Author Archives: josephhogue

Are the actual exam questions easier or harder than mock exams or practice problems?

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Leading up to the exams, I always wondered if my success on practice problems and mock exams would carry through to the actual test. My strategy of taking at least five full-length exams, one that I have written about on the blog, helps to build a confidence interval around your possible exam score. You’ve all been through the quant material so we won’t repeat how to use a collection of scores to estimate an average and predicted score.

Unfortunately, this method of prep is only as good as the tests you use to make the estimate. If the questions within the mock exams or the practice problems are significantly easier than the actual test questions then you’ll get an inflated estimate and may be in for an unpleasant surprise come June 1st.

So how do you know if the practice problems, mock exams or question banks are easier or harder than the actual exam?

From my own experience, the practice problems in the curriculum were probably the closest to the actual test questions in terms of difficulty. The problem with these is that taking a few singular questions provides a poor estimate on how you will do across 120 questions and 18 study sessions. You really need to complete a handful of practice problems from each topic and all at once.

The CFAI mock exams seemed a little harder than the actual exam for the years I took the test (2009-2011). Taking the mock exams each year, I was always a little disappointed in my score but then had no problem on the actual exam. I don’t know if it is intentional, but the Institute did a good job of making me study a little harder in the last couple of weeks.

I used Stalla and another prep provider (which I won’t name but it’s the most widely used) when I took the exams and before I knew about FinQuiz. The question bank problems did seem to be easier than the actual exam and much easier then the Institute’s mock exam. I was usually well into the 80% rate on practice exams through the software and was a little surprised when I took the actual exam.

Having helped prepare some of the questions for the FinQuiz mock exams, I think they are about the same level of difficulty as the actual exam. I have looked at samples across all three exams and there is a good range of easy to difficult problems, similar to the exam.

Your own experience may be different and there are other posts on the forums to help you with the question. One thing to remember when looking at your scores is that you will probably do better on an exam when relaxed in a study area with no consequence to your score compared to the 6-hour mental aerobics on June 1st. This is why I always liked to target a higher percentage score on the mock exams and practice problems than was necessary. If you are regularly making 75%-85% on these tests, you can be confident that you will do well on the actual exam.

As we’ve talked about previously, try not to worry during the exam even if the actual exam seems harder than your prep questions. You’ve done everything you can to prepare and getting nervous during the test will not help. I’ve talked to many candidates you came out of the exam feeling disappointed that it was much more difficult than they anticipated. They spend the next couple of months distraught because they think they failed, only to find out that they passed and put themselves through so much anxiety for nothing.

Spend the next two weeks finishing up your review. Keep to your plan and try to cover as much as possible, then don’t worry about it.

Good luck on the exam,
Joseph Hogue, CFA

 

CFA Level 3 Essay #9 2012

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The material on derivatives is worth between 5% and 15% of your overall score and last year (2012) was the first time in four years that it appeared in the morning section. This might have thrown some candidates if they were not expecting an essay question, so I thought I would go over one of the questions in this week’s post.

The essay questions, along with the guideline answers, are available on the Institute’s website for your practice.

Together, questions #8 and #9 were worth 25 points or about 7% of the overall exam. Problem #8 covered the use of equity futures in changing a portfolio’s beta, using equity and bond futures to adjust portfolio allocation, and pre-investing with futures. Problem #9 covered options with delta hedging and some conceptual material on how gamma changes closer to expiration. These are formula intensive sections but the calculations really are not that hard once you work through them.

The first thing you should notice when starting #9 is that the three parts (A,B,C) are worth 12 points. Unless you have saved some time elsewhere in the morning, you should try to get through these in no more than 10-15 minutes. Don’t spend 30 minutes on a question that is only worth 12 points! Use your time wisely.

You may want to underline or highlight key figures as you’re reading to make it easier to pick out data when you come to questions. Here things that jump out to me are 2,000 shares of equity, x-price of 1,300 Euros, premium of E19.09, etc.

  1. A put is a right to sell while a call is a right to buy, so being on the other side of the transaction (the writer of the option) would be the obligation to do the reverse (i.e. put is obligation to buy while call is obligation to sell). Knowing your ultimate exposure, you can figure out how to hedge it through an equity position. In this case you need to create an offsetting short position so you take the number of shares times the option delta times the current price.
  2. You need more in-depth knowledge of how options price here with the convex relationship between price and the underlying. You’ve seen this concept with mortgage-backed securities in the fixed income topic area so it shouldn’t be totally new. Remember, delta is the change in option price relative to stock price while gamma is the change in delta relative to the underlying. Long options (calls) have positive gamma (change in price is less for a decrease in underlying than the change for an increase in the underlying) while short options (puts) have negative gamma (change in option price will be greater for a decrease in underlying equity relative to the change from an increase in the underlying).
  3. The toughest part here is continuous compounding and the fact that you need to do six calculations for just five points. Don’t stare at the problem too long if you do not know it. Just get something down and move on to make sure you get the easy points in the exam. You will get partial credit if you hit on some of the points for which the graders are looking, so write something down!
    1. First, start with the trader’s net cash position which is the number of shares long times the price, minus the premium collected for the options sold.
    2. Even if you can’t remember how to do the continuous compounding, do the equation anyway and move on to the next steps. You can still get credit for doing the remaining calculations even if the result is off because of a prior mistake (and here the difference between continuous compounding is only $0.05).
    3. From here it’s just a matter of subtracting the short call position from the long equity position and finding the relative return.

 Of the 12 total points, you could have gotten 6 or 7 easily by just knowing the conceptual material and working through the equations quickly. The remaining points would have been a little harder and may have taken more time than they were worth if you really didn’t know the material. This is a great example of making sure you get the easy points and not spending too much time where it’s not going to pay off.

If you know that you don’t know something or it’s going to take a while to figure it out, move on and come back to it if you have time.

Two more weeks to the exam. Make sure you are ready for the first two questions (individual and institutional portfolio management) and get a few mock exams done.

‘til next time, happy studyin’
Joseph Hogue, CFA

Which formulas are the most important for the CFA Level 2?

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There are a ton of formulas you need to know for the Level 2 exam. For me, as with others, it is the most quantitatively intensive test I’ve ever taken.

But do you really need all those formulas, and how do you memorize so much in such a quick time?

In this post and continued through the next two Tuesdays, we’ll look at the most important formulas in the second exam and how to approach the massive amount of material. The usual disclaimer applies, while I have been writing on the exams for quite a while and took them myself, no one knows what will actually show up on the exam. All the curriculum is testable. I can only tell you what I have seen through my own experience and what I have seen on successive versions of the curriculum over the last four years.

We’ll start with a general approach to the formulas then look at each study session to pick out the most important formulas.

Remembering every single calculation from the curriculum is not practical for most candidates and it does seem that the Institute targets some material as more important than others. That said, it is extremely easy to get into the punter’s trap. I call the punter’s trap where you find a tough formula and decide to skip it and focus on easier points instead. Something like punting in football instead of going for the extra yardage. The problem is, once you start doing this it gets easier to do it again and again. Pretty soon, you are skipping a good portion of the curriculum and you are guaranteed some lost points on the exam. Spend the time and get these formulas down.

There’s two things you can do to help get through the tough formulas.

  • First, you need to understand what is conceptually happening in the formula. Trying to understand the myriad of symbols is crazy. If  WACC = (Vd/(Vd +Vce))rd (1-t) + (Vce/(Vd+Vce))rce) doesn’t make you go cross-eyed you are a stronger person than I am. Think about it intuitively and it makes sense. The overall cost of a firm’s funding capital is the cost and proportion of equity and debt. The percentage of each funding type relative to the total is multiplied by its cost. Debt is tax advantaged, so you need the after-tax cost.
  • Secondly, you have to work these formulas through practice and repetition. One of the most popular posts here shows that active learning (engaging the material through practice and conversation) allows you to remember much more than passive learning. The best way to approach tough formulas is to put them on flash cards. Write out a full practice question like those at the end of the chapters. Then work the questions each day. When you are able to do one easily, put it aside so the time necessary each day decreases. You will want to review them all every couple of weeks to make sure you haven’t forgotten any.

We’ll go through each study session to look at the high level important questions but make sure you are doing the end-of-chapter and blue-box questions in the curriculum. If the Institute is taking the time to write out a problem, then they want you to know the formula and you could see it on the exam.

There are no calculations in the first two study sessions, just ethics material but this is extremely important to your overall grade so you may want to review our posts on ethics and standards.

SS2/3 – Quantitative Methods
You need to know how to calculate the sample covariance and correlation coefficient. Learn the basics of the formula but you can do both of these on your calculator so learn how to input the data and you’ll save a lot of time.

You need to know how to calculate a value for a regression model, which is pretty easy by just plugging the numbers into the variables in the formula. The correlation coefficient is just the covariance divided by the standard deviations of each variable. Ryx = COVyx/sysxwith the covariance being the sum of the differences (y- average y)(x – average x) divided by the sample size minus one.

Remember, the slope estimate (b1) is the covariance divided by the variance. What gets most candidates is the various statistics on the ANOVA chart so learn the parts and be able to interpret their meaning.

Predicting the value of a time series or the autoregressive model is similar to the regression model, just plug in the numbers. Be sure you can work a formula with a seasonal lag as well. You may also need to calculate a mean reverting level.

SS4 – Economics
Forex can be tough, especially with the confusion around direct and indirect quotes. You need to be able to calculate the bid-ask spread as well as calculate the profit on a triangular arbitrage. I have included two video explanations to get you started.

A good explanation of Bid and Ask quotes is available on YouTube at:
http://www.youtube.com/watch?v=PmjUx8ZcsoY

Cross rates and arbitrage are easily testable and will really test whether you understand forex quotes and calculations. A good explanation of triangular arbitrage is available on YouTube at:
http://www.youtube.com/watch?v=FElk-K1vb_I

The forward premium or discount on a currency is just the relative difference between the forward and spot price (Fxy – Sxy)/ Sxymultiplied by the annualized time in the contract (12/# of months until settlement)

Interest rate parity is an important concept and the formula is fairly easy. It’s just the relative interest rates (1+rx/1+ry) times the spot price.

SS5 – FRA Inventories and Long-term Assets
You’re required to calculate the effect of inflation or deflation on inventory costs and ratios but I see this as more a conceptual problem. Understand what affect inflation or deflation has on the LIFO or FIFO methodologies and you’ll be fine.

We’ll cover study sessions 6-12 in the post next Tuesday and the remaining sessions in the post after that. We’ll be using the other posts through the next couple of weeks to review strategies for the exams and how to prepare.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Level 1 Review, Alternative Investments

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Study session 18 concludes the CFA Level 1 curriculum with two readings (66-67) covering alternative investments.

Introduction to Alternative Investments
The reading really focuses on the commonalities of alternative investments and how they differ from traditional bonds/stocks. You’ll get more detail into each type of alternative in the other two exams.

Understand the five common characteristics of alternatives:

  • Illiquidity – do not have as many buyers or open market transactions so may have to offer a premium
  • Lack of current market value – because of illiquidity, transactions are not continuous and the current value may need to be estimated
  • Data limitations – less risk and return data may be available because of infrequent trading
  • Asymmetric information – valuations may differ greatly depending on geographic characteristics and there may be considerable information asymmetries
  • Difficulty of analysis – since market transactions are less frequent and data limitations are higher the analysis work may be more difficult and have a lower degree of confidence

Understand the forms of real estate investment and advantages/limitations to each. Direct ownership can be prohibitively expensive and transaction costs are high but it is the most directly tied to prices. An indirect investment in equity or mortgages may have less transaction costs and limited liability. REITs are a hybrid between stock and real estate ownership that carry tax-advantages.

Remember the basic components of the NOI approach to real estate valuation and be able to do a calculation. Gross rental income minus vacancy or collection losses is the effective gross income. The effective gross minus (utilities, taxes, insurance, maintenance, management and advertising) equals the NOI.

Venture capital firms raise funds to invest in private companies or investments. The timeline is probably the most important material here but also understand some of the additional limitations and characteristics. The investment stages are broken into two groups: Formative stage (seed, startup, and first stage financing) and Later-stage (second stage, third stage, mezzanine, and IPO financing). Understand which stage of the production process coincides with each stage.

Hedge funds use a group of strategies for absolute returns, often through hedging or leverage. Understand the basic idea behind the most common strategies: long/short, market neutral, arbitrage, global macro, and event driven. Hedge funds normally charge a percentage of assets fee and an incentive fee of a percentage of profits over a benchmark return. Funds of funds are a single mutual fund or ETF that invests in hedge fund for smaller investors but has the disadvantage of adding another layer of fees.

Understand the problems in hedge fund performance measurement: self-selection, survivorship, smoothed pricing, option-like strategies, and fee structure gaming.

Investing in Commodities
The concept of backwardation and contango often seems to get candidates. The interplay between producers and other participants in the market can cause the future price of a commodity to be higher or lower than its spot. Generally, the future or forward price is lower than the spot (backwardation) because of carrying costs and is referred to as natural backwardation. Producers are willing to sell their expected inventory forward to lock in a price at the end of the season.

When prices are volatile, contango may occur where the future or forward price is above the spot price. This occurs because commodity buyers come into the market to hedge their future price risk.

The actual formula for cost-of-carry is not as important as the theory and the costs that go into it. The idea puts a theoretical max price on commodities referred to as ‘full carry’ and includes storage, insurance, transportation and financing costs.

Understand the three sources of return: collateral yield, roll yield and price return. Roll yield is not related to changes in the spot price but the return derived from selling expiring contracts and buying into longer dated contracts. The roll yield is positive for an investor in backwardation.

Beyond the first section, the commodities reading is largely conceptual and some fairly easy material. Understand the controversy around commodities as an asset class (i.e. do not generate cash flows, return may result from rebalancing instead of increase in asset price, roll yield may disappear). Also, understand the general principal behind the two types of commodity investment approaches: index funds and index-plus strategy.

An index fund involves buying an ETF or an index swap for exposure while the index-plus strategy may involve a collateral return strategy, roll management, rebalancing, or maturity management.

We’ve made it through each of the study sessions. Hopefully, you’ve been able to keep up and do practice problems and review for each topic as well as the readings.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Exam Day, What to Expect and How to Prepare

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Unfortunately, more than a few candidates have failed an exam not because they didn’t know the curriculum but because of a test day hurdle.

You’ll hear stories every year of the candidate that is refused admission because they don’t have the proper identification, arrived late or don’t have their admission ticket. On top of these problems, you also run the risk of being so distracted from test day jitters that you can’t focus on the exam.

Knowing how to prepare for exam day and what to expect can go a long way to having a successful June 1st.

Unless the testing center is within walking distance, don’t assume that you can get their without any planning. If you can, try to drive the route a few days before test day. You may be surprised to see detour signs or that construction will start over the weekend. Google maps or other GPS services are good but not infallible and they aren’t going to refund your hard work if you get lost and miss the exam.

Play it safe on the food. That big meal the night before might just keep you up all night with indigestion. Eat a good breakfast but nothing heavy on grease or sugar. If you drink coffee, have a cup to avoid caffeine withdrawal. You are allowed to use the restroom during the exam but it comes out of your allotted time.

Don’t forget to print out your admission ticket (available by clicking here). In fact, open a new internet window and do it now. Put it in a safe place and do not write on it. After you’ve done that, look for your passport. Go ahead, I’ll wait……

Ok, visually check to make sure your passport does not expire through the test day then put is with your admission ticket.

Some candidates bring ear plugs for the test. I never had a problem with noise distractions but it is a good idea just in case. I have heard horror stories of open windows and lawn mowers distracting candidates. If you are at all distracted by small noises, bring ear plugs.

On test day, you’ll all arrive and wait outside the exam room. There will be a table of exam admin to check people in. Just before the exam begins, you’ll all file into the room showing your admission ticket and identification. You’ll be given your seat assignment and put your materials in front of you on the table. Test procters will also check your calculator and any materials you have with you. There is usually a separate area outside the exam room to leave your personal items not allowed in test room but I’d recommend leaving your stuff in the car if you can.

The proctor will read off the test instructions just before the exam. From this point forward do not talked to anyone or look around for any reason. I know it may seem rude but you really cannot risk being flagged as a cheater. It does happen.

I wouldn’t get too anxious about what to do or not to do over lunch. Don’t be afraid to talk to other candidates, these are the best peers and connections you’ll have over your career. Obviously, don’t talk about the test or any specific questions but just use the opportunity to get to know people and what they do.

Just eat as you normally would for lunch. Stay as close to the test site as possible and don’t get in a rush.

Above all, do not second guess any answers you worked on in the morning session! It’s over, don’t worry about it. If you prepared, you did fine. Worrying about the morning session will only lose you points in the afternoon.

I usually studied flash cards for about 20 minutes during lunch. It helped refresh some of the more detailed formulas, but at this point don’t worry too much about learning new material.

The CFA Institute is always the last word on exam day do’s and don’ts. Linked here is the Main Exam Page, where you will find links to print your exam ticket and other useful information. Linked here is the main page for policies on identification, calculators, materials, personal belongings and the candidate pledge. Lastly, the link here is to the Institute’s FAQ page for the exams.

We’ve still got a couple of weeks to the exam. We’ll spend them reviewing and talking about how to squeeze out those last points. Stick with it and get your study time in and you’ll go into the exam confident and ready to pass.

‘til next week, happy studyin’
Joseph Hogue, CFA

CFA Level 3 Review GIPS

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The last study session you’ll ever need in the CFA curriculum is the reading on the Global Investment Performance Standards (GIPS) for study session 18.

The basic concept behind GIPS is:

  • GIPS applies to firms, not individuals. An analyst cannot be “GIPS compliant”
  • The goal is fair representation and disclosure across investment opportunities for the public
  • It fosters the notion of “self regulation” within the industry
  • Each section includes “requirements” and “recommendations” for compliance. I would focus on the requirements if time is limited.
  • All actual, fee-paying, discretionary portfolios must be included in at least one composite
  • No non-discretionary portfolios, but non-fee paying portfolios may be included
  • Must calculate time-weighted total portfolio returns with external cash flows using daily weighting
  • Only actual assets, no model portfolios or simulations

The material on disclosures is easily testable along with some of the differences between the real estate and private equity sections.

Firms must disclose:

  • If they have met all requirements using the appropriate compliance statement (verbatim!)
  • Definition of the firm and description of composites (with creation date) and benchmarks
  • If they are presenting gross of fees and any fees deducted
  • If presenting net of fees, if model or actual management fees are deducted
  • Currency used in presentation
  • Measure of internal dispersion
  • Fee schedule
  • Use and extent of leverage, derivatives and short positions
  • Date, description and reason for redefinition of firm or composites
  • Minimum asset levels for composites
  • Treatment of withholding taxes, dividends, interest and capital gains
  • Bundled fees and the types of bundled fees
  • Sub-advisors and the period in which they were used
  • Any portfolios that were not valued at month end or last business day
  • Use of subjective unobservable valuation inputs
  • If no benchmark is used and why
  • Custom benchmarks used; description, date of creation, components, weights and rebalancing process
  • Whether the performance of a past firm or affiliation is linked (only appropriate if substantially all decision makers came over to new firm, the process remains substantially the same, and the firm has documentation of the performance history).

The guidelines on presentation and reporting are also important:

  • Total benchmark return for each period must be presented
  • Composite assets at the end of each year
  • Total firm assets or % of firm assets in each composite
  • Returns of less than one year cannot be annualized
  • % of composite in non-fee paying portfolios
  • % of composite in bundled fee portfolios
  • Five years of GIPS compliant performance or since inception if 5-years not available
  • Firms must add one year each year until at least ten years of data is reported

Be able to calculate the income return and capital return for real estate funds

Remember the valuation hierarchy for GIPS if the asset’s actual market value is not available

  • prices of similar assets in active markets
  • prices of similar assets in inactive markets
  • observable market inputs other than prices such as dividends, cash flows for pricing models
  • subjective or unobservable inputs like discount rates and projections  

Wow, we’ve made it through the entire curriculum. Hopefully, you have been able to keep up and have been doing well on practice problems and using other resources. You’re not done just yet. There’s still three weeks left to the exam and they can be the most important three weeks of your preparation. We’ll cover what to expect on test day in Friday’s post and other tips and strategies in subsequent posts all the way up to test day.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Level 2 Review, Portfolio Management

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Study session 18 in the CFA Level 2 curriculum concludes the material with three readings (54-56) in Portfolio Management.

Portfolio Concepts
A lot of the quantitative stuff here you’ve already seen in the quant methods section so be ready to calculate the return and variance on a portfolio. Remember, the portfolio return is just the asset weights times the asset returns while the variance calculation involves standard deviation and correlations.

Understand the theory behind the efficient frontier and how the CAL and CML incorporate into the idea.

  • The capital allocation line (CAL) is a straight line from the risk-free rate to any portfolio in the risk/return area. The optimal portfolio is where the CAL lies on the efficient frontier.
  • The line between the risk-free rate (intercept point) and the optimal portfolio (the tangency of the efficient frontier) is the capital market line (CML). All points on this line are portfolios consisting of different proportions risk-free asset and risky assets. Where the portfolio falls on this line depends on the risk tolerance of the client.

Understand the assumptions used in the CAPM (i.e. optimal portfolios can be built from just expected returns, variances and covariances; identical expectations about returns and variances; ability to borrow and lend at risk-free rate; no trading costs or taxes) and be able to calculate with a historical or adjusted beta.

The material on APT and multifactor models is mostly conceptual so focus on the basic ideas as well as the differences between the two methods. Multi-factor models are basically just a simple regression so don’t get confused by all the terminology.

The Theory of Active Portfolio Management
The reading is almost entirely Treynor Black model with some quick conceptual stuff as an introduction. The Treynor-Black model is a portfolio optimization model that combines market inefficiency with MPT.

Understand the steps in Treynor-Black

1)      Estimate expected return and standard deviation for the passively managed portfolio

2)      Identify limited set of mispriced securities

3)      Determine weights for the mispriced securities

4)      Group securities with non-zero alpha into an active portfolio

5)      Allocate funds between the passive and active portfolio

Understand the use of R2 in Treynor-Black alpha forecasts and analyst accuracy

The Portfolio Management Process
The easiest reading, and possibly the most important, is on the portfolio management process. This material is really the focus of the level III CFA exam but is shown here in a summary version. Learning this material at level II will make next year all that much easier for you.

  • The ‘steps’ in the process (planning, execution, and feedback) are secondary to the other material and fairly obvious anyway. Understanding the pieces within each step will make it intuitive as to where in the process they occur and the overall flow.
  • Understand that the IPS benefits both the client (through a formalized and portable plan) and the advisor (showing fulfillment of duty to client).
  • At the second level, you are really only asked to remember the basic structure of the IPS and what each objective or constraint means. The acronym that always helped me was  R-R-TUTLL. Risk, Return, Taxes, Unique Circumstances, Time Horizon, Legal, Liquidity.
    • Risk tolerance is made up of willingness and ability to tolerate risk. Ability is usually a quantitative concept where a lower proportion of spending to total assets equals higher risk tolerance. Willingness is much more qualitative and comes from the client’s fears and hopes.
    • Return requirement and objective (simplified) is what the client wants to do with their money and what kind of return they need to get there.
    • Taxes is fairly explanatory
    • Liquidity is the spending needs the client needs, within the next year or during retirement
    • Time horizon- the material approaches this in terms of ‘stages’ around life events. Usually something like pre-retirement or pre-college spending and post-retirement.
    • Legal usually doesn’t factor into individual IPS expect with trusts and other legal documents
    • Unique Circumstances is a catch-all not addressed elsewhere, usually something like client prohibitions against investing in vice assets (smoking, alcohol, gambling, etc) or Socially-responsible investing

The tax material is fairly lengthy, but again time spent here will save you next year. Start with the basic formulas and concepts behind the different tax regimes. Pay attention to the concepts under tax loss harvesting or deferral within taxed accounts and the compare/contrast material with retirement accounts.

Wow, we’ve made it through the entire curriculum. Hopefully, you have been able to keep up and have been doing well on practice problems and using other resources. You’re not done just yet. There’s still three weeks left to the exam and they can be the most important three weeks of your preparation. We’ll cover what to expect on test day in Friday’s post and other tips and strategies in subsequent posts all the way up to test day.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Level 1 Review, Derivatives

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Study session 17 in the CFA Level 1 curriculum consists of six readings (60-65) covering derivatives. The material is still fairly conceptual but is pretty lengthy. While the topic is only worth 5% of your Level 1 score, you will need it as a base for the 5% to 15% in each of the next two exams. As with most of the CFA Level 1 curriculum, focus first on the basic concept and differences, advantages and limitations of each type of derivative.

Derivative Markets and Instruments
Derivatives are called such because they are instruments that ‘derive’ their value from the value of an underlying asset. The value of an option, futures contract or swap depends on the price of the asset on which it is written. How much you would pay for an option on a share of Apple depends on how much a share of Apple stock is worth.

Derivatives are traded either over-the-counter or on an exchange. The distinction is important and very testable. Over-the-counter is between two private parties while exchange traded is usually through a clearinghouse (a third party that takes both sides with each party). Exchange-traded derivatives usually have less transaction costs, are standardized and expire on regular calendar dates. The do not carry counterparty risk because of the clearinghouse and are usually marked –to-market with a margin. OTC derivatives have counterparty risk because you don’t really know if the other party can deliver but they are completely customizable to your needs.

Forwards and futures are basically the same instrument except futures are exchange traded while forwards are OTC. Swaps are an OTC agreement between two parties to exchange principal, i.e. an interest rate, currency or commodity.

An option gives the party the right to buy/sell an asset but not the obligation. The buyer can pay a small premium now for the privilege of locking-in the buy/sell price on a later date but does not have to worry about the obligation to deliver. Besides the derivatives material, options will be important in bonds and asset-backed securities as well.

Forward Markets and Contracts
Besides the basic concepts of a forward, the payoff calculation of a FRA is the most important and testable material here. The payoff for a Forward Rate Agreement is:

((Expiration rate – Contract rate) (days in rate/360)) divided by ((1+epiration rate) (days in rate/360))
Multiplied by the principal on the contract.

Think about it logically and the formula becomes easier to remember. You are looking for the difference in rates (adjusted for the term of contract since rates are quoted on an annual basis) as a percentage of the expiration rate. This factor is then multiplied by the contract principal (the notional) to get the payoff. *remember to use 360 days

Futures Markets and Contracts
Mostly conceptual stuff here with the focus on advantages of futures over forwards and the different participants in the futures market.

Option Markets and Contracts
Know the basic concepts behind a put and call as well as how to calculate the payoff at expiration. Most options are pretty easy to calculate but rate options get a little more complicated.

The payoff on a rate option is: (principal) *((exercise rate – rate at expirate)(days in rate/360))
*Remember, a rate option isn’t paid at expiration, it is paid the number of days in rate after the expiration (i.e. an option on 180-day LIBOR that expires in 90 days would be paid in 270 days but the payoff amount is calculated at expiration.

The put-call parity formula can be a pain but you will need it here and it will appear again in the second exam, so spend the time to learn it. Understand how puts and calls can be used to create a synthetic position.

Know the Greeks and their respective measures. Again, something were you just need the basics here but more detail in subsequent exams.  Three of the Greeks start with the same letter as the definitional word which is how I remembered them.

  • Delta- sensitivity to price change
  • Gamma- sensitivity to delta change
  • Rho – sensitivity to rate change
  • Theta – sensitivity to time change
  • Vega – sensitivity to volatility

Swap Markets and Contracts

Most swaps do not include an exchange of principal at initiation and the payments are netted but currency swaps do because the notionals are in different monies. Be able to calculate the amounts exchanged at initiation as well as on settlement dates.

Be able to calculate the basic payments for an equity swap for both parties and the reasons one would enter into a swap (i.e. protect capital gains while avoiding taxes or to hedge volatility)

Risk Management Applications of Options Strategies
I’m pretty active in the options market, both as a hedge and for investment, so I found this material interesting when I took the exam. The two main strategies are covered calls and protective puts (also called portfolio insurance). You’ll need to understand the basics of each, why investors might use them and to calculate the payoff at expiration.

  • Protective put: buying a      put option against a long position has limited downside but maintains      upside potential.
  • Covered call: Selling call      options against a long position has more downside risk and limited upside      potential but involves collecting a premium instead of paying for      protection. The strategy is best if rates/prices do not change.

Study session 18 concludes the CFA Level 1 curriculum with two readings covering alternative investments.

‘til next time, happy studyin’
Joseph Hogue, CFA

Which topics usually show up on the CFA Level 3 Essay Section?

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While I’m generally not one to recommend ‘gaming’ the CFA exams, knowing which topic areas and material has a better chance at showing up on the essay section of the Level 3 exam can help out big time. The afternoon section is worth just as many points and you still need to master all of the curriculum, but the morning section can make or break your day.

First, a disappointing experience in the morning can devastate your confidence and ruin your concentration during the afternoon. You need to go into the exam feeling like you’re going to pass and carry that optimism all the way through. Secondly, there are questions that are more suitable and do show up in the essays. Preparing for these through practicing old exams will put you way ahead anyone on test day.

Your first question on the exam will always be an individual portfolio management question. The individual management question is usually around 12% of the exam (44 points) and will either be a multi-period return or a single-period return. Within the question you’ll often see questions on taxes, investor behavior and estate planning but the core is built around the return objective, risk tolerance and the five constraints. We’ve covered a few of these in the past, linked here and here for review.

An institutional portfolio management question usually follows directly but last year it didn’t come until #6, but you will always see one. It is usually around 36 points (10% of the total exam) but ranges from 24 to 49 points. There’s really no way of knowing which institution type will show up but make sure you know the basic comparisons between them all for the IPS components. We’ve done a couple of past questions, linked here.

Practicing several (at least) old individual and institutional questions from past exams will make your day on that first Saturday of June. Imagine starting the exam being totally confident and easily completing the first two questions and knowing you’ve just aced about 20% of the exam!

Economics has been in the morning section in each of the last four years and has been worth an average of 11% of your morning score. Biases and sources of error in data is a popular topic along with one of the economic measurement tools  (tobin’s q, fed model, cobb douglas, h-model, yardeni ). We ran through the 2011 Economics question here.

Risk management is often in the morning section, though it skipped last year. The question is usually about 10% of your morning score and often has a question about hedging with options, forwards, futures or swaps.

Asset allocation is another that usually shows up but was skipped last year. Some will say that this makes it more likely to show up in an essay this year but there’s no real proof of it (though I would agree from what I’ve seen in the past tests). The question is around 15 points (about 8% of your morning score) and will often be a selection of an appropriate portfolio or calculation of corner portfolios. The basic concepts, differences and advantages/disadvantages of the portfolio techniques is also something that has come up in the past (Black-Litterman, Mean Variance Opt., resampled efficient frontier, Monte Carlo). Linked here is the 2011 Asset Allocation Question.

Performance evaluation and the material on monitoring/rebalancing are also frequent essay questions. Each has had a question in three of the last four years with an average of about 15-17 points. Make sure you can do a micro- and macro-attribution for performance evaluation as well as breaking total return down into its components. The buy/hold, constant mix, and cppi methods of rebalancing often show up as questions so make sure you spend some time there as well.

The material on fixed income and equity investments also frequently find themselves into an essay question though no specific formulas or processes jump out as regulars. Even if you receive a question in the morning section, the topics are a fairly large percent of your total score so you may get a question in the afternoon as well.

The material in corporate finance, financial reporting & analysis, and quantitative methods don’t usually show up in the morning section. The material in alternative investments shows up only rarely, with a question on swaps and futures in 2009 (question #8).

We cover study session 18 next week and will spend the last few weeks reviewing and talking about test day. Let me know if you have any questions,

‘til next week, happy studyin’
Joseph Hogue, CFA

CFA Level 3 Review, Portfolio Evaluation

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Study session 17 in the CFA Level 3 curriculum concludes the portfolio management topic area with two readings (41-42) on performance evaluation and attribution.

Evaluating Portfolio Performance
The curriculum gives several ways to calculate the rate of return on an account depending on if and when cash flows occur. Don’t try to memorize each individual method, instead think about it intuitively to work through the problem. If cash flows happen at the beginning of the period, then they should be included in the return metrics because it is money that was/wasn’t in the account for the entire period. If cash flows happen at the end of the period, they should not be included.

Understand the difference between time-weighted and money-weighted returns. The money-weighted return is the IRR and is only appropriate when the manager has discretion over deposits/withdrawals.

The material on benchmarks is fairly testable, make sure you know the types of benchmarks and advantages/limitations.

  • Absolute is the return objective or a minimum return target on the portfolio. It is simple and straightforward but not investable.
  • Manager universe  is usually the median manager or fund from a broad list. It is measureable but not investable, specified in advance, and is ambiguous.
  • Broad market is the comparison to a market index like the S&P500. The benchmark method is easy to understand, widely available and unambiguous, investable and measurable but there may not be an index appropriate for the manager’s investment style.
  • Factor model based uses models to relate systematic sources of returns to the account through  a regression model. It can be modeled to the manager’s specific style but may be difficult to use, ambiguous, and may not be investable.
  • Returns based benchmarks are constructed using the series of account returns and the series of style index returns over a period to make allocation weights. The method is intuitive and simple, unambiguous, investable and specified in advance but may not be matched to the manager’s actual style and require detailed data points.

Understand the basic steps to creating a custom security-based benchmark and its advantages/limitations.

Question #9 in the morning section of the 2010 and 2011 Level 3 exams was an attribution problem. I highly recommend that you download the test and the guideline answers to work through the problems. You need to be able to do both a macro-attribution and a micro-attribution analysis. The past three years of essay questions and guideline answers are available here.

Understand the objectives and basic process for a manager continuation policy.

Global Performance Evaluation
The reading revolves around breaking a total return out into its three components: capital gain (in the local currency), yield, and currency return.

Example: If you invest $100 in the Mexico index on January 1 2013 and by the end of the year the index has increased by 10% with a depreciation of 3% in the peso against the dollar, what is the return of the investment in dollars? (no dividends paid)

The return to currency is (% change in currency)(1+return +yield) = -.03(1+0.10+0)= -0.033
The return in the domestic currency is (cap gain)+(yield)+(currency)= 0.10+0+-0.033 = 6.7%
**Note it isn’t as simple as reducing the overall gain by the 3% depreciation

You will also need to be able to break the total portfolio return down further to its returns from market selection, security selection, yield and currency. The market selection return is that which would have been achieved with a passive investment in the local market index. The security selection component is made by the manager’s individual selections, in the local currency and compared to the market index.

Beyond the two types of global attribution analysis, the material on active and passive currency management is fairly testable. Passive currency management can be fully hedged to the exposure or selectively hedging some currencies but not others. Active currency management is a strategy that differs from the benchmark and creates different exposures. Currency management is usually done by futures or forwards as seen in the prior topic area.

Be sure to catch Friday’s post where we’ll look at what topics typically show up in the Level 3 morning essay section. We’ll cover study session 18 in the CFA Level 3 curriculum next week, which consists of one reading on the Global Investment Performance Standards (GIPS).

‘til next time, happy studyin,
Joseph Hogue, CFA