i i iii period FIN 4514 Exam III Review 1 Be familiar with the principals of mutual fund performance evaluation a Two most important key points with performance evaluation i The arithmetic mean is not a useful statistic in evaluating growth ii Dollars are more important than percentages 2 Know how to compute the traditional performance measures a The Sharpe measure evaluates return relative to standard deviation a measure of total risk includes unsystematic risk so only appropriate for well diversified portfolios b The Treynor measure evaluates return relative to beta or systematic risk ignored unsystematic risk so appropriate for individual securities and portfolios c The Jensen measure stems directly from the CAPM model i The constant term should be zero because securities with a beta of zero should have an excess return of zero according to finance theory ii However according to the Jenson measure if a portfolio manager happens to be better than average the alpha of the portfolio will be a positive measure 3 Be prepared to calculate the volume weighted average price a The ratio of the dollar transaction volume to the share over a particular time i Ex An institutional investor purchased shares of XYZ stock in the following separate batches 100 shares at 20 and 50 shares at 10 The volume weighted average price is 100 20 50 10 share volume 2500 150 16 66 4 Know how to compute the implementation shortfall a It is the difference between the value of an on paper theoretical portfolio and the actual portfolio purchased i On paper portfolio is based upon price of last reported trade ii Actual purchases are likely to lead to higher costs due to 1 Commissions 2 Bid Ask Spread the prior trade may have been at the bid price while your trade will be at the ask price 3 Market trend what are the prices doing Are they moving higher 4 Liquidity impact your demand may exceed the number of shares available at a lower price 5 Be familiar with performance measures that can be used in the presence of cash deposits and withdrawals a Daily valuation method i This method calculated the exact time weighted rate of return ii You must determine a value for the portfolio each time any cash flow occurs interest dividends additions or withdrawals to from the fund etc 1 2 MVEi market value of the portfolio at the end of period i before any cash flows in period i but including accrued income for the period 3 MVBi market value of the portfolio at the beginning of period i including any cash flows at the end of the previous subperiod and including accrued income b Modified BAI method i Approximates the internal rate of return for the investment over the period of time in question gets complicated with large portfolios with consistent daily cash flows ii iii Where 1 F the sum of the cash flows during the period 2 MVE the market value at the end of the period including accrued income 3 F0 the market value at the start of the period 4 wi CD Di CD 5 CD the total number of days in the period 6 Di the number of days since the beginning of the period in which the cash flow occurred c Approximate Method proposed by the American Association of Individual Investors i 6 Know how to measure performance when options are involved a b IRAR and ROS both focus on whether an option portfolio outperforms an unoptioned portfolio however they can overlook subjective considerations such as portfolio insurance Incremental risk adjusted return IRAR i ii Where 1 SHo Sharpe measure of the optioned portfolio 2 SHu Sharpe measure of the unoptioned portfolio 3 o standard deviation of the optioned portfolio iii IRAR can be used inappropriately if there is a floor on the return of the optioned portfolio i e if a portfolio manager uses protective puts 1 The standard deviation of the optioned portfolio o is a poor c Residual option spread ROS measure of risk in this case i This is an alternative performance measure for portfolios with options 1 Positive ROS indicated the use of options resulted in more terminal wealth than holding only the stock 2 Positive ROS doesn t necessarily mean that the incremental return is appropriate given the risk ii 1 Where Gt Vt Vt 1 and Vt value of portfolio in Period t 7 Understand the function of the commodity futures market a The basic function of the commodity futures market is to transfer risk from the hedger to the speculator who assumes the risk because of the opportunity for profit b The futures market would not work if people could back out of the trade without fulfilling their promise c Trades actually become sales to or by the clearing corporation of the exchange and each exchange has a clearing corporation that i Ensures the integrity of the futures contract ii Assumes the responsibility for open positions when a member is in financial distress iii Requires good faith deposits to help ensure the member s financial capacity to meet the obligations 8 Be familiar with the handling of performance bonds a Performance bonds deposited by member firms remain with the clearing corporation until the member either i Closes out her position by making an offsetting trade or ii Closes out her position by delivery of the commodity 9 Be able to identify the functions performed by the clearing process a The clearing process performs the following functions i Matching trades ii Supervising the accounting for performance bonds iii Handling intramarket settlements iv Establishing settlement prices v Providing for delivery 10 Know how to price foreign currency futures contracts a Pf spot rate 1 Ied Ilc days to delivery 365 b Where i Pf is the futures price ii iii Ied is the Eurodollar rate Ilc is the local currency rate 11 Understand how the value of a margin account is adjusted for changes in the commodity price a Commodity prices may move so much in a single day that good faith deposits for members are eroded before the day ends i This may result in a market variation call which calls on members to deposit more funds into their accounts during the day 12 Be able to distinguish between the three theories of futures contract pricing a Expectations Hypothesis i States that the futures price for a commodity is what the marketplace expects the cash price to be when the delivery month arrives ii One of the major functions of the futures market is price discovery the market s consensus about likely future prices for a commodity b Normal Backwardation cash price i Argues that the futures price is a downward biased estimate of