LIQUIDITY REQUIREMENTS

CFA Level III
#1

Gents,

can you share your approach about what to write down under the liquidity requirements section in the event they exceed the annual salary?

I am between writing down the gross liquidity requirements for the oncoming year and partially netting them off to the extent of the annual salary ù

(e.g. gross Liquidity req. 100 - annual salary 20 = net liquidity req is 80).

e.g. Mock 2011 Q2 net them out while in other mocks they are simply reported gross-of-salary despite they could be partially reduced.

It doesn’t seem to be a consistent approach across the mocks

thanks in advance for your help

#2

Personally I would net them out so any consistent negative balance between living expenses and salary becomes the liquidity need.

For example, wants to buy a boat in 6 months for 100k, has annual living expenses of 80k and an after tax salary of 60k…I would write his liquidity needs as 100k for the boat and 20k to cover excess of living costs over after tax salary.

That 20k has to be funded from the portfolio so it is a liquidity need.

#3

It definitely makes sense as it also sounds more precise in terms of working out and elaborate the given data but sometimes I come across

situations while they simply report the gross liquidity needs. No good.

#4

there is another post on the forum about this same question.

I would think in S666’s case - 100K is liquidity, IMMEDIATE, so you need to liquidate your portfolio.

The 20K excess of expenses over income - would be an ONGOING need - used to calculate the required return.

You would take off 100K from the net investable assets immediately.

then use the remaining net investable assets along with the 20K (net expenses over income) to calculate the required return.

#5

I agree with cpk123 that the 20k would be added to return requirement… But it us also a liquidity need in the first year I would think. That is how I will approach this if it happens in exam. Has to be factored into return requirement, and also mentioned in liquidity need.

#6

thanks for your help.

#7

Aren’t you computing your return for the 1st year? Then it is included there already isn’t it?

the 100K you took off (away) from your Net Investable assets, and the 20K is the excess expense over income …

so no, there is no need to mention that it is liquidity for the first year — that is what I think - and making it so - would mean double counting. What do you think?

#8

CFAI 2009 AM mock, Q1, Part C:

Answer for liquidity requirement:

PART C If they retire at age 60: The Tracys will need significant annual distributions (CAD 56,250 pretax or CAD 45,000 aftertax) from their investment portfolio to support their living expenses. They will also need CAD 100,000 to pay off their mortgage and income taxes associated with the withdrawal upon retirement. They expect no other significant inflows or outflows. In this question set up, the Tracey’s have an income of 80,000 CAD and annual expenses of 125,000 CAD. The difference is mentioned as a liquidity expense in the answer as shown above. The shortfall between income and expenses does need to be accounted for in the return requirement, but including it in the liquidity requirement wouldnt be “double counting” as you suggested, I’m 99.9% sure. Return is one thing, liquidity is a different thing entirely - you could gain that required return through a liquid money market asset, or an illiquid direct real estate holding. The required return is not up for debate - in the liquidity constraint we need to acknowledge that if expenses have to be met by liquidating some of the portfolio - that proportion of the portfolio needs to be held in liquid assets. I’m obviously stressing the point here…but that’s how I see it.

#9

thanks

any chance to agree a general principle to inspire to for both RR and Liquidity requirements? I might try here :

1. Income > Ongoing exp = A…(NET SAVER case)

1.1 No big expenses during the next 12m :

Liquidity requirements : small

RR : small (unless we need to grow capital to e.g. gift or fund retirement in x years, then use the calculator) where

FV = needed capital, PV = Current Asset base; PMT = A (net savings); I/Y = CPT

1.2 _we expect big expenses during the next 12m (_e.g. pay back the mortgage)

Liquidity requirements : Mortgage debt partially netted from the current saving ?

RR : small (unless we need to grow capital e.g. gift or to fund retirement in x years, then I’ll use the calculator where FV = needed capital PV = Current Asset base PMT = A (net savings); I/Y = CPT)

2. Income < Ongoing exp = B…( our inv ptf contributes to maintain our current life style)

2.1 No big expenses expected during the next 12 m :

Liquidity requirements : “B”,

RR : [“B” / asset base], we usually add inflation rate afterwards

2.2.we expect big expenses during the next 12m (e.g. pay back the mortgage)

Liquidity requirements: “B” + home mortgage

RR: is calculated as [“B” / asset base net-of mortgage debt] we usually add inflation rate afterwards

Perhaps the most difficult topic above.

Thanks