## Friday, August 31, 2012

### Campisi Fixed Income Attribution - Income Contribution Explained

Recall from my previous posting, the steps to executing the Campisi fixed income attribution model are:

1. Decompose the benchmark return into:
- income contribution
- Treasury contribution (i.e., price change due to changes in Treasury rates)
- spread contribution (i.e., price change due to changes in the average spreads of a risky bond class

2. Decompose the index portfolio return into:
- income contribution
- Treasury contribution (i.e., price change due to changes in Treasury rates)
- spread contribution (i.e., price change due to changes in the average spreads of a risky bond class
3. Calculate the index portfolio spread change.  This is the change in interest rates that will be used to calculate the spread contribution of the portfolio (more on this in a subsequent blog post).
4. Decompose the portfolio return into:
- income contribution
- Treasury contribution (i.e., price change due to changes in Treasury rates)
- spread contribution (i.e., price change due to changes in the average spreads of a risky bond class
- security specific contribution
- income effect = portfolio income contribution minus the benchmark income contribution
- Treasury effect = portfolio Treasury contribution minus the benchmark Treasury contribution
- selection effect = portfolio selection contribution (note - the benchmark has no selection contribution)
The first step under items 1, 2 and 4 above are to calculate an income contribution (for the benchmark, index portfolio and portfolio, respectively).

The income contribution is how much of the return comes from the income paid by the bonds in the portfolio or benchmark.  We express this income contribution as a rate of return, which has a numerator and a denominator.  The formula for this contribution is simply:

For example, in your reading, the portfolio's weighted average coupon is 7.118% and the  portfolio's weighted average price is 98.1.  Thus, the contribution of income to the total return of the portfoli may be calculated as:

To say it differently, out of the portfolio return of 0.31%, the portion that comes from income is the weighted average coupon divided by the weighted average price which is 7.26% in total.  Thus, obviously the sum of the other contributions must be negative.

The income contribution can also be calculated from money amounts:

Essentially, the income contribution is a form of current yield, comparing interest earned by the manager's portfolio to the market value invested to earn that income.

Given, then, that the portfolio return may be decomposed into income and price change, we have decomposed the income portion of the return.  All remaining elements are part of the price change component.  We'll tackle that subject next!

Happy studying!

## Friday, August 24, 2012

### Correction to Exercise on Sample Exam (Principles Level)

Last week, when I was teaching The Spaulding Group's CIPM Exam prep class for the Principles Level, a student asked me for help with a question on a sample exam from CFA Institute.  The question read:

Which of the following is most likely not a requirement of the GIPS standards for Presentation and Reporting?

a.       Annualizing returns for periods of less than one year.
b.      Presenting the total return for the benchmark for each annual period.
c.       Presenting the percentage of composite assets represented by non-fee-paying portfolios.

The sample exam stated that “b” was the correct answer, and the explanation states that the answer choice of “b” is not a requirement.

I indicated to the class that this appeared to be an error, as presenting the total return for the benchmark as of the end of each annual period is definitely required by GIPS provision I.5.A.1.e.   It seemed to me that the choice of "a" was the correct answer as we must never annualize returns of less than a year (GIPS I.5.A.4).

I later learned that the candidate that asked the question had a copy of an old sample exam, and that the question had been reworded as follows on the most recent copy of the sample exam:

Which of the following is most likely a requirement of the GIPS standards for Presentation
and Reporting?

A.      Annualizing returns for periods of less than one year.
B.      Presenting the total return for the benchmark for each annual period.
C.      Presenting the percentage of composite assets represented by non-fee-paying portfolios.

This time, the answer key indicated that "C" was the correct response.   While it is true that item "C" is a requirement, it is also true that item "B" is a requirement, based on GIPS provision I.5.A.1.e, as I indicated above.

To end this long story, I contacted CFA Institute, and they indicated that this is indeed an error, which will be corrected.    Thus, I wanted to pass this on to candidates who may have been perplexed by this question.  And if you are a Principles Level candidate and were perplexed by the question, don't feel bad... I passed this by my Expert Level class students last week, and an interesting debate ensued with views all over the map.  So, sometimes this stuff is not so easy!

### Decomposing the Campisi Fixed Income Attribution Model

For many CIPM Expert Level candidates, fixed income attribution is the most difficult topic.  This is evident when I teach The Spaulding Group's CIPM prep classes, as we devote an entire afternoon to the subject.  Among the three models that candidates are required to learn is the Campisi model, which is based around the idea of decomposing bond performance according to the picture above.

Over the next few days, I will present various points on the Campisi model, in order to simplify it for candidates.  This model is actually not very complicated - it is fairly intuitive - but candidates might benefit by having a roadmap to guide them through the process of calculating the attribution.

The diagram above is a decomposition of bond performance.  Thus, it can represent the decomposition of a single bond, a group of bonds, a portfolio of bonds and/or a benchmark of bonds.

The first level of decomposition applies to any asset one may own in a portfolio.  Return on an asset comes from two sources:

• income and expense (interest, dividends, and other expenses)
• price change (i.e., gains  and losses, both realized and unrealized)
In our situation, of course, we are dealing with bonds, so the income is from interest.

The next level of decomposition, which breaks up the sources of price change, is specific to bond investments.  Price change on bonds comes from three sources:
• price change that is due to changes in interest rates on the Treasury yield curve
• price change that is due to changes in spreads that non-Treasuries of a specific class (bond class and/or ratings class) pay above Treasuries of the same duration (average spreads)
• price change that is due to security specific traits of bonds that cause them to perform differently than the average for their class (nominal spreads)
A Treasury bill, note or bond could have return from the first and third sources.

A non-Treasury fixed income security could have return from all three sources.

Thus, the terminal nodes in the tree represent the lowest level of the decomposition:

• income
• price change due to changes in Treasury rates
• price change due to changes in the average spreads of a risky bond class
• price change due to security specific traits (i.e., due to nominal traits)
In order to calculate the Campisi attribution effects, the return of both the portfolio and the benchmark must be decomposed into contributions from these sources.  Thus, in order to calculate the Campisi attribution effects, the following steps must be taken (i.e., your roadmap):

1. Decompose the benchmark return into:
- income contribution
- Treasury contribution (i.e., price change due to changes in Treasury rates)
- spread contribution (i.e., price change due to changes in the average spreads of a risky bond class

2. Decompose the index portfolio return into:
- income contribution
- Treasury contribution (i.e., price change due to changes in Treasury rates)
- spread contribution (i.e., price change due to changes in the average spreads of a risky bond class
3. Calculate the index portfolio spread change.  This is the change in interest rates that will be used to calculate the spread contribution of the portfolio (more on this in a subsequent blog post).
4. Decompose the portfolio return into:
- income contribution
- Treasury contribution (i.e., price change due to changes in Treasury rates)
- spread contribution (i.e., price change due to changes in the average spreads of a risky bond class
- security specific contribution
- income effect = portfolio income contribution minus the benchmark income contribution
- Treasury effect = portfolio Treasury contribution minus the benchmark Treasury contribution
- selection effect = portfolio selection contribution (note - the benchmark has no selection contribution)

The picture below shows my scribblings from doing this in a recent class in the form of an attribution effects scoreboard - I recommend candidates mimic this during the exam to keep track of where they are:

More details to come!

## Thursday, August 23, 2012

### Futures Contracts: a Brief Primer

At the Expert Level of the CIPM curriculum, candidates are required to deal with return calculations of portfolios with futures contracts, as well as attribution analysis.  A good number of candidates, however, have little to no background on futures contracts, and the curriculum readings do not touch on this subject.

Thus, I write this blog post as a quick primer to give candidates some basic information on these instruments.  This is not meant to be comprehensive, but it should give candidates enough information to understand the basics of futures, and the concepts in the CIPM curriculum readings.

### What is a futures contract?

A futures contract is, essentially, a "standardized" forward contract.

### Forward contracts

A forward contract always involves a contract initiated at one time and performance in accordance with the terms of that contract at a future point in time.  The contract always involves an exchange of one asset for another.  The price at which the exchange occurs is set at the time of the initial contracting, and actual payment and delivery of the good occur in the future.

For example:  a person wanting a puppy agrees to purchase a puppy from a breeder at the time that the mother gives birth to the litter.  The breeder and the buyer agree to a price now, although the actual exchange will not occur until the puppy is weaned.  This is an example of an everyday forward contract.

The buyer is said to have a long position, while the seller has a short position. The act of buying is called going long, while the act of selling is called going short.

### How are futures contracts standardized forwards?

The main distinctions between futures and forward contracts are:

1.  Futures trade on organized exchanges.
2.  Futures contracts have standardized contract terms.
3.  Futures exchanges have associated clearinghouses to guarantee fulfillment of obligations
4.  Futures trading requires margin payments and daily settlement.
5.  Futures positions can be closed easily.
6.  Futures markets are regulated by identifiable agencies; forward markets are self-regulating.

Terms that are typically standardized in the contract include:
• Quality of the underlying commodity
• Expiration date
• Delivery terms and dates
• Minimum price fluctuations (tick size) and daily price limits
The clearinghouse effectively removes counterparty default risk in the futures markets.  The clearinghouse is able to ensure that traders honor their obligations by taking the position of buyer to each seller, and seller to each buyer.  Because of this, every trader has obligations not to other traders, but to the clearinghouse, and will expect that the clearinghouse will maintain its side of the trade.  Effectively, the trader must only have trust in the credibility of the clearinghouse, rather than another trader.

Besides the security of the clearinghouse, the primary safeguard against default is the requirement of margin and daily settlement.  Before trading a futures contract, the trader must deposit funds with a broker.  These funds serve as a good-faith deposit and are referred to as margin.  The margin can be in the form of cash, a bank letter-of-credit (LOC), or in short-term United States Treasury instruments (bills or notes).  While these funds are on margin the trader retains the title.

There are three types of margin.  When a trader deposits funds prior to trading, that is called initial margin.  The initial margin approximately equals the maximum daily price fluctuation permitted for the contract being traded.  The trader earns the interest accrued on any securities serving as margin.  For most contracts, the initial margin may be 5 percent or less of the underlying commodity value.

The initial margin can be so small in relation to the contract value because of the system of daily settlement or marking-to-market.   In futures markets,  it is required that traders realize any losses on the day they occur.  This means that the contract is marked-to-the-market.  When the funds on deposit with the broker reach a level called the maintenance margin, the trader must replenish the margin to its initial level.  This request for more margin is called a margin call.  The margin that is added is called the variation margin.

If a trader suffers a loss such that a margin call is made and the trader does not post the required additional margin, then the broker is empowered to close the futures position by deducting the loss from the trader's initial margin and returning the balance, less commission costs, to the trader.  In such a situation the broker would close the trader's entire brokerage account, since this is a violation of the trader's agreement with the broker.  Because the initial margin can cover any daily losses, there is no risk for the clearinghouse.

There are three ways to close a futures position:  delivery, offset, or an exchange-for-physicals (EFP).

Futures contracts may be based on a variety of underlying goods, including:  physical commodities (e.g., oil, sugar, cotton), currencies, interest-earning securities or instruments, and individual stocks.

Futures markets meet the needs of three groups of users:  those who wish to discover information about the future prices of commodities, those who speculate, and those who hedge. Price discovery is the determination of future market prices via the futures market.  There is a relation ship between the futures price and the price that can be expected to prevail for the commodity at the contract delivery date.  Hedging with futures involves using a futures contract as a substitute for a market transaction. Speculation involves trying to capitalize on the change in value of contracts over time.

Investors may use futures contracts to achieve a desired exposure in a simple, typically transaction-cost-efficient fashion.  For example, if one desires an exposure of \$2,000,000 USD to the 500 stocks in the Standard & Poor's 500 Index, one could achieve this in a couple of different ways:
• The investor could purchase all 500 stocks at allocations that match the weights in the S&P 500.  Doing this requires the investor spend \$2,000,000 in cash, plus the transaction costs associated with doing each trade.
• The investor could open a long position in a S&P 500 futures contract for \$2,000,000.  This requires only one transaction, would have negligible transaction expenses, and does not require \$2,000,000 in cash be spent.  Rather than spending actual cash, the investor obligates himself/herself to pay a cash obligation of \$2,000,000 by the contract's expiration date and receive the value of \$2,000,000 in stocks.
Most futures contracts of speculators are closed by offsetting trade.  Thus, as the value of the contract has changed over time, when the investor would offset the contract at the value at the time of closing, and the investor has captured a realized gain/loss equal to the difference in value at closing of the position vs when it was opened.  This realized gain/loss has been paid to the investor over time through the daily settlement (mark to market) process.