IFoA SP10 flashcards

32 cards. Read the term and the definition here. The deck at the top of this page is optional.

Real vs nominal return

The Fisher relationship states that (1 + nominal return) equals (1 + real return) multiplied by (1 + inflation). Real return measures purchasing power growth after inflation is removed.

Inflation risk premium

Extra yield investors demand on nominal bonds to compensate for uncertainty about future inflation. Index-linked bonds largely remove this exposure, leaving real yield and liquidity differences.

Duration price sensitivity

Modified duration approximates the percentage price change of a bond for a one percentage point parallel shift in yields. It is the weighted average time to cash flows divided by one plus yield.

Liquidity premium

Additional expected return required by investors to hold assets that cannot be sold quickly without a price concession. It compensates for transaction costs, search costs and forced-sale risk.

Equity risk premium

The expected excess return of equities over the risk-free rate. Historical realised excess returns are a noisy proxy because they depend heavily on the sample period chosen.

Modified duration formula

Modified duration equals Macaulay duration divided by one plus yield divided by coupon frequency. It converts Macaulay duration into a direct measure of percentage price sensitivity.

Convexity adjustment

For a yield change, percentage price change approximately equals minus modified duration times the change plus one half times convexity times the change squared. Convexity captures curvature.

Credit spread decomposition

Observed credit spread compensates for expected default loss, typically probability of default times loss given default, plus risk premium, liquidity and tax effects.

Property capitalisation rate

Net operating income divided by property value. It is the inverse of the income multiple and reflects required return, growth expectations and asset quality.

Covered interest parity

The forward exchange rate premium or discount equals the interest rate differential between two currencies for the same maturity, assuming free capital movement and negligible transaction costs.

Surplus-efficient frontier

Set of asset portfolios offering the highest expected surplus return for each level of surplus risk. Surplus is assets minus liabilities, so liability volatility is part of the risk measure.

Immunisation conditions

Present value of assets equals liabilities, asset duration equals liability duration, and asset convexity is at least liability convexity. This protects surplus against small parallel yield shifts.

Cash flow matching

Dedicating asset cash flows to exactly meet known liability outflows on each date. It removes reinvestment and interest rate risk but is costly and inflexible.

Liability-driven investment

Investment approach that selects assets by reference to liability cash flows and sensitivities rather than to a market index. Swaps and long bonds extend duration efficiently.

Solvency II SCR

Solvency Capital Requirement calibrated to a one-year value-at-risk at 99.5 percent confidence. It covers market, credit, life, non-life, health and operational risk modules.

Matching adjustment

Solvency II adjustment allowing insurers to add a spread to the discount rate for matching illiquid liabilities, subject to eligibility and ring-fencing conditions.

Gordon growth model

Equity value equals next year's dividend divided by required return minus dividend growth. It assumes growth is constant and below the required return forever.

Weighted average cost of capital

WACC equals equity weight times cost of equity plus debt weight times after-tax cost of debt. Market value weights and marginal costs should be used.

Free cash flow to firm

Operating profit after tax plus depreciation minus capital expenditure minus the increase in working capital. Discount at WACC to obtain enterprise value.

Equivalent yield property

The internal rate of return that equates the present value of term income and reversion proceeds to the property price. It allows comparison across lease structures.

Portfolio variance two assets

Portfolio variance equals the sum of squared weight times variance for each asset plus twice the product of weights, volatilities and correlation.

Marginal risk contribution

The change in portfolio volatility from a small increase in an asset's weight. It equals the weight times the asset's covariance with the portfolio divided by portfolio volatility.

Black-Litterman model

Combines equilibrium implied returns with investor views, weighted by confidence, to produce expected returns for optimisation. It reduces extreme and unstable portfolio weights.

Equal risk contribution

Portfolio construction where each asset contributes the same share of total portfolio risk. Weights are not equal unless volatilities and correlations are identical.

Rebalancing bands

Tolerance ranges around policy weights that trigger trades when breached. Wider bands reduce transaction costs but permit larger deviation from strategic allocation.

Value at risk

The loss threshold not expected to be exceeded with a stated probability over a defined horizon. It says nothing about the size of losses beyond that threshold.

Expected shortfall

Average loss conditional on losses exceeding the value-at-risk threshold. It is coherent and sub-additive, capturing tail severity that value-at-risk ignores.

Put-call parity

For European options on a non-dividend share, call price minus put price equals share price minus strike discounted at the risk-free rate to expiry.

Option Greeks

Delta measures value change per unit underlying move, gamma the change in delta, vega sensitivity to volatility, and theta sensitivity to time passing.

Basis risk

Risk that the hedging instrument and hedged exposure do not move perfectly together, leaving residual exposure. Common when hedging cash assets with futures or swaps.

Time-weighted return

Return calculated by geometrically linking sub-period returns, removing the effect of external cash flow timing. It measures manager performance rather than investor experience.

Brinson attribution

Decomposes excess return into allocation, selection and interaction effects by comparing portfolio and benchmark weights and returns across sectors.