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CFAI 2011 - Q5c

@alta12 @RaviVooda‌

Question:
Discussion two reasons, based on her human capital, why Finnegan's current allocation to equities should be lower.

The guideline answers:
1. Finnegan is young and has a large amount of human capital relative to her financial capital.

2. The correlation between Finnegan's income and equity market's performance is high. Thus, her overall allocation to "equity like" capital is extremely high. Investors whose human capital is highly correlated with equity returns should balance human capital risk through a lower allocation to equities in their investment portfolios.


My question:
How is point #1 even valid? I thought one may have a large human capital but if it's very fixed income like, then their financial capital should still have higher allocation to equities, shouldn't it ?

But if point #1 is referring to large human capital of equity like then isn't that exactly the same as point #2? That means the guideline answer provided 2 similar reasons from a different angle?
(i realise some other answers for other questions seem to have similar issues - providing similar reasons from different angle).

Comments

  • @vincentt, actually combination of both only will give the answer. Any reason in isolation can't give us full answer.

    I too felt the same when I was answering this question. Even some schweser answers were like that.
    vincentt
  • @RaviVooda‌ do you know how CFAI is gonna grade your answers if you were to put the 2 answers together in a paragraph?
  • @vincentt, not sure. But I think we will be given full score if we have given both the points in one paragraph. I see no reason why we should not be awarded full marks
  • @RaviVooda‌ because i'm not sure how are they going to differential say, when they ask for 2 reasons, we provide it in a paragraph with say more than 2 reasons (some are correct some are not).

    I know CFA mentioned something like they will not grade additional answers that you provide, but how are they going to split them up if it's within a paragraph?
  • Another example (2011 Q5):

    Question asking for 3 reasons:


    2 of the 3 points in the guideline:

    #1 Finnegan faces a significant penalty for not meeting her liabilities. if she misses her mortgage payment for 3 or more months, she risks losing her home. She does not want to sell assets to pay the mortgage. Therefore, a portfolio structure designed to meet liabilities would be appropriate.

    #2 Finnegan's mortgage payments are interest-rate sensitive. Holding investment assets with similarly sensitive cash flows would hedge this risk. Therefore, an ALM approach is more appropriate than an AO approach for her.


    @alta12 @RaviVooda‌

    Don't you think these 2 points are very similar just from a different angle?





  • @vincentt it's in the notes (AA section - reading 19 p.188):

    "What types of investors gravitate to an ALM approach? In general, the ALM approach tends to be favored when:
    ■ the investor has below-average risk tolerance;
    ■ the penalties for not meeting the liabilities or quasi-liabilities are very high;
    ■ the market value of liabilities or quasi-liabilities are interest rate sensitive;
    ■ risk taken in the investment portfolio limits the investor’s ability to profitably take risk in other activities;
    ■ legal and regulatory requirements and incentives favor holding fixed-income securities; and
    ■ tax incentives favor holding fixed-income securities"

    RaviVooda
  • I would try to remember the first 3. I'm not too sure about the last 3 in the list...
  • @vincentt, in this case both are different. First one says when you are risk averse, you opt for ALM. Second one says when liability is interest rate sensitive, opt for ALM.
  • @alta12, excellent. I like the way you read text book.
    Alta12 said:

    @vincentt it's in the notes (AA section - reading 19 p.188):

    "What types of investors gravitate to an ALM approach? In general, the ALM approach tends to be favored when:
    ■ the investor has below-average risk tolerance;
    ■ the penalties for not meeting the liabilities or quasi-liabilities are very high;
    ■ the market value of liabilities or quasi-liabilities are interest rate sensitive;
    ■ risk taken in the investment portfolio limits the investor’s ability to profitably take risk in other activities;
    ■ legal and regulatory requirements and incentives favor holding fixed-income securities; and
    ■ tax incentives favor holding fixed-income securities"

  • Thanks @alta12 for the list.

    "Finnegan's mortgage payments are interest-rate sensitive. Holding investment assets with similarly sensitive cash flows would hedge this risk. Therefore, an ALM approach is more appropriate than an AO approach for her."

    This is the main reason for ALM, which is to match duration so that's understandable.


    "Finnegan faces a significant penalty for not meeting her liabilities. if she misses her mortgage payment for 3 or more months, she risks losing her home. She does not want to sell assets to pay the mortgage. Therefore, a portfolio structure designed to meet liabilities would be appropriate."

    But in this case the point is talking about "portfolio structure designed to meet liabilities would be appropriate" is also referring to a mortgage payment which is interest rate sensitive.


    @RaviVooda‌ I keep having the thinking that you cannot talk about the same stuff twice for the x amount of reasons.

    I need to get used to this.
  • @vincentt, in this case, the risk of not meeting is high as she will lose her come. This matches with 2nd point in the list @alta12 mentioned.
    vincentt
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