CFA Revision

1. Tips-n-Tricks to crack entire
CFA syllabus 6 days
Portfolio Management, Derivatives,
Alternative Investments
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2. Tips and Tricks: Portfolio Management:Revise
 Investment Policy Statement: Investment Policy Statement (IPS) is the document that guides and
controls investment decision making
 Investment Objectives:
• Risk tolerance –
• Return objectives –
–
–
–
–
Capital Preservation –
Capital Appreciation –
Current Income
Total Return
 Constraints of an Investor:
• Time horizon
• Liquidity needs –
• Taxes –
• Legal & regulatory factors –
• Unique needs and preferences
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3. Tips and Tricks: Portfolio Management:Revise Contd …
Willingness vs Ability to take risk:
Willingness
to take risk
Ability to take risk
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High
Low
High
High risk Tolerance
Education required
Low
Education required
Low risk Tolerance
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4. Tips and Tricks: Portfolio Management:Revise Contd …
Characteristics of different types of clients
 Mutual Fund vs. Exchange Traded Fund
 Mutual funds vs. Separately Managed Accounts (SMA)
 Mutual Funds vs. Hedge Funds
 Mutual Funds vs. Buyout and Venture Capital Funds
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5. Tips and Tricks: Portfolio Management:Revise Contd …
 ASSET:
 Expected return of a PORTFOLIO
 Expected return
 Variance:
T
( Rt
t 1
T
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)
T
2
;
s
( R1 R) 2
t 1
T 1
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6. Tips and Tricks: Portfolio Management:Revise Contd …
Covariance & correlation coefficient:
 Covariance is a measure of how two variables move together
 Correlation: measures the strength of the linear relationship between two variables
cov( X , Y )
E (( X
X
)( Y
X
Y
Y
))
X ,Y
X
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Y
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7. Tips and Tricks: Portfolio Management:Revise Contd …
Portfolio Risk (Variance):
 Variance of Portfolio = wA2σA2 + wB2σB2 + 2 wAwB σAσBρAB
Risk Characteristics of an investor:
 Risk Aversion
 Risk Seeking
 Risk Neutral
Introduction of Risk Free Asset:
 Portfolio’s risk: Variance of Portfolio = wA2σA2 + wB2σB2 + 2 wAwB σAσBρAB
 Variance of Portfolio = wA2σA2 (a risk free asset )
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8. Tips and Tricks: Portfolio Management:Revise Contd …
CML Vs. SML:
Return
E(Rp)
SML
CML
Borrowing Portfolio
Efficient Frontier
E(Rm)
Market Portfolio
RFR
Market
Portfolio
RFR
Lending Portfolio
σp
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Systematic Risk
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9. Tips and Tricks: Portfolio Management:Revise Contd …
Portfolio Performance Evaluation:
1. Sharpe Ratio (Slope of the CAL)
Greater the ratio, the better the portfolio
Sharpe Ratio
p
2. Treynor Ratio (Substitutes Beta Risk for Total Risk)
Greater the ratio, the better the portfolio
Treynor Ratio
3. M-Squared (Based on Total Risk)
Greater the value, the better the portfolio
M2
4. Jensen’s Alpha (Based on Systematic Risk)
Greater the Alpha, the better the portfolio
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Rp - Rf
f
Rp - Rf
p
(Rp R f )
f
m
( Rm R f )
p
p
Rp [R f
( Rm R f )]

10. Tips-n-Tricks : Portfolio Management : Do Not Forget
 Don’t get confused between the different market lines! The CML uses Total Risk on the X-axis and SML
uses Systematic Risk on the X-axis.
 Remember that a risk free asset has a Beta of 0 and the market has a Beta of 1.
 Don’t get confused between Market Risk Premium (Rm-Rf) and Equity Risk Premium which is Beta*
(Rm-Rf)
 If you were to decide which fund is performing better, the result using M-Squared and Sharpe Ratio will
be exactly the same “ They use the same risk factor “ Total Risk
 If you were to decide which fund is performing better, the result using Jensen’s Alpha and Treynor’s ratio
will be exactly the same “ They use the same risk factor “ Systematic Risk (Beta)
 Remember “ investors are NEVER compensated for taking on unsystematic risk “ the reason being is that
they can be diversified away.
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11. Tips-n-Tricks : Derivatives : Revise
 Futures & Forward
• Comparison:
Forwards
Private contracts
Exchange-traded
Unique contacts
Standardized contracts
Default risk
Guaranteed by clearinghouse
Little or no regulation
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Futures
Regulated
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12. Tips-n-Tricks : Derivatives : Revise Contd…
 Arbitrage
• Second type of arbitrage:
• Law of one price
 Interest Rate Futures & Options
• Interest Rate Swap
• Forward Rate Agreements (FRA): payment to the long at settlement is:
(notional principal)* [{(floating rate-forward rate)*(days/360)}/{1+(floating rate)*(days/360)}]
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13. Tips-n-Tricks : Derivatives : Revise Contd …
American vs. European Options
Lower & Upper
Bounds for Options
Option
Minimum Value
European call (c) ct ≥ Max(0,St-(X/(1+RFR)t)
American Call (C) Ct ≥ Max(0, St-(X/(1+RFR)t)
European put (p) pt ≥Max(0,(X/(1+RFR)t)-St)
American put (P)
Pt ≥ Max(0, (X-St))
Where t is the time to expiration
Put-Call Parity
Maximum
Value
St
St
X/(1+RFR)t
X
If the asset has an underlying stream of cash
flows, the minimum value for European Options
change to:
c0≥Max{0,*S0-PV(CF,0,T)]–(X/(1+r)T)}
p0≥Max{0,(X/(1+r)T)- [S0-PV(CF,0,T)]}
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Put-call parity holds that portfolio with identical
payoffs must sell for the same price to prevent
arbitrage, the put-call parity relationship
c + X/(1+RFR)T = S+p
If the asset has an
underlying stream
of cash flows, the
put-call parity can
change to:
c0+(X/(1+r)T) = p0 +
[S0PV(CF,0,T)]
 Buyer of a call option - long
position in Call
 Writer of a call option - short
position in Call
 Buyer of a put option - long
position in Put
 Writer of a put option - short
position in Put
 Intrinsic value of a call option
= Max [O, S - X]
 Intrinsic value of a put option
= Max [O, X - S]
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14. Tips-n-Tricks : Derivatives : Do Not Forget
 Always remember, FRA payments are discounted using the FLOATING rate. Interest rate options
and Swaps payments are NOT discounted.
 Don’t get confused because of the name, a Eurodollar deposit is a Dollar denominated account
operating ANYWHERE outside the United States.
 Remember the shortcut: Because Eurodollar contracts are highly standardized, its structure works
out in a way that if interest rates change by 1bp, the change in contract value is $25. So in your
exam, if you see a question where there is a 3bps change in yield, the contract value changes by
3*25 = $75.
 Don’t get confused between margins in Derivatives and Equity! In case your account balance
drops below the maintenance margin, in Derivative, you need to deposit enough money to bring
it back to the INITIAL margin.
 Remember this to eliminate option in the exam: The Upper and Lower bounds for a European and
American CALL Option are IDENTICAL. The Upper and Lower bounds for a European and American
PUT Options are DIFFERENT.
 Don’t forget the important characteristics of these two swaps: for a currency swap, there is an
actual loan being made in the two currencies and the payments are NEVER netted. In an equity
swap, since equity can have a negative return, it is possible that the fixed payer actually pays
floating.
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15. Tips-n-Tricks : Alternative Investments : Revise
 Characteristics
 Fund of Funds
• Leveraged Buyouts (LBOs)
• Venture Capital: Stages of VC
– Formative Stage
– Later Stage:
– Mezzanine
• Development Capital
• Distressed Investing (or Vulture Investing)
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16. Tips-n-Tricks : Alternative Investments : Revise Contd …
 Private Equity
• Leveraged Buyouts (LBOs)
• Venture Capital: Stages of VC
– Formative Stage
– Later Stage:
– Mezzanine
• Development Capital
• Distressed Investing
• Valuation Methods
– Market or Comparable Approach
– Discounted Cash Flow (DCF)
– Asset – Based
 Valuation of Real Estate Investments
 Valuation methods: Cost method, sales comparison
method & income method
Net Operating Income (NOI):
 Equals gross operating income less estimated vacancy.
 Income method uses a discounted cash flow model
similar to that for a perpetuity: Value = NOI / Market
cap rate
 Collections & other operating expenses, (including
property taxes, but excluding income taxes). NOI does
not include depreciation or financing costs.
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17. Tips-n-Tricks : Alternative Investments : Revise Contd …
Hedge Funds
 Types of Hedge Funds
•
•
•
•
Event-driven strategies
Relative value strategies
Macro
Equity hedge:
 Risk
•
•
•
•
•
•
Liquidity
Potential for Mispricing
Settlement Errors
Counterparty Credit Risk
Short Covering
Margin Calls
 Hedge Fund Biases and Fees:
• Survivorship Bias:
• Fee Structure & Gaming:
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18. Tips-n-Tricks : Alternative Investments : Revise Contd …
Commodities :
 Three sources of return for a commodity futures contract:
• Roll Yield
• Collateral Yield
• Spot Price
 Pricing of Commodities Contracts: Storage and interest costs are known as the cost of carry
F
S (1 rf ) Storage Costs - Convenienc e Yield
Contango
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Backwardation
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19. Tips-n-Tricks : Alternative Investments : Do Not Forget
 NEVER consider depreciation and financing costs for calculating the NOI. Also, the only taxes
relevant for this calculation are property taxes (not the investor’s tax).
 Between MF’s and ETFs, ETF’s are clearly the best (due to in-kind creation and redemption).
Hence, don’t waste too much time studying the disadvantages of ETFs.
 Be sure to remember the advantages and disadvantages of High Watermark Provision and Fund of
Funds. They are highly testable.
 The Hedge Fund Return Reporting Biases are very important. Understand the biases through
diagrams (stick figures for fund managers, squares for funds, and graph depicting fund
performances).
 Remember the three components of Total Return on a Commodities Investment = Collateral Yield
+Price Return + Roll Yield
 Unlike Equity Funds, a Commodity Index Strategy is NOT a passive strategy. The index comprises
of not just Commodities but their Futures and Collateral. It is active because you need to roll over
futures positions and reinvest in T.Bills (collateral) that have matured.
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