Even with the change to topic area weights on the CFA exams this year, CFA Ethics and Professional Standards remain extremely important. It is a lot of material but fortunately doesn’t change much from year to year and you’ve got a real opportunity to carry over some points to each exam if you learn it early.
This post is going to offer the most important advice on HOW to study for the Chartered Financial Analyst exams, or really any exam.
CFA Level 3 experience
After CFA Level 2 exam, I enjoyed the final exam of the series though it presents its own challenges. If you approach it wisely, following these five points, CFA Level 3 exam can be just as enjoyable when you take it.
CFA Level 3 – It’s all about the Essays
The essay portion of the exam terrifies many candidates and for good reason. Not only are you asked to come up with your own answers, much more difficult that picking it out of three options, but the essays present a physical challenge as well. When is the last time you spent almost three hours straight writing by hand? The post-exam party is filled with more than a few horror stories about muscle cramps and aching hands. You must physically prepare yourself by doing consecutive essay problems and writing for hours or you will not make it through the morning section.
CFA Level 3 – Essay questions topics
Most of the topic areas are fair game for essay questions. The first two questions will always be on individual and institutional wealth management so being ready for those two topics can give you a huge confidence boost for the rest of the test. I covered the essay section in more detail in a prior post linked here.
CFA Level 3 – The only exam with prior year’s available
Ok, this one is about the essays as well but I thought it merited its own bullet. The Institute releases the essay section, along with guideline answers, for the last three years. This is huge and I don’t think most candidates take advantage of it. Working through these essay questions not only helps you study the material and practice writing for an extended period, it also helps you write more efficiently and get a feel for the types of information for which the Institute is scoring.
We worked through several essay questions from prior years, click here and scroll through last year’s study plan. While only the last three years’ exams are available, you should be able to get prior years’ essays from members of your local society. Ask around to see if anyone has the PDF copies. It is well worth the effort to have a couple more sets of practice essays, especially in the all-important wealth management topic area. Make sure you check for LOS changes between the test year and the current year for material that has been dropped or changed.
CFA Level 3 High Pass Rate – Don’t get overconfident
You’ve made it through two of the hardest exams of your academic life and notice that the pass rate for the CFA Level III exam is above that of the other two. Sounds like it is time to sit back and ease through to your charter, right?
You have put in too much work to get lazy now. While the pass rate on the Level III exam, 54% in 2016, is higher than that of the other exams it is still incredibly difficult. Think about it, every CFA Level III candidate has had the perseverance and has put in the effort to pass the other two exams but less than half will make it through the exam this year.
Put in just as much time and work for this final exam as you did for the other two levels. Not only will you be rewarded with a passing score, but mastering the essay section will give you the ability to talk through these topics in your job.
CFA Level 3 – Harder to ‘game’ the topic areas
You could clearly see in the other two exams which topic areas were most important and where you should focus your studying. The topic weights don’t help much on the CFA Level III exam. Ethics and the asset classes are weighted but the investment tool topic areas are wrapped up in portfolio management. This uncertainty throws some candidates for a loop and leads to inefficient use of study time.
Fortunately, by studying the prior essay sections, you can get a good idea of topic area importance. Look through the prior three years’ morning sections and you will see that the two portfolio management topics are always considered (with each historically above 10% of total exam points).
Again, studying these previous morning sections can give you nearly everything you need.
Do not wait until you pass CFA Level III exam to start thinking about the charter
You will not immediately be granted the charter after passing CFA Level III exam. You first need to fill out an application for membership and acquire two sponsors that will answer questions on your experience. One of these will need to be your current supervisor, the other needs to be a charter holder from the local society. Now is the time to start talking to society members and establishing a sponsor. In my own experience, it is frustrating when a candidate comes out of nowhere and asks for a sponsor when you have never talked or really know what they do.
CFA Level 3 – Work requirements
You will also need to complete the requirement for 48 months of professional experience. This is the sticking point for a lot of candidates and many have to wait years until they can use the designation. There is not much you can do if you are taking the exam this year and do not have the necessary experience. Review the work experience guidelines established by the Institute, linked here. If your current responsibilities do not qualify, you need to start looking at your options. Consider talking to your supervisor to add some responsibilities to your role that might help qualify.
CFA Level 3 – Study as hard as you did for the other two
As a level III candidate, you are almost there and the anticipation building up to the exam can be unbearable. Take a step back and realize that you still have one hurdle to jump. Study just as hard for the final exam as you did for the other two, maybe harder, and go into that first Saturday of June with the confidence to pass.
‘til next time, happy studyin’
Joseph Hogue, CFA
Last updated: October 7, 2016 at 3:34 am
On CFA Level 3 exam, a candidate has two sessions, one comprising of 10 item-set questions (afternoon session) and the other comprising of 9-15 essay questions (morning session). The afternoon session is quite similar to CFA Level 2 exam and therefore, should be handled in the same manner as the CFA level 2 questions. However, the format of the morning session is unique to this level. The morning session constitutes 9-15 essay questions, with each composed of 1-5 sub-parts. Following are some tips for preparing and attempting CFA Level 3 examination.
Preparation for CFA Level 3 Exam
- Most candidates believe that CFA Level 3 exam is easy and much less demanding than CFA Level 2 exam. They, therefore, take their preparations slow and easy. This is a grave misconception! Start early and spend at least 10-12 hours a week studying FinQuiz curriculum notes.
- In item sets, a student is provided with three options, one of which is correct. However, in essay questions, the student has to come up with the exact correct answer himself. Hence, it is imperative that you know, and are able to retain and recall, every important concept, formula and relationship.
- Analyze and identify the areas having a higher probability of being tested as essay questions. Examples of such areas would include behavioral finance, individual IPS, institutional IPS, fixed income and equity.
- Portfolio management is an area that carries the largest weight. Make sure you know this area inside out and can attempt questions presented from every angle and perspective.
Reading the material for CFA Level 3 Exam
While reading the material to prepare for such questions, use the following tips:
- After understanding a concept, try to memorize all important points related to it. A helpful way of doing this would be to box the important details while reading. You can also number the points by underlining them and writing superscripts 1, 2, 3 and so on for every topic. This way it will be easier to learn and retain the points.
- Reviewing the material as you progress is especially essential for essay questions. Have a proper review plan in place and follow it religiously.
- Know how one topic relates with the other. Flowcharts and similar graphical depictions can help in understanding relationships and are effective means of retention. FinQuiz Smart Summaries are excellent source for this.
Practice for CFA Level 3 Exam
- A great deal of practice will not only help familiarize you with the format of such questions, but will also illustrate how to approach them.
- Remember to review each practice test carefully after attempting it and determine what information was required and how it is graded. Analyze your mistakes and weaknesses. You would notice that, sometimes, you missed out on writing needed information even though you knew it and instead, wrote something that was not required. As you practice further, you will get better at attempting such questions.
- The only way to avoid leaving points during the final exam is to do practice essay questions under a time constraint over and over and over again. There is no substitute for intense essay practice.
Attempting CFA Level 3 Exam
- When attempting essay questions read the question first and then read the case. Try to keep in mind what is needed when you are going through the vignette.
- Apply your time management skills for this exam. Go through the exam once and answer the questions that come easy to you first. This will prevent you from failing to answer all the questions.
- Answer questions by focusing on key words in the vignette. If you don’t know the complete solution, answer with what you know since CFA Institute grants partial marks.
- Don’t miss easy points by assuming that they must be something the examiner would know. Remember, every point is important.
- Answer each sub-part using clear, precise and relevant statements. Remember, your answers are your only communication with the examiner—try to tell him/her that you know what you are talking about. Be as relevant as possible; writing unnecessary details will leave a bad impression on the examiner and will be a waste of your precious time.
- An appropriate format of attempting essay questions is to use bullet points.
- Space your words and sentences so that they are easy to read.
- Do not write lengthy answers; try to be as concise and accurate as possible and explain the answer in just a few lines or so. Knowing how answers are graded will illustrate how objective you have to be when answering; writing long, unnecessary stories will give you no extra points.
- When answering numerical questions, start by writing the data and the formula. Show your calculations and write the final answer prominently. Remember, there are marks for each important step of the calculation.
- No matter how poorly you have done in the morning session, don’t lose hope. The afternoon session carries equal weightage and is as critical to passing the exam as is the morning session. Try to relax during the mid-break and focus on the item sets in the afternoon. For many candidates, the afternoon session scores have been central to passing the exam.
You should review yesterday’s post CFA Level 3 – How to Pass as well.
Last updated: August 3, 2016 at 3:48 am
Arriving at CFA level 3 exam for the CFA charter is an accomplishment in itself. With a fail rate of around 50% at each level, you have made it where approximately 75% of candidates could not. While the final exam is not one to underestimate, there are some strategic decisions that will make it easier.
There are strategies that will get you through all three exams and those that you will need to change for each test. We will cover those strategies and advice specific to CFA Level 3 exam here and hold the broader suggestions for a future post. We will also look at two different schedules in the strategy post that could aid in planning.
CFA Level 3 Contents, Format and Basic Strategy:
CFA Level 3 exam can be the most intimidating for some because of the essay questions. Unlike the other two levels, you will be asked to take the concepts in the curriculum and develop your own recommendations and solutions. This can be tough for a lot of people and will almost certainly test your ability to manage time during the test. The good news is that the essay section does not have to be overly difficult, you just need to follow some basic preparation strategy. I was actually pretty surprised at how easy it seemed compared to what the monster I had built it up to be before exam day.
CFA Level 3 Exam – For those that can put everything together!
CFA level 3 exam is more conceptual and practically-based than the other two exams, making it easier for those that can put everything together. The morning session of the CFA Level 3 exam has a maximum score of 180 points and will include 10-15 essay questions with as many as 7-8 separate questions within each. Some questions will require that you write on lines directly under the questions, other questions will be answered in a template box on another page. Do not answer the ‘template’ box questions directly under the question on the exam. It will not be graded! It can be confusing answering some questions directly below while others are answered on separate pages so you want to go through and draw a line under the ‘template’ box questions so you are not tempted to put your answers under the question.
CFA Level 3 and time management
Time is many CFA level 3 candidate’s worst nightmare, but it doesn’t have to be. Just because you have five lines or a three-inch by three-inch box in which to answer does not mean that you must use this entire space. Nor does it mean that you cannot use bullets! Graders are not looking for spelling or grammatical ability, only that you understand the curriculum and can put together a solution.
CFA Level 3 – Topic Weight Differences on the Exam
Comparing the topic weights for CFA level 2 and CFA level 3 exam provided by the CFA Institute, there are a couple of things you should note.
- First, it is much harder to concentrate on ‘core’ topics because the Institute rolls up many of the topics into Portfolio Management. This means that, while the percentage weights for Investment Tools shows a zero weighting, these sections are still tested within the 45-55% of the exam under portfolio management.
- The topic weight ranges in Asset Classes is fairly wide and difficult to draw conclusions as well. Fixed Income is given a slightly higher weighting, but only on average. You are guaranteed of seeing at least one essay or item set from each topic, but could get more. This, combined with the fact that no clues are given as to which subjects within each topic are more important, means that you must cover these topics fairly broadly as well.
CFA Level 3 Exam and last three years’ essay exams
Fortunately, CFA level 3 exam revolves around the essay questions and the Institute makes available the last three years’ essay exams for practice. While the Institute changes the questions each year, practicing these essay exams is a great start to building your confidence and understanding of the material.
CFA Level 3 – Which questions to be answered first?
As with CFA level 2 strategy for item set questions, you may want to answer those essay questions which you feel strong in the material. This will get you the points you know, will help you bank some time and help your confidence. What I mean by ‘banking’ some time is that you will be able to do those questions you know in less time than the allotment leaving you more time for the more difficult questions.
Do not spend too much time on relatively low-point questions within the essay section. Time is a problem for many candidates, so If a question is only worth a few points it doesn’t make any sense spending 15 minutes trying to get it right. Spend time on the higher-point items and the easy ones, then return to unanswered questions if you have time.
Another critical point on the essay section is to show your calculations when the question asks for it. The graders are allowed to assign partial credit for correct procedures or partial answers. If you do not show your calculations in the exam booklet, not only will you not get partial credit you may not even get credit for correct answers.
Ethical and Professional Standards is off less importance on the last exam but still two item sets in the afternoon. You should have a good understanding of the Standards, so spend some time understanding the new material and move on to other topic areas.
Economics is again fairly conceptual section other than a few growth and market valuation formulas. The topic is also secondary, so make sure you understand the key points and reasoning then spend your time on other areas.
The asset classes (Alternative Investments, Derivatives, Equity Investments, Fixed Income) are also much less quantitatively intensive at the third exam but still include quite a few formulas. The impetus on the third exam is how these asset classes fit together in a portfolio. A large section is devoted to risk management and how the asset classes each have different fundamentals. Be sure to understand return drivers and risk characteristics for each class.
Focus of CFA Level 3 exam
Portfolio and Wealth Management is the focus of CFA level 3 exam. Your first two essay questions in the morning will be individual and institutional wealth questions. While these specifics of these two questions vary from year to year, there are a limited number of topics that are tested. This makes it extremely important to practice the old essay questions to get a feeling for what and how questions are asked.
Key in this section is the Investor Policy Statement (IPS) and its components. Spend as much time as you need to master this section because it will be big points on the exam. Understand the differences in risk and return needs for the institutional investors as well as their differences in IPS constraints. The biggest aid here is again the past essay exams posted by the Institute. Besides the exams, also available are guideline answers. These are important to get a feel for what the graders are looking for within the questions. Study the answers in detail to see what information you need to write in your own answers.
Joseph Hogue, CFA
Last updated: September 14, 2016 at 4:53 am
Miss these CFA level 3 changes in the 2017 curriculum and risk missing out on those important few points that could get you a passing score
The CFA Institute has published its curriculum changes for the 2017 exams. The CFA level 3 changes for 2017 are very limited, really only posing new material over the same learning outcome statements (LOS).
You can download a PDF copy of the CFA level 2 changes for the 2017 curriculum by clicking through this link. The curriculum changes are available in a combined document or individually for each of the 18 study sessions.
The CFA level 3 changes for 2017 are pretty minor compared to previous years. One reading has been removed and one reading added to Private Wealth Management in study session five.
A new reading (Risk Management for individuals) has replaced the old Reading No. 12 (Lifetime Financial Advice: Human Capital, Asset Allocation and Insurance) in Study Session Five (Private Wealth Management).
There are almost no other material changes to the CFA level 3 2017 curriculum.
As with the prior two exams, passing the Ethics material is about working end-of-chapter questions to get a feel for how the CFA Institute wants you to think about the issues. My own experience with the Ethics portion on the Level 3 exam was that it seemed relatively easy. I’m not sure if it’s because I had already worked the topic in the two prior exams or if the Institute figures you must know the material by the time you reach the third exam.
As always, success on the CFA Level 3 exam revolves around your preparedness for the morning essay section of the exam. We covered the importance of practicing the essay questions released by the CFA Institute in a prior post along with working some of the exam questions. It looks like this is going to be the case for the 2017 CFA level 3 exam as well. We’ll cover more essay questions in the lead-up to the exam next year.
‘til next time, happy studying
Last updated: November 18, 2016 at 1:12 am
The essay section of the CFA Level III exam is one of the toughest for candidates but you can use past exams to get an advantage
Ask CFA candidates which is the most difficult part of the Level III exam and they will almost unanimously say the essay morning section. The essay portion of the Level III CFA exam is so widely feared that it shows up as one of the top answers when candidates are asked about the most difficult part of all three exams.
The irony is that the essay portion could end up being one of the easiest parts of the CFA exams. I couldn’t wait to tackle the morning section on the Level III exam because I knew exactly what to expect and that I was going to score big points.
You can go into the third CFA exam with just as much confidence. It all comes down to using one of the best resources made available by the CFA Institute.
When else has the CFA Institute given you the answers?
It’s not even a secret but too many candidates don’t know that the CFA Institute releases the actual morning essay section along with guideline answers. That’s not mock exams or practice tests but the actual essay exams that were given in prior years and the answers that would have gotten you full points.
Normally, the Institute releases the last three years’ exams for download along with a separate download of answers. Click through here for the Level III exam prep page and copies of the past exams. Not only does the page include downloads for the last few years’ essay questions but also a brief summary of the exam structure and timing.
The essay section of the Level III CFA exam consists of between eight to 12 questions, each with between two and five sub-parts. Each question and sub-question can be worth a different amount of points but the entire morning session is worth 180 points.
In no other place does the CFA Institute give you so much help on the exams. Download every previous exam available and use it as a mock exam. Not only will it help you learn the curriculum but you will become more comfortable with the essay section and writing for three-hours straight.
We’ve covered several essay questions from previous exams, click on the Level III posts category and scroll through a few. Since the curriculum changes a little every year, questions from many years ago may not be as relevant so always make sure you check to make sure the LOS of the previous exam’s question is still included in your curriculum.
Focus most of your study on the portfolio management questions, always the first two or three questions on every exam. The LOS and required calculations for these don’t change much and doing really well on these first few questions is going to give you a huge confidence boost for the rest of the exam.
Pay attention to how the guideline answers are structured for the previous exam questions. You can save a lot of time and still get full points if you learn how to express your answer with bullet points.
As with the rest of the CFA exams, follow instructions exactly. If an essay question asks that you list two reasons, only write out two reasons. You will only be graded on the first two reasons (or however many are required) so writing out other answers is a waste of time.
The guideline answers are not necessarily the only answer you could have provided for credit but is just a blueprint of the answer for which the grader was looking. Remember, there is partial credit in the CFA Level III essay portion so write something out for every question. Even if it is a multiple part question and you don’t know all of it, write out what you can and show your calculations. Again, follow directions and show your calculations! Even if you get the final answer wrong, you may still get some points if you were on the right track.
Some of the essay questions will require that you write the answer out directly under the question while others may refer to another page for the answer. PAY ATTENTION HERE! Make sure you follow these directions. I wasn’t paying attention and put the answer to some of my essay questions directly below the question instead of on the appropriate page. Fortunately, I had enough time that I was able to copy the answers to the right page but not everyone is as lucky.
The Level III essay portion of the CFA exam does not have to be as scary as candidates make it out to be. Study the prior exams and take advantage of this huge gift from the Institute. Work at least three of the prior essay exams and you’ll be way ahead of many candidates and ready to tackle the CFA essay exam with all the confidence you need!
‘til next time, happy studyin’
Joseph Hogue, CFA
Last updated: July 18, 2016 at 15:48 pm
In past years, we’ve posted quite a few reviews of previous essay questions from the CFA Level 3 exam. The CFA Institute makes the last three years’ morning section available for download and review on the website. The three downloads include the morning section of the exam as well as the guideline answers provided by the Institute.
I highly recommend you click through and download the 2012 through 2014 Level III CFA essay questions for review. Studying and working these questions is the best way to practice for the Level 3 essay section.
Instead of working through the 2014 questions, I thought we would highlight prior essay questions this year to give you a good resource of practice problems.
There doesn’t really appear to be much in the CFA Level 3 2015 changes that would affect your morning section essays. I posted a review of the Level 3 changes last August. Only one new reading was added (Market Indexes and Benchmarks) while two readings (International Equity Benchmarks – Corporate Performance, Governance and Business Ethics) were removed. A few of the topics have been shuffled a little but the readings have stayed largely the same.
A post last year looked at topics that typically show up on the morning section of the CFA Level 3 exam. There is no guarantee that these will show up on this year’s essay exam but you can see a pattern by studying the prior exams. Having an idea of what to expect can really help drive your study plans and give you the confidence you need going into the exam.
Individual Portfolio Management
This post works through Question #2 on the 2013 CFA Level 3 exam, an individual portfolio management question. The morning section ALWAYS starts out with at least one question on individual portfolio management. You need to work as many of these as you can before the exam to really get confident about the topic. Doing really well on the very first question of the exam is going to give you a huge confidence boost for the rest of the test.
This post works through Question #1 on the 2013 CFA Level 3 exam, a single-period return calculation. There are two main types of return calculations you could see on the individual portfolio management section (you will always see one of the two, so be ready). A single-period return is usually what is needed or earned for the next year to a stated retirement date. A multi-period return is usually something like the necessary return over remaining years to retirement.
This post covers Question #2 of the 2011 CFA Level 3 exam, an individual portfolio management question with a single-period return calculation.
Institutional Portfolio Management
While exam year’s prior to 2012 are no longer available to download from the CFA Institute, you can contact Finquiz for copies of exams used in blog posts. The post from April 5th of last year covers Question #3 on the 2011 CFA exam. Like individual portfolio management, you will always get at least one question on institutional portfolio management and it will always be directly after the individual PM questions. So if you are well-prepared for these two sections (indiv. and institutional PM) you can bank a lot of time and may be able to get easy points on up to a fourth of your exam score.
Another post covers Question #3 on the 2009 CFA Level 3 exam, an institutional PM question covering a company and a foundation.
This post covers Question #3 on the 2009 CFA exam, an institutional PM question for a defined benefit pension plan.
The material in behavioral finance has changed a little over the past several years so it’s a good idea to read through the questions quickly to make sure the content is still relevant to this year’s curriculum. This is a good idea when working through any of these questions, not just those in behavioral finance. This post covers Question #4 in the 2012 CFA Level 3 exam on biases and cognitive errors. Behavioral finance often comes up in the morning section so make sure you are ready to select and explain answers.
Economics is also often tested in the morning but fortunately a few concepts seem to come up frequently. Learn the various production functions and models in the curriculum and you should be ready. This post works through Question #4 on the 2011 CFA Level 3 exam.
The asset allocation material on the exam is mostly conceptual but there are some basic calculations you’ll need to know and may have to perform on an essay question. This post on Question #5 of the 2011 CFA Level 3 exam covers conceptual material on different allocation models as well as the ALM.
This next post covers Question #9 on the 2012 CFA Level 3 exam, a question on options with delta hedging and conceptual material on how gamma changes closer to expiration. I included an important point in the article, budgeting your time on the morning essay section. This particular question is worth 12 points from three parts, or about 3% of your total exam score. That is significant and not something you want to skip over but you have to be realistic about your time as well. For each essay question, the time you spend should correspond to the number of points available, i.e. 12 points equals 12 minutes. If you can do the question in less time it will allow you to spend more time elsewhere. If you haven’t saved up a lot of time on other questions, and feel like it is going to take you a long time to answer one particular question, you may want to move to another questions and come back to the more difficult one.
The worst thing you could do is spend all your time struggling through one or two questions and not have time to get to later questions where you could have easily gotten the points.
Notice that I spend more time on the blog working through the essay questions for individual and institutional portfolio management. Again, it is extremely important that you work as many of the questions from these two topics as possible. Not only will it mean picking up around a fifth of your total exam score, it will give you the confidence you need to do well through the rest of the exam. Being able to complete these two topics quickly will save all the time you need to get through some of the more difficult essay questions.
Contact Finquiz for copies of the 2011 and 2009 Level 3 exams needed to complete linked posts here. The 2010 exam is also available for review.
Good luck, just six weeks left to the 2015 CFA exams!
‘til next time, happy studyin’
Joseph Hogue, CFA
Last updated: July 21, 2016 at 5:13 am
The readings and Learning Outcome Statements (LOS) are out for the 2015 CFA curriculum and there have been some significant changes. Make sure you download the curriculum outline and new LOS from the CFA Institute website.
The most surprising change has been a modification of the topic area percentage weights on the exams. The previous topic weights had been the same for years, before I was a candidate, and no one really saw the changes coming. The actual changes are relatively marginal but still surprising. While new topic weights were given to many topics in the first two exams, it looks like the weights have been removed altogether from the Level 3 exam.
At first glance there appears to be huge changes to the Level 3 curriculum this year but closer inspection reveals less new information and a simple reshuffling of study sessions and readings. The Institute has changed study sessions around, condensing some and separating others.
Private Wealth Management has been separated into two study sessions. Economics and Capital Market Expectations were two study sessions last year but have been rolled up into SS7 this year. Asset Allocation has been separated into two study sessions, eight and nine, this year. Equity Portfolio Management has been condensed from two study sessions to just one. There are also readings that have been moved from one study session to another.
After all that, only one new reading has been added (asset allocation) and three readings have been removed (one in Ethics and two in Equity Investments).
The new (11th) edition of the Code and Standards is not materially different from the previous edition. Some of the standards have been modified to include a more proactive requirement, i.e. the need for supervisors to take positive steps to promote compliance rather than disciplinary action.
(20) Market Indexes and Benchmarks
(3) Ethics in Practice(24) International Equity Benchmarks
(25) Corporate Performance, Governance and Business Ethics
The removal of topic weights from the exam is not necessarily a big change. Suggested topic weights for the Level 3 exam always had a large range and were not very useful anyway. Portfolio management, i.e. individual and institutional, are still going to be major sections and worth every minute of study time.
The Level 3 CFA exam is still all about the essay portion and the best way to approach it is still by going through old exams released by the Institute. The guideline answers to the essay exams reference a specific reading from the curriculum so make sure that reading is still included in the curriculum. We’ll cover several essay questions from prior exams in our review leading up to the 2015 exam.
‘til next time, happy studyin’
Joseph Hogue, CFA
An email from a Level III candidate brings our post today over two changes in the curriculum this year. The changes were not the only ones but the candidate wanted to know how to approach the two new readings, reading 13 (Concentrated Single Asset Positions) and reading 28 (Currency Management).
After looking back over the new readings, there may be less of a change than candidates are expecting. For those taking the exam for the first time, the change means little because they did not see the old curriculum. For those retaking the exam, the new material is going to look a lot like the old material.
Concentrated Single Asset Position
Previously, reading 13 covered Low-basis Stock but dealt with some of the same issues as we see in the new reading. Two of the previous LOS required candidates to understand psychological considerations, risk, tax issues and techniques for reducing a concentrated position. The new reading brings with it 10 new LOS but the reading looks relatively intuitive.
The reading revolves around the issue of diversification and company-specific risks that come with a large single-asset position. Not only do you have to worry about limiting these risks but your have to do it in a tax-efficient manner.
List material is always a good bet on the Level III exam. It is relatively easy to test on the exam, especially the essay part. Remember the considerations affecting a concentrated position (taxes, liquidity, market constraints, and psychological constraints) as well as the common strategies (sale, hedging, and monetization). Pay special attention to advantages and disadvantages to each strategy when available.
There doesn’t look like you need any calculations so make sure focus on the conceptual material. Lists and the advantages/disadvantages to different tax regimes and strategies should also be remembered.
Currency Management was previously seen in reading 35 as Currency Risk Management but now becomes reading 28 and Currency Management: An Introduction. The new reading is still within Study Session 14, Risk Management and the LOS look similar if not identical in spirit.
Foreign exchange concepts is probably one of the most difficult for many candidates but extremely important. You absolutely must understand the basics because you will need it within multiple topics (Financial Reporting in Level II, Portfolio Management, and Risk Management). If you did not master the basics in an earlier level, you might want to go back and review.
The important calculations are finding the mark-to-market value of a position and the return decomposition. Focus on these before any of the other formulas and spend your time on the conceptual elements of the material. As long as you understand the conceptual material and the two important calculations, you should be able to get most of the points on the exam. As with the section above, the list material is a good place to start. Lists can be easier to remember and have a good chance of showing up on the exam. Pay attention if any advantages or disadvantages are offered.
Both of the new readings are fairly large and it really isn’t possible to list out all the concepts in the space we have here. The FinQuiz notes condense the two readings down to 28 pages or you may want to create your own outline of the material for easier review. Less is better with an outline so try to describe each concept or step in a process in no more than a couple of sentences.
Just a couple of weeks to the exam and you need to start wrapping up your studying. Work those practice tests and understand where your strengths/weaknesses are on the material.
‘til next time, happy studyin’
Joseph Hogue, CFA
This post works through the second essay question on last year’s CFA level 3 exam. If you have not yet downloaded the exam and the guideline answers provided by the CFA Institute, do so here.
The second question on last year’s CFA level 3 essay exam was worth 15 points, a little over 4% of the entire test, and covered topics with which candidates often have a hard time. The four parts, each worth three or four points, cover estate planning and taxes. They are topics in which many candidates have not had much exposure and the curriculum includes a lot of legal points that can be difficult to remember.
The vignette material is relatively small so there isn’t too much information to handle. As always, I read through the material and highlighted data and important points before looking at the questions. Within the material, the investor’s age and any numerical data is usually pretty important as well as any preferences.
Part A was fairly straight forward from the text. The wife is entitled to one of two percentages of the estate, either the 25% of total assets or the 50% of the increase in the estate during the marriage.
As always, remember to show ALL YOUR CALCULATIONS on essay questions. The question was worth 4 points and I bet you would have gotten at least two points if you wrote out the calculations for both percentages even if you ultimately picked the wrong one.
Usually these heirship rules will be spelled out on the exam but make sure you understand the basic concepts and terms for estate planning.
Part B is an important one to study for this year’s candidates. Questions on trusts have come up frequently on the exam. It is not a quantitative section but you need to know the basic rules and especially the differences between revocable and irrevocable trusts, as well as the advantages/disadvantages of each. Notice that the guideline answers provide four possible answers but the question only asks for two. The grader will only look at your top two answers so lead with the best and do not waste your time writing down more than you need.
Remember, with trusts the idea is a transfer of assets outside of probate that may protect assets from other claims and avoid family disputes.
The material on taxes is extremely long and quantitative but many of the prior essay questions have come down to qualitative ideas of whether taxes can be deferred and whether the future rate will be higher than the current. Part C was one of these types of questions and all the information was laid out in the vignette. In these instances, if the question seems difficult, try reading through the vignette focusing on only one solution (either the gift or the estate) and list out the tax rules that apply. Then you can compare the two side by side.
Part D was tough because you basically knew generation skipping or you didn’t. You probably would have gotten at least one point if you described the benefit without explicitly naming it ‘generation skipping’ so make sure you write out your reasoning on all questions. There are some quantitative sections on the estate and tax topics but it seems that the terms and concepts are the most important and will get you a good amount of the points.
The CFA Level 3 essays last year included three questions on individual portfolio management for a total of 14% of your total exam score. That is a huge chunk and combined with the institutional questions, portfolio management was almost a quarter of your exam score. Make sure you hit those two topics hard and be ready for this year’s exam.
‘til next time, happy studyin’
Joseph Hogue, CFA
Behavioral finance is always a tough topic for candidates because the material can be a little confusing and the sheer volume can be overwhelming. The topic really doesn’t have to take a lot of time though and can be some easy points.
Behavioral Finance and the CFA Essays
Behavioral finance is typically tested in the morning essay section of the exam and has been worth an average of 14 points over the last three years. While you need every point you can get, that is just 3.8% of your total exam score. You want to approach the section with the idea of getting the concepts and basic definitions without taking valuable study time from higher point topic areas.
The material is extremely definitional and lends itself really well to flash cards. If you can get the basic definitions of the concepts and vocabulary then you should be able to get the vast majority of the points on the exam. Take a look at the prior years’ exams to get an idea of how the behavioral questions are asked.
Make sure you understand the basic difference whenever a contrast is offered, i.e. the difference between traditional finance and behavioral finance.
The cognitive and emotional biases have shown up on the essays frequently so make sure you have a good understanding of these.
Understand the five belief perseverance biases, consequences and detection:
Conservatism –failure to incorporate new info after a view is established
Confirmation – selectively seeking information that confirms a prior view
Representativeness – tendency to make decisions based on stereotypes or patterns
Illusion of control – belief of ability to influence uncontrollable events
Hindsight – overestimate “ex-post” the accuracy of forecasts
Understand the four processing error biases, consequences and detection:
Anchoring and adjustment – similar to conservatism but is usually tested as an under reaction to new information rather than avoidance of new info or no reaction at all
Mental Accounting – often tested as investors dividing total assets into ‘buckets’ based on categories (i.e. leisure, necessities, emergency)
Framing – tendency to respond differently depending on the situation
Availability – tendency to overestimate the possibility of an outcome based on ease of which the outcome comes to mind (know the four sources of availability bias)
Types of emotional biases:
Loss aversion – includes house money effect and myopic loss aversion, tendency to treat investments differently depending on whether it is a loss or a gain
Overconfidence – tendency to overestimate own ability or knowledge
Self control – preference for present consumption (certainty) versus future (uncertainty)
Status quo – avoidance of change
Endowment bias – emotional attachment to an asset or investment
Regret aversion – avoidance of decision due to fear of regret
The difference between a lot of these biases seem relatively minor and semantic but they often appear in the exam. Besides the basic definition and consequence, understand the slight difference between similar biases so you can distinguish them in a question. This is really where practice on some of the past essays comes in handy, to see how the Institute frames questions.
The material is extensive but you really do not need to memorize every detail. The Finquiz Study Guide has 32 pages of notes on Behavioral Finance for Study Session 3 and can better help to explain the topic. Again, my advice for the topic area is to get the basic idea and concepts and then move on to higher point topics. Even if you only get 60% of the points by just taking a quick look at the section, you’ve only missed 1.5% of the total exam.
I haven’t heard much from Level I or II candidates on which topics they want covered on the blog. Let me know if any particular study session or LOS is giving you problems and we will try to hit it in one of the blog postings.
‘til next time, happy studyin’
Joseph Hogue, CFA
Last updated: July 18, 2016 at 16:05 pm
Passing the Level III CFA exam is all about the essay questions. You know what to expect on the afternoon vignette section and the curriculum is more or less consistently difficult in both the morning and afternoon sessions. The only unknown variable is three hours of application and writing.
Do not underestimate the physical challenge of the morning essays. Who really writes things out by pencil or pen anymore? You need to condition the muscles in your hand to be able to write non-stop.
Fortunately, the CFA Institute is uncharacteristically generous to level III candidates and supplies copies of the actual essay questions and the guideline answers for the last three years’ exams. The single best advice I can offer to level III candidates is download and practice those exams. Work through each exam at least twice.
We’ve covered a general review of the Private Wealth Management topic area last year and not much has changed in the curriculum. Click here for a review of the topic and how to approach it. You absolutely must know how to work through the two types of return questions and apply the constraints of the IPS. Remember TUTLL!
2013 Level III Exam, Question #1 Individual Wealth Management
Between the first two questions last year, the individual wealth management topic accounted for nearly 10% of your entire exam score (35 points of 360). Besides the technical importance, starting off the day by doing well on the first couple of questions will give you a huge confidence boost and sets you up for success.
Hit this section hard and master it!
Last year’s first question covers the Voorts and their needs in retirement. Some candidates like to read the questions first then the vignette. I always liked reading through the vignette first and underlining important information. Try it both ways in practice to see which you prefer for the exam.
A) This is a single-period return calculation (as opposed to the other type of question you might see, a multi-period return calculation. Be ready for both). Notice almost every questions says, “Show your calculations.” You can get partial credit if you show your calculations even if your final answer is wrong. Don’t forget!
The guideline answer is a pretty standard format. List out the living expenses with an inflation adjustment and reduce it by any guaranteed income like pension payments. Taxes and inflation are two of the biggest hurdles in these. Make sure you note where you need to incorporate taxes and inflation into the given data.
After you know how much is needed from portfolio assets, you need to list out all investable assets to find the portfolio size. After that it is a fairly easy calculation of cash needs divided by the portfolio value. Note, this will give you a real return requirement (without inflation) so you need to adjust upwards.
B) Part B is fairly easy. Understand which factors go into ability and which factors affect willingness to assume risk. Remembering this, you can quickly scan the vignette for specific details when you see either word. Notice the guideline answers lists five possible answers but the question ask for only two. Do not waste your time listing every possible answer! The grader will only check the first two.
Typically portfolio size to needed cash is a strong factor in ability. Even if higher risk led to a decrease in portfolio value, they could still probably meet their needs. Age is also a common topic with younger people having the ability to return to work.
C) The liquidity requirement is basically done in the return calculation above but I guarantee a lot of candidates forgot to include the cash reserve. Liquidity is not necessarily only the money you plan to spend but what you need set aside.
D) This ‘choose the most appropriate portfolio’ is fairly common and easy points. A few pieces of information are key: goal return, preference for risk and the risk-adjusted return.
Given the goal return of 3.5% means a return of 8.57% on a nominal pre-tax basis ((3.5% +2.5%/(1- 0.7)). Only portfolios X and Z meet this preference.
The Voorts do not want the portfolio to decline by 10%. Only Portfolio Y and Z meet this requirement.
Only portfolio Z meets both reasons.
With a little preparation, that is 20 easy points, nearly 6% of the entire exam in the bag. Be ready for these essay questions and they will be no problem.
We reviewed multiple essay questions from previous years on the blog last year. Click here for the review of Question #1 in the 2011 exam and scroll through for other essay questions.
‘til next time, happy studyin’
Joseph Hogue, CFA
Last updated: July 18, 2016 at 16:27 pm
The changes to the 2014 Level 3 curriculum from last year’s edition are the most extensive I have ever seen. Eight readings have been dropped, two readings have been replaced and one reading has been added. In all, the number of readings has dropped from 43 to 35 in the 2014 curriculum.
The de-emphasis on emerging markets and international assets is clear with most of the material dropped or fit into other readings with a generalized spin. This follows the general theme in the markets as international and emerging markets have fallen out of favor against a more generalized approach.
Most of the LOS changes are the more minor wording-type changes that really do not change what you need to study or understand. I have tried to catch the more important LOS changes below but most of the changes will come from the new or replaced readings.
As we’ve talked about in other posts, it’s up for debate whether new material is tested more heavily or not on the exam. I doubt that the Institute would try to trip up repeat testers that haven’t focused on new material but it’s intuitive that they would want to test the new material to see how candidates adopt it. Regardless, it’s important to understand the new directions the Institute is taking and to plan your studying accordingly.
Changes 2013 – 2014
Reading 13, “Low-Basis Stock” is replaced by “Concentrated Single Asset Positions.” While the two topics will have some similarities, i.e. low-basis stock is often a concentrated position for management, the LOS have changed and repeat candidates may want to spend some extra time here.
Study Session 5, Reading 17 – “Allocating Shareholder Capital to Pension Plans” has been dropped
LOS 18-b has been greatly simplified from a specific mandate to a more simplified, “discuss challenges in developing capital market forecasts.”
Last year’s Reading 20 in SS7, “Dreaming with the BRICs” has been dropped from the curriculum.
SS8, Reading 19 Asset Allocation has four new LOS (k through n). Three of these address portfolio effects from nondomestic assets, replacing a little of the lost emphasis from the dropped readings.
Last year’s Reading 22 in SS8, “The Case for International Diversification” has also been dropped.
Last year’s Reading 26 in SS10, “Hedging Mortgage Securities to Capture Relative Value” has been dropped
Last year’s Reading 30 in SS12, “Emerging Markets Finance” has been dropped
Readings 32 and 33 from SS13, “Swaps” and “Commodity Forwards and Futures” have been dropped to the massive cheers of candidates everywhere. Good material but extremely tough and why was there so much detail on derivatives anyway?
Reading 35 in SS14, “Currency Risk Management” has been replaced with Reading 28, “Currency Management: An Introduction.” It looks like the material is a little more basic though many of the LOS look the same. You’ll probably recognize most of the material if you took last year’s exam but don’t neglect the reading because there is quite a bit of new stuff here.
Study Session 16 is now called, “Trading, Monitoring, and Rebalancing” from last year’s, “Execution of Portfolio Decisions; Monitoring and Rebalancing” though the readings have remained the same and the LOS changes are relatively minor wording-changes.
Reading 42 from SS17, “Global Performance Evaluation” has been dropped
We’ll cover the changes to the level 2 exam in two weeks. Let me know if you have any questions or need something covered.
‘til next time, enjoy your break!
Joseph Hogue, CFA
What if you were dramatically unprepared for the CFA Level 3 exam and needed to focus on the most important information for the upcoming test. What would you study over the next nine days?
Whatever the reason, many candidates find themselves unprepared at this point whether it be real for a lack of studying or imagined from simple anxiety. While I wouldn’t think it’s possible to do all your studying in just the next week and a half, there are some sections you can focus on to get the most points and have a chance at passing the exam.
The topic weights for the CFA Level 3 exam doesn’t really help like it may for the other two exams. We see that each of the asset classes are worth between 5% and 15%, with the exception of fixed income which is weighted a little more heavily. Beyond these four topics, we’re only told that the rest of the exam, between 45% and 55%, is wrapped up into portfolio management.
We do know that the exam is divided into an essay section in the morning and a item-set section in the afternoon. Since the afternoon item-set section isn’t really any different than that seen in the CFA Level 2 exam, the best use of your time might be to focus on the morning essay section.
There are a couple of reasons for this. First, there is a lot that goes into the morning section that just knowing the material. You need to be able to write for upward of three hours without getting tired and knowing the format of the exam helps a lot. Some questions can be answered directly under the problem while others are answered in a special template box.
Another reason to focus on the morning section for your last minute studying is that your performance on the essays can really help set the tone for your mood in the afternoon. Don’t underestimate the confidence boost from getting max points on the essays, in particular the first couple of portfolio management essay questions.
Fortunately, practicing the morning section is made easier by the Institute. You’ll find the last three years’ worth of essay questions along with guideline answers on the CFA Institute website. Using these helps to get a sense of what you might see on this year’s exam as well as how to approach it. Studying the last few years can also give you a sense of the topics that most frequently show up on the morning section, discussed in a previous post here.
If I had just one week to study for the Level 3 exam, I would focus first on the individual and institutional management questions in the last three years’ exams. These will be the first questions you get in the morning.
Remember, there are two primary types of return questions you will get for individual portfolio management, a single-period return calculation or a required return (multi-period) calculation. We’ve worked both of these in previous posts here on the blog. You also need to know the five portfolio constraints for the IPS and how they relate to the risk tolerance and return objectives.
We’ve reviewed each study session and several of the previous years’ essay questions in our 21-week study program, so you might want to start there as a quick review. If you do decide to just focus on the prior essay questions, you may want to review some material from the topics that do not typically appear in the morning section like: Financial Reporting & Analysis, Corporate Finance, and Quantitative Methods.
‘til next time, happy studyin’
Joseph Hogue, CFA
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.
- 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.
- 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).
- 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!
- 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.
- 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).
- 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
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
Last updated: July 18, 2016 at 16:00 pm
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
Last updated: July 18, 2016 at 16:03 pm
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
Study session 16 in the CFA Level 3 curriculum covers execution of portfolio decisions with two readings (39-40) on monitoring and rebalancing. The material is part of the large Portfolio Management topic area which is worth approximately half of your total test score.
Execution of Portfolio Decisions
Know the basic types of orders (market, limit, participate, portfolio, reserve) and what each means for price, timing, and liquidity.
Understand the basics for the type of markets (crossing networks, auction, dealer, and automated auctions). Don’t confuse electronic crossing networks (automated markets for institutionals that match buy and sell orders at specific times during the day) and Electronic communications Networks (ECN, computer-based auctions that operate throughout the day.
Understand the differences and roles of brokers and dealers. The relationship between the trader and dealer is adversarial while the broker represents the trader. Brokers help to find the opposite side of a trade, can supply market information, provide discretion and secrecy, and can provide other supporting investment services.
The material on transaction costs is the most testable portion of the reading and often shows up on the essay portion. Make sure you can work through an implementation shortfall problem and calculate explicit costs, realized profit/loss, delay costs, and the missed trade opportunity costs.
Be able to calculate the volume-weighted average price and describe differences between the two approaches.
Understand the motivations for each of the different types of traders (informational, value, liquidity, and passive) and what it means for timing and liquidity.
Monitoring and Rebalancing
The material on monitoring is basically understanding the constraints on the IPS and being able to see when an investor’s situation changes materially enough to take action. The curriculum is fairly basic and you should be able to work through it if you’ve spent the time on the individual/institutional management portions.
The rebalancing portion of the reading is the more testable. Understand the costs of rebalancing (transaction costs and taxes) and the two methods for rebalancing, calendar and percentage of portfolio.
Calendar rebalancing is simple and less costly because there is no need for monitoring but it is unrelated to market behavior so costs may outweigh benefits if the portfolio weights have not moved much. The percent-of-portfolio method requires frequent monitoring but has a relatively tighter control on allocations especially in a volatile market.
Understand the effect of transaction costs, risk tolerance, asset correlations, and volatility on the optimal corridor width.
The buy-and-hold, constant mix, and constant proportion portfolio insurance methods are also highly testable and you absolutely must understand the differences and how to calculate affect on the portfolio given different types of markets.
Study session 16 in the CFA Level 3 curriculum concludes the portfolio management topic area with two readings on performance evaluation and attribution.
‘til next time, happy studyin’
Joseph Hogue, CFA
Last updated: July 18, 2016 at 16:46 pm
Study session 15 in the CFA Level 3 curriculum concludes the readings on risk management with three readings (36-38) on applications of derivatives. The last three readings are a little more quantitatively intense. Resist the temptation to skip over the difficult parts. Instead use the practice problems until you are confident that you could reproduce the concepts in an essay question.
Risk Management Applications of Forward and Futures Strategies
The number of futures contracts for a portfolio hedge is extremely testable and you need to know how to work through the calculation. Think through the formula to understand what is going on and it will become easier to remember. # Futures contracts =
- (desired beta minus current beta) divided by beta on futures contracts: if you want to decrease the portfolio beta (decreasing risk) then you will be selling futures contracts and you’re answer should have a negative sign. Here you are taking the difference between the risk you want and the risk you have and dividing by the riskiness of the futures contracts to answer how much each futures contract will change the risk of your portfolio.
- Multiplied by (value portfolio divided by price of a futures contract): This tells you how many futures contracts you need given the portfolio size.
- * A common question is to reduce beta to zero so the formula would change to (0-portbeta)/futuresbeta * (portfolio value/ futures contract price)
- Pre-investing is also a common question and really just the opposite of the above. Here you need to create index beta from 0 so it would be (indexbeta-0/ futuresbeta)
Remember, a futures hedge on a portfolio is only a hedge for the similarity in risks between the index used for the futures contract and the portfolio. Example, the futures sold on the S&P500 would not be a good hedge on a portfolio of small-cap stocks because the index is a lg-cap index.
The formulas for creating a synthetic index fund and creating cash out of equity are also testable so do not avoid them.
Remember the advantages to using futures to manage risk (i.e. lower transaction costs, greater liquidity, provide better timing and allocation strategies, require less capital to trade).
Risk Management Applications of Options Strategies
Know the basic strategies (covered calls, protective puts, spreads, straddles, and collars) and how to figure out value at expiration. Here I think the curriculum is a little convoluted with the formulas when it is really a pretty basic concept.
Covered calls are holding a long stock position and selling calls against it to reduce some downside risk so you are going to deduct the collected premiums from your costs. Your upside is capped at the strike price plus the premium while you still risk losing everything except the premium (if the stock goes to zero).
Protective puts offer greater risk reduction and retain upside in the shares but cost more. The are formed by buying puts against a long stock position so you are going to add the cost of the puts into your costs.
Whether bull or bear, spreads involve two option strikes one higher and one lower so your costs will just be the difference in the premiums. Your risk is limited to the net difference in premiums while your upside is limited to the difference in the strike prices.
Collars involve both a call and a put option with the sell of one financing the purchase of the other. The most used example is a zero-cost collar where a call option is sold to fully finance a put option which provides downside protection at the expense of giving up upside potential.
Straddles involve buying a put and a call with the same strike and the same expiration and can be costly. The investor makes money if the shares move higher or lower than the combined price of the two options.
Risk Management Applications of Swap Strategies
For me, this was one of the most difficult readings in the curriculum. You need to be able to work through an example of a swap for interest rates, currency and equities and explain who has the risk in the transaction.
Remember, market value risk is the uncertainty associated with the value of an asset or liability while cash flow risk is the uncertainty associated with the size and timing of cash flows. Credit risk is the uncertainty that the other side of the transaction will be able to make their payment.
*Currency swaps usually involve the payment of notational principal at initiation and payments are not netted because they involve different currencies. This is different than other swaps where there is usually no initial principal exchanged and payments are netted.
Swaptions are options to enter into a swap either as payer or receiver. The payer swaption allows the holder to be a fixed-rate payer/floating-rate receiver and is similar to a bond put. The receiver swaption allows the holder to be the fixed-rate receiver/floating-rate payer and is similar to a bond call.
Study session 16 in the CFA Level 3 curriculum covers execution of portfolio decisions with two readings on monitoring and rebalancing.
‘til next time, happy studyin’
Joseph Hogue, CFA
Last updated: July 18, 2016 at 16:20 pm
Study session 14 in the CFA Level 3 curriculum begins the readings on Risk Management with two readings (34-35). The Level 3 exam puts a lot of emphasis on the topic area and it is extremely testable. There is typically a question in the morning essay section, in fact last year was the first time since 2007 that there was no risk management essay. REVIEW THOSE PAST ESSAY QUESTIONS.
The reading starts of with some basic concepts and is important but secondary to the later material. Understand the advantages and disadvantages of both a centralized risk management system versus a decentralized system. A centralized system is led by a senior management employee within its own department and benefits from economies of scale and can provide an integrated picture of the company’s risks. In a decentralized system, each department handles their own risks and allows people closer to the actual risk to directly manage it.
Understand the different categories of risk: financial, non-financial, and sovereign and the risks within each category:
Financial risks: market, credit, and liquidity
Non-financial risks: operational, model, regulatory and settlement
The measures of market risk are the more important material. You must understand standard deviation and value at risk, and the three methods of calculating value at risk.
Analytical– VAR = E® – z value (StDev)
Remember, you may need to adjust the standard deviation and expected return depending on the data provided and the question. Daily StDev =Annual StDev/(square root of 250)
Historical Method– uses actual historical returns ranking in decending order and picks out corresponding return for the % probability. For example, if there are 100 observations and we want a 5% probability, then we would select the fifth worst return (or the average of the two closest).
Monte Carlo Simulation – generates random outcomes according to assumed probability distribution and a set of parameters to estimate the VAR.
Understand the extensions/supplements to VAR like stress testing and scenario analysis, as well as the performance measures like the Sharpe and Sortino ratios.
Currency Risk Management
The reading can get pretty detailed and quantitatively intense but you need to be able to work through all the hedging exercises. Pay attention to whether the question asks for the return in the local or domestic currency and whether the expected future value is hedged or only the principal.
Understand the differences between hedging with futures and using options. Futures are less expensive and appropriate when the investor risks volatility in rates but has a clear view of the direction of change. Options may be more expensive but provide more precision and are appropriate when exposures are uncertain with respect to timing and magnitude of exchange rate changes.
Understand the concepts behind strategic and tactical currency risk management. The three types of approaches are strategic management with a balanced mandate, currency overlay (tactical management), and treating the currency as a separate asset class.
Study session 15 in the CFA Level 3 curriculum concludes the readings on risk management with three readings on applications of derivatives.
‘til next time, happy studyin’
Joseph Hogue, CFA