The Importance of Ethics
Definitions of Important Terms
The AIMR Code of Ethics
Ethical Responsibilities Required by the Code
Main Prescriptions of the Code
1. Act with integrity
2. Be a credit to the profession
3. Use independent professional judgment
Saturday, November 15, 2008
The AIMR code of Professional Conduct - A. Standard I.: Fundamental responsibilities
1. 1(A) Know and comply with laws, regulations, ethical codes and professional standardsa.
Required conduct
Members must comply with the laws and regulations of their home country when residing and working in foreign countries or in trading foreign securities, as well as with the local laws and regulations ad the AIMR Code of ethics and Standards of Professional conduct. When these laws, regulations, codes and standards are different, the member must comply with the most strict laws, regulations, codes and standards to which he or she is subject.
2. I(B): Do not knowingly Participate or assist others in any violations of applicable regulations or ethical codes
Required conduct
Members are responsible for legal and ethical violations in which they knowingly participate or assist. Although members are presumed to know all applicable laws and regulations, AIMR recognizes that a member may not realize there is a violation because he or she might not be aware of all the facts giving rise to the violation.
Required conduct
Members must comply with the laws and regulations of their home country when residing and working in foreign countries or in trading foreign securities, as well as with the local laws and regulations ad the AIMR Code of ethics and Standards of Professional conduct. When these laws, regulations, codes and standards are different, the member must comply with the most strict laws, regulations, codes and standards to which he or she is subject.
2. I(B): Do not knowingly Participate or assist others in any violations of applicable regulations or ethical codes
Required conduct
Members are responsible for legal and ethical violations in which they knowingly participate or assist. Although members are presumed to know all applicable laws and regulations, AIMR recognizes that a member may not realize there is a violation because he or she might not be aware of all the facts giving rise to the violation.
B. Standard II: Relationships with and Responsibilities to the Profession
1. II(A) Use of Professional designation
Required conduct
a. Members of AIMR may reference their membership only in a dignified and judicious manner. An accurate explanation of requirements that have been met to obtain membership may be included.
b. CFA charterholder members may use “Chartered financial Analyst,” or the CFA mark in a dignified and judicious manner. An accurate explanation of requirements tht have been met to obtain the designation may be included.
c. Candidates may reference their participation in the CFA program, as long as it is made clear that they are only a candidate. Only those awarded the CFA charter may use the initials “CFA” after their name. There is no special entitlement or partial designation to someone who has passed one or more CFA examinations, but who has not been awarded a charter.
2. II(B) Do not engage in any act that adversely reflects upon you honesty, trustworthiness, or professional competence
This standard goes beyond acts committed in a professional capacity (which are addressed in Standard I (A)). Standard II (B) concerns personal integrity and behavior that reflect on the entire profession. Violations include:
a. Convictions for a felony or any crime punishable by more than one year in prison, even if not related to professional activities.
b. Conviction or a misdemeanor involving moral turpitude, such as lying, cheating, stealing, and other dishonest conduct.
c. Repeated convictions of misdemeanors, no matter how inconsequential, because a large number of such convictions might suggest a disrespect for the law.
d. An action that reflects negatively on the level of ethical conduct of a CFA.
Required conduct
3. II© Do not plagiarise
Violations of this standard include the following:
a. Using parts of reports or articles prepared by other, either verbatim, or with only a slight change in wording without acknowledgement of the source.
b. Attributing specific quotations to “leading analysts”
or “investment experts,” without specifically referring to them by name.
c. Presenting statistical estimates or forecasts made by others with the source identified, but without any of the caveats that appeared in the source.
d. Using a chart or graph prepared by others without stating the source.
Required conduct
a. Members of AIMR may reference their membership only in a dignified and judicious manner. An accurate explanation of requirements that have been met to obtain membership may be included.
b. CFA charterholder members may use “Chartered financial Analyst,” or the CFA mark in a dignified and judicious manner. An accurate explanation of requirements tht have been met to obtain the designation may be included.
c. Candidates may reference their participation in the CFA program, as long as it is made clear that they are only a candidate. Only those awarded the CFA charter may use the initials “CFA” after their name. There is no special entitlement or partial designation to someone who has passed one or more CFA examinations, but who has not been awarded a charter.
2. II(B) Do not engage in any act that adversely reflects upon you honesty, trustworthiness, or professional competence
This standard goes beyond acts committed in a professional capacity (which are addressed in Standard I (A)). Standard II (B) concerns personal integrity and behavior that reflect on the entire profession. Violations include:
a. Convictions for a felony or any crime punishable by more than one year in prison, even if not related to professional activities.
b. Conviction or a misdemeanor involving moral turpitude, such as lying, cheating, stealing, and other dishonest conduct.
c. Repeated convictions of misdemeanors, no matter how inconsequential, because a large number of such convictions might suggest a disrespect for the law.
d. An action that reflects negatively on the level of ethical conduct of a CFA.
Required conduct
3. II© Do not plagiarise
Violations of this standard include the following:
a. Using parts of reports or articles prepared by other, either verbatim, or with only a slight change in wording without acknowledgement of the source.
b. Attributing specific quotations to “leading analysts”
or “investment experts,” without specifically referring to them by name.
c. Presenting statistical estimates or forecasts made by others with the source identified, but without any of the caveats that appeared in the source.
d. Using a chart or graph prepared by others without stating the source.
B. Standard II: Relationships with and Responsibilities to the Profession
1. II(A) Use of Professional designation
Required conduct
a. Members of AIMR may reference their membership only in a dignified and judicious manner. An accurate explanation of requirements that have been met to obtain membership may be included.
b. CFA charterholder members may use “Chartered financial Analyst,” or the CFA mark in a dignified and judicious manner. An accurate explanation of requirements tht have been met to obtain the designation may be included.
c. Candidates may reference their participation in the CFA program, as long as it is made clear that they are only a candidate. Only those awarded the CFA charter may use the initials “CFA” after their name. There is no special entitlement or partial designation to someone who has passed one or more CFA examinations, but who has not been awarded a charter.
2. II(B) Do not engage in any act that adversely reflects upon you honesty, trustworthiness, or professional competence
This standard goes beyond acts committed in a professional capacity (which are addressed in Standard I (A)). Standard II (B) concerns personal integrity and behavior that reflect on the entire profession. Violations include:
a. Convictions for a felony or any crime punishable by more than one year in prison, even if not related to professional activities.
b. Conviction or a misdemeanor involving moral turpitude, such as lying, cheating, stealing, and other dishonest conduct.
c. Repeated convictions of misdemeanors, no matter how inconsequential, because a large number of such convictions might suggest a disrespect for the law.
d. An action that reflects negatively on the level of ethical conduct of a CFA.
Required conduct
3. II© Do not plagiarise
Violations of this standard include the following:
a. Using parts of reports or articles prepared by other, either verbatim, or with only a slight change in wording without acknowledgement of the source.
b. Attributing specific quotations to “leading analysts”
or “investment experts,” without specifically referring to them by name.
c. Presenting statistical estimates or forecasts made by others with the source identified, but without any of the caveats that appeared in the source.
d. Using a chart or graph prepared by others without stating the source.
Required conduct
a. Members of AIMR may reference their membership only in a dignified and judicious manner. An accurate explanation of requirements that have been met to obtain membership may be included.
b. CFA charterholder members may use “Chartered financial Analyst,” or the CFA mark in a dignified and judicious manner. An accurate explanation of requirements tht have been met to obtain the designation may be included.
c. Candidates may reference their participation in the CFA program, as long as it is made clear that they are only a candidate. Only those awarded the CFA charter may use the initials “CFA” after their name. There is no special entitlement or partial designation to someone who has passed one or more CFA examinations, but who has not been awarded a charter.
2. II(B) Do not engage in any act that adversely reflects upon you honesty, trustworthiness, or professional competence
This standard goes beyond acts committed in a professional capacity (which are addressed in Standard I (A)). Standard II (B) concerns personal integrity and behavior that reflect on the entire profession. Violations include:
a. Convictions for a felony or any crime punishable by more than one year in prison, even if not related to professional activities.
b. Conviction or a misdemeanor involving moral turpitude, such as lying, cheating, stealing, and other dishonest conduct.
c. Repeated convictions of misdemeanors, no matter how inconsequential, because a large number of such convictions might suggest a disrespect for the law.
d. An action that reflects negatively on the level of ethical conduct of a CFA.
Required conduct
3. II© Do not plagiarise
Violations of this standard include the following:
a. Using parts of reports or articles prepared by other, either verbatim, or with only a slight change in wording without acknowledgement of the source.
b. Attributing specific quotations to “leading analysts”
or “investment experts,” without specifically referring to them by name.
c. Presenting statistical estimates or forecasts made by others with the source identified, but without any of the caveats that appeared in the source.
d. Using a chart or graph prepared by others without stating the source.
C. Standard III: Relationships with and responsibilities to the Employer
1. III(A) Inform Employers of the code of ethics and standards of professional conduct
Required conduct
Members must inform their immediate supervisor, in writing, that they are required to conform to the Code of Ethics and Standards of Professional Conduct. They are obligated to deliver a copy of the Code and Standards to their supervisor. This procedure is not necessary only if the employer has stated in writing, that the firm’s policies already include AIMR’s Code and Standards.
Compliance Procedures
2. III(B) Duties owed to employers
Required conduct
Do not undertake independent practice in competition with your employer that might result in some compensation or other benefit, unless you have written consent from both your employer and the outside entity (client) to do so.
If a member contemplates performing services for an entity other than his or her employer that could result in compensation, by rendering a service currently available by the employer, a written statement to the employer must be made describing:
a. The types of services offered.
b. The expected duration of the service.
c. The compensation.
No service should be rendered without the current employer’s written approval.
Compliance Procedures
3. III© Disclose conflicts of interest to employer
Required conduct
Members must disclose to employers any material fact that could reasonably be expected to interfere with their duty to the employer, or their ability to act in an unbiased and objective manner. A conflict of interest exists with any situation that would interfere with the member rendering unbiased investment advice, or cause the member not to act in the employer’s best interest. Material ownership of stock, participation in outside boards, and financial or other pressures that may influence a decision should be promptly reported to the employer, so their impact can be assessed and a decision made on how to resolve the conflict.
4. III(D) Disclose additional compensation arrangements
Required conduct
Inform employers in writing of compensation (monetary or other) for services that are in addition to the compensation received from the employer. The employer is entitled to have full knowledge of a member’s compensation arrangements in order to assess the true cost of services, and their likely effects on the employee’s loyalities and objectivity.
Members must make a written disclosure to their employers specifying any compensation they propose to receive, in addition to the compensation received from primary employer.
5. III(E) Responsibility of Supervisors
Required conduct
Members with supervisory responsibility are expected to understand what constitutes an adequate compliance system for their firm and to make reasonable efforts to see that appropriate procedures are established, documented, communicated to subordinates, monitored and enforced. They are expected to have in-depth knowledge of the Code and Standards, and must exercise their responsibility with respect to both persons who hold and do not hold the CFA designation.
Required conduct
Members must inform their immediate supervisor, in writing, that they are required to conform to the Code of Ethics and Standards of Professional Conduct. They are obligated to deliver a copy of the Code and Standards to their supervisor. This procedure is not necessary only if the employer has stated in writing, that the firm’s policies already include AIMR’s Code and Standards.
Compliance Procedures
2. III(B) Duties owed to employers
Required conduct
Do not undertake independent practice in competition with your employer that might result in some compensation or other benefit, unless you have written consent from both your employer and the outside entity (client) to do so.
If a member contemplates performing services for an entity other than his or her employer that could result in compensation, by rendering a service currently available by the employer, a written statement to the employer must be made describing:
a. The types of services offered.
b. The expected duration of the service.
c. The compensation.
No service should be rendered without the current employer’s written approval.
Compliance Procedures
3. III© Disclose conflicts of interest to employer
Required conduct
Members must disclose to employers any material fact that could reasonably be expected to interfere with their duty to the employer, or their ability to act in an unbiased and objective manner. A conflict of interest exists with any situation that would interfere with the member rendering unbiased investment advice, or cause the member not to act in the employer’s best interest. Material ownership of stock, participation in outside boards, and financial or other pressures that may influence a decision should be promptly reported to the employer, so their impact can be assessed and a decision made on how to resolve the conflict.
4. III(D) Disclose additional compensation arrangements
Required conduct
Inform employers in writing of compensation (monetary or other) for services that are in addition to the compensation received from the employer. The employer is entitled to have full knowledge of a member’s compensation arrangements in order to assess the true cost of services, and their likely effects on the employee’s loyalities and objectivity.
Members must make a written disclosure to their employers specifying any compensation they propose to receive, in addition to the compensation received from primary employer.
5. III(E) Responsibility of Supervisors
Required conduct
Members with supervisory responsibility are expected to understand what constitutes an adequate compliance system for their firm and to make reasonable efforts to see that appropriate procedures are established, documented, communicated to subordinates, monitored and enforced. They are expected to have in-depth knowledge of the Code and Standards, and must exercise their responsibility with respect to both persons who hold and do not hold the CFA designation.
D. Standard IV: Relationships with and Responsibilities to Clients and Prospects - Part I
1. IV(A.1) Recommendations and representations should have a reasonable basis
Required conduct
(1) Be diligent and thorough in investigations, when making recommendations, or when undertaking investment actions for others.
(2) Have a reasonable and adequate basis, supported by appropriate research, for recommendations and investments.
(3) Avoid material misrepresentation in any research report or investment recommendations.
(4) Maintain files and records to support the reasonableness of recommendations and investment decisions.
Members must make reasonable and diligent efforts to ensure any research report is accurate. Members should not use any information from a source he or she has reason to suspect is not accurate.
2. IV(A.2) research Reports
Required conduct
(1) Include all relevant factors in research reports.
(2) Distinguish between facts and opinions in research reports.
(3) Indicate the basic characteristics of the investment for any research reports containing an investment recommendation.
Research report encompasses all means of communicating an investment recommendation. These includes:
(1) Traditional research reports on the market, a class of investments, asset allocation, or a specific secuirity in paper form.
(2) IN-person or telephone recommendations.
(3) Media broadcasts
(4) Computer transmissions (e.g., the Internet)
Capsule recommendations (such as a “buy” or “sell” lists) must be supported by background reports or data that are available to interested members.
(5) A supervisory analyst should check research reports to assure compliance with these standards.
3. IV(A.3) Maintaining Independence 0and Objectivity
Required conduct
Every member should avoid situations that might cause, or be perceived to cause, a loss of independence and objectivity in recommending investments or taking investment action.
Analysts and portfolio managers violate this standard if they:
(1) Take an allocation of shares in oversubscribed IPOs for their personal account.
(2) Accept expensive gifts or entertainment from corporations (corporations that are not clients)
(3) Allow their firm’s business relationships with a company to affect a research review or investment decision.
(4) Allow compensation schedules to affect judgment.
4. IV(B.1) fiduciary Duties
The member has the responsibility to understand and comply with his or her fiduciary duties. This standard relates primarily to those who have discretionary authority in managing clients’ assets, or have other relationships of special trust. It is especially important in cases of managing trust and pension funds.
To satisfy this standard, members have an affirmative obligation to determine what their fiduciary duties are:
a. Required Conduct of Fiduciaries in General
(1) The duties of fiduciaries are to be found in :
(2) The general duties of fiduciaries are:
(a) Loyalty
(b) Care
(c) Prudence
(d) Impartiality
(e) Discretion
(3) Members with control over client assets should
b. Required Conduct of Trustees
(1) the Prudent Man Rule requires that every investment undertaken for a trust, standing alone, must be made prudently, i.e., with the prime directive of preserving the value of the corpus of the trust and secondarily, providing a safe return on the capital invested.
More recently, states have moved towards a Prudent Investor rule.
(a) Under the Prudent Man Rule, certain asset classes might be interpreted to be inherently imprudent (e.g., options), whereas no asset class is considered inherently imprudent under the Prudent Investor Rule. The riskiness of assets must be considered within a portfolio context in P.I.R.
(b) Under the P.M.R., the standard of prudence is applied to each asset held in trust, standing alone. Under the P.I.R. the standard of prudence is applied to the overall portfolio. The prime directive is to achieve a return/risk objective that is reasonable, without exceeding a level of overall portfolio risk that an investment professional would deem suitable to the trust under the prevailing circumstances. Employing overly conservative strategies may be subjected to less criticism under the traditional P.M.R. Under the P.I.R., overly conservative investment strategies may not be justified if they result in generating significantly inferior returns.
(c) The P.I.R. requires that trust investments be reasonably diversified.
(d) Under Traditional P.M.R. trustees were usually not permitted to delegate the authority to make investments. Under P.I.R. trustees may delegate the authority to make investment decisions to qualified investment managers, as long as those managers are selected prudently.
(e) Paying above average commissions for research or other services provided by a broker is permitted if the fiduciary comes to a bona fide conclusion that the services rendered are worth the extra cost.
(f) The modern P.I.R. standards generally impose a professional standard of care and prudence (Prudent Expert Standard).
(g) Other fiduciary duties that must be followed under U.S. law are:
(1) All of the beneficiaries of a trust should be treated equally.
(2) Best efforts must be applied to maximizing after-tax returns.
(3) Legal requirements, such as the filing of periodic financial statements and tax returns required by law, must be known and satisfied.
c. Required conduct for Managing Private Retirement Plans Governed by ERISA
Under ERISA, fiduciaries of retirement plans have the following affirmative duties:
(1) Loyalty: Loyalty, under ERISA, require them to act solely in the interest of the plan participants and beneficiaries with the exclusive purpose of: (a) Providing plan benefits. (b) Defraying reasonable plan expenses.
(2) Care: Care requires them to use all of the skills of a professional in carrying out their responsibilities. Thus ERISA applies a Prudent Expert standard.
(3) Prudence: Prudence requires them to take no risks that are likely to endanger the ability of the plan to provide promised benefits and earn a reasonable return commensurate with the risk taken.
(4) Know and Carry out their Responsibilities as Defined by the Plan’s Trust Documents
(5) ERISA prohibits fiduciaries from
(a) Self-Dealing
(b) Permitting conflicts of interest
(c) Receiving “Kickbacks”
(d) Dealing with Parties in Interest.
d. Legal Rights and Beneficiaries and participants under ERISA
Under ERISA, plan participants and beneficiaries who believe that their retirement trust is not being operated solely for their best interests may bring civil action again the plan fiduciaries. If victorious, they have the right to recover both the losses the court decides they have suffered as a result of breaches of duty by the plan fiduciaries and their attorney(s) fees.
e. Required Conduct for Fiduciaries Associated with Public Pension Plans
f. Required Conduct for Fiduciaries of Charitable Organizations and Endowments
(1) In the U.S. fiduciary duties of fiduciaries of charitable organizations and endowments are primarily contained in the Uniform Management of Institutional Funds Act (UMIFA), which embodies most of the same standards as those found in the Prudent Man and Prudent Investor Standards.
UMIFA does impose some unique affirmative duties on institutional fiduciaries. These are:
(a) Fiduciaries must formulate policies for the investment program of the organization’s assets. Such policies should be based on:
(1) the amount of funds needed on a long- and short term basis, to carry out the work of the institution.
(2) The current and probable future resources of the organization.
(3) The expected return on its assets.
(4) Probable future economic trends.
(b) to follow spending and investment policies adopted by the institution.
g. Required Conduct for Money Managers
(1) Money managers can look to the Investment Advisors Act of 1940 for some behavioral guidance. This act prohibits investment advisors from
(2) Some general principles that should guide a money manager are
(a) be honest and loyal to the client, acting always in the clients best interest.
(b) Use care and independent professional judgment in investment matters.
(c) Have a reasonable basis for investment decisions.
(d) Avoid conflicts of interest or make full disclosure of facts and circumstances that could be construed as a conflict of interest.
(e) Make sure investment actions and advice are suitable for the client.
(f) Obtain the best executions’ on trades for clients. Make sure that commissions and other expenses are reasonable for the service rendered.
(g) Avoid misrepresentations of all kinds, particularly with respect to performance presentations.
h. Required Conduct for Brokers and Dealers
In particular, brokers and dealers:
(1) Should not churn customer accounts.
(2) Should not accept funds when their firms are insolvent
(3) Should not engage in fraudulent, deceptive or manipulative practices.
(4) Should not exploit their customers’ trust or ignorance
(5) Should deal fairly with their clients.
i. Required Conduct for Security Analysts
Research analyst must:
(1) Do the best job they can for their employers and their employers’ clients.
(2) Se independent judgment.
(3) Have an adequate basis for their recommendations
(4) Deal fairly with clients and fellow professionals.
j. Other Issues Regarding the Required Conduct of Fiduciaries
(1) Social Investing: Social investing is permitted under most fiduciary laws and guidelines only if:
(a) The portfolio’s return and risk are not compromised.
(b) Diversification is still adequate
(c) Excessive costs are not incurred.
(2) Relationship Investing
(3) Proxy voting
The U.S. Dept of Labor has set forth specific regulations for proxy voting of shares held by qualified retirement plans governed by ERISA.
(a) The investment manager has the fiduciary responsibility of voting proxies arising form the retirement plans under his or her control, unless the plan documents designate some other person)s) as the responsible Party(s)
(4) Soft Dollars
When an investment manager pays for goods or services that benefit the manager by channeling security transactions through specific brokers who are paid commissions for those transactions, the funds paid are called “soft dollars.” When managers use their own funds to pay for goods and services, such payments are called “hard dollars.”
(a) The primary rule is that brokerage belongs to the client. Fiduciaries must not use client funds for their own benefit. However transactions involving soft dollars are permitted under the following circumstances:
(1) the goods or services purchased help the manager make a better investment decision.
(b) ERISA imposes a sole benefit test of loyalty for the management of pension plans.
5. IV(B.2) Portfolio Investment Recommendations and Actions
a. required conduct
Members shall:
(1) Inquire as to client’s financial situation, investment experience, and investment objectives before any investment recommendations or action are made. Update this information at least once a year.
(2) Before making a recommendation or taking investment action, determine the appropriateness and suitability of the action by considering:
(a) The client’s needs and circumstances
(b) The basic characteristics of the investment
(c) The client’s investment experience and objectives.
(3) Distiniguish between facts and opinions in presenting investment recommendations.
(4) Disclose to clients and prospects the basic format and general principles by which securities are selected and portfolios are constructed. Promptly disclose to clients and prospects any changes that might significantly affect this process.
(5) Obtain written authorization from the client to make changes.
Required conduct
(1) Be diligent and thorough in investigations, when making recommendations, or when undertaking investment actions for others.
(2) Have a reasonable and adequate basis, supported by appropriate research, for recommendations and investments.
(3) Avoid material misrepresentation in any research report or investment recommendations.
(4) Maintain files and records to support the reasonableness of recommendations and investment decisions.
Members must make reasonable and diligent efforts to ensure any research report is accurate. Members should not use any information from a source he or she has reason to suspect is not accurate.
2. IV(A.2) research Reports
Required conduct
(1) Include all relevant factors in research reports.
(2) Distinguish between facts and opinions in research reports.
(3) Indicate the basic characteristics of the investment for any research reports containing an investment recommendation.
Research report encompasses all means of communicating an investment recommendation. These includes:
(1) Traditional research reports on the market, a class of investments, asset allocation, or a specific secuirity in paper form.
(2) IN-person or telephone recommendations.
(3) Media broadcasts
(4) Computer transmissions (e.g., the Internet)
Capsule recommendations (such as a “buy” or “sell” lists) must be supported by background reports or data that are available to interested members.
(5) A supervisory analyst should check research reports to assure compliance with these standards.
3. IV(A.3) Maintaining Independence 0and Objectivity
Required conduct
Every member should avoid situations that might cause, or be perceived to cause, a loss of independence and objectivity in recommending investments or taking investment action.
Analysts and portfolio managers violate this standard if they:
(1) Take an allocation of shares in oversubscribed IPOs for their personal account.
(2) Accept expensive gifts or entertainment from corporations (corporations that are not clients)
(3) Allow their firm’s business relationships with a company to affect a research review or investment decision.
(4) Allow compensation schedules to affect judgment.
4. IV(B.1) fiduciary Duties
The member has the responsibility to understand and comply with his or her fiduciary duties. This standard relates primarily to those who have discretionary authority in managing clients’ assets, or have other relationships of special trust. It is especially important in cases of managing trust and pension funds.
To satisfy this standard, members have an affirmative obligation to determine what their fiduciary duties are:
a. Required Conduct of Fiduciaries in General
(1) The duties of fiduciaries are to be found in :
(2) The general duties of fiduciaries are:
(a) Loyalty
(b) Care
(c) Prudence
(d) Impartiality
(e) Discretion
(3) Members with control over client assets should
b. Required Conduct of Trustees
(1) the Prudent Man Rule requires that every investment undertaken for a trust, standing alone, must be made prudently, i.e., with the prime directive of preserving the value of the corpus of the trust and secondarily, providing a safe return on the capital invested.
More recently, states have moved towards a Prudent Investor rule.
(a) Under the Prudent Man Rule, certain asset classes might be interpreted to be inherently imprudent (e.g., options), whereas no asset class is considered inherently imprudent under the Prudent Investor Rule. The riskiness of assets must be considered within a portfolio context in P.I.R.
(b) Under the P.M.R., the standard of prudence is applied to each asset held in trust, standing alone. Under the P.I.R. the standard of prudence is applied to the overall portfolio. The prime directive is to achieve a return/risk objective that is reasonable, without exceeding a level of overall portfolio risk that an investment professional would deem suitable to the trust under the prevailing circumstances. Employing overly conservative strategies may be subjected to less criticism under the traditional P.M.R. Under the P.I.R., overly conservative investment strategies may not be justified if they result in generating significantly inferior returns.
(c) The P.I.R. requires that trust investments be reasonably diversified.
(d) Under Traditional P.M.R. trustees were usually not permitted to delegate the authority to make investments. Under P.I.R. trustees may delegate the authority to make investment decisions to qualified investment managers, as long as those managers are selected prudently.
(e) Paying above average commissions for research or other services provided by a broker is permitted if the fiduciary comes to a bona fide conclusion that the services rendered are worth the extra cost.
(f) The modern P.I.R. standards generally impose a professional standard of care and prudence (Prudent Expert Standard).
(g) Other fiduciary duties that must be followed under U.S. law are:
(1) All of the beneficiaries of a trust should be treated equally.
(2) Best efforts must be applied to maximizing after-tax returns.
(3) Legal requirements, such as the filing of periodic financial statements and tax returns required by law, must be known and satisfied.
c. Required conduct for Managing Private Retirement Plans Governed by ERISA
Under ERISA, fiduciaries of retirement plans have the following affirmative duties:
(1) Loyalty: Loyalty, under ERISA, require them to act solely in the interest of the plan participants and beneficiaries with the exclusive purpose of: (a) Providing plan benefits. (b) Defraying reasonable plan expenses.
(2) Care: Care requires them to use all of the skills of a professional in carrying out their responsibilities. Thus ERISA applies a Prudent Expert standard.
(3) Prudence: Prudence requires them to take no risks that are likely to endanger the ability of the plan to provide promised benefits and earn a reasonable return commensurate with the risk taken.
(4) Know and Carry out their Responsibilities as Defined by the Plan’s Trust Documents
(5) ERISA prohibits fiduciaries from
(a) Self-Dealing
(b) Permitting conflicts of interest
(c) Receiving “Kickbacks”
(d) Dealing with Parties in Interest.
d. Legal Rights and Beneficiaries and participants under ERISA
Under ERISA, plan participants and beneficiaries who believe that their retirement trust is not being operated solely for their best interests may bring civil action again the plan fiduciaries. If victorious, they have the right to recover both the losses the court decides they have suffered as a result of breaches of duty by the plan fiduciaries and their attorney(s) fees.
e. Required Conduct for Fiduciaries Associated with Public Pension Plans
f. Required Conduct for Fiduciaries of Charitable Organizations and Endowments
(1) In the U.S. fiduciary duties of fiduciaries of charitable organizations and endowments are primarily contained in the Uniform Management of Institutional Funds Act (UMIFA), which embodies most of the same standards as those found in the Prudent Man and Prudent Investor Standards.
UMIFA does impose some unique affirmative duties on institutional fiduciaries. These are:
(a) Fiduciaries must formulate policies for the investment program of the organization’s assets. Such policies should be based on:
(1) the amount of funds needed on a long- and short term basis, to carry out the work of the institution.
(2) The current and probable future resources of the organization.
(3) The expected return on its assets.
(4) Probable future economic trends.
(b) to follow spending and investment policies adopted by the institution.
g. Required Conduct for Money Managers
(1) Money managers can look to the Investment Advisors Act of 1940 for some behavioral guidance. This act prohibits investment advisors from
(2) Some general principles that should guide a money manager are
(a) be honest and loyal to the client, acting always in the clients best interest.
(b) Use care and independent professional judgment in investment matters.
(c) Have a reasonable basis for investment decisions.
(d) Avoid conflicts of interest or make full disclosure of facts and circumstances that could be construed as a conflict of interest.
(e) Make sure investment actions and advice are suitable for the client.
(f) Obtain the best executions’ on trades for clients. Make sure that commissions and other expenses are reasonable for the service rendered.
(g) Avoid misrepresentations of all kinds, particularly with respect to performance presentations.
h. Required Conduct for Brokers and Dealers
In particular, brokers and dealers:
(1) Should not churn customer accounts.
(2) Should not accept funds when their firms are insolvent
(3) Should not engage in fraudulent, deceptive or manipulative practices.
(4) Should not exploit their customers’ trust or ignorance
(5) Should deal fairly with their clients.
i. Required Conduct for Security Analysts
Research analyst must:
(1) Do the best job they can for their employers and their employers’ clients.
(2) Se independent judgment.
(3) Have an adequate basis for their recommendations
(4) Deal fairly with clients and fellow professionals.
j. Other Issues Regarding the Required Conduct of Fiduciaries
(1) Social Investing: Social investing is permitted under most fiduciary laws and guidelines only if:
(a) The portfolio’s return and risk are not compromised.
(b) Diversification is still adequate
(c) Excessive costs are not incurred.
(2) Relationship Investing
(3) Proxy voting
The U.S. Dept of Labor has set forth specific regulations for proxy voting of shares held by qualified retirement plans governed by ERISA.
(a) The investment manager has the fiduciary responsibility of voting proxies arising form the retirement plans under his or her control, unless the plan documents designate some other person)s) as the responsible Party(s)
(4) Soft Dollars
When an investment manager pays for goods or services that benefit the manager by channeling security transactions through specific brokers who are paid commissions for those transactions, the funds paid are called “soft dollars.” When managers use their own funds to pay for goods and services, such payments are called “hard dollars.”
(a) The primary rule is that brokerage belongs to the client. Fiduciaries must not use client funds for their own benefit. However transactions involving soft dollars are permitted under the following circumstances:
(1) the goods or services purchased help the manager make a better investment decision.
(b) ERISA imposes a sole benefit test of loyalty for the management of pension plans.
5. IV(B.2) Portfolio Investment Recommendations and Actions
a. required conduct
Members shall:
(1) Inquire as to client’s financial situation, investment experience, and investment objectives before any investment recommendations or action are made. Update this information at least once a year.
(2) Before making a recommendation or taking investment action, determine the appropriateness and suitability of the action by considering:
(a) The client’s needs and circumstances
(b) The basic characteristics of the investment
(c) The client’s investment experience and objectives.
(3) Distiniguish between facts and opinions in presenting investment recommendations.
(4) Disclose to clients and prospects the basic format and general principles by which securities are selected and portfolios are constructed. Promptly disclose to clients and prospects any changes that might significantly affect this process.
(5) Obtain written authorization from the client to make changes.
D. Standard IV: Relationships with and Responsibilities to Clients and Prospects - Part II
6. IV(B.3) Fair Treatment of clients
Required conduct
Deal fairly with clients regarding:
(1) Dissemination of recommendations
(2) Dissemination of changes of prior opinions
(3) Taking investment action.
Every effort should me made to communicate investment ideas to clients, for which the ideas are suitable and who have a known interest in them, as simultaneously as possible within reasonable limits defined by communications technology.
7. IV(b.4)Priority of Transactions
Required conduct
This standard applies to all members and access persons (defined as persons who have advanced knowledge pertaining to upcoming research recommendations, changes in opinions about securities, and/or pending investment actions to be taken either by the firm itself, or on behalf of clients).
There is nothing unethical about access persons investing for their own benefit. The personal investments of access persons and investment professionals must be undertaken within the confines of the following restrictions.
(1) Interests of clients, the employer, and the integrity of the professional must be put ahead of the access person’s or member’s own personal interests.
(2) Care must be taken that personal investments do not create conflicts of interest or impair the investment professional’s ability to be objective and render independent professional judgments about securities.
(3) All applicable laws, regulations, and compliance procedures must be followed.
(4) The investment professional should not receive a personal benefit from investment actions taken on behalf of a client (except for the usual and customary compensation for the service rendered).
Compliance Procedures
8. IV(B.5) Confidentiality
Required conduct
Preserve the confidentiality of client and employer information, unless it concerns illegal activities. The best approach is never to disclose information received from a client or employer, except to authorized persons on a “need to know” basis.
9. IV(B.6) Prohibition against misrepresentations
Required conduct
A member may not misrepresent:
(1) The performance of his or her (or the employer’s) services or investment performance.
(2) Their qualifications or the qualifications of their firm.
(3) Their academic and professional standards.
Members should ensure that misrepresentation does not occur in oral presentations, advertising, electronic communication, or written materials.
No guarantees should be given regarding the outcome or the probable return on an investment.
10. IV (B.7) Disclose conflicts of interest to clients and prospects
Required conduct
Members must disclose to clients and prospects any potential conflict of interest. Disclosure of any matter that could reasonably be expected to impair objectivity allows clients to judge motives and possible biases for themselves.
11. IV(B.8) Disclose referral fees
Required conduct
The existence of referral fees, their nature, and their amount should be disclosed in writing to any prospective client, as soon as the client is referred to a member.
Compliance Procedures
Required conduct
Deal fairly with clients regarding:
(1) Dissemination of recommendations
(2) Dissemination of changes of prior opinions
(3) Taking investment action.
Every effort should me made to communicate investment ideas to clients, for which the ideas are suitable and who have a known interest in them, as simultaneously as possible within reasonable limits defined by communications technology.
7. IV(b.4)Priority of Transactions
Required conduct
This standard applies to all members and access persons (defined as persons who have advanced knowledge pertaining to upcoming research recommendations, changes in opinions about securities, and/or pending investment actions to be taken either by the firm itself, or on behalf of clients).
There is nothing unethical about access persons investing for their own benefit. The personal investments of access persons and investment professionals must be undertaken within the confines of the following restrictions.
(1) Interests of clients, the employer, and the integrity of the professional must be put ahead of the access person’s or member’s own personal interests.
(2) Care must be taken that personal investments do not create conflicts of interest or impair the investment professional’s ability to be objective and render independent professional judgments about securities.
(3) All applicable laws, regulations, and compliance procedures must be followed.
(4) The investment professional should not receive a personal benefit from investment actions taken on behalf of a client (except for the usual and customary compensation for the service rendered).
Compliance Procedures
8. IV(B.5) Confidentiality
Required conduct
Preserve the confidentiality of client and employer information, unless it concerns illegal activities. The best approach is never to disclose information received from a client or employer, except to authorized persons on a “need to know” basis.
9. IV(B.6) Prohibition against misrepresentations
Required conduct
A member may not misrepresent:
(1) The performance of his or her (or the employer’s) services or investment performance.
(2) Their qualifications or the qualifications of their firm.
(3) Their academic and professional standards.
Members should ensure that misrepresentation does not occur in oral presentations, advertising, electronic communication, or written materials.
No guarantees should be given regarding the outcome or the probable return on an investment.
10. IV (B.7) Disclose conflicts of interest to clients and prospects
Required conduct
Members must disclose to clients and prospects any potential conflict of interest. Disclosure of any matter that could reasonably be expected to impair objectivity allows clients to judge motives and possible biases for themselves.
11. IV(B.8) Disclose referral fees
Required conduct
The existence of referral fees, their nature, and their amount should be disclosed in writing to any prospective client, as soon as the client is referred to a member.
Compliance Procedures
Friday, November 14, 2008
Relationships with and Responsibilities to the Investing Public
Ethical and Professional Standards
Standard V: Relationships with and Responsibilities to the Investing Public
1. V(A) Do not use material nonpublic information
Members shall not make any investment action (trade the security, or make a recommendation regarding the security), or communicate the information, when in the possession of material nonpublic information related to the value of a security if such action would breach a duty, the information was misappropriated, or if it relates to a tender offer. If such material nonpublic information is received, an effort should be made to get the company about whom the information relates to make a public disclosure of the information, except if the information was received because of a special or confidential relationship with the company (as in the case of “constructive” insider), and the information is to be kept in confidence.
a. Definitions of Material Nonpublic Information
(1) Traditional theory
(a) Information must be material. Information is material if:
(1) It pertains to a tender offer.
(2) It would significantly change the total mix of information about a company, its affairs, or its securities; i.e., a reasonable investor would want to know it before making an investment decision, or, if known it would probably have an impact on the price of a security.
(3) It is a specific fact, rather than an opinion.
(b) The information must be Nonpublic. Information becomes public as soon as the company discloses it in a way calculated to make it available to the general investing public. Corporate disclosure made to a “room full of analysts” does not constitute disclosure under the law.
(c) The source Must be an insider: Someone who knows the information because he or she is in a position to receive confidential information about a company’s affairs and who has a fiduciary duty not to disclose it.
Tippees, such as analysts who receive material nonpublic information, may legally use it, unless they are brought into the fold of confidentiality or then know that the information was mis-appropriated or obtained illegally. They are brought into the fold of confidentiality when they are given the information for a legitimate business purpose.
Note that a fiduciary duty exists as a matter of law; it cannot be imposed simply by telling someone to “keep this information confidential.”
(2) Misappropriation Theory
Under the misappropriation theory, individuals commit securities fraud if they obtain material nonpublic information from another to whom they owe a duty of trust and confidence, and then communicate that information or use it as the basis of a trade or recommendation, even if they owe no fiduciary duty to the issuer of the involved issuer. They also commit fraud if they obtain material nonpublic information illegally.
The concept is that material nonpublic information is “property.” If anyone who has access to this information uses it for their own personal benefit, or give it to others, they misappropriate company property. This is a form of theft, which is punishable by criminal and civil actions.
b. The Mosaic theory
Taking several immaterial and/or publicly available stand-alone facts from various sources and putting them together to form a complete and significant picture of a corporate situation is called the mosaic theory. This is the analyst’s job and is completely legal.
c. Required conduct
(1) Members shall not take any investment action or communicate information about a security or company, when in the possession of material nonpublic information related to the value of the security if such action would breach a duty owed to the company, the information was misappropriated, or if it relates to a tender offer.
(2) When acting as a consultant or any other role in which the member becomes a “temporary insider” keep information received confidential and do not use it for investment purposes or communicate it to others.
d. Legal Ramifications of Using or Communicating Inside or Misappropriated Information
Penalties include:
(1) Fines up to $1,000,000 for individuals ($2,500,000 for firms)
(2) Disgorgement of up to three times any illicit profits (or losses avoided) from trading (or recommending) securities based on inside or misappropriated information.
(3) Jail terms of up to 10 years.
(4) Civil suit for damages suffered by the counterparties to any illegal trades.
(5) Sanction by regulating bodies, primarily the SEC.
e. Compliance Procedures
(1) Do not seek out material nonpublic information.
2. V(B) Performance Presentation
Members may not misrepresent their investment performance record, either in terms of the presentation or the measurement of those results. When communicating data about the performance history of accounts or composites (group of accounts), either of the individual investment manager or of a firm, the member must give a fair and complete presentation. It is unethical to misrepresent past investment performance or the investment performance that a client can reasonably expect to obtain in the future.
a. Reasons Why Performance Presentation Standards are Necessary
Historically, investors have faced many difficulties in obtaining fair performance results that were comparable among various investment management firms.
Therefore, AIMR developed the AIMR Performance presentation Standards and Global Investment Performance Standards in the hope that a set of globally accepted common standards will enable performance results among various investment firms to become truly comparable.
b. Required conduct
(1) Members may not misrepresent
(2) When communicating data about the performance history of individual accounts, composites (groups of accounts), an individual investment manager, or an entire firm, the member must give a fair and complete presentation.
c. Compliance Procedures
(1) Compliance with the AIMR Performance Presentation Standards and/or the Global Investment Performance Standards is the best way to comply with this standard.
Standard V: Relationships with and Responsibilities to the Investing Public
1. V(A) Do not use material nonpublic information
Members shall not make any investment action (trade the security, or make a recommendation regarding the security), or communicate the information, when in the possession of material nonpublic information related to the value of a security if such action would breach a duty, the information was misappropriated, or if it relates to a tender offer. If such material nonpublic information is received, an effort should be made to get the company about whom the information relates to make a public disclosure of the information, except if the information was received because of a special or confidential relationship with the company (as in the case of “constructive” insider), and the information is to be kept in confidence.
a. Definitions of Material Nonpublic Information
(1) Traditional theory
(a) Information must be material. Information is material if:
(1) It pertains to a tender offer.
(2) It would significantly change the total mix of information about a company, its affairs, or its securities; i.e., a reasonable investor would want to know it before making an investment decision, or, if known it would probably have an impact on the price of a security.
(3) It is a specific fact, rather than an opinion.
(b) The information must be Nonpublic. Information becomes public as soon as the company discloses it in a way calculated to make it available to the general investing public. Corporate disclosure made to a “room full of analysts” does not constitute disclosure under the law.
(c) The source Must be an insider: Someone who knows the information because he or she is in a position to receive confidential information about a company’s affairs and who has a fiduciary duty not to disclose it.
Tippees, such as analysts who receive material nonpublic information, may legally use it, unless they are brought into the fold of confidentiality or then know that the information was mis-appropriated or obtained illegally. They are brought into the fold of confidentiality when they are given the information for a legitimate business purpose.
Note that a fiduciary duty exists as a matter of law; it cannot be imposed simply by telling someone to “keep this information confidential.”
(2) Misappropriation Theory
Under the misappropriation theory, individuals commit securities fraud if they obtain material nonpublic information from another to whom they owe a duty of trust and confidence, and then communicate that information or use it as the basis of a trade or recommendation, even if they owe no fiduciary duty to the issuer of the involved issuer. They also commit fraud if they obtain material nonpublic information illegally.
The concept is that material nonpublic information is “property.” If anyone who has access to this information uses it for their own personal benefit, or give it to others, they misappropriate company property. This is a form of theft, which is punishable by criminal and civil actions.
b. The Mosaic theory
Taking several immaterial and/or publicly available stand-alone facts from various sources and putting them together to form a complete and significant picture of a corporate situation is called the mosaic theory. This is the analyst’s job and is completely legal.
c. Required conduct
(1) Members shall not take any investment action or communicate information about a security or company, when in the possession of material nonpublic information related to the value of the security if such action would breach a duty owed to the company, the information was misappropriated, or if it relates to a tender offer.
(2) When acting as a consultant or any other role in which the member becomes a “temporary insider” keep information received confidential and do not use it for investment purposes or communicate it to others.
d. Legal Ramifications of Using or Communicating Inside or Misappropriated Information
Penalties include:
(1) Fines up to $1,000,000 for individuals ($2,500,000 for firms)
(2) Disgorgement of up to three times any illicit profits (or losses avoided) from trading (or recommending) securities based on inside or misappropriated information.
(3) Jail terms of up to 10 years.
(4) Civil suit for damages suffered by the counterparties to any illegal trades.
(5) Sanction by regulating bodies, primarily the SEC.
e. Compliance Procedures
(1) Do not seek out material nonpublic information.
2. V(B) Performance Presentation
Members may not misrepresent their investment performance record, either in terms of the presentation or the measurement of those results. When communicating data about the performance history of accounts or composites (group of accounts), either of the individual investment manager or of a firm, the member must give a fair and complete presentation. It is unethical to misrepresent past investment performance or the investment performance that a client can reasonably expect to obtain in the future.
a. Reasons Why Performance Presentation Standards are Necessary
Historically, investors have faced many difficulties in obtaining fair performance results that were comparable among various investment management firms.
Therefore, AIMR developed the AIMR Performance presentation Standards and Global Investment Performance Standards in the hope that a set of globally accepted common standards will enable performance results among various investment firms to become truly comparable.
b. Required conduct
(1) Members may not misrepresent
(2) When communicating data about the performance history of individual accounts, composites (groups of accounts), an individual investment manager, or an entire firm, the member must give a fair and complete presentation.
c. Compliance Procedures
(1) Compliance with the AIMR Performance Presentation Standards and/or the Global Investment Performance Standards is the best way to comply with this standard.
Ethical and Professional Standards - Corporate Governance
VI. Corporate Governance
A. Introduction
B. Fiduciaries Responsible for Voting Proxies
C. Proxy Voting Standards for Fiduciaries
D. Recommended elements in a proper Proxy Voting Policy
1. Designate a competent individual or policy making body as being responsible for implementing and monitoring a proxy voting policy. This person or body should:
2. Set up administrative procedures that:
E. Laws and Regulations Regarding the Voting of Proxies by Fiduciaries
A. Introduction
B. Fiduciaries Responsible for Voting Proxies
C. Proxy Voting Standards for Fiduciaries
D. Recommended elements in a proper Proxy Voting Policy
1. Designate a competent individual or policy making body as being responsible for implementing and monitoring a proxy voting policy. This person or body should:
2. Set up administrative procedures that:
E. Laws and Regulations Regarding the Voting of Proxies by Fiduciaries
Monday, March 17, 2008
Reading 58: Equity: Concepts and Techniques
LOS
The candidate should be able to:
a. classify business cycle stages and identify attractive investment opportunities for
each stage;
b. discuss, with respect to global industry analysis, the key elements related to
return expectations;
c. describe the industry life cycle and identify an industry’s stage in its life cycle;
d. discuss the specific advantages of both the concentration ratio and the
Herfindahl index;
e. discuss, with respect to global industry analysis, the elements related to risk, and
describe the basic forces that determine industry competition.
-----------------
Prescribed reading
“Equity: Concepts and Techniques”
Ch. 6, pp. 256–273, International Investments, 5th edition, Bruno Solnik and Dennis McLeavey (Addison Wesley, 2003)
“Industry Analysis”
Ch. 13, pp. 466–468, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)
For points to refresh on Industry analyis based on 7th edition of Reilly and Brown please visit
http://nrao-sapm-handbook.blogspot.com/2007/12/r-b-ch14-points-to-refresh.html
The candidate should be able to:
a. classify business cycle stages and identify attractive investment opportunities for
each stage;
b. discuss, with respect to global industry analysis, the key elements related to
return expectations;
c. describe the industry life cycle and identify an industry’s stage in its life cycle;
d. discuss the specific advantages of both the concentration ratio and the
Herfindahl index;
e. discuss, with respect to global industry analysis, the elements related to risk, and
describe the basic forces that determine industry competition.
-----------------
Prescribed reading
“Equity: Concepts and Techniques”
Ch. 6, pp. 256–273, International Investments, 5th edition, Bruno Solnik and Dennis McLeavey (Addison Wesley, 2003)
“Industry Analysis”
Ch. 13, pp. 466–468, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)
For points to refresh on Industry analyis based on 7th edition of Reilly and Brown please visit
http://nrao-sapm-handbook.blogspot.com/2007/12/r-b-ch14-points-to-refresh.html
Thursday, March 13, 2008
Reading 59: Company Analysis and Stock Valuation
Prescribed reading
“Company Analysis and Stock Valuation”
Ch. 14, pp. 513–516 and 533–548, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)
Visit for points to refresh of this chapter from 7th edition
http://nrao-sapm-handbook.blogspot.com/2007/12/r-b-ch15-points-to-refresh.html
“Company Analysis and Stock Valuation”
Ch. 14, pp. 513–516 and 533–548, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)
Visit for points to refresh of this chapter from 7th edition
http://nrao-sapm-handbook.blogspot.com/2007/12/r-b-ch15-points-to-refresh.html
Types of Stocks
59.a. differentiate between 1) a growth company and a growth stock, 2) a defensive
company and a defensive stock, 3) a cyclical company and a cyclical stock,
4) a speculative company and a speculative stock, and 5) a value stock and a
growth stock;
Company Analysis and Stock Valuation
By evaluating financial performance variable we can identify good companies. But good companies are not necessarily good investments. For finding a good investment, we have to compare the intrinsic value of a stock to its market value.
Stock of a great company may be overpriced and in such as a case the stock of a growth company may not be growth stock.
Growth Companies
Growth companies have historically been defined as companies that consistently experience above-average increases in sales and earnings. Financial theorists define in more specific terms a growth company as one with management and opportunities that yield rates of return greater than the firm’s required rate of return. So in the definition of financial theorists growth company has a return on investment that is greater than the required rate of return based on its risk measure.
Growth Stocks
Growth stocks are not necessarily shares in growth companies.
A growth stock has a higher rate of return than other stocks with similar risk. Growth stocks give a higher return in comparison to the risk adjusted return that is expected from stocks with similar risk measure.
Superior risk-adjusted rate of return occurs because in the market they are undervalued at that point of time compared to other stocks
Defensive Companies and Stocks
Defensive companies’ future earnings are more likely to withstand an economic downturn. They have low business risk and not excessive financial risk
Defensive stocks are stocks with low or negative systematic risk (beta values). While defensive companies' stocks can be defensive stocks, they are defensive stocks only when their beta value is significantly less than one. So the analyst have to calculate beta value of a stock before declaring any stock as defensive stock.
Cyclical Companies and Stocks
Cyclical companies are those whose sales and earnings will be heavily influenced by aggregate business activity.
Cyclical stocks are those that will experience changes in their rates of return greater than changes in overall market rates of return. In this case beta value of stocks are significantly higher than one.
Speculative Companies and Stocks
Speculative companies are those whose assets involve great risk but those that also have a possibility of great gain.
Speculative stocks possess a high probability of low or negative rates of return and a low probability of normal or high rates of return. When markets are at historical peaks or stocks are way above their intrinsic values, many stocks may become speculative.
Value versus Growth Investing
In the debate about growth and value investing, both growth and value stocks are have higher risk adjusted returns compared to other stocks.
IN this context, growth stocks will have positive earnings surprises and above-average risk adjusted rates of return because the stocks are undervalued relative the growth of earnings and dividends expected from them.
Value stocks appear to be undervalued for reasons besides earnings growth potential. The growth potential in earnings and dividends is not spectacular in these stocks, and the undervaluation will be because of apprehension that the sales and earnings may decline relative to average companies.
On the basis of quantitative criteria, value stocks (population or all the companies from value stocks are identified) usually have low P/E ratio or low ratios of price to book value. Growth stocks (population or all the companies from which growth stocks are identified) usually have high P/E ratios and high price to book value ratios.
company and a defensive stock, 3) a cyclical company and a cyclical stock,
4) a speculative company and a speculative stock, and 5) a value stock and a
growth stock;
Company Analysis and Stock Valuation
By evaluating financial performance variable we can identify good companies. But good companies are not necessarily good investments. For finding a good investment, we have to compare the intrinsic value of a stock to its market value.
Stock of a great company may be overpriced and in such as a case the stock of a growth company may not be growth stock.
Growth Companies
Growth companies have historically been defined as companies that consistently experience above-average increases in sales and earnings. Financial theorists define in more specific terms a growth company as one with management and opportunities that yield rates of return greater than the firm’s required rate of return. So in the definition of financial theorists growth company has a return on investment that is greater than the required rate of return based on its risk measure.
Growth Stocks
Growth stocks are not necessarily shares in growth companies.
A growth stock has a higher rate of return than other stocks with similar risk. Growth stocks give a higher return in comparison to the risk adjusted return that is expected from stocks with similar risk measure.
Superior risk-adjusted rate of return occurs because in the market they are undervalued at that point of time compared to other stocks
Defensive Companies and Stocks
Defensive companies’ future earnings are more likely to withstand an economic downturn. They have low business risk and not excessive financial risk
Defensive stocks are stocks with low or negative systematic risk (beta values). While defensive companies' stocks can be defensive stocks, they are defensive stocks only when their beta value is significantly less than one. So the analyst have to calculate beta value of a stock before declaring any stock as defensive stock.
Cyclical Companies and Stocks
Cyclical companies are those whose sales and earnings will be heavily influenced by aggregate business activity.
Cyclical stocks are those that will experience changes in their rates of return greater than changes in overall market rates of return. In this case beta value of stocks are significantly higher than one.
Speculative Companies and Stocks
Speculative companies are those whose assets involve great risk but those that also have a possibility of great gain.
Speculative stocks possess a high probability of low or negative rates of return and a low probability of normal or high rates of return. When markets are at historical peaks or stocks are way above their intrinsic values, many stocks may become speculative.
Value versus Growth Investing
In the debate about growth and value investing, both growth and value stocks are have higher risk adjusted returns compared to other stocks.
IN this context, growth stocks will have positive earnings surprises and above-average risk adjusted rates of return because the stocks are undervalued relative the growth of earnings and dividends expected from them.
Value stocks appear to be undervalued for reasons besides earnings growth potential. The growth potential in earnings and dividends is not spectacular in these stocks, and the undervaluation will be because of apprehension that the sales and earnings may decline relative to average companies.
On the basis of quantitative criteria, value stocks (population or all the companies from value stocks are identified) usually have low P/E ratio or low ratios of price to book value. Growth stocks (population or all the companies from which growth stocks are identified) usually have high P/E ratios and high price to book value ratios.
Reading 60: An Introduction to Security Valuation: Part II
Prescribed reading
“An Introduction to Security Valuation: Part II”
Ch. 11, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)
LOS
60a. state the various forms of investment returns;
Visit - for refresher points on this chapter
http://nrao-sapm-handbook.blogspot.com/2007/12/r-b-ch11-points-to-refresh.html
“An Introduction to Security Valuation: Part II”
Ch. 11, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)
LOS
60a. state the various forms of investment returns;
Visit - for refresher points on this chapter
http://nrao-sapm-handbook.blogspot.com/2007/12/r-b-ch11-points-to-refresh.html
Earnings Multiplier Model from DDM
c. show how to use the DDM to develop an earnings multiplier model, and explain
the factors in the DDM that affect a stock’s price-to-earnings (P/E) ratio;
DDM model in terms of price (when the market is in equilibrium - each stock's is equal to its value determined by DDM model)
P = D1/k-g
Dividing both sides by E1 (Expected Earnings per share)
P/E1 = (D1/E1)/k-g
so the equilibrium P/E1 ratio is determined by D1/E1, k and g and the DDM model can be used to develop the earnings multiplier model also.
the factors in the DDM that affect a stock’s price-to-earnings (P/E) ratio;
DDM model in terms of price (when the market is in equilibrium - each stock's is equal to its value determined by DDM model)
P = D1/k-g
Dividing both sides by E1 (Expected Earnings per share)
P/E1 = (D1/E1)/k-g
so the equilibrium P/E1 ratio is determined by D1/E1, k and g and the DDM model can be used to develop the earnings multiplier model also.
Components of Investor's Required Rate of Return
d. explain the components of an investor’s required rate of return (i.e., the real riskfree rate, the expected rate of inflation, and a risk premium) and discuss the risk factors to be assessed in determining a country risk premium for use in estimating the required return for foreign securities;
Five risk components determine risk premiums
Business risk
Financial risk
Liquidity risk
Exchange rate risk
Country risk
Equity risk premiums are to be derived for each country in which assets are to be acquire for a portfolio.
The five risk components differ substantially between countries:
Business risk varies across countries because it is a function of the variations in the economic activity within a country and also of the operating leverage used by firms within a country. For example, for many years the financing of companies in India was done on the basis of a long debt to equity ratio of 2:1. It is only recently that more conservative debt equity ratios became the norm.
(to be continued)
Five risk components determine risk premiums
Business risk
Financial risk
Liquidity risk
Exchange rate risk
Country risk
Equity risk premiums are to be derived for each country in which assets are to be acquire for a portfolio.
The five risk components differ substantially between countries:
Business risk varies across countries because it is a function of the variations in the economic activity within a country and also of the operating leverage used by firms within a country. For example, for many years the financing of companies in India was done on the basis of a long debt to equity ratio of 2:1. It is only recently that more conservative debt equity ratios became the norm.
(to be continued)
Reading 61: Introduction to Price Multiple
Prescribed reading:
John D. Stowe, Thomas R. Robinson, Jerald E. Pinto, and Dennis W. McLeavey (AIMR, 2003)
LOS
The candidate should be able to:
a. discuss the rationales for, and the possible drawbacks to, the use of price to
earnings (P/E), price to book value (P/BV), price to sales (P/S), and price to cash
flow (P/CF) in equity valuation;
b. calculate and interpret P/E, P/BV, P/S, and P/CF.
John D. Stowe, Thomas R. Robinson, Jerald E. Pinto, and Dennis W. McLeavey (AIMR, 2003)
LOS
The candidate should be able to:
a. discuss the rationales for, and the possible drawbacks to, the use of price to
earnings (P/E), price to book value (P/BV), price to sales (P/S), and price to cash
flow (P/CF) in equity valuation;
b. calculate and interpret P/E, P/BV, P/S, and P/CF.
Price to Cash Flow Valuation Multiple
The use of this ratio is also becoming popular.
According to Reilly and Brown, the growth in popularity of this relative valuation technique can be traced to concern over the propensity of some firms to manipulate earnings per share. Cash flow values are generally less prone to manipulation.
Discounted cash flow techniques use only cash flow as the basis for valuation.
According to Reilly and Brown, the growth in popularity of this relative valuation technique can be traced to concern over the propensity of some firms to manipulate earnings per share. Cash flow values are generally less prone to manipulation.
Discounted cash flow techniques use only cash flow as the basis for valuation.
Wednesday, March 12, 2008
STUDY SESSION 14 ANALYSIS OF EQUITY INVESTMENTS:
Industry and Company Analysis
This study session focuses on industry and company analysis and describes the
tools used in forming an opinion about investing in a particular stock or group
of stocks.
This study session begins with the essential tools of equity valuation: the
discounted cash flow technique and the relative valuation approach. These
techniques provide the means to estimate reasonable price for a stock. The
readings on industry analysis are an important element in the valuation process,
providing the top–down context crucial to estimating a company’s potential.
Also addressed is estimating a company’s earnings per share by forecasting
sales and profit margins.
The last reading in this study session focuses on price multiples, one of the
most familiar and widely used tools in estimating the value of a company, and
introduces the application of four commonly used price multiples to valuation.
LEARNING OUTCOMES
Reading 56: An Introduction to Security Valuation: Part I
The candidate should be able to explain the top-down approach, and its
underlying logic, to the security valuation process.
Reading 57: Industry Analysis
The candidate should be able to describe how structural economic changes
(e.g., demographics, technology, politics, and regulation) may affect
industries.
Reading 58: Equity: Concepts and Techniques
The candidate should be able to:
a. classify business cycle stages and identify attractive investment opportunities for
each stage;
b. discuss, with respect to global industry analysis, the key elements related to
return expectations;
c. describe the industry life cycle and identify an industry’s stage in its life cycle;
d. discuss the specific advantages of both the concentration ratio and the
Herfindahl index;
e. discuss, with respect to global industry analysis, the elements related to risk, and
describe the basic forces that determine industry competition.
Reading 59: Company Analysis and Stock Valuation
The candidate should be able to:
a. differentiate between 1) a growth company and a growth stock, 2) a defensive
company and a defensive stock, 3) a cyclical company and a cyclical stock,
4) a speculative company and a speculative stock, and 5) a value stock and a
growth stock;
b. describe and estimate the expected earnings per share (EPS) and earnings
multiplier for a company and use the multiple to make an investment decision
regarding the company.
Reading 60: An Introduction to Security Valuation: Part II
The candidate should be able to:
a. state the various forms of investment returns;
b. calculate and interpret the value both of a preferred stock and a common stock
using the dividend discount model (DDM);
c. show how to use the DDM to develop an earnings multiplier model, and explain
the factors in the DDM that affect a stock’s price-to-earnings (P/E) ratio;
d. explain the components of an investor’s required rate of return (i.e., the real riskfree
rate, the expected rate of inflation, and a risk premium) and discuss the risk
factors to be assessed in determining a country risk premium for use in estimating
the required return for foreign securities;
e. estimate the implied dividend growth rate, given the components of the required
return on equity and incorporating the earnings retention rate and current stock
price;
f. describe a process for developing estimated inputs to be used in the DDM,
including the required rate of return and expected growth rate of dividends.
Reading 61: Introduction to Price Multiples
The candidate should be able to:
a. discuss the rationales for, and the possible drawbacks to, the use of price to
earnings (P/E), price to book value (P/BV), price to sales (P/S), and price to cash
flow (P/CF) in equity valuation;
b. calculate and interpret P/E, P/BV, P/S, and P/CF.
This study session focuses on industry and company analysis and describes the
tools used in forming an opinion about investing in a particular stock or group
of stocks.
This study session begins with the essential tools of equity valuation: the
discounted cash flow technique and the relative valuation approach. These
techniques provide the means to estimate reasonable price for a stock. The
readings on industry analysis are an important element in the valuation process,
providing the top–down context crucial to estimating a company’s potential.
Also addressed is estimating a company’s earnings per share by forecasting
sales and profit margins.
The last reading in this study session focuses on price multiples, one of the
most familiar and widely used tools in estimating the value of a company, and
introduces the application of four commonly used price multiples to valuation.
LEARNING OUTCOMES
Reading 56: An Introduction to Security Valuation: Part I
The candidate should be able to explain the top-down approach, and its
underlying logic, to the security valuation process.
Reading 57: Industry Analysis
The candidate should be able to describe how structural economic changes
(e.g., demographics, technology, politics, and regulation) may affect
industries.
Reading 58: Equity: Concepts and Techniques
The candidate should be able to:
a. classify business cycle stages and identify attractive investment opportunities for
each stage;
b. discuss, with respect to global industry analysis, the key elements related to
return expectations;
c. describe the industry life cycle and identify an industry’s stage in its life cycle;
d. discuss the specific advantages of both the concentration ratio and the
Herfindahl index;
e. discuss, with respect to global industry analysis, the elements related to risk, and
describe the basic forces that determine industry competition.
Reading 59: Company Analysis and Stock Valuation
The candidate should be able to:
a. differentiate between 1) a growth company and a growth stock, 2) a defensive
company and a defensive stock, 3) a cyclical company and a cyclical stock,
4) a speculative company and a speculative stock, and 5) a value stock and a
growth stock;
b. describe and estimate the expected earnings per share (EPS) and earnings
multiplier for a company and use the multiple to make an investment decision
regarding the company.
Reading 60: An Introduction to Security Valuation: Part II
The candidate should be able to:
a. state the various forms of investment returns;
b. calculate and interpret the value both of a preferred stock and a common stock
using the dividend discount model (DDM);
c. show how to use the DDM to develop an earnings multiplier model, and explain
the factors in the DDM that affect a stock’s price-to-earnings (P/E) ratio;
d. explain the components of an investor’s required rate of return (i.e., the real riskfree
rate, the expected rate of inflation, and a risk premium) and discuss the risk
factors to be assessed in determining a country risk premium for use in estimating
the required return for foreign securities;
e. estimate the implied dividend growth rate, given the components of the required
return on equity and incorporating the earnings retention rate and current stock
price;
f. describe a process for developing estimated inputs to be used in the DDM,
including the required rate of return and expected growth rate of dividends.
Reading 61: Introduction to Price Multiples
The candidate should be able to:
a. discuss the rationales for, and the possible drawbacks to, the use of price to
earnings (P/E), price to book value (P/BV), price to sales (P/S), and price to cash
flow (P/CF) in equity valuation;
b. calculate and interpret P/E, P/BV, P/S, and P/CF.
STUDY SESSION 15 Fixed Income Investments
STUDY SESSION 15 Fixed Income Investments Basic Concepts
This study session presents the foundation for fixed income investments, one of
the largest and fastest growing segments of global financial markets. It begins
with an introduction to the basic features and characteristics of fixed income securities
and the associated risks. The session then builds by describing the primary
issuers, sectors, and types of bonds. Finally, the study session concludes with an
introduction to yields and spreads and the effect of monetary policy on financial
markets. These readings combined are the primary building blocks for mastering
the analysis, valuation, and management of fixed income securities.
LEARNING OUTCOMES
Reading 62: Features of Debt Securities
The candidate should be able to:
a. explain the purposes of a bond’s indenture, and describe affirmative and negative
covenants;
b. describe the basic features of a bond, the various coupon rate structures, and the
structure of floating-rate securities;
c. define accrued interest, full price, and clean price;
d. explain the provisions for redemption and retirement of bonds;
e. identify the common options embedded in a bond issue, explain the importance
of embedded options, and state whether such options benefit the issuer or the
bondholder;
f. describe methods used by institutional investors in the bond market to finance
the purchase of a security (i.e., margin buying and repurchase agreements).
Reading 63: Risks Associated with Investing in Bonds
The candidate should be able to:
a. explain the risks associated with investing in bonds;
b. identify the relations among a bond’s coupon rate, the yield required by the market,
and the bond’s price relative to par value (i.e., discount, premium, or equal
to par);
c. explain how features of a bond (e.g., maturity, coupon, and embedded options)
and the level of a bond’s yield affect the bond’s interest rate risk;
d. identify the relationship among the price of a callable bond, the price of an
option-free bond, and the price of the embedded call option;
e. explain the interest rate risk of a floating-rate security and why such a security’s
price may differ from par value;
f. compute and interpret the duration and dollar duration of a bond;
g. describe yield curve risk and explain why duration does not account for yield
curve risk for a portfolio of bonds;
h. explain the disadvantages of a callable or prepayable security to an investor;
i. identify the factors that affect the reinvestment risk of a security and explain why
prepayable amortizing securities expose investors to greater reinvestment risk
than nonamortizing securities;
j. describe the various forms of credit risk and describe the meaning and role of
credit ratings;
k. explain liquidity risk and why it might be important to investors even if they
expect to hold a security to the maturity date;
l. describe the exchange rate risk an investor faces when a bond makes payments
in a foreign currency;
m. explain inflation risk;
n. explain how yield volatility affects the price of a bond with an embedded
option and how changes in volatility affect the value of a callable bond and a
putable bond;
o. describe the various forms of event risk.
Reading 64: Overview of Bond Sectors and Instruments
The candidate should be able to:
a. describe the features, credit risk characteristics, and distribution methods for
government securities;
b. describe the types of securities issued by the U.S. Department of the Treasury
(e.g., bills, notes, bonds, and inflation protection securities), and differentiate
between on-the-run and off-the-run Treasury securities;
c. describe how stripped Treasury securities are created and distinguish between
coupon strips and principal strips;
d. describe the types and characteristics of securities issued by U.S. federal agencies;
e. describe the types and characteristics of mortgage-backed securities and explain
the cash flow, prepayments, and prepayment risk for each type;
f. state the motivation for creating a collateralized mortgage obligation;
g. describe the types of securities issued by municipalities in the United States, and
distinguish between tax-backed debt and revenue bonds;
h. describe the characteristics and motivation for the various types of debt issued by
corporations (including corporate bonds, medium-term notes, structured notes,
commercial paper, negotiable CDs, and bankers acceptances);
i. define an asset-backed security, describe the role of a special purpose vehicle in
an asset-backed security’s transaction, state the motivation for a corporation to
issue an asset-backed security, and describe the types of external credit enhancements
for asset-backed securities;
j. describe collateralized debt obligations;
k. describe the mechanisms available for placing bonds in the primary market and
differentiate the primary and secondary markets in bonds.
Reading 65: Understanding Yield Spreads
The candidate should be able to:
a. identify the interest rate policy tools available to a central bank (e.g., the U.S.
Federal Reserve);
b. describe a yield curve and the various shapes of the yield curve;
c. explain the basic theories of the term structure of interest rates and describe the
implications of each theory for the shape of the yield curve;
d. define a spot rate;
e. compute, compare, and contrast the various yield spread measures;
f. describe a credit spread and discuss the suggested relation between credit
spreads and the well-being of the economy;
g. identify how embedded options affect yield spreads;
h. explain how the liquidity or issue-size of a bond affects its yield spread relative to
risk-free securities and relative to other securities;
i. compute the after-tax yield of a taxable security and the tax-equivalent yield of a
tax-exempt security;
j. define LIBOR and explain its importance to funded investors who borrow
short term.
Reading 66: Monetary Policy in an Environment
of Global Financial Markets
The candidate should be able to:
a. identify how central bank behavior affects short-term interest rates, systemic liquidity,
and market expectations, thereby affecting financial markets;
b. describe the importance of communication between a central bank and the
financial markets;
c. discuss the problem of information asymmetry and the importance of predictability,
credibility, and transparency of monetary policy.
This study session presents the foundation for fixed income investments, one of
the largest and fastest growing segments of global financial markets. It begins
with an introduction to the basic features and characteristics of fixed income securities
and the associated risks. The session then builds by describing the primary
issuers, sectors, and types of bonds. Finally, the study session concludes with an
introduction to yields and spreads and the effect of monetary policy on financial
markets. These readings combined are the primary building blocks for mastering
the analysis, valuation, and management of fixed income securities.
LEARNING OUTCOMES
Reading 62: Features of Debt Securities
The candidate should be able to:
a. explain the purposes of a bond’s indenture, and describe affirmative and negative
covenants;
b. describe the basic features of a bond, the various coupon rate structures, and the
structure of floating-rate securities;
c. define accrued interest, full price, and clean price;
d. explain the provisions for redemption and retirement of bonds;
e. identify the common options embedded in a bond issue, explain the importance
of embedded options, and state whether such options benefit the issuer or the
bondholder;
f. describe methods used by institutional investors in the bond market to finance
the purchase of a security (i.e., margin buying and repurchase agreements).
Reading 63: Risks Associated with Investing in Bonds
The candidate should be able to:
a. explain the risks associated with investing in bonds;
b. identify the relations among a bond’s coupon rate, the yield required by the market,
and the bond’s price relative to par value (i.e., discount, premium, or equal
to par);
c. explain how features of a bond (e.g., maturity, coupon, and embedded options)
and the level of a bond’s yield affect the bond’s interest rate risk;
d. identify the relationship among the price of a callable bond, the price of an
option-free bond, and the price of the embedded call option;
e. explain the interest rate risk of a floating-rate security and why such a security’s
price may differ from par value;
f. compute and interpret the duration and dollar duration of a bond;
g. describe yield curve risk and explain why duration does not account for yield
curve risk for a portfolio of bonds;
h. explain the disadvantages of a callable or prepayable security to an investor;
i. identify the factors that affect the reinvestment risk of a security and explain why
prepayable amortizing securities expose investors to greater reinvestment risk
than nonamortizing securities;
j. describe the various forms of credit risk and describe the meaning and role of
credit ratings;
k. explain liquidity risk and why it might be important to investors even if they
expect to hold a security to the maturity date;
l. describe the exchange rate risk an investor faces when a bond makes payments
in a foreign currency;
m. explain inflation risk;
n. explain how yield volatility affects the price of a bond with an embedded
option and how changes in volatility affect the value of a callable bond and a
putable bond;
o. describe the various forms of event risk.
Reading 64: Overview of Bond Sectors and Instruments
The candidate should be able to:
a. describe the features, credit risk characteristics, and distribution methods for
government securities;
b. describe the types of securities issued by the U.S. Department of the Treasury
(e.g., bills, notes, bonds, and inflation protection securities), and differentiate
between on-the-run and off-the-run Treasury securities;
c. describe how stripped Treasury securities are created and distinguish between
coupon strips and principal strips;
d. describe the types and characteristics of securities issued by U.S. federal agencies;
e. describe the types and characteristics of mortgage-backed securities and explain
the cash flow, prepayments, and prepayment risk for each type;
f. state the motivation for creating a collateralized mortgage obligation;
g. describe the types of securities issued by municipalities in the United States, and
distinguish between tax-backed debt and revenue bonds;
h. describe the characteristics and motivation for the various types of debt issued by
corporations (including corporate bonds, medium-term notes, structured notes,
commercial paper, negotiable CDs, and bankers acceptances);
i. define an asset-backed security, describe the role of a special purpose vehicle in
an asset-backed security’s transaction, state the motivation for a corporation to
issue an asset-backed security, and describe the types of external credit enhancements
for asset-backed securities;
j. describe collateralized debt obligations;
k. describe the mechanisms available for placing bonds in the primary market and
differentiate the primary and secondary markets in bonds.
Reading 65: Understanding Yield Spreads
The candidate should be able to:
a. identify the interest rate policy tools available to a central bank (e.g., the U.S.
Federal Reserve);
b. describe a yield curve and the various shapes of the yield curve;
c. explain the basic theories of the term structure of interest rates and describe the
implications of each theory for the shape of the yield curve;
d. define a spot rate;
e. compute, compare, and contrast the various yield spread measures;
f. describe a credit spread and discuss the suggested relation between credit
spreads and the well-being of the economy;
g. identify how embedded options affect yield spreads;
h. explain how the liquidity or issue-size of a bond affects its yield spread relative to
risk-free securities and relative to other securities;
i. compute the after-tax yield of a taxable security and the tax-equivalent yield of a
tax-exempt security;
j. define LIBOR and explain its importance to funded investors who borrow
short term.
Reading 66: Monetary Policy in an Environment
of Global Financial Markets
The candidate should be able to:
a. identify how central bank behavior affects short-term interest rates, systemic liquidity,
and market expectations, thereby affecting financial markets;
b. describe the importance of communication between a central bank and the
financial markets;
c. discuss the problem of information asymmetry and the importance of predictability,
credibility, and transparency of monetary policy.
Tuesday, March 11, 2008
Yield Curve Risk
The yield curve risk is how your portfolio will react with different exposures based on how the yield curve shifts.
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa11.asp
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa11.asp
Disadvantages of Callable Securities
h. explain the disadvantages of a callable or prepayable security to an investor;
Call and prepayment risk is concerned with the holders having their bonds paid off earlier than the maturity date. This is due to decreasing marker rates, which cause the issuer to call the bonds. It can also occur when the borrowers in a MBS or ABS refinance or pay off their debt earlier than the stated maturity date.
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa9.asp
Call and prepayment risk is concerned with the holders having their bonds paid off earlier than the maturity date. This is due to decreasing marker rates, which cause the issuer to call the bonds. It can also occur when the borrowers in a MBS or ABS refinance or pay off their debt earlier than the stated maturity date.
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa9.asp
Reinvestment Risk
i. identify the factors that affect the reinvestment risk of a security and explain why prepayable amortizing securities expose investors to greater reinvestment risk
than nonamortizing securities;
Reinvestment risk is the risk that the proceeds from the payment of principal and interest, which have to be reinvested at a lower rate than the original investment.
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa10.asp
than nonamortizing securities;
Reinvestment risk is the risk that the proceeds from the payment of principal and interest, which have to be reinvested at a lower rate than the original investment.
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa10.asp
Credit Risk
j. describe the various forms of credit risk and describe the meaning and role of
credit ratings;
Default risk: the counterparty or the company that issued debt securities is not in a position to pay the coupon on the debt securities.
Credit spread risk: Spread is the difference between the yield on risky bonds and yield on government securities. If it increases, the prices of risky bonds come down.
Downgrade risk: the quality of the bond as assessed by credit rating agencies may come down. Due to which the spread on the bond will increase and its price decreases
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa12.asp
credit ratings;
Default risk: the counterparty or the company that issued debt securities is not in a position to pay the coupon on the debt securities.
Credit spread risk: Spread is the difference between the yield on risky bonds and yield on government securities. If it increases, the prices of risky bonds come down.
Downgrade risk: the quality of the bond as assessed by credit rating agencies may come down. Due to which the spread on the bond will increase and its price decreases
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa12.asp
Liquidity Risk
k. explain liquidity risk and why it might be important to investors even if they
expect to hold a security to the maturity date;
Liquidity risk is concerned with an investor having to sell a bond below its indicated value, the indication having come from a recent transaction.
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa13.asp
expect to hold a security to the maturity date;
Liquidity risk is concerned with an investor having to sell a bond below its indicated value, the indication having come from a recent transaction.
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa13.asp
Exchange Rate Risk
l. describe the exchange rate risk an investor faces when a bond makes payments
in a foreign currency;
Exchange-rate risk is the risk of receiving less in domestic currency when investing in a bond that is in a different currency denomination than in the investor's home country.
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa14.asp
in a foreign currency;
Exchange-rate risk is the risk of receiving less in domestic currency when investing in a bond that is in a different currency denomination than in the investor's home country.
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa14.asp
Inflation Risk;
63.m. explain inflation risk;
Also known as Purchasing Power Risk, this risk arises from the decline in value of securities cash flow due to inflation, which is measured in terms of purchasing power.
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa16.asp
Also known as Purchasing Power Risk, this risk arises from the decline in value of securities cash flow due to inflation, which is measured in terms of purchasing power.
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa16.asp
Reading 65: Understanding Yield Spreads
LOS
The candidate should be able to:
a. identify the interest rate policy tools available to a central bank (e.g., the U.S.Federal Reserve);
What is the federal funds market?
From day to day, the amount of reserves a bank wants to hold may change as its deposits and transactions change. When a bank needs additional reserves on a short-term basis, it can borrow them from other banks that happen to have more reserves than they need. These loans take place in a private financial market called the federal funds market.
The interest rate on the overnight borrowing of reserves is called the federal funds rate or simply the "funds rate." It adjusts to balance the supply of and demand for reserves. For example, if the supply of reserves in the fed funds market is greater than the demand, then the funds rate falls, and if the supply of reserves is less than the demand, the funds rate rises.
What are open market operations?
The major tool the Fed uses to affect the supply of reserves in the banking system is open market operations—that is, the Fed buys and sells government securities on the open market. These operations are conducted by the Federal Reserve Bank of New York.
Suppose the Fed wants the funds rate to fall. To do this, it buys government securities from a bank. The Fed then pays for the securities by increasing that bank's reserves. As a result, the bank now has more reserves than it wants. So the bank can lend these unwanted reserves to another bank in the federal funds market. Thus, the Fed's open market purchase increases the supply of reserves to the banking system, and the federal funds rate falls.
When the Fed wants the funds rate to rise, it does the reverse, that is, it sells government securities. The Fed receives payment in reserves from banks, which lowers the supply of reserves in the banking system, and the funds rate rises.
What is the discount rate?
Banks also can borrow reserves directly from the Federal Reserve Banks at their "discount windows," and the discount rate is the rate that financially sound banks must pay for this "primary credit." The Boards of Directors of the Reserve Banks set these rates, subject to the review and determination of the Federal Reserve Board. ("Secondary credit" is offered at higher interest rates and on more restrictive terms to institutions that do not qualify for primary credit.) Since January 2003, the discount rate has been set 100 basis points above the funds rate target, though the difference between the two rates could vary in principle. Setting the discount rate higher than the funds rate is designed to keep banks from turning to this source before they have exhausted other less expensive alternatives. At the same time, the (relatively) easy availability of reserves at this rate effectively places a ceiling on the funds rate.
http://www.frbsf.org/publications/federalreserve/monetary/tools.html
The candidate should be able to:
a. identify the interest rate policy tools available to a central bank (e.g., the U.S.Federal Reserve);
What is the federal funds market?
From day to day, the amount of reserves a bank wants to hold may change as its deposits and transactions change. When a bank needs additional reserves on a short-term basis, it can borrow them from other banks that happen to have more reserves than they need. These loans take place in a private financial market called the federal funds market.
The interest rate on the overnight borrowing of reserves is called the federal funds rate or simply the "funds rate." It adjusts to balance the supply of and demand for reserves. For example, if the supply of reserves in the fed funds market is greater than the demand, then the funds rate falls, and if the supply of reserves is less than the demand, the funds rate rises.
What are open market operations?
The major tool the Fed uses to affect the supply of reserves in the banking system is open market operations—that is, the Fed buys and sells government securities on the open market. These operations are conducted by the Federal Reserve Bank of New York.
Suppose the Fed wants the funds rate to fall. To do this, it buys government securities from a bank. The Fed then pays for the securities by increasing that bank's reserves. As a result, the bank now has more reserves than it wants. So the bank can lend these unwanted reserves to another bank in the federal funds market. Thus, the Fed's open market purchase increases the supply of reserves to the banking system, and the federal funds rate falls.
When the Fed wants the funds rate to rise, it does the reverse, that is, it sells government securities. The Fed receives payment in reserves from banks, which lowers the supply of reserves in the banking system, and the funds rate rises.
What is the discount rate?
Banks also can borrow reserves directly from the Federal Reserve Banks at their "discount windows," and the discount rate is the rate that financially sound banks must pay for this "primary credit." The Boards of Directors of the Reserve Banks set these rates, subject to the review and determination of the Federal Reserve Board. ("Secondary credit" is offered at higher interest rates and on more restrictive terms to institutions that do not qualify for primary credit.) Since January 2003, the discount rate has been set 100 basis points above the funds rate target, though the difference between the two rates could vary in principle. Setting the discount rate higher than the funds rate is designed to keep banks from turning to this source before they have exhausted other less expensive alternatives. At the same time, the (relatively) easy availability of reserves at this rate effectively places a ceiling on the funds rate.
http://www.frbsf.org/publications/federalreserve/monetary/tools.html
Monetary policy in an environment of global financial markets
Reading recommended by the institute for this LOS
Professor Otmar Issing, Launching Workshop of the ECB-CFS Research Network on "Capital Markets and Financial Integration in Europe", Frankfurt am Main, 29 April 2002
Let me first say that it is a great pleasure to open the launching workshop for the Research Network "Capital Markets and Financial Integration in Europe ". Understanding global financial linkages is important, not least from the perspective of a central banker. Further integration of European financial markets is one of the expected benefits from monetary unification. By focusing on these issues, the Network will stimulate research on topics we as policymakers can benefit from.
In my remarks today, I would like to focus on the interaction between the central bank and financial markets. Specifically, I will first address the interdependence between monetary policy making and financial market expectations. Linked to this, I will then discuss some of our experiences of the first years of policy making at the ECB. I will conclude by briefly mentioning the recent changes that we have witnessed in the euro area financial landscape, and touch upon some areas where I believe more research is needed and where your contribution will be particularly valuable.
Let me start by elaborating on the issue of how central bank behaviour affects financial markets. In this respect, financial markets can be seen as a transmission channel of monetary policy. The central bank controls the short-term interest rate, but what matters for consumers' and firms' decisions are market interest rates beyond the direct control of the monetary authority. In this regard, the role of private banks in the transmission of monetary policy has traditionally been strong in the euro area and still plays a dominant role. Increases in liquidity are redistributed to end users through the banking system, at interest rates reflecting both current and expected future refinancing costs for the banks. Therefore, not only the actual situation of banks' balance sheets, but also market expectations about the future course of monetary policy and future inflation become important, since these expectations to a large extent determine those interest rates.
In this context, the monetary policy strategy is crucial. By a clear commitment to price stability, the ECB provides the markets with a reference against which new information can be consistently evaluated. If new information indicates risks to price stability, and markets understand the strategy, expectations will adjust in anticipation of the appropriate reaction of monetary policy. This fosters a smooth implementation of policy, where much of the actual work is done by themarket's adjustment of the term structure of interest rates.
We have structured the strategy of the ECB around two pillars, which can be seen as a means of organising information concerning risks to price stability. The first pillar assigns a prominent role to money, and in this context monetary aggregates are carefully monitored to reveal such threats. Under the second pillar, other macroeconomic and financial variables that contain information about future price developments are analysed. Financial markets, by their inherent forward-looking nature, provide the central bank with valuable information about expected economic developments. Two key markets to be monitored in this context are bond markets and equity markets. The former gives an assessment of expected interest rates through the term structure of interest rates. Bond derivatives can provide important information of the prevailing uncertainty about future interest rate developments. Such information is especially useful when deciding on communication issues, should market expectations deviate too far from the central banks own evaluation of the current circumstances. Equity markets can convey information about future economic activity. They also have a direct role in the transmission of economic shocks, in that changes in consumer's wealth can impact consumption. Traditionally, this effect has been stronger in the US than in Europe . However, recent trends point to an increase in equity holdings by Europeans which might make this channel more important. Increasing globalisation and cross-border ownership seems to have resulted in faster transmission of shocks, perhaps also more oriented towards sectors rather than countries. For example, the recent IT bubble both gained momentum and collapsed simultaneously across a number of countries. This has major impact on our economies because the traditional mitigating effects of trade and diversification do not apply when similar events take place everywhere.
To conclude, under the second pillar the financial markets (as well as other markets such as those for labour and goods) provide the central bank with relevant information about risks to price stability. This, together with the monetary analysis under the first pillar, allows two complementary pictures of the threats to price stability to emerge. In turn, this facilitates cross-checking, stimulates internal discussion, and ultimately, I believe, leads to appropriate monetary policy decisions.
Traditionally, bank lending was the main source of financing economic activities in most countries of the euro area and banks were therefore the main "actors" in the monetary transmission process. However, market based financing has become more important during the last few years. An interesting questions for research is how the evolution of financial markets, for example the continuing expansion of corporate bond markets, will impact the transmission of monetary policy.
Let me turn to the issue of predictability of monetary policy. In the environment I have just described, deliberate attempts to surprise markets would be counterproductive. Rather, implementation of policy will be smoother the more predictable it is. Woodford e.g. emphasises [1] that developments in financial markets have increased the possibilities of the central bank to influence markets, to the extent that it may do so by signalling without actually moving interest rates:
"The more sophisticated markets become, the more scope there will be for communication about even subtle aspects of the bank's decision and reasoning, and it will be desirable for central banks to take advantage of this opportunity."
Communicating with sophisticated financial markets is indeed important. At the same time it is a tricky issue, since the central bank needs to ensure that it guides rather than follows the markets. An eloquent quote by Alan Blinder illustrates the danger of failing to do so:[2] "...Following the markets may be a nice way of unsettling financial surprises, which is a legitimate end in itself. But I fear that it may produce rather poor monetary policy for several reasons. One is that speculative markets tend to run in herds and to overreact to almost everything. Central bankers need to be more cautious and prudent. Another is that financial markets seem extremely susceptible to fads and speculative bubbles which sometimes stray far from fundamentals. Central bankers must innoculate themselves against whimsy and keep their eyes on the fundamentals."
It is of utmost importance that the financial markets believe the stated goals of policy and understand the monetary policy strategy. In time, markets can evaluate the track-record of the ECB relative to the goal of price stability. Adherence to the strategy should gradually enhance the credibility in that markets can interpret monetary policy decisions through the strategy. In this respect, communication with markets is essential to foster a proper understanding of the strategy, and to send clear signals about the central banks current assessment of economic conditions.
It is therefore interesting to study actual developments in market-based indicators in order to gain some insight into how market participants have perceived the predictability and credibility of the ECB. Concentrating initially on the issue of predictability, Gaspar et al. (2001) examine the behaviour of overnight interest rates between the start of 1999 and early 2001[3]. They find that the markets during that period did not appear to make systematic errors with respect to monetary policy announcements. Moreover, Hartmann et al. (2001) find that overnight rates on average moved by less than 5 basis points immediately following monetary policy announcements by the ECB. [4] Finally, if we take a look at the behaviour of implied short-term forward rates at the one-month horizon during the entire period since the introduction of the euro, we see that the majority of ECB interest rate moves have been in line with the expectations of financial market participants. In this regard, the track record of the ECB is comparable to that of other major - and substantially older - central banks, such as the US Federal Reserve or the Bank of England. In my view, this performance is not bad for a young central bank like the ECB.
Of course, one could not claim that the money market has perfectly anticipated policy moves on every single occasion. Sometimes, rapidly changing economic conditions or extraordinary events, such as the September 11 terrorist attacks, require swift and decisive policy action that cannot be fully anticipated in advance. Furthermore, at times the monetary authority has access to information that market participants do not have. This information asymmetry may on rare occasions lead to policy moves that are unexpected by markets. This being said, I again repeat that there can be no interest in the monetary authority deliberately aiming to surprise the financial markets. Such a strategy would merely increase uncertainty in the markets and damage the credibility of the monetary authority.
Turning to this very aspect, taking due account of caveats such as liquidity and risk premia considerations, the market for French index- linked government bonds provides a useful measure of the credibility of monetary policy. The ten-year break-even inflation rate obtained from this market has consistently been in line with the ECB's quantitative definition of price stability, indicating a persistently high degree of credibility. Moreover, there is little evidence that monetary policy moves have generated any systematically higher volatility in the break even rate. This would seem to indicate that markets have perceived ECB monetary policy actions as transparent, in the sense that they do not appear to have induced investors to revise their beliefs about the objective of the ECB. Interestingly, in the last few months, the French treasury has issued new index-linked bonds linked to a measure of euro area HICP, which I am convinced will provide us with additional useful information in this respect.
Consistent with the notion that the monetary policy actions of the ECB have not resulted in increased market uncertainty, there is some evidence that bond market volatility has even declined since the introduction of the euro. For example, since 1999 the implied volatility on 10-year German Bund futures has - apart from a brief surge following September 11 - declined to historically low levels. All these indications from prices of financial instruments, determined by market forces which continuously judge the actions of the ECB, lead me to conclude that our monetary policy has been credible and largely transparent to investors.
This being said, it is also clear to me that we still have much to learn about what determines financial asset prices. Moreover, the nature of financial markets, constantly changing and evolving, adds to the need of widening and deepening our understanding of these markets. This is particularly true for financial markets in the euro area, which arguably have seen the most remarkable pace of change among all developed financial markets over the last few years. For example, the euro area money market has undergone a substantial transformation, including the creation of completely new segments, such as the EONIA swap market. Similarly, the bond market has evolved considerably, with very rapid growth of the corporate bond market segment over the last few years and a sizeable expansion of the international issuance of euro-denominated bonds.
No doubt, the introduction of the single currency and a common monetary policy framework acted as a powerful catalyst in bringing about many of the changes to the euro area financial landscape that we have witnessed in recent years. However, we still need to better understand the exact mechanisms which brought about these developments. In addition, as markets evolve and new financial instruments are introduced, this will bring about new ways to extract market information which may be highly relevant for monetary policy purposes. The Research Network can make a very valuable contribution on these topics, and generally with respect to the increasing importance of finance research - both at the macro and at the micro level - for central banks. We should also learn more about international financial linkages as well as the role of global trends and other international factors in determining the evolution of financial markets in Europe. The ongoing financial integration process within the euro area should have beneficial effects for monetary policy, for example by facilitating policy signaling and transmission through enhanced market liquidity. Financial integration and international linkages are the core areas of the Research Network. All these issues which I have mentioned are key for policymakers since we need to correctly interpret the information coming from markets, and also understand how monetary policy is propagated to the real economy through financial markets.
I am convinced that the Research Network will contribute significantly to our understanding of these and other issues. I personally will follow the progress of your work with great interest. I would like to end by wishing you a very productive and fruitful workshop, and all the best in your future research work on these important topics.
--------------------------------------------------------------------------------
[1] Michael Woodford, "Monetary Policy in the Information Economy", in Economic Policy for the Information Economy, Kansas City Fed, 2001.
[2] Alan Blinder, "Central Banking in Theory and Practice", MIT Press, 1998, p. 61.
[3] Gaspar, Perez-Quiros & Sicilia (2001), “ The ECB Monetary Policy Strategy and the Money Market", International Journal of Finance and Economics 6(4).
[4] Hartmann, Manna and Manzanares (2001), “ The microstructure of the euro money market", Journal of International Money and Finance 20
European Central Bank
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Press and Information Division
Kaiserstrasse 29, D-60311 Frankfurt am Main
Tel.: +49 69 1344 7455, Fax: +49 69 1344 7404
Internet: http://www.ecb.europa.eu
Reproduction is permitted provided that the source is acknowledged
Source
http://www.ecb.int/press/key/date/2002/html/sp020429_1.en.html
Professor Otmar Issing, Launching Workshop of the ECB-CFS Research Network on "Capital Markets and Financial Integration in Europe", Frankfurt am Main, 29 April 2002
Let me first say that it is a great pleasure to open the launching workshop for the Research Network "Capital Markets and Financial Integration in Europe ". Understanding global financial linkages is important, not least from the perspective of a central banker. Further integration of European financial markets is one of the expected benefits from monetary unification. By focusing on these issues, the Network will stimulate research on topics we as policymakers can benefit from.
In my remarks today, I would like to focus on the interaction between the central bank and financial markets. Specifically, I will first address the interdependence between monetary policy making and financial market expectations. Linked to this, I will then discuss some of our experiences of the first years of policy making at the ECB. I will conclude by briefly mentioning the recent changes that we have witnessed in the euro area financial landscape, and touch upon some areas where I believe more research is needed and where your contribution will be particularly valuable.
Let me start by elaborating on the issue of how central bank behaviour affects financial markets. In this respect, financial markets can be seen as a transmission channel of monetary policy. The central bank controls the short-term interest rate, but what matters for consumers' and firms' decisions are market interest rates beyond the direct control of the monetary authority. In this regard, the role of private banks in the transmission of monetary policy has traditionally been strong in the euro area and still plays a dominant role. Increases in liquidity are redistributed to end users through the banking system, at interest rates reflecting both current and expected future refinancing costs for the banks. Therefore, not only the actual situation of banks' balance sheets, but also market expectations about the future course of monetary policy and future inflation become important, since these expectations to a large extent determine those interest rates.
In this context, the monetary policy strategy is crucial. By a clear commitment to price stability, the ECB provides the markets with a reference against which new information can be consistently evaluated. If new information indicates risks to price stability, and markets understand the strategy, expectations will adjust in anticipation of the appropriate reaction of monetary policy. This fosters a smooth implementation of policy, where much of the actual work is done by themarket's adjustment of the term structure of interest rates.
We have structured the strategy of the ECB around two pillars, which can be seen as a means of organising information concerning risks to price stability. The first pillar assigns a prominent role to money, and in this context monetary aggregates are carefully monitored to reveal such threats. Under the second pillar, other macroeconomic and financial variables that contain information about future price developments are analysed. Financial markets, by their inherent forward-looking nature, provide the central bank with valuable information about expected economic developments. Two key markets to be monitored in this context are bond markets and equity markets. The former gives an assessment of expected interest rates through the term structure of interest rates. Bond derivatives can provide important information of the prevailing uncertainty about future interest rate developments. Such information is especially useful when deciding on communication issues, should market expectations deviate too far from the central banks own evaluation of the current circumstances. Equity markets can convey information about future economic activity. They also have a direct role in the transmission of economic shocks, in that changes in consumer's wealth can impact consumption. Traditionally, this effect has been stronger in the US than in Europe . However, recent trends point to an increase in equity holdings by Europeans which might make this channel more important. Increasing globalisation and cross-border ownership seems to have resulted in faster transmission of shocks, perhaps also more oriented towards sectors rather than countries. For example, the recent IT bubble both gained momentum and collapsed simultaneously across a number of countries. This has major impact on our economies because the traditional mitigating effects of trade and diversification do not apply when similar events take place everywhere.
To conclude, under the second pillar the financial markets (as well as other markets such as those for labour and goods) provide the central bank with relevant information about risks to price stability. This, together with the monetary analysis under the first pillar, allows two complementary pictures of the threats to price stability to emerge. In turn, this facilitates cross-checking, stimulates internal discussion, and ultimately, I believe, leads to appropriate monetary policy decisions.
Traditionally, bank lending was the main source of financing economic activities in most countries of the euro area and banks were therefore the main "actors" in the monetary transmission process. However, market based financing has become more important during the last few years. An interesting questions for research is how the evolution of financial markets, for example the continuing expansion of corporate bond markets, will impact the transmission of monetary policy.
Let me turn to the issue of predictability of monetary policy. In the environment I have just described, deliberate attempts to surprise markets would be counterproductive. Rather, implementation of policy will be smoother the more predictable it is. Woodford e.g. emphasises [1] that developments in financial markets have increased the possibilities of the central bank to influence markets, to the extent that it may do so by signalling without actually moving interest rates:
"The more sophisticated markets become, the more scope there will be for communication about even subtle aspects of the bank's decision and reasoning, and it will be desirable for central banks to take advantage of this opportunity."
Communicating with sophisticated financial markets is indeed important. At the same time it is a tricky issue, since the central bank needs to ensure that it guides rather than follows the markets. An eloquent quote by Alan Blinder illustrates the danger of failing to do so:[2] "...Following the markets may be a nice way of unsettling financial surprises, which is a legitimate end in itself. But I fear that it may produce rather poor monetary policy for several reasons. One is that speculative markets tend to run in herds and to overreact to almost everything. Central bankers need to be more cautious and prudent. Another is that financial markets seem extremely susceptible to fads and speculative bubbles which sometimes stray far from fundamentals. Central bankers must innoculate themselves against whimsy and keep their eyes on the fundamentals."
It is of utmost importance that the financial markets believe the stated goals of policy and understand the monetary policy strategy. In time, markets can evaluate the track-record of the ECB relative to the goal of price stability. Adherence to the strategy should gradually enhance the credibility in that markets can interpret monetary policy decisions through the strategy. In this respect, communication with markets is essential to foster a proper understanding of the strategy, and to send clear signals about the central banks current assessment of economic conditions.
It is therefore interesting to study actual developments in market-based indicators in order to gain some insight into how market participants have perceived the predictability and credibility of the ECB. Concentrating initially on the issue of predictability, Gaspar et al. (2001) examine the behaviour of overnight interest rates between the start of 1999 and early 2001[3]. They find that the markets during that period did not appear to make systematic errors with respect to monetary policy announcements. Moreover, Hartmann et al. (2001) find that overnight rates on average moved by less than 5 basis points immediately following monetary policy announcements by the ECB. [4] Finally, if we take a look at the behaviour of implied short-term forward rates at the one-month horizon during the entire period since the introduction of the euro, we see that the majority of ECB interest rate moves have been in line with the expectations of financial market participants. In this regard, the track record of the ECB is comparable to that of other major - and substantially older - central banks, such as the US Federal Reserve or the Bank of England. In my view, this performance is not bad for a young central bank like the ECB.
Of course, one could not claim that the money market has perfectly anticipated policy moves on every single occasion. Sometimes, rapidly changing economic conditions or extraordinary events, such as the September 11 terrorist attacks, require swift and decisive policy action that cannot be fully anticipated in advance. Furthermore, at times the monetary authority has access to information that market participants do not have. This information asymmetry may on rare occasions lead to policy moves that are unexpected by markets. This being said, I again repeat that there can be no interest in the monetary authority deliberately aiming to surprise the financial markets. Such a strategy would merely increase uncertainty in the markets and damage the credibility of the monetary authority.
Turning to this very aspect, taking due account of caveats such as liquidity and risk premia considerations, the market for French index- linked government bonds provides a useful measure of the credibility of monetary policy. The ten-year break-even inflation rate obtained from this market has consistently been in line with the ECB's quantitative definition of price stability, indicating a persistently high degree of credibility. Moreover, there is little evidence that monetary policy moves have generated any systematically higher volatility in the break even rate. This would seem to indicate that markets have perceived ECB monetary policy actions as transparent, in the sense that they do not appear to have induced investors to revise their beliefs about the objective of the ECB. Interestingly, in the last few months, the French treasury has issued new index-linked bonds linked to a measure of euro area HICP, which I am convinced will provide us with additional useful information in this respect.
Consistent with the notion that the monetary policy actions of the ECB have not resulted in increased market uncertainty, there is some evidence that bond market volatility has even declined since the introduction of the euro. For example, since 1999 the implied volatility on 10-year German Bund futures has - apart from a brief surge following September 11 - declined to historically low levels. All these indications from prices of financial instruments, determined by market forces which continuously judge the actions of the ECB, lead me to conclude that our monetary policy has been credible and largely transparent to investors.
This being said, it is also clear to me that we still have much to learn about what determines financial asset prices. Moreover, the nature of financial markets, constantly changing and evolving, adds to the need of widening and deepening our understanding of these markets. This is particularly true for financial markets in the euro area, which arguably have seen the most remarkable pace of change among all developed financial markets over the last few years. For example, the euro area money market has undergone a substantial transformation, including the creation of completely new segments, such as the EONIA swap market. Similarly, the bond market has evolved considerably, with very rapid growth of the corporate bond market segment over the last few years and a sizeable expansion of the international issuance of euro-denominated bonds.
No doubt, the introduction of the single currency and a common monetary policy framework acted as a powerful catalyst in bringing about many of the changes to the euro area financial landscape that we have witnessed in recent years. However, we still need to better understand the exact mechanisms which brought about these developments. In addition, as markets evolve and new financial instruments are introduced, this will bring about new ways to extract market information which may be highly relevant for monetary policy purposes. The Research Network can make a very valuable contribution on these topics, and generally with respect to the increasing importance of finance research - both at the macro and at the micro level - for central banks. We should also learn more about international financial linkages as well as the role of global trends and other international factors in determining the evolution of financial markets in Europe. The ongoing financial integration process within the euro area should have beneficial effects for monetary policy, for example by facilitating policy signaling and transmission through enhanced market liquidity. Financial integration and international linkages are the core areas of the Research Network. All these issues which I have mentioned are key for policymakers since we need to correctly interpret the information coming from markets, and also understand how monetary policy is propagated to the real economy through financial markets.
I am convinced that the Research Network will contribute significantly to our understanding of these and other issues. I personally will follow the progress of your work with great interest. I would like to end by wishing you a very productive and fruitful workshop, and all the best in your future research work on these important topics.
--------------------------------------------------------------------------------
[1] Michael Woodford, "Monetary Policy in the Information Economy", in Economic Policy for the Information Economy, Kansas City Fed, 2001.
[2] Alan Blinder, "Central Banking in Theory and Practice", MIT Press, 1998, p. 61.
[3] Gaspar, Perez-Quiros & Sicilia (2001), “ The ECB Monetary Policy Strategy and the Money Market", International Journal of Finance and Economics 6(4).
[4] Hartmann, Manna and Manzanares (2001), “ The microstructure of the euro money market", Journal of International Money and Finance 20
European Central Bank
Directorate Communications
Press and Information Division
Kaiserstrasse 29, D-60311 Frankfurt am Main
Tel.: +49 69 1344 7455, Fax: +49 69 1344 7404
Internet: http://www.ecb.europa.eu
Reproduction is permitted provided that the source is acknowledged
Source
http://www.ecb.int/press/key/date/2002/html/sp020429_1.en.html
STUDY SESSION 15 Fixed Income Investments
STUDY SESSION 15 Fixed Income Investments Basic Concepts
This study session presents the foundation for fixed income investments, one of
the largest and fastest growing segments of global financial markets. It begins
with an introduction to the basic features and characteristics of fixed income securities
and the associated risks. The session then builds by describing the primary
issuers, sectors, and types of bonds. Finally, the study session concludes with an
introduction to yields and spreads and the effect of monetary policy on financial
markets. These readings combined are the primary building blocks for mastering
the analysis, valuation, and management of fixed income securities.
LEARNING OUTCOMES
Reading 62: Features of Debt Securities
The candidate should be able to:
a. explain the purposes of a bond’s indenture, and describe affirmative and negative
covenants;
b. describe the basic features of a bond, the various coupon rate structures, and the
structure of floating-rate securities;
c. define accrued interest, full price, and clean price;
d. explain the provisions for redemption and retirement of bonds;
e. identify the common options embedded in a bond issue, explain the importance
of embedded options, and state whether such options benefit the issuer or the
bondholder;
f. describe methods used by institutional investors in the bond market to finance
the purchase of a security (i.e., margin buying and repurchase agreements).
Reading 63: Risks Associated with Investing in Bonds
The candidate should be able to:
a. explain the risks associated with investing in bonds;
b. identify the relations among a bond’s coupon rate, the yield required by the market,
and the bond’s price relative to par value (i.e., discount, premium, or equal
to par);
c. explain how features of a bond (e.g., maturity, coupon, and embedded options)
and the level of a bond’s yield affect the bond’s interest rate risk;
d. identify the relationship among the price of a callable bond, the price of an
option-free bond, and the price of the embedded call option;
e. explain the interest rate risk of a floating-rate security and why such a security’s
price may differ from par value;
f. compute and interpret the duration and dollar duration of a bond;
g. describe yield curve risk and explain why duration does not account for yield
curve risk for a portfolio of bonds;
h. explain the disadvantages of a callable or prepayable security to an investor;
i. identify the factors that affect the reinvestment risk of a security and explain why
prepayable amortizing securities expose investors to greater reinvestment risk
than nonamortizing securities;
j. describe the various forms of credit risk and describe the meaning and role of
credit ratings;
k. explain liquidity risk and why it might be important to investors even if they
expect to hold a security to the maturity date;
l. describe the exchange rate risk an investor faces when a bond makes payments
in a foreign currency;
m. explain inflation risk;
n. explain how yield volatility affects the price of a bond with an embedded
option and how changes in volatility affect the value of a callable bond and a
putable bond;
o. describe the various forms of event risk.
Reading 64: Overview of Bond Sectors and Instruments
The candidate should be able to:
a. describe the features, credit risk characteristics, and distribution methods for
government securities;
b. describe the types of securities issued by the U.S. Department of the Treasury
(e.g., bills, notes, bonds, and inflation protection securities), and differentiate
between on-the-run and off-the-run Treasury securities;
c. describe how stripped Treasury securities are created and distinguish between
coupon strips and principal strips;
d. describe the types and characteristics of securities issued by U.S. federal agencies;
e. describe the types and characteristics of mortgage-backed securities and explain
the cash flow, prepayments, and prepayment risk for each type;
f. state the motivation for creating a collateralized mortgage obligation;
g. describe the types of securities issued by municipalities in the United States, and
distinguish between tax-backed debt and revenue bonds;
h. describe the characteristics and motivation for the various types of debt issued by
corporations (including corporate bonds, medium-term notes, structured notes,
commercial paper, negotiable CDs, and bankers acceptances);
i. define an asset-backed security, describe the role of a special purpose vehicle in
an asset-backed security’s transaction, state the motivation for a corporation to
issue an asset-backed security, and describe the types of external credit enhancements
for asset-backed securities;
j. describe collateralized debt obligations;
k. describe the mechanisms available for placing bonds in the primary market and
differentiate the primary and secondary markets in bonds.
Reading 65: Understanding Yield Spreads
The candidate should be able to:
a. identify the interest rate policy tools available to a central bank (e.g., the U.S.
Federal Reserve);
b. describe a yield curve and the various shapes of the yield curve;
c. explain the basic theories of the term structure of interest rates and describe the
implications of each theory for the shape of the yield curve;
d. define a spot rate;
e. compute, compare, and contrast the various yield spread measures;
f. describe a credit spread and discuss the suggested relation between credit
spreads and the well-being of the economy;
g. identify how embedded options affect yield spreads;
h. explain how the liquidity or issue-size of a bond affects its yield spread relative to
risk-free securities and relative to other securities;
i. compute the after-tax yield of a taxable security and the tax-equivalent yield of a
tax-exempt security;
j. define LIBOR and explain its importance to funded investors who borrow
short term.
Reading 66: Monetary Policy in an Environment
of Global Financial Markets
The candidate should be able to:
a. identify how central bank behavior affects short-term interest rates, systemic liquidity,
and market expectations, thereby affecting financial markets;
b. describe the importance of communication between a central bank and the
financial markets;
c. discuss the problem of information asymmetry and the importance of predictability,
credibility, and transparency of monetary policy.
This study session presents the foundation for fixed income investments, one of
the largest and fastest growing segments of global financial markets. It begins
with an introduction to the basic features and characteristics of fixed income securities
and the associated risks. The session then builds by describing the primary
issuers, sectors, and types of bonds. Finally, the study session concludes with an
introduction to yields and spreads and the effect of monetary policy on financial
markets. These readings combined are the primary building blocks for mastering
the analysis, valuation, and management of fixed income securities.
LEARNING OUTCOMES
Reading 62: Features of Debt Securities
The candidate should be able to:
a. explain the purposes of a bond’s indenture, and describe affirmative and negative
covenants;
b. describe the basic features of a bond, the various coupon rate structures, and the
structure of floating-rate securities;
c. define accrued interest, full price, and clean price;
d. explain the provisions for redemption and retirement of bonds;
e. identify the common options embedded in a bond issue, explain the importance
of embedded options, and state whether such options benefit the issuer or the
bondholder;
f. describe methods used by institutional investors in the bond market to finance
the purchase of a security (i.e., margin buying and repurchase agreements).
Reading 63: Risks Associated with Investing in Bonds
The candidate should be able to:
a. explain the risks associated with investing in bonds;
b. identify the relations among a bond’s coupon rate, the yield required by the market,
and the bond’s price relative to par value (i.e., discount, premium, or equal
to par);
c. explain how features of a bond (e.g., maturity, coupon, and embedded options)
and the level of a bond’s yield affect the bond’s interest rate risk;
d. identify the relationship among the price of a callable bond, the price of an
option-free bond, and the price of the embedded call option;
e. explain the interest rate risk of a floating-rate security and why such a security’s
price may differ from par value;
f. compute and interpret the duration and dollar duration of a bond;
g. describe yield curve risk and explain why duration does not account for yield
curve risk for a portfolio of bonds;
h. explain the disadvantages of a callable or prepayable security to an investor;
i. identify the factors that affect the reinvestment risk of a security and explain why
prepayable amortizing securities expose investors to greater reinvestment risk
than nonamortizing securities;
j. describe the various forms of credit risk and describe the meaning and role of
credit ratings;
k. explain liquidity risk and why it might be important to investors even if they
expect to hold a security to the maturity date;
l. describe the exchange rate risk an investor faces when a bond makes payments
in a foreign currency;
m. explain inflation risk;
n. explain how yield volatility affects the price of a bond with an embedded
option and how changes in volatility affect the value of a callable bond and a
putable bond;
o. describe the various forms of event risk.
Reading 64: Overview of Bond Sectors and Instruments
The candidate should be able to:
a. describe the features, credit risk characteristics, and distribution methods for
government securities;
b. describe the types of securities issued by the U.S. Department of the Treasury
(e.g., bills, notes, bonds, and inflation protection securities), and differentiate
between on-the-run and off-the-run Treasury securities;
c. describe how stripped Treasury securities are created and distinguish between
coupon strips and principal strips;
d. describe the types and characteristics of securities issued by U.S. federal agencies;
e. describe the types and characteristics of mortgage-backed securities and explain
the cash flow, prepayments, and prepayment risk for each type;
f. state the motivation for creating a collateralized mortgage obligation;
g. describe the types of securities issued by municipalities in the United States, and
distinguish between tax-backed debt and revenue bonds;
h. describe the characteristics and motivation for the various types of debt issued by
corporations (including corporate bonds, medium-term notes, structured notes,
commercial paper, negotiable CDs, and bankers acceptances);
i. define an asset-backed security, describe the role of a special purpose vehicle in
an asset-backed security’s transaction, state the motivation for a corporation to
issue an asset-backed security, and describe the types of external credit enhancements
for asset-backed securities;
j. describe collateralized debt obligations;
k. describe the mechanisms available for placing bonds in the primary market and
differentiate the primary and secondary markets in bonds.
Reading 65: Understanding Yield Spreads
The candidate should be able to:
a. identify the interest rate policy tools available to a central bank (e.g., the U.S.
Federal Reserve);
b. describe a yield curve and the various shapes of the yield curve;
c. explain the basic theories of the term structure of interest rates and describe the
implications of each theory for the shape of the yield curve;
d. define a spot rate;
e. compute, compare, and contrast the various yield spread measures;
f. describe a credit spread and discuss the suggested relation between credit
spreads and the well-being of the economy;
g. identify how embedded options affect yield spreads;
h. explain how the liquidity or issue-size of a bond affects its yield spread relative to
risk-free securities and relative to other securities;
i. compute the after-tax yield of a taxable security and the tax-equivalent yield of a
tax-exempt security;
j. define LIBOR and explain its importance to funded investors who borrow
short term.
Reading 66: Monetary Policy in an Environment
of Global Financial Markets
The candidate should be able to:
a. identify how central bank behavior affects short-term interest rates, systemic liquidity,
and market expectations, thereby affecting financial markets;
b. describe the importance of communication between a central bank and the
financial markets;
c. discuss the problem of information asymmetry and the importance of predictability,
credibility, and transparency of monetary policy.
STUDY SESSION 16 ANALYSIS OF FIXED INCOME
STUDY SESSION 16
ANALYSIS OF FIXED INCOME
INVESTMENTS:
Analysis and Valuation
This study session illustrates the primary tools for valuation and analysis of fixed
income securities and markets. It begins with a study of basic valuation theory
and techniques for bonds and concludes with a more in-depth explanation of the
primary tools for fixed income investment valuation, specifically, interest rate and
yield valuation and interest rate risk measurement and analysis.
LEARNING OUTCOMES
Reading 67: Introduction to the Valuation of Debt Securities
The candidate should be able to:
a. explain the steps in the bond valuation process;
b. identify the types of bonds for which estimating the expected cash flows is difficult,
and explain the problems encountered when estimating the cash flows for
these bonds;
c. compute the value of a bond and the change in value that is attributable to a
change in the discount rate;
d. explain how the price of a bond changes as the bond approaches its maturity
date, and compute the change in value that is attributable to the passage
of time;
e. compute the value of a zero-coupon bond;
f. explain the arbitrage-free valuation approach and the market process that forces
the price of a bond toward its arbitrage-free value, and explain how a dealer can
generate an arbitrage profit if a bond is mispriced.
Reading 68: Yield Measures, Spot Rates, and Forward Rates
The candidate should be able to:
a. explain the sources of return from investing in a bond;
b. compute and interpret the traditional yield measures for fixed-rate bonds, and
explain their limitations and assumptions;
c. explain the importance of reinvestment income in generating the yield computed
at the time of purchase, calculate the amount of income required to generate
that yield, and discuss the factors that affect reinvestment risk;
d. compute and interpret the bond equivalent yield of an annual-pay bond and the
annual-pay yield of a semiannual-pay bond;
e. describe the methodology for computing the theoretical Treasury spot rate curve,
and compute the value of a bond using spot rates;
f. differentiate between the nominal spread, the zero-volatility spread, and the
option-adjusted spread;
g. describe how the option-adjusted spread accounts for the option cost in a bond
with an embedded option;
h. explain a forward rate, and compute spot rates from forward rates, forward rates
from spot rates, and the value of a bond using forward rates.
Reading 69: Introduction to the Measurement of Interest Rate Risk
The candidate should be able to:
a. distinguish between the full valuation approach (the scenario analysis approach)
and the duration/convexity approach for measuring interest rate risk, and explain
the advantage of using the full valuation approach;
b. demonstrate the price volatility characteristics for option-free, callable,
prepayable, and putable bonds when interest rates change;
c. describe positive convexity, negative convexity, and their relation to bond price
and yield;
d. compute and interpret the effective duration of a bond, given information about
how the bond’s price will increase and decrease for given changes in interest
rates, and compute the approximate percentage price change for a bond, given
the bond’s effective duration and a specified change in yield;
e. distinguish among the alternative definitions of duration, and explain why effective
duration is the most appropriate measure of interest rate risk for bonds with
embedded options;
f. compute the duration of a portfolio, given the duration of the bonds comprising
the portfolio, and explain the limitations of portfolio duration;
g. describe the convexity measure of a bond, and estimate a bond’s percentage
price change, given the bond’s duration and convexity and a specified change in
interest rates;
h. differentiate between modified convexity and effective convexity;
i. compute the price value of a basis point (PVBP), and explain its relationship to
duration.
ANALYSIS OF FIXED INCOME
INVESTMENTS:
Analysis and Valuation
This study session illustrates the primary tools for valuation and analysis of fixed
income securities and markets. It begins with a study of basic valuation theory
and techniques for bonds and concludes with a more in-depth explanation of the
primary tools for fixed income investment valuation, specifically, interest rate and
yield valuation and interest rate risk measurement and analysis.
LEARNING OUTCOMES
Reading 67: Introduction to the Valuation of Debt Securities
The candidate should be able to:
a. explain the steps in the bond valuation process;
b. identify the types of bonds for which estimating the expected cash flows is difficult,
and explain the problems encountered when estimating the cash flows for
these bonds;
c. compute the value of a bond and the change in value that is attributable to a
change in the discount rate;
d. explain how the price of a bond changes as the bond approaches its maturity
date, and compute the change in value that is attributable to the passage
of time;
e. compute the value of a zero-coupon bond;
f. explain the arbitrage-free valuation approach and the market process that forces
the price of a bond toward its arbitrage-free value, and explain how a dealer can
generate an arbitrage profit if a bond is mispriced.
Reading 68: Yield Measures, Spot Rates, and Forward Rates
The candidate should be able to:
a. explain the sources of return from investing in a bond;
b. compute and interpret the traditional yield measures for fixed-rate bonds, and
explain their limitations and assumptions;
c. explain the importance of reinvestment income in generating the yield computed
at the time of purchase, calculate the amount of income required to generate
that yield, and discuss the factors that affect reinvestment risk;
d. compute and interpret the bond equivalent yield of an annual-pay bond and the
annual-pay yield of a semiannual-pay bond;
e. describe the methodology for computing the theoretical Treasury spot rate curve,
and compute the value of a bond using spot rates;
f. differentiate between the nominal spread, the zero-volatility spread, and the
option-adjusted spread;
g. describe how the option-adjusted spread accounts for the option cost in a bond
with an embedded option;
h. explain a forward rate, and compute spot rates from forward rates, forward rates
from spot rates, and the value of a bond using forward rates.
Reading 69: Introduction to the Measurement of Interest Rate Risk
The candidate should be able to:
a. distinguish between the full valuation approach (the scenario analysis approach)
and the duration/convexity approach for measuring interest rate risk, and explain
the advantage of using the full valuation approach;
b. demonstrate the price volatility characteristics for option-free, callable,
prepayable, and putable bonds when interest rates change;
c. describe positive convexity, negative convexity, and their relation to bond price
and yield;
d. compute and interpret the effective duration of a bond, given information about
how the bond’s price will increase and decrease for given changes in interest
rates, and compute the approximate percentage price change for a bond, given
the bond’s effective duration and a specified change in yield;
e. distinguish among the alternative definitions of duration, and explain why effective
duration is the most appropriate measure of interest rate risk for bonds with
embedded options;
f. compute the duration of a portfolio, given the duration of the bonds comprising
the portfolio, and explain the limitations of portfolio duration;
g. describe the convexity measure of a bond, and estimate a bond’s percentage
price change, given the bond’s duration and convexity and a specified change in
interest rates;
h. differentiate between modified convexity and effective convexity;
i. compute the price value of a basis point (PVBP), and explain its relationship to
duration.
Monday, March 10, 2008
LOS 67 Introduction to the Valuation of Debt Securities
LOS 67 Introduction to the Valuation of Debt Securities
a. explain the steps in the bond valuation process;
Steps involved in bond valuation
The fundamental principle of valuation is that the value is equal to the present value of its expected cash flows. The valuation process involves the following three steps:
1. Estimate the expected cash flows.
2. Determine the appropriate interest rate or interest rates that should be used to discount the cash flows.
3. Calculate the present value of the expected cash flows found in step one by using the interest rate or interest rates determined in step two.
a. explain the steps in the bond valuation process;
Steps involved in bond valuation
The fundamental principle of valuation is that the value is equal to the present value of its expected cash flows. The valuation process involves the following three steps:
1. Estimate the expected cash flows.
2. Determine the appropriate interest rate or interest rates that should be used to discount the cash flows.
3. Calculate the present value of the expected cash flows found in step one by using the interest rate or interest rates determined in step two.
Estimating Expected Cash Flows - Difficulties
b. identify the types of bonds for which estimating the expected cash flows is difficult,
and explain the problems encountered when estimating the cash flows for
these bonds;
Bonds With Difficult Expected Cash Flow Estimation
The bonds for which it is difficult to estimate expected cash flows fall into three categories:
1.Bonds for which the issuer or investor has an option or right to change the contract due date for the payment of the principal. These include callable bonds, puttable bonds, MBSs and ABSs.
2.Bonds for which coupon payment rate is reset occasionally based on a formula with values that change, such as reference rates, prices or exchange rates. A floating-rate bond would be an example of this type of category.
3. Bonds for which investor has the option to convert or exchange the security for common stock.
For more See
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa35.asp
The above page has information useful for the next LOS 67.c also.
and explain the problems encountered when estimating the cash flows for
these bonds;
Bonds With Difficult Expected Cash Flow Estimation
The bonds for which it is difficult to estimate expected cash flows fall into three categories:
1.Bonds for which the issuer or investor has an option or right to change the contract due date for the payment of the principal. These include callable bonds, puttable bonds, MBSs and ABSs.
2.Bonds for which coupon payment rate is reset occasionally based on a formula with values that change, such as reference rates, prices or exchange rates. A floating-rate bond would be an example of this type of category.
3. Bonds for which investor has the option to convert or exchange the security for common stock.
For more See
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa35.asp
The above page has information useful for the next LOS 67.c also.
Computing Value of Bond for a Change in Dicount Rate
c. compute the value of a bond and the change in value that is attributable to a
change in the discount rate;
see
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa36.asp
change in the discount rate;
see
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa36.asp
Price of a Bond near Maturity Date
d. explain how the price of a bond changes as the bond approaches its maturity
date, and compute the change in value that is attributable to the passage
of time;
See
www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa36.asp
date, and compute the change in value that is attributable to the passage
of time;
See
www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa36.asp
Arbitrage-free Valuation Approach Bonds
LOS
67
.f. explain the arbitrage-free valuation approach and the market process that forces
the price of a bond toward its arbitrage-free value, and explain how a dealer can
generate an arbitrage profit if a bond is mispriced.
The value of the bond based on the spot rates is the arbitrage-free value.
How Does a Dealer Generate Arbitrage Profits?
A dealer has the ability to strip a security or to take apart the cash flows that make up the bond and create new securites out of them. These Treasury strips can be sold to investors. So if the market price of a Treasury security is less than the value using the arbitrage-free valuation, a dealer will buy the security, strip the bond (break the bond into strips) and then sell the Treasury strips at a higher amount than the purchase price for the whole bond.
See for more
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa37.asp
67
.f. explain the arbitrage-free valuation approach and the market process that forces
the price of a bond toward its arbitrage-free value, and explain how a dealer can
generate an arbitrage profit if a bond is mispriced.
The value of the bond based on the spot rates is the arbitrage-free value.
How Does a Dealer Generate Arbitrage Profits?
A dealer has the ability to strip a security or to take apart the cash flows that make up the bond and create new securites out of them. These Treasury strips can be sold to investors. So if the market price of a Treasury security is less than the value using the arbitrage-free valuation, a dealer will buy the security, strip the bond (break the bond into strips) and then sell the Treasury strips at a higher amount than the purchase price for the whole bond.
See for more
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa37.asp
LOS 68 Yield Measures, Spot Rates, and Forward Rates
a. explain the sources of return from investing in a bond;
Interest
Capital appreciation
Reinvestment income
-------------
return of Principal
Interest
Capital appreciation
Reinvestment income
-------------
return of Principal
Traditional Yield Measures for Bonds
b. compute and interpret the traditional yield measures for fixed-rate bonds, and
explain their limitations and assumptions;
Current yield
To obtain the current yield, the annual coupon interest is divided by the market price.
Yield to maturity
The yield on any investment is the interest rate that will make the present value of the cash flows from the investment equal to the price of the investment.
Yield to call
For bonds that may be called prior to the stated maturity date another yield measure is commonly quoted: it is the yield to call.
To compute the yield to call, the cash flows that occur if the issue is called on its first call date are used.
http://www.paranzasoft.com/help/pages/glBondYieldMeasures.html
explain their limitations and assumptions;
Current yield
To obtain the current yield, the annual coupon interest is divided by the market price.
Yield to maturity
The yield on any investment is the interest rate that will make the present value of the cash flows from the investment equal to the price of the investment.
Yield to call
For bonds that may be called prior to the stated maturity date another yield measure is commonly quoted: it is the yield to call.
To compute the yield to call, the cash flows that occur if the issue is called on its first call date are used.
http://www.paranzasoft.com/help/pages/glBondYieldMeasures.html
Reinvestment Income and Reinvestment Risk
c. explain the importance of reinvestment income in generating the yield computed
at the time of purchase, calculate the amount of income required to generate
that yield, and discuss the factors that affect reinvestment risk;
Read about it from
The Handbook of Fixed Income Securities By Frank J. Fabozzi
http://books.google.co.in/books?id=jup2d1pEyWcC&pg=PA22&lpg=PA22&dq=reinvestment+income+and+reinvestment+risk&source=web&ots=wJORArm5cR&sig=cHzpjvT_6hs_vYEg0Vr397jLIdk&hl=en
at the time of purchase, calculate the amount of income required to generate
that yield, and discuss the factors that affect reinvestment risk;
Read about it from
The Handbook of Fixed Income Securities By Frank J. Fabozzi
http://books.google.co.in/books?id=jup2d1pEyWcC&pg=PA22&lpg=PA22&dq=reinvestment+income+and+reinvestment+risk&source=web&ots=wJORArm5cR&sig=cHzpjvT_6hs_vYEg0Vr397jLIdk&hl=en
Option Adjusted Spread
f. differentiate between the nominal spread, the zero-volatility spread, and the
option-adjusted spread;
If a bond has embedded options, its Option-adjusted spread (OAS) is the spread at which it presumably would be trading over a benchmark if it had no embedded optionality. More precisely, it is the instrument's current spread over the benchmark minus that component of the spread that is attributable to the cost of the embedded options:
OAS = spread - spread due to option
For more see
http://www.riskglossary.com/link/option_adjusted_spread.htm
option-adjusted spread;
If a bond has embedded options, its Option-adjusted spread (OAS) is the spread at which it presumably would be trading over a benchmark if it had no embedded optionality. More precisely, it is the instrument's current spread over the benchmark minus that component of the spread that is attributable to the cost of the embedded options:
OAS = spread - spread due to option
For more see
http://www.riskglossary.com/link/option_adjusted_spread.htm
OAS - Option Cost Relation
g. describe how the option-adjusted spread accounts for the option cost in a bond
with an embedded option;
with an embedded option;
LOS 69 Interest Rate Risk Measurement
a. distinguish between the full valuation approach (the scenario analysis approach)
and the duration/convexity approach for measuring interest rate risk, and explain
the advantage of using the full valuation approach;
The primary focus of interest rate risk is measuring the impact after an adverse rate change. Two approaches are used to measuring interest rate risk: the full valuation approach and the duration/convexity approach.
The full valuation approach also known as scenario analysis. It examines the value of bonds under a variety of interest rate scenario changes. For example, a portfolio manager might examine the change in a bond with assumed interest rate increases of 50, 100,150 and 200 basis point increases and decreases. This approach is useful when there is a good valuation model and can be used for parallel and nonparallel shifts in the yield curve.
Highly leveraged investors (such as hedge fund investors) often use extreme scenario tests, known as stress testing, to examine the impact of wide interest rate changes. This is fine so long as the manager has a good valuation model to estimate what the price of the bonds will be in each interest rate scenario.
The advantage of the duration/convexity measure is that it is a simpler measure that will show how a portfolio or single bond will change if there is change in a parallel fashion.
Material to be added
and the duration/convexity approach for measuring interest rate risk, and explain
the advantage of using the full valuation approach;
The primary focus of interest rate risk is measuring the impact after an adverse rate change. Two approaches are used to measuring interest rate risk: the full valuation approach and the duration/convexity approach.
The full valuation approach also known as scenario analysis. It examines the value of bonds under a variety of interest rate scenario changes. For example, a portfolio manager might examine the change in a bond with assumed interest rate increases of 50, 100,150 and 200 basis point increases and decreases. This approach is useful when there is a good valuation model and can be used for parallel and nonparallel shifts in the yield curve.
Highly leveraged investors (such as hedge fund investors) often use extreme scenario tests, known as stress testing, to examine the impact of wide interest rate changes. This is fine so long as the manager has a good valuation model to estimate what the price of the bonds will be in each interest rate scenario.
The advantage of the duration/convexity measure is that it is a simpler measure that will show how a portfolio or single bond will change if there is change in a parallel fashion.
Material to be added
c. describe positive convexity, negative convexity, and their relation to bond price
and yield;
Convexity is a measure of the curvedness of the price-yield relationship. This curvedness is different for each bond.
The lower the coupon, the greater the convexity.
The longer the maturity, the greater the convexity.
The lower the yield to maturity, the greater the convexity.
In summary, the change in price of a bond comes from two sources: its modified duration and its convexity.
The computation of the price change for a bond that is due to the convexity:
Convexity Effect = 1/2 * Price * Convexity * Δyield²
Callable bonds will exhibit negative convexity at certain price-yield combinations. Negative convexity means that as market yields decrease, duration decreases as well.
See
http://www.investopedia.com/university/advancedbond/advancedbond6.asp
and yield;
Convexity is a measure of the curvedness of the price-yield relationship. This curvedness is different for each bond.
The lower the coupon, the greater the convexity.
The longer the maturity, the greater the convexity.
The lower the yield to maturity, the greater the convexity.
In summary, the change in price of a bond comes from two sources: its modified duration and its convexity.
The computation of the price change for a bond that is due to the convexity:
Convexity Effect = 1/2 * Price * Convexity * Δyield²
Callable bonds will exhibit negative convexity at certain price-yield combinations. Negative convexity means that as market yields decrease, duration decreases as well.
See
http://www.investopedia.com/university/advancedbond/advancedbond6.asp
Duration Measures
LOS
69.e. distinguish among the alternative definitions of duration, and explain why effective duration is the most appropriate measure of interest rate risk for bonds with embedded options;
DURATION MEASURES
Macaulay Duration: The weighted average time to full recovery of principal and interest payments.
= [ΣCt*t/(1+i)t]/[ΣCt/(1+i)t]
Characteristics of Macaulay Duration:
1. The duration of a bond with a coupon is always less than the term to maturity.
2. The larger the coupon, the smaller the duration.
3. There is normally a positive relationship between term to maturity and duration. As term to maturity increases, so does duration, but at a decreasing rate.
4. There is an inverse relationship between the yield to maturity and duration.
5. Sinking funds and call features can reduce the duration significantly.
Modified duration: an adjusted measure of duration called modified duration can be used to approximate the interest rate sensitivity of a noncallable bond. Modified duration equals Macaulay duration divided by 1 plus the current yield to maturity divided by the no. of payments in a year.
Modified Duration = Macaulay duration[1+(ytm/number of payments per year)]
The percentage change in the price of a bond for a given change in interest rates can be approximated by:
100*ΔP/P = -Dmod*Δi
ΔP = change in price
Δi = change in interest rate
Dmod = Modified duration
For More
http://www.duke.edu/~charvey/Classes/ba350/bondval/duration.htm
69.e. distinguish among the alternative definitions of duration, and explain why effective duration is the most appropriate measure of interest rate risk for bonds with embedded options;
DURATION MEASURES
Macaulay Duration: The weighted average time to full recovery of principal and interest payments.
= [ΣCt*t/(1+i)t]/[ΣCt/(1+i)t]
Characteristics of Macaulay Duration:
1. The duration of a bond with a coupon is always less than the term to maturity.
2. The larger the coupon, the smaller the duration.
3. There is normally a positive relationship between term to maturity and duration. As term to maturity increases, so does duration, but at a decreasing rate.
4. There is an inverse relationship between the yield to maturity and duration.
5. Sinking funds and call features can reduce the duration significantly.
Modified duration: an adjusted measure of duration called modified duration can be used to approximate the interest rate sensitivity of a noncallable bond. Modified duration equals Macaulay duration divided by 1 plus the current yield to maturity divided by the no. of payments in a year.
Modified Duration = Macaulay duration[1+(ytm/number of payments per year)]
The percentage change in the price of a bond for a given change in interest rates can be approximated by:
100*ΔP/P = -Dmod*Δi
ΔP = change in price
Δi = change in interest rate
Dmod = Modified duration
For More
http://www.duke.edu/~charvey/Classes/ba350/bondval/duration.htm
Duration of a bond portfolio
f. compute the duration of a portfolio, given the duration of the bonds comprising
the portfolio, and explain the limitations of portfolio duration;
duration writeup
http://www.treasurer.ca.gov/cdiac/publications/duration.pdf
Duration, Convexity, and Other Bond Risk Measures By Frank J. Fabozzi
http://books.google.co.in/books?id=7i6ob9SB5jgC&pg=PA6&lpg=PA6&dq=%22duration+of+a+portfolio%22&source=web&ots=ZmSpP6g2Ks&sig=Jgf-3gdgb2O47YENTrQvTtwJ-OI&hl=en
Osborne, Mike J., "A Simple, Accurate Formula for the Duration of a Portfolio of Bonds Under a Non-Parallel Shift of a Non-Flat Yield Curve" (September 5, 2004). Available at SSRN:
http://ssrn.com/abstract=587242
the portfolio, and explain the limitations of portfolio duration;
duration writeup
http://www.treasurer.ca.gov/cdiac/publications/duration.pdf
Duration, Convexity, and Other Bond Risk Measures By Frank J. Fabozzi
http://books.google.co.in/books?id=7i6ob9SB5jgC&pg=PA6&lpg=PA6&dq=%22duration+of+a+portfolio%22&source=web&ots=ZmSpP6g2Ks&sig=Jgf-3gdgb2O47YENTrQvTtwJ-OI&hl=en
Osborne, Mike J., "A Simple, Accurate Formula for the Duration of a Portfolio of Bonds Under a Non-Parallel Shift of a Non-Flat Yield Curve" (September 5, 2004). Available at SSRN:
http://ssrn.com/abstract=587242
Convexity of a bond
g. describe the convexity measure of a bond, and estimate a bond’s percentage
price change, given the bond’s duration and convexity and a specified change in
interest rates;
Advanced Bond Concepts: Convexity
http://www.investopedia.com/university/advancedbond/advancedbond6.asp
price change, given the bond’s duration and convexity and a specified change in
interest rates;
Advanced Bond Concepts: Convexity
http://www.investopedia.com/university/advancedbond/advancedbond6.asp
Modified Convexity and Effective Convexity
h. differentiate between modified convexity and effective convexity;
From Google books
The Handbook of Fixed Income Securities By Frank J. Fabozzi
http://books.google.co.in/books?id=jup2d1pEyWcC&pg=PA116&lpg=PA116&dq=modified+convexity+and+effective+convexity&source=web&ots=wJORAlm2kL&sig=Bv5apvCK-H50KWpySX0uzIRGnrI&hl=en
From Google books
The Handbook of Fixed Income Securities By Frank J. Fabozzi
http://books.google.co.in/books?id=jup2d1pEyWcC&pg=PA116&lpg=PA116&dq=modified+convexity+and+effective+convexity&source=web&ots=wJORAlm2kL&sig=Bv5apvCK-H50KWpySX0uzIRGnrI&hl=en
Price value of a basis point (PVBP) Fixed Income Securities
LOS
69.i. compute the price value of a basis point (PVBP), and explain its relationship to
duration.
What is basis point value, (BPV)?
BPV is a method that is used to measure interest rate risk. It is sometimes referred to as a delta or DV01. It is often used to measure the interest rate risk associated with swap trading books, bond trading portfolios and money market books.
It is not new. It has been used for years. In many financial institutions it has been replaced or is used in conjunction with value at risk.
What does it show?
BPV tells you how much money your positions will gain or lose for a 0.01% parallel movement in the yield curve. It therefore quantifies your interest rate risk for small changes in interest rates.
How does it work?
Let's suppose you own a $10m bond that has a price of 100%, a coupon of 5.00% and matures in 5 years time. Over the next 5 years you will receive 5 coupon payments and a principal repayment at maturity. You can value this bond by:
A. Using the current market price from a dealer quote, or
B. Discounting the individual bond cash flows in order to find the sum of the present values
Let's assume you use the second method. You will use current market interest rates and a robust method for calculating accurate discount factors. (Typically swap rates are used with zero coupon methodology).
For the sake of simplicity we will use just one interest rate to discount the bond cash flows. That rate is 5.00%. Discounting the cash flows using this rate will give you a value for the 5 year bond of $10,000,000. (How to do this using a financial calculator is explained on the second page of this document).
We will now repeat the exercise using an interest rate of 5.01%, (rates have increased by 0.01%). The bond now has a value of $9,995,671.72.
There is a difference of $4,328.28.
It shows that the 0.01% increase in interest rates has caused a fall in the value of the bond. If you held that bond you would have lost $4,328.28 on a mark-to-market basis.
This is the BPV of the bond.
For some more details see
http://www.barbicanconsulting.co.uk/quickguides/bpv
69.i. compute the price value of a basis point (PVBP), and explain its relationship to
duration.
What is basis point value, (BPV)?
BPV is a method that is used to measure interest rate risk. It is sometimes referred to as a delta or DV01. It is often used to measure the interest rate risk associated with swap trading books, bond trading portfolios and money market books.
It is not new. It has been used for years. In many financial institutions it has been replaced or is used in conjunction with value at risk.
What does it show?
BPV tells you how much money your positions will gain or lose for a 0.01% parallel movement in the yield curve. It therefore quantifies your interest rate risk for small changes in interest rates.
How does it work?
Let's suppose you own a $10m bond that has a price of 100%, a coupon of 5.00% and matures in 5 years time. Over the next 5 years you will receive 5 coupon payments and a principal repayment at maturity. You can value this bond by:
A. Using the current market price from a dealer quote, or
B. Discounting the individual bond cash flows in order to find the sum of the present values
Let's assume you use the second method. You will use current market interest rates and a robust method for calculating accurate discount factors. (Typically swap rates are used with zero coupon methodology).
For the sake of simplicity we will use just one interest rate to discount the bond cash flows. That rate is 5.00%. Discounting the cash flows using this rate will give you a value for the 5 year bond of $10,000,000. (How to do this using a financial calculator is explained on the second page of this document).
We will now repeat the exercise using an interest rate of 5.01%, (rates have increased by 0.01%). The bond now has a value of $9,995,671.72.
There is a difference of $4,328.28.
It shows that the 0.01% increase in interest rates has caused a fall in the value of the bond. If you held that bond you would have lost $4,328.28 on a mark-to-market basis.
This is the BPV of the bond.
For some more details see
http://www.barbicanconsulting.co.uk/quickguides/bpv
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