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- 1. Tips-n-Tricks to crack entire CFA syllabus 6 days Portfolio Management, Derivatives, Alternative Investments © EduPristine © EduPristine – www.edupristine.com
- 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 © EduPristine 1
- 3. Tips and Tricks: Portfolio Management:Revise Contd … Willingness vs Ability to take risk: Willingness to take risk Ability to take risk © EduPristine High Low High High risk Tolerance Education required Low Education required Low risk Tolerance 2
- 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 © EduPristine 3
- 5. Tips and Tricks: Portfolio Management:Revise Contd … ASSET: Expected return of a PORTFOLIO Expected return Variance: T ( Rt t 1 T © EduPristine ) T 2 ; s ( R1 R) 2 t 1 T 1 4
- 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 © EduPristine Y 5
- 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 ) © EduPristine 6
- 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 © EduPristine Systematic Risk 7
- 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 © EduPristine 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. © EduPristine 9
- 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 © EduPristine Futures Regulated 10
- 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)}] © EduPristine 11
- 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)]} © EduPristine 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] 12
- 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. © EduPristine 13
- 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) © EduPristine 14
- 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. © EduPristine 15
- 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: © EduPristine 16
- 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 © EduPristine Backwardation 17
- 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. © EduPristine 18
- 20. Thank You ! help@edupristine.com www.edupristine.com © EduPristine – www.edupristine.com

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