbook. the PORTFOLIO’S investment
understand the FIRM’S policies
iii. All the FIRM’S actual, management agreement
and procedures for establishing
fee-paying, discretionary and/or investment guidelines
and maintaining compliance with
c. Knowledge of the FIRM: Verifiers PORTFOLIOS are and the FIRM’S policies and
all the applicable
MUST gain an understanding of the included in at least one procedures for determining
REQUIREMENTS and adopted
FIRM, including the corporate COMPOSITE investment discretion.
RECOMMENDATIONS of the GIPS
structure of the FIRM and how it standards. The verifier MUST
operates. obtain a copy of the FIRM’S iv. The FIRM’S definition of
d. Data Review: For selected
policies and procedures used in discretion has been
PORTFOLIOS, verifiers MUST
establishing and maintaining consistently applied over
perform sufficient
e. Knowledge of Valuation Basis and compliance with the GIPS time
procedures to determine that
Performance Calculations: Verifiers standards and ensure that all the treatment of the
MUST understand the policies, applicable policies and v. At all times, all
following items is consistent
procedures, and methodologies procedures are properly included PORTFOLIOS are included
with the FIRM’S policy
used to value PORTFOLIOS and and adequately documented. in their respective
compute investment performance. COMPOSITES and no
PORTFOLIOS that belong i. Classification of
in a particular COMPOSITE PORTFOLIO flows (e.g.,
c. Allocation of PORTFOLIOS to COMPOSITES: Verifiers MUST obtain lists of all have been excluded receipts,
open (both new and existing) and closed PORTFOLIOS for all COMPOSITES for disbursements,
the periods being verified. Verifiers MUST select PORTFOLIOS from these lists dividends, interest,
and perform sufficient procedures to determine that: vi. The FIRM’S policies and fees, and taxes);
procedures for ensuring
i. The timing of inclusion in the COMPOSITE is in accordance with policies the existence and ii. Accounting treatment
and procedures of the FIRM ownership of client of income, interest, and
assets are appropriate dividend accruals and
ii. The timing of exclusion from the COMPOSITE is in accordance with and have been receipts
policies and procedures of the FIRM.
vii. The COMPOSITE iii. Accounting treatment
iii. The PORTFOLIO’S investment mandate, objective, or strategy, as BENCHMARK reflects the of taxes, tax reclaims,
indicated by the PORTFOLIO’S investment management agreement, investment mandate, and tax accruals;
investment guidelines, PORTFOLIO summary, and/or other appropriate objective, or strategy of
documentation, is consistent with the COMPOSITE DEFINITION the COMPOSITE;
iv. Accounting treatment
viii. The FIRM’S policies and of purchases, sales, and
iv. PORTFOLIOS are completely and accurately included in COMPOSITES by the opening and closing
tracing selected PORTFOLIOS from: procedures for creating
and maintaining of other positions
a. The PORTFOLIO’S investment management agreement and/or COMPOSITES have been

consistently applied v. Accounting treatment
investment management guidelines to the COMPOSITE(S)
and valuation
ix. The FIRM’S list of methodologies for
b. The COMPOSITE(S) to the PORTFOLIO’S investment management COMPOSITE investments, including
agreement and/or investment guidelines. DESCRIPTIONS is derivatives.
complete
v. PORTFOLIOS sharing the same investment mandate, objective, or strategy
are included in the same COMPOSITE. x. TOTAL FIRM ASSETS are
appropriately calculated
vi. Movements from one COMPOSITE to another are appropriate and and disclosed.
consistent with documented changes to a PORTFOLIO’S investment
mandate, objective, or strategy or the redefinition of the COMPOSITE.

B. REQUIRED VERIFICATION PROCEDURES
2. VERIFICATION Procedures:
e. Performance Measurement f. COMPLIANT PRESENTATIONS: g. Maintenance of h. Representation Letter: The verifier MUST
Calculation: Recognizing that Verifiers MUST perform Records: The verifier obtain a representation letter from the
VERIFICATION does not sufficient procedures on a MUST maintain FIRM confirming that policies and
provide assurance that specific sample of COMPLIANT sufficient procedures used in establishing and
COMPOSITE returns are PRESENTATIONS to determine documentation to maintaining compliance with the GIPS
correctly calculated and that the presentations include all support all procedures standards are as described in the FIRM’S
presented, verifiers MUST the information and disclosures performed supporting policies and procedures documents and
determine that the FIRM has REQUIRED by the GIPS the issuance of the have been consistently applied
calculated and presented standards. The information and VERIFICATION throughout the periods being verified.
performance in accordance disclosures MUST be consistent REPORT, including all The representation letter MUST confirm
with the FIRM’S policies and with the FIRM’S records, the significant judgments that the FIRM complies with the GIPS
procedures. Verifiers MUST FIRM’S documented policies and and conclusions made standards for the period being verified.
perform the following procedures, and the results of by the verifier. The representation letter MUST also
procedures: the verifier’s procedures. contain any other specific representations
made to the verifier during the
VERIFICATION.
i. Recalculate rates of return for a sample of ii. Take a sample of iii. If a custom BENCHMARK or
PORTFOLIOS, determine that an acceptable COMPOSITE and combination of multiple BENCHMARKS
return formula as REQUIRED by the GIPS BENCHMARK is used, take a sample of the
standards is used, and determine that the calculations to BENCHMARK data used by the FIRM to
FIRM’S calculations are in accordance with the determine the accuracy determine that the calculation
FIRM’S policies and procedures. The verifier of all required methodology has been correctly applied
MUST also determine that any fees and numerical data (e.g., and the data used are consistent with
expenses are treated in accordance with the risk measures, the BENCHMARK disclosure in the
GIPS standards and the FIRM’S policies and INTERNAL COMPLIANT PRESENTATION.
procedures. DISPERSION).
C. PERFORMANCE EXAMINATIONS
In addition to a VERIFICATION, a FIRM may choose to have a specifically focused PERFORMANCE
EXAMINATION of a particular COMPOSITE COMPLIANT PRESENTATION. However, a PERFORMANCE
EXAMINATION REPORT MUST NOT be issued unless a VERIFICATION REPORT has also been issued.
The PERFORMANCE EXAMINATION may be performed concurrently with the VERIFICATION.
A PERFORMANCE EXAMINATION is not REQUIRED for a FIRM to be verified. The FIRM MUST NOT
state that a COMPOSITE has been examined unless the PERFORMANCE EXAMINATION REPORT
has been issued for the specific COMPOSITE. Please see the Guidance Statement on PERFORMANCE
EXAMINATIONS for additional guidance.

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2018 Study Session # 1, Reading # 1

“CODE OF ETHICS AND STANDARDS

Circumstances Which Can Prompt Inquiry

Self disclosure by member/candidate on PCS which

Written complaints about member/candidate received by professional

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Standards of Professional Conduct

6. Conflicts of Interest 7. Responsibilities as a CFAI Member or CFAI Candidate

A. Knowledge of Law B. Independence & Objectivity C. Misrepresentation D. Misconduct

2. Integrity of Capital Markets

A. Material Non-Public Information B. Market Manipulation

A. Loyalty, B. Fair Dealing C. Suitability D. Performance E. Preservation of

A. Loyalty B. Additional Compensation C. Responsibility of

5. Investment Analysis, Recommendations& Actions

A. Diligence & Reasonable B. Communication with C. Record Retention

A. Disclosure of conflicts B. Priority of Transactions C. Referral Fees

7. Responsibilities as a CFAI Member or CFAI Candidate

A. Conduct as Members and Candidates in B. Reference to CFA Institute, the CFA

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Guidance ⇒ Code & Standards VS Local Law

Guidance ⇒ Participation in or Association with Violation by Others

Recommended Procedures for Compliance-Members

Recommended Procedure for Compliance-Firms

Members should encourage their firms to:

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1 B. Independence & Objectivity

Investment process must not be influenced by any external sources.

Guidance-Investment Banking Relationships

Do not limit research to discussions with company management.

Guidance-Buy Side Clients

Guidance-Fund Manager Relationships

Guidance-Credit Rating Agency

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Guidance-Issuer Paid Research

Analyst’s compensation for such researches should be limited.

Recommended Procedures for Compliance

M&C must not knowingly make any misrepresentations relating to investment

Misrepresentation causes mistrust.

Recommended Procedure for Compliance

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Recommended Procedures for Compliance

Firms are encouraged to adopt these policies and procedures to:

2. INTEGRITY OF CAPITAL MARKETS

2 A. Material Non-Public Information

M&C must not act or cause others to act on the

Material information ⇒ if disclosure would impact price of security.

No prohibition on reaching an investment decision through public and non-material

Recommended Procedures for Compliance

Make reasonable efforts to achieve public dissemination of information.

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2B. MARKET MANIPULATIONS

M&C must not engage in practices that mislead

Spreading false rumors is prohibited (which can distort market).

3 A. Loyalty, Prudence & Care

Recommended Procedures of Compliance

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3B. Fair Dealing

No discrimination among clients while disseminating recommendations or taking investment decision.

Recommended Procedures for Compliance

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Develop IPS at beginning of the relationship.

Recommended Procedures for Compliance

Recommended Procedures for Compliance