CIPM Test Prep Q & A with John D. Simpson, CIPM

CIPM Test Prep Q & A with John D. Simpson, CIPM

Join us for a Webinar on April 12


Space is limited.
Reserve your Webinar seat now at:
https://www2.gotomeeting.com/register/769471026


Join us on April 12, 2011 as John D. Simpson, CIPM tackles your last minute questions as you prepare for the rigorous CIPM examinations. During this session you will get study tips from The Spaulding Group's specialists that have been through the study and exam process. This class is free to any CIPM candidate that attended our classes, Performance Measurement Forum members, TSG verification clients and discounted for everyone else.

Title: CIPM Test Prep Q & A with John D. Simpson, CIPM
Date: Tuesday, April 12, 2011
Time: 12:00 PM - 2:00 PM EDT

After registering you will receive a confirmation email containing information about joining the Webinar.

System Requirements
PC-based attendees
Required: Windows® 7, Vista, XP or 2003 Server

Macintosh®-based attendees
Required: Mac OS® X 10.4.11 (Tiger®) or newer

CIPM Expert Level - Sample Exam Solutions, #5 and #6

One of the students in my CIPM Expert Level Prep Classes asked me to explain the solution to the questions #5 and #6 from the sample exam questions found on the CFA Institute's CIPM Program page (). The vignette and questions follow below:


Longitudinal Asset Management is a US-based portfolio manager investing in international equities. One of the firm’s portfolios is invested entirely in Canadian and United Kingdom equities. At the beginning of an evaluation period, the market values of the portfolio’s Canadian and UK segments are 5,000,000 Canadian dollars (CAD) and 3,000,000 pounds sterling (GBP), respectively. At the prevailing exchange rates, one CAD equals 0.80 US dollars (USD), and one GBP equals 2.00 USD.
Excluding dividend income, at the end of the period the Canadian equities are valued at CAD 5,300,000 and the UK equities are valued at GBP 2,880,000. The CAD now equals 0.90 USD while the GBP now equals 1.90 USD. Dividend payments of CAD 100,000 and GBP 180,000, respectively, are received at the prevailing exchange rates on the last day of the period.

5. The total return of the portfolio’s UK equities segment expressed in base currency (USD) is closest to:
A. –8.8%.
B. –5.1%.
C. –3.1%.

6. The portfolio’s total return, expressed in base currency, is the sum of the capital gain, yield, and currency components of return. In this framework, the capital gain component of the entire portfolio’s total return is closest to:
A. 0.00%.
B. 1.00%.
C. 2.42%.



Solution to #5: First important point is to realize that total return is equal to change in value plus period income, divided by beginning value. This is the holding period return that is referred to multiple times in the Expert Level curriculum:

HPR = (EMV - BMV - D) / BMV

where HPR is the holding period return, EMV is the ending value, BMV is the beginning value and D is the period income.

The starting value of the UK equities is 3,000,000 GBP, which converts to 6,000,000 USD at the beginning of period exchange rate of 1 GBP = 2 USD.

The ending value of the UK equities is 2,880,000 GBP for the stocks, plus the dividend income of 180,000 GBP, for a total of 3,060,000 GBP. This converts to 5,814,000 USD at the end of period exchange rate of 1 GBP = 1.9 USD.

Thus, the total return of the portfolio's UK equities is (5,814,000 - 6,000,000) / 6,000,000. This amounts to a return of -3.1%.



Solution to #6: For this problem, we are focused on the capital gain component of the portfolio's total return. Thus, we ignore the income that was earned (as well as the currency component of the total return), and focus on the equities.

At the start of the period, there are two positions, the UK equities and the CA equities:

- the value of 3,000,000 GBP converts to 6,000,000 USD at the exchange rate of 1 GBP = 2 USD.
- the value of 5,000,000 CAD converts to 4,000,000 USD at the exchange rate of 1 CAD = .8 USD.

Thus the starting value of portfolio is 6,000,000 + 4,000,000 = 10,000,000 USD.


At the end of the period:

- the value of 2,880,000 GBP converts to 5,760,000 USD at the exchange rate of 1 GBP = 2.0 USD.
- the value of 5,300,000 CAD converts to 4,240,000 USD at the exchange rate of 1 CAD = .8 USD.

Thus the ending value of the portfolio is 5,760,000 + 4,240,000 = 10,000,000 USD.

Given that the starting value of the portfolio equals the ending value of the portfolio, it should be straightforward that the total return is 0.00%.

About Modified IRR... (don't think too hard)

Over the last couple of weeks, I have been teaching our prep courses for the CIPM exams. While teaching the Principles Level course, I came across a sentence that caused some confusion:

"The Modified IRR method is another estimation approach acceptable prior to 1 January 2011."

This sentence appears in the Study Session II document called "Overview of GIPS Principles," at the bottom of the page numbered as 22.

The sentence caused me to stop because it seemed (to me) to imply that the Modified Internal Rate of Return is not an acceptable estimation approach for time-weighted return calculations for firms that claim compliance with the Global Investment Performance Standards (GIPS). I know, of course, that this is not the case. GIPS provision 2.A.2.b requires if compliant firms are not revaluing the portfolio on the date of every cash flow, then they must use a method that adjusts for daily-weighted cash flows. Both Principles Level and Expert Level candidates should be aware of this provision. Additionally, Expert Level candidates should also be aware that the Guidance Statement on Calculation Methodology points out that the Modified BAI method is acceptable - this is essentially another name for the Modified IRR method.

I asked the CIPM Prep Providers program about the sentence in question, and they explained to me that the sentence does not actually say that the Modified IRR method is not acceptable after January 1, 2011 - it merely states that it is acceptable before that date! In re-reading the sentence, I agreed that what they said is true... and that I read too much into the sentence.

Having said that, I suggested that the sentence could possibly be misconstrued by many, and they did indicate that they will point this out in the errata. So, another good reason for candidates to periodically check the curriculum errata, as clarifications may be made there in addition to corrections!

"Calculating" the hedge ratio...?

When I teach The Spaulding Group's prep courses for the CIPM exams, I always advise candidates to carefully consider the Learning Outcome Statements in each study session, as these statements describe the subject matter that candidates are required to master. In particular, I tell the candidates to focus on the verbs in each statement (e.g., compare, contrast, state, calculate, describe), as I see these as really the centerpiece of each statement.

At the Expert Level, there is a Learning Outcome Statement in Study Session II that reads:

Calculate the hedge ratio (delta) of an option and conclude whether the option is in-the-money, at-the-money or out-of-the money

The word "calculate" has a fairly specific meaning in my mind, but I decided to consult with Merriam Webster:

transitive verb

• 1a : to determine by mathematical processes <calculate the rate of acceleration>
• 1b : to reckon by exercise of practical judgment : estimate <calculate the likelihood of success>
• 1c : to solve or probe the meaning of : figure out calculate his expression — Hugh MacLennan>

• 2a: to design or adapt for a purpose calculated the timing of his arrival for maximum impact>

• 3a : to judge to be true or probable b : intend calculate to do it or perish in the attempt — Mark Twain>

intransitive verb

• 1a : to make a calculation
• 1b : to forecast consequences
• 2a : count, rely

In checking the list of formulae for the Expert Level, I don't see a specific formula for the hedge ratio, and I don't see one in the assigned readings. Thus, I don't think "calculate" is what is intended - at least not in the common, every day usage of the word.

Having said that, it is important to understand the characteristics of the hedge ratio (of a call option) in certain situations:

• Hedge ratio is a function of stock price, term of the option contract, the expected variance of the underlying stock's price, and the risk-free rate
  
  
• If the underlying stock's price is considerably below the option's strike price (i.e., the option is deeply "out-of-the-money"), the hedge ratio approaches zero and it is not desirable to exercise the option.
  
  
• If the underlying stock's price is "at-the-money" (i.e., the stock price and the strike price of the option are approximately equal), the hedge ratio is close to .5, as it makes little difference if the stock is acquired via market purchase or by exercising the call option
  
  
• If the option is deep "in-the-money", the hedge ratio approaches 1, and it is advantageous to acquire the underlying stock by exercising the option.

Note that all of this describes call options only (i.e., options where the holder has the right to purchase the underlying security). Put options are not currently covered in the CIPM curriculum.

Note: The graphic above illustrates Bloom's Taxonomy, upon which the Learning Outcome Statements of the CIPM curriculum are based.

Did the Expert Level Just Get *More* Difficult?

Well, I'm not sure if it got harder... but certainly there is quite a bit more content?

I am in the process of updating the materials I use to teach The Spaulding Group's CIPM Prep Classes (Principles and Expert Levels), and in reviewing the 2011 curriculum, I see that some of the content has shifted from the Principles Level curriculum to the Expert Level curriculum.

I suppose that's a "good news / bad news" thing for new CIPM candidates. The good news is that the Principles Level curriculum is a bit lighter, content wise, as some subjects are now deferred to the Expert Level. But, the bad news, there's more information to master at the
Expert Level than there was in the past.

The following subjects have been removed from the Principles Level curriculum, and are now entirely covered at the Expert level:

• real estate
• private equity
• (most of) verification
• GIPS standards related to model portfolios
• GIPS standards related to switching of portfolios between composites
• GIPS standards related to measuring composite dispersion
• GIPS standards related to portability of past performance

In prior examination windows, I would characterize what was required of candidates for these topics as essentially learning the provisions at the Principles Level, and being able to apply the related guidance and interpretations (as well as deal with some additional calculations) at the Expert Level. Now all of this will be covered at the Expert Level.

While this change does not increase the overall content, it does make the Expert Level more "packed."

So, CIPM candidates, be aware! (Details can be found here.)

P.S. I have received some lighthearted flak from candidates for making this suggestion at conferences, but I wonder aloud again if it would be worthwhile for the CIPM Body of Knowledge to be covered in three (3) exams rather than two...

Is the S&P 500 actively managed?

Earlier this week, my boss, David Spaulding surmised on his blog about the possibility that the mere existence of indexes may be a reason for "above average" performance, as changes in index constituents often results in trading in the newly added stocks, which often causes their prices to rise.

The question of whether the Standard & Poor's 500 is actually a managed portfolio is addressed in one of the "Benchmarks" study session readings at the CIPM Expert Level. The reading, authored by Laurence B. Siegel, refers to some research done by Sandy Rattray and Pravin Manglani. The article on that research is not required reading for CIPM candidates, but it may be of interest, and can be found online here.

The GRAP attribution linking formula

At the Expert Level, CIPM candidates are required to learn a few of the more commonly used linking methodologies for smoothing the attribution effects that come from arithmetic models. The required methodologies include:

• Cariño

• Menchero

• GRAP
  

Of these methods, the GRAP method is my personal favorite because of it's simplicity... which may not be apparent looking at the formula! Upon first glance, the GRAP formula, which appears above, may seem intimidating for a couple of reasons:

• It uses three "series" one summation series a two multiplication series.
  
  
• The three series have different indexes (T=1 through N, t = 1 through T-1, and t = T+1 through N).

When teaching the GRAP method, I find that it is easier to explain what it does, effectively, rather than explaining the formula.

Consider a situation where we are linking together monthly attribution effects for the first six months of the calendar year (January through June). Let's consider how we obtain the "G" factor that we will use to smooth the attribution effects for the month of April. Basically, what the GRAP formula tells us is that:

• The excess return is the sum of the "smoothed" attribution effects
  
  
• We obtain the smoothed attribution effects by multiplying the original attribution effects by the "G" factor
  
  
• The G factor for a particular month is a combination of portfolio returns and benchmark returns for the periods being linked together.
  
  
• In our example, we are smoothing the attribution effects for April. This will be done by multiplying together:
  

1. the unitized portfolio returns for the months preceding April (January, February, March)
2. the unitized benchmark returns for the months coming after April (May, June)

Thus, the following formula yields the G factor that we can use to smooth the April attribution effects:


Thus, the GRAP formula is very easy to remember, and much simpler to use than the Menchero or Cariño methods.