1
Q
goal of private wealth management
A
help investors seek the benefits as well as navigate the complexities of financial market
2
Q
private client
A
inv. objective:
objective may not be clearly defined or quantified.
Constraints:
Time horizon: relatively short (lifelong)
Scale: smaller (more limitations)
taxes: significant and complex
investment governance less formal
distinction
Inv. sophistication:
emotional, subject to behavioral biases
regulation: separate regulation or shared regulatory structure
uniqueness and complexity:
similar objective may have different inv. strategies
3
Q
institutional clients
A
inv. objective:
specified, clearly defined
Constraints:
Time horizon: theoretically infinite
Scale: larger
taxes: depends on institutions
investment governance: formal
distinction
Inv. sophistication:
a higher degree, professionals
regulation: separate regulation or shared regulatory structure
uniqueness and complexity:
similar objective may have different inv. strategies
4
Q
information needed in advising private client
A
- personal info
- financial information
- tax considerations
5
Q
basic tax strategies
A
tax avoidance
tax reduction
tax deferral
6
Q
tax avoidance: TEA
A
tax exempt account TEA that investor are allowed to contribute a limit account
- various wealth transfer techniques
7
Q
tax reduction
A
tax exempt bonds
tax efficient asset classes (stock paying a high dividend)
8
Q
tax deferral
A
same investor in a progressive tax system seek to defer taxes because they anticipate lower futures tax rates
9
Q
the wealth manager rols
A
goal quantification
goal prioritization
goal changes
10
Q
private client risk tolerance
A
willingness to tolerate risk
11
Q
risk aversion
A
unwillingness to tolerate risk
12
Q
risk capacity
A
ability to accept financial risk, more obligate in nature
13
Q
risk perception
A
subjective assessment of the risk involved in the outcome of an investment decision
- questionnaire for risk tolerance score
- risk tolerance conversion
14
Q
capital sufficiency analysis/ capital needs analysis
A
process by wealth manager determines likely to accumulate, sufficient financial resources to meet his/her objectives
2 methods
- deterministic forecasting
- monte carlo simulation
15
Q
- deterministic forecasting
portfolio growth occurs in a straight line
A
wealth manger must specify: portfolio return assumption current value of the portfolio anticipated future contribution CF the portfolio that represent client needs
disadvantage:
the use of single return assumption is not representative of the actual market volatility
16
Q
2 monte carlo simulation
A
allows a wealth manager to model the uncertainty of several key variable and therefore the uncertainty or variability in the future outcome
- assume a simple average (arithmetic mean) return and a std of YoY returns for the portfolio
- forward looking assumption should be the foundation for the analysis
17
Q
when the probability of success falls below the acceptable range, potential solution include:
A
- increase the amount of contribution
- reduce the goal amount
- adoption an investment strategy with higher expected return
18
Q
deterministic planing
retirement stage of life
A
education: develop human capital
early career: save for retirement goal starts
career development:
35-50 career development: financial obligation and accumulate financial capital
51-60 peek accumulation : financial capital is greatest
early retirement: lnv. portfolio fund their lifestyle
retirement: accurate financial capital
late retirement: medical expense increase
(face longevity risk)
19
Q
analyzing relevant goals
A
- mortality table
indicate individual life expectation at specific ages
potential drawback: individual clients pro. of living to a certain age may exceed that of the general population
- ammunities lump sum
provide a series of fixed pmt, entire for life or for a specific period in exchange for a lump sum payment.
It helps to mitigate the longevity risk. - monte carlo simulation
adv: applicability to the client, actual asset allocation
It can flexibly model different scenario and explore issues that are important to clients
disadvantage:
it cannot predict the future due to the limitation of use of historical data
- the output is highly sensitive to small changes in input assumption
- the output indicates the prob. of reaching a good but not accessary the “shortfall magnitude”
20
Q
immediate annuity
A
pay an initial lump sum in return for a guarantee of specific future monthly payment, beginning immediately over a specific period of time
21
Q
deferred annuity
A
the specific future monthly payment begin at a later date
22
Q
longevity risk
use annuity
A
risk of outliving one’s financial resources
life annuities hep mitigate it.
23
Q
behavioral consideration in retirement planning
A
- heightened loss aversion
- consumption gap between actual and potential consumption
- the annuity puzzle: not prefer to invest in annuity
- invest’s reluctance to give up hope of substantial life style
- the dislike of losing control of assets
- high cost of annuities - preference for investment income over capital appreciation
spending only the interest and not the principal is a self-control mechanism
spending dividend rather then selling stock
24
Q
IPS
A
ADV:
- encourage investment discipline and reinforces client’s commitment to fall out the strategy
- focus on LT goals rather than ST performance
for individual:
1. return: variable objectives
may conflict internally and change over time
return maybe titled toward income
- risk: difficult to determine
subject to behavioral influences
smaller asset based increases sensitivity of risk - constraint
- liquidity
may be variable and subject to period shortfall - time horizon:
long >10 years
but short than pension plan - tax
fully taxable with some tax advantaged and tax-exempt accounts - legal/regulatory
ordinarily very few
25
portfolio traditional approach
1. identify asset clases
2. developed CME
3. determine portfolio allocation
4. asset constraint
5. implement the portfolio
6. determine asset allocation
26
goal-based
| optimized with stated max level of volatility of % of success
adv: it may be easier for clients to express their risk tolerance on a goal -specific basis rather than at the overall portfolio level
disadv:
the combination of goal portfolio allocations may not be sufficient
27
Ethic consideration
fiduciary duty and suitability
know your customer
confidentiality
conflict of interest
28
private client segments
-robo-advisor
automated advisors, lower fees use questionnaire
-mass affluent segment asset levels between $250,000 and $1 million
serves clients who are focused on building their portfolios and want help with financial planning needs.
greater technology, no customization
- high net worth client
smaller # of customer, tailored investment solution, tax planning, estate planing, contain sophisticated strategy
asset levels between $1 million and $10 million and can provide a team of specialized advisers that supports more customized strategies for more sophisticated investments with longer time horizons, greater risk, and less liquidity.
- ultra high net work segment:
low client to manager ratio
luxury service
multi-genration family member
asset levels over $50 million for clients with multi-generational time horizons and provides a wider range of services for complex tax situations, estate planning, bill payment, concierge services, travel planning, and advice on acquiring high-end assets.
29
tax aware investment model are valuable:
1. tax codes change over time
can be applied in a broad range of circumstance representing diff. taxing justifications, asset classes, and account types
2. can provide a framework with which advisor can better communicate the impact to taxes of portfolio returns to private clients and develop techniques to improve their after tax performance
30
tax structure
tax on:
income
wealth-based
consumption
31
common progressive regime:
progressive tax rates for ordinary income,
favorable treatment in interest, dividend, capital gain
most common
32
heavy dividend tax regimes
progressive tax system for ordinary income and favorable treatment for some int. capital gains but dividends at ordinary rates
33
heavy capital gain tax regimes
favorite treatment for interest dividend
progressive tax system for ordinary income
capital gains tax at ordinary rates
34
heavy interest tax regime
interest income at ordinary rate
35
light capital gain tax regime
second most common observed
progressive for income, int, dividend,
fav or capital gains
36
flat and light regime
favorable for int, dividend and capital gains
flat tax system and treats interest, dividend and capital gains favorably
37
flat and heavy regime
favorite for interest income
flat tax system for ordinary income
dividends and capital gains
no favorable treatment for dividend and capital gains
but favorable treatment for interest income
38
TDA tax deferred account
Deferred tax for capital gain is: (1+r)^n(1-tcg)+tcg
Deferred tax account is :(1+r)^n(1-T)
defers taxation on investment return
may permit a deduction for contribution
may occasionally permit tax free distribution
39
single tax environment FV
= (1+r(1-rt))^n
tax drag: gain lost to taxes = gain without tax - gain after taxes
tax drag % = tax drag $/gaini without taxes
tax drag% > tax rates due to compounding
R & T increase both tax drag and tax drag %
40
deferred capital gains (deferred until realized)
| FV
FVcg = (1+r)^n *( 1-tcg)+tcg
no lost compounding of return
tax drag $ increase with time horizon and rate of return
if B=0( non initial unrealized g/l)
tax drag %= tax rate
if b <1 (initial unrealized gain) tax drag % > tax rate
if b >1 (unrealized loss) tax drag% < tax rate
41
wealth based taxes
applied annually to a specific capital base
FV =[ (1+r)(1-tw)]^n
inv. horizon increase lead to tax drag % $ both increase
inv. horizon decrease lead to tax % decrease, $ increase
42
blended taxing environment
interest
dividend
capital gains
weighed avg realized tax rate (WARTR)
WARTR = %w%R
| Riti +Rdtd+Rcgtcg
43
return after realized taxes r*=
r(1-awrtr)
r* = r(1 – %w%t)
overstates true after-tax return because there's no unrealized gain an a potential future tax liability to be paid on this gain.
44
Effective capital gains tax T*
| TAE
TAE T* =
Tcg(1- sum of %weight)
/(1-wartr)
= 1- R*/R
WARTR = sum of %w%t
45
FV* taxbable =
b= basis cost/ current investment value
there already capital appreciation
FVIFTaxable = (1 + r*)^n(1 – T*) + T* – (1 – B)tcg, B = 1
(1 + r*)^n(1 – T*) + T* – (1 – B)tcg, B = 1
46
accrual equivalent tax Rate=
r(1-TAE)
initial investment value * (1+RAE)^n = AFTER TAX investment value
- used to measure tax efficiency of different asset class or pm styles
- illustrates to clients the tax impact of lengthening the average holding periods of stocks they own
- assess the impact of futures tax law changes
47
taxable account
gove't bear part of investment risk
after tax income invested
| taxed return
48
TDA deferred account
before tax income
taxed when withdraw
FV = (1+r)^n(1-tn)
49
TEA exempt account
inter bear all investment risk
has no future tax liabilities
=(1+r)^n
50
tax loss harvesting
= loss * t
| realize a loss to offset gain
51
mean- variance optimization
use accrual equivalent after-tax return
| and af tax std
52
estate planing in a global context
1. can be applied in a variety of jurisdiction
2. provides an international perspective that advisors can use to counsel clients with a multi-jurisdiction foot print
3. provides a framework advisors can use to communicate tax and succession planning consideration to private clients to develop technique to address the need and objectives of such clients
4. inheritance laws and tax codes in many jurisdictions are fluid over time
53
Estate planning
process of preparing for the disposition of one's estate upon death and during one's lifetime
Will: outlines the rights others sill have over one's party after death
probate:
legal process to confirm the validity of the will so that executors hires and other interest parties can rely on it authenticity
intestate: a decedent outline a valid will or with a will that does not dispose to their property
54
civil law
| roman low
developed primary through legislative status or executive action
55
common law
| Britain
developed primary through decisions of the courts
56
forced heirship rule
- children have the right to a fixed share
- may reduce a forced heirship claim by gifting of denoting assets
- may move asset into a offshore trust governed by a different domicile to avoid forced heirship rule
- clawback provisions bring such lifetime gifts back into the estate to calculate the child's share
57
common property regimes
each spouse has an indivisible 1/2 interest in income earned during marriage
58
separate property regime
prevalent in civil law countries, each spouse is able to own and control property as an individual which enables each to dispose of property as they wish, subject to spouse's other rights
59
estimate core capital with mortality table
- incorporate inflation effet over long-time horizon
| - forecast nominal speeding need and discount to pv using nominal rates
60
survival prob= p( joint survival) =
use mortality table
subject to longevity risk
to mitigate, can incorporate safety reserve
p(husband survives) +p(wife survives)
| -p(h)*p(W)
61
pv(spending needs) =
sum or p(survival)*spending /(1+r)^n
r= 1+r/1+g
62
safety reserve
1. provide a capital cushion if capital produce s sequence of unusually poor return that jeopardize the sustainability of the planned spending program
2. allows the 1st generation to increase their spending beyond that explicit articulated in the spending program
63
est. core capital with monte carlo analysis
- incorporate recurring spending needs, irregular liquidity needs, taxes, inflation, and other factors in to the analysis
- exp(r) derived from the market expectations of the assets
capture the interaction of distribution and the sequence of returns, a form of path dependency
64
probability or ruin
reaching a zero portfolio value
based on different start date for retirement and distribution %.
delay retirement or lowering distribution % make it less likely the portfolio can be exhausted.
65
transferring excess capital
| lifetime gifts and testamentary bequests
gifting now likely give up control and cannot be revoked if circumstances change with tax issues
relative value >1 tax perspective is favorable to gift
relative value <1 bequest if more favorable 遗嘱
66
Relative value RV=
| RV = FVg/FVb
FV after tax to the receiver if gifted now
| / fv after tax to the receiver if bequested
67
tax free gift
RV = FVg/FVb
=[1+rg(1-tig)]^n
/[1+rb(1-tib)]^n (1-tb)
68
taxable gifts (tax paid by receiver)
FVg changes
RV=
[1+rg(1-tig)]^n * (1-tg)
/[1+re(1-tie)]^n (1-te)
69
taxable gifts (tax paid by giver)
FVg changes
RV=
[1+rg(1-tig)]^n * (1-tg + TgTe)
/[1+re(1-tie)]^n (1-te)
TgTe = tax benefit from reducing the value of the taxable estate
70
location of the gift tax liability
- a cross broader gift could return in both the donor and the recipient being taxes in their home counters
- if the tax liabilities is imposed on the donor's taxable estate rather than on the recipient, the tax benefit of the lifetime gift vs. the bequest increase
more attractive when the gift tax is paid by the donor
if tax rates are the same, gifting reducing the size of the taxable estate which is better to gift
71
Generation skipping
benefit from skipping by 1/(1-t)
1st to 2rd generation in 15 year tax =40%
3rd in 30 years
after tax return =5% on asset
```
FVno skipping
= pv(
(1.05)^15 *(1-0.4)
* (1.05)^30)(1-0.4))
=pv(3.2344)
```
FV skipping:
=pv(
(1.05)^45(1-0.4))
=pv(5.3910)
by 1/(1-t) = 1/(1-0.4)=1.6667
5.3910/3.2344 = 1.6667
72
Spousal exemptions
most jurisdiction with estate or inheritance also allow dependent to make bequest and gift to their spouses without transfer tax liability
it's advisable to transfer the exclusion amount to someone other than the spouse, child tax free
73
Deemed disposition
is used when a person is considered to have disposed of a property, even though a sale did not take place.
74
charitable contribution transfer
1. most charitable donations are not subject to a gift transfer tax
2. most jurisdictions permits income tax deductions for charitable donations
75
RV charitable gift =
FV charitable gift /FV bequest
=[ (1+rg)^n +Tincome ] * (1+re(1-tincome)]^n *(1-Testate)
/
[1+re(1-tincome)]^n * (1-testate)
76
valuation discounts
liquidity, minority discounts can reduce the value of wealth transfer and the associated taxes, individuals will utilize them by transferring interests in a family business
77
estate planning tools
- gratuitous transfer are often implemented through structures that either maximize for benefit produce a non-tax benefit, or both
trust
foundations
life insurance
and companies
78
trusts
arrangement created by settlor/grantor who transfer assets to a trustee
trustee is responsible for reporting and paying taxes on income
reason to use trust:
0. protection of asset within the trust from claims outside the family.
1. avoid disputes within the family
2. provide privacy protection without publicity associated with probate.
3. permit nomination of a trustee of choosing to manage the insurance benefit.
4. trustee may be given discretionary power to alter the timing of amount of payment if situations changes or needs change over time
79
revocable trust
settlor retains the right to revoke the trust relationship and regain title to the trust asset
80
irrevocable trust
the settler has no ability to revoke the trust relationship, provide greater asset protection from bondholder claims
81
Fixed trust
occur at certain time or in certain amount
82
discretionary trust
asset protection from claims against the beneficiaries
trustee to determine whether and how much to distribute based on his general welfare and in the sole and uncontrolled discretion of he trustee
83
control
motivation for using trust
| 1. to make resources available to a beneficiary without yielding complete control of those resources to them
84
Foundation
Legal entity
| set up to hold assets to promote education or for philanthropy
85
life insurance
perfect hedge against the loss of human capital in the event of death,
policy holder transfers assets (premium) to an insurer who has a contractual obligation to pay death benefit proceeds to the beneficiary names in the policy
- death benefit proceeds paid to life insurance are tax except.
- offer asset protection in combination with a trust
- offer liquidity to pay estate taxes upon death
- payment of premium reduce value of estate, and lower future estate tax
86
Companies and controlled foreign corporations CFC
A company locate outside a taxpayer's home country in which the taxpayer has a controlling interest as defined under the home country law
- tax on earnings can be deferred until either the earnings are actually distributed to shareholders or the company is sold or shares otherwise disposed
CFC rule trigger:
if taxpayer 50% of feign company's share
87
Deemed distribution
CFC may tax shareholders of a CFC on the company's earnings as if the earning were distributed to shareholders even through no distribution has been made.
88
cross-boarder estate planing
the hague conference on private international law is inter gov't organization that works toward the convergence of private international law.
purpose:
to simplify or standardize processes and facilitate international trade.
89
The Hague conference of the conflict law
relating to the form of testamentary dispositions address varying form of will issue
39 countries excluding US
90
A will is valid if it's consistent with the international law associate with
- the place the will was made
- the nationality, domicile, or habitual residence of the testator on
the location of immovable assets covered under the wil
91
tax system
a country that taxes income sources within its border is said to impose source jurisidication also referred to as a territorial tax system
92
taxation of income
residence jurisdiction, applies to worldwide income
93
taxation of wealth
| under source-jurisdiction,
transfer taxes are livedor assets location within or transferred within a country whether by citizen or foreign
94
under residence jurisdication
citizens and residents pay transfer taxes regardless of the worldwide location of the assets
95
exit taxation
tax on individual giving up their citizenship or residency
96
Deem disposition
exist tax amount to a tax on unrealized gains accrued on assets leaving the taxing jurisdiction
may also include an income tax on income earned over a fixed period after expatriation called a "shadow period"
97
double taxation
interaction of country tax systems can result in tax conflicts in which 2 countries claim to have taxing authority over the same income or assets
Intended to facilitate internet trade, and investment by eliminate double taxation
98
residence-residence conflict
2 countires may claim residence of the same individual, subjecting the individual's worldwide income to taxation by both countries
99
source-source conflict
2 countries may claim source jurisdiction of the same asset
100
residence -source conflict
an individual might be subject to residence jurisdiction and receive income on assets in a foreign country with source jurisdiction
- most common, most difficult to avoid
US citizen owning AU situated real estate would be subjected to US income tax and AU income tax on rental income
101
proving tax credit provision
provide its taxpayer relief from residence-source conflicts using
```
credit method (complete reduction)
exemption method (complete reduction)
deduction method (partial reduction)
```
102
Credit method
Credit method = max ( T residence, T source)
the residence country reduces its taxpayer's domestic tax liability for taxes paid to a foreign country exercising source jurisdiction
Credit method = max ( T residence, T source)
103
Exemption Method
Exemption method = T source
the residence country imposes no tax on foreign source income by providing taxpayers with an exemption, which in effect, eliminates the residence-source conflict by having only one jurisdiction impose tax.
Exemption method = T source
104
Deduction Method
partial
T deduction method =Tresident + T source - Ts*Tr
the residence country allows tax payers to reduce their taxable income by the amount of taxes paid to foreign government in respect of foreign -source income.
105
OECD
solves both residence-source conflict and Residence-resident conflict
organization for Econ. co-operation and development model treaty section eh exemption and credit method to resolve residence-source conflict.
106
tax avoidance / minimization
developing straggles that can form to both the spirt and the better of the tax codes of the jurisdiction with tax authority
107
tax evasion
the practice of circumventing/avoid tax obligations by illegal means such as mis-resporting or not reporting revenant information to tax authorities
108
tax evasion
the practice of circumventing/avoid tax obligations by illegal means such as mis-reporting or not reporting revenant information to tax authorities
109
concentrated single asset positions
public-traded single stock positions
private held business including family owned business
investment real estate
110
inv. risk of concentrated positions
1. systematic risk
that cannot be eliminated by holding a well-diversified portfolio
CAPM
macro economies
2. company-specific risk
non-systematics or idiosyncratic risk that is specific to a particular company's operations, reputations, and business environment
3. property - specific risk
nonsystematic risk that is specific to owning a particular piece of real estate
111
a single asset portfolio has more extreme positive skew for 2 reasons:
1. a higher average ending value reflecting the benefit of tax deferred
2. a much higher of probability of total loss due to bankruptcy of a single asset
112
general principal of managing concentrated single-asset positions
objectives (3)
1. reduce risk of wealth concentration
2. generate liquidity to diversify and satisfy the cash flow need
3. Optimize the tax efficiency by enter structuring transaction involving concentrated position so as not to trigger an immediate taxable event and if a taxable event will be triggered, structuring the transaction in a manner that minimize the tax the owner will incur.
113
client objective and concerns on concentrated position
1. mandated to hold shares
2. maintain effective voting rights
3. enhance current income
4. necessary for the successful operations
5. significant taxable capital gain
6. concentrated positions are generally liquid
7. psychological considerations
114
consideration affection an concentrated positions
tax consequences of an outright sale
- deferring or eliminating in CGT is typically a primary objective for investor who own a concentrated position
liquidty
115
institutional & capital maket constraints
margin-lending rules:
determine how much a bank or brokerage from lend again securities positions that their customers own
-Rule based system, the amount can be borrowed against a security that the investor owns will depend on strict rules deciding with the use of the load proceeds
- Risk based
portfolio margins provides additional flexibility to achieve the desired economic and tax results
116
Prepaid variable forward
collar & loan combined with a single instrument
secured lending
- off-balance sheet debt
- not subject to margin rules
A variable prepaid forward contract is a strategy used by stockholders to cash in some or all of their shares while deferring the taxes owed on the capital gains.
The sale is not finalized. That's an advantage for holders of stock options with a later exercise date.
117
security laws and regulation
may define the owner as an "insider" who is presumed to have moderate nonpublic information and impose restrictions, regulations, and reporting requirements on the position.
118
Contractual restriction and employers mandates
may impose restrictions (such as minimum holding period or black out period when sales may not be made) bond those of securities law and regulations
119
capital market limitation
borrow and shorting the underlying asset is often required for the dealer to hedge their risk.
this is prohibited in some markets without sufficient price history and liquidity in the underlying instruments, monetization techniques may be unavailable.
120
Goal-based planing is the concentrated position decision making process
to overcome psychological bias
121
aspiration risk bucket
goal: the opportunity to increase wealth substantially to have the possibility of moving upward in the wealth spectrum
p/e
| real estate
122
market risk bucket
goal: maintain the current living standard
public equities and bonds
123
personal rick bucket
goal: protection from poverty or a dramatic decrease in life style
T-bill
CD
property
124
asset location and wealth transfer
asset location determines the method of taxation that will apply
can used together with gifting strategy to minimize transfer taxes with respect to concentrated positions.
125
wealth transfer before significant appreciation
involve estate planing and gifting to dispose of excess wealth
early transfer in the ownership life of a concern trade position often enables the owner to shift future wealth with little or no transfer tax consequences.
the specific strategies used depend on the tax law of the country and the owner's situation
key consideration:
1. advisor can have the greater impact by working with clients before significant unrealized gains occur. If there are no unrealized gains, there are generally no financial limitations on disposing of the concentrated position.
2. donating assets with unrealized gains to charity is generally tax-free even if there are gains
3. LIMITED partnership
an estate tax freeze is a strategy to transfer future appreciation and tax liability to future generation. This strategy usually involve a partnership or corp. structure.
gift tax due on the value of asset when the transfer is made.
The asset will be exempt from future estate and gift taxes in the givers estate
126
technique to use after significant appreciation has occurred to minimize transfer taxes:
- family limited partnership
Parent generally retain partnership interest and therefore retain control of the partnership and the concentrated position within it.
the parents gift the limited partnership interest to their child.
- limited partnership interest is valued for transfer tax purpose, value generally < a proportionate value of the assets held in the partnership.
This arises because:
1. lack of marketability
2. general partner retrain control, limited partners' non-controlling interest is worth less because he has very little ability to influence against of the partnership and the underlying assets
127
Tax savy
if concentrated position appreciate further b/w date of gift and gift of parent's death
128
5 step in concentrated wealth decision making
1. identify and establish objectives and constrains
2. identify tools/strategies that can satisfy these objective
3. compare tax advantages and disadvantages
4. compare non-tax advantages and disadvantages
5. formulate and document an overall strategy
129
3 techniques used to manage concentrated positions
1. sell the asset
outright sale will trigger a tax liabiltiy and loss of control
```
2. monetization strategy
borrow against its value and use the load proceeds to accomplish client objective
- margin loans
- fixed and floating rate debt
- recourse and non-recourse debt
- loans embedded with a derivatives
- short sale against the box
- restricted stock sale
- public capital market based transaction
```
3. hedge the asset value
often done using derivatives to limit downside risk
- exchange traded options
- OTC derivatives (options, forwards, swaps)
drawback:
1. expensive premium if purchase a lot of contract
2. counterpart risk for OTC derivatives
130
OTC
create counterpart credit risk
| provide flexibility in setting the specific terms of instrument
131
exchange traded instruments
1. facilitate closing the transaction early by entering an offsetting transaction
2. provide price disclosure because transaction prices are publicly reported
3. provide more transparent fees and transaction costs because it's easier for a dealer to embed transaction costs in complex OTC derivatives
132
monetization strategies
investors holding a concentrated position:
1. hedging against a fall in price of a stock
2. defer capital gains tax
3. generate liquidity (cash )
- hedge remove a large portion of risk
- borrow against the hedge position
a high LTV can be achieved as the stock position is hedged
- borrowing is quite inexpensive because the income generate on the hedge position offset cost of borrowing
- transform of a concentrated position in cash
- transact that are distend to empower an investor to receive cash for their stock position through a manner other than an outright sale in a way that avoid trigger taxable event.
133
equity monetization tool set 4
1. short sale against the box
-least expensive technique for hedge monetize and potentially defer the capital gains tax on a concentrated position.
- hedging technique require borrowing and shorting the company stock.
investor shorting a security that is held long
134
equity monetization tool set 4
2. total return equity swap
stock position is completely hedged, monetization with a very high LTV ratio should be possible
contract for a series of exchange of the total return on a specific asset in return for specified fixed or floating payment.
135
equity monetization tool set 4
3. forward conversion with option
partially hedge, monetization with a very high LTV ratio should be possible
involves the construction of a synthetic short forward position against the asset held long
payoff of a short forward position is identical to
= long put + short call
136
equity monetization tool set 4
4. equity forward sale contract
perfectly hedged, monetization with a very high LTV ratio should be possible
private contract for the forward sale of an equity position
137
equity monetization tool set 4
4. equity forward sale contract
perfectly hedged, monetization with a very high LTV ratio should be possible
private contract for the forward sale of an equity position
138
tax treatment of equity monetization strategy
- can eliminate concentrated risk and generate about the same amount of cash that would be generated by an outright sale
139
tax treatment of equity monetization strategy
- can eliminate concentrated risk and generate about the same amount of cash that would be generated by an outright sale
-yield enhancement with covered call
drawback of covered call: limited upside and no downside protection
140
tax-optimized equity strategies
1. index tracking with active tax mgmt
tax on div > cgt, invest in low dividend yield stocks
2. completeness portfolio
if have a concentrated position in auto stock, could invest in other stocks with low correlation of auto stocks
cross hedge
if has a concerned option in JetBlue but not available puts on JetBlue, could choose to long a put on comparable company such as Delta
or short an index with high correlation .
3. buy puts on a proxy asset in that the put and stock are different types of asset
-Exchange funds involve doing other individual who have concentrated position on other companies with each investor contributing their shares to the funds, all investors now own a portfolio to the resulting diversified portfolio.
No tax liability are realized on the initial contribution of shares
Lock in unrealized gains: hedging
1. purchase of puts short puts
- lock in floor price
- retain unlimited upside potential
- defer the capital gains ax
2. collar, cashless collar
- hedge against a decline in the price
- retain a certain degree os upside potential
- defer the capital gains tax while avoiding any out of pocket expenditures
3. prepaid variable forward
141
issue: mismatch in character
when the gain or loss in the concentrated position and the offset loss or gain in hedge are subject to different tax treatment
142
managing the risk of private business equity
- valuation level of target company
- tax rate applicable to a particular exist strategy
- condition of credit market
- level of interest rates
- amount of buying power
- currency valuation
143
financial tool set for managing private business equity
allow company owners to generate full or partial liquidity
exist plan
1. sale to 3rd party investor
strategic buyer (trigger a capital gains tax liability)
: take a buy and hold perspective and generally offer higher price + stock synergies
Financial buyer: offer a PE fund planning to restructure the business, add value, resell,
purchase more mature, establish businesses and offer a lower price than a strategic buyer
2. sale to mgmt MBO
3. recapitalization
used for establish but les mature companies
multi-strategy stray that owner transfer a portion os stock to a PE for cash and retain a minority ownership, interest
Later, pE will acquire the rest of the interest
- provide liquidity, reduce risk and retain incentive but will lose control of the firm
4. IPO
5. use diff. sources of capital
- senior debt
- mezzanie debt
0equities
6. divesture
if a business owner is not yet ready to retire and wish to continue run the business but would like to generate some liquidity now, he/she may consider selling a certain line of business or closing a division
7. personal line of credit
the owner arranges a persona loan secured by his/her shares in the private company, no immediate taxable event if structured properly
8. ESOP
selling some or all of the company shares to certain types of pension plan
144
managing the risk of investment real estate
factors affect value:
- current valuation vs. historical level & future expectations
- tax rate applicable to a particular property and transaction
- condition of the credit market and lending conditions
- level of interest rates
145
monetization strategies for real estate owners
mortgage financial
sale and lease back
charitable donation
146
leveraged recapitalization
a strategy involves retooling a company's B/S in partnership with a PE firm.
allow the owner to have 2 liquidity event:
1 up-front and a second typically within 3-5 year time frame when the PE firm cashes out the investment.
the pe firm invest equity capital and arranges debt with senior or subordinated lender. The owner transfer stock for cash and an ownership interest in the newly capitalized entity. This allow the owner to monetize a significant upside potential with the remming ownership.
from the tax perspective, owner is taxes currently on the cash received and typically receive a tax deferral o the stock rolled over into the new entity
disadvantage:
1. Financial buyer price paid not as high as strategic buyer
2. owner lose control of the company
147
risk management for individual
| life cycle finance
helping investor achieve their goal, including an adequate retirement income, by taking a holistic view of the individual's financial situation
recognize that as investors age, the fundamental active of their total wealth evolves as do the risks that they face.
148
Economic net worth
= net worth from traditional b/s
+ pv(futures earning)
- pv(consumption goal)
-pv(bequets)
149
risk avoidance
choose action to avoid the chance of the loss occurring, avoiding the risk altogether
150
risk reduction
high frequency low loss
choose action that reduce the likelihood or amount of loss
151
risk transfer
buying insurance
infrequently high loss
use insurance products to transfer the loss to others
152
risk retention
infrequently low loss
maintain sufficient assets to absorb the loss
153
earnings risk
disability income insurance
insure with disability insurance
| the risk of getting unemployed, disabled, or unable to work affecting both human capital and financial capital.
154
premature death risk
insure with life insurance, the risk of the death of an individual earlier than anticipated
155
property risk
insure with property insurance
| it relates to the prob. that a person's property is damaged, destroyed, stolen or lost
156
liability risk
liability insurance
insure with liability insurance
the possibility that an individual maybe held legal liable of the financial costs associated with property damaged as physical injury
157
health risk
insure with health insurance
| risk and implications associated with illness and injury
158
life insurance
protects against the lost of human capital for those who depend on an individual's future earnings
- provide hedge against protective death
- estate planing tool, provide immediate liquidity to a beneficiary
- tax-sheltered saving instrument
159
temporary life insurance
| term life
that covers for a certain period of time specified at purchase. Cost is lower than permanent life insurance.
160
permanent life insurance
- whole life insurance /life time coverage (fixed premium)
- universal life insurance
a form of permanent insurance that can remain in force until death and typically has more options for investing the cash value than do whole life policies.
provide more options for investing the cash value
161
key consideration in policy of life insurance
1. mortality expectation
generalize mortality table adjusted to additional factor
underwriting process reduces the likelihood of adverse selection (Adverse selection is when sellers have information that buyers do not have, or vice versa)
higher than average risk are more likely to apply for life insurance
2. net premium/ gross premium/ discount rate
representing an assumption of insurance company's return on portfolio is expected to the cash flow
- discount value of futures death benefit
gross premium: adds a load to net
3. loading
covers operating cost and expense for underlying the policy
162
whole life policy offer advantage of level premium and an accumulation of cash value within the policy that:
1. can withdrawn by the policy owner when the policy matures or when he/she terminate the policy
2. can be borrowed as a loan while keeping the policy in force
- premium stays constant
- face value stays the same
- cash value increase
- insurance value decrease
non-forfeiture clause
163
policy reserve
a liability on the insurance company's B/S
| = pv of future benefits- pv of future net premiums
164
net payment cost index
assumes policy will be surrendered at the end of the period and that the policy owner will receive the projected cash value
= fv of premium (annuity due, BOE)
- fv of dividend (ordinary income EOD)
= LUMP SUM
求pmt
index value = pmt / 100
165
Surrender cost index
fv of premium (bod)
- fv of dividend (eod)
- cash value (given)
= insurance cost
求pmt， pmt/100 = index value
the lower the index value, the better the value
166
primary purpose of life insurance
replace the pv of future earning
- immediate financial expense
- legal goals
167
annuity
pay income as long as the owner is alive
- one-time premium payment in exchange for fixed payments received for the life of the amount
the initial investment/ premium is not returned at the end
payment are the interest and a return of principal
168
deferred annuity
| variable annuity
the annual receipts start at a deferred future date
allow the owner to select from a list of investment options
169
Deferred fixed insurance
pay a fixed benefit for life that starts at a defined future date
- the longer the delay b/w initial premium paid and start of pmt received, all else the same, the lower cost of the annuity as the company can invest and increase the funds available before making payment on annuity
170
advanced life deferred annuity
relative low cost to hedge the longevity risk
- require immediate premium pay out at purchase
- payment are fixed, delay period is long
age 80 or 85 after
low premium reflect:
1. long delay before payout begin allow the company to grow asset
2. the period of payment will be shorter as the life expectancy the older annuitant will be shortened when payment begin
3. a greater protection of the annuitants will die before they receive any payments
171
factor favor use annuity over self-insurance:
- a longer than average life expectancy
- a desire for lifetime income
- conservative investors ( high risk aversion)
- an absence of other guaranteed income sources such as pensions
- less desire to leave an estate for the benefit of others
172
adjusted discount rate =
(1+r) / (1+g)
173
Joint life annuity
2 or more individual
husband and wife
receive pmt until all beneficiaries die
174
fixed annuity
benefit:
1. known and constant income stream
2. lower fee cost
3. investment performance risk borne by annuity provider
disadvantage:
1. rate of return fixed at once
2. inflation erodes purchasing power of cash flow
3. no early access to funds once established
175
variable annuity
benefit:
1. may better adjust payout for inflation over time
2. performance adjusts to current market environment
3. growth within annuity product tax-deferred
4. possible to reclaim some asset early
disadvantage:
1. payout uncertain
2. performance risk borne by annuitant
3. higher fee cost
176
Both the liability-relative and goals-based approaches consider assets relative to liabilities. The main difference between the two approaches is that
the liability-relative approaches focus on institutional investor liabilities
while the goals-based approaches focus on individual investor liabilities.
177
minimum entitlement to estate taxes
= max (1/2 of increase of total estate during marriage under community property, 1/3 under forced heirship)
178
avoid probate
joint ownership
living trusts
retirement plan
life insurance strategies
179
reduce impact of forced heirship
moving assets into an offshore trust
gifting or donating
purchasing life insurance by move assets outside of realm of forced heirship provisions.
180
conflict of taxation
residence-residence
source-source conflict
residence source
181
the income yield is higher when expected longevity is shorter;
therefore, the income yield will be higher for an older person.
2021 CFA Level III
flashcards
Decks in class (12)
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