1
Q
The formula for taxes levied and paid on an annual basis.
A
FV = Cost Basis x [1 + r(1 – ti)]n
ti = Interest Tax Rate
2
Q
The formula for capital gains taxes deferred until realized.
A
FV = Cost Basis x [(1 + r)n(1 – tcg) + tcg]
tcg = Capital Gains Tax Rate
3
Q
What is the formula for the FV of an investment when the market value and cost basis are different?
A
FV = MV x [(1 + r)n(1 – tcg) + tcg(CB/MV)]
tcg = Capital Gains Tax Rate
CB = Cost Basis
MV = Market Value
4
Q
What is the formula for a wealth based tax?
A
FV = Cost Basis x [(1 + r)(1 – tw)]n
tw = Wealth Tax Rate
5
Q
How do you calculate the annual return after realized taxes? (r*)
A
r* = r(1 – piti – pdtd – pcgtcg)
pi = % of return attributable to interest ti = Interest Tax Rate
pd = % of return attributable to dividends td = Dividend Tax Rate
pcg = % of return attributable to capital gains tcg = Capital Gains Tax Rate
6
Q
What is the formula for tax obligations from gains not yet realized in a portfolio? (T*)
A
T* = tcg(1 – pi – pd – pcg)/(1 – piti – pdtd – pcgtcg)
tcg = Capital Gains Tax Rate
pi = % of return attributable to interest pd = % of return attributable to dividends pcg = % of return attributable to capital gains
ti = Interest tax rate td = dividends tax rate tcg = capital gains tax rate
7
Q
What is the formula for the future after-tax accumulation for each unit of currency in a taxable portfolio? In this scenario, you have to adjust for future capital gains taxes.
A
FV = MV x [(1 + r*)n(1 – T*) + T* – (1 – B)tcg]
r\* = annual realized return after taxes T\* = tax obligations from gains not yet realized
If the cost basis is equal to market value then B = 1
8
Q
What is the formula for calculating accrual equivalent returns?
A
MV(1 + RAE)n = FV
RAE = Accrual equivalent return
9
Q
What is the formula for calculating accrual equivalent tax rates?
A
r(1 – TAE) = RAE
RAE = Accrual Equivalent Return
TAE = Accrual Equivalent Tax Rate
10
Q
What is a benefit of tax loss harvesting?
A
Realizing a loss saves taxes in the current year and means that the tax savings can be reinvested. This technique increases the amount of capital the investor can put to use.
11
Q
What three assumptions does traditional finance make about investors?
A
- They are risk averse
- They have rational expectations
- They practice asset integration
12
Q
What three assumptions does behavioural finance make about investors?
A
- They exhibit loss aversion
- They hold biased expectations
- The practice asset segregation
13
Q
Describe Methodical investors
A
- More risk averse
- Decisions based primarily on thinking
14
Q
Describe Individualist investors
A
- Less risk averse
- Decisions based primarily on thinking
15
Q
Describe Cautious investors
A
- More risk averse
- Decisions based primarily on feeling
16
Q
Describe Spontaneous investors
A
- Less risk averse
- Decisions based primarily on feeling
17
Q
What three questions do you need to consider when assessing an investors ability to take risk?
A
- What are the investor’s financial needs and goals, both short term and long term?
- How important are these goals? How serious are the consequences if they are not met?
- How large an investment shortfall can the investor’s portfolio bear before jeopardizing its ability to meet major short term and long term goals?
18
Q
What should investors and managers know about a particular Monte Carlo product in order to be confident that it provides reliable information?
A
- Any user of Monte Carlo should be wary of a simulation tool that relies only on historical data.
- It should simulate the performance of specific investments, not just asset classes.
- It must take into account tax consequences.
19
Q
What are the 5 investment constraints of an IPS?
A
- Liquidity
- Time Horizon
- Taxes
- Legal and Regulatory Environment
- Unique Circumstances
20
Q
When calculating total liquid reserves are current cash equivalents included?
A
Yes.
Net proceeds from sale of shares + Cash equivalents = total liquid reserves
21
Q
How can investments provide tax deferral benefits?
A
- Investments that are not taxed until sold provide a tax deferral benefit.
- If dividend taxes are higher than capital gain taxes then NOT paying dividends is a form of tax deferral benefits.
22
Q
What is the formula for calculating the tax rate on foreign income when the deduction method is used?
A
TDeduction Method = TResidence + TSource − (TResidence × TSource)
23
Q
What is financial capital?
A
Financial capital includes the tangible and intangible assets (outside of human capital) owned by an individual or household. Financial capital would include the vested portion but not the unvested portion of an employer pension plan.
24
Q
Define Human Capital
A
Human capital is the net present value of the individual’s future expected labor income weighted by the probability of surviving to each future age.
25
Richard is 55 years old and would like to retire in 5 years. He has saved $200,000 in a taxable investment account and plants to contribute $10,000 to it at the end of each year for the next 5 years. He will receipe a lump-sum bonus payment of $50,000 before tax when he retires. The bonus will be taxed at 20%. If he is able to accumulate $350,000 in his investm ent account he will be able to retire comfortably.
State the return objective for Richard's investment account.
The return objective for Richard's investment account is to see the plan, _including annual contributions of $10,000_ and a _one-time payment of $40,000 in five years' time_ grow to a nominal value of $350,000 in five years when he is ready to retire.
26
When does a portfolio have liquidity constraints?
Only when withdrawals are needed to fund expenses. If the portfolio is being funded on an annual basis with no need of withdrawals _the plan itself has no liquidity constraints._
27
Frank and Alice would like to maintain annual spending of $75,000 on an inflation-adjusted basis. Inflation is assumed to be 2%.
Referencing the attachment, calculate the capitzalized value of their core capital spending needs over the next three years.
Capitalized value = 72,206 + 70,271 + 68,230 = 210,777
28
Identify the risk of outliving one's assets and an investment product that addresses this risk.
Longevity Risk. Life annuities, either fixed or variable, are products that address longevity risk.
29
Explain what a leveraged recapitalization is.
A leveraged recapitalization is essentially a leveraging of a company’s balance sheet, usually accomplished by working with a private equity firm. The private equity firm generally invests equity and provides or arranges debt with senior and mezzanine (subordinated) lenders. The owner transfers a portion of her stock for cash and retains a minority ownership interest in the freshly capitalized entity.
Doing so allows the owner to monetize a large portion of her business equity (typically 60–80%) and retain significant upside potential (20–40%) from that point forward. Because of the retained stake, the owner should remain highly motivated to grow the business.
30
Explain what a divesture is.
If a business owner is not yet ready to retire and wishes to continue to run the business but would like to generate some liquidity now in order to diversify, the owner may wish to sell or dispose of non-core assets. Non-core assets can be broadly defined as those that are not essential to the continued operation or growth of the company.
31
What is one of the key beneifts of a personal line of credit secured by a company?
One of the key benefits is that this type of borrowing should not cause an immediate taxable event to the company or the owner if structured properly. This technique basically uses corporate debt capacity (assuming it is available) to avoid a taxable stock sale or dividend.
The transaction is usually structured with a “put” arrangement back to the company to make the lender comfortable. The company can support this put obligation either through its existing credit arrangement or with a standby letter of credit issued for this specific purpose.
The exercise of the put to the company as a source of repayment of the loan would likely be considered a taxable event to the business owner. Also, at some point the debt will need to be repaid.
32
What are the acronyms for cognitive biases?
* *R**epresentativeness
* *I**llusion of Control
* *C**onservatism
* *C**onfirmation
* *H**indsight
* *F**raming
* *A**vailability
* *M**ental Accounting
* *A**nchoring and Adjustment
33
What is the acronym for emotional
34
What is the acronym for emiotional biases?
* *L**oss-Aversion
* *O**verconfidence
* *S**tatus Quo
* *S**elf-Control
* *E**ndownment
* *R**egret Aversion
35
Describe Loss Aversion
Loss Aversion is an emotional bias where investors hold their losers even if an investment has little or no chance of going buck up. Similarily, they lock in profits too soon, thus limiting their upside.
36
What are the consequences of loss aversion?
* Hold investments in a loss position longer than justified by fundamental analysis
* Sell investments in a gain position earlier than justified by fundamental analysis
* Limit the upside potential of a portfolio by selling winners and holding losers
* Trade excessively as a result of selling winners
* Hold riskier portfolios than is acceptable. This is caused by the sale of investments that are winners and the retention of investments that are losers. FMPs may accept more risk in their portfolios than they would if they had based their decision on risk/return objectives and fundamental analysis.
37
Describe Overconfidence Bias
Overconfidence is an emotional biases in which people demonstrate unwarranted faith in their own intuitive reasoning, judgements, and cognitive abilities.
38
What are the consequences of overconfidence bias?
As a result of overconfidence bias, FMPS may do the following:
* Underestimate risk and overestimate expected returns
* Hold poorly diversified portfolios
* Trade excessively
* Experience lower returns than those of the market
39
Describe Self-Control Bias
40
What are the three specific roles of fixed-income securities in a portfolio?
1. Diversification benefits
2. Regular cash flows
3. Inflation heding potential
41
Why do inflation-linked bonds typically exhibit lower return volatility than conventional bonds and equities?
Because the volatility of the returns on inflation-linked bonds depends on the volatility of **real**, rather than **nominal**, interest rates.
42
Describe a fixed-coupon bond's exposure to inflation.
Coupon: Inflation unprotected
Principal: Inflation unprotected
43
Describe a floating-coupon bond's exposure to inflation.
Coupon: Inflation protected
Principal: Inflation unprotected
44
Describe an inflation-linked bond's exposure to inflation.
Coupon: Inflation protected
Principal: Inflation protected
45
What are the two conditions that need to be satisfied for achieving immunization with a duration matching fixed-income mandate?
1. A bond portfolio's duration must equal the duration of the liability portfolio
2. The PV of the bond portfolio's assets must equal the PV of the liabilities at *current* interest rate levels
The idea is that changes in the bond portfolio’s market value closely match changes in the liability portfolio, whether interest rates rise or fall.
46
What are the key features of liability-based fixed income mandates? (Duration matching and cashlow matching)
* Yield curve assumptions
* Basic principle
* Rebalancing
* Complexity
See attached breakdown:
47
What is contingent immunization?
Contingent immunization combines immunization with an active management approach **when the asset porfolio's value exceeds the pv of the portfolio liability**.
48
What is horizon matching?
Horizon matching comines cash flow duration matching approaches. Liabilities are categorized as short-term and long-term liabilities. The short-term liability (up to five year) is covered by a cash flow matching approach and long term liabilities are covered by a duration matching approach.
49
Describe a model for fixed-income returns
See attached formula.
The expected change in price is calculated as follows:
[-MD x ΔYield) + (.5 x Convexity x ΔYield2)
50
How do you calculated a fixed-income investment's expected change in price?
E(Change in price) = [-MD x ΔYield) + (.5 x Convexity x ΔYield2)
51
How do you calculated a leveraged fixed-income portforlio return?
rp = ri + ((VB/VE) x (ri - rb))
52
What is a type 1 liability?
* Known: Amount of cash outlay
* Known: Timing
53
What is a type II liability?
Known: Amount of cash outlay
Uncertain: Timing
54
What is a type III liability?
Uncertain: Amount of cash outlay
Known: Timing
55
What is a type IV liability?
Uncertain: Amount of cash outlay
Uncertain: Timing
56
Changes in the yield curve can be distilled into what three movements?
1. Level (Parallel)
2. Slope (Flattening or Steepening)
3. Curvature
57
What is the formula for the butterfly spread?
Butterfly spread = -(Short term yield) + (2 x Medium term yields) - (Long term yield)
58
What are the 4 active bond strategies under the assumption of a stable yield curve?
1. Buy and Hold
2. Roll down/riding the yield curve
3. Sell convexity
4. The carry trade
59
What are the 3 active strategies for yield curve movement of level, slope, and curvature?
1. Duration management
2. Buy convexity
3. Bullet and barbell structures
60
What two conditions need to hold in order to ride the yield curve?
1. The yield curve must be upward sloping
2. The manager must buy a bond with longer than desired maturities.
61
What two stragies can be used to sell convexity?
1. Sell calls on bonds held in the portfolio
2. Sell puts on bonds the manager would be willing to own if, in fact, the put was exercised.
Keep in mind - convexity only benefits a bondholder if there is volatility in the market. ie. Bond prices are changing.
62
In what two scenarios is duration managment used for fixed income portfolios?
1. Duration management shortens duration in anticipation of rising interest rates
2. Lengthens duration in anticipation of falling interest rates.
63
Describe a bullet portfolio and when it is used
A bullet portfolio targets a single segment of the curve. It is typically used to take advantage of a steepening yield curve.
64
Describe a barbell portfolio and when it is used
A barbell portfolio combines securities concentrated in short and long maturities, relative to the benchmark. It is typically used to take advantage of a flattening yield curve.
65
What are the 3 basic ways to impelement a carry trade to exploit a stable, upward sloping yield with bonds?
1. Buy a bond and finance it in the repo market.
2. Receive fixed and pay floating on an interest rate swap.
3. Take a long position in a bond (or note) futures contract.
66
Describe the relative performance of bullets and barbells under different yield curve scenarios.
See attached.
67
What is the formula for the Cobb-Douglas production function?
% Growth in GDP = % Growth in TFP + (Elasticity of Capital)(% Growth in Capital) + (Elasticity of Labor)(% Growth in Labor)
68
What is the formula for the Cyclically Adjusted P/E Ratio (CAPE)
Current Cape = Equity Price Index (Real) / 10-Year Average Earnings (Real)
69
Distinguish between a positive and negative output gap
A positive output gap means growth is above the trend rate and is inflationary. A negative output gap means an economic downturn with unemployment.
70
Explain the permanent income hypothesis.
This hypothesis asserts that consumers' spending behavior is largely determined by their long-run income expectations. Consequently, short-term economic fluctuations are less likely to affect consumer spending.
71
What is the Grinold-Kroner formula for expected return on equities?
R = Expected nominal earnings growth + Expected repricing return + expected income return
Expected nominal earings growth = **Expected** Inflation + **Real** Total Earnings Growth Rate
Expected Repricing Return = Change in PE Multiple
Expected Income Return = **Expected** Dividend Yield - Change in Shares Outstanding
72
What is the Taylor Rule?
ROptimal = RNeutral + [.5x(GDPForecast - GDPTrend) + .5x(IForecast - ITrend)]
73
How do you calculate the required return of a bond using the risk premium approach?
E(Rb) = Real risk-free interest rate + Inflation premium + Default risk premium + Illiquidity premium + Maturity premium + Tax premium
74
How do you calculate the sharpe ratio?
Sharpe Ratio = (Expected Return - RF Return) / Standard Deviation
75
What is the formula for Tobin's Q
Tobin's Q = (MV Equity + MV Debt) / Replacement Cost of Assets
76
What is the formula for Equity Q?
MV of Equity / (Replacement Cost of Assets - Market Value of Debt)
77
What is the primary source of income for equity portfolios?
Dividends. Taxation is an important consideration for this type of income.
78
What are three secondary sources of income for equity portfolios?
1. **Securitized lending**, a form of collateralized lending, may be used to generate income for portfolios.
2. **Dividend capture** is a strategy where stocks are purchased just before their ex-dividend dates to receive their dividend and then sold immediately after.
3. **Writing options**.
79
Describe a high-water market in the context of portfolio management and its purpose.
A high-water mark is the highest value, net of fees, that the fund has reached and this protects investors from paying twice for the same performance.
80
What are the two key characteristics of a tactical asset allocation?
SS 10
1. It is short term only
2. It is an asset-only approach
81
What three approaches can be used to measure the success of a tactical asset allocation (TAA)?
SS 10
1. Sharpe Ratio
2. Evaluating the Information Ratio of the average excess of return
3. Plotting the realized return of the TAA against other porfolio's efficient frontier.
82
What are the two ways that taxes impact a portfolio's return?
SS 10
1. Lowers the mean return
2. Lowers volatility of return
83
What are the 3 characteristics of a bond portfolio designed to immunize a single liablity?
SS 11
1. Has an initial market value that equals or exceeds the pv of the liability
2. Has a portfolio Macaulay duration that matches the liability's due date
3. Minimizes the portfolio convexity statistic
84
What are the 4 approaches for managing multiple liabilities?
SS 11
1. Cash flow matching
2. Duration matching
3. Derivatives overlay
4. Contingent immunization
85
What are laddered portfolios desirable for liquidity management?
SS 10
Because there is always a bond close to redemption, the soon-to-mature bond can provide emergency liquidity needs.
Barbell portfolios have maturities only at the short-term and long-term and thus are much less desirable for liquidity management.
86
How do you calculate the number of futures contracts needed to fully remove the duration gap between asset and liability portfolios?
SS 10
Nf = (BPVL − BPVA)/BPVf
87
Why are value-weighted bond indexes more susceptible to credit quality deterioration?
SS 10
Compared with other weighting schemes, such as equally weighted, value-weighted indexes are tilted toward issuers with higher levels of debt. The more an issuer or sector borrows, the greater the tilt toward that issuer in the index. Leverage and creditworthiness are negatively correlated, so a value-weighted index will be more susceptible to credit quality deterioration than an equally weighted index will be.
88
Liability-Driven Investing (LDI) and Asset-Driven Investing (ADL) are special cases of Asset-Liability Management (ALM). Explain the key differences.
SS 10
The key difference is that with ADL, the assets are given and the liabilities are structured to manage interest rate risk; whereas with LDI, the liabilities are given and the assets are managed.
All ALM strategies require the manager to incorporate the interest rate sensitivity of both the assets and the liabilities in the portfolio management process.
89
What is the formula for convexity?
SS 10
Convexity = (Macaulay Duration2 + Macaulay Duration + Dispersion)/(1 + Cash Flow Yield)2
90
What is the formula for Effective Duration?
SS 10
Effective Duration = (PV-) - (PV+) / (2 x Curve x PV0)
91
How do you calculate the notional principal (NP) on an interest rate swap needed to close an asset-liability duration gap to zero
Asset BPV + (NP x (Swap BPV/100)) = Liability BPV
Solve for NP
92
Are investment grade bonds more or less sensitive to interest rate changes and credit migration than high yield bonds?
Investment-grade bonds have lower credit and default risks than high-yield bonds and are more sensitive to interest rate changes and credit migration, which cause credit spread volatility.
The much higher credit loss rate experienced with high-yield bonds results in an emphasis on credit risk and the market value of the position to evaluate high-yield risk.
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