OID111847485.

Last Revised: 05/10/2022

2023 Level 3 - Section 3

Readings Page

Overview of Fixed-Income Portfolio Management 2

Liability-Driven and Index-Based Strategies 14

Yield Curve Strategies 30

Fixed-Income Active Management: Credit Strategies 41

Overview of Equity Portfolio Management 56

Passive Equity Investing 63

Active Equity Investing: Strategies 69

Active Equity Investing: Portfolio Construction 79

Review 89

This document should be used in conjunction with the corresponding readings in the 2023 Level 3 CFA® Program curriculum.
Some of the graphs, charts, tables, examples, and figures are copyright 2022, CFA Institute. Reproduced and republished with
permission from CFA Institute. All rights reserved.

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© markmeldrum.com. All rights reserved.

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OID111847485.

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Overview of Fixed-Income Portfolio Management

a. discuss roles of fixed-income securities in portfolios and how fixed-income

mandates may be classified;

b. describe fixed-income portfolio measures of risk and return as well as

correlation characteristics;

c. describe bond market liquidity, including the differences among market sub-
sectors, and discuss the effect of liquidity on fixed-income portfolio
management;

d. describe and interpret a model for fixed-income returns;

e. discuss the use of leverage, alternative methods for leveraging, and risks that
leverage creates in fixed-income portfolios;

f. discuss differences in managing fixed-income portfolios for taxable and tax-

exempt investors.

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Overview of Fixed-Income PM

LOS a (9p) Roles in a portfolio and FI mandates - discuss

LOS b (5p) Measures of risk and return - describe

LOS c (5.5p) Bond Market Liquidity - describe, discuss

LOS d (5.5p) A model for fixed-income returns - describe, interpret

LOS e (5p) Leverage - discuss

LOS f (3p) Taxation - discuss

Page 1
1/ Diversification Benefits - when combined with LOS a
other asset classes in a portfolio - discuss

lower correlations = higher diversification benefits and

lower portfolio risk

- correlations are not constant over time HY can act like a

- in any period (i.e. market stress), proxy for equities in a
correlations can differ from the fixed-income portfolio
average correlation (very low, even negative,
Empirical duration)
- bonds are also less volatile than other
major asset classes (IG ~ 4%, HY ~ 6-9%, SnP500 ~ 19.4%)

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Page 2
2/ Benefits of Regular Cash Flows - coupon + principal LOS a
on known dates - discuss
- portfolios can be structured to meet some future obligation
- default and optionality threaten this benefit
(e.g. credit-risky bonds, callable bonds, MBS)

3/ Inflation Hedging Potential

outperforms if actual
inflation < expected
inflation
$1000 FV inflation
e.g. 3% coupon FV = 1020 - low return volatility vs.
⇒ conventional bonds
CPI ↑ 2% CPN = 30.60 - very useful for investors with
real return very long IHs
Ex. #1

Page 3
➞ Mandates/ LOS a
1/ Liability-based - managed to match or cover expected - discuss
liability payments with future projected cash flows
(asset-liability management - ALM, liability-driven investing - LDI)

e.g./ individuals funding specific cash flow and lifestyle needs,

banks, insurance companies, pension funds

a) cash-flow matching - immunization approach

- attempts to ensure all future liability payouts are
matched by CFs from bonds (no need for reinvestment or
bond sales)

b) Duration matching - immunization approach

- match the duration of the assets and liabilities
- assets and liabilities should be affected similarly by a
change in rates

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Page 4
➞ Mandates/ LOS a
1/ Liability-based - discuss

c) derivatives overlay - close duration gaps between assets

and liabilities or alter risk exposures of the assets

d) contingent immunization - when A > L, combines immunization

with active management

Page 5
➞ Mandates/ LOS a
2/ Total Return Mandates - objectives based on absolute - discuss

or relative return

a.k.a. full replication - highest mgmt. fees

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Page 6
➞ Mandates/ LOS a
- discuss
ESG considerations - avoid unfavourable ESG factors
Ex. #2
- companies more likely to encounter future ESG-related
incidents ➞ financial risk
LOS b
- describe
𝐧 𝟏 + 𝐲* !𝐢
𝐂𝐅 % 𝐤+
=" 𝐭𝐢
𝐏𝐕
𝐢$𝟏
weight time

ModDur = 𝐌𝐚𝐜𝐃𝐮𝐫
𝟏 + 𝐲/𝐤

∆par curve

Page 7
LOS b
- describe
𝐧
EffDur = " 𝐊𝐑𝐃𝐢
𝐢$𝟏

observed

ModDur x 𝐏𝐕𝐟𝐮𝐥𝐥

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Page 8
PVBP = MD x .0001 = ModDur x 𝐏𝐕𝐟𝐮𝐥𝐥 x .0001 LOS b
- describe
(DV01 - calibrated to 100 of par)
BPV - basis point value e.g.: .08 ➞ ∆𝐏𝐕𝐟𝐮𝐥𝐥 = 8¢/100 par for ∆r = 1 pb.

Convexity ➞ second order effect since yield/price relationship is not linear

- pos. Convexity ➞ higher return than an identical-duration bond

with lower convexity for ∆rates
➞ Convexity typically results in lower YTM
- desirable with higher interest rate volatility

Coupon paying bonds have more convexity than ZCB with the same
duration
e.g. 30-yr. coupon paying bond with ModDur = 18
has more convexity than an 18-yr. ZCB
- more CF dispersion around the duration point ➞ greater convexity

Effective Convexity ➞ for a ∆par curve

Page 9
➞ Portfolio measures of risk and return/ LOS b
- describe
𝐉 MV of each security
𝐌𝐕𝐣
𝐀𝐯𝐠. 𝐌𝐨𝐝𝐃𝐮𝐫 = 1 𝐌𝐨𝐝𝐃𝐮𝐫𝐣 2 3
𝐌𝐕
𝐣&𝟏
𝐌𝐕𝐏
𝐉
𝐌𝐕𝐣 - portfolios with higher convexity
𝐀𝐯𝐠. 𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲 = 1 𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲𝐣 2 3 typically have lower YTMs
𝐌𝐕
𝐣&𝟏
- MBS, Callable bonds, short options
- all have neg. Convexity
𝐏𝐕( − 𝐏𝐕) 𝐏𝐕( + 𝐏𝐕) − 𝟐𝐏𝐕𝐟𝐮𝐥𝐥
𝐄𝐟𝐟𝐃𝐮𝐫 = 𝐄𝐟𝐟𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲 =
𝟐 ∆𝐜𝐮𝐫𝐯𝐞 𝐏𝐕𝐟𝐮𝐥𝐥 (∆𝐜𝐮𝐫𝐯𝐞)𝟐 𝐏𝐕𝐟𝐮𝐥𝐥

Spread Duration: %∆𝐏𝐕𝐟𝐮𝐥𝐥 for ∆credit spread

longer maturity
DTS SD x credit spread ➞ increase credit risk exposure lower quality
Portfolio dispersion variance of time to CF w.r.t. MacDur
(weighted variance)
higher dispersion ➞ higher convexity

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Page 10
➞ Liquidity/ - most bonds have a less active secondary LOS c
market vs. equities - many do not trade on a - describe

given day
- bonds are very heterogeneous
- bond markets are typically OTC (search costs, price discovery)
- liquidity is highest right after issuance (supply not yet
bought up by buy-and-hold investors)
- liquidity affects bond yields - illiquidity premiums - compensate
for exit costs prior to maturity
- premium depends on issuer, issue size, date of maturity

Liquidity among Bond Market Subsectors/ - subsectors can be categorized

by issuer type, credit quality, issue size, maturity

Page 11
Liquidity among Bond Market Subsectors/ LOS c
- describe
sovereign government bonds - typically most liquid
issuers
non-sovereign gov’t. bonds large issuance size
gov’t. related bonds collateral in repo market
corporate bonds (a.k.a. credits) well-recognized issuers
securitized bonds use as benchmark bonds

many more issuers, small issue sizes, wide range of credit quality (IG - HY)
- low credit quality issues ➞ may be difficult to even find a dealer
with inventory (or that wants inventory)
- small issues typically excluded from bond indexes with minimum
issue size requirements

Effects of Liquidity on Fixed-Income Port. Mgmt./

1) Pricing - many issues may have stale prices or prices that
are often estimated (recent transaction prices may
not be valid)

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Effects of Liquidity on Fixed-Income Port. Mgmt./ LOS c
1) Pricing - matrix pricing can be used - describe

2) Portfolio construction - trade-off between yield and liquidity

- many buy-and-hold investors will prefer illiquid bonds
for the higher yield (illiquidity premium)
- some investors restrict maturities to a certain segment
- reduces need to sell bonds to generate cash inflows
- riskier bonds will also have wider bid-ask spreads (compensation
to dealer for holding inventory longer)
- thus making them illiquid
- complex bonds will also have wider bid-ask spreads

➞ smaller spreads ➞ gov’t. bonds vs. corporates

plain vanilla vs. optionality
large, high-credit quality issuers vs. small, less creditworthy

Page 13
Effects of Liquidity on Fixed-Income Port. Mgmt./ LOS c
- describe
3) Alternatives to direct investment in bonds

MF, ETFs ➞ mgmt. fees

➞ more liquid than the underlying securities
Exchange-traded derivatives (interest rate futures)
OTC derivatives (swaps, CDS, TRS)

TR Index CFs + Appreciation TR

receiver payer
Libor + spread
+ Index Depreciation Index Returns
+ Default Losses
Underlying
Bond
Index

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Page 14
- investment strategies should be evaluated in terms LOS d
of expected return, E(R), and not just yields - describe
- interpret
➞ Decomposing E(R) ≈ Coupon Income
+⁄− Rolldown Return
+⁄− E(∆price due to investor’s view of benchmark yields)
+⁄− E(∆price due to investor’s view of yield spreads)
+⁄− E(∆price due to investor’s view of currency changes)

- Coupon Income (current yield) ➞ 𝐚𝐧𝐧𝐮𝐚𝐥 𝐜𝐨𝐮𝐩𝐨𝐧 + 𝐫𝐞𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭

𝐜𝐮𝐫𝐫𝐞𝐧𝐭 𝐛𝐨𝐧𝐝 𝐩𝐫𝐢𝐜𝐞

- Rolldown Return - change in price by the passage of time

➞ %∆𝐏𝐕 assuming an unchanged yield curve over the

strategy horizon

Page 15
- Rolldown Return = 𝐁𝐨𝐧𝐝 𝐩𝐫𝐢𝐜𝐞𝐞𝐧𝐝 − 𝐁𝐨𝐧𝐝 𝐩𝐫𝐢𝐜𝐞𝐛𝐞𝐠. LOS d
- describe
𝐁𝐨𝐧𝐝 𝐩𝐫𝐢𝐜𝐞𝐛𝐞𝐠.
- interpret
Coupon Income + Rolldown Return = rolling yield

➞ View of benchmark yields (curve effect)

E(∆price based on investor’s views of yields and yield volatility)
= (-ModDur x ∆curve) + [𝟏G𝟐 x Convexity x (∆curve)2]

➞ View of yield spreads (credit spreads)

E(∆price based on investor’s view of spreads)
= (-ModDur x ∆spread) + [𝟏G𝟐 x Convexity x (Spread)2]
(SD if FRN)

- spreads can change due to economic conditions & credit migration

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Page 16
➞ Views of currency value changes LOS d
- describe
E(currency gains/losses) ➞ 𝐑 𝐅𝐗
- interpret

𝐑 𝐃𝐂 = (𝟏 + 𝐑 𝐅𝐂 )(𝟏 + 𝐑 𝐅𝐗 )
- estimation of inputs ➞ yield curve changes
➞ changes in spreads ex. #4

➞ currency changes

return on assets LOS e

interest - discuss
𝐏𝐨𝐫𝐭𝐟𝐨𝐥𝐢𝐨 𝐑𝐞𝐭𝐮𝐫𝐧 𝐫𝐈 × (𝐕𝐂 + 𝐕𝐁 ) − (𝐕𝐁 × 𝐫𝐁 ) expense
𝐫𝐏 = =
𝐏𝐨𝐫𝐭𝐟𝐨𝐥𝐢𝐨 𝐄𝐪𝐮𝐢𝐭𝐲 𝐕𝐄
equity
𝐫𝐈 ➞ return on invested funds
𝐕𝐄 ➞ value of equity if 𝐫𝐈 > 𝐫𝐁 - leverage will
𝐕𝐁 ➞ value of borrowed funds increase portfolio
𝐫𝐁 ➞ borrowing costs returns

Page 17
- expanding the numerator: LOS e
𝐫𝐈 𝐕𝐄 + 𝐫𝐈 𝐕𝐁 − 𝐫𝐁 𝐕𝐁 𝐫𝐈 𝐕𝐄 + 𝐕𝐁 (𝐫𝐈 − 𝐫𝐁 ) - discuss
𝐫𝐏 = =
𝐕𝐄 𝐕𝐄
excess over
if (𝐫𝐈 − 𝐫𝐁 ) < 0, 2
nd
term < 0 𝐕 borrowing costs
= 𝐫𝐈 + 𝐁G𝐕 (𝐫𝐈 − 𝐫𝐁 )
⇒ 𝐄
if (𝐫𝐈 − 𝐫𝐁 ) > 0, 2nd term > 0 leverage factor

➞ Methods of Leverage/
1/ Futures contracts - margin deposit only
𝐍𝐨𝐭𝐢𝐨𝐧𝐚𝐥 𝐯𝐚𝐥𝐮𝐞 − 𝐌𝐚𝐫𝐠𝐢𝐧
𝐋𝐞𝐯𝐞𝐫𝐚𝐠𝐞𝐟𝐮𝐭𝐮𝐫𝐞𝐬 =
𝐌𝐚𝐫𝐠𝐢𝐧
2/ Swap agreements receive fixed, pay fl. ➞ positive duration
pay fx., rec. fl. ➞ negative duration

- collateral may need to be posted

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Page 18
➞ Methods of Leverage/ LOS e
- discuss
3/ Repurchase Agreements - a sale and a repurchase - basically a
collateralized loan
- point of view of borrower (of funds) (lender ➞ reverse repo)
- difference between the sale and repurchase price called the repo rate
𝐝𝐚𝐲𝐬G
Interest = Principal x repo rateR 𝟑𝟔𝟎W
e.g./ $15M repo @ 5%
interest = 15M x .05$𝟏)𝟑𝟔𝟎* = 2083.33
- overnight
- typically overnight to a few days (maybe longer)
- repo may be - cash-driven ➞ borrow cash to buy assets
- general collateral bonds
- security-driven ➞ borrow particular securities
➞ hedging, arbitration, speculation
(tend to be longer term ~ 30 days)

Page 19
➞ Methods of Leverage/ LOS e
- discuss
3/ Repurchase Agreements
- protection against default provided by the collateral
- high quality ➞ 97%-99% borrowing capacity - called the
‘haircut’
- lower quality, higher volatility ➞ lower borrowing
capacity
4/ Security Lending
- to facilitate short sales (lend to short sellers)
- for financing purposes (lend bonds in exchange for cash)
- security loans are collateralized by cash or high credit-quality bonds

- earn return on cash in excess of the value

+ loan fee borrowed (e.g. 102%)
- if for financing purposes, fee is
negative (lender pays borrower)

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Page 20
➞ Methods of Leverage/ LOS e
- discuss
4/ Security Lending - when bonds are posted as collateral,
income earned flows back to borrower
Rebate rate = Collateral earnings rate - Security lending rate
- if borrowed securities are difficult to borrow, lending rate
may be greater than the return on the collateral
- typically open-ended agreements

➞ Risks of Leverage/ leverage alters risk-return properties of a portfolio

- magnified losses, higher risk, forced liquidations

e.g. 𝐃𝐄 = 𝐃𝐀 𝐀 − 𝐃𝐋 𝐋
𝐄 ∴ r ↑ 100bps
𝐃𝐏 = 𝟒 A = 140M ➞ 𝐃𝐄 = 𝟒(𝟏𝟒𝟎) − 𝟏(𝟏𝟎𝟎) = 𝟏𝟏. 𝟓 A ↓ 4%
𝟒𝟎
𝐃𝐋 = 𝟏 E = 40M E ↓ 11.5%

Page 21
➞ Taxation/ LOS f
- discuss
2 primary sources of taxable income:
a) interest (marginal tax rates) taxed when
received
b) capital gains (favourable tax rates)

ZCB ➞ all interest ➞ income is implied each year

- capital gains are typically taxed at a lower rate than interest

- capital losses reduce capital gains only (use of tax-loss harvesting)
- short-term capital gains may be considered income
delay sales with
- Investment vehicles gains
- interest income typically passed-through move up sales
- cap.-gains ➞ may be passed-through, may with losses
just increase NAV.

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Liability-Driven and Index-Based Strategies

a. describe liability-driven investing;

b. evaluate strategies for managing a single liability;

c. compare strategies for a single liability and for multiple liabilities, including
alternative means of implementation;

d. describe construction, benefits, limitations, and risk-return characteristics of

a laddered bond portfolio;

e. evaluate liability-based strategies under various interest rate scenarios and

select a strategy to achieve a portfolio’s objectives;

f. explain risks associated with managing a portfolio against a liability

structure;

g. discuss bond indexes and the challenges of managing a fixed-income

portfolio to mimic the characteristics of a bond index;

h. compare alternative methods for establishing bond market exposure

passively;

i. discuss criteria for selecting a benchmark and justify the selection of a

benchmark.

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Liability-Driven and Index-Based Strategies

LOS a (2.5p) Liability-Driven Investing - describe

LOS b (13p) Single Liability - Immunization - evaluate

LOS c (4p) Cash Flow Matching - compare

LOS d (3p) Laddered Bond Portfolios - describe

LOS e (23.5p) Liability-Based Strategies vs. Interest - evaluate

Rate Scenarios
LOS f (5p) Risks in LDI - explain

LOS g (5.5p) Bond Indexes - discuss

LOS h (4p) Passive Bond Market Exposure - compare

LOS i (3p) Benchmark Selection - discuss

Page 1
➞ LDI - liability-driven investing - assets are managed to LOS a
meet future liabilities - describe

(i.e. the liabilities are the benchmark)

Classes of Liabilities
Type $ Amount Timing e.g.
MacDur/ModDur I Known Known - principal repayment
II Known Unknown - life insurance payout
EffDur III Unknown Known - floating rate note
IV Unknown Unknown - P&C insurance, post-retirement
health care benefits
LOS b
➞ Immunization - Single Liability/
- evaluate
- construct a portfolio that, over a specified horizon,
minimizes the variance in the realized rate of return

- matching a future liability with an equal term ZCB settles it

(no price or reinvestment risk ~ cash flow matching)

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Page 2
LOS b
- if we must deal with - evaluate
drop in price
coupon-paying bonds, we have
for +∆yield/∆curve
price and re-investment risk

- immunization will require

reinvestment the management of
offsets price duration

- for a single liability,

set 𝐈𝐇𝐋 = 𝐌𝐚𝐜𝐃𝐮𝐫𝐏

+ 𝐏𝐕𝐀 ≥ 𝐏𝐕𝐋

Page 3
➞ Side notes - from ‘Numerical Example’ LOS b
- evaluate
𝐧 𝐲 (𝐢
𝐂𝐅𝐢 \𝟏 + G𝐤^
MacDur = " 𝐭𝐢 𝐲 = portfolio CF yield (𝐈𝐑𝐑 𝐏 , mwrr)
𝐢$𝟏 𝐏𝐕 𝐲 > w.a. yields if curve is
𝐧 upward sloping
Dispersion = " 𝐏𝐕(𝐂𝐅𝐢 ) (𝐭 𝐢 − 𝐌𝐚𝐜𝐃𝐮𝐫)𝟐
𝐏𝐕 - assets should target
𝐢$𝟏
𝐲, not w.a. yield
𝐧
𝐏𝐕(𝐂𝐅𝐢 )
Convexity = " (𝐭 𝐢 × 𝐭 𝐢)𝟏 )
𝐢$𝟏
𝐏𝐕

Portfolio duration ≠ weighted average duration - using w.a. statistics

𝐃𝐏 > 𝐃𝐰𝐚 for upward sloping curve introduces model
risk
Portfolio dispersion > weighted average dispersion

Portfolio convexity > weighted average convexity

higher Dispersion
𝐌𝐚𝐜𝐃𝐮𝐫 𝟐 + 𝐌𝐚𝐜𝐃𝐮𝐫 + 𝐃𝐢𝐬𝐩𝐞𝐫𝐬𝐢𝐨𝐧 = higher Convexity
𝐈𝐦𝐦𝐮𝐧𝐢𝐳𝐞𝐝 𝐂𝐨𝐧𝐯𝐏 =
𝐲 𝟐
O𝟏 + *𝐤P

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Page 4
➞ Single Liability/ LOS b
- evaluate
1/ Set 𝐌𝐚𝐜𝐃𝐮𝐫𝐏 = 𝐈𝐇𝐋
2/ initial PV of portfolio CFs ≥ PV of liability
𝐌𝐕𝐀
3/ Portfolio convexity is minimized ➞ goal is immunization, not
outperformance
- immunization is essentially an interest rate hedging strategy
- the market yield will fluctuate over the IH
∴ 𝐌𝐚𝐜𝐃𝐮𝐫𝐏 will change as both yields change and time passes
- portfolio will need to be rebalanced so that 𝐌𝐚𝐜𝐃𝐮𝐫𝐀 = 𝐈𝐇𝐋

An immunization strategy is essentially a ‘zero replication’ strategy

i.e. immunizing with coupon-paying bonds entails continuously matching
𝐌𝐚𝐜𝐃𝐮𝐫𝐏 with MacDur of a ZCB

Page 5
- 𝐌𝐚𝐜𝐃𝐮𝐫𝐏 = 𝐈𝐇 in all 3 cases/ LOS b
- evaluate
① principal
ZCB no risk immunization strategy

T = IH
zero variance in ROR
② principal
Bullet portfolio - portfolio CFs are
coupon concentrated around the horizon date

low variance in ROR

principal Barbell portfolio - portfolio CFs dispersed

coupons

- variance in ROR results from volatility

---
---
---
---
---
---
---
---
---

high variance in ROR

of rates and structural risk

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Page 6
➞ Structural risk: risk that YC twists and LOS b
non-parallel shifts cause 𝐌𝐚𝐜𝐃𝐮𝐫𝐏 ≠ 𝐌𝐚𝐜𝐃𝐮𝐫𝐙𝐂𝐁 - evaluate

- reduced by minimizing the dispersion of the bond positions

- minimizing dispersion is the same as minimizing convexity.
ex. #2
LOS c
- compare
𝐁𝟒 𝐁𝟑 𝐁𝟐 𝐁𝟏
𝐅𝐕(𝐁𝟏 ) = 𝐋𝟒 − 𝐂𝟏
𝐅𝐕(𝐁𝟐 ) = 𝐋𝟑 − 𝐂𝟏 − 𝐂𝟐
principal
𝐅𝐕(𝐁𝟑 ) = 𝐋𝟐 − 𝐂𝟏 − 𝐂𝟐 − 𝐂𝟑
𝐅𝐕(𝐁𝟒 ) = 𝐋𝟏 − 𝐂𝟏 − 𝐂𝟐 − 𝐂𝟑
coupon

𝐋𝟏 𝐋𝟐 𝐋𝟑 𝐋𝟒

Page 7
➞ Cash Flow Matching/ build a dedicated asset portfolio LOS c
- compare
of high quality bonds that, as closely as possible,
match the amount and timing of cash outflows
- all bonds HTM ➞ no price risk
- repurchasing bonds may be too expensive

- can also improve a company’s credit rating (dedicated assets reduce

liability risk)
- may be able to use ‘accounting defeasance’
- ability to remove both the asset and liability from the B.S.

- cash-in-advance constraint - bonds are not sold to meet obligations,

they mature ➞ maturity timing mismatches mean funds must be
available before each liability payment
- may lead to large cash holdings ➞ reinvestment risk
(esp. with steep YCs)

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Page 8
➞ Laddered Portfolios/ LOS d
- describe
- Spread bonds more or less evenly
along the YC
- better protection from shifts/twists
in the YC (cash flows diversified across
time)
- balances cash flow reinvestment and
market price risk (similar to dollar cost
averaging)
- bonds mature each year and are reinvested
at the long end of the ladder (∴ portfolio
duration is constant)

Liquidity - always a bond that is close to

redemption ➞ low duration, stable price

Page 9
➞ Duration Matching/ - matching multiple liabilities LOS e
- evaluate
1/ 𝐌𝐕𝐀 ≥ 𝐏𝐕𝐋
- select
2/ 𝐃𝐃𝐀 = 𝐃𝐃𝐋 or 𝐁𝐏𝐕𝐀 = 𝐁𝐏𝐕𝐋
3/ distribution of individual portfolio assets must have a
wider range than the distribution of the liabilities
(higher dispersion, ∴ higher convexity)
Numerical example/
𝐀𝐬𝐬𝐞𝐭 𝐏 Liabilities
BPV 117,824 117,824 ➞ 𝐁𝐏𝐕𝐀 = 𝐁𝐏𝐕𝐋
𝐂𝐅𝐲𝐢𝐞𝐥𝐝 3.5822% 3.7608% ➞ corporate liabilities vs. high-quality assets
MacDur 5.9308 6.004 (gov’t./IG)
- assets will grow at a lower
ModDur 5.8264 5.89318
rate, ∴
Dispersion 12.3048 8.2594
Convexity 48.6846 > 45.5359
MV 202,224,094 200,052,250 𝐌𝐕𝐀 > 𝐏𝐕𝐋

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Page 10
➞ Duration Matching/ LOS e
- evaluate
must have an asset with ModDur ≤ shortest duration
- select
liability
Ex. #5 and an asset with ModDur ≥ longest duration liability

Note: for equal durations, a more convex portfolio outperforms a less convex
portfolio
➞ Derivatives Overlay/
- long an interest rate futures contract increases a portfolio’s sensitivity
to interest rates (increases duration)
- short ➞ decrease sensitivity (decreases duration)
- trade on both short-term (T-Bills, Eurodollar futures)
and long-term (Treasury notes, bonds) underlying
30-yr. - important risk mgmt. tool in ALM > 15 yr.
10-yr. - more important in terms of liquidity 6.5 - 10 yr.
2016 ➞ Ultra 10 yr. 9.5 - 10 yr.

Page 11
➞ Derivatives Overlay/ LOS e
- numerical example: Assets ➞ $222,750,000 MacDur = .8532 - evaluate
𝐂𝐅𝐲 = 1.9804% ➞ 𝐏𝐕𝐋 = 222,552,788 - select

BPV = 18,819 BPV = 117,824

Futures ➞ recall: underlying is a generic 6% semi-annual 100,000 bond
CTD - cheapest to deliver
CF - to make it equivalent to the generic bond
- duration of the futures contract = duration of CTD
𝐁𝐏𝐕𝐋 − 𝐁𝐏𝐕𝐀 𝐁𝐏𝐕𝐂𝐓𝐃 CTD: 6.5 yr. 10 yr.
𝐍𝐟 =
𝐁𝐏𝐕𝐅 𝐂𝐅 BPV: 56.8727 81.6607
𝟏𝟏𝟕, 𝟖𝟐𝟒 − 𝟏𝟖, 𝟖𝟏𝟗 CF .8226 .8516
𝐍𝟔.𝟓 = = 𝟏, 𝟒𝟑𝟐
𝟔𝟗. 𝟏𝟑𝟕𝟕 𝐁𝐏𝐕𝐅 = 𝟓𝟔. 𝟖𝟕𝟐𝟕 𝟖𝟏. 𝟔𝟔𝟎𝟕
𝟏𝟏𝟕, 𝟖𝟐𝟒 − 𝟏𝟖, 𝟖𝟏𝟗 . 𝟖𝟐𝟐𝟔 . 𝟖𝟓𝟏𝟔 Ex. #6
𝐍𝟏𝟎 = = 𝟏, 𝟎𝟑𝟐 = 69.1377 = 95.8905
𝟗𝟓. 𝟖𝟗𝟎𝟓

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Page 12
➞ Contingent Immunization/ - hybrid passive-active strategy LOS e
- evaluate
MVA – PVL = surplus
- select
- the PM can pursue active investment strategies as if operating
under a total return mandate, as long as the surplus is above a
designated threshold
- if performance is poor and the surplus evaporates, mandate reverts
to a purely passive strategy (e.g. #7)

➞ Interest Rate Swaps/ - manage duration gaps

- pay floating, receive fixed ➞ long a fixed + short a floating
rate bond rate bond
- adds duration
𝐁𝐏𝐕𝐬𝐰𝐚𝐩 = 𝐁𝐏𝐕𝐟𝐱 − 𝐁𝐏𝐕𝐟𝐥
- pay fixed, receive floating
- reduces duration typically small
- 𝐃𝐟𝐱 ~ 75% of term, 𝐃𝐟𝐥 ~ 𝟏G𝟐 reset period

Page 13
LOS e
➞ Interest Rate Swaps/
- evaluate
𝐁𝐏𝐕𝐬𝐰𝐚𝐩 - select
𝐁𝐏𝐕𝐀 + g𝐍𝐏 × h = 𝐁𝐏𝐕𝐋
𝟏𝟎𝟎
𝐁𝐏𝐕𝐀 = 𝐌𝐕𝐀 × 𝐃𝐀 × . 𝟎𝟎𝟎𝟏
𝐁𝐏𝐕𝐬𝐰𝐚𝐩 = 𝐃𝐬𝐰𝐚𝐩 × 𝟏𝟎𝟎 × . 𝟎𝟎𝟎𝟏 𝐁𝐏𝐕𝐋 = 𝐏𝐕𝐋 × 𝐃𝐋 × . 𝟎𝟎𝟎𝟏

➞ 𝐁𝐏𝐕𝐬𝐰𝐚𝐩 𝐁𝐏𝐕𝐍𝐏 = 𝐍𝐏 × 𝐃𝐬𝐰𝐚𝐩 × . 𝟎𝟎𝟎𝟏

= 𝐃𝐬𝐰𝐚𝐩 × . 𝟎𝟎𝟎𝟏
𝟏𝟎𝟎
𝐁𝐏𝐕𝐋 − 𝐁𝐏𝐕𝐀
∴ 𝐍𝐏 = × 𝟏𝟎𝟎 - hedging ratio:
𝐁𝐏𝐕𝐬𝐰𝐚𝐩
leave the duration gap ➞ 0%
gains
pay fx., rec. fl.
0% < Strategic hedging < 100%

close the duration gap ➞ 100%

r

losses rec. fx., pay fl.

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Page 14
➞ Interest Rate Options/ LOS e
pay fl. - evaluate
Buy ➞ Receiver swaption Known Cost
rec. fx. - select
gains
exercise if rates are
strike below strike
rates
- rec. strike, pay lower
cost of the MRR
losses receiver swaption

pay fx.
Buy ➞ Payer Swaption Known Cost
rec. fl.

exercise if rates are

strike
above the strike
rates
- pay strike, rec. higher MRR
cost of the
payer swaption

Page 15
➞ Interest Rate Options/ LOS e
pay fx. Rate Contingent - evaluate
Sell ➞ Receiver swaption
rec. fl. losses - select
gains
exercised if rates are
below strike
rates
- pay strike, rec. lower
MRR
losses

pay fl.
Sell ➞ Payer Swaption Rate Contingent losses
rec. fx.

exercised if rates are

above the strike
rates
- rec. strike, pay higher MRR

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Page 16
➞ Interest Rate Options/ LOS e
rec. fx. - evaluate
Swaption Collar Buy ➞ Receiver Swaption pay fl. - select

rec. fx.
Sell ➞ Payer Swaption
pay fl.

rates < 𝐫𝐚 ➞ exercise rec. fx., pay fl. swap

𝐫𝐚 𝐫𝐛
- get 𝐫𝐚 , pay lower MRR
𝐫𝐚 ≤ rates ≤ 𝐫𝐛 ➞ both swaptions OTM
rates > 𝐫𝐛 ➞ exercised rec. fx., pay fl. swap
- get 𝐫𝐛 , pay higher MRR
➞ Interest rate anticipation strategies/
- rates expected ↓ increase duration rates expected ↑ decrease duration
- long futures - sell futures
- rec. fx., pay fl. swap - rec. fl., pay fx. swap
- if 𝐁𝐏𝐕𝐚 > 𝐁𝐏𝐕𝐋 ➞ do nothing - if 𝐁𝐏𝐕𝐚 < 𝐁𝐏𝐕𝐋 - do nothing

Page 17
gains gains LOS e
- evaluate
- select
buy payer
swaption
swaption collar swaption
collar
B A C C A B
D
D buy receiver
swaption pay fixed
receive fixed
swap
swap
losses losses

rates < A ➞ rec. fx. swap rates > A ➞ pay fx. swap

A < rates < C ➞ swaption collar A > rates > C ➞ swaption collar

rate > D ➞ receiver swaption rates < D ➞ payer swaption

high conviction moderate conviction low conviction

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Page 18
➞ Risks in LDI/ LOS f
𝐁𝐏𝐕𝐀 × 𝚫𝐲𝐢𝐞𝐥𝐝𝐬𝐀 + 𝐁𝐏𝐕𝐇 × 𝚫𝐲𝐢𝐞𝐥𝐝𝐬𝐇 ≈ 𝐁𝐏𝐕𝐋 × 𝚫𝐲𝐢𝐞𝐥𝐝𝐬𝐋 - explain

100% hedge ratio

Model risk: whenever assumptions are made about future events and
approximations are used to measure key parameters (𝐁𝐏𝐕𝐚 , 𝐁𝐏𝐕𝐋 )

Measurement error: approximating portfolio duration using the weighted-

average of the individual durations of the component
bonds instead of the cash flow yield (𝐁𝐏𝐕𝐚 )
- also, 𝐁𝐏𝐕𝐇 ➞ an approximation is used %𝐁𝐏𝐕𝐂𝐓𝐃*𝐂𝐅+

Implicit assumption that ∆yields are equal for A, H, and L

- source of risk if assets, derivatives, and liabilities are
positioned at varying points along the curve and at
varying spreads (∆yield for A and L refer to various classes
of corporate bonds) L or A may be IG or HY

Page 19
➞ Risks in LDI/ LOS f
𝐁𝐏𝐕𝐀 × 𝚫𝐲𝐢𝐞𝐥𝐝𝐬𝐀 + 𝐁𝐏𝐕𝐇 × 𝚫𝐲𝐢𝐞𝐥𝐝𝐬𝐇 ≈ 𝐁𝐏𝐕𝐋 × 𝚫𝐲𝐢𝐞𝐥𝐝𝐬𝐋 - explain

100% hedge ratio

Spread risk: underlying of 𝐁𝐏𝐕𝐇 may be Treasuries, 𝐁𝐏𝐕𝐋 are typically corporate
obligations (𝛒HL < 1)
(IG corporate yields less volatile than Treasury yields)
- less volatility in the corporate/swap spread than the corporate/Treasury
spread
Counterparty credit risk: when not collateralized
- since 2008-09, OTC derivatives include a CSA:
Credit Support Annex (similar to margin)
- can be one-way (with zero or positive threshold) or two-way

Collateralization risk: the risk that available collateral becomes exhausted

Asset Liquidity: for CI, if active strategy fails

ex. #9

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Page 20
➞ Benchmarking to a bond index/ LOS g
- no specific ROR is targeted - discuss
- relative performance (match/exceed ROR of the index)

objective
- known as investing on a benchmark relative basis

1/ Pure indexing: full replication approach (zero tracking risk)

2/ Enhanced indexing: sampling – match primary risk factors (limited

tracking risk)
3/ Active management: deviation from primary risk factors

➞ Challenges of benchmarking
1/ fixed income markets are much larger and broader
- # of outstanding securities much larger
- much wider range of borrowers

Page 21
➞ Challenges of benchmarking LOS g
- discuss
1/ fixed income markets are much larger and broader
e.g. Bloomberg Barclays Global Aggregate ➞ IG debt in 24 currency markets
- more than 16,000 securities
US Aggregate (one of 4 regional aggregates)
- Treasuries, gov’t. agency, corporates, MBS, ABS, CMBS

- neither feasible nor cost-effective to pursue full replication

2/ Array of characteristics - maturity, ratings, put/call features, security,

subordination
- relative liquidity and performance characteristics may differ
greatly depending on how recently the bond was issued and
the magnitude of discount or premium

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Page 22
➞ Challenges of benchmarking LOS g
3/ Unique Issuance and Trading Patterns - discuss

- fixed income is a dealer market ➞ added cost of complying

with Basel-III capital requirements has lowered liquidity
- lower trading inventories, limited willingness to transact at
narrow bid-ask spreads, less willingness to handle block trades,
significant decline in proprietary trading
- many bonds do not trade at all or only a few times a year
< 1% trade daily

∴ pricing/valuation challenges
- matrix pricing ➞ creates variation between portfolios and
the index
4/ Index composition changes frequently - maturities, callability, new issues
- typically recreated monthly ➞ can change risk profiles

Page 23
LOS g
➞ Primary risk factors/
- discuss
1/ portfolio modified adjusted duration - EffDur, option-adjusted, Convexity
2/ Key rate duration - captures the effects of shifts at key points on the
- matching KRDs instead of just EffDur will reduce tracking risk YC

3/ Sector and quality percent - match the %’age weight in the various
sectors and qualities of the index (further away, greater
the tracking risk)

4/ Sector and quality spread duration - match the sector and quality
duration exposure (combined with #3 matches spread risk-
changes in yield for other than rate changes)

5/ Sector/coupon/maturity call weights – match the optionality exposure

of sectors

6/ Issuer exposure – match issuer-event risk

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Page 24
➞ PV of distribution of CFs (alternative to KRD matching) LOS g
- discuss
𝐏(𝐂𝐅𝐂 ) 𝐏(𝐂𝐅𝐂 ) 𝐏(𝐂𝐅𝐂 ) 𝐏(𝐂𝐅𝐂 ) ➞ callable
𝐢+𝐩 𝐢+𝐩 𝐢+𝐩 𝐢 + 𝐩 ➞ non callable
manager tries to CF1 CF2 CF3 CF4
duplicate this
PV semi-annual
(goal is to minimize periods
PV
tracking error)
PV

PV
∑PV called verticies
𝐏𝐕𝐂𝐅𝟏 𝐏𝐕𝐂𝐅𝟐
= %𝟏 = %𝟐 . . . .
𝚺𝐏𝐕 𝚺𝐏𝐕
contribution to
- each CF can be seen as a ZCB
duration
∴ Bond Index duration = (. 𝟓 × %𝟏 ) + (𝟏 × %𝟐 ) + (𝟏. 𝟓 × %𝟑 ) + ⋯

- portfolio being managed will be largely protected from deviations

from the benchmark associated with YC changes

Page 25
➞ Passive - assumes bond market expectations are correct, LOS h
so set the portfolio’s risk profile identical to the benchmark - compare
index’s risk profile
- Strategies/
1/ full replication (pure bond indexing) - reflects belief that:
a) active managers cannot consistently outperform
b) investor cannot identify a skilled manager in advance
or/ c) investor is not prepared to go through periods of underperformance
- produce a portfolio that is a perfect match to the index
- own all the bonds in the same %’age as the index
- very difficult and costly
- many issues are illiquid/infrequently traded - esp. non-Treasuries
- full replication rarely attempted in fixed-income

2/ enhanced indexing (sampling) – attempt to match the

primary risk factors and reach a higher return versus
full replication

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Page 26
2/ enhanced indexing (sampling) LOS h
- done by stratified sampling (cell approach) - compare

- reduces construction and maintenance costs

- larger tracking error vs. full replication
- enhanced indexing strategies
1/ lower cost enhancements - tight controls on trading costs and mgmt.
fees
- lower transaction costs by limiting the # of issues selected

2/ issue selection enhancements - identify and select undervalued

securities, select possible ‘credit upgrade’ issues, avoid
possible ‘credit downgrade’ issues

3/ yield curve enhancements - overweight the undervalued areas

of the curve, underweight the overvalued areas

Page 27
2/ enhanced indexing (sampling) LOS h
- compare
- enhanced indexing strategies
4/ Sector/quality enhancements - periodic over/under-weighting of
sectors/qualities across the business cycle
e.g. overweight Treasuries when spreads are expected to widen

5/ Call exposure enhancements - underweight callable bonds if

rates are expected to drop
- a drop in rates may cause a callable bond to shift from being
priced on a YTM basis to a yield-to-call basis (neg. Convex.)

- Alternatives to direct investing/

FI mutual funds - lower investment requirement without sacrificing
diversification
- redemption at NAV rather than a need to sell particular
securities

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Page 28
LOS h
- Alternatives to direct investing/
- compare
ETFs - greater liquidity vs. MFs and vs. underlying bonds

TRS - total return swap - synthetic index position

- carries counterparty risk
- less initial cash outlay than direct investment plus exposure
to difficult-to-access securities
LOS i
- qualities of an index:
- discuss
1/ unambiguous - the identities and weights of the - justify
benchmark components are clearly defined (clear, transparent
rules for security inclusion and weighting)
2/ Investable

3/ Measurable - benchmark returns are readily calculable on a reasonably

frequent basis

Page 29
LOS i
- finite nature of bonds in a portfolio imply that duration - discuss
will drift downward over time - justify
- rebalancing continually required to match duration

- bond index risk characteristics will reflect bond issuer propensity and
preferences - low rates favour long-term issues
- index will be dominated by these maturities

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Yield Curve Strategies

a. describe the factors affecting fixed-income portfolio returns due to a change

in benchmark yields;

b. formulate a portfolio positioning strategy given forward interest rates and an

interest rate view that coincides with the market view;

c. formulate a portfolio positioning strategy given forward interest rates and an

interest rate view that diverges from the market view in terms of rate level,
slope and shape;

d. formulate a portfolio positioning strategy based upon expected changes in

interest rate volatility;

e. evaluate a portfolio’s sensitivity key rate durations of the portfolio and its
benchmark;

f. discuss yield curve strategies across currencies;

g. evaluate the expected return and risks of a yield curve strategy.

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Yield Curve Strategies

LOS a (7p) Key YC and FI Concepts - describe

Portfolio Positioning
LOS b (6p) Stable Curve

LOS c (11p) Dynamic Curve formulate

LOS d (5p) ∆Volatility (Interest Rate)

LOS e (2p) KRDs for a Portfolio - evaluate

LOS f (7p) Active FI Mgmt. Across Currencies - discuss

LOS g (4p) Evaluate YC Strategies - evaluate

Page 1
E(R) ≈ Coupon Income LOS a
+⁄− Rolldown Return - describe
+⁄− E(∆price due to investor’s view of benchmark yields)
+⁄− E(∆price due to investor’s view of yield spreads)
+⁄− E(∆price due to investor’s view of currency value changes)

maturity gaps ➞ require interpolation

➞ stylized YC
on-the-run vs. off-the-run

KRs less liquid

-
-
-
-
-
-
-

5 yr. inclusion would pull YC higher

may not be derived from a traded security

- must be derived from available YTMs using some type of model

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Page 2
e.g./ Constant Maturity Yield - estimates what a T-yr. LOS a
bond YTM would be if a bond were available - describe
with exactly T-years to maturity
- different models can produce different YCs
- this difference more pronounced as YTMs (par rates) are
converted to spot and forward rates

amplify par curve steepness and curvature

➞ Primary YC risk factors: levels (parallel movements) 82%

slope (steepening, flattening twists) 12%
2s30s spread shape (butterfly movement) 4%
- higher = steeper of UST ∆yields
- lower = flatter butterfly spread = -s.t.y + 2 x m.t.y - L.t.y
- negative = inverted (2) (10) (30)

- larger positive values = more curvature

Page 3
➞ Primary YC risk factors: LOS a
- describe
more curvature = positive butterfly spread
- not to be confused with a positive butterfly shift
· but negative
➞ E(∆price from ∆curve) butterfly spread

%∆𝐏𝐕𝐟𝐮𝐥𝐥 ≈ −(𝐌𝐨𝐝𝐃𝐮𝐫 × ∆𝐲𝐢𝐞𝐥𝐝) + p𝟏G𝟐 × 𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲 × (∆𝐲𝐢𝐞𝐥𝐝)𝟐 q

𝐉
𝐌𝐕𝐣
- PMs tend to use: Avg.ModDur = / 𝐌𝐨𝐝𝐃𝐮𝐫𝐣 6 7
𝐌𝐕𝐏
𝐣$𝟏 approximations
𝐉
𝐌𝐕𝐣 only
Avg.Convexity = / 𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲𝐣 6 7
𝐌𝐕𝐏
𝐣$𝟏
more important consideration
for portfolio performance convexity mgmt. more closely associated
with YC slope and shape changes
Recall: for convexity
- long maturity bonds have higher convexity
- the greater the dispersion of CFs, the higher the convexity

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Page 4
Recall: for convexity LOS a
- high convexity portfolio will outperform a - describe
lower convexity portfolio of similar duration for a ∆rates
- will also have lower yield
LOS b-e
➞ Expectations of a static YC (upward sloping)
- formulate
- add duration or use leverage - evaluate

1) Buy and hold - buy bonds with a duration greater than the
benchmark (higher coupon income)
- may involve less liquid (higher YTM) bonds i.e. off-the-run

2) Rolling down the YC - coupon income + capital appreciation by

selling the bond at a higher price

(upward sloping curve, so shorter maturity bond will have

a lower YTM, ∴ higher price)

Page 5
➞ Expectations of a static YC (upward sloping) LOS b-e
- formulate
2) Rolling down the YC - buy a bond with a maturity
- evaluate
beyond the IH ➞ total return greater than a
maturity-matching strategy

3) Repos - buy a bond financed in the repo market (adds leverage)

e.g./ buy $1000 bond, sell in repo market, get back $980
($20 - haircut)
($20 to control $1000)
(Coupon Income + Rolldown Return) - Repo rate

- Derivatives-based/
1/ Long futures position (∆price for a ∆yield) - margin cost

(∆price CTD)/CF

- requires up-front margin + MTM valuation

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Page 6
- Derivatives-based/ LOS b-e
2/ Receive-fixed swap swap rate(fx.) - MRR - formulate
+ ∆swap MTM for a ∆yield - evaluate

Ex. #1 Portfolio A: $50M , ModDur 4.880 , Convexity 26.5

𝐃𝐀 = 𝐃𝐁
Portfolio B: 58.94% - 2 yr. ➞ ModDur 1.994, Convexity 5.0
41.06% - 10 yr. ➞ ModDur 9.023, Convexity 90.8

+∆50bps? A: -(4.880 x .005) + (.5 x 26.5 x .0052) = -2.407%

B: .5894(-1.994 x .005) + (.5 x 5 x .0052)
+ .4106(-9.023 x .005) + (.5 x 90.8 x .0052) = -2.390%

-∆50bps A: +2.473% B: +2.490%

- Portfolio B ➞ replicate the 10-yr. bond with futures

41.06% x 50M = $20.53M CTD: PV = 100,000 ModDur = 8.84
ModDur = 9.023 CF = .684
BPV = 20.53 x 9.023 x .0001 = 18,524 𝐁𝐏𝐕𝐅 = (8.84 x 100k x .0001)/.684 = 129.24

Page 7
- Derivatives-based/ 𝐁𝐏𝐕𝟏𝟎𝐲𝐫. = 18,524 𝐁𝐏𝐕𝐅 = 129.24 LOS b-e
- formulate
𝐍𝐟 = 𝟏𝟖, 𝟓𝟐𝟒G𝟏𝟐𝟗. 𝟐𝟒 = 𝟏𝟒𝟑 long futures contracts - evaluate

Example 3/ ① Buy 10-yr., 2.25% semi @ 93.947067 (YTM = 2.9535%)

② 10 yr. rec. fx. swap at 2.8535% with semi-annual resets

6-mos. MRR = .5925%

- 6 mos. IH, £100M par value portfolio, YTM ↓ 50bps, 𝐫𝐟𝐱 ↓ 50bps.

① Coupon Income: 100M x . 𝟎𝟐𝟐𝟓G𝟐 = 1,125,000

Rolldown Return: 𝐈G𝐘 = 𝟐. 𝟗𝟓𝟑𝟓G𝟐 , N = 19, PMT = 1.125M , FV = 100M
CPT PV = 94,209,430.70 (+262,363)
E(∆price/∆yield) 𝐈G𝐘 = 2.4535/2, N = 19, PMT = 1.125M , FV = 100M
CPT PV = 98,284,846 (+ 4,075,415)

34
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Last Revised: 05/10/2022

Page 8
Example 3/ ② 10 yr. rec. fx. swap at 2.8535% with LOS b-e
- formulate
semi-annual resets 6-mos. MRR = .5925%
- evaluate
- 6 mos. IH, £100M par value portfolio, YTM ↓ 50bps, 𝐫𝐟𝐱 ↓ 50bps

Swap Carry: [(2.8535% - .5925%)/2] x 100M (+ 1,130,500)

MTM: 𝐏𝐕𝐟𝐥 = par

𝐏𝐕𝐟𝐱 = (N = 19, 𝐈G𝐘 = 2.3535/2, PMT = 2.8535M/2, FV = 100M)
CPT PV = 104,234,260 (+ 4,234,260)

➞ Dynamic Yield Curve/ ➞ Rate Level

- rates expected to drop

1/ extend duration with longer-dated bonds
(-ModDur x ∆yield)

higher = greater price appreciation

Page 9
➞ Dynamic Yield Curve/ LOS b-e
- rates expected to drop - formulate
- evaluate
2/ Receive fixed swap - carry + MTM gain

3/ Long futures - MTM gains

- rates expected to rise

1/ reduce duration with shorter maturity bonds (or short sales of
long-maturity bonds)
smaller price declines
versus index

2/ Pay fixed swap (MRR - 𝐫𝐟𝐱 ) + MTM gains

3/ short futures MTM gains

- Derivative strategies tend to be favoured over buying/selling in the

portfolio
- esp. with short positions

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Page 10
➞ Dynamic Yield Curve/ ➞ Slope LOS b-e
- barbell (generalized) ➞ short-term and long-term - formulate
- evaluate
positions move in opposite directions
-∆level (bullish) +∆level (bearish)
+⁄− ∆slope +∆slope (steepener) -∆slope (flattener)
bear bear
steeper steepener
flattener

flatter bull
bull flattener
steepener

∆slope or (∆level + ∆slope) ➞ long or short positions in both

short and long maturities

- Steeper ➞ long short-maturity, short long-maturity (flatter ➞ opposite)

Page 11
➞ Dynamic Yield Curve/ ➞ Slope
LOS b-e
Recall Ex. #1: 2y ➞ 58.94% 10 yr. ➞ 41.06% (DP = 100% 5 yr.) - formulate
- if 𝐌𝐕𝐏 = 127.6M: 2y = 75.207M 10 yr. = 52.393M - evaluate
buy 𝟖𝟖. 𝟓𝟗𝟑𝐌 sell 𝟖𝟖. 𝟓𝟗𝟑𝐌
𝟏𝟔𝟑. 𝟖𝐌 −𝟑𝟔. 𝟐𝐌
- Steepeners/ 1/ Duration neutral - long short maturity, short long maturity
e.g./ Tenor Coupon MV D Conv.
long 2y .25% 163.8M 1.994 5.0
short 10y 2.00% -36.2M 9.023 90.8
127.6M
𝐃𝐏 = 𝟏. 𝟗𝟗𝟒 × O𝟏𝟔𝟑. 𝟖*𝟏𝟐𝟕. 𝟔P + 𝟗. 𝟎𝟐𝟑O−𝟑𝟔. 𝟐*𝟏𝟐𝟕. 𝟔P = 𝟐. 𝟓𝟓𝟗𝟔𝟗 + (−𝟐. 𝟓𝟓𝟗𝟖) ≈ 𝟎
𝐂𝐨𝐧𝐯𝐏 = 𝟓. 𝟎 × O𝟏𝟔𝟑. 𝟖*𝟏𝟐𝟕. 𝟔P + 𝟗𝟎. 𝟖O−𝟑𝟔. 𝟐*𝟏𝟐𝟕. 𝟔P = 𝟔. 𝟒𝟏𝟖𝟒𝟗𝟓 + (−𝟐𝟓. 𝟕𝟓𝟗𝟖) ≈ −𝟏𝟗. 𝟑𝟒
slope + 50bps 2 yr.(-1.994 x -.0025) + (𝟏)𝟐 x 5 x .00252) x 163.8M = 819,102
2y - 25bps
10y + 25bps
10 yr.(-9.023 x .0025) + (𝟏)𝟐 x 90.8 x .0025)2 x -36.2M = 826,310
➞ for any steepening combination of ∆slope 1,645,412

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Page 12
➞ Dynamic Yield Curve/ ➞ Slope
LOS b-e
- Steepeners/ 2/ Bull steepener - formulate
- s.t. yields fall by more than L.t. yields - evaluate

- same example but add $50M to the long 2-yr.

net long D
𝐃𝐏 = 𝟏. 𝟗𝟗𝟒\𝟐𝟏𝟑. 𝟖G𝟏𝟕𝟕. 𝟔^ + 𝟗. 𝟎𝟐𝟑\−𝟑𝟔. 𝟐G𝟏𝟕𝟕. 𝟔^ = 𝟐. 𝟒 + (−𝟏. 𝟖𝟑𝟗𝟏𝟒𝟕) ≈ . 𝟓𝟔𝟏𝟑
𝐂𝐨𝐧𝐯𝐏 = 𝟓. 𝟎\𝟐𝟏𝟑. 𝟖G𝟏𝟕𝟕. 𝟔^ + 𝟗𝟎. 𝟖\−𝟑𝟔. 𝟐G𝟏𝟕𝟕. 𝟔^ = 𝟔. 𝟎𝟏𝟗 − 𝟏𝟖. 𝟓𝟎 ≈ −𝟏𝟐. 𝟒𝟖𝟗
𝐃𝐍 +D
2 yr. - 25bps +819,102 + 1,069,133 -∆level
10 yr. - 25bps -826,853 - 826,853
(7751) 242,280 - + 250,031
2 yr. - 50bps 1,643,323 2,144,948 -∆level (40bps)
10 yr. - 25bps - 826,853 - 826,853 +∆slope (25bps)
816,470 1,318,095 ➞ + 501,625
2 yr. - 75bps 2,472,653 3,227,444 -∆level (60bps)
10 yr. - 50bps -1,674,250 -1,674,250 +∆slope (25bps)
798,403 1,553,194 ➞ + 754,791

Page 13
➞ Dynamic Yield Curve/ ➞ Slope LOS b-e
- Steepeners/ 3/ Bear steepener - L.t. yields rise by more - formulate
than s.t. yields - evaluate

- net negative duration position (reduce long pos. or add

- gain from rates ↑ (-D) to short pos.)

- gain from steepening

- Flatteners/
1/ Duration neutral - short short-maturity, long long-maturity
- gain from slope decrease
2/ Bull flattener - net positive duration (L.t. yields drop by more
- gain from slope decrease than s.t. yields)
- gain from rates ↓ (+D)
3/ Bear flattener - net negative duration position (s.t. yields rise
- gain from slope decrease by more than L.t. yields)
- gain from rates ↑ (-D)

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Page 14
➞ Dynamic Yield Curve/ ➞ Shape LOS b-e
- formulate
Butterfly spread: -2y + 2 x 10 yr. - 30 yr. - evaluate
(10y - 2y > 30y - 10 yr.) ∴ Btfly. spread usually positive

wings up wings down

positive negative
butterfly butterfly
twist twist
(but neg. btfly. (but pos. btfly.
spread) spread)
short mid. long (maturities) short mid. long (maturities)

- long the bullet (body) - short the bullet

- short the barbell (wings) - long the wings

- butterfly trades add convexity

Page 15
➞ Dynamic Yield Curve/ ➞ Volatility LOS b-e
- formulate
value of call - evaluate

𝐏𝐕_ − 𝐏𝐕)
𝐄𝐟𝐟𝐃𝐮𝐫 =
100 putable 𝟐 ∆𝐜𝐮𝐫𝐯𝐞 𝐏𝐕𝟎
value of put
neg. 𝐏𝐕( + 𝐏𝐕) − 𝟐𝐏𝐕𝟎
option free
conv. 𝐄𝐟𝐟𝐂𝐨𝐧𝐯. =
callable (∆𝐜𝐮𝐫𝐯𝐞)𝟐 𝐏𝐕𝟎

Put/call options on bonds ➞ based on bond’s price

rates ↓, P ↑ ∴ long call (+D)
rates ↑, P ↓ ∴ long put (-D)
Swaptions ➞ rates ↑ Buy payer (pay fx., rec. fl.) (-D)
rates ↓ Buy receiver (pay fl., rec. fx.) (+D)

Put/call options on futures ➞ same effect as options on bonds Ex. #8/9/10

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Page 16
➞ Dynamic Yield Curve/ ➞ Key Rate Durations LOS b-e
- formulate
- measures portfolio sensitivity over multiple
- evaluate
maturities
%∆𝐏𝐕𝐟𝐮𝐥𝐥 = −𝐊𝐑𝐃 × ∆𝐫𝐤
−𝟏 ∆𝐏𝐕
𝐊𝐑𝐃 = ∆𝐏𝐕
𝐏𝐕 ∆𝐫𝐤 = −𝐊𝐑𝐃 × ∆𝐫𝐤 (x PV)
𝐏𝐕
𝐧
∆𝐏𝐕 = −𝐊𝐑𝐃 × ∆𝐫𝐤 × 𝐏𝐕 (x - 1)
1 𝐊𝐑𝐃𝐤 = 𝐄𝐟𝐟𝐃𝐮𝐫
𝐊&𝟏 −∆𝐏𝐕 = 𝐊𝐑𝐃 × ∆𝐫𝐤 × 𝐏𝐕 (÷ ∆𝐫𝐤 )
−∆𝐏𝐕
𝐊𝐑𝐃 × 𝐏𝐕 = (÷ PV)
∆𝐫𝐤

Ex. #11

Page 17
➞ extending from a single YC to multiple YCs LOS f
𝐑 𝐃𝐂 = (𝟏 + 𝐑 𝐅𝐂 )(𝟏 + 𝐑 𝐅𝐗 ) - discuss

- differences in inflation,
Country A economic growth, Country B
monetary/fiscal
policy, etc..

𝐒𝐀O
𝐁

- stable or 𝟏 + 𝐢𝐀 %
𝐝𝐚𝐲𝐬* - stable or
𝟑𝟔𝟎+
dynamic 𝐂𝐈𝐑𝐏: 𝐅𝐀6 = 𝐒𝐀6 ^
𝐝𝐚𝐲𝐬*
_ dynamic
𝐁 𝐁
- forecast for 𝟏 + 𝐢𝐁 % 𝟑𝟔𝟎 + - forecast for
levels (𝟏 + 𝐫𝐀 )𝐓 levels
slope 𝐨𝐫 𝐅𝐀6 = 𝐒𝐀6 slope
𝐁 𝐁 (𝟏 + 𝐫𝐁 )𝐓
shape shape

using a forward to fully hedge foreign cash flows

will earn the domestic 𝐫𝐟

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Page 18
In general, higher yielding currencies will trade at LOS f
a forward discount - discuss
forward discount
(𝟏 + 𝐢𝐏 )𝐓 (𝟏 + 𝐢𝐏 )𝐓
𝐅𝐏O
𝐁
= 𝐒𝐏O
𝐁 (𝟏 + 𝐢𝐁 )𝐓
➞ 𝐢𝐟 𝐢 𝐁 > 𝐢 𝐏 ,
(𝟏 + 𝐢𝐁 )𝐓
< 𝟏 𝐚𝐧𝐝 𝐅𝐏O < 𝐒𝐏O
𝐁 𝐁

(𝟏 + 𝐢𝐏 )𝐓
𝐢𝐟 𝐢𝐁 < 𝐢𝐏 , > 𝟏 𝐚𝐧𝐝 𝐅𝐏O > 𝐒𝐏O
(𝟏 + 𝐢𝐁 )𝐓 𝐁 𝐁
forward premium
- UIRP ➞ implies same result as CIRP
➞ investing in foreign country assets with a higher yield will still
return the domestic country’s yield as 𝐒𝐝0 declines to equate
𝐟
risk-adjusted returns
i.e. forward rates are unbiased predictors of future spot rates

forward rate bias ➞ premiums tend to

overstate and discounts tend to
x x
premium discount understate actual currency moves

Page 19
∴ since UIRP does not hold, carry trades are possible LOS f
- discuss
- buy securities in high yielding currencies and finance
this with borrowing in low yielding currencies (unhedged)

- risks ➞ YC movements in both countries

➞ depreciation of high yielding currency

high yielding currency low yielding currency

rec. fx. pay fx.
rec. fx. pay fl.
Ex. #12/13
rec. fl. pay fl.
rec. fl. pay fx.

LOS g - evaluate Ex. #14-16

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Fixed-Income Active Management: Credit Strategies

a. describe risk considerations for spread-based fixed-income portfolios;

b. discuss the advantages and disadvantages of credit spread measures for

spread-based fixed-income portfolios, and explain why option-adjusted
spread is considered the most appropriate measure;

c. discuss bottom-up approaches to credit strategies;

d. discuss top-down approaches to credit strategies;

e. discuss liquidity risk in credit markets and how liquidity risk can be
managed in a credit portfolio;

f. describe how to assess and manage tail risk in credit portfolios;

g. discuss the use of credit default swap strategies in active fixed-income

portfolio management;

h. discuss various portfolio positioning strategies that managers can use to

implement a specific credit spread view;

i. discuss considerations in constructing and managing portfolios across

international credit markets;

j. describe the use of structured financial instruments as an alternative to

corporate bonds in credit portfolios;

k. describe key inputs, outputs, and considerations in using analytical tools to

manage fixed-income portfolios.

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Last Revised: 05/10/2022

Credit Strategies

LOS a (9p) Key Credit and Spread Concepts - describe

LOS b (15p) Credit Spread Measures - discuss/explain

LOS c (8p) Bottom-Up Credit Strategies - discuss

LOS d (6.5p) Top-Down Credit Strategies - discuss

LOS e (2p) Liquidity Risk - discuss

LOS f (2.5p) Tail Risk - describe

LOS g (6p) Synthetic Credit Strategies - discuss

LOS h (9.5p) Credit Spread Curve Strategies - discuss

LOS i (4.5p) Global Credit Strategies - discuss

LOS j (2.5p) Structured Credit - describe

LOS k (2.5p) Fixed-Income Analytics - describe

Page 1
➞ focus: E(∆price due to investor’s view of yield spreads) LOS a
- describe
~(𝐘𝐓𝐌𝐛𝐢𝐝 − 𝐘𝐓𝐌𝐚𝐬𝐤 )
yield liquidity premium varies based on
spread + credit risk market conditions
YTM
𝐫𝐟 credit risk has 2 key components
1) default risk (POD) ➞ %’age in annual terms
2) loss severity (LGD) ➞ %’age of par

Spread ≈ LGD x POD (one period credit spread)

one period CDS swap, no upfront
∴ POD ≈ 𝐒𝐩𝐫𝐞𝐚𝐝G𝐋𝐆𝐃
payment ➞ default only possible
one period POD at maturity
PMT PMT PMT CDS Spread ≈ (1 - RR) x POD
𝐘𝐓𝐌𝐂 − 𝐘𝐓𝐌𝐆 = 𝐒𝐩𝐫𝐞𝐚𝐝
L2

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Page 2
- credit loss rate: realized %’age of par value lost to LOS a
default from a group of bonds ➞ LGD - describe

∴ POD = (𝐘𝐓𝐌𝐂 − 𝐘𝐓𝐌𝐆 )y𝐥𝐨𝐬𝐬 𝐫𝐚𝐭𝐞

𝐜𝐫𝐞𝐝𝐢𝐭 𝐫𝐚𝐭𝐢𝐧𝐠

rises as the depends on the bond’s relative position

economy slows in the capital structure and whether it is
(see exh. #3) secured or unsecured (see exh. #4)
- will also depend on economic conditions

➞ Credit Migration: changes in a bond’s public credit rating

(typically neg. effect on bond prices)
- P(downgrade) > P(upgrade)
- yield spread decreaseupgrade < yield spread increasedowngrade

from exh. #5 AAA A B

POD .03% .14% 7.83%
downgrade 16.22% 8.81% 5.22%

Page 3
LOS a
IG - higher credit ratings, lower default risk, higher - describe
recovery rates, lower all-in YTMs, less impact from adverse
market events
➞ Credit Spread Curves: portfolio positioning to capitalize on
expected curve changes - level
- slope
- spread curves usually categorized by rating, issuer type, and/or
Spread corporate sector
(over gov’t.
bond or swap
- downgrade/default
curve)
probabilities that are
maturities equally likely over time
- low near-term POD or likelihood
of downgrade that rises over time

- curve changes are driven by the credit cycle

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Page 4
LOS a
- describe

lower rated issuers tend to

experience greater slope
and level changes over
the cycle
higher-rated issuers ➞ smaller spread changes
➞ upward sloping credit curves

➞ spread differences between rating categories tend to narrow during

periods of strong economic growth and widen when growth is expected
to slow

Page 5
ModDur/EffDur for HY bonds tends to overstate LOS a
- describe
%∆𝐏𝐕𝐟𝐮𝐥𝐥 for ∆rates
- neg. corr. between credit spreads and rates (more so for HY)
- the magnitude of credit spread changes is greater for HY vs. IG
➞ Empirical duration a better estimate of expected realized changes

Note Ex. #3: = MDURATION(DATE(2022,1,1), DATE(2027,1,1),6.75%, 5.40%,2,0)

= PRICE(DATE(2022,1,1), DATE(2027,1,1),6.75%, 5.40%, 100,2,0)
redemption

LOS b
Fixed Rate Bonds ➞ yield spread/G/I/ASW/Z/CDS basis/OAS
- discuss
Floating Rate Bonds ➞ QM/DM/Z-DM
Portfolio Level ➞ DTS/EXR
March
‘Credit Spreads Explained’ ➞ 2004 Dominic O’Kane
(Lehman Bros.) Saurav Sen

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Page 6
Fixed-Rate Bond Credit Spread Measures LOS b
- discuss
1/ yield spread (a.k.a. yield-yield spread)
- explain
Corporate YTM - nearest on-the-run Treasury yield
(similar, but not necessarily identical)

- has curve slope and maturity mismatch bias

- will not be a good measure of carry (i.e. long credit, short UST)
(return) (D hedge)
- only useful in relative value for bonds of identical maturity
- benchmark security can change over time

2/ G-spread - uses constant maturity T-yields as the benchmark

- maturity yields are interpolated (Ex. #4)

3/ I-spread - uses interest rate swap rates as the benchmark

- quoted across all maturities
- based on MRR - transaction-based, secured overnight funding rate
(vs. Libor - survey-based, unsecured, overnight funding)

Page 7
3/ I-spread - can be used as a duration hedge directly LOS b
- can more accurately measure carry return - discuss
- explain
for a leveraged position
- better used as a way to express the price of a bond
relative to a curve (YTM-based, so not a very good
measure of credit risk)

4/ ASW - asset swap spread

- asset swaps convert a bond’s fixed coupon rate to MRR +⁄− spread
(Coupon rate - fixed rate) + MRR
for a bond at or very of a fx.-fl. swap that matches the coupon dates
close to par for the remaining life of the bond

- full duration hedge ∴ low/no price volatility

- get MRR + ASW Ex. #5

better measure of credit risk over MRR

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Page 8
5/ Z-spread (zero volatility) - constant spread over LOS b
spot (or swap) rates, not YTMs - discuss
- explain
𝐏𝐌𝐓 𝐏𝐌𝐓 𝐏𝐌𝐓 + 𝐏𝐕
𝐏𝐕 = + + ⋯+
(𝟏 + 𝐳𝟏 + 𝐙) (𝟏 + 𝐳𝟐 + 𝐙) 𝟐 (𝟏 + 𝐳𝐧 + 𝐙)𝐍
different discount rate for each CF
(I & G use the same discount factor/CF)
- more accurate than G or I

6/ CDS basis - difference between the Z-spread on an issue and the

CDS spread of the same maturity for the same issuer
- basically difference in spread between the cash market and
derivative market

CDS spread < bond Z-spread = negative basis

(CDS spread - Z-spread)
- sets up a negative basis trade ➞ buy bond, buy CDS

Page 9
7/ OAS - option adjusted spread - constant spread over forward LOS b
rates in a tree (or model) that equates bonds with - discuss
embedded options with their price - explain

- takes account of the shape of term structure

- can compare ➞ option-free, callable, putable, and structured FI securities
- highly dependent on volatility and model assumptions Ex. #6

Floating-Rate Note Credit Spread Measures/

Recall LI: (𝐌𝐑𝐑 + 𝐐𝐌) × 𝐅𝐕 (𝐌𝐑𝐑 + 𝐐𝐌) × 𝐅𝐕
𝐦 𝐦 + 𝐅𝐕
𝐏𝐕 = + ⋯ +
𝐌𝐑𝐑 + 𝐃𝐌 𝟏 𝐌𝐑𝐑 + 𝐃𝐌 𝐍
R𝟏 + 𝐦 W R𝟏 + 𝐦 W

QM = quoted margin DM = discount margin

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Page 10
Floating-Rate Note Credit Spread Measures/ LOS b
- discuss
QM - quoted margin - yield spread over MRR on issuance - explain
- does not (generally) reflect credit risk changes over time
DM - discount margin - reflects changes in credit risk
QM = DM QM > DM QM < DM Ex. #8
FRN price = par premium discount

➞ Z-DM (zero discount margin) incorporates forward MRR

(𝐌𝐑𝐑 + 𝐐𝐌) × 𝐏𝐕 (𝐙𝟐 + 𝐐𝐌) × 𝐏𝐕 (𝐙𝐧 + 𝐐𝐌) × 𝐅𝐕
𝐦 𝐦 𝐦 + 𝐅𝐕
𝐏𝐕 = + + ⋯ +
𝐌𝐑𝐑 + 𝐙 − 𝐃𝐌 𝟏 𝐙𝟐 + 𝐙 − 𝐃𝐌 𝟐 𝐙𝐧 + 𝐙 − 𝐃𝐌 𝐍
R𝟏 + 𝐦 W R𝟏 + 𝐦 W R𝟏 + 𝐦 W

- for upward sloping YC, Z-DM < DM

DM similar to YTM measure
expresses price of FRN relative to the current MRR level
does not take into account the shape of the YC ➞ Z-DM does
(very close to DM)

Page 11
LOS b
- discuss
➞ Portfolio Level impacts of yield spreads/
- explain
%∆𝐏𝐕𝐩𝐨𝐫𝐭𝐟𝐨𝐥𝐢𝐨 ≈ −(𝐄𝐟𝐟𝐃𝐮𝐫 × ∆𝐬𝐩𝐫𝐞𝐚𝐝) + 𝟏G𝟐 × 𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲 × ∆𝐬𝐩𝐫𝐞𝐚𝐝𝟐 )

typically means OAS

- portfolios will have both option-free and
embedded option bonds
∴ most appropriate measure for a portfolio level spread is OAS
𝐍
𝐌𝐕𝐢
Average OAS ➞ portfolio’s credit quality 1 𝐎𝐀𝐒𝐢 2 3
𝐌𝐕𝐏
𝐢&𝟏
- will not account for credit spread volatility
e.g./ 𝐏𝟏 ➞ 30 yr. bonds, Avg. OAS = 100 𝐏𝟐 ➞ 2 yr. bonds, Avg. OAS = 100
𝐍
𝐌𝐕𝐢
Average SD ➞ portfolio’s spread duration 1 𝐒𝐃𝐢 2 3
𝐌𝐕𝐏
𝐢&𝟏
DTS - duration x spread ➞ attempts to account for both avg. OAS and avg. SD

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𝐍
Page 12
𝐌𝐕𝐢 LOS b
𝐃𝐓𝐒𝐏 = 1 𝐃𝐓𝐒𝐢 2 3 𝐰𝐡𝐞𝐫𝐞 𝐃𝐓𝐒 = 𝐎𝐀𝐒 × 𝐒𝐃 - discuss
𝐌𝐕𝐏
𝐢&𝟏 Ex. #11 - explain
Excess (spread) return ➞ return on a bond after interest rate risk
has been hedged
➞ objective then is to select bonds with the highest EXR
XR

EXR = (𝐭 × 𝐒𝐩𝐫𝐞𝐚𝐝𝐝 ) − (∆𝐒 × 𝐒𝐃) − (𝐭 × 𝐏𝐎𝐃 × 𝐋𝐆𝐃)

annualized POD
time in original change spread Ex. #12
years spread in spread duration at horizon end
(holding period)
- active credit managers typically manage interest rate risk and
credit related risks separately
- Note: for FRNs ➞ Rate duration very low
➞ Spread duration ~ SD of a fixed rate bond with same
maturity

Page 13
LOS c
➞ Bottom-Up Credit Strategies/ - discuss

Define the credit universe - the eligible bonds within a mandate

- grouped into categories that allow for relative value
analysis
(e.g. Industry sectors/sub-sectors)
- PM prefers company-level risk exposure rather than industry or
macro risk exposure to be the dominant risk factor
- compare company-specific financial information to spread-related
compensation
competitive position within the industry
operating history EBITDA/TA - profitability
financial ratios (Exh. #16) Debt/Capital - leverage
EBITDA/Int. Exp. - coverage
- use of structural credit models ➞ based on the structure of the BS.
E = max.(A-L, 0) D = max.(𝐃𝐓 , 𝐀𝐓 )
reduced form credit models ➞ solve for POD

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Page 14
reduced form credit models LOS c
➞ e.g. Altman Z-score Ex. #14 - discuss

- lower scores = higher likelihood of financial distress

➞ Bottom-up relative value analysis/

- use of EXR = (𝐭 × 𝐒𝐝 ) − (∆𝐒𝐏 × 𝐒𝐃) − (𝐭 × 𝐏𝐎𝐃 × 𝐋𝐆𝐃) Ex. #16

- other considerations: optionality, capital structure priority,

liquidity (bid-ask spread) for short IHs,
long IH ➞ liquidity would add to EXR,
rating outlook, possible M&A activity
- issuers with several bonds ➞ can construct credit spread curves Ex. #17
- can be used for relative value analysis among
companies with similar credit ratings (Exh. 18)

Page 15
➞ Top-Down Credit Strategies/ - focus on a broader set LOS d
of factors affecting the bond universe - discuss

(economic growth, real rates + inflation, corporate profits, default rates,

market volatility, risk appetite, recent credit spread changes, industry
trends, geopolitical risks, currency movements)
- determine the desired credit quality of the portfolio - lower or
higher than the benchmark
influenced 1) credit cycle expectations both influenced by
by: 2) credit spread change expectations macro factors

- expectations of ↑ GDP growth ⇒ expectations for lower default rates +

smaller credit spreads ➞ overweight lower credit quality
- now determine which sectors of the credit market have
attractive relative value ➞ overweight

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Page 16
➞ Assessing Credit Quality in a Top-Down Approach/ LOS d
- discuss
- once desired credit quality is determined, assess credit quality
of current portfolio
- bond risks do not change in a linear manner across credit rating
categories
i.e. default risk increases more quickly as an issuer’s credit rating declines
- use of non-arithmetic weightings can handle this non-linearity
ordinal weighted
50% A1/A +
5 70
e.g. P
50% Ba3/BB- 13 1766
18 1836
Avg. = 9 ➞ Baa2/BBB Avg. = 918 ➞ Ba1/BB+
➞ considering credit rating limitations (tend to lag the market), measures
like average OAS, average SD, and DTS are preferred
- spread-based measures also facilitate measurement of ∆PV (% or $)
Ex. #18

Page 17
- consideration can also be given to: LOS d
Factor-based portfolios - key factors affecting credit spreads - discuss

measured by
Carry - E(R) if POD is unchanged OAS
Defensive ➞ exposure to safer low-risk Market-based leverage
assets profitability
(deliver higher risk-adjusted return) low duration
Momentum ➞ bonds with higher recent trailing 6-mos. excess bond and
returns (outperform) equity returns
Value - low MV versus fundamental value Spread - POD

ESG considerations
screening ➞ exclude unfavourable issuers
ESG rating ➞ target favourable issuers (ESG and credit ratings
tend to be positively correlated)
Issuers that directly fund ESG initiatives ➞ green bonds

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Page 18
➞ Liquidity Risk/ - credit market liquidity relies heavily LOS e
on dealers and their inventory levels - discuss

- TRACE ➞ Trade Reporting and Compliance Engine (US credits)

- tracks real-time price and volume for bond transactions

- managing liquidity risk:

a) favour on-the-run gov’t. bonds or most recently issued credits for
short-term tactical portfolio positioning
- less liquid bonds for buy and hold

b) liquid alternatives - CDS

- ETFs - available across the credit spectrum,
maturities, markets
- neither mature nor experience duration shift

c) asset swaps for unwinding large illiquid positions

(duration hedge, MRR + spread)

Page 19
➞ Tail Risk/ risk of extreme adverse outcomes LOS f
- describe
assessment: parametric method - VaR
- tends to understate frequency and severity of tail events
- fails to capture corr.(liquidity, market stress)
- only provides a minimum loss, not average loss
- CVaR - conditional VaR - avg. loss given that VaR is exceeded
- most often estimated with historical simulation or
Monte Carlo simulation
- IVaR - Incremental VaR - measures impact of adding or
removing a position
- Relative VaR - measures expected tracking error

VaR of (𝐏𝐨𝐫𝐭𝐟𝐨𝐥𝐢𝐨𝐡𝐨𝐥𝐝𝐢𝐧𝐠𝐬 − 𝐁𝐞𝐧𝐜𝐡𝐦𝐚𝐫𝐤 𝐡𝐨𝐥𝐝𝐢𝐧𝐠𝐬 )

VaR of ∆w

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Page 20
➞ Tail Risk/
LOS f
- describe

- managing tail risk: issuer

- establish position limits ratings
regions/sectors
use derivatives to protect against downside losses

Page 21
LOS g
➞ Synthetic Credit Strategies/
- discuss
CDS Review: protection buyer = long CDS = short credit quality
protection seller = short CDS = long credit quality
IG fixed spread = 1% HY fixed spread = 5%
- if CDS spread > fixed spread ➞ buyer pays seller upfront fee
- if CDS spread < fixed spread ➞ seller pays buyer upfront fee
[(𝐟𝐢𝐱𝐞𝐝 𝐬𝐩𝐫𝐞𝐚𝐝 − 𝐂𝐃𝐒 𝐬𝐩𝐫𝐞𝐚𝐝) × 𝐒𝐃𝐂𝐃𝐒 ] × 𝐍𝐀 = upfront payment to
buyer
price per $1 ➞ [𝟏 + (𝐟𝐢𝐱𝐞𝐝 𝐬𝐩𝐫𝐞𝐚𝐝 − 𝐂𝐃𝐒 𝐬𝐩𝐫𝐞𝐚𝐝) × 𝐒𝐃𝐂𝐃𝐒 ]

- discount from par ➞ buyer pays seller

- premium to par ➞ seller pays buyer
%∆𝐂𝐃𝐒 𝐩𝐫𝐢𝐜𝐞 ≈ −\𝐒𝐃𝐂𝐃𝐒 × ∆𝐂𝐃𝐒𝐬𝐩𝐫𝐞𝐚𝐝 ^ × 𝐍𝐀 Ex. #22/23

single name CDS ➞ long or short credit quality of an issuer

Index-based CDS ➞ long or short index credit (IG or HY)

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Page 22
payer option on CDS Index ➞ right to buy protection LOS g
(pay premiums) - discuss
receiver option on CDS Index ➞ right to sell protection (receive premiums)

CDS commonly used to over or under weight credit exposure to

individual issuers, specific sectors, or borrower types

➞ CDS curve/ CDS spreads across maturities for an issuer or index

- CDS positioning strategies based on expected changes in
level , slope, or shape
widen near-term balloon payments
narrow or longer-term at specific maturities outsized
Ex. #24 stress balloon payment
Ex. #25

-
-
-
-
-
-
-
7 yr.

- CDS strategies are available to both bottom-up (single-name CDS)

and top-down (index-based CDS) strategies

Page 23
➞ Credit Spread Curve Strategies/ LOS h
- discuss

- profits rise - lower defaults - higher leverage - rising defaults

- defaults remain high - increasing profitability and inflation - falling profitability
expectations

➞ Static Credit Spread Curve Strategies/ belief spreads are correctly

priced and curves will remain unchanged over some IH
1/ lower portfolio credit quality for same SD or extend SD for the
same credit quality (see exh. #29)
- buy and hold or ‘carry and roll down’

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➞ Credit Spread Curve Strategies/ LOS h
2/ Derivatives to add spread duration - discuss

- sell CDS (single-name or index-based) Ex. #27

➞ Dynamic Credit Spread Curve Strategies/

- strategies for ∆level, ∆slope, ∆shape Ex. #28-31

➞ Global Credit Strategies/ LOS i

- discuss
Developed Countries
well established and liquid derivative and capital markets
broad range of public and private issuers
bonds denominated in a freely-floating domestic currency
Emerging/Frontier Countries - dominated by sovereign issuers, state-
owned or controlled enterprises, banks, and producers operating
in a dominant industry such as basic commodities

Page 25
LOS i
Emerging/Frontier Countries - discuss
- often in a restricted domestic currency with varying degrees of
liquidity
- sovereigns often issue global bonds in USD or EUR
- characterized by higher, more volatile, and less balanced growth
- greater geopolitical risk, currency restrictions, and capital controls
- significant external debt denominated in foreign currencies
𝐞𝐱𝐭𝐞𝐫𝐧𝐚𝐥 𝐝𝐞𝐛𝐭G 𝐜𝐮𝐫𝐫𝐞𝐧𝐜𝐲 𝐫𝐞𝐬𝐞𝐫𝐯𝐞𝐬
𝐆𝐃𝐏 G𝐆𝐃𝐏
(leverage) (liquidity)

- higher concentration in both the lower portion of IG (sovereign)

and the upper portion of HY (corporate)
(sovereign ceiling)
- much lower levels of liquidity, higher premiums
- currency volatility can be significant

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Page 26
- Other Market Differences/ LOS i
- discuss
sector composition (gov’t., credits, securitized)
accounting standards
differences in credit cycles
LOS j
➞ Structured Credit/ - securities that are backed by collateral
- describe
- typically offer higher returns through tranching
- can offer improved portfolio diversification - types of
asset pools backing the securities may have different
fundamental drivers of value than corporate or gov’t. bonds

CDOs - Collateralized Debt Obligations - backed by a pool of debt

obligations - usually corporate loans
- profiles unavailable in the cash bond market

Page 27
➞ Structured Credit/ LOS j

CLO - collateralized loan obligations - backed by a pool of

floating-rate leveraged loan obligations

MBS - mortgage-backed securities - backed by a pool of

commercial (CMBS) or residential (RMBS) mortgages

ABS - asset-backed securities - non-mortgage assets used as collateral

(auto loans, credit card receivables, student loans)

Covered bonds - senior debt obligations backed by a pool of mortgages

or other assets (segregated pool, not securitized)
- full recourse to issuer
- non-performing assets replaced

➞ LOS k/ describe ➞ exh. #31

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Overview of Equity Portfolio Management

a. describe the roles of equities in the overall portfolio;

b. describe how an equity manager’s investment universe can be segmented;

c. describe the types of income and costs associated with owning and
managing an equity portfolio and their potential effects on portfolio
performance;

d. describe the potential benefits of shareholder engagement and the role an

equity manager might play in shareholder engagement;

e. describe rationales for equity investment across the passive-active spectrum.

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Introduction to Equity PM
Page 1
1. Capital appreciation ➞ long-term returns from
LOS a
cap. appr. among the highest (historically) among - describe
major asset classes
other
strong economic growth – equities outperform
Periods of asset
weak economic growth – equities underperform classes
2. Dividend Income ➞ common & preferred (discretionary)
less variable/volatile component of total return

3. Diversification with other asset classes ➞ in a portfolio

context when combined with other asset classes
(assuming less than perfect correlation)
not constant over time
- in periods of market crisis, correlations across all
asset classes increase (reduce the benefit of diversification)

Page 2
4. Hedge against inflation – some individual stocks LOS a
or sectors as opposed to the whole asset class - describe

success is mixed
e.g. companies may be able to
pass on increases in input costs
(e.g. oil, mining)
inflation
Client Considerations/ growth, income, factor exposure interest
rates…
ESG considerations - negative screening – exclude
- positive screening – include
- thematic investing – energy efficiency (e.g.)
- impact investing – seek to achieve
targeted social/environmental objectives +
financial performance

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1. Segmentation by Size & Style LOS b
- describe
size: market cap
style: based on some scoring
blue system (𝐏*𝐁, 𝐏*𝐄, earnings growth,
chip div. yield)

+/ portfolio construction simplified

(desired risk, return, income)
no loss of diversification within
a style/size category

micro help define an appropriate

cap benchmark
deep value high growth help keep managers within
their style
–/ categories have no clear
standardized definitions
- may be defined differently among investors

Page 4
2. Segmentation by Geography LOS b
- typically based on the stage of market’s developed - describe
macroeconomic development & wealth emerging
frontier
+/ global diversification
–/ specific market indexes may not be as ‘local’ as desired
currency risk

3. Segmentation by Economic Activity

- grouped into industries/sectors

e.g./ GICS – Global Industry Classification Standard (market oriented)

ICB – Industrial Classification Benchmark
TRBC – Thomson Reuters Business Classification (production
RGS – Russell Global Sectors Classification oriented)

- useful in the creation of industry performance benchmarks

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Page 5
3. Segmentation by Economic Activity LOS b
- describe
market-oriented ➞ groups companies based on the markets
they serve, the way revenue is earned, and the way
customers use companies’ products
production-oriented ➞ groups companies that manufacture similar
products or use similar inputs in their manufacturing process

e.g./ coal company basic materials (production)

energy sector (market)
Note: large businesses
may span more
than one industry
or sub-industry

Page 6
4. Segmentation of Equity Indexes & Benchmarks LOS b
- combine elements of 1-3 - describe

e.g./ geography + size/style

MSCI Europe Large-Cap Growth Index
MSCI World Small-Cap Value Index

geography + industry/sector

Global Natural Resources – S&P Global Natural Resources Index

Worldwide Oil + Natural Gas – MSCI World Energy Index
Multinational Financials – Thomson Reuters Global Financials Index

investment approaches
e.g./ ESG

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Page 7
Income/ LOS c
1) Dividends - regular & special - describe
- optional stock dividends (cash or new shares)

2) Securities lending income - stock lending, typically to short

sellers
- stock loans are collateralized with cash or
other high quality securities
- loan can earn .2 - .5% annualized return (developed)
- higher (1 - 2%) in emerging mkts.
- can be higher ➞ 5 - 15% (specials)
- can also earn cash collateral interest
- borrower pays lender any dividends

3) Ancillary Investment Strategies

dividend capture ➞ buy stock before ex-dividend
➞ sell after (may not drop by Div.)
covered calls ➞ possible exit
cash-covered puts ➞ possible entry

Page 8
Fees/ LOS c
1) Management Fees - typically on AUM (ad-valorem) - describe
- fund research & portfolio management

2) Performance Fees - a.k.a. incentive fees (e.g. hedge funds)

- hurdle rates, high water marks, clawbacks

3) Administration Fees - processing of corporate actions,

measurement of performance, voting (provided by the
investment management fund itself)
charged
custody fees – safe-keeping of assets by a custodian
by external
depository fees – paid to custodians
parties
registration fees – for mutual fund ownership

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Page 9
Fees/ LOS c
4) Marketing & Distribution Costs - describe

- marketing, sales staff, advertising, sponsorships,

brochures, sales commissions, platform fees

5) Trading Costs
- transaction costs
➞ explicit ➞ implicit
- brokerage commission - bid-offer spread
- taxes - market impact
- exchange fees - delay costs (slippage)

Page 10
Shareholder Engagement/ – the process whereby LOS d
investors actively interact with companies - describe

- voting ➞ BoD, compensation, etc.

+/ more company information

chance to add value for active managers

–/ time consuming & costly

pressure on companies to meet s.t. targets
potential selective disclosure of info. to select shareholders
potential conflicts of interest (company is an investor in
the fund holding shares)

Equity Manager/ typically involve regular meetings w/ the

company
activist investing – create change to generate a gain

voting – major corporate issues, proxy voting, empty voting

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Page 11
Confidence to outperform LOS e
- describe
Client Preference – ability to attract funds (investor belief
in manager strategy)

Suitable Benchmark – liquid with broad #

of securities (must offer potential to
generate alpha)

Client-Specific Mandates – unique circumstances

(ESG, unacceptable activities)

Risks/Costs of active mgmt. – expense, reputation, key-person

Taxes

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Passive Equity Investing

a. discuss considerations in choosing a benchmark for a passively managed

equity portfolio;

b. compare passive factor-based strategies to market-capitalization-weighted

indexing;

c. compare different approaches to passive equity investing;

d. compare the full replication, stratified sampling, and optimization

approaches for the construction of passively managed equity portfolios;

e. discuss potential causes of tracking error and methods to control tracking

error for passively managed equity portfolios;

f. explain sources of return and risk to a passively managed equity portfolio.

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Passive Equity Investing

Page 1
LOS a
- discuss
Passive Investing Indexing ⇒ replicate the
- any rules-based, transparent, low cost performance of a
& investable strategy that broad diversification benchmark index

⇒
does not involve identifying tax efficiency changes made
mispriced securities
only when the
⇒

changes made as rules dictate index changes

⇒ Selecting a Benchmark/
an existing index – must meet 3 requirements
➀ must be rules-based – criteria for inclusion, rebalancing
must be objective, consistent, predictable
➁ transparent – disclosure of rules and constituents
➂ investable – performance can be replicated in the market
(basically, can buy and sell the constituents easily)
(liquidity)

Page 2
Terminology/ Buffering – ranges around break-points
LOS a
that defines whether a stock belongs in one index or another - discuss
x x
- makes index transitions
Size
more gradual & orderly
sm.-cap. mid-cap. lg.-cap.

Packeting – splitting stock positions into multiple parts

mid-cap. lg.-cap.
⇒ What to consider (when choosing a benchmark index)
the desired market exposure
market segment (broad vs. sectors, domestic vs. international)
equity capitalization (large, mid, small)
style (value, growth, core/blend)
other exposures (momentum, volatility, quality)

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Page 3
⇒ Index Construction/ exhaustive vs. selective LOS b
(US Total Market (S&P500) - compare
Index)
weighting ➞ will influence its performance

a) market-cap – recall: cap-weighted market portfolio is mean-variance

(free-float) optimal
- if index is a good proxy for the
market portfolio ➞ any tracking portfolio will be
cap weighting ~ liquidity weighting ~ greatest capacity
to handle investor flows
- low cost, rules-based construction, transparency, investable
- based on EMH
- subject to concentration risk
𝐧

𝐇𝐇𝐈 = 1 𝐰𝐢𝟐 (Herfindahl-Hirschman Index)

𝐢&𝟏 - range from 𝟏*𝐍 to 1.0

- effective # of stocks = 𝟏G𝐇𝐇𝐈

Page 4
⇒ Index Construction/
LOS b
b) Factor-based strategies – goal is to improve upon the - compare
risk or return performance of the market-cap weighted strategy
Portfolio #1 Portfolio #2 passive rules for
growth growth underweight inclusion
value overweight (transparency on
size size over lg. factor selection,
Factors overweight
yield weighting, rebalancing)
momentum
underweight
quality active decisions
equal
quality regarding degree and
underweight
volatility timing of factor
⇒
⇒

selective factor exposures

Benchmark Index
exposure tilts (take place up front)
(diversified risk
factors) concentrated risk factors
- will leave investors exposed during periods
when a chosen risk factor is out of favour

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Page 5
⇒ Index Construction/ LOS b
b) Factor-based strategies growth - compare
dividend yield
absolute value
➀ Return-oriented strategies momentum
fundamentally weighted

➁ Risk-oriented strategies - volatility weighting (inverse)

- based on past return - minimum variance investing
data

➂ Diversification-oriented strategies
- equally weighted indexes $𝟏)𝐧* (low amount of single stock
- maximum diversification strategies risk)

- changing exposures to specific risk factors as market

conditions change is known as factor rotation

Page 6
1/ Pooled Investments – easy to purchase, hold & sell LOS c
(open-end mutual funds, ETFs) - compare
MF/ low cost, administrative convenience
ETF/ low fees, ease of trading, tax efficiency (vs. MF)
creation process 2) delivers a ‘creation unit’
(i.e. ETF
3) sells ETF Dealer ETF
shares)
shares
1) delivers basket of shares

process is reversed to retire ETF shares

2/ Derivatives-Based approaches - options, swaps, futures

- low cost, easy to implement, provide leverage, but they
expire
- typically used to adjust a pre-existing portfolio (overlay)
e.g./ target beta, target asset class weight
(completion overlay) (rebalancing overlay)

- increase/decrease exposure in a single transaction, sometimes

with more liquidity than the underlying cash assets

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Page 7
2/ Derivatives-Based approaches LOS c
- may introduce basis risk (futures), counterparty - compare
credit risk (OTC)

3/ Separately Managed Equity Index-Based Portfolios – actually buying

the shares (requires an entire trading/admin. infrastructure)

LOS d
1/ Full replication - hold all securities of the index - compare
- lowest tracking error, higher transaction costs
- seek to replicate an index that is priced at the close
of business each day (∴ use market-on-close orders)

2/ Stratified sampling - hold a limited sample of index constituents

- sample from strata that are mutually exclusive & exhaustive
- higher tracking error, lower transaction costs
⇒ used when index is large
AUM is low

Page 8
3/ Optimization LOS d
max. a desirable characteristic s.t. one or - compare
involves either
min. an undesirable characteristic more constraints
+/ lower amount of tracking error vs. stratified sampling
explicitly accounts for the covariance among constituents

4/ Blended approach - full replication for more liquid issues

- optimization or sampling for less liquid issues
LOS e
⇒ Tracking Error/ measured: ➞ 𝐓𝐄 = …𝐕𝐚𝐫\𝐑 𝐩 − 𝐑 𝐛 ^ - discuss

➞ 𝐄𝐱𝐜𝐞𝐬𝐬 𝐑𝐞𝐭𝐮𝐫𝐧 = 𝐑 𝐩 − 𝐑 𝐛

Causes ➞ fees (higher fees = lower excess return & higher TE)
➞ # of constituents held vs. benchmark (sampling = higher TE)
➞ intraday trading of the constituents (any price bought or
sold different from closing price = higher TE)
➞ trading commissions
➞ cash balances (cash drag ➞ negative in rising markets)

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⇒ Tracking Error/ LOS e
Controlling ➞ trade-off: benefits of full replication - discuss

vs. costs
➞ minimizing cash held (maintain 𝛃 = 𝟏. 𝟎 relative to
the benchmark)

LOS f
⇒ Sources of Return & Risk/
- explain
- attribution analysis company specific
(exhibit 13) sector
country
currency

- securities lending requires a lending agent (typically the

custodian)
- investor activism & engagement (?)

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Active Equity Investing: Strategies

a. compare fundamental and quantitative approaches to active management;

b. analyze bottom-up active strategies, including their rationale and associated

processes;

c. analyze top-down active strategies, including their rationale and associated

processes;

d. analyze factor-based active strategies, including their rationale and

associated processes;

e. analyze activist strategies, including their rationale and associated processes;

f. describe active strategies based on statistical arbitrage and market

microstructure;

g. describe how fundamental active investment strategies are created;

h. describe how quantitative active investment strategies are created;

i. discuss equity investment style classifications.

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Active Equity Investing: Strategies

Page 1
Fundamental ➞ based on research LOS a
➞ involve analyst judgment/discretion in - compare
making decisions

Quantitative ➞ based on quantitative models of security returns

➞ look for market characteristics and patterns
that have predictive power
➞ decisions are non-discretionary, systematic

Page 2
Quantitative e.g./ LOS a
X1 – earnings yield - compare
𝐲 = 𝐛𝟎 + 𝐛𝟏 𝐗 𝟏 + 𝐛𝟐 𝐗 𝟐 + 𝐛𝟑 𝐗 𝟑
X2 – size
high R2 = evidence of relationship X3 – market sentiment
based on past data
factors
(use a very large group of stocks)
rewarded factors
- then model is used to predict future (those shown to be
expected returns positively related to long-
∴ investment success depends on model quality term return premium)
⇒ Risk/ Fundamental ➞ risk is at the company unrewarded factors
level (not been empirically
(valuation, forecasts, convergence time frame) proven to offer a
Quantitative ➞ risk is at the persistent return premium)
portfolio level
(factor returns will not perform as expected)

⇒ Rebalancing/ Fundamental ➞ discretionary

Quantitative ➞ systematic, typically monthly/quarterly

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⇒ Bottom-up strategies/ business model LOS b
& branding - analyze
- begin analysis at company level
valuation: DCF, DDM, 𝐏)𝐄, 𝐏)𝐁, 𝐄𝐕)𝐄𝐁𝐈𝐓𝐃𝐀
competitive advantages
company mgmt. & corp. governance
1/ Value-based approaches (value added performance)
a) relative value – vs. sector peers
b) contrarian investing – typically depressed cyclical stocks
– tend to rely more on market sentiment
c) high-quality value – above average ROE, financial strength,
consistent earnings power
d) income investing – high dividend yields, positive dividend growth
(tends to give price support) rates
e) deep-value investing – very low 𝐏G𝐁, financial distress
(limited market interest ➞ inefficient pricing)
f) restructuring/distressed investing
g) special situations – corporate events ➞ divestitures, restructuring

Page 4
⇒ Bottom-up strategies/ LOS b
2/ growth-based approaches - analyze
- focus on companies expected to grow faster than
their industry or the overall market
- above average valuation multiples
GARP – growth at a reasonable price ⇒ PEG ratio = 1

⇒ Top-Down Strategies/ ETFs, futures, swaps, custom LOS c

- analyze
basket of stocks
1/ Country & Geographic allocation – futures or ETFs
2/ Sector & Industry rotation – sector & industry ETFs
3/ Volatility-based strategies – VIX futures, options
4/ Thematic Investing – broad macro, demographic or political drivers
- futures, ETFs, currencies

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⇒ Factor-based strategies Factor - a variable or LOS d
characteristic with which individual asset returns are correlated - analyze
– rewarded or unrewarded
- goal ➞ identify significant factors that can predict future returns
& construct a portfolio that tilts towards those factors
- equity style rotation strategies ➞ based on the belief that
different factors work well during some periods but
less well during others (more of a quantitative approach)

⇒ Hedged Portfolio approach ➞ select factor, then rank stocks by

that factor, divide into quartiles/quintiles
- go long the best group, short the worst group or deciles

–/ info. in the middle groups not used

requires shorting stocks
portfolios tend to be concentrated (sector, industry) & crowded
assumes relationship between factor & future returns is linear
hedged portfolio is not a ‘pure’ factor portfolio

Page 6
⇒ Factor-based strategies LOS d
ignored - analyze

⇒ Long-only portfolio ➞ factor tilting

- tracks a benchmark index closely, but provides exposure
to the chosen factor (weighting +/–)
- Style Factors/
1/ Value low 𝐏G𝐄, high earnings yield, low 𝐏G𝐁
- value premium as compensation for increased risk of
financial distress (Fama/French)
- behavioral biases (Lakonisok, Shleifer, Vishny)

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⇒ Factor-based strategies LOS d
Style Factors/ - analyze
2/ Price Momentum – winners over past 12 months tend to
outperform past losers (over next 2 - 12 months)
- typically attributed to overreaction to information
(tend to become crowded and subject to extreme
- can also be sector/industry concentrated tail risk)
(Ex. 11-13)

3/ Growth – using historical or projected forward growth rates

4/ Quality e.g./ earnings quality, profitability, solvency risk,
analyst sentiment
5/ Unconventional Factors based on unstructured data
– satellite images, online mentions

Page 8
⇒ Activist Strategies – taking stakes in listed LOS e
companies and advocating changes for the purpose - analyze
of producing a gain on the investment (typically < 10%
ownership)
- Tactics/

Company
Defenses:
dual-class
share structures
poison pills
shareholder
rights
staggered
boards

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⇒ Activist Strategies LOS e
⇒ typical targets ➞ slower revenue & earnings growth than - analyze
the market
➞ negative share price momentum
➞ weaker than average corporate governance
- activist investors are thus more likely to win support for
their actions from other shareholders & the wider public
(Example #6)
LOS f
- describe
A/ Statistical Arbitrage/ uses statistical & technical analysis
(stat. arb.) to exploit pricing anomalies
➞ take advantage of mean reversion in share prices
e.g./ pairs trading – identify 2 securities that are historically
highly correlated with each other
- when price relationships deviate from long-term
average ⇒ long underperforming stock
⇒ short outperforming stock

Page 10
A/ Statistical Arbitrage/ LOS f
⇒ pairs trade ➞ biggest risk is that observed price - analyze
(e.g. #7) divergence is not temporary (may be structural)
B/ Market Microstructure/ very short-term mispricing opportunities
e.g. Buy/Sell imbalances
- requires high speed executions (HFT)
LOS g
⇒ Process/ - describe
1/ Define the investment universe and the market opportunity
what it is and why it is
2/ Pre-screen the investment universe the investment thesis there
3/ Understand ➞ industry & competitive analysis
➞ analysis of financial reports
4/ Forecast company performance ➞ cash flows or earnings
5/ Convert forecasts to valuations ➞ identify ex ante profitable
investments

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⇒ Process/ LOS g
6/ Construct portfolio with desired risk profile - describe
7/ Rebalance with buy and sell disciplines
➞ Pitfalls/ Behavioral Bias confirmation bias loss aversion
illusion of control regret aversion
availability bias overconfidence
Value Trap – stock may appear to be attractively valued
(low 𝐏G𝐄, low 𝐏G𝐁), but still may be overpriced
given its worsening future prospects
Growth Trap – further growth may not materialize or
everything may already be priced into the stock
LOS h
⇒ Process/ - describe
1/ Define the market opportunity (investment thesis)
2/ Acquire & Process Data – company mapping, company fundamentals,
survey data, unconventional data

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⇒ Process/ LOS h
3/ Back-testing the strategy - describe
– measure of factor performance:
the factor’s Information Coefficient – the correlation
between factor exposures and their holding period returns for
a cross-section of securities (linear association)
Pearson IC = corr.(𝐟𝐚𝐜𝐭𝐨𝐫 𝐬𝐜𝐨𝐫𝐞𝐬𝐭 , 𝐬𝐭𝐨𝐜𝐤 𝐫𝐞𝐭𝐮𝐫𝐧𝐬𝐭)𝟏 )
Spearman rank IC = corr.(𝐫𝐚𝐧𝐤𝐞𝐝 𝐟𝐚𝐜𝐭𝐨𝐫 𝐬𝐜𝐨𝐫𝐞𝐬𝐭 , 𝐫𝐚𝐧𝐤𝐞𝐝
(exhibit #28) 𝐟𝐨𝐫𝐰𝐚𝐫𝐝 𝐫𝐞𝐭𝐮𝐫𝐧𝐬𝐭)𝟏 )
(Pearson IC ➞ very sensitive to outliers)
⇒ creating a multi-factor model – factors may be effective
individually but may not add material value to a
factor model (multicollinearity)
4/ Evaluating the strategy – out-of-sample back-test
5/ Portfolio Construction

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➞ Pitfalls/ LOS h
Survivorship bias – back-testing without including - describe
failed companies
Look-Ahead bias – using information that was unavailable or
unknown at the time of an investment decision
Data mining – can result in model overfitting
Turnover, transaction costs, short availability – back-tracking often
ignores these issues
LOS i
⇒ Style Classifications/ - split stocks into groups - discuss
with similar characteristics
- returns of stocks within a style group should be correlated
& between groups should have less correlation
➞ allows active equity managers with similar styles to be
compared with one another
➞ allows returns or positions to be compared with a
claimed style index

Page 14
⇒ Style Classifications/ LOS i
1/ Holdings-based approach – look at a manager’s holdings - discuss
and classify each stocks style (value, growth, size)
- portfolio’s active exposure = sum of style attributes
weighted by active positions

e.g./ Morningstar Style Box Morningstar & Thomson Reuters

stock’s attribute for a specific
style = 1 if it is included in
that style, else = 0
MSCI & FTSE Russell
stocks can have characteristics
of two styles at the same
time
e.g./ 70% value, 30% growth

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⇒ Style Classifications/ LOS i
2/ Returns-based style analysis 𝐫𝐭 – fund return - discuss
𝐦
𝐑𝐒𝐭 – return of style index s
𝐫𝐭 = 𝛂 + 1 𝛃𝐬 𝐑𝐬𝐭 + 𝛆𝐭
𝐬&𝟏
𝛃𝐒 – fund’s exposure to style s
𝛂 – constant (value-added)
constrained multivariate
𝐦
regression 𝐬 𝐬
A/ 𝛃 = 𝟏, 𝛃 < 𝟎 F
𝐬$𝟏

3/ Manager self-identification
– as described in the fund prospectus

holdings-based generally more accurate than returns-based analysis

Style Identification Techniques

Page 15
1/ Returns-based style analysis ( RBSA – Sharpe) LOS i
regress portfolio returns (monthly) on a - compare
- characterize
return series of a set of securities indices

- constraint: mutually exclusive

➀ ∑𝛃𝐢 = 𝟏 & ➁ ∀ 𝐢, 𝛃𝐢 > 𝟎 exhaustive w.r.t. PM’s
investment universe
distinct source of risk
e.g. (i.e. low 𝛒𝐗𝐘 )
𝐑 𝐩 = 𝐛𝟎 + 𝐛𝟏 𝐋𝐂𝐕 + 𝐛𝟐 𝐋𝐂𝐆 + 𝐛𝟑 𝐒𝐂𝐕 + 𝐛𝟒 𝐒𝐂𝐆
➞ style weights, Sharpe-style
.75 0 .25 0
weights
PM follows a value style with some exposure to
small-cap stocks

∴ the benchmark, or normal portfolio, would be (.75 LCVI + .25SCVI)

R2 = measure of fit 1 – R2 = selection return e.g. 6 & 7

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⇒ Holdings-based style analysis – categorizes LOS i
individual securities by their characteristics - compare
and aggregates results - characterize
e.g. 8

- must decide on the set of characteristics and aggregating

decisions - value or growth exclusively? e.g./ P/E < 16.50
- value if X < Y, growth if X > Y + y = value, else
growth
e.g./ PE < 16.50 = value, P/E > 24.50 = growth
- part value, part growth?
(0–100%) (0–100%)

Page 17
LOS i
Advantages Disadvantages - compare
- characterize
Returns-based style Characterizes entire portfolio May be ineffective in characterizing current
analysis Facilitates comparisons of portfolios style
Aggregates the effect of the investment Error in specifying indexes in the model may
process lead to inaccurate conclusions
Different models usually give broadly simi-
lar results and portfolio characterizations
Clear theoretical basis for portfolio
categorization
Requires minimal information
Can be executed quickly
Cost effective

Holdings-based style Characterizes each position Does not reflect the way many portfolio manag-
analysis Facilitates comparisons of individual ers approach security selection
positions Requires specification of classification attri-
In looking at present, may capture changes butes for style; different specifications may give
in style more quickly than returns-based different results
analysis More data intensive than returns-based analysis

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Active Equity Investing: Portfolio Construction

a. describe elements of a manager’s investment philosophy that influence the

portfolio construction process;

b. discuss approaches for constructing actively managed equity portfolios;

c. distinguish between Active Share and active risk and discuss how each
measure relates to a manager’s investment strategy;

d. discuss the application of risk budgeting concepts in portfolio construction;

e. discuss risk measures that are incorporated in equity portfolio construction

and describe how limits set on these measures affect portfolio construction;

f. discuss how assets under management, position size, market liquidity, and
portfolio turnover affect equity portfolio constructions decisions;

g. evaluate the efficiency of a portfolio structure given its investment mandate;

h. discuss the long-only, long extension, long/short, and equitized market-

neutral approaches to equity portfolio construction, including their risks,
costs, and effects on potential alphas.

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Active Equity Investing: Portfolio Construction

Page 1
an active manager will generate positive active LOS a
returns if: - describe

𝐑 𝐀 = ∑(𝛃𝐏𝐤 − 𝛃𝐛𝐤 ) × 𝐅𝐤 + (𝛂 + 𝛆)
active
luck/noise
return exposures to priced or
alpha – rewards that cannot
rewarded risks (factors)
be explained by long-term
that are different from
those of the benchmark exposure to rewarded risks
(alternative beta)

Page 2
- 3 sources of RA remain the same regardless of LOS a
exposure to style - describe
rewarded factors proportions of
alpha fundamental/discretionary
RA will vary
luck quantitative/systematic
among managers &
top-down/bottom-up
approaches

⇒ Building Blocks used in Portfolio Construction

1. over/under weight rewarded factors ➞ relative to the benchmark

(Ex. #2)

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2. alpha – exposure to known rewarded factors is no LOS a
longer considered a source of alpha - describe
- however, timing that exposure would be – factor timing
- alpha can also be generated by timing exposure to
unrewarded factors

3. sizing positions
⇒ manager confidence in mitigating idiosyncratic
vs.
their alpha and factor insights risk
A/ factor-orientation much greater in
- target specific exposures to factors concentrated portfolios
- maintain diversified portfolio to
minimize idiosyncratic risk - proportion of 𝛔𝐑 𝐀 attributed
to 𝛔𝛆 more significant
B/ stock-picker
- concentrated portfolio assuming
a higher degree of idiosyncratic risk

Page 4
4. Breadth of experience LOS a
- describe
Recall: ‹‹‹ √𝐁𝐑 𝛔𝐑 𝐓𝐂
𝐄(𝐑 𝐀 ) = 𝐈𝐂 𝐀
where BR = # of
truly independent decisions
⇒ success is a function of a
made each yr. (uncorrelated
manager’s breadth of experience decisions are
- broader expertise may increase the manager’s diversifying)
likelihood of generating consistent, positive active returns

Basically, confidence in a manager’s ability to outperform his

benchmark increases when that performance can be attributed
to a larger sample of independent decisions
(example #1)

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LOS b
⇒ Top-Down vs. Bottom-Up
- discuss
- emphasize macro factors - emphasize security specific
- more likely to involve factor timing (𝛂) factors (𝛂)
- more likely to have concentrated - diversified or concentrated
portfolios (w.r.t. macro factors) w.r.t. security selection
- diversified or concentrated w.r.t.
security selection

𝐧 Page 6
⇒ Active Share/ = 𝟏 1Ž𝐰 − 𝐰 Ž measures the extent
LOS c
𝐩𝐢 𝐛𝐢
𝟐 - distinguish
𝐢&𝟏 to which number &
- discuss
e.g./ P B
sizing positions differ from the
X .40 .30 benchmark
Y .40 .30 |. 𝟒 − . 𝟑| + |. 𝟒 − . 𝟑| + |. 𝟐 − . 𝟒| . 𝟏 + . 𝟏 + . 𝟐
Z .20 .40 𝐀𝐒 = = = .𝟐
𝟐 𝟐
⇒ Active Risk/ – affected by the degree of cross-correlation
(active share is not)
greater effect on
e.g./ GM +1% over vs. GM +1% over
active risk than
Ford -1% under NFLX -1% under
(GM, Ford) pair
(51:49 vs. 50:50) AS = .01
P B
AS = .01

⇒ manager can completely control active share but not active

risk (since 𝛔𝐑𝐀 depends on correlations & variances of securities)

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𝛔𝐑 𝐀 = •𝛔𝟐 (∑(𝛃𝐏𝐤 − 𝛃𝐛𝐤 ) × 𝐅𝐤 ) + 𝛔𝟐𝛆 active risk attributed LOS c
- distinguish
to active share will
- discuss
be smaller if ➀ # of securities
high net exposure to a risk factor is large
will lead to a high level of active risk ➁ average
(if the factor exposure is fully neutralized ➞ 𝛃𝐏𝐤 − 𝛃𝐛𝐤 = 0, idiosyncratic
active risk fully attributed to active share) risk is small
level of active risk will rise with an increase
in factor and idiosyncratic volatility

Page 8
- optional
⇒ desired outcome (may also
be expressed in terms of
risk metrics)
bounds of
permissible
actions

- nature of objective function & constraints can indicate manager’s

philosophy and style – explicitly stated for systematic managers (less so for
discretionary managers)

may not have explicit return and risk forecasts

- allocation driven by judgment about risk/return tradeoff
- stock picker ➞ fewer, more permissive constraints on security weights
vs. multi-factor manager
- sector-rotation ➞ more permissive constraints than a value manager
(Ex. 3, 4)

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⇒ an effective risk management process requires the PM to: LOS d
1. Determine which type of risk measure is most appropriate to the - discuss
strategy (absolute vs. relative) – driven by manager mandate & investor goals
benchmark agnostic most AUM are managed relative to a benchmark

2. Understand how each aspect of the strategy contributes to its

overall risk
causes/sources of absolute risk
s of if a new asset added to a portfolio has a higher Covariance
term
in with the portfolio than most current securities, total
single
a or portfolio risk will rise
et
ass tor
fac if an asset is replaced with another asset that has a higher
risk
Covariance with the portfolio, total portfolio risk will rise
(Exhibit #10)
attributed to factor exposures
s
- absolute portfolio variance
erm unexplained variance
in t or 𝐊
t
fac re
of 𝐕𝐩 = 𝐕𝐚𝐫 A/$𝛃𝐢𝐩 × 𝐅𝐢 *F + 𝐕𝐚𝐫$𝛆𝐩 *
osu
exp 𝐢$𝟏

(Exhibit #11) factor exposures unexplained by factor exposures

Page 10
2. Understand how each aspect of the strategy contributes LOS d
to its overall risk - discuss
causes/sources of relative/active risk
- low risk assets will not always reduce active risk
- high risk assets will not always increase active risk
- its not the volatility of the asset, but the relative volatility that
low σ2 asset increases active risk matters
portfolio
high σ2 asset lowers active risk if the asset has
a high covariance with the benchmark

exhibit #13 high σ2

benchmark

3. Determine the appropriate level of risk

- a subjective exercise (sensitive to style and conviction
in ability to add value)
- different managers with similar styles may have different risk
appetites
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3. Determine the appropriate level of risk LOS d
- some other limits to risk - discuss
a) Implementation constraints – no short positions, no leverage
b) limited diversification opportunities – portfolios with high
absolute risk targets eventually run out of high return
investment opportunities
c) leverage levels – beyond a certain level, volatility reduces
compounded returns (in a multi-period setting)
𝟐
𝐑 𝐆 = 𝐑 𝐀 − 𝛔 G𝟐

4. Properly allocate risk among individual positions/factors

- a fund’s style and strategy will also dictate much of
the structure of its risk budget
➞ implies strategy and portfolio structure is also
revealed by the sources of risk

Page 12
⇒ Additional risk measures used in portfolio construction/ LOS e
- discuss
- risk constraints may be either formal or heuristic
- describe
1/ heuristic – often based on experience or practice
e.g.: limits on ➞ exposure concentrations (security, sector, industry)
- results in absolute ➞ net exposures to factors (beta, size, value)
or relative risk ➞ net exposure to currencies
being constrained ➞ degree of leverage
even without explicit ➞ turnover/trading related costs
absolute or relative
risk constraints

2/ formal - often statistical in nature and directly linked

to the distribution of returns
e.g. volatility, active risk, skewness, drawdowns, VaR, CVaR, IVaR, MVaR

- requires estimates or predictions of risk

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Costs
LOS f
↓ implicit ↑ implicit - discuss
↑ explicit ↓ explicit
smaller = ↓ ADV
small large
↑ %’age/day
of cap
AUM
affect
Position Size market market cap
f(·)
impact +
affect Liquidity average daily trading
(ADV) volume
Turnover price movement
benefits resulting from a
costs manager’s sale/purchase

⇒ a manager’s investment approach and style will influence the

extent to which he is exposed to market impact costs

Page 14
e.g./ LOS f
Company A ➞ market cap = $2B - discuss
➞ ADV = 1% ~ $20M/day
$200M AUM $1B AUM
manager ➞ no position > 10% ADV = $2M max. position = $2M max. pos.
➞ no position > 2% AUM = $4M max. position = $20M max. pos.

liquidity constraint limits position

regardless of AUM

⇒ Strategy of a manager must be consistent with the feasibility

of implementing it
e.g./ Large-cap fund can support higher level of AUM
than small-cap fund
limit AUM
must either hold more diversified portfolio
limit turnover
use derivatives

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⇒ Well constructed portfolio possesses: LOS g
- evaluate
deliver the a clear investment philosophy & a consistent investment process
promised
characteristics risk & structural characteristics as promised to investors
in a risk & a risk-efficient delivery methodology
cost efficient
reasonably low operating costs given the strategy
way
+ low idiosyncratic risk relative to total risk
LOS h
⇒ Long/Short: - discuss
- conviction of negative views can be expressed through
short-selling (profit from negative insights)
- short-selling can reduce exposures (markets, sectors, regions)
- extract ‘pure’ factor exposure (requires a long-short portfolio)
- net exposure = long position value – |short position value|
- gross exposure = long position value + |short position value|

Page 16
⇒ Long Extension (enhanced active equity strategy) LOS h
e.g./ 130/30 ➞ 130% long, 30% short - discuss
➞ net exposure = 100%, gross exposure = 160%
allows for greater alpha
more efficient exposure to rewarded factors

⇒ Market-Neutral: hedge out most market risk

- attempt to match and exactly offset the systematic
risks of the long positions with those of the short positions
e.g./ long $100 with 𝛃 = 1
short $80 with 𝛃 = 1.25
- can be implemented for a variety of risk factors
⇒ objective is to neutralize risks for which the manager
has no comparative forecasting advantage
- usually less volatile than long-only
- benchmarks typically fixed-income instruments
- correlations with other types of strategies is low (diversification role)

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Page 17
⇒ Market-Neutral: LOS h
pairs trading (long strong, short weak) - discuss
examples
statistical arbitrage (long underperf., short overperf.)

2 limitations 1/ not all risks can be efficiently hedged

2/ have limited upside in bull markets
(of long/short strategies)

⇒ Long-only long-term risk premium to be earned for bearing market

low transactional complexity risk
limit legal liability
lower mgmt. costs (vs. shorting)

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REVIEW

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Overview of Fixed-Income PM
Review - 1
LOS a - discuss/

diversification benefits - when combined with other asset classes

- bonds are generally less volatile than other major asset
benefits of regular cash flows classes
inflation-hedging potential (inflation linked, floating rate)
principal + coupon coupon only

Liability-based mandates - managed to match/cover expected

liability payments with future projected portfolio cash flows

a) cash flow matching - all future liability payouts are matched by

CFs from bonds - no need for reinvestment

b) Duration matching - match 𝐃𝐀 = 𝐃𝐋 (A&L should be affected similarly

by ∆rates)
- immunization approach - immunized only at a
point in time - requires periodic rebalancing

Review - 2
LOS a - discuss/

Liability-based mandates
c) derivatives overlay - close duration gaps with futures and swaps

d) contingent immunization - when A > L, immunization + active mgmt.

Total-return mandates
1) pure indexing - target 𝐑 𝐀 and 𝛔𝐑𝐀 are both zero
- full replication - very costly
- sampling - match risk factor exposures with a sample

2) enhanced indexing - match benchmark’s primary risk factors

and generate modest outperformance
- minor risk factor mismatches (target 𝛔𝐑𝐀 < 50 bps/yr.)

C) active management - larger risk factor mismatches

- most notably duration

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Review - 3
LOS b - describe/ 𝐧
𝐂𝐅(𝟏 8 𝐲/𝐤)$𝐢
MacDur - weighted-average time to receipt of CFs = 1 𝐭𝐢
𝐏𝐕
𝐢&𝟏
ModDur - %∆𝐏𝐕𝐟𝐮𝐥𝐥 for ∆yield = 𝐌𝐚𝐜𝐃𝐮𝐫y 𝟏 + 𝐲
R G W
𝐤
EffDur - %∆𝐏𝐕𝐟𝐮𝐥𝐥 for ∆curve 𝐧

key rate duration - %∆𝐏𝐕𝐟𝐮𝐥𝐥 for ∆key rate ModDur = 1 𝐊𝐑𝐃𝐢

(EffDur) 𝐢&𝟏
Empirical duration - %∆𝐏𝐕𝐟𝐮𝐥𝐥 based on observed ∆curve
Money duration - $∆𝐏𝐕𝐟𝐮𝐥𝐥 for ∆yield/curve ModDur × 𝐏𝐕𝐟𝐮𝐥𝐥 (× . 𝟎𝟏)
PVBP (DV01, BPV) - $∆𝐏𝐕𝐟𝐮𝐥𝐥 for 1 bps change in yield
= ModDur × 𝐏𝐕𝐟𝐮𝐥𝐥 × . 𝟎𝟎𝟎𝟏
Convexity - second order effect
higher Conv. ➞ higher return than identical duration bond
more CF dispersion around the duration point ➞ greater Convexity
Effective Convexity ➞ for ∆curve

Review - 4
LOS b - describe/
𝐉 𝐉
𝐌𝐕𝐣 𝐌𝐕𝐣
𝐀𝐯𝐠. 𝐌𝐨𝐝𝐃𝐮𝐫𝐏 = " 𝐌𝐨𝐝𝐃𝐮𝐫𝐣 k l 𝐀𝐯𝐠. 𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲 = " 𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲𝐣 k l
𝐌𝐕𝐏 𝐌𝐕𝐏
𝐣$𝟏 𝐣$𝟏
𝐉 𝐉
𝐌𝐕𝐣 𝐌𝐕𝐣
𝐀𝐯𝐠. 𝐄𝐟𝐟𝐃𝐮𝐫𝐏 = " 𝐄𝐟𝐟𝐃𝐮𝐫𝐣 k l 𝐀𝐯𝐠. 𝐄𝐟𝐟𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲 = " 𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲𝐣 k l
𝐌𝐕𝐏 𝐌𝐕𝐏
𝐣$𝟏 𝐣$𝟏

Spread Duration - %∆𝐏𝐕𝐟𝐮𝐥𝐥 for ∆credit spread

longer maturity
DTS = SD × Spread ➞ increase credit exposure lower quality
Portfolio dispersion ➞ variance of time to CF w.r.t. MacDur

LOS c - describe/
- Bond Market Liquidity
most bonds have less active secondary market (vs. equities)
bonds are very heterogeneous (each issue is different)
typically OTC dealer markets (search costs, price discovery)
liquidity is highest right after issuance
liquidity affects bond yields (illiquidity premiums)

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Review - 5
LOS c - describe/
➞ Among Subsectors: (sovereign, non-sovereign, gov’t. related, corporates,
securitized)
Sovereign:
- more liquid, larger issue size, high credit quality, used as benchmark
Corporates: bonds
- many more issuers, smaller issue size, range of credit quality
typically excluded low quality may be difficult
from benchmarks to find inventory

➞ Effects of Liquidity on Fixed-Income PM

1) Pricing - stale prices, requires estimation
2) Portfolio construction - trade-off between yield and liquidity
- buy-and-hold ➞ higher yield/lower liquidity

wider bid-ask spreads

small spreads - gov’t. bonds, plain vanilla, large IG issuers

vs. corporates optionality small HY issuers

Review - 6
LOS c - describe/

3) Alternatives to direct investing in bonds

- derivatives (exchange-traded and OTC), MFs, ETFs
- generally more liquid than their underlying

LOS d - describe/interpret/
- Decomposing E(R) ≈ Coupon Income (coupon + reinvestment)/current price
+⁄− Rolldown Return O𝐛𝐨𝐧𝐝 𝐏𝐞𝐧𝐝 − 𝐛𝐨𝐧𝐝 𝐏𝐛𝐞𝐠. P/𝐛𝐨𝐧𝐝 𝐏𝐛𝐞𝐠.
- assumes unchanged YC
+⁄− E(∆price from ∆curve) (-ModDur × ∆curve) + [𝟏)
𝟐 Convex. (∆𝐜𝐮𝐫𝐯𝐞) ]
𝟐

+⁄− E(∆price from ∆yields/spreads)

(-ModDur × ∆spread) + [𝟏)𝟐 Convex. (∆𝐬𝐩𝐫𝐞𝐚𝐝)𝟐 ]

SD if FRN
+⁄− E(∆price due to ∆fx-rates) 𝐑 𝐅𝐗
𝐑 𝐃𝐂 = (𝟏 + 𝐑 𝐅𝐂 )(𝟏 + 𝐑 𝐅𝐗 )

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Review - 7
LOS e - discuss/ 𝐫𝐈 - return on invested funds
𝐕𝐁 𝐫𝐁 - borrowing costs
𝐫𝐏 = 𝐫𝐈 + G𝐕 (𝐫𝐈 − 𝐫𝐁 )
𝐄
𝐕𝐄 - value of equity
leverage factor 𝐕𝐁 - value of borrowed funds

- if 𝐫𝐈 > 𝐫𝐁 , leverage will increase portfolio returns

Methods of Leverage/
𝐧𝐨𝐭𝐢𝐨𝐧𝐚𝐥 𝐯𝐚𝐥𝐮𝐞 − 𝐦𝐚𝐫𝐠𝐢𝐧
1/ Futures contracts 𝐥𝐞𝐯𝐞𝐫𝐚𝐠𝐞𝐟 =
𝐦𝐚𝐫𝐠𝐢𝐧
2/ Swap agreements rec. fx., pay fl. ➞ adds duration
3/ Repurchase agreements - basically a collateralized loan
may be - cash driven - borrow cash to buy assets
- security driven - borrow particular securities

𝐝𝐚𝐲𝐬G
Interest = Principal × repo rateR 𝟑𝟔𝟎W

Review - 8
LOS e - discuss/
Methods of Leverage/
4/ Security Lending - cash used as collateral (generates a collateral
yield)
- if bonds used as collateral, income
earned flows back to borrower (coupon rate - lending rate
= Rebate rate
Risks of Leverage/
if securities on loan are
- magnified losses, higher risk,
in short supply, lending
forced liquidations rate > coupon rate
LOS f - discuss/ ∴ rebate rate < 0
Taxation: interest - marginal tax rate
capital gains - favourable rates (LT)
- ZCB - all taxed as interest each year
- Investment funds - pass through interest
- may also pass through cap. gains

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Liability-Driven and Index-Based Strategies

Review - 1
LOS a – describe/ managing assets to meet given liabilities
class of
liabilities ➞ principal repayment
➞ life insurance payout
➞ FRN
➞ post-retirement
health-care benefits
LOS b – evaluate/ Single liability - immunization – use a zero coupon bond
- done!
- using coupon bonds ➞ price and reinvestment risk

variance in the realized ROR

∴ requires the management of duration
➞ set MacDura = Investment Horizon
𝐃𝐀 will change as rates change
+ 𝐏𝐕𝐏 (𝐂𝐅𝐬) = 𝐏𝐕𝐋 + 𝐦𝐢𝐧. 𝐂𝐨𝐧𝐯𝐞𝐱 𝐚

requires rebalancing

Review - 2
LOS b – evaluate/ - for upward sloping YC:
𝐃𝐏 > 𝐃𝐰𝐚 𝐃𝐢𝐬𝐩𝐞𝐫𝐬𝐢𝐨𝐧𝐚 > 𝐃𝐢𝐬𝐩𝐞𝐫𝐬𝐢𝐨𝐧𝐰𝐚 𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲𝐏 > 𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲𝐰𝐚
- 𝐏𝐕𝐋 arrived at by discounting with portfolio CF yield
- 𝐂𝐅𝐲 > 𝐰𝐚𝐲
coupon
principal

ZCB Bullet Barbell

zero variance in ROR - low variance in ROR - high variance in ROR
· no-risk immunization

- MacDurP = IH in all 3 cases, only dispersion varies

∴ immunizing with coupon paying bonds entails continuously matching

the MacDurP with the MacDur of a ZCB over time as the
YC shifts (zero replication strategy)

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Review - 3
LOS b – evaluate/
- Structural risk - non-parallel shifts in the YC (𝐌𝐚𝐜𝐃𝐮𝐫𝐏 ≠ 𝐌𝐚𝐜𝐃𝐮𝐫𝐙𝐂𝐁 )

reduced by minimizing the dispersion of the bond positions

i.e. minimizing Convexity

LOS c - compare/ Cash flow matching (all bonds HTM ➞ no price risk)
𝐋𝟐 − 𝐂𝟒 − 𝐂𝟑 − 𝐂𝟐 = 𝐁𝟐
can improve a company’s credit rating
𝐋𝟒 − 𝐂𝟒 = 𝐁𝟒
may be able to use accounting defeasance
𝐋𝟏 − 𝐂𝟒 − 𝐂𝟑 − 𝐂𝟐 = 𝐁𝟏 𝐋𝟑 − 𝐂𝟒 − 𝐂𝟑 = 𝐁𝟑 (remove both the A & L from the BS)

cash-in-advance constraint – maturity timing mismatches mean funds

must be available before each liability payment

LOS d - describe/ - bonds spread evenly along YC ➞ better protection

from shifts/twists
- bonds mature each year and are reinvested at
the longer end of the ladder (𝐃𝐏 is constant)

Review - 4
LOS e - evaluate/select/
Duration matching (multiple L)
a) 𝐌𝐕𝐚 ≥ 𝐏𝐕𝐋
b) 𝐁𝐏𝐕𝐚 = 𝐁𝐏𝐕𝐋 (= ModDurP x MVp x .0001 or ModDurL x PVL x .0001)
c) 𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲𝐚 > 𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲𝐋 ➞ but minimized thereafter
(dispersion of assets must be wider than dispersion of liabilities)

Derivatives Overlay
increase duration - long interest rate futures
decrease duration - short short-term (T-Bills)
𝐁𝐏𝐕𝐋 − 𝐁𝐏𝐕𝐚 long-term (Tr. Notes/Bonds)
𝐍𝐟 = 30 yr. > 15 yrs.
𝐁𝐏𝐕𝐅
𝐁𝐏𝐕𝐂𝐓𝐃
more liquid ➞ 10 yr. 6.5y. - 10y.
𝐂𝐅
Contingent Immunization 𝐌𝐕𝐚 − 𝐌𝐕𝐋 = surplus
- PM can pursue active strategies as long as the
surplus is above some threshold

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Review - 5
LOS e – evaluate/select/
Interest Rate Swaps
pay fl., rec. fx. ➞ adds duration 𝐁𝐏𝐕𝐬𝐰𝐚𝐩 = 𝐁𝐏𝐕𝐟𝐱 − 𝐁𝐏𝐕𝐟𝐥
pay fx., rec. fl. ➞ reduces duration very small
(+)
𝐁𝐏𝐕𝐋 − 𝐁𝐏𝐕𝐚 rec. fl., pay fx.
𝐍𝐏 = × 𝟏𝟎𝟎
𝐁𝐏𝐕𝐬𝐰𝐚𝐩
(-)
Interest Rate Options rec. fx., pay fl.

Buy Receiver Payer Sell Payer Receiver

Swaption Swaption Swaption Swaption
(pay fl., rec. fx.) (pay fx., rec. fl.) (pay fl., rec. fx.) (pay fx., rec. fl.)

Known Cost Rate Contingent Losses

Review - 6
LOS e – evaluate/select/ Buy - Rec. Swaption - rec. fx.
Interest Rate Options pay fl.

- swaption collar
Sell - Payer Swaption - rec. fx.
pay fl.
($0 Cost, Rate Contingent Losses)

Interest rate anticipation strategies:

rates expected ↓ : increase duration rates expected ↑: decrease duration
- long futures, long int. rate options - short futures, short int. rate options
- swap (pay fl., rec. fx.) - swap (pay fx., rec. fl.)
- if 𝐁𝐏𝐕𝐚 > 𝐁𝐏𝐕𝐋 ➞ do nothing - if 𝐁𝐏𝐕𝐚 < 𝐁𝐏𝐕𝐋 ➞ do nothing
(hedge ratio closer to 0%) (hedge ratio closer to 0%)

LOS f - explain/ - risks

1/ Model risk - whenever assumptions are made about future events &
approximations are used to measure key parameters
𝐁𝐏𝐕𝐚 , 𝐁𝐏𝐕𝐋 , 𝐁𝐏𝐕𝐇

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Review - 7
LOS f – explain/

2/ Measurement error – using w.a. duration instead of portfolio duration

3/ assuming that 𝚫yields are equal for A, H & L
𝐁𝐏𝐕𝐚 × 𝚫𝐲𝐢𝐞𝐥𝐝𝐬𝐚 + 𝐁𝐏𝐕𝐇 × 𝚫𝐲𝐢𝐞𝐥𝐝𝐬𝐇 ≈ 𝐁𝐏𝐕𝐋 × 𝚫𝐲𝐢𝐞𝐥𝐝𝐬𝐋
100% hedge ratio
4/ Spread risk – futures contracts ➞ Treasuries, Liabilities ➞ corporate obligations
- swaps ➞ MRR
- less vol. in swap/corporate spread than in Treasury/corporate spread

5/ Counterparty credit risk – OTC derivatives that are not collateralized

6/ Collateralization risk – the risk that available collateral becomes exhausted
7/ Asset Liquidity – for CI, if active strategies fail

LOS g - discuss/ Benchmarking to a bond index - relative return

- match/exceed ROR of the index

Review - 8
LOS g - discuss/
a) Pure Indexing - full replication (zero tracking risk)
b) Enhanced Indexing - sampling, match primary risk factors (limited
tracking risk)
c) Active management - deviations from primary risk factors

Challenges of benchmarking/
fixed income markets are much larger, # of outstanding securities much
larger, more heterogeneous
- neither feasible nor cost-effective to pursue full replication
array of characteristics - maturity, ratings, put/call features, security,
subordination
unique issuance and trading patterns
- Dealer market - complying with Basel III has lowered liquidity
- lower inventories, wider spreads, less willingness to handle
block trades
- pricing/valuation challenges
- matrix pricing ➞ creates variation between portfolios
and the index

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Review - 9
LOS g - discuss/
Challenges of benchmarking/
Index composition changes frequently - maturities, callability, new
issues
Primary risk factors/
1/ portfolio duration and convexity
2/ Key rate durations - non-parallel shifts, reduces tracking risk
3/ Sector and quality %
4/ Sector and quality SD
5/ Sector/coupon/maturity call weights
6/ Issuer exposure

PV of distribution of CFs (alternative to matching KRDs)

match 𝐏𝐕𝐂𝐅𝐧 + 𝐏(𝐂𝐅𝐜 )
= % in each semi-annual period
∑𝐏𝐕
non-callable callable

Duration = (.5 x %𝟏 ) + (1 x %𝟐 ) + (1.5 x %𝟑 ) … each CF is seen as a ZCB

Review - 10
LOS h - compare/
Passive ➞ assumes bond market expectations are correct
1/ full replication - produce a portfolio that is a perfect match to the
- very difficult and costly index
- rarely attempted
2/ enhanced indexing - match primary risk factors
- done by stratified sampling
lower cost enhancements - tight control on trading costs/mgmt. fees
issue selection enhancements - select undervalued securities plus
possible credit upgrade targets
yield curve enhancements - o.w. undervalued areas of the curve
sector/quality enhancements - periodic over/under weight of
securities over the business cycle
call exposure enhancements - underweight callables if rates
expected to drop

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Review - 11
LOS h - compare/
Alternatives to direct investing:
1. Mutual funds - lower investment required, redemption at NAV
2. ETFs - greater liquidity vs. MFs
3. Total return swaps - rec. Index returns, pay MRR
- synthetic index position

LOS i - discuss/justify/
- qualities of a benchmark
1/ unambiguous - identities/weights of constituents known
2/ investable
3/ Measurable - returns are readily calculable
- bond portfolio duration will drift downward over time unless rebalanced
- bond index characteristics reflect bond issuer propensity/preferences

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Yield Curve Strategies

Review - 1
LOS a – describe/
E(R) ≈ Coupon Income %∆𝐏𝐕𝐟𝐮𝐥𝐥 = (−𝐌𝐨𝐝𝐃𝐮𝐫 × ∆𝐲𝐢𝐞𝐥𝐝𝐬) +
+⁄− Rolldown Return ?𝟏)𝟐 × 𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲 × ∆𝐲𝐢𝐞𝐥𝐝𝐬𝟐 F
+⁄− E(∆price due to investor’s view of benchmark yields)
+⁄− E(∆price due to investor’s view of yield spreads)
+⁄− E(∆price due to investor’s view of currency value changes)

- primary YC changes: levels (parallel movements) ➞ duration mgmt.

slope (steepening, flattening, twists) duration +
2s30s shape (butterfly movement) convexity
higher = steeper mgmt.
- s.t.y + 2 x mty - Lty
lower = flatter
(2) (10) (30)
negative = inverted
- negative spread = positive butterfly shift ↑ ↓ ↑

- larger positive values = more curvature

Review - 2
LOS b - formulate/ - expectations of a static YC
- add duration or use leverage

1/ Buy and hold - buy bonds with a duration greater than the benchmark
- higher yield + illiquidity premium (off-the-run bonds)

2/ Rolling down the YC - buy a bond with a maturity beyond the IH

- total return > maturity matching strategy
- coupon income + capital appreciation

3/ Repos - buy a bond financed in the repo market

- (Coupon Income + Rolldown Return) - Repo rate

- Derivatives-based:
1/ Long futures (∆price for a ∆yield) - margin cost

2/ Receive fixed swap (swap rate - MRR) + ∆swap MTM for a

∆yield

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Review - 3
LOS c - formulate/ - dynamic YC ➞ Rate Level
- rates expected to drop (↓) ➞ extend duration
1/ extend duration with longer-dated bonds Coupon + Cap. app.

2/ Receive fixed swap - carry + MTM gain

3/ Long futures - MTM gains

- rates expected to rise (↑) ➞ decrease duration

1/ reduce duration with shorter-dated bonds (or short sales of
long-maturity bonds)
2/ pay fixed swap

3/ short futures

- derivative positions tend to be favoured over buying/selling in the

portfolio
➞ Slope - use of a barbell portfolio
steeper ➞ long short-maturity (+D), short long-maturity (-D)
flatter ➞ short short-maturity (-D), long long-maturity (+D)

Review - 4
LOS c - formulate/ ➞ Slope (+D -D)
Steepeners
1/ Duration neutral - gain from ∆slope

2/ Bull steepener - add duration - gain from ∆slope + -∆levels

- s.t. yields fall more than L.t. yields

3/ Bear steepener - reduce duration - gain from ∆slope + +∆levels

- L.t. yields rise more than s.t. yields

Flatteners (-D +D)

1/ Duration neutral - gain from ∆slope (↓)

2/ Bull flattener - add duration - gain from -∆slope + -∆yields

- L.t. yields drop by more than s.t. yields

3/ Bear flattener - decrease duration - gain from -∆slope + +∆yields

- s.t. yields rise more than L.t. yields

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Review - 5
LOS c - formulate/ ➞ Shape
1/ Positive Butterfly shift (neg. btfly. spread)
- wings up, body down ↑ ↓ ↑ ➞ -D +D -D
- long the bullet
- short the barbell
2/ Negative Butterfly shift (pos. btlfy. spread)
- wings down, body up ↓ ↑ ↓ ➞ +D -D +D
- long the barbell
- short the bullet
➞ LOS d - formulate/ ➞ Volatility
Put/Call options on bonds rates ↓ P ↑ ∴ long call (+D)
or futures rates ↑ P ↓ ∴ long put (-D)

Swaptions rates ↓ Buy receiver (rec. fx., pay fl.) +D

rates ↑ Buy payer (pay fx., rec. fl.) -D

Review - 6
LOS e - evaluate/ ➞ Key Rate Durations
- measures portfolio sensitivity over multiple maturities

e.g./ Tenor Active Index Difference

2 y. .39 .74 -.35
5 y. -.86 1.69 -2.55
10 y. 9.51 2.75 6.76

KRD = −𝟏 ∆𝐏𝐕
𝐏𝐕 ∆𝐫𝐤

LOS f - discuss Country A Country B forecasts for both

· levels
· slope
𝐒𝐏# · shape
𝐁

- Stable or dynamic - Stable or dynamic

UIRP - does not hold, ∴ carry trades possible

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Review - 7

LOS f - discuss high yielding currency low yielding currency

rec. fx. pay fx.

rec. fx. pay fl.
rec. fl. pay fl.
rec. fl. pay fx.

- buy securities in high yielding currency - trade at forward

discounts
- borrow in low yielding currency
- trade at forward premiums

- risks ➞ YC movements in both countries

➞ depreciation of high yielding currency

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Credit Strategies
Review - 1
LOS a – describe/ yield spread ➞ liquidity premium + credit risk
(𝐘𝐓𝐌𝐛𝐢𝐝 − 𝐘𝐓𝐌𝐚𝐬𝐤 ) default risk (POD)
loss severity (LGD)
𝐒𝐩𝐫𝐞𝐚𝐝G
POD ≈ 𝐋𝐆𝐃 where spread ➞ 𝐘𝐓𝐌𝐂 − 𝐘𝐓𝐌𝐆
LGD ➞ credit loss rate for a particular
rises widens rises
credit rating
as the economy slows
Credit Migration: changes in a bond’s public credit rating
- typically neg. effect P(downgrade) > P(upgrade)

Credit Spread Curves - usually categorized by rating, issuer type, sector

Spread
rising - curve changes in level and
POD slope driven by the
over time constant POD credit cycle
Maturity

Review - 2
LOS a – describe/ Credit Spread Curves
- lower rated issuers ➞ greater slope and level changes over the
cycle
- spread difference between rating categories (IG - HY) narrows
during periods of strong economic growth

ModDur/EffDur ➞ overstates %∆𝐏𝐕𝐟𝐮𝐥𝐥 ➞ more so for HY

- neg. corr. between rates and credit spreads
- Empirical duration is a better measure

LOS b - discuss/ Fixed Rate Bonds

1/ yield spread Corporate YTM - nearest o.t.r. UST YTM
- slope and maturity mismatch
- not a good measure of carry

2/ G-spread Corporate YTM - maturity matching UST YTM

(interpolated if needed)

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Review - 3
LOS b - discuss/ Fixed Rate Bonds
3/ I-Spread Corporate YTM - maturity matching swap rate
(interpolated if needed)
- more accurately measures carry for a leveraged position

4/ ASW (Corporate bond coupon - swap fixed rate) + MRR

- synthetic FRN
- full duration hedge ∴ no/low price volatility

5/ Z-spread constant spread over spot/swap rates, not YTMs

- more accurate than G or I

6/ CDS basis CDS spread - Z-spread

- if CDS spread < Z-spread, sets up a negative basis trade
- buy bond, buy CDS

7/ OAS - option adjusted spread - constant spread over forward rates in

a pricing model (can compare all bonds ➞ option free or not)

Review - 4
LOS b - discuss/ Floating Rate Notes
1/ QM - quoted margin - yield spread over MRR on issuance
2/ DM - discount margin - reflects changes in credit risk
(spread over MRR discount rate)
3/ Z-DM - zero discount margin - yield spread over forward MRRs
(𝐌𝐑𝐑 + 𝐐𝐌) × 𝐅𝐕 (𝐙𝟏 + 𝐐𝐌) × 𝐅𝐕 - takes the shape
𝐏𝐕 = 𝐦 + 𝐦 + ⋯ of the YC into
𝐌𝐑𝐑 + 𝐃𝐌 𝟏 𝐙𝟏 + 𝐃𝐌 𝟐
R𝟏 + 𝐦 W R𝟏 + 𝐦 W account

- for upward sloping YC, Z-DM < DM

Portfolio Level:
𝐌𝐕𝐢
Average OAS - portfolio credit quality ∑𝐎𝐀𝐒𝐢 R G𝐌𝐕 W
𝐏

𝐌𝐕𝐢
Average SD - portfolio spread volatility ∑𝐒𝐃𝐢 R G𝐌𝐕 W
𝐏

𝐌𝐕
DTS - duration × spread ∑𝐃𝐓𝐒𝐢 R 𝐢G𝐌𝐕 W
𝐏

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Review - 5
LOS b - discuss/ Excess spread return

EXR = (𝐭 × 𝐬) − (∆𝐒 × 𝐒𝐃) − (𝐭 × 𝐏𝐎𝐃 × 𝐋𝐆𝐃)

spread annualized POD
expected original change in
duration
spread OAS

LOS c - discuss/ Bottom-up Credit Strategies

define the credit universe
compare company-specific financial information
assess POD structural models - use the structure of the
balance sheet E = max.(𝐀𝐓 − 𝐃𝐓 , 𝟎) 𝐃𝐓 = max.(𝐃𝐓 , 𝐀𝐓 )
reduced form models e.g. Altman Z-score
- lower scores ➞ higher likelihood of fin. distress
- use of EXR = (𝐭 × 𝐬) − (∆𝐒 × 𝐒𝐃) − (𝐭 × 𝐏𝐎𝐃 × 𝐋𝐆𝐃)
- other considerations - optionality, capital structure priority, liquidity,
ratings outlook

Review - 6
LOS d - discuss/ Top-down credit strategies
focus on broad economic/sector data
- determine the desired credit quality of the portfolio vs.
benchmark
- use of weighted credit ratings
average OAS average SD DTS

facilitate measurement of ∆PV (% or $)

also Factor-based portfolios (carry, defensive, momentum, value)

ESG considerations (screening, ratings, green bonds)

LOS e - discuss/ Liquidity Risk

managing liquidity a) on-the-run or most recently issued bonds
b) liquid alternatives - ETFs, CDS
c) asset swaps for unwinding large illiquid
positions

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Review - 7
LOS f - describe/ Tail Risk
assessment parametric method - VaR
CVaR - avg. loss if VaR is breached
IVaR - VaR of adding/subtracting a position
relative VaR - VaR of active positions
Historical simulation can be used with
Monte Carlo analysis optionality
managing establish position limits
use derivatives to protect against downside losses

LOS g - discuss/ Synthetic Credit Strategies

protection buyer = long CDS = short credit quality (underweight)
protection seller = short CDS = long credit quality (overweight)

fixed spread % > 1 - premium ➞ seller pays buyer

CDS spread % < 1 - discount ➞ buyer pays seller

Review - 8
LOS g - discuss/ Synthetic Credit Strategies
upfront payment = [(fixed spread - CDS spread) x SD] x NA
to buyer
price per $1 [1 + (fixed spread - CDS spread) x SD]

%∆CDS price ≈ -(𝐒𝐃𝐂𝐃𝐒 × ∆𝐂𝐃𝐒𝐬𝐩𝐫𝐞𝐚𝐝 ) x NA

- payer option ➞ right to buy CDS (pay premiums)

- receiver option ➞ right to sell CDS (receive premiums)

CDS curve - CDS positioning strategies based on changes in

levels ➞ widening = buy CDS, narrowing = sell CDS
slope ➞ greater = sell short-mat. CDS, buy long-mat. CDS
➞ less ➞ reverse

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Review - 9
LOS h - discuss
Static Credit Spread Curve
1/ lower portfolio quality (higher OAS) or extend SD for
same credit quality (or both)
buy and hold ➞ or ‘carry and roll down’
2/ use derivatives to add SD - sell CDS

Dynamic Credit Spread Curve

∆levels ↑- buy CDS ↓ - sell CDS
- raise credit quality - lower credit quality
- decrease SD - increase SD

∆slope ↓ buy short-mat. CDS, sell long-mat. CDS

↑ sell short-mat. CDS, buy long-mat. CDS

Review - 10
LOS i - discuss/ Global Credit Strategies
Emerging/Frontier markets - dominated by sovereign issuers, state
owned enterprises, banks, commodity producers
- less diversification across sectors, less liquidity
- often a restricted currency, or much more volatile
- external debt denominated in EUR or USD
𝐜𝐮𝐫𝐫𝐞𝐧𝐜𝐲 𝐫𝐞𝐬𝐞𝐫𝐯𝐞𝐬
- G𝐆𝐃𝐏 - liquidity ratio

- higher concentration in lower IG and upper HY

sovereign corporates

LOS j - describe/ Structured Credit ➞ securities backed by collateral

CDO - backed by a pool of debt obligations (corporate loans)
CLO - backed by a pool of floating-rate leveraged loans
MBS - backed by commercial/residential mortgages

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Review - 11
LOS j - describe/ Structured Credit
ABS - backed by non-mortgage assets
Covered bonds - segregated debt obligations
- full recourse to issuer, non-performing assets
replaced
- typically offer higher returns through credit tranching

LOS k - describe/ see exhibit 31

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Introduction to Equity PM
Review - 1
LOS a – describe/
1/ Capital appreciation – growth
2/ Dividend income – less variable component of total return
3/ Diversification with other asset classes – equities as a whole
4/ Hedge against inflation – individual stocks as opposed to the
whole asset class
- client considerations for including equities in a portfolio – growth,
income, factor exposures (inflation, interest rates), ESG considerations

LOS b – describe/
small, mid., large cap
1/ Size and style
value, growth, core or blend - based on some
scoring system
+/ portfolio construction simplified
help define an appropriate benchmark
help keep managers within their style
no loss of diversification within a style/size category

Review - 2
LOS b – describe/
1/ Size and style
-/ categories have no clear standardized definition

2/ Geography – typically based on market’s macroeconomic

development (developed, emerging, frontier)
+/ global diversification
-/ specific market indexes may not be as local as desired
currency risk

3/ Economic Activity – industries/sector classification systems

(e.g. GICS, ICB)
market oriented – group companies based on the
markets they serve, the way revenue is earned, and the
way customers use products/services
production oriented – group companies that manufacture similar
products or use similar inputs
-/ large businesses may span several industries/sectors

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Review - 3
LOS b – describe/
4/ Segmentation of Equity Indexes & Benchmarks
geography + size/style
geography + industry/sector
investment approaches
LOS c - describe/
Income 1/ Dividends
2/ Securities lending income (to short sellers)
3/ Ancillary Investment strategies – dividend capture
- covered calls
- cash-secured puts
Fees 1/ Management Fees – typically AUM-based
2/ Performance Fees
3/ Administration Fees – by the fund
external party fees – custody, depository, registration
4/ Marketing/Distribution costs bid-offer spread
5/ Trading Costs – explicit & implicit market impact
transaction costs delay costs

Review - 4
LOS d – describe/
Shareholder engagement – process whereby investors actively
interact with companies
+/ more company information
chance to add value for active managers
-/ time consuming and costly
pressure on companies to meet s.t. targets
potential selective disclosure of info. to select investors

⇒ Equity Manager Role/ activist investing

voting

LOS e – describe/ Confidence to Outperform

Client Preference – ability to attract funds
Suitable benchmark – liquid with a broad # of securities
Client-specific Mandates – ESG, unacceptable activities
Risk/costs of Active Mgmt. – expense
Taxes – efficiency

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Passive Equity Investing

Review - 1
LOS a - discuss/
Passive - any rules-based, transparent & investable strategy that
does not involve identifying mis-priced securities
- selecting a benchmark
must be rules-based - criteria for inclusion & rebalancing
transparent - disclosure of rules & constituents
investable - performance can be replicated in the market
- ranges around
Terminology ➞ Buffering
break-points
➞ Packeting - splitting stocks
sm. mid lg.
into multiple parts
considerations in choosing a benchmark/ momentum
market segment, market cap, style, other exposures volatility
broad sector sm. mid lg. value, growth quality

LOS b - compare/
weighting method will influence performance

LOS b - compare/ Review - 2

a) market-cap weighting ⇒ if index is a good proxy for market

portfolio, any tracking portfolio will be mean-variance
cap weighting ∼ liquidity weighting optimal

- low cost, rules-based construction, transparency, investable

- subject to concentration risk
𝐧

𝐇𝐇𝐈 = I 𝐰 𝟐
⇒ effective # of stocks = 𝟏G𝐇𝐇𝐈
𝐢
𝐢.𝟏

b) factor-based strategies
Portfolio 1 Portfolio 2 passive rules for
growth growth underw. inclusion
value overw.
size size overw. active decisions
factors yield overw. regarding degree and
momentum underw. timing of factor
quality quality equal
exposures (takes
volatility underw.
selective place up front)
diversified exposure factor tilts
risk factors
concentrated risk factors

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Review - 3
LOS b - compare/
b) factor-based strategies dividend yield
return-oriented strategies momentum
fundamentally weighted
risk-oriented strategies - volatility weighting
diversification strategies - equal weighting

LOS c - compare/
1/ Pooled investments - MF, ETFs
+/ low cost, ease of trading, administrative convenience
both ETF MF
2/ Derivatives-based approaches – options, swaps, futures
+/ low cost, easy to implement, provide leverage
- typically used to adjust an existing portfolio
3/ Separately Managed Equity Index-Based Portfolios
- actually buying the shares

Review - 4
LOS d - compare/
1/ full replication - hold all securities of the index
- lowest tracking error, highest transaction costs
2/ stratified sampling - hold a limited sample of index constituents
- higher tracking error, lower transaction costs
- used when index is large AUM is low
3/ optimization - max. a desirable characteristic or min. an
undesirable characteristic
- lower tracking error vs. ➁
4/ Blended approach - full replication for more liquid issues
- ➁ or ➂ for others
LOS e - discuss/
Causes: fees
# of constituents held vs. benchmark
intraday trading of the constituents
trading commissions
cash balances

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Review - 5
LOS e - discuss/
Controlling: trade-off ➞ benefits of full replication vs. costs
minimize cash balances
maintain 𝛃 = 𝟏. 𝟎 w.r.t. the benchmark

LOS f - explain/ company specific

attribution analysis sector
country exhibit # 13
currency
securities lending
lending activism & engagement

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Active Equity Investing

Review - 1
LOS a - compare/

- Quantitative/ 𝐲 = 𝐛𝟎 + 𝐛𝟏 𝐱 𝟏 + 𝐛𝟐 𝐱 𝟐 + 𝐛𝟑 𝐱 𝟑 𝐱 𝐢 - factors
- rewarded - those shown to
high R2 ➞ the model is used
be positively related to
to predict future expected
long-term return premiums
returns
- unrewarded - no empirical
evidence

Review - 2
LOS a - compare/
Risk ➞ fundamental: risk is at the company level (valuation, forecasts)
quantitative: risk is at portfolio level (factor returns)

Rebalancing ➞ fundamental ➞ discretionary

➞ quantitative ➞ systematic, typically monthly/quarterly

LOS b - analyze/
1/ Value-based approaches relative value contrarian
high quality value deep value
income restructuring/distressed
special situations

2/ Growth-based approaches - companies expected to grow faster

than their industry or overall market

GARP - growth at a reasonable price ➞ PEG ratio = 1

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Review - 3
LOS c - analyze/
ETFs, futures, swaps, custom baskets of stocks
1/ Country & Geographic allocation 2/ Sector/industry rotation
3/ Volatility-based strategies 4/ Thematic investing

LOS d - analyze/ goal ➞ identify significant factors that can

predict future returns and construct a portfolio that tilts
towards those factors
Equity style rotation strategies - factor rotation
Hedged portfolio approach - rank stocks by a factor, long top
quartile, short bottom quartile
-/ ignores the middle groups
portfolios tend to be concentrated
assumes a linear relationship between factor & future return
hedged factor is not a pure factor
Long-only portfolio - factor tilting

Review - 4
LOS d - analyze/
Style factors ➞ Value, Price Momentum, Growth, Quality,
Unconventional Factors based on unstructured data
LOS e - analyze/ (satellite images, online mentions)
- taking stakes in listed companies and advocating changes for
the purposes of providing a gain on the investment
Defenses ➞ dual-class share structure, poison pills, shareholder rights,
staggered boards
Targets ➞ slower revenue/earnings growth than the market
➞ negative share price momentum
➞ weaker than average corporate governance

LOS f - describe/
Statistical Arbitrage - uses statistical & technical analysis to
exploit pricing anomalies
- take advantage of mean reversion in share prices
e.g./ Pairs trade ➞ identify 2 stocks that are historically highly correlated
➞ long underperforming, short overperforming

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Review - 5
LOS f - describe/
Statistical Arbitrage - risk is that divergence may not
be temporary (e.g. structural change)
Market Microstructure - very short-term mispricing opportunities
(e.g. Buy/sell imbalances)
LOS g - describe/
1/ Define the investment universe and the market opportunity
2/ Prescreen the investment universe
3/ Understand the industry and business
4/ Forecast company performance
5/ Convert forecasts to valuations
6/ Construct portfolio with desired risk profile
7/ Rebalance with buy/sell disciplines
- Pitfalls/ Behavioral Biases (confirmation, loss aversion, overconfidence, etc..)
Value Traps Growth Traps

Review - 6
LOS h - describe/
1/ Define the market opportunity
2/ Acquire and process data
3/ Back-test the strategy - measures of factor performance
max the IC ➞ Pearson IC = corr.(𝐟𝐚𝐜𝐭𝐨𝐫 𝐬𝐜𝐨𝐫𝐞𝐬𝐭 , 𝐬𝐭𝐨𝐜𝐤 𝐫𝐞𝐭𝐮𝐫𝐧𝐬𝐭)𝟏 )
➞ Spearman rank IC = corr.(𝐫𝐚𝐧𝐤𝐞𝐝 𝐟𝐚𝐜𝐭𝐨𝐫 𝐬𝐜𝐨𝐫𝐞𝐬𝐭 ,
𝐫𝐚𝐧𝐤𝐞𝐝 𝐟𝐨𝐫𝐰𝐚𝐫𝐝 𝐫𝐞𝐭𝐮𝐫𝐧𝐬𝐭)𝟏 )
- creating a multi-factor model: factors may be effective
individually, but may not add material value to a
factor model
4/ Evaluate the strategy ➞ out-of-sample data
5/ Portfolio construction
Pitfalls/ Survivorship Bias
Look-ahead Bias
Data Mining
Turnover, transaction costs, short availability

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Review - 7
LOS i - discuss/
- split stocks into groups with similar characteristics
- returns of stocks within groups should be more highly
correlated than between groups
1/ Holdings-based approach - look at a manager’s holdings
and classify each stocks style
e.g./ Morningstar Style Box value, blend, growth × sm., mid, large
- generally most accurate
2/ Return’s based approach
𝐦
𝐑𝐬𝐭 - return of style index S
𝐫𝐭 = 𝛂 + 1 𝛃 𝐬
𝐑𝐬𝐢 + 𝛆𝐭 𝛃𝐬 - funds exposure to style S
𝐒&𝟏
(∑𝛃𝐬 = 𝟏 , 𝛃𝐬 > 𝟎)

3/ Manager self-identification - as described in fund prospectus

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Active Equity Investing: Portfolio Construction

Review - 1
LOS a - describe/
𝐑 𝐀 = ∑(𝛃𝐏𝐤 − 𝛃𝐛𝐤 ) × 𝐅𝐢 + (𝛂 + 𝛆) luck/noise
active return
exposure to priced alpha - returns not explained by
or rewarded factors exposure to rewarded risks

- all 3 sources of RA remain the same regardless of style/approaches

- proportions of RA from each will vary however
➞ Building blocks used in portfolio construction
1/ factor weightings - over/under rewarded factors
2/ alpha - factor timing or exposure to unrewarded factors
3/ sizing positions - must balance:
A/ mgr. confidence in their alpha B/ mitigating
and factor insights idiosyncratic risk
➞ factor orientation ➞ diversified security much greater in
selection concentrated portfolios
➞ stock picker ➞ concentrated portfolio

Review - 2
LOS a - describe/
4/ Breadth - # of truly independent decisions made each yr.
- confidence in a manager’s ability to outperform a
benchmark increases when that performance can be
attributed to a larger sample of independent decisions

LOS b - discuss/

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Review - 3
LOS c - distinguish/ 𝐧
𝟏
Active Share = 1Ž𝐰𝐏𝐢 − 𝐰𝐛𝐢 Ž - percent of portfolio that
𝟐
𝐢&𝟏 differs from the benchmark
Active Risk - affected by the degree of cross-correlation
- higher = less effect on active risk
𝛔𝐑 𝐀 = •𝛔𝟐 (∑(𝛃𝐏𝐤 − 𝛃𝐛𝐤 ) × 𝐅𝐢 ) + 𝛔𝟐𝛆

high net exposure to a risk factor ➞ high level of 𝛔𝐑 𝐀

level of 𝛔𝐑 𝐀 rises with ↑ factor & idiosyncratic volatility
𝛃𝐏𝐤 − 𝛃𝐛𝐤 = 𝟎 ➞ 𝛔𝐑 𝐀 fully attributed to active share ➞ 𝛔𝐑 𝐀 attributed to
active share will be
smaller if:

1/ # of securities is large

2/ average idiosyncratic
risk is small

Review - 4
LOS d - discuss/ absolute
1/ Which type of risk measure relative
2/ Causes/sources of A/ absolute risk - if an asset is added/replaced
that has a higher Cov. w/ rest of portfolio:
absolute risk will rise
- absolute portfolio risk can be attributed/budgeted to:
1/ desired factor exposures (rewarded)
2/ other than rewarded factors

B/ relative risk low 𝛔𝟐 asset increases active risk

portfolio
high 𝛔𝟐 asset lowers active risk if the
asset has a high covariance
with the benchmark
high 𝛔𝟐
benchmark

3/ Determine the appropriate level of risk - different managers

with similar styles may have different risk appetites

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Review - 5
LOS d - discuss/
3/ Determine the appropriate level of risk
a) Implementation constraints - no short positions, no leverage
b) limited diversification opportunities - portfolios with
high absolute risk targets eventually run out of
high return investment opportunities
c) leverage levels - beyond a certain level, volatility
reduces compounded returns
4/ Properly allocate risk among individual positions/factors
- a fund’s style/strategy will dictate much of the structure
of its risk budget ∴ risk budget not really free to spend

LOS e - discuss/describe/
1/ heuristic - limits on concentration, leverage, turnover
2/ formal - often statistical in nature
- requires estimates/predictions of risk

Review - 6
LOS f - discuss/ Costs
↓ implicit implicit ↑
smaller = ↓ ADV
↑ explicit explicit ↓
↑ %’age/day
small large of cap
AUM
affect
Position Size market ➞ f(.) ➞ market cap
Liquidity impact +
affect
ADV
Turnover
- strategy of the manager must be consistent with the
feasibility of implementing it
e.g./ Large cap fund can support a higher level of
AUM than small cap fund
limit AUM
must either be more diversified
limit turnover

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Review - 7
LOS g - evaluate/
well constructed portfolio possesses:
a clear investment philosophy & a consistent investment process
risk & structural characteristics as promised to investors
a risk efficient delivery methodology
reasonably low costs given the strategy

LOS h - discuss/
Long-short conviction of negative views can be expressed
short selling can reduce exposures
net exposure = long - |short|
gross exposure = long + short
Long Extension e.g. 130:30 ➞ allows for greater alpha
Market Neutral - hedge out most market risk
- can be implemented for a variety of risk factors
- benchmark usually fixed-income instruments

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