LEVEL III SCHWESER’S QuickSheet

Critical Concepts for the 2024 CFA® Exam

CAPITAL MARKET EXPECTATIONS Pitfalls of MVO analysis include: estimating the Choosing Options Strategies Based on Direction
Long-term economic growth rate: inputs, concentrated allocations, and a single and Volatility of the Underlying Asset
pop growth + labor force part. + new cap. period analysis. Outlook on the Trend of Underlying Asset
spending + TFP Utility maximization: Um = E(Rm) − 0.005 × λ × Varm Bearish Neutral Bullish
Write
Taylor rule: Um = the investor’s utility from investing Expected Decrease Write calls
straddle
Write puts
ntarget = rneutral + iexpected + [0.5(GDPexpected in a portfolio with asset allocation m move in
Remain Write calls Calendar Buy calls and
implied
− GDPtrend) + 0.5(iexpected − itarget)] E(Rm) = the expected return of the portfolio with volatility
unchanged and buy puts spread write puts
asset allocation m (expressed as a %) Increase Buy puts Buy straddle Buy calls
ntarget = target nominal short-term interest rate λ = the investor’s risk aversion Interest rate swaps
rneutral = neutral real short-term interest rate coefficient (“lambda”) Converting fixed-rate and floating-rate exposures:
GDPexpected = expected GDP growth rate Varm = σ2m= the variance of the portfolio with asset
Existing Interest Rate
GDPtrend = long-term trend in the GDP growth allocation m (expressed as a %) Exposure Converting Swap Required Beneficial When:
rate • Reverse optimization solves for the E(R)s based Floating-rate floating rates
Floating to fixed Payer swap
iexpected = expected inflation rate on market weights. liability expected to rise
• Black-Litterman view adjusts these returns and Fixed-rate floating rates
itarget = target inflation rate liability
Fixed to floating Receiver swap
expected to fall
then resolves for an EF.
Floating-rate floating rates
• Monte Carlo simulation models how an allocation Floating to fixed Receiver swap
Risk premium approach to expected bond asset expected to fall
return: may perform over time. Fixed-rate floating rates
Fixed to floating Payer swap
asset expected to rise
risk-free rate + term premium + credit premium
+ liquidity premium The notional principal of the interest rate swap.
​​(​  _________​​ )​​​ ​(​MV​  P​​)​​​​​​
​MD​  T​​− ​MD​  P​​
Grinold-Kroner model:
E(Re) ≈ D/P + (%ΔE − %ΔS) + %ΔP/E
DERIVATIVES AND CURRENCY NPS − ​MD​   ​ S

E(Re) = expected equity return MANAGEMENT where:

D/P = dividend yield
%ΔE = percentage change in earnings
%ΔS = percentage change in shares
outstanding
%ΔP/E = expected repricing return
Singer-Terhaar model:
Risk premium assuming full integration:
RPi = ρi,Mσi(market Sharpe ratio)
Risk premium assuming full segmentation:
RPi = σi(market Sharpe ratio)
Weighted average risk premium:
RPi = (degree of integration of i) (ERP assuming
full integration) + (degree of segmentation of i)
(ERP assuming full segmentation)
Commercial real estate:
Cap rate = NOI / (property value)
E(Rre) = cap rate + NOI growth rate
Option Strategies
Know the inherent payoff patterns of the option
combinations, then:
• Calculate profit/loss at any ending price for the
underlying as sum of initial investment versus
ending value of the positions held.
• Max gain and loss: examine the payoff pattern
and, from that underlying’s price, sum the initial
investment versus ending value of the positions
held.
• Breakeven(s): examine the payoff pattern and, from
either max gain or loss, determine how much the
underlying must increase or decrease.
Synthetic long forward = long call + short put.
Both options are short the underlying.
• Covered Call Protective Put
NPS = notional swap principal
MDT = target modified duration
MDP = current portfolio modified duration
MDS = modified duration of swap
MVP = market value of portfolio
Forward rate agreements are typically used to hedge
the uncertainty about a future short-term borrowing
or lending rate.
Hedging Interest Rate Risk Using Treasury
Futures
To hedge the interest rate risk of a long bond portfolio
the fund manager will use Treasury bond futures.
A duration-based hedge ratio (BPV HR) is
calculated to determine the number of futures
contracts required for a hedge.
​−BPV​  portfolio​​
​BPVHR​ = _________ ​​ × CF
​​  ​BPV​   ​​​​
CTD

For a finite time period: E(Rre) = cap rate + Basis point value (BPV) is the expected change in
NOI growth rate − %Δcap rate value of a security or portfolio given a one basis
point (0.01%) change in yield.
• Bull Spread BPVHR = number of short futures
Collar: Payoff pattern is BPVPortfolio = MDPortfolio × 0.01% × MVPortfolio
ASSET ALLOCATION identical to a bull spread
but includes owning the
MD = modified duration
BPVCTD = MDCTD × 0.01% × MVCTD
Asset Allocation Approaches underlying.
MVCTD = CTD price / 100 × $100,000
• Asset-only: focuses on asset return and standard
deviation. To achieve a target duration, the formula can be
• Bear Spread Straddle amended to:
• Liability-relative: focuses on growth of the surplus ​BPV​  target​​ ​−BPV​  portfolio ​​
and standard deviation. ​BPVHR​ = ________
  
​​  ​BPV​   ​​​​
​​ × CF
• Goals-based: uses subportfolios to meet specified CTD

goals. BPVTarget = MDTarget × 0.0001 × MVPortfolio

Asset classes:
• Assets within a class are similar and don’t fit in
more than one class.
• Classes have low correlation to other classes, cover
all investable assets, and are liquid.
Calendar rebalancing is done at a set frequency.
Percentage range rebalancing is when a band
is violated. Wider bands for: higher transaction
cost and correlations between classes, higher risk
tolerance, momentum markets, and less volatile asset
classes.
MVO use E(R), σ, and correlations to solve
for the efficient frontier (EF) and asset
allocation.
• Calendar spread—Options have different
expirations.
• Volatility smile—Further-from-ATM options have
higher implied volatilities resulting in a U-shaped
(smiling) curve when implied volatility is plotted
against strike price.
• Volatility skew—Implied volatility increases for
more OTM puts, and decreases for more OTM
calls. Explained by OTM puts being desirable
as insurance against market declines while the
demand for OTM calls is low.
• For an expected increase in equity market volatility
buy an ATM call on volatility index (VIX) futures
and sell an OTM put on VIX futures.
Currency forwards and futures allow users to
exchange a specified amount of one currency for a
specified amount of another currency on a future
date. Forwards are customized while futures are
standardized contracts.
The hedge ratio for futures can be calculated as:
amount of currency to be exchanged
​HR = _____________________________
​       ​​
futures contract size
Equity swaps can be used to create a synthetic
exposure to physical stocks, allowing market
participants to increase or decrease their exposure to
equity returns.
continued on next page...

CFA_L3_QS_Spreads.indd 1 15/05/23 1:19 PM

 DERIVATIVES AND CURRENCY MANAGEMENT continued...
The three main types of swaps:
1. Pay fixed, receive equity return
2. Pay floating, receive equity return
3. Pay another equity return, receive equity return
Equity Futures and Forwards
Equity futures are exchange-traded, standardized,
require margin, have low transaction costs, and are
available on indexes and single stocks. They enable
market participants to:
• Implement tactical allocation decisions (alter the
exposure to equity of a portfolio).
Š Selling futures (short position) reduces equity
exposure.
Š Buying futures (long position) increases equity
exposure.
• Achieve portfolio diversification.
• Gain exposure to international markets.
• Make directional bets on the direction of the
market.
Forwards provide the same advantages but lack
liquidity, are not subject to mark-to-market margin
adjustments, counterparty credit risk exists, major
advantage is they can be customized.
Achieving a target portfolio beta:
number of futures required = ​( ​​ )​(
​β_____
​T​​− ​β​P​​
​ ​  ​β​  ​ ​ __
​  F ​
F
where:
βT = target portfolio beta
βP = current portfolio beta
βF = futures beta (beta of stock index)
MVP = market value of portfolio
F = futures contract value = futures price ×
multiplier
Note that to fully hedge the portfolio from market
risk βT = 0.
VIX Futures
• Negative correlation between the VIX and stock
returns which becomes more pronounced during
equity market downturns.
• An equity holding can be protected from
extreme downturns (tail risk) by buying VIX
futures. If volatility increases the equity portfolio
will decline in value but VIX futures should
increase in value.
• VIX futures will increase in value when the
market’s expectation of future volatility at
contract maturity increases.
Position Term structure
Long futures position Contango
Short futures position Contango
Long futures position Backwardation
Short futures position Backwardation
VIX Options
• Call options gain in value if expectations of
volatility at maturity of the option increase.
• Put options gain in value if expectations of
volatility fall.
Variance swaps are based on variance (σ2) rather
than volatility (standard deviation).
Implied variance K2
(fixed at initiation)
Counterparty Counterparty
1 2
Realized variance σ2
(unknown at initiation)
There is no initial exchange of notional principal,
no interim settlement periods, and a single
payment at the expiration of the swap based on the
difference between actual and implied variance over
the life of the swap.
Settlement amountT =
(variance notional)(realized variance − variance
strike)
CFA_L3_QS_Spreads.indd 2
Long (purchaser) describes the counterparty who • Carry trade: borrow in a lower interest rate
receives the realized variance (actual) and pays the currency and invest in a higher interest rate currency.
swap’s variance strike (implied volatility). • Volatility trading: profit from predicting changes
Realized Buyer (long) of swap in currency volatility. If volatility is expected to
> strike increase, purchase an at-the-money call and put
volatility makes a profit
(long straddle). Sell volatility by selling both
Realized Buyer (long) of swap
< strike options (a short straddle).
volatility makes a loss
Forward Premiums or Discounts and Currency
The notional amount for a variance swap can be Hedging Costs
expressed as either variance notional (NVAR) or
If the hedge requires: FP/B > SP/B, iB < iP FP/B < SP/B, iB > iP
vega notional (NVEGA).
The forward price The forward price
vega notional curve is upward curve is downward
variance notional = ___________
​​      ​​, so sloping. sloping.
2×strike price (K)
A long forward Negative roll yield, Positive roll yield,
profit or loss = NVAR × (σ2 − K2) = position in currency B which increases which decreases
​ ​  vega​​​ × ​(​  ___ )​​ ​​
​ ​​ 2​− ​K​​ 2​
σ the hedge earns: hedging cost and hedging cost and
2K ​
N discourages hedging. encourages hedging.
​ A short forward Positive roll yield, Negative roll yield,
where: position in currency B which decreases which increases
the hedge earns: hedging cost and hedging cost and
σ = realized volatility encourages hedging. discourages.
K = strike volatility (implied volatility)
The minimum-variance hedge ratio (MVHR): a
Both the actual (σ) and the implied volatility (K)
regression of past changes in value of the portfolio
on the swap are quoted in standard deviations, but
to past changes in value of the foreign currency.
remember that this is a variance swap; therefore, we
The hedge ratio is the beta (slope coefficient) of
must square the volatility.
that regression.
The market convention is to quote the notional • Strong positive correlation between RFX and RFC
on a swap as vega notional (NVEGA) rather than increases the volatility of RDC resulting in a hedge
)​​
​MV​  ​​ variance notional (NVAR). Recall that vega refers to ratio > 1.0.
P
the change in option premium per a 1% change • Strong negative correlation between RFX and RFC
∆premium decreases the volatility of RDC resulting in a hedge
in volatility, _
​​   ​​, a natural way to think ratio < 1.0.
∆volatility
about the return for volatility.
Foreign Currency Equations
RDC = (1 + RFC)(1 + RFX) − 1 = RFC + RFX + FIXED INCOME
(RFC)(RFX) Liability-based mandates:
RDC ≈ RFC + RFX • Cash flow matching directly funds liabilities with
RFC = return on the foreign asset and coupon and par amounts.
RFX = return on the foreign currency • Duration matching requires:
σ2(RDC) ≈ σ2(RFC) + σ2(RFX) + 2σ (RFC) σ(RFX) • PVA = PVL; there are exceptions when asset
ρ(RFC,RFX) and liability discount rates differ.
• DA = DL or BPVA = BPVL
If RFC is a risk-free asset:
σ(RDC) = σ(RFX)(1 + RFC) • Minimize portfolio convexity but make it
greater than that of the liabilities.
Currency Management Strategies • Derivatives overlays:
• Passive hedging: eliminates currency risk relative • involving the use of futures or swaps contracts,
to the benchmark. can be used to implement duration matching or
• Discretionary hedging allows the manager to contingent immunization strategies.
deviate modestly from passive hedging. The goal is Regularly rebalance the portfolio:
risk reduction. Š BPVfutures ≈ BPVCTD / CFCTD
• Active currency management allows a manager to
have greater deviations from passive hedging. The Š BPV = MD × V × 0.0001
Roll yield Š Nf = (BPVL − current BPV) / BPVfutures
goal is adding value.
Negative
• Currency overlay is the outsourcing of currency • Nonparallel yield curve shifts can be
Positive
Positive
management to another manager. a problem, match key rate durations:
Negative Factors That Shift the Strategic Decision Toward %Δ value = −MDkey rate n Δyn
a Benchmark Neutral or Fully Hedged Strategy • Contingent immunization: active management
if the surplus is positive.
• A short time horizon for portfolio objectives.
(PV− ) − (PV+ )
• High risk aversion. Effective duration =
• Little weight given to the opportunity costs of 2 ( ∆ Curve ) (PV0 )
missing positive currency returns.
(PV− ) + (PV+ ) − 2(PV0 )
• High short-term income and liquidity needs. Effective convexity =
• Significant foreign currency bond exposure. (∆ Curve )2 (P V0 )
• Low hedging costs.
• Clients who doubt the benefits of discretionary where:
management. PV0 = current value of the portfolio
Tactical Currency Management PV− = value of portfolio when benchmark curve
• Economic fundamentals: in the long term, is shifted down
relative currency values will converge to their fair PV+ = value of portfolio when benchmark curve
values. Increases in currency values are associated
is shifted up
with currencies:
Š That are undervalued relative to their ΔCurve = change in benchmark curve
fundamental value. Return can be projected (or actual return
Š That have the greatest rate of increase in decomposed) as the sum of:
fundamental value. 1. Coupon income: annual coupon amount /
current bond price
Š With higher real or nominal interest rates.
Š With lower inflation relative to other countries. 2. Rolldown return, assuming no change in yield
Š Of countries with decreasing risk premiums. curve: (projected ending bond price (BP) −
beginning BP) / beginning BP
15/05/23 1:20 PM
 3. Price change due to investor yield change
predictions: (−MD × ΔY) + (½C × ΔY2)
4. Price change due to investor spread change
predictions: (−MD × ΔS) + (½C × ΔS2)
5. Currency G/L: projected change in value of foreign
currencies weighted for exposure to the currency
Coupon income + rolldown return may be referred
to as rolling yield.
Leveraged return = rI + [(VB / VE) × (rI − rB)].
where:
rp = return on portfolio
rI = return on invested assets
rB = rate paid on borrowings
VB = amount of leverage
VE = amount of equity invested
Active management for a stable upward sloping
yield curve:
• Buy and hold: extend duration to get higher yields.
• Roll down the yield curve: portfolio weighting
highest for securities at the long end of the
steepest yield curve segments, maximize gains on
securities from declines in yield as time passes.
• Repo carry trade: borrow at lower rates to
purchase securities with higher rates.
• Long futures position
• Receive-fixed swap
Active management for a changing yield curve:
• Increase (decrease) portfolio duration if rates are
expected to decrease (increase).
• Add call options on either a bond price or a bond
futures contract to increase duration.
• Add put options on either a bond price or bond
futures contract to decrease duration.
• A payer swaption (right to enter a pay-fixed swap
decreases duration.
• A receiver swaption (right to enter a receive-fixed
swap) increases duration.
change in portfolio value
KeyRateDur = −
portfolio value × change in key rate
• Increase portfolio convexity (decreasing yield)
when large changes in rates are expected.
• Bullet portfolios have more yield, but barbells
have more convexity and also tend to outperform
in curve-flattening environments.
Curvature of the yield curve can be measured through
the butterfly spread: butterfly spread = −(short-term
yield) + (2 × medium-term yield) − long-term yield
• % Δ value = −MDΔy
• %Δrelative value = −SDΔs where spread
duration (SD) measures a portfolio’s percentage
sensitivity to a 1% change in credit spreads (Δs).
• spread = yhigher yield − ygovernment
• credit spread ≈ POD × LGD
(PV– ) – (PV )
• EffRateDurFRN =
2 (∆ MRR ) (PV0 )
• EffSpreadDurFRN =
(PV− ) − (PV+ )
2( ∆ DM)(PV0 )
(PV− ) − (PV+ )
• effective spread duration =
2( ∆ spread )(PV0 )
(PV− ) + (PV+ ) − 2(PV0 )
• effective spread convexity =
( ∆ spread )2 (PV0 )
• %Δprice = (−EffSpreadDur × Δspread) +
(½ × EffSpreadCon × Δspread2)
• Expected excess spread = spread − (EffSpreadDur
× Δspread) − (POD × LGD)
• Effective spread for a buy order = trade size ×
(trade price − midquote)
• Effective spread for a sell order = trade size ×
(midquote − trade price) where: midquote = (bid
+ ask) / 2
• CDS price ≈ 1 + [(fixed coupon − CDS spread)
× EffSpreadDurCDS]
CFA_L3_QS_Spreads.indd 3
EQUITY quantitative pair trading referred to as statistical
arbitrage.
Constructing and maintaining the index involves:
• The weighting method to construct the index: Benefits of long/short strategies include the ability
(1) market-cap weighting, (2) price weighting, to better express negative views, the ability to gear
(3) equal weighting, or (4) fundamental weighting. into high-conviction long positions, the removal
• Considering the level of stock concentration. The of market risk to diversify, and the ability to better
“effective number of stocks” can be determined as the control risk factor exposures.
reciprocal of the Herfindahl-Hirschman index (HHI): Drawbacks of long/short strategies include
n potential large losses since share prices are not
HHI = ∑ w 2i bounded above, negative exposures to risk
i =1 premiums, potentially high leverage for market-
effective number of stocks = _
effective number of stock s =HHI
​ ​ 1 1 ​​ neutral funds, and the costs of borrowing securities
HHI and collateral demands from prime brokers. Being
Common equity risk factors: growth, value, size, subject to a short squeeze on short positions is also
yield, momentum, quality, and volatility.
a risk.
Factor-based strategies: return oriented, risk
oriented, and diversification oriented.
Common approaches to passive equity investing
use: (1) pooled investments, such as open-end mutual ALTERNATIVE INVESTMENTS
funds and ETFs, (2) derivatives-based strategies, and
Hedge Funds Strategies:
(3) separately-managed index-based portfolios.
1. Equity related with the primary source of risk
Three methods of constructing passively managed
index-based equity portfolios: (1) full replication, being equity risk.
a. Long/short equity—The fund manager takes
(2) stratified sampling, often based on cell matching,
(3) technical and quantitative approach (optimization) long positions in stocks that they think will
rise in value, and takes short positions in stocks
Fundamental managers use discretionary judgment
vs. quantitative managers use rules-based that they believe will fall in value.
b. Dedicated short bias funds—These seek
(systematic) data-driven models.
overpriced securities to sell short.
Fundamental law of active management: c. Equity market neutral—These seek to attain a
E(R A ) IC BRσ RA TC near-zero overall exposure to the stock market.
Š Take long positions in undervalued stocks
Active share measures the degree to which the number and short positions in overvalued stocks with
and sizing of the positions in a manager’s portfolio the betas of the positions summing to zero.
differ to those of a benchmark:
n Š Alpha occurs through mean reversion.
1
Active share ∑ Wp,i – Wb,i 2. Event-driven relate to corporate actions such
2 as governance activities, mergers, acquisitions,
i=1
bankruptcies, and other major business events.
Active risk (tracking error), is the standard The main risk is event risk.
deviation of active returns (portfolio returns minus a. Merger arbitrage earns a return from the
benchmark returns). uncertainty that exists in the market from when
The contribution of Asset i to portfolio variance an acquisition is announced until completed
(CVi) is given by the equation: (i.e., the fund manager purchases the stock of
n
the target company and shorts the stock of the
​​CV​  i​​ ​= ​ ∑ ​​​​w​  i​​ ​w​  j​​ ​C​  ij​​ ​= ​w​  i​​ ​C​  ip​​​
acquiring company, anticipating the deal will be
j=1
completed).
where:
b. Distressed securities take positions in the securities
wj = Asset j’s weight in the portfolio
of firms that are in financial distress, including
Cij = the covariance of returns between Asset firms that are in bankruptcy or near-bankruptcy.
i and Asset j 3. Relative value strategies profit from the relative
valuation differences between securities.
Cip = the covariance of returns between Asset
a. Fixed-income arbitrage takes advantage
n
( j=1 )
i and the portfolio ​​​ ​​=​  ∑ ​​ ​​w​  j​​ ​C​  ij​​​ ​​​​ of temporary mispricing of fixed-income
instruments by going long undervalued
securities and short overvalued securities.
The contribution of Factor i to portfolio variance is Š Yield curve trades go long and short fixed-
income investments in order to profit from the
given by the formula:
n
anticipated yield curve steepening or flattening.
​​CV​  i​​ ​= ​∑​  ​​​β​  i​​ ​β​  j​​ ​C​  ij​​ ​= ​β​  i​​ ​C​  ip​​​ Š Carry trade the portfolio manager shorts a
j=1
low-yielding security and goes long a high-
where:
yielding security.
​β​i​ = sensitivity of portfolio to Factor i b. Convertible bond arbitrage the manager purchases
(regression coefficient) the convertible bond which is often underpriced
Cij = the covariance of Factor i and Factor j and short sells the underlying equity.
Cip = the covariance of Factor i and the 4. Opportunistic strategies employ a top-
down approach making macro investments on a
portfolio (
​​​ ​= ​  ∑​​ ​β​j​​C​ij​)​​​
n
global basis across regions, sectors, and asset classes.
j=1
a. Global macro profits from making correct
Long extension portfolios guarantee investors assessments and forecasts of various global
100% net exposure with a specified short exposure. economic variables.
A typical 130/30 fund will have 130% long and b. Managed futures strategies take long and short
30% short positions.
positions in derivatives contracts.
Market-neutral portfolios aim to remove market 5. Specialist strategies require specialized market
exposure through offsetting long and short expertise or knowledge.
positions. Pairs trading is a common technique a. Volatility strategies trade volatility-related assets
in building market-neutral portfolios, with
globally.
15/05/23 1:20 PM
 b. Insurance/reinsurance strategies:
Š Insurance strategy—An insured person sells
their insurance policy (through a broker) to
a hedge fund.
Š Reinsurance strategies—Insurance companies
sell off some of their risk to reinsurance
companies who may then sell the risk to
hedge funds in exchange for capital.
6. Multimanager strategies use other hedge fund
strategies as building blocks, combining different
strategies together, rebalancing exposures over time.
Drawdown:
• Defined as the percentage peak-to-trough decline
for a portfolio.
• High-water mark refers to the maximum value the
portfolio has ever reached.
Estimating investor cash flows to and from a
private investment:
• Capital contribution in period t = percentage
to be called in period t × (committed capital −
capital previously called)
• Distributions in period t = percentage to be
distributed in period t × [NAV in period t − 1 ×
(1 + growth rate)]
• NAV in period t = [NAV in period t − 1 ×
(1 + growth rate)] + contributions in period t −
distributions in period t
PRIVATE WEALTH MANAGEMENT
OVERVIEW OF PRIVATE WEALTH
MANAGEMENT
Behavioral Biases Associated with Retirees:
• Increased loss aversion. Affects return assumptions
and asset allocation decisions in retirement.
• Consumption gaps. Consumption spending tends
to be lower than what economic studies forecast,
can be attributed to loss aversion and uncertainty
about future retirement spending.
• The “annuity puzzle”. Individuals tend to
avoid buying annuities, possible explanations
include: (a) clinging to hope of funding a
better retirement lifestyle, (b) a desire to keep
control of assets, and (c) the high cost of annuities.
• Mental accounting and lack of self-control. Retirees
prefer to meet their spending needs from investment
income rather than liquidating securities.
IPS for a Private Clients:
• Client Background obtained from relevant
personal, financial and tax information. Investment
Objectives may be planned, unplanned, ongoing, or
one-off. Multiple objectives should be prioritized
into primary and secondary objectives.
• Key Investment Parameters:
Š Risk tolerance—willingness and ability, low risk
tolerance usually associated with high priority
goals and near-term goals.
Š Time horizon—described as a range (e.g. in excess
of 15 years for a long horizon and less than 10
years for a short horizon). If multiple objectives, a
different time horizon for each objective.
Š Other investment parameters—include asset class
preferences, liquidity preferences (including a cash
reserve), unique investment preferences.
Š Constraints—restricting investments for client’s
portfolio.
• Asset Allocation—Strategic long-term target
asset allocation for each asset class and tactical
asset allocation as an active management strategy
specifying a range for each asset class.
• Portfolio Management and Implementation
guidelines for discretionary authority, portfolio
rebalancing, tactical asset allocation changes, and
acceptable investment vehicles.
• Wealth Manager Duties and Responsibilities
include; formulating/reviewing the client’s IPS,
CFA_L3_QS_Spreads.indd 4
constructing the portfolio, monitoring and
rebalancing the portfolio, monitoring portfolio
costs and third-party providers, and reporting
portfolio performance.
• IPS Appendix includes modelled portfolio
performance and capital market expectations.
Portfolio Construction:
• Traditional Approach—views risk in an overall
portfolio context.
• Goals-based investing—separate portfolios are
created for each of the client’s goals. Mean-variance
optimization used to maximize expected returns
for a given level of risk or to meet a specified
probability of success is carried out for each goal
portfolio rather than for the entire portfolio.
TOPICS IN PRIVATE WEALTH
MANAGEMENT
• Main categories of taxes: income tax, capital gains
tax, wealth/property tax, stamp duties, wealth
transfer tax.
• General equation for capital gains: net sales price
− tax (cost) basis = capital gain/loss.
• Three main types of investment accounts: taxable,
tax-deferred (TDA), and tax-exempt (TEA).
Common metrics used in examining tax
efficiency:
1. After-tax holding period return R' =
[(value1 − value0) + income − tax] / value0
Alternatively, R' = R − (tax / value0).
2. After-tax post-liquidation return (RPL) involves
deducting the implied tax:
RPL = [(1 + R' 1)(1 + R' 2)…(1 + R' n)(1 − liqui-
dation tax/final value)]1/n − 1. Liquidation tax =
(final value − tax basis) × tax rate on capital gains
3. After-tax excess return (x') is computed as the
after-tax return of the portfolio (R') minus the
after-tax return of the benchmark (B'):
x' = R' − B'. In this regard, the tax alpha would
be defined as after-tax excess return (x') minus the
pretax excess return (x): αtax = x' − x
4. Tax-efficiency ratio (TER) is calculated as after-tax
return (R') divided by pretax return (R):TER = R' / R
Taxable accounts involve one or more tax rates on
income (e.g., interest, dividends) or return (e.g., realized
capital gains) to determine R’: FVAT = (1 + R’)n
Tax exempt accounts (TEAs), after-tax funds are
deposited so no tax is due on the returns earned or
on withdrawals: FVAT = (1 + R)n
Tax deferred accounts (TDAs), pretax funds
are deposited and the investor may take a tax
deduction for the amount contributed thereby
reducing taxable income and taxes due. All tax is
deferred until withdrawal allowing tax-deferred
compounding: FVAT = (1 + R)n(1 − t)
Tax-efficient assets (e.g., equities that generate capital
gains are often subject to lower tax rates) should be
placed in taxable accounts. Tax-inefficient assets (e.g.,
taxable bonds that generate taxable interest, which is
often subject to higher tax rates) should be placed in
tax-exempt or tax-deferred accounts.
Four common investment vehicles include:
• Partnership
• Mutual fund
• Exchange-traded fund (ETF)
• Separately managed account (SMA)
Tax loss harvesting involves the sale of securities
with embedded losses to offset gains, which will
lower the tax liability for the current year.
• Highest in, first out (HIFO) is generally optimal
• In case future tax rates are expected to be higher
than current tax rates, first in, first out (FIFO)
may be better
• In case future tax rates are expected to be lower
than current tax rates, last in, first out (LIFO)
may be better
Strategies for managing a concentrated position in
public equities:
• Staged diversification strategy over multiple years
to spread out tax liability
• Completion portfolio using other assets to
complement/complete the concentrated position
• Equity monetization by hedging a large part of
the risk in the position using derivatives and then
borrow using the hedged position as collateral
• Zero-cost collars are used to lower initial cost by
giving up some stock upside. The put premium
paid and call premium received are equal.
• Covered call writing is possibly a staged
diversification assuming the share price
appreciates sufficiently
• Exchange fund with a pooling of investments on
a tax-free basis
• Charitable remainder trust to benefit both
beneficiaries and a designated charity
Strategies for managing concentrated positions in
privately owned businesses:
• IPO
• Direct sale to another investor
• Sale of non-essential business assets
• Personal line of credit secured by company shares
(owner borrows from company or from a third-
party lender)
• Leveraged recapitalization (e.g., private equity
firm)
• Sale to employee stock ownership plan
Lifetime Gifts vs. Testamentary Bequests
Basic form of the relative value (RV) ratio: FV
after-tax to the receiver if gifted now / FV after-tax
to the receiver if bequeathed at death:
Two tax scenarios to consider:
• The gift now is tax free to both the receiver and
the donor
• The gift is taxable with tax paid by the receiver
Relevant tax factors to consider:
• rg and tg are the pretax return earned and the
applicable tax rate on those earnings for assets
held by the gift receiver
• re and te are the pretax return earned and the
applicable tax rate on those earnings for assets
held by the gift giver
• Te is the estate tax rate and would be paid from
the estate
• Tg is the gift tax rate and is assumed to be paid
by the receiver
FVgift = [1 + rg(1 − tg)]n
FVbequest = [1 + re(1 − te)]n(1 − Te)
• RV of a tax-free gift, Tg = 0
​FV​  ​​ ​ 1+​r​  ​​​ 1−​t​  ​​ ​ ​​​​ n​
[ g( g)]
• ​​RV​ Tax Free Gift​​= ​​  ____ ___________
​FV​   ​​​​ =   
​​      ​​
Gift
​[1+​r​  e​​​(1−​t​  e​​)​]​​​​ ​​(1−​T​  e​​)
n
Bequest
• RV of a taxable gift, Tg paid by receiver
​FV​  ​​ ​[1+​r​  g​​ ​(1−​t​  g​​)​]​n​(1−​T​  g​​)​
​​ V​Taxable Gift​​​ = ____
• R ​​  Gift
​FV​  Bequest​​
____________
 ​ =   
​      ​
​[1+​r​  e​​​(1−​t​  e​​)​]​ ​(1−​T​  e​​)
n
RISK MANAGEMENT FOR ­INDIVIDUALS
• Total wealth is composed of both human capital
(HC) and financial capital (FC). HC is the
discounted present value of expected future labor
income. FC is the sum of all the other assets of an
individual.
• Net wealth is the sum of the individual’s FC
and HC less any liabilities owed by the individual.
• The economic (holistic) balance sheet extends the
traditional balance sheet assets to include HC.
Liabilities can also be extended to include
consumption and bequest goals.
• Earnings risk: Use disability income insurance.
• Premature death risk: Use life insurance.
• Longevity risk of living too long: Use annuities.
continued on next page...
15/05/23 1:20 PM
 PRIVATE WEALTH MANAGEMENT continued... Invest- Short term Long/me- Long Long Long Liquidity Driven by deposit Varies by product
ment dium term term term term needs withdrawals and line—P&C liquidity
• Property risk: Loss in value of physical property potential need to raise needs generally higher
time dependent
(FC). Use property insurance (homeowner’s and horizon on in- liquidity in adverse than life. Liquidity
market conditions. needs will increase in times
automobile). vestment
Regulators apply of high interest rates due to
• Liability risk: If legally responsible for damages. projects
liquidity coverage ratios policyholders surrendering
Liquidity Highest Generally Lowest Interme- Varies: and net stable funding in search of high yields
Use liability insurance. needs low diate low ratios. elsewhere.
• Health risk: Direct loss of FC to pay illness or during
External Highly regulated due to importance to real
injury related expenses and may reduce HC. Use accumula-
constraints economy and systemic risk, particularly SIFIs.
tion stage,
health and medical insurance. higher Main goal of regulators is to ensure the institution
holds sufficient risk-based capital to absorb losses.
Asset allocation based on investor’s total economic during
Three different types of accounting systems apply:
wealth, FC and HC: decumu-
lation 1. Standard financial reporting (GAAP or IFRS)
• Individual employed in a high risk profession stage 2. Statutory accounting for regulators (more
conservative than financial reporting)
would choose lower risk FC. External Established by national legislation. Best practice set by 3. True economic accounting (marked-to-market)
• If HC is positively correlated with the stock con- ISWF’s Santiago Principles. Banks and insurers are fully taxable.
straints Generally tax exempt.
market then best to select asset classes other than Investment Manage liquidity and risk mismatches between
Invest- Capital Real Maintain Grow Earn objectives the institution’s non-investment assets and
equity for risky assets used. ment ob- preserva- growth real faster returns liabilities. This needs to be done in the context
• Avoid FC tied directly to employer. jectives tion higher perpetual than to meet of the institution’s overall profit maximization
than real spending yield on future objective.
Risk Management Decision Matrix GDP central unfunded
growth bank/ govern- The change in the market value of equity for banks
Characteristic of the Loss Occurs Regularly Infrequent
govern- ment and insurers:
Very severe Risk avoidance Risk transfer ment pension
bonds payments
%∆E = ​ %∆A(M) − ​ %∆L(M − ​ 1)
Not severe Risk reduction Risk retention where:
Stakeholders and key elements of the IPS for %ΔE ​ = percentage change in the value of equity
university endowments and private foundations: %ΔA ​ = percentage change in the value of assets
INSTITUTIONAL INVESTORS University Endowments Private Foundations %ΔL ​ =p  ercentage change in the value of
Stakeholders and key elements of the IPS for Stakeholders Current and future Founding family, donors, liabilities
defined benefit (DB) pension plans vs. defined students, alumni, grant recipients and M ​ = leverage multiplier, A /​ E
university employees broader community,
contribution (DC) pension plans: governments The duration of the equity of a bank or insurer:

DB Plan
Stakeholders Employers, plan
beneficiaries,
investment staff,
investment committee/
board, governments,
shareholders
Liabilities Present value of future
benefits promised
to plan participants.
Higher when:
• Employees work longer
• Salaries are higher
• Participants live longer
• Lower employee
turnover leads to
higher vesting
• Discount rate is low
Investment Longer if proportion of
time horizon active lives is higher
Liquidity Higher with:
needs • More retired lives
• Older workforce
• Higher funded
status (may reduce
contributions)
• Flexibility of
participants to switch
plans
External • Regulations vary by
constraints country: IORP II
in Europe, ERISA
in U.S.
• Tax treatment
favorable
• Accounting rules: ASC
715 requires funded
status to be shown
on balance sheet
(U.S. GAAP); public
pension plans follow
Investment
GASB
Achieve a long-term
objectives target return over a
specified horizon with
appropriate risk to meet
contractual liabilities.
Stakeholders and key elements of the IPS for the
five types of sovereign wealth funds (SWF):
Budget
Stabiliza- Develop-
tion ment Savings Reserve
Stake- Country’s citizens, the government, external and inter-
holders nal investment management
Liabilities Uncertain: Linked to Spending Yield
linked to socio- on future promised pension
commod- economic genera- on cen- Payments
ity prices/ invest- tions
economic ments
cycle
( ∆y )
DC Plan Liabilities Set by the future
spending promised to
U.S. tax rules require
minimum spending ​  ∆i  ​ ​​​​​​
​​D​  E​​ ​= ​D​  A​​  (M) ​− ​D​  L​​  (M ​− 1)​​​​ _
Employers, plan the university. of 5% of assets plus
beneficiaries, where:
Spending policy should investment expenses.
investment staff, consider (1) ongoing Must also spend DE ​ = modified duration of the institution’s
investment committee/
board, governments
donations, (2) reliance donations in the same equity capital
of university on year they are received. DA ​ = modified duration of the institution’s
spending, (3) ability to
No liability to plan issue debt. Spending assets
sponsor once required may use a spending rule DL ​ = modified duration of the institution’s
contribution to plan has which takes a weighted
been met average of last period’s
liabilities
spending adjusted for M ​ = leverage multiplier, A /​ E
​​  ∆i  ​​ =
inflation and a fixed _
spending rate applied to ​ estimated change in yield of liabilities, i,
average AUM. ∆y relative to a unit change in yield of assets, y
Investment Perpetual Typically perpetual, but
time horizon shortened for limited-life
The expected volatility (i.e., standard deviation) of
foundations the percentage change in the market value of equity
Dependent on the age Liquidity The spending rate net of Higher than capital for a bank or insurer:
of participant: longer if needs donations is very low at endowments—legally
younger 2%−4% of assets. required to spend 5% ​​σ2​ E ​ ​  = ​M​​ 2​ ​σ2​ A ​  ​  + ​(M − 1)​​ 2​ ​σ2​ L ​  ​  − 2(M)(M − 1) ​σ​ A​​ ​σ​ L​​ ​ρ​ AL​​​
Higher with: of assets. Reliance
• Older workforce on spending by where:
• Flexibility of foundation is usually ​​σ​  E ​​ ​  = standard deviation of percentage
participants to switch higher than the change in the market value of equity
plans reliance of a university
on endowment ​​σ​  A ​ ​  ​ = s tandard deviation of percentage
spending. change in the value of assets
External Typically tax exempt. Regulation varies by ​​σ​  L ​​ ​  = standard deviation of percentage
constraints jurisdiction but generally requires a total return change in the value of liabilities
• Regulations vary by approach and prudence in investing (UPMIFA in
country: IORP II U.S., The Trustee Act in the U.K.). M = leverage multiplier, A / E
in Europe, ERISA Investment Generate a total real Generate a real ρAL = c orrelation of percentage value changes
in U.S.
• Sponsor must offer
objectives return after inflation return over consumer in assets and liabilities
measure by the HEPI price inflation of
appropriate default of about 5% on a the spending rate
option to disengaged 3−5 year rolling basis, (minimum 5%) plus
participants
TRADING, PERFORMANCE
with reasonable annual investment expenses on
• Plans are tax deferred volatility in the range of a 3−5 year rolling basis,
10%−15% with reasonable annual
volatility in the range of
10%−15%
EVALUATION, AND MANAGER
Prudently grow assets to Stakeholders and key elements of the IPS for banks SELECTION
meet spending needs in and insurers: Implementation shortfall (IS) at the highest level
retirement.
Banks Insurers the absolute value is:
Stakeholders External: shareholder, External: shareholders, IS = paper return − actual return
depositors, borrowers, policyholders, derivatives
creditors, credit counterparties, creditors, IS can be decomposed into the following parts:
ratings agencies, regulators, credit ratings • Execution cost occurs due to executing shares at a
regulators, and agencies
communities Internal: employees, less favorable price than the original decision price.
Pension Execution cost can be further broken down into:
Reserve Internal: employees, management, and board
management, and board Š Delay cost occurs due to adverse price movements
Liabilities Primarily deposits Life insurers: long in the time between the portfolio manager
which are short term duration contract
Future payouts submits the order to the trader and the time the
P&C insurers: shorter trader releases the order to the market. For a buy
and less certain contract
tral bank/ order: delay cost = shares executed × (arrival
payouts
govern- price − decision price)
ment Investment While perpetual organizations, investments are Š Decision price = price when manager decides
bonds time horizon run on a short/medium term LDI basis. to buy (or sell).

CFA_L3_QS_Spreads.indd 5 15/05/23 1:20 PM

 Š Arrival price = price when the order is placed
by trader.
Š Trading cost: due to the market impact of
executing the trade.
Trading cost = shares executed × (average
purchase price − arrival price)
• Opportunity cost is the cost of not trading any unfilled
part of the order. The paper portfolio assumes that
all shares are executed immediately at the original
decision price. The actual trade may have only filled
part of the order and the lost profit on the unfilled
portion is the opportunity cost. For a buy order:
Opportunity cost = portion of order not filled ×
(closing price − decision price)
• Fixed fees are any explicit commissions or fees
incurred in executing the trade.
Fixed fees = ∑ executed × commission per share
Total IS value ($) = delay cost + trading cost +
opportunity cost + fixed fees
All of the components of and total IS can be expressed
in terms of basis points (bps) of the original cost of the
paper portfolio. A basis point is 1/100th of one percent.
A decimal number is multiplied by 10,000 to convert
it to basis points.
Trade costs represent costs relative to the benchmark,
a positive value represents underperformance:
Absolute cost ($) = side × (execution price −
benchmark price) × shares executed
Trade cost (bps) =
(execution price – benchmark price)
side ×
benchmark price
×10, 000
where:
side = +1 for a buy order, −1 for a sell order
Market-adjusted cost is used to remove the impact
of market movements on trade cost which ensures
a trader is not penalized or rewarded for general
market movements over the trade horizon.
index cost (bps) =
(index VWAP – index arrival price)
side × ×100, 000
index arrival price
Market-adjusted cost (bps) = arrival cost (bps) − β
× index cost (bps)
where:
arrival cost is the arrival cost of the trade based on
an arrival price benchmark
β = beta of the security vs. the index used to
calculate index cost
Added value is a different method of trade cost
analysis comparing the arrival cost of the trade with
the estimated pre-trade cost.
Added value (bps) = arrival cost (bps) −
estimated pre-trade cost (bps)
A negative cost is a benefit—the trader has added
value through their trading decisions.
Micro Attribution vs. Macro Attribution
• Micro attribution analyzes the portfolio at the
portfolio manager’s level.
• Macro attribution analyzes investment decisions at
the fund sponsor’s level.
Returns-Based, Holdings-Based, and
Transactions-Based Attribution
• Returns-based attribution uses regressions to analyze
the portfolio returns over time and isolates the
asset class components through indices that would
have generated these returns.
• Holdings-based attribution uses beginning-of-period
portfolio assets.
• Transactions-based attribution updates the
beginning-of-period holdings-based attribution for
any subsequent trades.
Brinson-Fachler and Brinson, Hood,
Beebower (BHB) models quantify the portfolio
returns into three attribution effects: allocation
effect, security selection effect, and the
interaction effect.
CFA_L3_QS_Spreads.indd 6
• Allocation effect refers to the portfolio
manager’s decision to overweight or underweight
specific sector weightings versus the benchmark. Using
the Brinson-Fachler model, the contribution to the ith
sector is equal to the portfolio’s sector weight minus
the benchmark’s sector weight, times the benchmark
sector return minus the overall benchmark return:
Ai = (wi − Wi)(Bi − B). For the BHB model, the
contribution to the ith sector is equal to the portfolio’s
sector weight minus the benchmark’s sector weight,
times the benchmark sector return: Ai = (wi − Wi)Bi
• Security selection is the portfolio manager’s
value added by selecting individual securities
(stock picking) within the sector and weighting the
portfolio differently compared to the benchmark’s
weightings. The contribution to selection in the
ith sector is equal to the benchmark sec­tor weight
times the portfolio’s sector return minus the
benchmark’s sector return: Si = Wi(Ri − Bi)
• Interaction effect is a residual amount (e.g.,
plug) that ensures the arithmetic return minus
the relative benchmark is fully accounted for in
attribution analysis. The contribution to the ith
sector is equal to the portfolio sector weight minus
the benchmark sector weight, times the portfolio
sector return minus the benchmark sector return:
Ii = (wi − Wi)(Ri − Bi)
Carhart model is a fundamental factor model
calculating the excess return from active
management decisions by determining the impact
on the portfolio due to the following factors:
(1) market index (RMRF), (2) market-capitalization
(SMB), (3) book-value-to-price (HML), and (4)
momentum (WML):
Rp − Rf = ap + bp1RMRF + bp2SMB + bp3HML
+ bp4WML + Ep
Benchmark quality of a portfolio return can be
broken up into three components: market, style,
and active management.
P=M+S+A
where:
P = investment manager’s portfolio return
M = return on the market index
S = B − M = excess return to style; difference
between the manager’s style index
(benchmark) return and the market return
(S can be positive or negative)
A = P − B = active return; difference between
the manager’s overall portfolio return and
the style benchmark return
Performance Appraisal
Sharpe ratio
R – r
SA = A f g = annual growth rate
σA
Treynor ratio
R – rf
TA = A
βA
Information ratio is used to measure a portfolio’s
performance against the benchmark accounting for
differences in risk.
E (rp ) – E (rB )
IR =
σ (rp – rB )
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Appraisal ratio is calculated as alpha divided by the
standard deviation of the residual/unsystematic risk
(the standard error of regression).
α
AR =
σε
Sortino ratio only considers the standard deviation
of the downside risk where rT refers to the
minimum acceptable return (MAR) and (σD) refers
to target semistandard deviation.
E (rp ) – rt
SR D =
σD
Capture ratios determine the manager’s relative
performance when markets are up or down.
Capture is calculated as portfolio return divided by
benchmark return. The capture ratio is calculated as
upside capture divided by downside capture.
Type I and II errors in hiring managers and
continuation decisions
• Null hypothesis (H0) is that there is no value
added.
• Type I error is when the null hypothesis is rejected
when in fact there was no value added.
• Type II error is when the null hypothesis is not
rejected when in fact there was value added.
CASES IN PORTFOLIO
MANAGEMENT AND RISK
MANAGEMENT
Calculating life insurance needs
Human life value method estimates the amount of future
earnings that must be replaced.
1. Start with the current amount of after-tax income
to be replaced
2. Subtract annual expenses attributable to the
person passing away
3. Add any employee benefits such as contributions
to pension plans that would not be earned
4. Gross up to a required pretax payout
5. Use the growth-adjusted discount rate (r*) to
calculate the present value of the pretax annuity due.
These calculations use the growth-adjusted discount
rate (r*) entered as I/Y on your financial calculator to
calculate a growing annuity due (beginning of period
payments) with the calculator in BGN mode.
r* = (1 + r)/(1 + g)
where:
r = annual discount rate
6. Subtract existing life insurance = additional life
insurance needs
Needs analysis method estimates the amount needed to
cover living expenses.
1. Determine the total cash needs (funeral,
emergency fund, debts)
2. Plus the capital needs which are the PV of surviving
spouse’s annual living expenses minus PV of
survivor’s income until retirement using the growth-
adjusted discount rate r* = total financial needs
3. Subtract the capital available (savings)
4. Less PV of vested retirement accounts attributable to
the surviving spouse = additional life insurance needs
• Review the SchweserNotesTM and/or Module Videos.
ETHICS (INCLUDING GIPS)
Review the SchweserNotesTM and/or Module
Videos and questions in the SchweserNotesTM,
CFA® text, and SchweserProTM Qbank.
15/05/23 1:20 PM