2022 Li PM

Last Revised: 05/31/2021
MarkMeldrum.com
Level I - Portfolio Management

Readings Page
Portfolio Management: An Overview 2
Portfolio Risk and Return: Part I 13
Portfolio Risk and Return: Part II 33
Basics of Portfolio Planning and Construction 53
The Behavioural Biases of Individuals 60
Introduction to Risk Management 71
Technical Analysis 85
Fintech in Investment Management 98
Reviews 104
This document should be used in conjunction with the corresponding readings in the 2022 Level I CFA® Program curriculum.
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Portfolio Management: An Overview
a. describe the portfolio approach to investing;
b. describe the steps in the portfolio management process;
c. describe types of investors and distinctive characteristics and needs of each;
d. describe defined contribution and defined benefit pension plans;
e. describe aspects of the asset management industry;
f. describe mutual funds and compare them with other pooled investment
products.
Portfolio Approach
LOS a
select securities w.r.t. vs. investing in - describe
their contribution to the individual securities, evaluating
characteristics of the each in isolation
whole portfolio
2 Rules/ Given 2 assets with the same return,
select the one with the lowest risk
Given 2 assets with the same risk,
select the one with the higher return
Key Point/ Portfolio management primarily involves

reducing risk rather than increasing return
LOS a
- Diversification Benefits
- describe
1) Portfolios may offer equivalent
returns with lower volatility
non-systematic risk of returns vs. individual
(diversifiable) securities
2) Asset class selection

(i.e. weighting/security) more
systematic risk
important than security
-
# of
selection
securities
-
32
- s.d. of an equally-weighted
portfolio
(lower = better - s.d. of a random component
effect)
LOS a
Index Mgr. X Mgr. Y - describe
Cash 10% 11% 9%
Fixed-Income 6% 8% 4%
Equities 25% 30% 20%
Asset Mix
Cash 5% 5%
Fixed-Income 70% 25%
Equities 25% 70%
$1000 Returns (Equally w)

Cash $5.50 4.50 33.33
Fixed-Income 56.00 10.00 20.00
Equities 75.00 140.00 83.33
136.50 154.50 136.66
13.65% 15.45% 13.66%
LOS a
E(R)
So, - describe
, but
A is the superior portfolio $
but
A is the superior portfolio
Limits to diversification/ · cannot eliminate systematic

risk
· in adverse markets, all correlations

move towards 1
diversification does not necessarily provide

downside protection
Portfolio Mgmt. Process

LOS b
Planning Step
- describe
· KYC - Understand the client’s needs
· IPS - Prepare an Investment Policy Statement
Execution Step
- Asset Allocation
- Security Analysis
- Portfolio Construction
Feedback Step
- Portfolio Monitoring and rebalancing
- Performance measurement and reporting
LOS b
Planning/
- describe
KYC - objectives, constraints
safety
+ liquidity
income
taxes
growth
time horizon
IPS - written planning document describing
objectives & constraints
- performance benchmark
- revised as client’s circumstances can
change by chance or just over time
LOS b
Execution/ Asset Allocation - describe
- the distribution of investable funds between
various asset classes (money market, equities, fixed-
income, alternatives)
- asset allocation choices explain most of the
difference between portfolio returns
Top Down more securities

- economy rebalancing held over
- industry as economy
securities - several cycles
- security and industry
Bottom up (i.e. Timberland)
EIS change
Execution/ Security analysis LOS b

- describe
· identify undervalued securities
Portfolio Construction
· in line with the IPS, consistent with stated
risk tolerances asset
· target asset allocation, weightings class
securities
· buy orders initiated
LOS b
Feedback/ Monitoring & Rebalancing
- describe
· the economy fix drift - prices will drift
· the markets from the asset allocation
· the asset classes mix
· the securities dynamic rebalancing - get back
· the client to original mix
tactical rebalancing
- intentional deviations from
the mix
Performance Measurement/Reporting
vs. benchmark
Investors
LOS c
Individual Investors/ · from safety to growth
- describe
· from short-term to 40+ yrs.
· risk averse to risk tolerant
Institutional Investors/
· Pension Plans - long-term, Income-growth, low liquidity
needs, moderate risk tolerance
· Endowments/Foundations - preservation of capital (on

an inflation-adjust basis), perpetual
life very long-term, moderate to high
risk tolerance, low liquidity needs,
Income + growth
LOS c
Institutional Investors/ - describe
· Banks - low risk, very liquid, short-term, Income
· Insurance Companies - low risk, high to moderate

liquidity, time horizon is policy type
dependent as is preservation of capital
priority, Safety-Growth-Income
· Investment Companies - varies (LOS d)
· Sovereign Wealth Funds - a government-owned

investment fund
- usually charged with investing revenues
from a finite source (i.e. oil) to benefit future
generations (or to manage forex reserves)
Pension Plans
LOS d
Defined Benefit/ · employer has an
- describe
obligation to pay a prespecified benefit
on retirement
i.e. 2%/yr. service of the last 5-yr. wage avg.
Defined Contribution/ · specifies how much goes into the

plan
· employer contributes either some % or $
· benefit depends on · contributions (empl. + emp.)
· length of investment
· performance
Overview - Asset Mgmt. Industry

LOS e
Overview · global AUM = $79.2T 80% NA/Europe - describe
(assets professionally managed for a fee)
· buy-side represents investors

· sell-side broker/dealers, research firms
Active vs. Passive
15% AUM, but 43%

of industry revenue
20% AUM, but 6% of

industry revenue
LOS e
Traditional vs. Alternative HF, PE, VC
- describe
long only equity, fixed-income, multi-asset strategies
Ownership Structure
· majority of asset mgmt. firms are privately owned
· typically limited liability corporations or partnerships
· some are publicly traded
Asset Mgmt. industry Trends

· growth of passive investing
· Big Data structured data sets twitter
unstructured - social media data facebook
- imagery/sensory data
(satellite/geo-location)
· Robo-advisors
- automation/investment algorithms
· trends growing demand from mass affluent and younger
investors, lower fees, new entrants
Pooled Investments
LOS f
- are managed funds
- describe
Investor1 sells
.
pool Assets
.
fund
funds buys
.
Investorn
Mutual Funds quite
units accessible
ETFs
Hedge Funds more
Mutual Funds/
- individual/institutional Private Equity Funds exclusive
investors
- diversification, professional mgmt.
- all income flows through to the unit holders
- value of the fund Net Asset Value - NAV
- calculated daily
LOS f
Mutual Funds/
- describe
Open-ended funds - accept new funds and
issue new units at NAV
- redeem all units at NAV
must have ready liquidity (cannot be 100%
invested)
Closed-end funds - fixed number of units/shares

- shares are exchange-traded
- can trade at premium, discount or equal
to NAV
Load funds annual fee + buy/sell fees

No-load funds annual fee based on NAV (= AUM)
LOS f
Mutual Funds/ Types/ - describe
· Money Market tax free/taxable

· Bond Funds bonds/preferreds
· Equity/Stock funds stocks/indicies
· Hybrid/Balanced funds stocks & bonds
Active higher MERs, attempt to beat benchmark

higher turnover, faster cap. gains realization
10%
90%
Bonds
glide path
90%
Equities
10%
25 age 65
LOS f
Exchange-Traded Funds - ETFs - describe
- issue shares trade on an exchange
- passive designed to track some asset class/index
- tend to stay very close to NAV
ETF vs. Index MF

· lower MER but · no brokerage costs but
brokerage costs higher MER
- one price
· sell/buy in open mkt. - continuous · sell/buy from fund
pricing daily
· shorting/margin · long only
· pay out dividends · reinvest dividends
tax adv.
LOS f
Separately Managed Account - SMA
- describe
(wrap account)
client IPS objectives & constraints
account
manages PM
$
non-pooled, client actually owns the assets

- more control over timing of cap. gains
- higher buy-in
Hedge Funds/ - absolute vs. relative return

- short-selling, leverage, derivatives
LOS f
Hedge Funds/ - minimal regulation, exempt
- describe
from most reporting requirements
- accredited investors only
- lock-up periods, redemption dates
- mgmt. fee + performance fee
may also have a hurdle rate +
high water mark
· Convertible Arbitrage
· Dedicated Short Bias · Fixed-Income Arbitrage
· Emerging Market · Global Macro
· Equity market neutral · Long/Short
· Event Driven
LOS f
Buyout and Venture Capital Funds/
- describe
- LBO funds buy public companies, restructure,
and re-IPO
- significant debt used
- VC - provides financing to start-ups
- both take active role in mgmt.
- exit is critical since all investments are illiquid.

Portfolio Risk and Return: Part I
a. calculate and interpret major return measures and describe their appropriate
uses;
b. compare the money-weighted and time-weighted rates of return and evaluate

the performance of portfolios based on these measures;
c. describe characteristics of the major asset classes that investors consider in

forming portfolios;
d. calculate and interpret the mean, variance, and covariance (or correlation) of
asset returns based on historical data;
e. explain risk aversion and its implications for portfolio selection;
f. calculate and interpret portfolio standard deviation;
g. describe the effect on a portfolio’s risk of investing in assets that are less
than perfectly correlated;
h. describe and interpret the minimum-variance and efficient frontiers of risky

assets and the global minimum-variance portfolio;
i. explain the selection of an optimal portfolio, given an investor’s utility (or

risk aversion) and the capital allocation line.
Return Measures
LOS a, b, c
- all financial assets have 2 common
- calculate
characteristics - interpret
an expected return - compare
uncertainty regarding that return - risk - describe
all financial assets can be described by risk & return
Return - typically derived from 2 sources income

cap. gains/losses
Holding Period Return
- cap. gains/losses
- div. yield
LOS a, b, c
Holding Period Return
- calculate
R1 R2 R3 - interpret
-
T0 T1 T2 T3 - compare
- describe
Arithmetic Mean
assumes -50% 35% 27%
no
-
T0 T1 T2 T3
compounding
$1 50¢ $1 $1.27
tells us only the
$1 $1.35
avg. return over a
given random 1-period
time frame
LOS a, b, c
Geometric Mean - calculate
- interpret
considers -50% 35% 27% - compare
compounding -
-
T0 T1 T2 T3 - describe
$1 50¢ 67.5¢ 85.725%

- represents growth over a given time period
or/
LOS a, b, c
Money-weighted Return (IRR) - calculate
11,557 - interpret
-50% 35% 27%
CF0 = -10,000 - compare
-
-
T0 T1 T2 T3 - describe
CF1 = -1,000
10,000 1,000 1,000
CF2 = -1000 =
( + )
CF3 = 11,557
11,557
-1.35%
350
CF0 = -100 1270
-50% 35% 27%
CF1 = -950 IRR = 26.108%
-
T0 T1 T2 T3
CF2 = 350
100 950 1270
CF3 = 1270
1350
· accurately reflects what a specific investor earned
but/ lacks comparability
Portfolio Return
time-weighted rr measures the compounded rate of

growth of $1 over the measurement
period.
P1 P2 P3 P4
-
HPR1 HPR2 HPR3 HPR4 etc… -
15% 6.67%
-
t =0 1 2
Return Measures
LOS a, b, c
e.g./
- calculate
Year AUM R - interpret
HPR
1 30M 15% - compare
2 45M -5% - describe
3 20M 10%
4 25M 15% Arithmetic
5 35M 3%
Geometric
22.75 36.05
mwrr 15% -5% 10% 15% 3%
IRR =
-
T0 T1 T2 T3 T4 T5
30M 34.5 20M 22
5.86%
CF0 = -30
10.5 -22.75 3
CF1 = -10.5
45 42.75 25 28.75
CF2 = 22.75
6.25
CF3 = -3 CF4 = -6.25 CF5 = 36.05
35
Annualized Returns/ LOS a, b, c

- calculate
- interpret
- compare
52
- describe
e.g./ .2% 1 week
.4% 15 days
14.2% 1½ yrs.
e.g. 2/
6.2% 100 days
2% 4 weeks . %
5% 3 mos.
LOS a, b, c
Portfolio Return/ weighted average of
- calculate
the individual returns - interpret
- compare
where - describe
inv.
Other Return Measures/

1) Gross and net returns
gross returns Total return - trading fees
basis for comparing manager
performance
smaller funds
disadvantaged
net return gross return - mgmt./admin. fees
here
what the investor earns
LOS a, b, c
Other Return Measures/ - calculate
Pre-tax & After-tax Nominal Return - interpret
- components of the gain matter - compare
s.t. - describe
cap. gains
l.t. pref. tax treatment
interest
income
dividends pref. tax treatment
Real Returns
nominal real risk- inflation risk

free premium premium
real ‘risky’ rate
LOS a, b, c
Other Return Measures/ - calculate
Leveraged Returns - interpret
- either by use of derivatives or margin - compare
- gains are magnified, as are losses - describe
- must also account for margin loan interest

e.g./
YR. AUM net R = 20% Calculate: real
1 30M 15% = 2% after-tax R5
2 45M -5%
3 20M 10%
4 25M 15%
5 35M 3% .39%
HPR = 42.35% = 7.6% = 7.32%
Measures of Risk
LOS d
Variance/ - a measure of the dispersion
- calculate
of returns - interpret
since we
typically don’t
know pop. parameters,
we use sample stats.
Standard Deviation/
LOS d
Variance of a Portfolio of Assets/ - calculate
· need the variance of each asset - interpret
+ the covariance of each asset with each other
variances & covariances are additive
var. of each covar. of each asset

asset with each other
port. var. = sum of all the vars. +

all the covars.
LOS d
Variance of a Portfolio of Assets/ - calculate
- interpret
variances + covariances
e.g./ 2 asset portfolio
…………………
and
LOS d
- calculate
S&P500 80% 9.93% 16.21% - interpret
MSCI 20% 18.20% 33.11%
RP = ? W1R1 + W2R2
= .8(.0993) + .2(.1820)
= 0.1158 or 11.58%
= ?
0
(.8)2(.1621)2 + (.2)2(.3311)2 + 2(.8)(.2)(.005)
(-1 +1)
.01682 + .00439 + .00160
= .02281
LOS d
Expected Return vs. Historical Return - calculate
- interpret
1 + E(R) = (1 + rf) x - based on actual
[1 + E( )] x results
[1 + E(RP)] - as a practical matter, we often
assume that historical mean return
is an adequate representation of
expected return
Other Investment Characteristics/
Skewness #
25 - Quant.
kurtosis
Risk Aversion
LOS e
Sure thing Gamble
- explain
$25 .5 $50
E(R) = $25
.5 $0
preferences 1) risk aversion

- take the sure thing
- max. return for a given level of
risk, and min. for a given level of
return
2) risk-seeking
- take the gamble
- get satisfaction from the uncertainty
3) risk neutral
- indifferent
- seek higher returns regardless of risk
LOS e
Risk Tolerance/ - level of risk willingly - explain
accepted to achieve investment goals
lower the level of
lower risk tolerance
acceptable risk
higher the risk aversion
Utility Theory/Indifference Curves/(microeconomics)
investors derive satisfaction (utility)

from particular choices (relative to others)
risk averse E(R) - expected return

A - a measure of risk aversion
i.e. marginal return required to
accept additional risk
LOS e
- explain
assumes/ · investors are generally risk averse but
prefer more return to less
· investors are able to rank different
portfolios based on their preferences
· preferences are internally consistent
Conclusions/ · utility is unbounded on both sides

(i.e. can be highly neg. or highly pos.)
· higher return results in higher utility
· higher risk results in lower utility
· the higher the value of A (higher risk aversion)
the higher the negative effect on utility
LOS e
> 0 risk-averse - explain
A = 0 risk-neutral
< 0 risk-seeking (ignorance)
Indifference Curves/ - plots the risk-return tradeoff

for a given level of utility
high
U - upward sloping - higher risk must
moderate U be accompanied by higher return
low U - curved (non-linear) - increasing slope

- required return increases at an
increasing rate
(diminishing marginal utility of wealth)
LOS e
high risk - explain
aversion moderate risk
aversion
low risk key assumption/ Investors
aversion are risk-averse
risk seeking
e.g./
Inv. E(R) A= 4 A= 2 A= 0
1 12% 30% -0.06 - RA .03 .12
2 15 35 -0.095 .0275 .15
3 21 40 -0.11 .05 - RA .21
4 24 45 -0.165 .0375 .24 - √
LOS e
- Let’s begin with 2 assets - explain
E(R) = rf
risk-free
= 0
E(Ri)
risky (market)
> 0
( ) Let w1 be the weight of the

) = 100%
( −
risk-free asset
= 100% then
& = +( − ) + ( − )
0 0
0
LOS e
- explain
capital allocation line
- represents the portfolios available
( ) to an investor
So, if the
= − + − − ( )
= − + × ( )
0 ( )−
+
[ ( )− ]
= +
slope
( )− market price
= + ×
of risk
LOS e
- explain
Indifference curves
+
l
b Capital allocation Line
m
Point: n - undesirable
n - move up to get
a higher return for the same risk
l - unattainable
b & a - indifferent (as with n)

0 m - higher than n, higher
point m optimal portfolio than b & a
for this investor
LOS e
- explain
A = 2 CAL
A = 4
k
j larger =
more risk averse
0
Portfolio Risk
LOS f, g
- calculate
- interpret
- describe
and
-1 to + 1
Correlation ( ) - determines the effect on portfolio
risk when 2 assets are combined
e.g./ Let = 1, then
weighted-average of the
individual risks
LOS f, g
now let < 1 - calculate
then - interpret
- describe
thus <
e.g./
1)
Rp = .5(.10) + .5(.1) = 10% Rp = 10% Rp = 10%
= (.5)2(.2)2 + (.5)2(.2)2 = (.5)2(.2)2 + (.5)2(.2)2 = .02 - .02 = 0
+ 2(.5)(.5)(1)(.2)(.2) = .04 = .02
LOS f, g
- calculate
- interpret
- describe
4 2
w1 = 0.676 P12 = 0.20
15 - %
RP = 9.588 Asset 1: R1 = 7%
= 0% = 12%
P12 = 1.0 Asset 2: R2 = 15%
10 - = 25%
P12 = 0.50 Plot points for:
P12 = -1.0 1 w1 = 0% w1 = 100%
5 -
& P12 = 1.0 P12 = .5
P12 = .2 P12 = -1
-
5 10 15 20 25
LOS f, g
Diversification/ - correlation is the key - calculate
- interpret
1) invest in a variety of asset
- describe
classes
stocks vs. bonds vs. cash vs. real assets
energy large cap corp.
vs. vs. vs.
pharma small cap gov’t.
2) use index ETFs - minimizes costs of diversification
3) diversity across countries

- exposure to different industries
- different phases of the business cycle
4) don’t own employer’s stock

- pension plan should not own sponsor’s
stock as well
Diversification/ - correlation is the key LOS f, g

- calculate
5) add if the risk-adjusted - interpret
return benefits the portfolio - describe
Sharpe ratio
6) Buy insurance
- buying put options
Minimum Variance Portfolio

LOS h, i
Recall, Z D - Markowitz
- describe
- efficient - interpret
D
Asset 2 frontier - explain
X A
P12 = 1.0 -
Asset 1 B
minimum-variance
- Z
frontier
Points C, A & D:
(risky assets
minimum-variance C only)
portfolio for a given
return
-
0
Point z: global minimum-variance
portfolio
LOS h, i
Adding a risk-free asset/
the optimal
- describe
y CAL(P) CAL
- interpret
- explain
· for every point on CAL(A),
x there is a point on CAL(P)
p
with higher E(RP) for the
Z same
CAL(A)
A Note/ · P dominates Z
Minimum Variance Frontier · Y dominates X
of risky assets
achieved by leveraging
Portfolio (P)
0
LOS h, i
The Two-Fund Separation Theorem/ - describe
- all investors, regardless of taste, risk - interpret
preferences, or wealth, will hold a combination of - explain
2 portfolios, a risk-free asset and a risky portfolio
The Investment Decision/

CAL - identify the optimal risky
portfolio w/o regard to investor
preferences
Markowitz
efficient CAL - linear combination of the
frontier risk-free asset and the risky asset
The Financing Decision/
- lending or borrowing
Comprehensive Problem
Asset E(Ri)
A 20% 50% P12 = 0
B 15% 33%
1. w1 = 10% (1 - w1) = 90%
E(Rrp) = (.1)(.2) + (.9)(.15) = 0.155 or 15.5%
or 30.12%
25 -
20 -
15 -
10 -
5-
10 20 30 40 50 60
-
Asset E(Ri)
A 20% 50% P12 = 0 Introduce rf = 3.0% = 0
B 15% 33% CAL = ?
CAL
25 -
20 -
15 -
10 -
5-
rf
10 20 30 40 50 60
-
-
Asset E(Ri)
A 20% 50% P12 = 0 What is if = 20%
B 15% 33%
.20 = .03 + .4978
= 34.2%
CAL
25 - vs. 50% A
A
20 -
B
15 -
at U(A = 2.5)
10 - 3% 0 .03
9% 12.1 .0717
5- 15% 24.1 .0774
20% 34.2 .0546
-
10 20 30 40 50 60
Q1: What about short selling?

e.g./ E(R)
A 12% $10k
B 20% $25k
C -40% -$20k
$15k
Q: How do you find w1 & w2 in the global min.-var. port.?

A B
E(R) .015 0.02
.05 .06
.224 .245
Q: How do you find w1 & w2 in the global min.-var. port.?

A B
E(R) .015 0.02
.05 .06
.224 .245
set = 0 and solve for w1
But/ only if = .5
= 59.07 and volatility does not
change
Q: Are any stocks negatively correlated with any others?
Typically - no! (Rare)
but a short sale can easily solve the problem.
Q: Won’t become difficult as n increases?
Yes i.e/ n = 50 requires 50

+ 1225
rather than comparing securities
with each other, we compare them with
a benchmark. A
benchmark
only 50 s B
Portfolio Risk and Return: Part II
a. describe the implications of combining a risk-free asset with a portfolio of

risky assets;
b. explain the capital allocation line (CAL) and the capital market line (CML);
c. explain systematic and nonsystematic risk, including why an investor should

not expect to receive additional return for bearing nonsystematic risk;
d. explain return generating models (including the market model) and their
uses;
e. calculate and interpret beta;
f. explain the capital asset pricing model (CAPM), including its assumptions,
and the security market line (SML);
g. calculate and interpret the expected return of an asset using the CAPM;
h. describe and demonstrate applications of the CAPM and the SML;
i. calculate and interpret the Sharpe ratio, Treynor ratio, M2, and Jensen’s
alpha.
CAL/CML
ID1 LOS a, b
E(Rp) - describe
CAL(C) - explain
A = 2 y
ID1 A, B, C portfolios of
C CAL(B) risky assets (lie on
A = 4 x the Markowitz efficient
B frontier)
CAL(A)
E(RA) CAL(C) - optimal CAL
rf A
x - lending portfolio
y - borrowing portfolio
0
LOS a, b
E(Rp) - describe
- explain
CAL(C)
y
C CAL(B)
x
B CAL(A)
A
rf
LOS a, b
- homogeneity of expectations - describe
- explain
- all investors have the same economic
expectations (i.e. the same expectations regarding the
risk-return distribution for each asset) E(Ri)
only 1 optimal risky portfolio
- if expectations are not homogenous, multiple optimal

risky portfolios
- assume markets are informationally efficient
- no excess return to active investing
- if not, then active investing may deliver excess return
LOS a, b
E(Rp) E(Rp)
- describe
- explain
CAL(C) y CAL(B)
y
CAL(B)
C B
CAL(C)
x x C
B CAL(A)
CAL(A)
A A
rf rf
LOS a, b
- homogeneity of expectations - describe
- all investors have the same economic - explain
expectations (i.e. the same expectations regarding the

risk-return distribution for each asset)
- if expectations are not homogenous, multiple optimal

risky portfolios
×# .
- assume markets are informationally efficient
- no excess return to active investing
- if not, then active investing may deliver excess return
LOS a, b
Market/ - typically includes all assets
- describe
that are investable and tradable - explain
- usually limited to a country’s major equity index
E(Rp)
CML a CAL where the risky
portfolio is the market
portfolio.
(i.e. M - optimal risky
*
*
M * * * asset portfolio given
* * individual
* * * homogenous expectations)
securities
rf
Slope market price of risk

LOS a, b
CML - describe
E(Rp) - explain
e.g./ rf = 5% Rm = 15% = 20%
Rm
M
- every unit of delivers
.5 units of on the CML
rf
w1 w2 E(Rp)
100 0 5% 0
75 25 7.5% 5%
50 50 10% 10%
25 75 12.5% 15%
0 100 15% 20%
LOS a, b
- describe
E(Rp) - explain
CML
e.g./ rf = 5% Rm = 15% = 20%
Leverage @ 25%, 50%, 100%
25%/ w1 = -25% w2 = 125%

Rm M w2 = 100%
rf w1 = 100% 50%/ w1 = -.5 w2 = 1.5
100%/ w1 = -1 w2 = 2
LOS a, b
E(Rp) lend @ rf = 5% - describe
borrow @ rb = 7% - explain
Rm M w2 = 100%
( )− e.g. borrow 75% w1 = -.75

+ ×
rf w1 = 100% w2 = 1.75
vs./
Nonsystematic Risk
LOS c
- explain
nonsystematic risk
· diversifiable - pertains to a
single company or industry
a portfolio of assets that

are not highly correlated with
each other
15 - 20 systematic risk
· nondiversifiable
· market risk
-
-
-
-
-
-
-
# of
-
Total variance
= nonsys. var. + sys. var. securities - affects the entire
market or economy
50 e.g./ interest rates, inflation,
economic cycles, geopolitical uncertainty
LOS c
· assume we receive a return for both - explain
systematic & nonsystematic risk
since this is diversifiable, we would

buy assets with large amounts of
nonsystematic risk, then diversify it away
get paid for risk we can avoid
- so would all investors

end result/ demand for diversifiable risk would increase,
driving up the price of asseti, thereby reducing
potential return
no incremental reward can be earned for taking

diversifiable risk
LOS c
· Describe the sys. & nonsys. risk of:
- explain
1. 3 mos. T-Bill
2. S&P500 with = 20%
15% sys.
· 2 assets , A - total risk = 30%
15% nonsys.
B - total risk = 17% - all sys.
Which asset should have the higher expected return?
Capital Market Theory the market will expect a higher

return on the investment that has a higher
level of systematic risk, regardless of total risk
(nonsystematic risk is not rewarded by an efficient
market)
Return Generating Models

LOS d
So… 1) nonsystematic risk can be avoided - explain
and is therefore not rewarded
2) securities are priced to reward systematic

risk only
3) securities with more systematic risk should

offer a higher return
Constructing an Optimal Portfolio/
market portfolio all available assets

- requires all correlations
1000 return estimates
1000 assets 1000 s.d.
499,500 correlations
LOS d
Alternative/ Begin with a known portfolio - explain
i.e./ equity index SnP500
- measure E(Rn) & using historical data
benchmark for sys. risk
- compare a security’s Ri to Rm using linear regression
So… if we only get rewarded

based on sys. risk, we need
gives us an estimate of the some way of determining what
security’s systemic risk E(Ri) should be
LOS d
- a model that can provide an estimate - explain
of E(Ri) growth
macroeconomic interest rates, etc…
multi-factor model/
fundamental earnings
statistical cash flows, etc…
k factors
excess - factor weights
return
- in a regression, the
excess market inclusion of
Note/ financial will ‘absorb’ variance
return
research finds little from other factors
evidence that the 2nd term
is very useful
LOS d
Single-Index Model/
single factor linear model - explain
E(Rp)
2nd term
CML
is dropped
rf
LOS d
- explain
not
rewarded
for
CAPM
LOS d
single factor model - explain
e.g./ WMT vs. SnP500

daily returns
= .0001 = .9
now move from expectations RWMT = .0001 + .9Rm + ΣWMT
to actual values if Rm = 1% today & RWMT = 2%
find RWMT due to nonsys.
Ri = + market
risk.
model
& can now be
.02 - ( − )
estimated using historical .02 - (.0001 + .9(.01))
security market returns = .0109 or 1.09%
Review
LOS e
E(R) - calculate
- interpret
CML
100% in Securityi with the

highest E(R)
M - mkt. portfolio
if
Markowitz/
100% in the
- require
rf global minimum-variance
1) security
portfolio
universe
includes all possible
constant investments
greater the #
Cov(rf,Rm) = 0 2) covariance
of securities in the
matrix between all
portfolio
possible combinations
Preview
E(R)
Security Market Line
M - market portfolio
(1,E(Rm))
So… given any ,
we can estimate
rf
0 1.0
both rf & E(Rm) change as economic conditions change
slope of SML market price of risk
eta
LOS e
- calculate
- interpret
- a measure of systematic
risk would be Cov(Ri,Rm)
Recall/ factor loading

in the single index
model
LOS e
- calculate
- interpret
contains an adjustment for
- a measure of how sensitive an asset’s return is

to the market as a whole
- captures an asset’s systematic risk
avg. of stocks in the market must

also be 1
- most have
e.g./ = 25%, find
1) 30-day T-Bill 2) Gold, = 25% = 0 3. = 60% = -0.1
4) = 40% = 0.7
LOS e
So… we can calculate if we have
- calculate
an estimate of - interpret
an estimate of
a value of
- more practical way/ calculate directly by using the

market model
regression
analysis
Q: over what
time frame?
LOS e
e.g. 1/ - calculate
Before After - interpret
Pre Post
e.g. 2/ = 3% = 10% = 1.5
What if drops to 1.1?

CAPM & SML

LOS f
CAPM/ single-index model - explain
Assumptions/ utility maximizing

1. Investors are risk-averse
rational
frictionless + borrowing &
2. Markets are no transaction costs lending at rf
no taxes
3. All investors have the same single-period
investment horizon
LOS f
CAPM/ single-index model - explain
Assumptions/
4. Investors have homogeneous expectations
- therefore arrive at the same
valuation for any given asset
5. All investments are infinitely divisible

i.e. can invest as little or as
much as an investor wants
6. Investors are price takers

- no investor is large enough to
influence prices
LOS f
E(R) - explain
SML
CAL & CML

- applied only to
efficient portfolios
rf
SML
- extends to both
individual securities
1 and inefficient
portfolios
(since captures only
systematic risk)
LOS f
e.g./
w Asset - explain
20% 30-day T-Bill @ 4%

30% SnP500 with E(Rm) = 16%
50% U.S. stock with = 2.0
Proof/
= ?
= ?
CAPM
LOS g
e.g./ P0 = 20.07 = 1.15
- calculate
D0 = $1.22 30-day T-Bill rate = 2.1% - interpret
g = 6.1% ERP = 8.4%
Buy - Hold - Sell? 5% threshold
- since we only get

paid for systematic
risk, E(R) = required
rate of return
Sell @ P0 Buy @ P0
-5% +5%
×
-
19.07 P0 21.07
Hold
Applications of CAPM
LOS h
Estimate of E(Ri) - LOS g - describe
e.g./ Rm = 12% rf = 2% - demonstrate
YR. CF Project = 2.3
1 -500M NPV = ?
2 -200M
.5 -100 + 500
200 200 200 500
3
.5 0
-
1 2 3 4 5 6
.5 400 500 200
4 .5 0
.5 400 − −
= + + + +
5 .5 . ( . ) ( . ) ( . ) ( . )
0
.5 400 + 600 = -147.07 M +
( . )
6
.5 0
LOS i
2) Portfolio Performance Evaluation - calculate
- interpret
total risk = sys. + non-sys. just the systematic

risk
Jensen’s alpha
excess excess
return on actual what the
return on
Portfolio P the market return return should
have been
.
=
.+ − .
LOS i
- interpret
Mgr. R E(R)
X 10% 20% 1.1 X .03 + 1.1(.09 - .03) = 9.6%
Y 11 10 .7 Y .03 + .7(.09 - .03) = 7.2%
Z 12 25 .6 Z .03 + .6(.09 - .03) = 6.6%
Sharpe Ratio: Treynor ratio:
X X
Y Y
Z Z
M M
LOS i
- all portfolios - calculate
E(R) E(R) - interpret
(.36) (0.15)
z z SML
12% - CML 12% - (.064)
- y (.80) - y x
-- x (.35) - (.114)
9% -
M (0.32) 9% - M (0.06)
- -
rf rf
=
-
-
-
-
-
10% 19% 25% .6 1 1.1
efficient portfolios only all securities
LOS i
- interpret
Mgr. R E(R)
X 10% 20% 1.1 X .03 + 1.1(.09 - .03) = 9.6%
Y 11 10 .7 Y .03 + 0.7(.09 - .03) = 7.2%
Z 12 25 .6 Z .03 + 0.6(.09 - .03) = 6.6%
Jensen’s
X (. −. ). . − (. −. )=. % X . − [. + . (. )] = . %
Y (. −. ). . − (. −. )= . % Y . − [. +. (. )] = . %
Z . − [. +. (. )] = . %
Z (. −. ). . − (. −. )= . %
M . − . + [. ] =
M (. −. ). . − (. −. )= %
LOS i
- interpret
Mgr. R E(R)
X 10% 20% 1.1 X .03 + 1.1(.09 - .03) = 9.6%
Y 11 10 .7 Y .03 + 0.7(.09 - .03) = 7.2%
Z 12 25 .6 Z .03 + 0.6(.09 - .03) = 6.6%
Total Risk Systematic only

Sharpe Treynor Jensen
1 Y Y Z Z
2 Z Z Y Y
3 X X X X
4 M M M M
for anything for fully diversified portfolios
only
LOS i
3) Security Selection - heterogeneous - calculate
Ri expectations - interpret
undervalued
SML
A1
M all securities that reflect the
B1 C consensus view
B
RA < C1
A overvalued - differences in beliefs can
relate to future cash flows
<
systematic risk
of the security
-
-
both
priced on the SML

- the return it should offer
(required return)
LOS i
4) Security Characteristic Line/ - calculate
− - interpret
rearrange terms
excess excess
return on return on
the market
Jensen’s
− - select/overweight
securities with > 0
- deselect/underweight/short
securities with < 0
Basics of Portfolio Planning and Construction
a. describe the reasons for a written investment policy statement (IPS);
b. describe the major components of an IPS;
c. describe risk and return objectives and how they may be developed for a
client;
d. explain the difference between the willingness and the ability (capacity) to
take risk in analyzing an investor’s financial risk tolerance;
e. describe the investment constraints of liquidity, time horizon, tax concerns,

legal and regulatory factors, and unique circumstances and their implications
for the choice of portfolio assets;
f. explain the specification of asset classes in relation to asset allocation;
g. describe the principles of portfolio construction and the role of asset

allocation in relation to the IPS;
h. describe how environment, social, and governance (ESG) considerations

may be integrated into portfolio planning and construction.
IPS
LOS a
Portfolio Portfolio
- describe
Planning Construction
IPS - starting point of the planning process

- a plan for investment success
achieving goals
willingness within constraints
risk
tolerance objectives
Client (E(R), )
wealth
ability IPS
constraints
income
liquidity time
responsibilities
taxes
…etc
LOS a
helps investor decide on realistic - describe
investment goals (manage expectations)
creates a standard to measure performance
guides actions of port. mgr. (assess suitability of

particular investments)
Institutional IPS/ · governance arrangements

- appointing/reviewing port. mgr.
- mgr. discretion
IPS should be reviewed & updated regularly

- since client circumstances change over time
IPS Components
LOS b
Introduction - describes the client
- describe
Statement of Purpose
Statement of Duties and Responsibilities - of the client,

the custodian, and the inv. mgr.
Procedures - steps required to keep the IPS up to date

- procedures to follow to respond to contingencies
Investment Objectives the heart of

Investment Constraints the IPS
LOS b
Investment Guidelines - how the policy - describe
should be executed (leverage, derivatives) and
specific asset types that must be excluded
(i.e. no gun maker, no alcohol/gambling)
Execution and Review - feedback on investment results
Appendices A) Strategic Asset Allocation (SAA)

dynamic
B) Rebalancing Policy
tactical
Risk/Return Objectives
LOS c, d
Portfolio Risk Risk Tolerance - describe
- distinguish
ability willingness
lower of the
two
Risk Objectives Absolute - capital preservation such
as a maximum loss in any
12-month period
operationalize select risk level such that
a 95% probability exists that the
fund will not suffer a loss > 4% in
any given 12-month period
Relative - relates risk to a benchmark

(tracking error)
LOS c, d
Institution risk objective may be - describe
- distinguish
tied to some future liability (i.e. pension plans)
Risk Tolerance/ a function of ability & willingness
time horizon disposition

explain the conflict & financial
income
above avg. implications wealth understanding
high risk high risk
tolerance tolerance
ability
low risk low risk
talk the client “down”
tolerance tolerance
below avg. willingness above avg.

LOS c, d
Return Objectives/ - must be realistic - describe
- distinguish
Absolute i.e. X% (required rate of return)
Relative vs. benchmark

- can be stated on a pre or post - fee basis
- tax basis
- inflation basis
Constraints
LOS e
1) Liquidity - redemption/withdrawal requirements
- describe
- need to have readily convertible investments
to cash at a price close to fair value
2) Time Horizon - shorter time horizon, more difficult it

is to overcome losses
3) Tax Concerns - registered - not a consideration

non-registered - income vs. dividends
s.t.
vs. cap. gains
l.t.
4) Legal/Regulatory
i.e. self-investment limits for pension
plans w.r.t. the sponsor
5) Unique Considerations - restricted assets, holding requirements,

concentration restrictions
Asset Allocation
LOS f, g
Strategic Asset Allocation
- explain
- % allocated to each asset class - describe
in order to achieve the a category of assets
client’s objectives that have similar
characteristics & risk-return
relationships
- allocation across asset classes
tends to be the primary driver of returns
(i.e. exposure to the systematic risk factors
that drive the class)
being in the right asset class at
the right time
- Capital Market Expectations
LOS f, g
Asset Class Sub-classes - explain
comm. pap. - describe
Cash
T-Bills
diversification
Equities large cap domestic benefits
small cap international across
domestic asset
government
Fixed-Income foreign classes
corporate
inv. grade vs. non-inv. · low
Real Estate residential
commercial
Alternative Inv.
- similar E(R) & within each
mutually exclusive
& exhaustive class
- high within
LOS f, g
Steps towards an actual portfolio/ - explain
1. Risk Budgeting dividing the - describe
desired level of portfolio risk (determined

in the IPS) across the different asset classes
passive (the SAA)
Core- 2. Tactical Asset Allocation - intentional deviations

satellite from the SAA in the short-term
approach 3. Security selection - within the asset class
active 4. Portfolio rebalancing - correct drift from the
SAA due to income & price changes
ESG Considerations
LOS h
- describe
· unique
circumstances
· constraints
ESG in portfolio planning security selection appropriate data may not be

available
screening strategy best-in-class
exclusionary
Implementation finding thematic PMs
investments are selected on their potential to positively
impact ESG issues (typically negative impact on returns)
The Behavioral Biases of Individuals
a. compare and contrast cognitive errors and emotional biases;
b. discuss commonly recognized behavioural biases and their implications for

financial decision making;
c. describe how behavioral biases if investors can lead to market characteristics

that may not be explained by traditional finance.
The Behavioral Biases of Individuals
LOS a (½p) Categorization of Behavioral Biases - compare, contrast
LOS b Cognitive Errors/Emotional Biases - discuss
conservatism loss aversion

confirmation overconfidence
5.5p representativeness self control
9p
illusion on control status quo
hindsight endowment
anchoring/adjustment regret aversion
mental accounting
7p
framing
availability
LOS c (4p) How Influences Market Behavior - describe
Page 1
Cognitive errors - biases based on faulty cognitive reasoning LOS a
- compare
- more easily corrected than emotional biases
- contrast
better information, education, advice
Emotional biases - our reasoning is influenced by feelings or emotions

- stem from impulse or intuition
- best adapted to (decisions are made that recognize
and adjust for these biases)
LOS b
1/ Belief perseverance biases - tendency to cling to prior
- discuss
beliefs by committing statistical, information-
processing or memory errors
- related to cognitive dissonance - new information conflicts with

previously held beliefs
- people may a) modify conflicting information

b) consider only confirming information
Page 2
a) Conservatism bias/ maintain prior views or forecasts by LOS b
inadequately incorporating new, conflicting information - discuss
- overweight prior probability of an event
- underweight new information (underreact)
Consequences: maintain or be slow to update a view or forecast,

even when presented with new information
maintain a prior belief rather than dealing with
the mental stress of updating beliefs
Detection/Guidance: properly analyzing and weighting new information

- if information is cognitively costly (difficult to
understand), seek advice from experts
b) Confirmation bias/ people tend to look for and notice what confirms
their beliefs and ignore or undervalue what contradicts
their beliefs
Page 3
b) Confirmation bias/ LOS b
Consequences: consider only positive information - discuss
about an existing investment and ignore any
negative info.
develop screening criteria and ignore information that

refutes the validity of the criteria
under-diversify portfolios (hold on to stocks too long
waiting for them to recover, or add to losing positions)
hold a disproportionate share of assets in their company’s
stock
Detection/Guidance: actively seek out information that
challenges existing beliefs
- get corroborating support
c) Representative bias/ tendency to classify new information based on

past experiences and classifications
(e.g. stereotyping)
Page 4
c) Representative bias/
LOS b
types: i) base-rate neglect - categorization - discuss
without considering the probability
ii) sample-size neglect - assume small samples
are representative of populations
Consequences: adopt a view or forecast based almost exclusively

on individual, specific information or a small sample
update beliefs based on simple classifications
rather than deal with mental stress of updating beliefs
Detection/Guidance: - be aware of statistical mistakes

- think about the probability before classification
- be sensitive to sample sizes
d) Illusion of control bias/ people tend to believe they can control

or influence outcomes when, if fact, they cannot
Page 5
d) Illusion of control bias/ LOS b
Consequences inadequately diversify portfolios (hold - discuss
concentrated positions in company stock)
trade more than is prudent
construct financial models and forecasts that are overly

detailed (belief that forecasts control uncertainty)
Detection/Guidance: understand that investment is probabilistic - you cannot

control the market
- seek contrary viewpoints
e) Hindsight bias/ seeing past events as having been predictable and

reasonable to expect
- tend to remember our own predictions as having been more
accurate
Consequences: overestimate the degree to which a prediction was accurate
(leads to overconfidence)
unfairly assess the performance of others - assess what
happened instead of the expectation of what would happen
Page 6
e) Hindsight bias/ LOS b
Detection/Guidance: understand why investments did or did - discuss
not work vs. what was originally thought
- keep a log
2/ Processing Errors/ information being processed and used illogically/irrationally

a) Anchoring and adjustment bias/ when required to estimate a value with
unknown magnitude, people generally begin by envisioning
some initial default number (the anchor) which they
adjust up or down to reflect subsequent information and analysis
- the adjustment is usually insufficient (too much weight on
the anchor)
Consequences: stick too closely to original estimates
of value
- hold investments too long or sell too early
Detection/Guidance: awareness
Page 7
b) Mental accounting bias/ mentally dividing money into LOS b
accounts that influence decisions - discuss
- will treat one sum of money differently that another
equal-sized sum based on which mental account the money
is assigned to
- investors construct portfolios in a layered pyramid format
with each layer addressing a specific financial goal
Consequences: neglect opportunities to reduce risk by combining assets

with low correlations (inefficient risk/return portfolios)
neglecting total return and focusing on income at the
expense of capital gains
safe with principal, risk with returns - suboptimal levels of
risk
Detection/Guidance: awareness
- take a traditional portfolio approach - asset allocation
across all assets, asset location decisions after
Page 8
c) Framing bias/ a person responds differently based on LOS b
how a problem is framed - discuss
- narrow framing - focusing on one or two specific points
at the expense of the whole
Consequences: misidentify risk tolerances - become more risk-averse

when presented with a gain frame and more risk-seeking
when presented with a loss frame
focus on short-term price fluctuations, overweight volatility
as a measure of risk
Detection/Guidance/ reframe the problem

focus on future expectations, not current gains/losses
d) Availability bias/ estimate probability based on how easily something

comes to mind
Page 9
d) Availability bias/ easily recalled outcomes are perceived as LOS b
more likely - discuss
i) Retrievability - an answer or idea that comes to mind

more quickly will likely be chosen as correct
ii) Categorization - of you can’t name an instance of something,
you may conclude that the category is small
iii) Narrow range of experience - generalizing based on your
experience, or lack of experience
iv) Resonance - biased by how closely a situation parallels their
own personal situation
Consequences: limit the investment opportunity set (traditional investments

in domestic markets)
select investments/advisors based on current awareness only
fail to diversify
Page 10
d) Availability bias/ LOS b
Detection/Guidance: develop an appropriate investment - discuss
policy strategy, research investment options
3/ Emotional Biases/ may only be possible to recognize and adapt to it

rather than correct for it
a) Loss-Aversion bias/ people tend to strongly prefer avoiding losses as

opposed to achieving gains (losses are significantly
more powerful, emotionally, than gains)
risk aversion leads to the disposition effect

in gains - selling winners too soon
losses and holding loser too long
risk-seeking gains
in losses
Utility
Page 11
a) Loss-Aversion bias/ LOS b
Consequences: hold investments in a loss position longer - discuss
than justified by the fundamentals in hopes they will
break even
sell investments in gain positions out of
hold riskier
fear they will give back trade
portfolios
excessively
Detection/Guidance: discipline, rules, investment policy statement
b) Overconfidence bias/ people demonstrate unwarranted faith in their own

abilities, reasoning, and judgement
- intensified by self-attribution bias - take credit for successes
assign responsibility for failures (self-enhancing)
(self-protecting)
Prediction overconfidence - incorporating too little variation in

predictions (narrow confidence intervals)
- tend to underestimate downside risk
Page 12
b) Overconfidence bias/ LOS b
- discuss
Certainty overconfidence: probabilities assigned to outcomes
tend to be too high
Consequences underestimate risks and overestimate expected returns

hold poorly diversified portfolios (significant downside risk)
Detection/Guidance: keep a record of all trades/outcomes - review past

performance, calculate portfolio return
- conduct post-investment analysis on both winners and losers
c) Self-control bias/ people fail to act in pursuit of their long-term goals

in favour of short-term satisfaction
- may be a lack of self-control (e.g. saving vs. spending)
- may be a function of hyperbolic discounting - preferring small
payoffs now compared with larger payoffs in the future
Page 13
LOS b
c) Self-control bias/ - discuss
Consequences: save insufficiently for the future which
may result in accepting too much risk in portfolios
in an attempt to generate return
borrow excessively to finance present consumption
Detection/Guidance: proper investment plan + personal budget

(all in writing)
- maintain an optimized strategic asset allocation
d) Status-quo bias/ people choose to do nothing instead of making a change

even when change in warranted
- positions are maintained largely because of inertia rather than
conscious choice
(vs. endowment or regret-aversion biases
in which positions are maintained because of conscious, but
possibly incorrect, choices)
Page 14
d) Status-quo bias/ LOS b
Consequences: unknowingly maintain portfolios with - discuss
inappropriate risk characteristics

fail to explore other opportunities
Detection/Guidance: education is essential - quantify the risk-reducing

and return-enhancing advantages of proper diversification
and proper asset allocation
e) Endowment bias/ people value an asset more when they own it versus
when they do not own it (ownership endows the asset with
added value)
Consequences: fail to sell certain assets and replace
them with others
continue to hold classes of assets with which they are
(may believe they understand the characteristics familiar
of investments owned better than those not owned)
Page 15
e) Endowment bias/
LOS b
Consequences: may maintain an inappropriate asset - discuss
allocation
Detection/Guidance: reframe the problem
‘Would you buy the current portfolio at your asking price?’
‘If you had cash instead, would you buy the same assets
as was given to you?’
f) Regret-aversion bias/ people tend to avoid making decisions that will

result in an outcome out of fear that the decision will
turn our poorly
error of omission - regret from an action not taken

error of commission - regret from an action taken
Consequences: too conservative in investment choices as a result of

past poor outcomes - can lead to long-term underperformance
Page 16
f) Regret-aversion bias/ LOS b
Consequences: engage in herding behavior - stay with - discuss
what is popular (choosing stocks of less-familiar

companies may be perceived as risker)
Detection/Guidance: quantify the risk-reducing and return-enhancing

advantages of diversification and proper asset allocation
- recognize that losses happen to everyone
LOS c
Market Anomalies: deviations from market efficiency
- describe
- persistent abnormal returns that differ from
zero and are predictable in direction
- not attributable to 1/ choice of asset pricing model

2/ statistical issues (small samples, data mining)
3/ temporary disequilibria
Market Anomalies: Page 17

LOS c
1/ Momentum (trending effects) - future price behavior
- describe
correlates with that of the recent past
- typically lasts for up to 2 years before showing a reversal
availability - reasoning is based on recent experience (recency

effect)
- if prices have been rising, expectations
of future increases arise
hindsight bias - reduce regret of missing out by buying past winners
2/ Bubbles and Crashes

overconfidence (overtrading, underestimation of risk, failure to
diversify, rejection of contradictory information)
confirmation and self-attribution bias - selling winners confirms
the success of their strategy
regret aversion - the fear of missing out
Page 18
Market Anomalies: LOS c
2/ Bubbles and Crashes - describe
anchoring - early stages of the crash - pullbacks
still seen as opportunities to continue to add
- investors eventually capitulate when the losses
become too large
3/ Value - value tends to outperform growth

(low PE, high , low .)
halo effect - extending a favourable
evaluation of one characteristic to another
e.g.: good growth record = good investment
- potentially leading growth stocks to be overvalued
Introduction to Risk Management
a. define risk management;
b. describe features of a risk management framework;
c. define risk governance and describe elements of effective risk governance;
d. explain how risk tolerance affects risk management;
e. describe risk budgeting and its role in risk governance;
f. identify financial and non-financial sources of risk and describe how they
may interact;
g. describe methods for measuring and modifying risk exposures and factors to
consider in choosing among the methods.
Risk Management
LOS a
Risk/ · the effect of uncertainty in pos. - define
objectives
neg.
(a deviation from
expectations)
· eliminating all risk

opportunity is undesirable
risk · may prevent the
erosion of value
but/ · also prevents value

- a measure of creation
uncertainty, volatility, risk
· risk of an event, risk of a consequence

P(E) P(A|E)
LOS a
Risk Exposure/ · how much risk are we - define
currently taking
acceptable, planned unacceptable, unplanned
e.g./ Long 1 zc for Sep. 16 @ $3.60 - USD contract

CAD funds
· acceptable risk - price USD CAD = 1.2650
· unacceptable risk - currency
Risk Exposure - price & forex Risk Appetite - price
Risk Management - forex hedge

LOS a
Risk Management/ · the process by which - define
the level of risk that should be taken is
compared to the level of risk that is actually
being taken and brings the two into congruence
planned &
unplanned Current Target acceptable levels
risks Risk Risk of risk only
Exposure Exposure
Risk Management not about minimizing

not about predicting
risk, it’s about taking
risk, but being prepared
acceptable risk
for unplanned risks
LOS a
Risk Management/ · does not prevent losses - define
(but those losses should be acceptable losses)
4 main elements
Identification current
risk
Assessment rooted in probability
exposure
Mitigation
towards target
Monitoring risk exposure
Risk Mgmt. Framework

LOS b
- a formal way to respond to risk
- describe
the infrastructure, processes, and analytics required
to support the RM function
covers/ · risk governance

· risk identification & measurement
· risk infrastructure
(ISO 31000)
- codified
· defined policies & processes
standards · risk monitoring, mitigation, and management
for RM · communications
· strategic analysis or integration
LOS b
Risk governance/ - describe
· Board of Directors Risk Mgmt. Committee

defines ‘Risk Appetite’ in
alignment with goals
(enterprise risk mgmt.)
Risk identification and measurement/

- ongoing process of identifying risk exposures,
calculating risk metrics (i.e. the probabilities
of the possibilities), and scanning for potential
risk drivers
any factor that gives rise to a risk that

is relevant
LOS b
Risk Infrastructure/ - describe
- people, systems, technology required to
track risk exposures databases, models
- process of risk capture (i.e. historical data)
Policies & Processes/

- translate risk governance into day-to-day
operations and procedures
if X, then Y by doing Z (mitigate how)
check W every Q hours/days etc… (updating)
Do A every B units of time (backing up)
LOS b
Monitoring, Mitigating, Management/ - describe
- risks evolve, come and go
Communications/ · governance parameters down

· risk metrics up
· risk issues reviewed/discussed
· feedback loop to governance body
so parameters can evolve
Strategic analysis/integration/
· governance body defines goals of
organization and determines its risk
tolerance
LOS b
Strategic analysis/integration/
- describe
· management executes goals & provides
a risk mgmt. framework
· risks identified and measured
may lead then monitored

to modifications then mitigated if outside
to risk exposures acceptable parameters
may lead to
a change in
allocation of capital
LOS b
Benefits/
- describe
- lower probability of being surprised
by an event
- less defense, fewer errors
- more discipline, better consideration of the

risk-return tradeoffs
- faster response, smaller losses

Risk Governance
LOS c
top-down process and guidance from
- define
the Board keeps mgmt. actions and - describe
organ. goals in alignment
· determines organ.’s goals/priorities
· determines organ.’s risk appetite & tolerance
what risks are acceptable

what risks need to be mitigated
what risks are unacceptable
· risk mgmt. oversight
LOS c
Desirable Properties/
- define
· should provide a sense of the worst - describe
loss that can be managed
· clear guidance balanced with execution flexibility
· focus should be on ‘enterprise risk mgmt.’
objectives, health and value of

the whole
e.g./ should a pension fund hold
shares of the sponsor’s stock?
- all employees have exposure to the company as a
result of employment
· risk management committee ~ (audit)

· chief risk officer (CRO)
Risk Tolerance
LOS d
the extent to which the entity is - explain
willing to experience losses or opportunity costs and
fail to meet its objectives
defines the entities risk appetite
· Internal factors/ - shortfalls within the organization

that would cause it to fail to achieve
critical goals
i.e. liquidity, experience
· External factors/ environmental forces
i.e. forex, interest rates
hedge
LOS d
- once internal & external factors identified, - explain
define dimensions of risk they are unwilling to
accept
- factors that affect risk tolerance (i.e. higher)
· stronger competitive position
· greater the loss that can be sustained
· greater response agility (speed, expertise, flexibility)
· should ignore/
· personal motivations
· beliefs
Risk Budgeting
LOS e
Risk Tolerance
- describe
· acceptable quantifying and allocating
vs. tolerable risks to various Risk
unacceptable activities/investments Budgeting
· Single-dimensional risk measures

/$ delete add.
s.d., , VaR (marginal, component, incremental, relative)
· multi-dimensional risk approaches

· portfolio margining (risk is evaluated based on the
risk profiles of the underlying classes)
i.e. Risk Budgeting - portfolio weights based on security

risk contribution
Capital Budgeting - portfolio weights based on security

return contribution
Sources of Risk
LOS f
Financial/ Market Risk
- identify
- changes in interest rates, stock prices, forex,
commodity prices
drivers fundamental economic

conditions, industry or company events
Credit Risk (default/counterparty)

- when one party fails to pay or perform
an obligation
drivers economic weakness, drops in

demand
LOS f
Financial/ Liquidity risk (transaction cost) - identify
· having to sell an asset below fair value
drivers · widening bid-ask spreads in times of

market strain
· changes in market conditions or the
market for a specific asset
· size of the position
Non-Financial/ Settlement Risk (Herstatt risk) German bank
· a party fails to deliver even though

it has been paid
LOS f
Non-Financial/ Legal - identify
- being sued
- not making the legal argument
Compliance (regulatory, accounting, tax)

- includes ‘injurious reliance’
Model Risk
- valuation errors from either a
mis-specified or a mis-used model
· tail risk events in the tail

occurring more frequently than expected
by the model
(Teleb, Black Swan events)
LOS f
Non-Financial/ Operational Risk - identify
· internal people/processes - JIT
vicarious liability
Solvency Risk
· running out of cash (being unable to
secure financing or of rolling over debt)
Individuals/
· Theft
· health
· mortality Insurance
· accident
· wealth
LOS f
Interactions/ e.g. credit risk can be made - identify
worse by market risk
(wrong-way risk)
(systemic risk)
e.g. concentration
- owning a home in a one-factory
town, while employed at the factory, and
holding company stock in the pension plan
(GM & Flint, MI)
‘Minsky’ Model Hyman Minsky Financial Instability

Hypothesis (FIH)
Measures & Modifications

LOS g
Risk Metrics/ · Probability - describe
· Standard Deviation - normal dist., no fat-tails,
use portfolio s.d. - not asset s.d.
· eta - systematic risk
Derivative Metrics/
· Delta - rate of change of Pd w.r.t. Pa
· Gamma - rate of change of delta w.r.t. Pa
· Vega - rate of change of Pd w.r.t. volatility
· Rho - rate of change of Pd w.r.t. rf
Bonds/
· Duration
LOS g
Value at Risk (VaR) - measures financial - describe
risk across all asset classes
- is a ‘minimum extreme loss’ metric

(no maximum loss
stated)
Value at
Risk
VaR expressed profits
-
as: e.g. $4M @ 3% for today

currency period of
probability
amount time
- since VaR must assume a distribution of profit, it is

subject to model error
- extreme value theory attempts to overcome left-tail

shortcomings of the normal dist.
LOS g
Scenario analysis/Stress Testing - describe
- used to complement VaR
Credit ratings, CDS pricing credit markets
Others operational, compliance, legal

- difficult to quantify
- use of subjective measures
Risk Modifications/
· risk prevention/avoidance - those risks where
the associated activities are not worth pursuing
e.g. Jewellery maker moving from hedging gold pieces

to speculating on them
LOS g
Risk Modifications/ - describe
· risk acceptance
- self insurance keeping the risk
exposure (may be too costly to eliminate)
but using internal means to reduce fallout
(i.e. loan-loss reserves)
- diversification reduce non-systematic
risk
· risk transfer - typically in the form of an

insurance policy
- pay a premium, protect against loss

(e.g. buying index puts)
LOS g
Risk Modifications/ - describe
· risk transfer
- insurers can also transfer risk
- re-insurance, CAT bonds
- other transfer devices : surety bonds,

fidelity bonds, indemnity clauses
(bond not debt, just a promise)
· risk shifting - changes the distribution of

risk outcomes
- typically derivatives (forwards, futures)
Technical Analysis
a. explain principles and assumptions of technical analysis;
b. describe potential links between technical analysis and behavioral finance;
c. compare principles of technical analysis and fundamental analysis;
d. describe and interpret different types of technical analysis charts;
e. explain uses of trend, support, and resistance lines;
f. explain common chart patterns;
g. explain common technical indicators;
h. describe principles of intermarket analysis;
i. explain technical analysis applications to portfolio management.

Technical Analysis
LOS a (2.5p) TA: Principles, Assumptions explain
LOS b (2p) Links between TA & describe
LOS c (3p) TA vs. FA compare
LOS d (11p) Charts describe
LOS e (3.5p) Trend/Support/Resistance Lines explain
LOS f (19.5p) Common Chart Patterns explain
LOS g (19.5p) Technical Indicators explain
LOS h (4p) Intermarket Analysis describe
LOS i (13p) TA applied to PM explain
Page 1
TA - uses price and volume data to forecast future price
LOS a
movement
requires a freely-traded market - explain
prices are the result of interactions between supply and

demand
- used on equities, bonds, futures, forex
Logic supply and demand determine price

changes in supply and demand cause changes in price
past price action can be used to anticipate potential future
prices using charts and other technical tools
- can be applied on any time frame (daily, weekly, monthly, yearly)
Principles/Assumptions:
markets discount everything
prices move in trends/countertrends (the trend is your friend,
price action creates reoccurring or cyclical patterns until the end)
(due to market psychology)
Page 2
TA - study of collective investor psychology or sentiment
LOS b
- study of cognitive/emotional biases in decision making - describe
study of the patient TA - study of the patient’s footsteps
TA/ : humans are often irrational and emotional and tend to

behave similarly in similar circumstances
TA - market trends and patterns reflect this irrational human

behavior, and since human behavior is frequently repeated,
trends and patterns tend to repeat
∴ they are identifiable and predictive
TA/ FA/
price/volume analysis financial/economic analysis + societal
- data internal to the market + political
- attempt to predict where - data external to the market
prices will go - attempt to predict what price a
security should be valued at
Page 3
TA/ FA/ LOS c
- all fundamental data is reflected - financial statements - compare
in prices reflect what has happened subject
- price and volume actually happen to assumptions and estimates
- but why it happened and what it - but why it happened and what it
means subjective interpretation means subjective interpretation
research no significant relationships research - clear persistence in
fundamental data
- late to the trend (in and out)
(p139 p2, last s., p3 first s.) - ahead of the trend (in and out)
Charts/ high
LOS d
Bar Chart - describe
price
close
Line chart:
- line connecting open
closing prices low
time volume
Page 4
Bar Charts aids in the identification of support and
LOS d
resistance levels (See exh. 3/4) - describe
Candlestick Charts/
H H price movements much more visible
wick/shadow
C O
than bar charts
body
- sellers and buyers balanced
O C
L L
- may signal a reversal if at the
end of a long up/down trend
bullish bearish
Scale/
Arithmetic Logarithmic - appropriate
for longer
equal $ equal % time frames or
changes changes
larger prices moves
Page 5
Scale/ upward sloping logarithmic trend lines are broken LOS d
sooner than upward-sloping linear trendlines - describe
- opposite for downtrends
a breakdown occurs when the price of an asset moves

below a support level
a breakout occurs when the price of an asset moves

above a resistance level
Volume/ volume should confirm price movement
- rising volume on rising prices typically

- falling volume on rising prices is bearish
Time Intervals/ yearly, monthly, weekly, daily, hourly, minute
- shorter time intervals subject to more randomness/noise

Page 6
Relative Strength: used to compare the performance of a LOS d
particular asset with that of some benchmark - describe
(or another security)
outperformance
underperformance
time
LOS e
Trends/ Uptrend Downtrend - explain
- long-term pattern of higher lower highs
movement in a highs and
particular direction lower lows
retracement
higher
lows
Trends/ Page 7
breakdown resistance LOS e
- explain
support
breakout
consolidations Change in Polarity:
breakout
support
resistance
support
resistance
- once resistance is breached, it becomes

support
- once support is breached, it becomes
resistance
Page 8
Chart Patterns/ formations in charts that create a
LOS f
recognizable shape over time - explain
- often lead to similar subsequent price movements
Reversal Patterns/ - signals the end of the trend that formed the pattern
head and shoulders Inverse H&S

head new price high, but
not new downtrend
left right
volume high
(divergence)
breakdown
uptrend
neckline Price Target = Price Target =
Neckline Neckline +
lower - (head - neckline) (Neckline - head)
volume
rising in,
falling out
Page 9
Double Tops/Bottoms
LOS f
buying - explain
weakens
x
x
selling
price
weakens
target
volume on high volume on

breakdown breakout
lower lower
volume volume
Note: a pattern is not known until

after the fact
triple top (rare) - it is the breakdown/breakout that
matters most
Page 10
Double Tops/Bottoms LOS f
- the greater the number of tops/bottoms, the longer - explain
the time interval over which this occurs, the more significant
the pattern
- bottoms tend to be more stable predictors than tops
Continuation Patterns/ used to predict the resumption (continuation)

that was in place prior to the formation of the pattern
- may signal a change of stock ownership
1/ Triangles
Price Target = B + (B - A) Price Target = A - (B - A)
continues consolidation
B B B B
A A A A
spike
volume
Ascending Descending Symmetrical
Page 11
1/ Triangles
LOS f
- breakouts/breakdowns halfway to ¾ of the way - explain
through the pattern
- the longer the pattern, the more sustained the breakout/down
will be
2/ Rectangles
- its a double bottom until it becomes a
Bearish
B triple bottom (reversal pattern)
Rectangle
- then its a triple bottom until it
A
becomes a rectangle (continuation)
- same price target process as triangles
B
Bullish Long Term Short Term
Rectangle Rectangle Flag
A
Triangle Pennant
Page 12
Technical Indicators/ any measure based on price, market LOS g
sentiment, or funds flow that can be - explain
used to predict changes in price
Price-Based Indicators/
1) Moving Average - average of closing prices over a specified
number of periods (smooths volatility)
- simple moving average (SMA) - weights each price equally
- exponential moving average (EMA) - greater weights to
more recent prices
- 20, 50, 60, 100, 200
month quarter
- can be used with a price trend - determine support/resistance

- can be used relative to each other - e.g. 50 dma vs. 200 dma
- crosses are significant events faster slower

(golden, death)
Page 13
1) Moving Average LOS g
acts as
resistance - explain
50 dma
50 dma
200 dma
acts as
support
200 dma
50 dma
Uptrend Downtrend Golden cross Death cross
- price > SMA Price < SMA Bullish Bearish
or/ bullish crossover or/ bearish crossover
2) Bollinger Bands
when fast MA > slow MA, trend is ↑
sell signals SMA + n(sd) fast MA < slow MA, trend is ↓
SMA
- the more volatile the price, the wider the
bands
SMA - n(sd)
- contrarian strategy - sell at upper bands,
buy signals
buy at lower bands
Page 14
2) Bollinger Bands - works best in a trendless market LOS g
- buy stops above the upper bands, stop losses - explain
+ 1 sd below lower bands
SMA
- note - as price volatility decreases, band width
squeeze
- 1 sd
also decreases
Bollinger Band Width = ( − )

×
Squeeze - when vol. falls to very low levels

- theory is that this will be followed by periods of high vol.
Momentum Oscillators/ capture the rate of change of price data

uses: 1/ determine the strength of a trend
2/ determine a change in the trend
3/ identify buy/sell points in a trendless market
Page 15
1) Rate of Change (ROC) Oscillator: pure momentum
LOS g
indicator
- explain
(oscillates around 0) (oscillates around 100)
M = (V - VX) x 100 M = x 100
last closing closing price x

price days ago (typically 14)
- if oscillator crosses above (below) 0

in the same direction as the trend:
buy (sell) signal (convergence)
- if the oscillator crosses opposite the

trend (divergence), can be ignored
- of price hits new high when oscillator

hits new high - convergence
else, divergence
Page 16
2) Relative Strength Index - used to measure inner LOS g
momentum - explain
(i.e. not relative to another security)
RSI = 100 - and RS =
- provides information on overbought/sold conditions typically 14 days
positive divergence price hits new

low but RSI records higher low
negative divergence price hits new

high but RSI does not
early signs of a reversal
Page 17
3) Stochastic Oscillator: momentum indicator LOS g
- compares a closing price to a range of prices over a period - explain
closing of time
lowest price over
last 14 days
shorter time periods produce a
more volatile oscillator that will
(range: 0 - 100) highest price over generate more false signals
last 14 days
< 20 - oversold bullish
> 80 - overbought bearish (between 20 - 80 short-term noise)
slow
when %k crosses %D from below - bullish

above - bearish
fast
signal line
- in uptrends, prices tend to close at the high end of the recent range
(opposite in downtrends)
Page 18
3) Stochastic Oscillator: LOS g
overbought
- explain
oversold bearish
%D %k
bullish
4) MACD/moving-average (convergence/divergence) Oscillator
- difference between 2 exponential moving averages

1 fast (12d) and 1 slow (26d)
- signal line = 9d ema of the MACD
- oscillates around zero with no upper/lower bound
Page 19
4) MACD LOS g
uses: 1/ identify crossovers (signal vs. MACD) - explain
(indicate change in trend)
2/ identify movement outside normal range
3/ use trendlines on the MACD itself
crossovers
Page 20
Sentiment Indicators - gauge investor activity for signs LOS g
of bullishness/bearishness - explain
Calculated statistical indexes

a) Put/Call ratio typically call buying is
greater than put buying
- a contrarian indicator: ∴ ratio < 1
high value = bullish
typically at extremes
low value = bearish
b) CBOE Volatility Index - measure of near-term market volatility
VIX S&P500 vol. = IV of a 30-day put at 90% of

VIXN Nasdaq index value
c) margin debt - contrarian indicator

high level = caution (bearish)
low level = opportunity (bullish)
Page 21
Intermarket Analysis: look for inflection points in one
LOS h
market as a sign/clue to start looking for - describe
changes in trend in a related market
Relative Strength - chart the price of one security divided by

the price of another
ratio sec. 1 outperforms

(num)
sec. 2 outperforms (den)

time
Page 22
TA applied to PM/ LOS i
- explain
Top-down approach
- applied to global benchmarks (frontier, emerging, developed
market indexes)
- relative performance analysis
- identify consolidation periods then participate in
the trend (reversal, continuation)
- intermarket analysis between asset classes to
support tactical asset allocation
Bottom-up approach
Security-level analysis
- select investment universe
- select a screening criteria (e.g. momentum,
breakouts)
Fintech in Investment Management
a. describe “fintech”;
b. describe Big Data, artificial intelligence, and machine learning;
c. describe fintech applications to investment management;
d. describe financial applications of distributed ledger technology.


Page 1
Fintech - technological innovation in the design and
LOS a
delivery of financial services and products - describe
data processing decision execution decision making
(then) (now)
1/ Analysis of large datasets traditional data (economic, financial, prices)

alternative data (social media, sensor
networks)
2/ Analytical tools AI - artificial intelligence (identify complex, non-linear
relationships)
3/ Automated trading - executing investment decisions through computer
algorithms or automated trading applications
4/ Automated advice - Robo-advisers
5/ Financial record keeping - distributed ledger technology (DLT) - a secure
way to track ownership of financial assets on a P2P
basis
Page 2
Big Data - traditional + alternative sources - sensor
LOS b
stock networks
companies use of - describe
social media
exchanges government electronic
company exhaust - data
devices
generated in the normal
- big data typically refers to the datasets course of doing business
advertising
having the following characteristics
a) Volume - millions, even billions, of data points
b) Velocity - real-time or near real-time data
c) Variety - many different sources and in a variety of formats
- Sources · financial markets (price, volume) structured

semi-structured
· businesses (fin. st., transactions, advertising)
unstructured
· government (economic data)
· individuals (credit card purchases, search logs, posts, reviews)
· sensors (satellites, traffic patterns)
· Internet-of-Things (IoT) (smart buildings, appliances)
Page 3
- 3 main sources of alternative data:
LOS b
1) individuals - text, video, audio, photo, website clicks, - describe
time spent on a page, web searches
- primarily unstructured
2) Business processes - sales information, supply chain information,
banking records, point-of-sale scanner data
- primarily structured
3) Sensor data - smart phones, cameras, RFID, satellites
- Internet of Things
- primarily unstructured
- legal/ethical issues (privacy)
Artificial Intelligence and Machine Learning

- computer programs that are able to learn how to complete
- requires large data sets tasks
e.g. neural networks
Page 4
Artificial Intelligence and Machine Learning LOS b
- describe
inputs
training program validation output
outputs
training dataset evaluation dataset

- danger of overfitting
- types of ML/
a) supervised learning - model relationships based on labeled data
- inputs & outputs are labeled or identified
b) unsupervised learning - no labels, only data from which the
algorithm seeks structure
Deep Learning (supervised or unsupervised data)

neural networks many hidden layers
multi-stage, non-linear processing to
identify patterns
Page 5
Selected Applications/ LOS c
1. Text analytics and Natural Language Processing: - describe
· analyze and derive · analyze and interpret human language

meaning from: · translation
· company filings · speech recognition
· written reports · text mining
· quarterly earnings calls · sentiment analysis
· social media · topic analysis
· email
· identify trends in shorter timespans and with greater scale

and accuracy than is humanly possible
e.g./ · monitor analyst commentary and assign sentiment ratings
· monitor policymakers’ commentary
Page 6
Selected Applications/
LOS c
2. Robo-Advisory Services - provide investment solutions through - describe
online platforms (most follow a passive investment approach)
- robo-advisers in the US must be established as registered
investment advisers, regulated by the SEC
- include: automated asset allocation, trade execution, portfolio
optimization, tax loss harvesting, rebalancing
low fees, low account minimums, tend to use MF or ETFs
· Fully Automated Digital Wealth Managers - no human
· Adviser-Assisted Digital Wealth Managers - human adviser also
3. Risk Analytics - monitor risk in real time (identify weakening

market conditions and adverse trends in advance)
- employ risk mgmt. techniques sooner
4. Algorithmic Trading - buying/selling in accordance with pre-specified

rules and guidelines (e.g. high-frequency trading)
Page 7
Distributed Ledger Technology/ offers potential LOS d
improvements in financial record keeping (peer-to-peer basis) - describe
- greater accuracy, transparency, security
- faster transfer of ownership
but/ · not quite secure yet
· require massive amounts of energy to verify transactions
- distributed ledger a distributed database
each participant has a matching copy of the
database
- elements of DLT
· digital ledger
· consensus mechanism
(transaction validation &
agreement on ledger update)
· participants
Page 8
Distributed Ledger Technology/ LOS c
- uses cryptography to encrypt data - describe
- can accommodate ‘smart contracts’ - self-executing programs on the
basis of pre-specified terms and conditions
Blockchain/ a type of DL
- data is recorded in blocks that are linked, or chained, together
a grouping of transactions + a secure link (hash) to the
previous block
- new transactions are inserted only after validation
- consensus mechanism includes a problem that must be solved by
some computers on the network (miner)
Permissionless networks/ - open to any user who wishes to make a

transaction all users can see all transactions
- does not depend on a centralized authority to confirm or
deny the validity of transactions
Page 9
Permissionless networks/ LOS c
- no single point of failure exists - describe
- once a transaction is added, it cannot be changed e.g./ bitcoin
- trust is not a requirement between transacting parties
Permissioned networks/ - members may be restricted form

participating in certain network activities
- controls or permissions are used
Applications/
· Cryptocurrencies - digital currency, allows real-time transactions
without a need for a bank
- issued by ICO (initial coin offering) - unregulated process
· Tokenization - representing ownership rights to physical assets on a DL
· Post-trade clearing and settlement
· Compliance - more accurate record keeping, greater transparency for
external auditors
Portfolio Management - An Overview

Review - 1
- select securities w.r.t. their contribution to the
characteristics of the whole portfolio
2 assets w/ equal r, select lowest risk
but - select A
2 assets w/ equal risk, select highest r
but - select A
s.d. of an equally
unsystematic weighted port.
risk (captures risk s.d. of a random
(diversifiable) reduction benefits)
component
systematic risk
cannot eliminate systematic risk

· limits to diversification
does not provide downside
protection
Types of Investors/ Review - 2

safety to growth
1) Individual
ST to LT
risk averse to risk tolerant
L.T. · moderate risk tol.
Pension Funds
2) Institutional Income · low liquidity
Endowments perpetual life · safety
low liquidity · mod. - high risk
· Banks · Insurance Co. · Inv. Co. · SWF tol.
- low risk - low risk · risk varies · low - mod. risk
- high liquidity - mod. high liquid. · growth · safety/income
- income - safety/income
Pension Plans/ DBPP - benefit DCPP - contribution
Port. Mgmt. Process/ 1) Planning Step (KYC, IPS)
2) Execution Step Asset Allocation
Security Selection
Port. Construction
3) Feedback Step
- rebalancing
Review - 3
Port. Mgmt. Process/ KYC
1) Planning Step: objectives constraints
· safety · income · liquidity · taxes
· growth · time horizon
IPS - written investment policy statement
2) Execution Step
a) Asset Allocation - explain most of the difference
between portfolio returns
b) Security Analysis - identify undervalued securities
c) Portfolio Construction
3) Feedback Step - Monitoring & Rebalancing

· economy · price drift
· markets · dynamic rebalancing
· asset classes · tactical rebalancing
· securities
· client
Review - 4
Pooled Investments/ managed
Investors pool funds fund Assets
Mutual Funds
· Mutual Funds ETFs
· diversification, prof. mgmt. Hedge Funds
· all income flows through to Private Equity Funds
unit holders (in the form earned)
- all units bought/sold: at NAV open-end funds
at, below or
Money Mkt.
at market closed-end funds
above NAV
types Bonds
Equity higher MER
Active
Balanced higher turnover (faster cap. gains
realization)
Review - 5
Pooled Investments/
2) ETFs - passive, exchange-traded, tend to stay very
close to NAV
lower MER
vs. Index MF
continuous trading
pay-out divs. (versus reinvesting)
- separately managed accts./

client IPS · wrap
non-pooled
PM account
account
Hedge Funds/ · absolute vs. relative return

· short selling, leverage, derivatives
· minimal regulation
· accredited investors only
Private Equity Buyout firms & Venture Capital

- illiquid Investments
Portfolio Risk-Return
Review - 1
- all financial assets can be described by risk ( )
and return (r) - cap.
income cap. gain/loss g/L
multi-period = [( + )( + ) +⋯+( + )] − - Div.

yield
arithmetic mean return
- avg. return for a
given period E(R)
geometric mean return

- growth of $1 over
a period of time
mwrr IRR PV(outflows) = PV(inflows) - accurate reflection of

investor return
- lacks comparability
Review - 2
Annualized Return/
Portfolio Return/ weighted average of the individual returns
- gross vs. net returns - gross returns - mgmt./admin. fees
Total return - trading fees
basis for comparing managers
- pre-tax & after tax nominal returns - components of the

gain matter
- real returns
nominal real inflation risk premium
real ‘risky’ rate

Review - 3
Portfolio Return/
derivatives or margin
· leveraged Returns
must account for loan interest
e.g./ = 2% t = 20% r = 3%
real after-tax return =
= Measures of Risk/
variance/
standard deviation/
of each component
· variance of a portfolio - need
Cov(A,B) A,B
- sum of all the variances & covariances
Review - 4
· variance of a portfolio
2 assets/
Risk Aversion/ - maximize return for a given level of risk

or minimize risk for a given return
(vs. risk neutral & risk seeking)
(Max R) (Max )
Risk Tolerance/ level of risk willingly accepted to achieve

+ goals
Utility Theory/ A - a measure of risk
· investors are risk averse aversion
higher risk = lower utility > 0 risk averse
· they prefer more return to less A = 0 risk neutral
higher return = more utility < 0 risk seeking
Review - 5
E(R) = rf E(Ri)
risk-free market
= 0 > 0
( − ) = 100%
= 100%
tradeoffs of market portfolio

& risk-free asset
- line is called the ‘Capital Allocation Line’ (CAL)
- overlay ID curves
on the CAL
int.
- market price of risk
Review - 6
A =2
e
b A = 4
d
a c
· a b & c - indifferent
· d dominates c · e unattainable
Correlation/ determines effect on portfolio risk when

= -1.0 2 assets are combined
= .20
Diversification
R2 = 15% = 25% - correlation is the
Asset 2
key
= 1.0 - variety of asset classes
= .50 - use Index ETFs
Asset 1
R1 = 7% = 12% - diversify across countries
Review - 7
Diversification/ add new asset if:
Minimum Variance Portfolio/ optimal

CAL
borrowing
x D
A
lending p 100% risky
minimum variance
asset
Z frontier z
(risky assets only)
C
point z - global minimum-variance

100% risk-free asset
portfolio
Markowitz
segment Z D onwards:
efficient frontier
Portfolio Risk and Return (2)

Review - 1
E(R) optimal CAL (highest slope)
borrowing
portfolio
lending
P.
optimal risky
Homogeneity of Expectations/
portfolio
- all investors have the same
rf
economic expectations
Market/ all assets that (passive approach)
are investable & tradeable
(usually limited to a country’s major equity index)
CML - Capital Market Line - a CAL where the risky portfolio
is the market portfolio
Review - 2
lend at rf
rb borrow at rb
e.g./ borrow 75%

= -.75(rb) + 1.75(E(Rm))
rf
Non-systematic Risk
· since non-sys. risk can be
diversified, no incremental reward
can be earned for taking diversifiable risk
non-systematic risk
(diversifiable) Capital Market Theory: market will
expect a higher return on higher
levels of systematic risk,
regardless of total risk
systematic risk
# of (market
risk)
securities
Review - 3
· non-sys. risk can be avoided
· only sys. risk is rewarded
· more sys. risk should = higher exp. R
E(R)
Market
SML model
sys. risk non-sys. risk
- security market
line e.g./ = .0001 = .9
M E(Ri) can be estimated Ri = 2% Rm = 1%
if we have + Rm .02 = .0001 + .9(.01) +
rf
.02 = .0091 +
= .0109 + or 1.09%
1.0 return due to non-sys. risk
Review - 4
- captures an asset’s systematic risk
- need , ,
calculate by using regression
CAPM & SML vs. CML/CAL
extends to both applied only to efficient portfolios

individual securities &
efficient portfolios
Portfolio Performance Evaluation/
(total risk = sys. + non-sys.)

sys. risk only
Jensen’s
Portfolio Planning/Construction
Review - 1
IPS - Investment Policy Statement - starting point of
planning process
(willingness) risk
tolerance objectives - E(R),
Client
constraints liquidity
(ability) wealth
taxes
income
time horizon
responsibilities
IPS - sets realistic goals reviewed and

- creates a standard of performance updated
- guides actions of Port. Mgr. regularly
+ governance arrangement (Institutional IPS)

Components/ · Introduction · Investment Constraints
· St. of Purpose · Investment Guidelines
· St. of Duties/Responsibilities · Execution & Review
· Procedures · Appendices asset allocation
· Investment Objectives rebalancing
Review - 2
- SAA - Strategic Asset Allocation
dynamic - back to SAA
rebalancing
tactical - intentional short-term
departures from SAA
Risk Objectives Absolute - i.e. max. loss in
any 12-month period
Relative
- relates risk to a benchmark
- tracking error or
tied to some future liability (pension funds)
Risk Tolerance/ ability & willingness disposition
explain financial understanding
+
implications
ability talk client
- down
- willingness +
Review - 3
Return Objectives/ must be realistic
1) Absolute - required rate of return
2) Relative - vs. benchmark
fees
Stated pre or post
taxes
inflation
Constraints/ liquidity - redemption/withdrawal requirements

time horizon
tax concerns - registered vs. non-registered
Legal/Regulatory
Unique Considerations - restricted assets, holding requirements
(endowments)
Strategic Asset Allocation/
· % allocated to each asset class in order to
meet client objectives (primary driver of returns)
Review - 4
Strategic Asset Allocation/
- being in the right asset class at the right
residential time
· Cash sm. · Real Estate
commercial
· Equities mid cap.
· Alternative Investments
lg.
· Fixed-Income - gov’t., corporate
- similar E(R) & within each asset class (high within)

- low between asset classes (diversification benefits)
Portfolio Construction/
passive 1) Risk Budgeting - asset class decision - SAA
core 2) Tactical AA
satellite
approach 3) Security Selection
active 4) Rebalancing - correct drift from SAA

Behavioral Biases of Individuals
LOS a - distinguish/ Review - 1
cognitive errors - biases based on faulty cognitive reasoning

- more easily corrected (better information, education, advice)
emotional biases - reasoning influenced by feelings or emotions
- best adapted to
LOS b - discuss/ Cognitive errors (2 categories)

1/ Belief perseverance - tendency to cling to one’s beliefs
irrationally or illegally
a) Conservatism bias - inadequately incorporating new information

- overweight initial beliefs, under-react to new info.
(overweight the base rate i.e. prior probabilities)
Result: slow to update a view or forecast, opt to maintain
a prior belief
b) Confirmation bias - look for and notice
what confirms prior beliefs
- ignore or undervalue what contradicts their beliefs
Review - 2
1/ Belief perseverance
b) Confirmation bias Result: consider only positive info.

about an existing investment, ignore negative info.
- may hold on to losing stocks too long = undiversified portfolio
c) Representativeness Bias - classify new info. based on past
experience & classifications
types: 1/ Base rate neglect - categorize w/o considering probabilities
2/ Sample size neglect - assume small samples are
representative
Result: under-weight base rates, over-weight new info.
- adopt a view/forecast based almost exclusively on
new info. or small samples
d) Illusion of control - belief that they control/influence
outcomes
Result: over-trading, underdiversification
Review - 3
1/ Belief perseverance
e) Hindsight Bias - see past events as having been predictable
- tend to remember our own predictions as having been more
Result: lead to overconfidence, unfairly assess the accurate
performance of others
2/ Information-processing biases
a) Anchoring & adjustment bias - some initial default value acts

as an anchor, will adjust to new info. from the anchor
(too much weight on the anchor, adjustment usually insufficient)
Result: stick too closely to original estimate of value
hold to long, sell too early
b) Mental Accounting Bias - treat money differently depending
on which mental account the money is assigned to
Result: neglect a) correlations among assets in different
layers b) opportunities to reduce risk by combing assets
with low corr. c) total return
Review - 4
2/ Information-processing biases
c) Framing Bias - a person responds differently depending on
how a problem is framed
Result: misidentify risk tolerances, choose sub-optimal investments,
focus on short-term price fluctuations
d) Availability bias - estimate probability based on how
easily something comes to mind (easily recalled outcomes
perceived as more likely)
(retrievability, resonance, narrow range of experience, categorization)
Result: lack of diversification (International, Alt. Inv.)
Emotional Biases/
a) Loss Aversion - people prefer avoiding losses as opposed
to achieving gains (losses are emotionally more powerful)
- may lead to disposition effect - sell winners too
soon, hold losers too long
Review - 5
LOS b - discuss/ Emotional Biases/
a) Loss Aversion
Results: hold positions longer than justified = riskier portfolio
- sell winners too quickly = excessive trading
b) Overconfidence - people demonstrate unwarranted faith in
their own abilities, reasoning & judgement
(illusion of knowledge, self-attribution bias leads to overconfidence)
Results: underestimate risks, overestimate returns, hold poorly
diversified portfolios, trade excessively, underperform
c) Self-Control bias - people fail to act in pursuit of their
long-term goals because of lack of self discipline
Results: save insufficiently for the future, accept too much
risk to catch up, asset allocation imbalances
d) Status-quo bias - people do nothing instead of making
a change
Review - 6
LOS b - discuss/ Emotional Biases/
d) Status-quo bias Results: maintain portfolios with
inappropriate risk characteristics
e) Endowment bias - people value an asset more when they
have rights to it than when they do not
Results: fail to sell certain assets and replace them with others
- maintain inappropriate asset allocation
- continue to hold asset classes the investor may be familiar
f) Regret-Aversion bias - people tend to avoid making decisions
that will result in action out of fear the decision will
turn out poorly (hold losing positions too long for fear that
the price may rise after selling)
- errors of commission/errors of omission
Results: too conservative in investment choices
- engage in herding behavior - stay with what is popular
Review - 7
LOS c - describe/ Market anomalies - deviations from market
efficiency that generate persistent abnormal returns
- not attributable to choice to asset pricing model

statistical issues (small samples, data mining)
temporary disequilibria
1/ Momentum - herding behavior/trending effect

availability - rising prices raise expectations of rising prices
hindsight bias - reduce regret of missing out by buying past
winners
2/ Bubbles and Crashes
overconfidence - overtrading, underestimation of risk
confirmation and self-attribution bias - selling winners confirms
regret aversion (FOMO) the success of the strategy
anchoring
3/ Value vs. growth halo effect

good growth record = good investment potentially
leading growth stocks to be overvalued
Risk Management
pos. Review - 1
Risk/ - the effect of uncertainty neg.
- eliminating all risk is undesirable - no risk = no return
- a measure of risk (a deviation from expectation)
Risk Exposure/ - how much risk we are currently taking
acceptable, planned unacceptable, unplanned

risk management
Risk Appetite/ - acceptable risk only
Risk Mgmt./ the process by which Risk Exposure is compared with

Risk Appetite and brings the two into congruence
(not about minimizing risk - it’s about taking acceptable risk)
- does not prevent losses
Steps/ Identify Assess Mitigate Monitor

current risk target risk exposure
exposure
towards
Review - 2
Risk Management Framework/ - a formal way to respond
to risk
1) Risk Governance - BOD - Risk Mgmt. Committee
- defines ‘Risk Appetite’ & Risk Budgets
2) Identification/Measurement
- identify risk exposures, scan for potential risk drivers
3) Risk Infrastructure - people, systems, technology

- risk capture (historical data)
4) Policies & Processes - translates governance into day-to-day

operations & procedures · if X then Y
5) Monitoring, Mitigating, Managing · do z every Q hours
6) Communications - governance down, metrics up
7) Strategic analysis/Integration - risk tolerance in

congruence with organizational goals
Review - 3
Risk Governance/ top-down process & guidance from BOD
acceptable
- determines organ.’s risk appetite & tolerance mitigated
- focus is on ‘enterprise risk management’ unacceptable
· objectives, health, & value of the whole
Risk Tolerance/ - defines Risk Appetite
- willingness to experience losses and fail to meet objectives
· Internal factors (liquidity, experience)
· External factors (forex, interest rates)
identify risks unwilling to accept

stronger competitive position
· risk tolerance greater if
greater the loss that can be
sustained
greater response agility
Review - 4
Risk Budgeting/ quantify & allocate tolerable risks to
various activities & investments
- single-dimensional risk measures marginal

s.d. VaR component
incremental
relative
- multi-dimensional risk approaches considers
- portfolio margining - risk is evaluated based on the whole interactions
Sources of Risk/ interest rates Drivers
Market Risk forex · fundamental
1) Financial economic, industry &
stock prices
company events
default
Credit Risk · economic weakness
counterparty
· drops in demand
Liquidity Risk - ability to sell
· spreads, market
(transaction costs)
conditions, size
Review - 5
Sources of Risk/
2) Non-Financial
· Settlement Risk (Herstatt Risk) a party fails to deliver even

though it has been paid
· Legal - law suits
· Compliance - regulatory, accounting, tax
· Model Risk - mis-specified or mis-used model
- tail-risk (events occurring more often than model expects)
· Operational - internal - people/processes
· Solvency - unable to secure financing/roll over debt
3) Individuals theft
health Interactions/
mortality Insurance non-financial &
accident financial risks can
wealth interact
Review - 6
Risk Metrics/ · probability · s.d. · eta
delta - underlying asset price changes
· Derivatives
gamma - delta risk
vega - volatility
rho - change in interest rates
· Bonds - Duration
Value at Risk/ - a ‘minimum extreme loss’ metric

- measures financial risk across all asset classes
e.g. $4M @ 3% for today - 3% probability of

currency probability time
losing at least $4M
amt. frame
Measures & Modifications/

· Scenario analysis/Stress testing
· Credit ratings
Review - 7
Risk Modifications/
· risk prevention/avoidance
self insurance (loan-loss
· risk acceptance
reserves)
diversification
- reduce non-systematic risk
· risk transfer - insurance (+ re-insurance)

- others - surety bonds, indemnity clauses
· risk shifting - change the distribution of risk

outcomes
- derivatives
Technical Analysis
Review - 1
patterns attempt
LOS a - explain/ study of price and volume
trends to predict future
indicators price movements
assumptions: 1/ markets discount everything
2/ prices move in trends/countertrends
3/ price action create reoccuring/cyclical patterns (due to
market psychology)
LOS b - describe/ - humans are often irrational and emotional (BeFi) and
tend to behave similarly in similar circumstances
TA - market trends/patterns reflect this behavior, and since
human behavior is frequently repeated, trends/patterns repeat
LOS c - compare/ TA FA
- price/volume - financial/economic data
- predict where price will go - determine what price should be
- late to the trend (in and out) - early to the trend (in and out)
Review - 2
LOS d - describe/
H H
C O body colour
C
indicates
direction
O O C
L
L
Line chart bar chart

- closing prices only (open, low, high, close)
arithmetic equal $ amounts

Scale
logarithmic equal % amounts (appropriate for longer time
frames)
Volume should confirm price (rising volume on rising prices)
Time Intervals - minute, hour, day, week, month, year

Review - 3
LOS d - describe/ outperformance
Relative Strength
underperformance
LOS e - explain/
higher downtrend resistance
highs & (resistance)
low
uptrend
(support) support consolidation
lower highs & lows
change in polarity
- support (resistance) once
breakdown breakout breached becomes resistance
(support)
Review - 4
LOS f - explain/ Reversals
resistance
price target
neckline
price target support
volume
Inverse H&S Double Top Double Bottom
Head and Shoulders (a pattern is not known until after the fact)
Continuation Patterns
continues
consolidation
B B
B B
A A A A
spike
volume
Ascending Descending Symmetrical

Review - 5
LOS f - explain/ Continuation Patterns
Long Term Short Term

Rectangle Flag
Triangle Pennant
Bearish Rectangle Bullish Rectangle
LOS g - explain/ Indicators
Price-based/ 1/ Moving Averages - closing price over a number of periods

SMA - simple moving average - weights each price equally
EMA - exponential MA - greater weights to more recent
prices
acts as
- 20d, 50d, 60d, 100d, 200d 50dma 200dma
support
fast slow
200dma 50dma
- crosses are significant Golden Death
Review - 6
LOS g - explain/ 2/ Bollinger Bands
sell signals SMA + n(sd)
more volatile + 1 sd
SMA prices = wider SMA
bands squeeze
SMA - n(sd) - 1 sd
buy signals
when vol. falls to low

Momentum Oscillators/ levels
ROC (Rate of Change) Oscillator
Oscillates around: if momentum = uptrend (buy)
M = (V - VX) x 100 0
M = x 100 100
trend reversals
Review - 7
LOS g - explain/ 2/ Relative Strength Index
RSI = 100 - RS =
100
70 overbought
30
0 oversold
early sign
positive divergence = price hits new low, RSI records higher low
of a
negative divergence = price hits new high, RSI does not
reversal
3) Stochastic Oscillator
100 overbought
80
(0 - 100) %D %k
20 oversold
0
bullish bearish
signal line
Review - 8
LOS g - explain/ 4) MACD
cross-
- difference between 2 EMAs (12d, 26d) overs
- signal line = 9d EMA of the MACD
crossovers indicated potential

change in trend
Sentiment Indicators/
Put-Call ratio high value = bullish
low value = bearish
CBOE Volatility Index - vol. and equity prices are inversely

related
margin debt high level = caution

low level = opportunity
Review - 9
LOS h - describe/ Intermarket Analysis
asset 1 outperforms asset class
(price of one asset sector

divided by another) asset 2 outperforms
security
LOS i - explain/
Top-down: Intermarket analysis
Identify consolidation periods then participate in the
trend
Bottom-up: Security-level analysis

- select investment universe
- select screening criteria

Review - 1
LOS a - describe/
- technological innovation in the design/delivery of financial
products/services
traditional
· analysis of large datasets
alternative (social media, sensor
· artificial intelligence
networks)
· automated trading - HFT
· automated advice - Robo-advisors
· financial record keeping - distributed ledger technology (DLT)
LOS b - describe/
· Big Data - traditional + alternative sources
- datasets with 1/ Volume billions of data points
2/ Velocity real-time structured
3/ Variety sources and formats semi-structured
Sources: financial markets, business, government unstructured
individuals, sensors, Internet-of-things
Review - 2
LOS b - describe/
· Artificial intelligence and machine learning - computer programs
that are able to learn how to complete tasks
- requires large datasets
inputs
training program validation output
outputs
· supervised learning - inputs & outputs are labeled

· unsupervised learning - no labels, algorithm seeks structure
· Deep Learning - neural networks with many (> 20) hidden layers
LOS c - describe/
· Text analytics and Natural Language Processing
(analyze and derive meaning from)
- identify trends in shorter timespans and with greater

scale and accuracy
Review - 3
LOS c - describe/
· Robo-Advisory services - provide investment solutions through
online platforms
(asset allocation, trade execution, portfolio optimization, etc…)
· fully automated Digital Wealth Manager - no human
· Advisor-assisted Digital Wealth Manager - human advisor also
· Risk Analytics - monitor risk in real time
· Algorithmic Trading - buying/selling through pre-specified rules
LOS d - describe/
· distributed ledger a distributed database, each participant
has a matching copy of the database (P2P)
- uses cryptography to encrypt data
· Blockchain - data is recorded in blocks that are chained together

- new transactions are inserted after validation
Review - 4
LOS d - describe/
· Permissionless networks - open to any user
- does not depend on a centralized authority
- once a transaction is added, it cannot be changed
· Permissioned networks - members may be restricted from

participating in certain network activities
Applications:
· Cryptocurrencies
· Tokenization - representing ownership rights to physical assets
· Post-trade clearing/settlement on a DL
· Compliance - more accurate records, greater transparency

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Last Revised: 05/31/2021

Level I - Portfolio Management

Portfolio Management: An Overview 2

Portfolio Risk and Return: Part I 13

Portfolio Risk and Return: Part II 33

Basics of Portfolio Planning and Construction 53

The Behavioural Biases of Individuals 60

Introduction to Risk Management 71

Fintech in Investment Management 98

© markmeldrum.com. All rights reserved.

Portfolio Management: An Overview

a. describe the portfolio approach to investing;

b. describe the steps in the portfolio management process;

c. describe types of investors and distinctive characteristics and needs of each;

d. describe defined contribution and defined benefit pension plans;

e. describe aspects of the asset management industry;

Key Point/ Portfolio management primarily involves

2) Asset class selection

$1000 Returns (Equally w)

Limits to diversification/ · cannot eliminate systematic

· in adverse markets, all correlations

diversification does not necessarily provide

Portfolio Mgmt. Process

Top Down more securities

Execution/ Security analysis LOS b

· Endowments/Foundations - preservation of capital (on

· Insurance Companies - low risk, high to moderate

· Investment Companies - varies (LOS d)

· Sovereign Wealth Funds - a government-owned

Defined Contribution/ · specifies how much goes into the

Overview - Asset Mgmt. Industry

· buy-side represents investors

Active vs. Passive

15% AUM, but 43%

20% AUM, but 6% of

Asset Mgmt. industry Trends

Closed-end funds - fixed number of units/shares

Load funds annual fee + buy/sell fees

· Money Market tax free/taxable

Active higher MERs, attempt to beat benchmark

ETF vs. Index MF

client IPS objectives & constraints

non-pooled, client actually owns the assets

Hedge Funds/ - absolute vs. relative return

- VC - provides financing to start-ups

- both take active role in mgmt.

- exit is critical since all investments are illiquid.

Portfolio Risk and Return: Part I

b. compare the money-weighted and time-weighted rates of return and evaluate

c. describe characteristics of the major asset classes that investors consider in

e. explain risk aversion and its implications for portfolio selection;

f. calculate and interpret portfolio standard deviation;

h. describe and interpret the minimum-variance and efficient frontiers of risky

i. explain the selection of an optimal portfolio, given an investor’s utility (or

all financial assets can be described by risk & return

Return - typically derived from 2 sources income

$1 50¢ 67.5¢ 85.725%

time-weighted rr measures the compounded rate of

HPR1 HPR2 HPR3 HPR4 etc… -

Annualized Returns/ LOS a, b, c

Other Return Measures/

nominal real risk- inflation risk

real ‘risky’ rate