SCHWESERNOTES™
FOR THE

FRM EXAM

FRM 2013
Book 4

Part II

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Risk Management and Investment Management;
Current Issues in Financial Markets

1 of 2

KAPLAN

SCHWESER


FRM PART II BOOK 4: RISK
MANAGEMENT AND INVESTMENT
MANAGEMENT; CURRENT ISSUES IN
FINANCIAL MARKETS
READING ASSIGNMENTS AND AIM STATEMENTS

3

RISK MANAGEMENT AND INVESTMENT MANAGEMENT
53: Portfolio Construction
54: Portfolio Risk: Analytical Methods
55: VaR and Risk Budgeting in Investment Management

12

56: Risk Monitoring and Performance Measurement
57: Empirical Evidence on Security Returns

57

24
41
63


5H: Portfolio Performance Evaluation
59: Overview of Hedge Funds
60: Hedge Fund Investment Strategies

103

61: Overview of Private Equity

125

62: Hedge Funds

135

63: Risk Management for Hedge Funds: Introduction and Overview
64: Trust and Delegation
65: MadolF: A Riot of Red Flags

146

HI

112

161

169

CURRENT ISSUES IN FINANCIAL MARKETS

66: Sovereign Creditworthiness and Financial Stability:
An International Perspective

67: Of Runes and Sagas: Perspectives on Liquidity Stress Testing
Using an Iceland Example
6K: Tails of the Unexpected
69: The Dog and the Frisbee
70: Challenges of Financial Innovation
71: Exchange-Traded Funds, Market Structure and die Flash Crash
SELF-TEST;

17H

1H9

203
215
22H

235

RISK MANAGEMENT AND INVESTMENT

MANAGEMENT; CURRENT ISSUES IN FINANCIAL MARKETS

253

PAST FRM EXAM QUESTIONS

259


FORMULAS

271

APPENDIX

275

INDEX

279
©2013 Kaplan, Inc.

Page 1


FKM PART IJ ROOK 4: RISK MANAGEMENT AND INVESTMENT MANAGEMENT; CURRENT
ISSUES IN FINANCIAL MARKETS
£>201 3 Kaplan, foe., d.b.a. Kaplan Schweser. All rights reserved.

Printed in the Uni Led States of America.
ISBN: 97ft-1-4277ÿ474-6 l

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Disclainier:Tbe .SchweserNotes should lie used in conjunction with die original readings as set forth by
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accurate.

However, dieir accuracy cannot be guaranteed nor is aov warranty conveyed as to your ultimate exam

success.

Page 2

Kaplan., Inc.


READING ASSIGNMENTS AND
AIM STATEMENTS
Thefollowing material is a review of the Risk Management and Investment Management, and
Current Issues in Financial Markets principles designed to address the AIM statements setforth
by the Global Association of Risk Professionals.

READING ASSIGNMENTS
Risk Management and Investment Management


Richard Grinold and Ronald Kahn, Active Forfolio Management: A Quantitative
Approachfor Producing Superior Returns and Controlling Risk, 2nd Edition (New York:
McGraw-Hill, 2000).

53. “Portfolio Construction,” Chapter 14

(page 12)

Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk,
3rd Edition. (New York: McGraw Hill, 2007).

54. “Portfolio Risk: Analytical Methods,” Chapter 7

(page 24)

55. “VaR and Risk Budgeting in Investment Management,” Chapter 17

(page 41)

RoherL Litterman and the Quandcative Resources Group, Modem Investment
Management: An Equilibrium Approach (Hoboken, NJ: John Wiley & Sons, 2003).

56. “Risk Monitoring and Performance Measurement,” Chapter 17

(page 57)

Zvi Bodie, Alex Kane, and Alan J. Marcus, Investments, 9th Edition (New York McGraw-

Hill, 2010).


57. “Empirical Evidence on Security Returns,” Chapter 13

(page 68)

58. “Portfolio Performance Evaluation,” Chapter 24

(page 81)

David P. Stowed, An Introduction to Investment Banks, Hedge Funds, and Private Equity
(Academic Press, 2010).

59. “Overview ofHedge Funds,” Chapter 11

(page 103)

60. “Hedge Fund Investment Strategies,” Chapter 12

(page 112)

©2013 Kaplan, Inc.

Page 3


Book A
Reading Assignments and ATM Statements

61. ""Overview ofPriva.ce Equity/ Chapter 16


(page 125)

G. Constantinides, M. Harris and R. Stulz. Ed., Handbook of the Economics of Finance,
Volume 2B (Oxford: Elsevier, 2013).
62. “Hedge Funds/ Chapter 17

(page 135)

63. Andrew W. Lo, "Risk Management for Hedge Funds: Introduction and Overview/
Financial AnalystsJournal, Vol. 57, No. 6 (Nov to Dec, 2001), pp. 16-33. (page 146)
64. Stephen Brown, William Goetzmann, Bing Liang, Christopher Schwarz, “Trust and
Delegation/ May 28, 2010.
(page 161)
65. Greg N. Gregoriou and Franÿois-Serge Lhabitant,
December, 2008.

A Riot of Red Flags/
(pag£ 169)

Current Issues in Financial Markets

66. Jaime Caruana and Stefan Avdjiev, ''Sovereign Creditworthiness and Financial Stability:
An International Perspective.11 Banque de France Financial Stability Review, No. 16
(April 2012), pp. 71-85.
{page 17ft)

67. Li Lian Ong and Martin Cihdk, “Of Runes and Sagas: Perspectives on Liquidity Stress
Testing Using an Iceland Example/ IMF Working Paper WP/10/ 156,
July 20 10.
(page 189)

68. Andrew G. Haldane and Benjamin Nelson, “Tails of the Unexpected.” Speech from
“The Credit Crisis Five Years On: Unpacking the Crisis1’ Conference at the University of
Edinburgh (Bank of England, June 8 2012).
(page 203)

69. Andrew G. Haldane and Vasileios Madouros, “The Dog and the Frisbee/ Speech from
the Federal Reserve Bank of Kansas City's 36th Economic Policy Symposium (Bank of
England, August 31 2012).
(page 215)

Gerald Rosenlield, Jay Lorsch, Rakesh Khurana (eds.), Challenges to Business in the
Twenty-First Century, (Cambridge: American Academy of Arts & Sciences, 2011).
70. “Challenges of Financial Innovation/ Chapter 2

(page 228)

71. Ananth Madliavan, “Exchange-Traded Funds, Market Structure and die Flash Crash/
October 2011.
(page 235)

Page 4

©2013 Kaplan, Tnc.


Book 4
Reading Assignments and AIM Statements

AIM STATEMENTS
53. Portfolio Construction

Candidates, after completing this reading, should be able to:
1 . Identify the inputs to the portfolio construction process, {page 12)
2. Describe the motivation and methods for refining alphas in die implementation

3.

4.
5.
6.

7.
8.

process, {page 12)
Describe neutralization and methods for refining alphas to be neutral, (page 13)
Describe the implications of transaction costs on portfolio construction, (page 14)
Explain practical issues in portfolio construction such as determination of risk
aversion, incorporation of specific risk aversion, and proper alpha coverage.
{page 14)
Describe portfolio revisions and rebalancing and the tradeoffs between alpha, risk,
transaction costs anti time horizon, (page 16)
Describe the optimal no-trade region for rebalancing with transaction costs.
{page 16)
Describe the following portfolio construction techniques, including strengths and
weaknesses:
Screens
*

Stratification
Linear programming

• Quadratic programming
{page 17)
9. Describe dispersion, explain its causes and describe methods for controlling forms
of dispersion, (page 18)
*
*

54. Portfolio Risk: Analytical Methods
Candidates, after completing this reading, should be able to:
1 . Define and distinguish between individual VaR, incremental VaR and diversified
portfolio VaR. (page 24)
2. Explain the role correlation has on portfolio risk, (page 25)
3. Compute diversified VaR, individual VaR, and undiversified VaR of a portfolio.
{page 24)
4. Define, compute, and explain the uses of marginal VaR, incremental VaR, and
component VaR. (page 28)
5. Describe the challenges associated with VaR measurement as portfolio size increases.
(page 29)
6. Demonstrate how one can use marginal VaR to guide decisions about portfolio
VaR. (page 33)
7. Explain the difference between risk management and portfolio management, and
demonstrate how to use marginal VaR in portfolio management, (page 34)

55. VaR and Risk Budgeting in Investment Management
Candidates, after completing this reading, should be able to:
1 . Define risk budgeting, (page 4 1)

2. Describe the impact of horizon, turnover and leverage on the risk management
process in the investment management industry. (page4l)
3. Describe the investment process of large investors such as pension funds, (page 42)

4. Describe the risk management challenges with hedgie funds, {page 43)

©2613 Kaplan, Inc.

Page 5


Boole 4
Reeling Assignments and AIM Statements

5. Define and describe die following types of risk: absolute risk, relative risk, policymis risk, active management risk, funding risk and sponsor risk, (page 43)
6. Describe how VaR can be used to check compliance, monitor risk budgets and
reverse engineer sources of risk, (page 46)
7. Explain how VaR can be used in die investment process and development of

guidelines, (page 48)
Describe the risk budgeting process across asset classes and active managers.

investment
8.

(page 49)

56. Risk Monitoring and Performance Measurement
Candidates, after completing this reading, should be able to:
1. Define, compare and contrast VaR and tracking error as risk measures, (page 57}
2. Describe risk planning including objectives and participants in its development.
(page 58)
3. Describe risk budgeting and the role of quantitative methods, (page 59)
4. Describe risk monitoring and its role in an internal control environment, (page 59)

5. Identify sources of risk consciousness within an organization, (page 59)
6. Describe die objectives of a risk management unit in an investment management
firm, (page 60)
7. Describe how risk monitoring confirms that investment activities are consistent
with expectations, (page 61)
8. Explain die importance of liquidity considerations for a portfolio, (page 61)
9. Describe die objectives of performance measurement, (page 62)
10. Describe common features of a performance measurement framework, (page 62)

57. Empirical Evidence on Security Returns
Candidates, after completing this reading, should be able

to:

1. Interpret die expected return-beta relationship implied in the CAPM,

2.

34.

5.
6.
7.
8.

9.

Page 6

and describe


the methodologies for estimating the security characteristic line and the security
market line from a proper dataset, (page 68)
Describe the two-stage procedure employed in early tests of die CAPM and explain
the concerns related to these early test results, (page 69)
Describe and interpret Rolls critique to the CAPM, as well as expansions of Rolfs
critique, (page 69)
Describe the methodologies for correcting measurement error in beta, and explain
historical test results of these methodologies, (page 70}
Explain the test of the single-index models that accounts for human capital, cyclical
variations and non traded business, (page 71)
Summarize the tests of multifactor CAPM and APT. (page 72)
Describe and interpret the Fama-French three-factor model, and explain historical
test results related to this model, (page 73)
Summarize different models used to measure the impact of liquidity1' on asset
pricing and asset returns, (page 74)
Explain die "equity premium puzzle" and describe the different explanations to diis
observation, (page 75)

©201 3 KapLan, Inc.


Bonk 4
Reading Alignments and AIM Statements

53. Portfolio Performance Evaluation
Candidates, after completing this reading, should he able to:
Differentiate between the time-weighted and doliar-weighted returns of a portfolio
and their appropriate uses, {page Si)
2. Describe the different risk-adjusted performance measures, such as Sharpe’s

measure, Treynor’s measure, Jensen's measure (Jensen’s alpha), and information
ratio, (page 84)
3. Descrihe the uses for the Modigliani-squared and Treynor’s measure in comparing
two portfolios, and the graphical representation of these measures, (page 84)
4. Descrihe the statistical significance of a performance measure using standard error
and the t-statisric. (page 91)
5. Explain the difficulties in measuring the performances of hedge funds, (page 92)
6. Explain how portfolios with dynamic risk levels can affect the use of the Sharpe
ratio to measure performance, (page 92}
7. Descrihe techniques to measure the market timing ability of fund managers with a
regression and with a call option model, (page 93)
8. Descrihe style analysis, (page 94)
9. Descrihe the asset allocation decision, (page 94)

1.

59. Overview of Hedge Funds
Candidates, after completing this reading, should be able to:
1 . Descrihe the common characteristics attributed to hedge funds, and how they
differentiate from standard mutual funds, (page 103)
2. Explain the investment strategies used by hedge funds to generate returns.

3.

4.
5.
6.
7.
8.


9.

(page 104)
Describe how hedge funds grew in popularity and their subsequent slowdown in
2008. (page K)4)
Explain the fee structure for hedge funds, and the use of high-water marks and
hurdle rates, (page 105)
Assess academic research on hedge fund performance, (page 105)
Explain how hedge funds helped progress die financial markets, (page 106)
Descrihe the liquidity of hedge fund investments and die usage of lock-ups, gates
and side pockets, (page 106)
Compare hedge funds to private equity and mutual funds, (page 107)
Descrihe funds of funds and provide arguments for and against using them as an
investment vehicle, (page 107)

60. Hedge Fund Investment Strategies
Candidates, after completing this reading, should he able to:
1. Descrihe equity-based strategies of hedge funds and their associated execution
mechanics, return sources and costs, (page ] 12)
2. Summarize how macro strategies are used to generate returns by hedge funds*

(page 113)
3. Explain the common arbitrage strategies of hedge funds, including fixed-incomebased arbitrage, convertible arbitrage and relative value arbitrage, (page 113)
4. Descrihe the mechanics of an arbitrage strategy using an example, (page 115)
5. Descrihe event-driven strategies, including activism, merger arbitrage and distressed
securities,

(page 1 16)

©2013 Kaplan, Inc.


Page 7


Bonk 4
Reading Assignment; and AIM Statements

6. Explain the mechanic; involved in event-driven arbitrage, including their upside
benefits and downside risks, (page I IS)
7. Describe and interpret a numerical example of the following strategies: merger
arbitrage, pairs trading, distressed investing and global macro strategy, (page 119}
6 1. Overview of Private Equity

Candidates, after completing this reading, should be able

to:

I . Describe and differentiate between major types of private equity investment
activities,

(page 125)

2. Describe die basic structure of a private equity fund and its sources and uses of
cash, (page 125)
3. Describe private equity funds of funds and die secondary markets for private equity.
(page 126)
4. Describe the key characteristics of a private equity transaction, (page 127)
5. Identify the key participants in a private equity transacdon and the roles they play.
(page 127)
6. Identify and describe methods of funding private equity transactions, (page 12B)

7. Identify issues related to the interaction between private equity firms and die
management of target companies, (page 129)
8. Describe typical ways of capitalizing a private equity portfolio company, (page 129)
9. Describe the potential impact of private equity transactions, including leveraged
recapitalizations, on target companies, (page 130)
62. Hedge Funds

Candidates, after completing this reading, should be able

to:

I . Describe die characteristics of hedge funds and die hedge fund industry, and
compare hedge funds widi mutual funds, (page 135)
2. Explain die evolution of the hedge fund industry and describe landmark events
which precipitated major changes in the development of the industry, (page 135)
3. Describe die different hedge fund strategies, explain their return characteristics, and
describe the inherent risks of each strategy, (page 136)
4. Describe die historical performance trend of hedge funds compared to equity
indices, and evaluate statistical evidence related to the strategy of investing in a
portfolio of top performing hedge funds, (page 139)
5. Descrihe the market events which resulted in a convergence of risk factors for
different hedge fund strategies, and explain the impact of such a convergence on
portfolio diversification strategies, (page 140)
6. Describe the problem of risk sharing asymmetry hetween principals and agents in
the hedge fund industry, (page 141}
7. Explain the impact of institutional investors on die hedge fund industry and assess
reasons for the trend towards growing concentration of assets under management
(AUM} in die industry, (page 141}

63. Risk Management lor Hedge Funds: Introduction and Overview

Candidates, after completing this reading, should be able to:
1. Compare and contrast the investment perspectives between institutional investors
anti hedge fund managers, (page 146)
2. Explain how proper risk management can itself he a source of alpha for a hedge
fund, (page 147)

Page 8

©2013 Kaplan, Inc.


Book 4
Statements
and
AIM
Reading Assignments

3. Explain die limitations of the VaR measure in capturing the spectrum of hedge
fund risks, {page 148)
4. Explain how survivorship bias poses a challenge for hedge fund return analysis.
(page 150)
5. Describe how dynamic investment strategies complicate the risk measurement
process for hedge funds, (page 151)
6. Describe how the phase-locking phenomenon and nonlinearities in hedge fund
returns can he incorporated into risk models, (page 153)
7. Explain how autocorrelation of returns can be used as a measure of liquidity of the
asset,

(page 155)


64. Trust and Delegation

Candidates, after completing this reading, should he able to:
1. Explain the role of third party due diligence firms in the delegated investment
decision-making process, (page 161)
2. Explain how past regulatory and legal problems with hedge fund reporting relates to

expected future operational events, (page 1 63)
3- Explain the role of the due diligence process in successfully identifying inadequate
or failed internal process, (page 164)

65. Madoff: A Riot of Red Flags
Candidates, after completing this reading, should be able to:
1. Describe Bernard MadofF Investment Securities (BMIS) and its business lines.
(page 169)
2. Explain what is a split-strike conversion strategy, (page 170)
3. Describe the returns reported on MadoiF’s feeder funds, (page 171)
4. Explain how the securities fraud at BMLS was caught, (page 171)
5. Describe the operational red flags at BMIS conflicting with the investment
professions standard practices, (page 171)
6. Describe investment red flags that demonstrated inconsistencies in BMIS'
investment style, (page 172)

66. Sovereign Creditworthiness and Financial Stability: An International Perspective

Candidates, after completing this reading, should be able to:
1. Explain three key initial conditions that helped spread of the economic crisis

globally among sovereigns, (page 178)
2. Describe three ways in which the financial sector risks are transmitted to sovereigns.


(page 179)
3. Describe five ways in which sovereign risks are transmitted to the financial sector.
(page ISO)
4. Summarize the activity of hanks and sovereigns in die European Union during die
2002-2007 period leading up to die economic crisis, (page 180)
5. Summarize the activity of banks and sovereigns in the European Union during die
economic crisis, (page 181)
6. Describe how risks were transmitted among banks and sovereigns in the European
Union during the economic crisis, giving specific examples, (page 1 H 1)
7. Describe the economic condition of the European financial sector in 2012, and
explain some possihle policy implementation that can help mitigate the spread of

future crises, (page 183)

©2013 Kaplan, Inc.

Page 9


Book 4

Reading Assignments and ATM Statements

67. Of Runes and Sagas: Perspectives on Liquidity Stress Testing Using an Iceland
Example
Candidates, after completing this reading, should he able to:
I . Summarize the events of the Icelandic debt crisis, (page IS!))
2. Descrihe the typical solvency and liquidity scenarios present at Icelandic hanks in
the periods leading up to the Icelandic debt crisis, (page 190)

3. Explain how the weighting of shocks in short-term assets and short-term liabilities
are adjusted in stress tests drat account for a liquidity crisis, (page 191)
4. Contrast the stress test methods of the Financial Supervisory Authority (FME) and
Sedlabanki, and compare their results to die resultant funding gap at Sedlabanki
from the actual shocks, (page ] 94)
5. Descrihe several ways to improve die management of solvency risk at banks.

(page 197)
6S. Tails of the Unexpected

Candidates, after completing this reading, should be able to:
J . Summarize the history of normality in physical, social, and economic systems.
(page 204}
2. Describe the evidence of fat tails, the implications of fat tails, and explanations for
fat tails, (page 206)
3. Identify examples of system-based interactions that can lead to fit tails, (page 210)
4. Describe non- normality in regards to asset pricing and risk management took.

(page 210)

69. The Dog and the Frisbee
Candidates, after completing this reading, should be able to:
]

. Describe heuristics and explain why using heuristic rules can be an optimal response
complex environment, (page 215)
Descrihe the advantages and disadvantages of using simple versus complex rules in a
decision making process, (page 216)
Descrihe ideal conditions and situations where simple decision making strategies
can outperform complex rule sets, (page 217)

Summarize the evolution of regulatory structures and regulatory responses
to financial crises, and explain criticisms of the level of complexity in current
regulatory structures, (page 218)
Compare the effectiveness of simple and complex capital weighting structures in
predicting hank failure given smaller and larger sample sizes, and explain the results
of the study of FDIC-insured banks, (page 219)
Compare the results provided by simple and complex statistical models in
estimating asset returns and portfolio VaR over varying time periods and portfolio
to a

2.
3.

4.

5.
6.

sizes,

(page 220)
7. Descrihe possible solutions to manage or reduce complexity in a regulatory
framework,

Page 10

(page 221)

©2013 Kaplan, Inc.



Book 4
Reading Assignments and AIM Statements

70. Challenges of Financial Innovation
Candidates, after completing this reading, should be able to:
1. Describe crucial functions of a financial system, (page 228}
2. Describe how accounting systems and protocols can affect how risk is presented.
(page 229}
3. Describe significant issues related to risk in the savings market, {page 230}
4. Describe the use of hedging versus raising equity capital as it relates to managing
risk, (page 230)
Describe
the interaction between speculative behavior and financial innovation.
5.
(page 231)
71. Exchange-Traded Funds, Market Structure and the Flash Crash
1 . Describe the chronology of the Flash Crash and the

discussed

in recent research,

2. Describe the data set,

possible triggers for this event

(page 235)
flags, and multiple regression models used in


measurements,

the study, (page 238)
3. Calculate the maximum drawdown, concentration ratio, and the volume and quote

Herfindahl index, (page 238}
4. Summarize the results of the study including the descriptive statistics, the time
series variation in fragmentation, and the determinants of fragmentation and
drawdown, (page 244)

©2013 Kaplan, Inc.

Page 1 1


The following is 1 neview of ihe Riitlt Man IÿIIKIIL anil IfivcaUheni MafiagtcnefU principle* designed lu address
foe AIM siatemefiLS set font iiy GART®. This topic Is also covered in:

PORTFOLIO CONSTRUCTION
Topic 53

EXAM FOCUS
This topic addresses techniques for optimal portfolio construction. "We will discuss important
inputs into die portfolio construction process as well as ways to modify allocations by refining
die position alphas within a portfolio. This topic also goes into detail regarding transactions
costs and bow they influence allocation decisions with regard to portfolio monitoring and
rebalancing. For the exam, pay attention to the discussions of refining alpha and the implications
of transactions costs. Also, he familiar with the different techniques used co construct optimal
portfolios.


THE PORTFOLIO CONSTRUCTION PROCESS
AIM 53.1: Identify the inputs to the portfolio construction process.
The process of constructing an investment portfolio has several inputs which include:
*

*
*

•

*

Current portfolio: The assets and weights in the current portfolio. Reladve to the other
inputs, the current portfolio input can be measured with the most certainty.
Alphas: The excess return of each asset. This input is subject to error and bias and as a
result is somedmes unreasonable.
Covariances. Covariance measures how die returns of the assets in the portfolio are
related. Estimates of covariance often display elements of uncertainty.
Transactions costs: Like covariance, transaction costs are an important input for portfolio
construction, however, these costs also contain a degree of uncertainty. Transaction
costs must be amortized over the investment horizon in order to determine the optimal

portfolio adjustments.
Active risk aversion: This input must he consistent with the specified target active risk
level. Active risk is another name for tracking error, which is the standard deviation of
active return (i.e., excess return).

REFINING ALPHAS
AIM 53.2: Describe the motivation and methods for refining alphas in the
implementation process.

The motivation for refining alpha is to address the various constraints that each investor
or manager might have. For the investor, constraints might include not having any short
positions and/or a restriction on die amount of cash held within the portfolio. For the
manager, the constraints might include restrictions on allocations to certain stocks
and/or making the portfolio neutral across sectors. The resulting portfolio will be different
from a corresponding unconstrained portfolio and as a result will likely he less efficient.

Page 12

©2013 Kaplan, Inc.


Topic 53
Cross Reference to CARP Assigned Reading Grinold & Kahn, Chapter 14

—

Constrained optimization methods for portfolio construction are often cumbersome to
implement.
A method that involves refining die alphas can derive the optimal portfolio, given the
consideration of portfolio constrain ts, in a less complicated manner. This method refines
the optimal position alphas and then adjusts each position's allocation. In other words, if
no short sales are allowed, then the modified alphas would be drawn closer to zero, and
the optimization that would follow would call for a zero percent allocation to those short
positions. If, in addition to short sales, all long position allocations were required to more
closely resemble the benchmark weights, dien all modified alphas would he pulled closer
to zero relative to die original alphas, indicating that die constrained portfolio would more
closely resemble the benchmark portfolio (i.e., since alpha Is closer to zero, the returns
between die benchmark and portfolio are now closer). The main idea to this approach is
that refining alphas and then optimizing position allocadons can replace even the most

sophisticated portfolio construction process.
A manager can refine the alphas by procedures known as scaling and trimming. By

considering the structure of alpha, we can understand how to use the technique of scaling.
alpha = (volatility) x (information coefficient) x (score)
hi this equation, score has a mean of zero and standard deviation of one. This means that
alphas will have a mean zero and a range that is determined by the volatility (i.e., residual
risk) and die Information coefficient (i.e., correlation between actual and forecasted
outcomes). The manager can rescale the alphas to make them have the proper scale for the
portfolio construction process. For example, if die original alphas had a standard deviation
of 2%, the rescaled alphas could have a lower standard deviation of 0.5%.

Trimming extreme values is another method of refining alpha. The manager should
scrutinize alphas that are large in absolute value terms. ‘‘Large11 might be defined as
three times die scale of the alphas. It may be die case that such alphas are the result of
questionable data, and the weights for those position allocations should he set to zero.
Those extreme alphas that appear genuine may be kept but lowered to be within some limit,
say, three times the scale.

AIM 53.3: Describe neutralization and methods for refining alphas to be neutral.
Neutralization is the process of removing biases and undesirable bets from alpha. There
are several types of neutralization: benchmark, cash, and risk-factor. In all cases, the type of
neutralization and the strategy for the process should be specified before the process begins.
Benchmark neutralization involves adjusting the benchmark alpha to zero. This means the
optimal position that uses the benchmark will have a beta of one. This ensures that the
alphas are benchmark-neutral and avoids any issues with benchmark timing. For example,
suppose that a modified alpha has a beta of 1.2. By making this alpha benchmark-neutral, a
new modified alpha will be computed where the heta is reduced to one. Making the alphas
cash-neutral involves adjusting the alphas so that the cash position will not he active. It is
possible to simultaneously make alphas both cash and benchmark-neutral.

©2013 Kaplan, Inc.

Page 13


Topic 53
Cross Reference to GARP Assigned Reading Grinold & Kahn, Chapter l4

-

The risk-factor approach separates returns along several dimensions (e.g., industry). The
manager can identify each dimension as a source of either risk or value added. The manager
should neutralize the dimensions or factors that are a source of risk (for which the manager
does not have adequate knowledge).

TRANSACTIONS COSTS
AJM 53.4: Describe the implications of transaction costs on portfolio construction.
Transactions costs are the costs of moving from one portfolio allocation to another. They
need to be considered in addition to the alpha and active risk inputs in the optimization
process. When considering only alpha and active risk, any problem in setting the scale of
the alphas can he offset by adjusting active risk aversion. The introduction of transactions
costs increases the importance of the precision of the choice of scale. LSome researchers
propose that the accuracy of estimates of transactions costs is as important as tire accuracy
of alpha estimates. Furthermore, the existence of transactions costs increases die importance
of having more accurate estimates of alpha

When considering transactions costs, it is important to realize that diese costs generally
occur at a point in time while the benefits (i.e., the additional return) are realized over a
time period. This means that the manager needs to have a rule concerning how to amortize
the transactions costs over a given period. Beyond the implications of transactions costs, a

full analysis would also consider the causes of transactions costs, how to measure them, and
how to avoid them.
To illustrate the role of transactions costs and how to amortize them, we will assume
forecasts can he made with certainty and the risk-free rate is zero. The cost of buying and
selling stock is $0.05. The current prices of stock A and B are both $10. The forecasts are
for dre price of stock A to he $11 in one year and the price of stock B to be $12 in two
years; therefore, the annualized alphas are the same at 10%. Also, neither stock will change
in value after reaching the forecasted value. Now, assume in each successive year that the
manager discovers a stock with the same properties as stock A and every two years a stock
exactly like stock B. The manager would trade the stock-A type stocks each year and incur
$0.10 in transactions costs at the end of each year. The alpha is 10%, and the transactions
casts are 1% for type-A stocks for a net return of 9%. For the type-B stocks, the annual
return is also 10%, but the transactions costs per year are only 0.5% hecause they are
incurred every other year. Thus, on an annualized basis, the after-cost-return of type-B
stocks is greater than drat of type-A stocks.

PORTFOLIO CONSTRUCTION ISSUES
AIM 53.5: Explain practical issues in portfolio construction such as determination
of risk aversion, incorporation of specific risk aversion, and proper alpha coverage.
Practical issues in portfolio construction include tire level of risk aversion, the optimal risk,
and the alpha coverage.

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Topic 53


Cross Reference to GASP Assigned Reading Grinold & Kahn, Chapter l4

Measuring the level of risk aversion is dependent on
following expression:

risk aversion =

accurate

measures of the inputs in the

information ratio
2 x acrive risk

For example, assuming diat the information ratio is 0,8 and die desired level of active risk
is 10%, dien die implied level of risk aversion is 0.04. Being able to quantify risk aversion
allows the manager to understand a client’s utility in a mean -variance framework. Utility
can he measured as: excess return - {risk aversion x variance).

Professor's Note: Remember here that active risk is just another namefor
tracking error.

Aversion to specific factor risk is important for two reasons. It can help the manager
address the risks associated with having a position with the potential for huge losses, and die
potential dispersion across portfolios when the manager manages more dian one portfolio.
This approach can help a manager decide die appropriate aversion to common and specific

risk factors.
Proper alpha coverage refers to addressing the case where the manager has forecasts of

stocks that are not in the benchmark and the manager doesn’t have forecasts for assets in
the bench mark. When the manager has information on stocks not in the henchmark, a
benchmark weight of zero should he assigned with respect to benchmarking, but active
weights can he assigned to generate active alpha.
When there is not a forecast for assets in die henchmark, alphas can be inferred from the
alphas of assets for which there aue forecasts. One approach is to first compute the following
two

measures:

value-weigh ted fraction of stocks widi forecasts = sum of active holdings with forecasts
average alpha for the stocks with forecasts =

(weighted average of the alphas with forecasts)
(value-weighted fractionof stocks with forecasts)

The second step is to suhtract this measure from each alpha for which there is a forecast
and set alpha to zero for assets that do not have forecasts. This provides a set of benchmarkneutral forecasts where assets without forecasts have an alpha of zero.

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Topic 53

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Cross Reference to GARP Assigned Reading Grinold & Kahn, Chapter l4


PORTFOLIO REVISIONS AND REBALANCING
AIM 53.6: Describe portfolio revisions and rebalancing and the tradeoffs between
alpha, risk, transaction costs and time horizon.
AIM 53.7: Describe the optimal no-trade region for rebalancing with transaction
costs.

If transactions costs are zero, a manager should revise a portfolio every time new
information arrives. However, in a practical setting, the manager should make trading
decisions based on expected active return, active risk, and transactions costs. The manager
may wish co he conservative due to die uncertainties of these measures and the manager's
ability co interpret them. Underestimating transactions costs, for example, will lead to
trading too frequendy. In addition, the frequent trading and short time-horizons would
cause alpha estimates to exhibit a great deal of uncertainty. Therefore, the manager must
choose an optimal time horizon where the certainty of the alpha is sufficient to justify a
trade given the transactions costs.
The rebalancing decision depends on the tradeoff hetween transactions costs and the value
added from changing the position. Portfolio managers must be aware of die existence of
die no-trade region where die benefits are less than die costs. The benefit of adjusting die
number of shares in a portfolio of a given asset Is given by the following expression:

marginal contribution

to value

-

added (alpha of asset} - [2 x (risk aversion) x (active risk)
x (marginal contribution to active risk of asset)]

As long as this value is between the negative cost of selling and die cost of purchase, the

manager would not trade that particular asset. In other words, the no-trade range is as

folloWSt

—(cost of selling) < (marginal contribution to value added) < (cost of purchase)
Rearranging this relationship with respect

to

alpha gives a no- trade range for alpha:

[2 x (risk aversion) x (active risk) x (marginal contribution to active risk)] - (cost of
selling) < alpha of asset < [2 x (risk aversion) x (active risk) x (marginal contribution co
active risk)] + (cost of purchase)

The size of die no-trade region is determined by transactions costs, risk aversion, alpha and
the riskiness of the assets.

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Topic 53

Cross Reference to GARP Assigned Reading Grin old & Kahn, Chapter l4

PORTFOLIO CONSTRUCTION TECHNIQUES

AJM 53-S: Describe tbe following portfolio construction techniques, including

strengths and weaknesses:
*

Screens

*
*

Stratification
Linear programming
Quadratic programming

The following four generic classes of procedures cover most of the applications of
institutional portfolio construction techniques: screens, stratification, linear programming,
and quadratic programming. In each case the goal is the same: high alpha, low active risk,
and low transactions costs. The success of a manager is determined by the value they can

add minus any transaction costs:
(portfolio alpha) - (risk aversion) x (active risk) - (transactions costs)
Screens
Screens are accomplished by ranking the assets by alpha, choosing die top performing

and composing either an equally weighted or capitalization-based weighted portfolio.
Screens can also rebalance portfolios; for example, the manager can sort the universe of
portfolios hy alpha; then, (1) divide the universe of assets into buy, hold, and sell decisions
based on the rankings, (2) purchase any assets on the buy list not currently in the existing
portfolio, and (3) sell any stocks in the portfolio that are on the sell list.
assets,


Screens are easy to implement and understand. There is a clear link between the cause
(being in the buy/hold/sell class) and the effect (being a part of the pot cfolio). This
technique is also robust in that extreme estimates of alpha will not bias die outcome. It
enhances return by selecting high-alpha assets and controls risk by having a sufficient

number of assets for diversification. Shortcomings of screening include ignoring
information within the rankings, die fact there will be errors in the rankings, and excluding
those categories of assets that tend to have low alphas (e.g., utility stocks) . Also, other chan
having a large numher of assets for diversification, this technique does not properly address
risk management motives.

Stratification
Stratification builds on screens by ensuring that each category or stratum of assets is
represented in the portfolio. The manager can choose to categorize the assets by economic
sectors and/or by capitalization. If there are five categories and three capitalization levels
(i.e., small, medium and large), then there will be 15 mutually exclusive categories. The
manager would employ a screen on each category to choose assets. The manager could
then weight the assets from each category based on their corresponding weights in the
benchmark.

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Topic 53

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Cross Reference to GASP Assigned Reading Grinnid & Kahn. Chapter l4

Stratification has the same benefits as screening and one fewer shortcoming in that it has
solved the problem of the possible exclusion of some categories of assets. However, this
technique still suffers from possible errors in measuring alphas.

Linear Programming
Linear programming uses a type of stratification based on characteristics such as industry,
size, volatility, beta, etc. without making the categories mutually exclusive* The linear
programming methodology will choose die assets that produce a portfolio which closely
resembles the benchmark portfolio. This technique can also include transactions costs,

reduce turnover, and set position limits.
Linear programming’s strength is that the objective is to create a portfolio that closely
resembles the benchmark. However, the result can be very different from the benchmark
with respect to the number of assets and some risk characteristics.

Quadratic Programming
Quadratic programming explicitly considers alpha, risk, and transactions costs. Like linear
programming techniques, it can also incorporate constraints. Therefore, it is considered
the ultimate approach in portfolio construction. This approach is only as good as its data,
however, as there are many opportunities to make mistakes. Although a small mistake could
lead to a large deviation from die optimal portfolio, this is not necessarily the case since
small mistakes tend to cancel out in the overall portfolio.
The following loss function provides a measure that illustrates how a certain Wei of
mistakes may only lead to a small loss, hut the losses increase dramatically when die
mistakes exceed a certain level:
loss

value added


actual market volatility
1estimated market volatility

212

If actual market volatility is 20%, an underestimate of 1% will only produce a loss-to-value
ratio of 0.0117. Underestitnations of 2% and 3% will produce loss-to-value ratios equal to
0.055 and 0*1475, respectively. Thus, the increase in loss increases rapidly in response to
given increa*ses in error*

PORTFOLIO RETURN DISPERSION
AJM 53.9: Describe dispersion, explain its causes and describe methods for

controlling forms of dispersion.
Dispersion is a measure of how much each individual client’s portfolio might he different
from die composite returns reported by the manager. One measure is the difference between
the maximum return and minimum return for separate account portfolios. The basic causes
of dispersion are die different histories and cash flows of each of the clients.

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Topic 53

Cross Reference to CARP Assigned Reading Grinold & Kahn, Chapter 14


Managers can control some forms of dispersion lint unfortunately not all forms. One source
of dispersion beyond the manager's control is the differing constraints chat each client has
(e.g., not being able to invest in derivatives or other classes of assets}. Managers do, however,
have the ability to control the dispersion caused by different betas since this dispersion
often results from the lack of proper supervision. If the assets differ between portfolios, the
manager can control this source of dispersion by trying to increase die proportion of assets
that are common to all the portfolios.
The existence of transactions costs implies that there is some optimal level of dispersion*
To illustrate die role of transactions costs in causing dispersion, we will assume a manager
has only one portfolio that is invested 60% stocks and 40% bonds. The manager knows
the optimal portfolio is 62% stocks and 38% bonds, but transactions costs would reduce
returns more than the gains from rebalancing the portfolio. If the manager acquires a
second client, he can dien choose a portfolio with weights 62% and 38% for that second
client. Since one client has a 60/40 portfolio and the other has a 62/38 portfolio, there
will be dispersion. Clearly, higher transactions costs can lead to a higher probability of
dispersion.
A higher level of risk aversion and lower transactions costs leads to lower tracking error.
Without transactions costs, there will be no tracking error or dispersion because all
portfolios will be optimal. The following expression shows how dispersion is proportional
active risk:

to

E(max portfolio return - min portfolio return} = 2 x NÿfOA1ÿ) x (active risk)

where:

- number of portfolios


Nÿ1 inverse of the cumulative normal distribution function N

J

=r

Adding more portfolios will tend to increase the dispersion because there is a higher chance
of an extreme value with more observations. Over time, as die portfolios are managed to
pursue the same moving target, convergence will occur. However, there is no certainty as to
tiie rate this might occur.

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Topic 53

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Cross Reference to GASP Assigned Reading Giinold & Kahn. Chapter l4

KEY CONCEPTS
AIM 53.1

The inputs into die portfolio construction process are the current portfolio, the alphas,
covariance estimates, transactions costs, and active risk aversion. With the exception of the
current

portfolio, all of these are subject


to

error and. possible hias.

AIM 53.2

Refining alpha is one method for including both investor constraints (e.g., no short
selling) and manager constraints (e.g., proper diversification). Using refined alphas and
then performing optimization can achieve the same goat as a complicated constrained
optimization approach.
AIM 53.3

Neutralization is the process of removing hiases and undesirable hets from alphas*
Benchmark neutralization involves adjusting the benchmark alpha to zero. Gash
neutralization eliminates the need for active cash management. Risk-factor neutralization
neutralizes return dimensions that are only associated with risk and do not add value.
AIM 53.4
Transactions costs have several implications. First, they may make it optimal not to adjust
even in the face of new information. Second, transactions costs increase the importance of
making alpha estimates more robust.

Including transactions costs can be complicated because they occur at one point in time,
hut the benefits of the portfolio adjustments are measured over the investment horizon.
AIM 53.5

Practical issues in portfolio construction are die level of risk aversion, die optimal risk, and
the alpha coverage. The inputs in computing the level of risk aversion need to be accurate.
The aversion to a specific risk factor can help a manager address the risks of a position
with a large potential loss and the dispersion across portfolios. Proper alpha coverage refers

to addressing the case where the manager makes forecasts of stocks that are not in the
benchmark and the manager not having forecasts for assets in die benchmark*
AIM 53.6

In the process of portfolio revisions and rebalancing, there are tradeoffs hetween alpha, risk,
transaction costs, and time horizon. The manager may wish to he conservative hased on
the uncertainties of the inputs. Also, the shorter the horizon, the more uncertain the alpha,
which means the manager should choose an optimal time horizon where the certainty of the
alpha is sufficient to justify a trade given the transactions costs*

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Topic 53
Cross Reference to CARP Assigned Reading Giinold & Kahn, Chapter 14

-

AIM 53.7
Because of transactions costs, there will be an optimal no- trade region when new
information arrives concerning the alpha of an asset. That region would he determined
by die level of risk aversion, active risk, the marginal contribution to active risk, and the
transactions costs.

AIM 53.8

Portfolio construction techniques indude screens, stratification, linear programming, and
quadratic programming. Stratification builds on screens, and quadratic programming builds

on linear programming,
Screens simply choose assets based on raw alpha. Stratification first screens and then chooses
stocks based on the screen and also attempts to include assets from all asset classes.

Linear programming attempts to construct a portfolio that dosely resembles the benchmark
by using such diaracteristics as industry, size, volatility, and beta. Quadratic programming
builds on the linear programming methodology by explicitly considering alpha, risk, and
transactions costs.

AIM 53.9

For a manager with several portfolios, dispersion is die result of portfolio returns not being
identical. The basic causes of dispersion are the different histories and cash flows of each
of the clients, A manager can control this source of dispersion by trying to increase the
proportion of assets that are common to all portfolios.

©2013 Kaplan, Inc.

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Topic 53

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Cross Reference to GASP Assigned Reading Giinold & Kahn. Chapter l4

CONCEPT CHECKERS
1.


The most measurable of the inputs into the portfolio construction process is the:
A. position alphas.
B. transactions costs.
C. current portfolio.
D* active risk aversion.

2.

Which of the following is correct with respect to adjusting die opdmal portfolio for
portfolio constraints?
A. No reliahle method exists.
B. By refining the alphas and then optimizing, it is possible to include constraints
of hoth the investor and die manager.
C. By refining the alphas and dien optimizing, it is possible to include constraints
of the investor, but not the manager.
D* By optimizing and then refining the alphas, it is possible to include constraints
of both the investor and die manager.

3.

An increase in which of the following factors will increase die no- trade region for the

alpha of an asset?
1. Risk aversion.
IT. Marginal contribution

to

active risk.


A. T only.
B. II only.
C. Both I and TI.
D. Neither I nor II.

4.

Which of the following statements most correctly describes a consideration chat
complicates the incorporation of transactions costs into the portfolio construction
process?
A. The transactions costs and the benefits always occur in two distinct time
periods.
B. The transactions costs are uncertain while the benefits are relatively certain.
C. There are no complicating factors from the introduction of transactions costs.
D. The transactions costs must he amortized over the horizon of the benefit from
the trade.

5.

A manager has forecasts of stocks A, B, and C, but not of stocks D and E. Stocks A
B, and D are in the benchmark portfolio. Stocks C and E are not in the benchmark

portfolio. Which of die following are correct concerning specific weights the
manager should assign in tracking the benchmark portfolio?
A. w(- = 0.
B. wD 0.
C.
(wA + WB}/2.
D.
= wD=wE.


wr -

wc

For additional Book

43 Topic 53 practice questions see;

Past FRM Exam Questions: # 1—2 (page 259)

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Topic 53
Cross Reference to GASP Assigned Reading Grinold & Kalin, Chapter l4

—

CONCEPT CHECKER ANSWERS
1„

C

The current portfolio is the only input that is directly observable,

2.


B

The approach of first refining alphas and then optimizing can replace even the most
sophisticated portfolio construction process. With this technique both the investor and
manager constraints arc considered,

3,

C

This is evident from the definition of the no-tradc region for the alpha of the asset,

-

[2 x (risk aversion) x (active risk) x (marginal contribution to active risk)! (cost of selling)
< alpha of asset < [2 x {risk aversion) x [active risk) x (marginal contribution to active risk)] +
(cost of purchase)
4,

D

A challenge is to correctly assign the transactions costs to projected future benefits. The
transactions costs must he amortized over the horizon of the benefit from the trade. The
benefits (c,g,, the increase in alpha) occurs over rime while the transactions costs generally
occur at a specific rime when the portfolio is adjusted,

5,

A


The manager should assign a tracking portfolio weight equal to zero for stocks for which
there is a forecast hut that arc not in the benchmark, A weight should be assigned to Stock
D, and it should he a function of the alphas of the other assets,

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Page 23


The following i* i ttrtriew bf lie Risk Management. and InveiUheJll Management principles JesigheJ lb ailiires.H
the AIM vLit-etticfitis iel forth by GART®. Tibi topic is also cuvefeil fo:

PORTFOLIO RISK: ANALYTICAL METHODS
Topic 54

EXAM FOCUS
Due to diversification, the value at risk (VaR) of a portfolio will be less than or equal to the
sum of the VaRs of the positions in die portfolio. If all positions are perfectly correlated,
then the portfolio VaR equals the sum of the individual VaRs. A manager can make optimal
adjustments to the risk of a portfolio with such measures as marginal VaR, incremental VaR,
and component VaR. This topic is highly quantitative. Be able to find die optimal portfolio
using the excess-return-to-marginal VaR ratios. For the exam, understand how correlations
impact the measure of portfolio VaR. Also, it is important that you know how to compute
incremental VaR and component VaR using the marginal VaR measure. We have included
several examples to help widi application of diese concepts.

Portfolio theory depends a lot on statistical assumptions. In finance, researchers and analysts
often assume returns are normally distributed. Such an assumption allows us to express
relationships in concise expressions such as beta. Actually, beta and other convenient
concepts can apply if returns follow an elliptical distribution, which is a broader class of

distributions that includes the normal distribution. In what follows, we will assume returns
follow an elliptical distribution unless otherwise seated.

AIM 54. 1: Define and distinguish between individual VaR, incremental VaR and
diversified portfolio VaR.
AIM 54.3: Compute diversified VaR, individual VaR, and undiversified VaR of a

portfolio.

Professor's Note: AIM 54.1 is addressed throughout this topic.
DIVERSIFIED PORTE QUO VAR
Diversified VaR is simply the VaR of the portfolio where the calculation takes into account
the diversification effects. The basic formula is:

VaRp = Zc x (1ÿ x P
where:
Zc = die 3-score associated with die level of confidence c
Up - the standard deviation of die portfolio return
P = the nominal value invested in the portfolio
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