CFA Level 3 - Institutional Investors

Institutional Investors
endowment annual total return = annual contribution + expense growth + management fees
(inflation is captured in expense growth)

the greater the reliance on the endowment to fund operations w/o any other sources of funds, the lower the risk tolerance of the endowment. If endowment can get donations even when it supports 75% of univ operating budget, the risk tolerance is considered high.

min return requirement of DB pension plan -> the rate that equates PV of plan assets to PV of plan liabilities, if plan is fully funded, use the discount rate to compute pernsion benefit obligation.

casualty insurance risk tolerance: uncertain loss claims by clients -> short duration, lower risk tolerance

endowment above average risk tolerance : long investment time horizon

In a defined benefit pension plan, meeting the liability is the investment objective and portfolio's benchmark.

Liability mimicking

The managers create an investment benchmark from assets that mimic the specific market-related risks associated with the pension liabilities. Then managers use derivatives to hedge the market-related exposures of the liability-mimicking assets making up the investment benchmark. This is more efficient than investing in the low risk portfolio defined by the investment benchmark because the derivatives require far less capital, thus freeing up funds. The funds can then be used for efficient return generation within asset-only space once the liabilities have been hedged. The funds invested in this asset-only space allow the pension plan to generate returns in excess of the pension liabilities, thereby decreasing the need for future cash contributions.

Investment Policy Statement (IPS) case study 

The Somchai Foundation (SF), was established to provide grants in perpetuity. SF has just received word that the foundation will receive a $45 million cash gift three months from now. The gift will greatly increase the size of the foundation’s endowment from its current $10 million. The foundation’s grant-making (spending) policy has been to pay out virtually all of its annual net investment income. Because its investment approach has been conservative, the endowment portfolio now consists almost entirely of fixed-income assets. The finance committee understands that these actions are causing the real value of foundation assets and the real value of future grants to decline because of inflation effects. Until now, the finance committee believed it had no alternative to these actions, given the large immediate cash needs of the research programs being funded and the small size of the foundation’s capital base. The foundation’s annual grants must at least equal 5 percent of its assets’ market value to maintain SF’s tax-exempt status, a requirement that is expected to continue indefinitely. The foundation anticipates no additional gifts or fundraising activity for the foreseeable future.

Given the change in circumstances that the cash gift will make, the finance committee wishes to develop new grant-making and investment policies. Annual spending must at least meet the 5 percent of market value requirement, but the committee is unsure how much higher spending can or should be. The committee wants to pay out as much as possible because of the critical nature of the research being funded; however, it understands that preserving the real value of the foundation’s assets is equally important in order to preserve its future grant-making capabilities. You have been asked to assist the committee in developing appropriate policies.

Identify and discuss the three key elements that should determine the foundation’s grant-making (spending) policy.

Formulate and justify an investment policy statement for the foundation.

Answer:
Three key elements:

• expected inflation
• expected nominal return
• the 5% min payout requirement to maintain tax exempt status

IPS (Investment Policy Statement)
return objectives:
the foundation must maintain the real value of its capital, after grants. The minimum return requirement should be spending rate + expected inflation + management fee
risk objectives:
based on long time horizon and low liquidity need, the foundation's risk tolerance is above average.
liquidity needs:
low 
time horizon:
foundation has long time horizon, unlimited life span
tax considerations:
tax exempt if annual spending more than 5% of its assets' market value
legal and regulatory constraints:
the foundation is governed by IRS and UMIFA regulations.
unique circumstances:
none

CFA Level 3 - Fixed Income Portfolio Management

Managing funds against a bond market index benchmark
- Pure bond indexing
- Enhanced indexing by matching primary risk factors
- Enhanced indexing by small risk factors mismatches
- Enhanced indexing by larger risk factors mismatches
- Active management by larger risk factor mismatches
- Full blown active management

Managing funds against liabilities
- Immunization: locking in a guaranteed return over a particular horizon
1) single period immunization (classical immunization). It requires offsetting price risk and reinvestment risk. It can be done by duration matching (matching the duration of portfolio to liabilities)

for upward sloping yield curve, the immunization target rate of return < ytm because of lower reinvestment return. (price risk -> high yield lowers bond prices, price change is more than the increase in reinvestment of coupons )

type of risks:
interest rate risk, contingent claim risk (mortgage back securities when underlying mortgage prepay principal), cap risk (asset return are capped)

2) Multiple liabilities Immunization: composite return of portfolio equal composite return of liabilities

- Cash flow matching
match liability flow with assets flows of the portfolio. Immunization require less money to fund liabilities

Duration hedging
Basis risk : the difference between cash price and futures price is called basis, risk that basis will change is called basis risk
Unhedged position - has price risk, which is a risk that cash market price will move adversely
A hedged position substitute basis risk for price risk

hedged ratio = Factor exposure of bond to be hedged/factor exposure of hedging instrument
= (D_T-D_I)P_I/D_CTDP_CTD * conversion factor of CTD bond

Derivative Strategies
-interest rate future
-interest rate swap: dollar duration of swap = dollar duration of fixed rate bond -  dollar duration of floating rate bond
-interest rate options
-credit risk instruments

International bond investing
 Δ in value of foreign bond = duration * Δin foreign yield given change in domestic yield
 Δ in value of foreign bond = duration * Δin yield * country beta

Duration definition
Macaulay duration: weighted average time to receive of CFs, using PV of each CF as the weight on time until it is received
Modified duration: % Δ bond price  for 1% Δ in the its ytm, assuming CFs don't change
Effective duration:  % Δ bond price  for 1% Δ in the its ytm, assuming CFs might change
spread duration:  % Δ bond price  for 1% Δ in its spread over treasury of same maturity
key rate duration: % Δ bond price  for 1% Δ in the ytm of treasury of a given maturity

Duration of Foreign bonds
adjusted duration = county duration * country beta
ΔPrice = adjusted duration * Δyield
Contribution = % weight * adjusted duration

Important points
As interest rate changes, portfolio duration will change (look at the price yield curve), portfolio must be re-balanced to adjust duration to desired level.

Portfolio can be managed to generate additional returns, the incremental difference between min return and higher possible immunized rate, is known as cushion spread. When there is cushion spread, manager can actively manage part of the portfolio. Contingent immunization is to integrate immunization strategies within active mgt strategies.

When manager expects credit spread will widen due to economic worsening, curve adjustment trades take place. The strategy is to shift the portfolio exposure to shorten the spread duration by buying shorter maturity bonds, and sell longer maturity bonds, and lower the contribution to spread duration

To immunize portfolio target yield against change in market yield, the bond portfolio must be (1) duration = investment horizon (2) Initial PV of all CFs = PV of future liability

Given a upward sloping yield curve, bond's ytm increase as maturity of the bond portfolio increase. A long duration portfolio will fall more in price than the short duration portfolio.

Hedging of foreign bonds
Example: domestic currency USD, holds Euro denominated bonds, Euro rate 2.50% US rate 0.25%

According to IRP, USD appreciates by 0.25%-2.50% = -2.2.5% (Euro depreciates)

expected depreciation of euro is 1.75%.

There is no need to hedge in this case.

Working Capital

Operating capital: capital used in daily operations of a business
Working capital: includes inventory, cash, raw materials, and A/R
Net Operating Working capital: measure operating liquidity of a business

NWC = CA - CL
NOWC = (CA - Cash) - CL
NWCInv (for calculating FCF) = does not include cash, cash equivalent, notes payable and current portion of debt

CA are Inventory, A/R, Prepaid expense
-- Cash, marketable securities are considered non-operating assets, not included in CA
CL is A/P, Accruals, non interesting bearing liabilities
-- Notes payable is not included in CL


When finding the net increase in working capital for the purpose of calculating free cash flow, we define working capital to exclude cash and cash equivalents as well as notes payable and the current portion of long-term debt. Cash and cash equivalents are excluded because a change in cash is what we are trying to explain. Notes payable and the current portion of long-term debt are excluded because they are liabilities with explicit interest costs that make them financing items rather than operating items.