Caia®
2009
March
Level 2
CAIA®
Book 2
Schweser Study Notes for the CAIA® Exam
CurrENt & INtEgrAtEd topICS
Part 5, topic 8.3
Cross-Reference to CAIA Association Assigned Reading – Perold & Sharpe
Figur
P
e 11: ortfolio Values in a 4-Period Oscillating Market
Initial
Period 1
Period 2
Period 3
Period 4
Strategy
Value
Return = +25%
Return = –20%
Return = +25%
Return = –20%
Constant Mix
Stock index
$60
75 / 69
55.2 / 60.72
75.9 / 69.83
55.86 / 61.45
t-bill
$40
40 / 46
46 / 40.48
40.48 / 46.55
46.55 / 40.96
CM por tfolio value
$100
$115
$101.20
$116.38
$102.41
Buy-and-Hold
Stock index
$60
75
60
75
60
t-bill
$40
40
40
40
40
BH portfolio value
$100
$115
$100
$115
$100
CPPI (m = 2, floor = 70)
Stock index
$60
75 / 90
72 / 54
67.5 / 81
64.8 / 48.6
t-bill
$40
40 / 25
25 / 43
43 / 29.5
29.5 / 45.7
CPPI portfolio value
$100
$115
$97
$110.50
$94.30
as we can see from the data in Figure 11, in an oscillating market, constant mix strategies
outperform buy-and-hold strategies, and buy-and-hold strategies outperform CPPI
strategies. We can generalize that concave strategies (e.g., constant mix), which are
contrarian (i.e., purchase risky assets after negative performance and sell risky assets after
positive performance), outperform linear or convex strategies (e.g., CPPI) in a flat but
oscillating market.
LO 8.13: Discuss the motivations for and impact of resetting the parameters of
dynamic strategies.
the parameters of dynamic asset allocation strategies concern the decision rules that are to
be followed when rebalancing. this matter is of particular relevance to the CPPI strategy
and the specification of the floor and multiplier values. For example, it might be tempting,
following a large increase in stock market value, to increase the value of the floor to lock in
profits. For example, if the floor is initially set at $70 and the value of the portfolio increases
to $150, increasing the floor to $100 would lock in $30 of profit. While this makes sense
intuitively, if the floor increases in lockstep with the portfolio value, the CPPI strategy
will effectively be transformed into a constant mix strategy. Similarly, if the value of the
multiplier is set to one, the CPPI strategy will effectively be transformed into a
buy-and-hold strategy. thus, the manager must be aware of how resetting the parameters
can alter the nature of the asset allocation strategy.
©2008 Kaplan Schweser
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Part 5, topic 8.3
Cross-Reference to CAIA Association Assigned Reading – Perold & Sharpe
Key Concepts
1.
regardless of the allocation strategy used, a portfolio will have the same ending
value prior to rebalancing. However, the allocation strategy used will determine the
portfolio’s rebalancing requirements. (Lo 8.10.a, b, c)
2.
Buy-and-hold portfolios have a linear payoff profile, CPPI and oBPI strategies
generate a convex payoff profile, and constant mix strategies generate a concave payoff
profile. (Lo 8.11)
3.
relative portfolio performance will be determined by the asset allocation strategy and
market conditions. (Lo 8.12.a, b)
4.
Convex strategies (CPPI, oBPI) are trend-following and outperform both
buy-and-hold and concave strategies in trending (bull or bear) markets. (Lo 8.12.a)
5.
Concave strategies (constant mix) are contrarian, and outperform both buy-and-hold
and convex strategies in flat but oscillating markets. (Lo 8.12.b)
6.
Changing the parameters that define the decision rules for a CPPI strategy can
effectively transform it into a buy-and-hold or constant mix strategy. (Lo 8.13)
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Part 5, topic 8.3
Cross-Reference to CAIA Association Assigned Reading – Perold & Sharpe
Concept Checkers
1.
use the following information to answer the following questions. Your portfolio
begins with $1,000: 60% in equities and 40% in the risk-free asset. over the next
period, the value of the equities increases by 100%, while the value of the risk-free
asset is unchanged.
a.
Calculate the resulting portfolio value, and describe numerically what
actions should be taken under a buy-and-hold strategy.
b.
Calculate the resulting portfolio value, and describe numerically what
actions should be taken under a constant mix strategy.
c.
Calculate the resulting portfolio value, and describe numerically what
actions should be taken under a constant-proportion portfolio insurance
strategy, if m = 1.5 and F = $600.
2.
Describe how the payoff profiles differ between the common asset allocation
strategies.
3.
Discuss which type of asset allocation strategy (buy-and-hold, constant mix, or
CPPI/oBPI) works best in a trending market.
©2008 Kaplan Schweser
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Part 5, topic 8.3
Cross-Reference to CAIA Association Assigned Reading – Perold & Sharpe
4.
Discuss which type of asset allocation strategy (buy-and-hold, constant mix, or
CPPI/oBPI) works best in a flat but oscillating market.
5.
Discuss the motivation for resetting the parameters that underlie the decision rules
guiding dynamic asset allocation strategies and the potential impact of such an
action.
Page 84
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Part 5, topic 8.3
Cross-Reference to CAIA Association Assigned Reading – Perold & Sharpe
Concept Checker Answers
1.
a.
new equity value = $1,200 (which represents a 100% increase from the original equity
position of $600); total portfolio value = $1,600. no adjustments are to be made to
the allocation under the buy-and-hold strategy. the resulting allocation is now 75%
stocks/25% risk-free assets.
b. new equity value = $1,200; total portfolio value = $1,600. target allocation to equity
= 0.6 × $1,600 = $960, so sell $240 equity and purchase $240 of the risk-free asset. this
restates the portfolio to its original 60% stocks/40% risk-free assets under the constant
mix strategy.
c. new equity value = $1,200; total portfolio value = $1,600. target allocation to equity
= ($1,600 – 600) × 1.5 = $1,500, so sell $300 of the risk-free asset and purchase $300
equity. this results in a revised allocation of $1,500 in stocks (94%) and $100 in
risk-free assets (6%).
2.
the payoff profile shows the relationship between the total value of assets held and the value
of the risky assets. this relationship is linear for the buy-and-hold strategy, concave for the
constant mix strategy, and convex for the CPPI and oBPI strategies.
3.
Convex strategies, such as the CPPI and oBPI, perform best in trending markets. this is
because they are trend-following strategies, requiring the portfolio manager to buy risky
assets as they increase in value and sell risky assets as they decrease in value. So as long as the
trend persists (increases are followed by increases, or decreases by decreases), these strategies
will outperform.
4.
Concave strategies, such as constant mix, perform best in oscillating markets. this is because
they are contrarian strategies. Following an increase (decrease) in the value of risky assets, the
portfolio manager is required to sell (buy) risky assets to maintain the constant mix. the net
result is that in a market with reversals, the manager is forced to sell just prior to a drop in
the value of the risky assets, and vice versa.
5.
the motivation could be to adjust the aggressiveness of the strategy by changing the value
of the multiplier or to lock in profits after a bull market by increasing the floor. as the
multiplier approaches one, the CPPI strategy effectively becomes a buy-and-hold strategy. If
the floor increases in lockstep with total account value, the CPPI strategy effectively becomes
a constant mix strategy.
©2008 Kaplan Schweser
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2009
march
Level 2
CAIA®
Book 3
Schweser Study Notes for the CAIA® Exam
PrACtICE ExAmS
Exam 1 Part 1: Multiple Choice
Pr
ofessional Standards and Ethics
1.
Which of the following statements concerning knowledge of the law and member
actions is CORRECT? in the event that there is a conflict between the Standards
and the relevant local law:
a. the local law applies. in the event that a violation is detected, members are
required to report to the appropriate governmental authorities.
B. the more strict of the two applies. in the event that a violation is detected,
members are required to report to the appropriate governmental authorities.
c. the local law applies. in the event that a violation is detected, members are not
required to report to governmental authorities, though this may be advisable in
some circumstances.
D. the more strict of the two applies. in the event that a violation is detected,
members are not required to report to governmental authorities, though this
may be advisable in some circumstances.
2.
Which of the following statements is FALSE with respect to the determination of
investment suitability for a particular client?
a. investments should be suitable given the investor’s financial situation.
B. each investment should be evaluated for its suitability on the basis of its total
risk.
c. investor information should be updated regularly, no less frequently than
annually.
D. investments should be evaluated in the context of the investor’s risk and return
objectives.
3.
Wilson Briggs has received an offer from a client to pay him a $10,000 bonus if
certain performance objectives are met. With respect to this offer, which of the
following statements is CORRECT?
a. He cannot accept the offer under any circumstances.
B. He can accept the offer if he receives written consent from his employer and the
client.
c. He can accept the offer without written consent from any party because it is
compensation for service.
D. He can accept the offer if he receives written consent from his employer, but
does not need written consent from the client.
©2008 Kaplan Schweser
Page 7
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exam 1
Part 1
4.
after working nearly 20 years on Wall Street, Kevin Gentry decides to leave New
York and open his own investment firm on tiny, but wealthy, turtle island, located
in the caribbean. Gentry has selected turtle island as his new base of operations
for the lifestyle it affords as well as the country’s securities laws that are much less
stringent than the code of ethics and the Standards of Professional conduct that
he had operated under while working in the United States. as anticipated, many
of his U.S.-based clients have agreed to keep Gentry as their portfolio manager
and move their assets to his new firm. after a few months of operations, Gentry
has encountered several instances where turtle island regulations relieve him of
disclosing information to investors that he had been required to disclose while
working in New York. according to the code and Standards, Gentry must adhere to
the:
a. laws of turtle island, since it is where his business is conducted.
B. code and Standards because it is “more strict” than the applicable law.
c. laws of turtle island, but disclose any discrepancies to U.S.-based clients.
D. code and Standards because he must adhere to the code and Standards under
all circumstances.
5.
Julie moore reports directly to Jim Black, who is the president of a mid-sized money
management firm. moore discovers that Black is the subject of several investigations
by various authorities regarding alleged trading violations. She has worked closely
with him and has observed some possible violations. Which course of action must
moore take in this situation?
a. cooperate with the Professional conduct Program and provide all information
requested.
B. immediately resign her position and discontinue all participation in the
investigation in order to preserve confidentiality to her former employer and
clients.
c. Provide information regarding only those clients who have giv
en their written
consent.
D. execute a settlement agreement with the money management firm with
a confidentiality clause that will relieve her of any obligation to provide
information.
6.
Jonathan Song has recently been hired as a portfolio manager for a small investment
advisory firm that specializes in managing personal trusts. the firm hired Song
in preparation for a new marketing campaign aimed at attracting new clients.
one of Song’s first tasks is to prepare an investment performance presentation for
prospective clients that will clearly and accurately represent the firm’s track record.
Which of the following strategies adheres the closest to the obligations of the
Standards of Professional conduct? the firm should:
a. include terminated accounts as a part of performance history.
B. present a minimum of five years of historical performance data.
c. comply with the Global investment Performance Standards (GiPS).
D. present an estimate of returns over the next 12 months, given the current
portfolio composition.
Page 8
©2008 Kaplan Schweser
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exam 1
Part 1
7.
rob carter works for a Wall Street investment banking institution as an analyst for
the consumer goods industry. carter is preparing a research report on clean Bright,
a U.S.-based company that manufactures cleaning products used in the home. clean
Bright was once an industry leader, but has suffered several years of lackluster sales
after the death of its founder. after reviewing industry statistics and consulting with
several suppliers of clean Bright, carter discovers that clean Bright has become
alarmingly slow in meeting its accounts payable obligations. carter believes that the
company may soon face bankruptcy. Before carter can issue a sell recommendation
in his research report, carter is required to:
a. take no additional action.
B. wait until suppliers contact other analysts about clean Bright.
c. make full disclosure of the conversations with the suppliers to a compliance
officer at his firm.
D. contact management at clean Bright to disclose the results of his conversations
with suppliers.
8.
two Level 1 caia candidates working in the same large investment firm have
purchased two different independent review materials to help them prepare for
the caia exam. although the materials are copyright protected, the candidates
make copies and exchange them with one another. according to the Standards of
Professional conduct:
a. the candidates have violated the Standards.
B. so long as no legal charges are brought, no violation has occurred.
c. in the absence of legal copyrights within the candidates’ home country, no
violation has occurred.
D. until at least one of the candidates has completed Level 1, the Standards do not
apply.
9.
the Northern Saving trust department has an internally managed, commingled
stock fund where all of its smaller client accounts are pooled together. For larger
clients, Northern handles the accounts individually, setting up individual portfolios
for each customer. the stocks held in the individual accounts are by and large
the same as those held in the commingled fund. Northern always trades in the
individual accounts first, and in the commingled fund last. this policy is:
a. in violation of the Standards by failing to deal fairly with all clients.
B. in violation of the Standards by inappropriately using the same investment
strategy for individual and commingled accounts.
c. in violation of the Standards by pooling individual investments into a
commonly managed fund.
D. acceptable under the Standards.
©2008 Kaplan Schweser
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Exam 1 Part 1 Answers
Professional Standards and Ethics
1. D When there is a conflict between the Standards, local law, regulations, or other rules, the
more strict measure applies to member actions. thus, members can be held to a standard
that is higher than the local law. When a violation is detected, members are not necessarily
required to report to governmental authorities, but it may be advisable to do so in some
circumstances. (Lo 1.1.a)
2. B an investment should not be evaluated on the basis of its total risk. investments should
instead be evaluated in a portfolio context in order to determine suitability. all of the other
statements are correct. (Lo 1.3.c)
3. B the Standard concerning additional compensation arrangements states that such
compensation can only be accepted if written consent is obtained from all parties involved.
all parties involved would include both the employer and client. (Lo 2.1.b)
4. B Standard i(a). When applicable law and the code and Standards have differing
requirements, candidates and members must follow the “more strict” of either the local law
or the code and Standards. (Lo 1.1a)
5. A Standard iii(e). members will not be violating their duty to preserve confidentiality by
forwarding confidential information to cFa institute. (Lo 1.3.e)
6. C compliance with the GiPS standards is the best method for members and
candidates to meet
their obligations under Standard iii(D). (Lo 1.3.d)
7. A Standard ii(a). according to Standard ii(a), the analyst’s conclusions are covered by the
mosaic theory, so no additional disclosure is required. (Lo 1.2.a)
8. A Standard i(D). Unauthorized copying of copyrighted materials is theft and would be a clear
violation of the Standard. (Lo 1.1.d)
9. A Standard iii(B). the policy is consistent but unfair and would be in violation even if
disclosed. Standard vi(B) covers trading activity in one’s own account ahead of employers or
clients; it does not address putting one client’s interests ahead of another’s. (Lo 1.3.b)
10. C Standard ii(B), market manipulation, is not intended to prohibit transactions that are done
in order to minimize income taxes or trading strategies that are Not intended to distort
prices or artificially inflate trading volume. thus, neither Gordon nor turpin is in violation.
(Lo 1.2.b)
11. C Standard vi(a). members shall disclose to their clients and prospects all matters that could
impair the member’s ability to make objective recommendations. (Lo 2.3.a)
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