Level 3 CFA Curriculum Changes 2015



 

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.

New readings:
(20) Market Indexes and Benchmarks

Dropped readings:
(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

CFA Level III Reading 13 and 28



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

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

Level III Essay Review – Question #2 2013 Exam



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

CFA Level 3 Review, Behavioral Finance



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

2013 Level 3 Essay Question #1 Review



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.

The exams are available on the Institute’s website here.

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

5 Things I Wish I Knew about the CFA Level III Exam



We’ve already covered the top five things you should know about the CFA Level I and Level II Exams, along with the exams in general. After the Level II exam, I enjoyed the final exam of the series though it presents its own challenges. If you approach it wisely, following these five points, the Level III exam can be just as enjoyable when you take it.

  • 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.

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. Corporate Finance, Financial Reporting, Quantitative Methods and Alternative Investments are the least likely to show up as essay questions but will be in the afternoon section. I covered the essay section in more detail in a prior post linked here.

  • 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 last year 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.

  • 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, 49% in 2013, 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.

  • 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 the exam to start thinking about the charter

You will not immediately be granted the charter after passing the 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 charterholder 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.

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.

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

Changes to the 2014 Level 3 CFA Curriculum



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

CFA Level 3 Emergency Preparation



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

CFA Level 3 Essay #9 2012



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

CFA Level 3 Review GIPS



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

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



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



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

CFA Level 3 Review, Monitoring and Rebalancing



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

CFA Level 3 Review, Risk Management with Derivatives



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

CFA Level 3 Review, Risk Management



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.

Risk Management
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

CFA Level 3 2011 Essay Question #3



You will always have an institutional portfolio management question in the essay portion. The question from 2011 was worth 26 points (14.4% of morning session and 7.2% of total exam points) while last year’s question was worth 34 points (almost 10% of your total exam score!).

Please download the essay and guideline answers from the CFA Institute’s website here.

We covered the reading on institutional investors back in February, linked here. Each type of institution (pensions, foundations, endowments, insurance, and banks) have their own special idiosyncracies but there are some commonalities as well. As with the individual investor material, you need to understand their risk and return needs and how the five IPS constraints fit into them.

The question from 2011 had five parts, each with a couple of sub-questions. I read the questions quickly to find out the specific data for which I am looking but a lot of candidates start by reading the vignette.  You absolutely must be practicing these old essay exams to figure out what information the Institute is looking for and how you will approach the questions.

Skimming the questions, we see that we need:

  • Return objective- *** Remember, this is an explicit statement of what the investor needs or wants. Just writing out a numerical return percentage won’t cut it. These are easy points, most of the objective will be a cut and paste from within the vignette. Things like, the investor needs to grow assets at a rate sufficient enough to cover X% of the institution’s spending needs and maintain the real value of the portfolio.
  • Calculate a required return- the instructions say SHOW YOUR CALCULATIONS for a reason. Show all steps to make sure you at least get some partial credit.
  • Factors in Risk Tolerance, remember risk tolerance is compose of both willingness and ability. You need to know what factors influence each. When in doubt, go with the more risk averse objective.
  • Liquidity and Time Horizon constraints for the IPS
  • Spending rule affect on goals and funding
  • More risk tolerance factors

endowments & foundations are often tested together because they are similar but with important differences.

  • Know the spending rules: volatility/riskiness in funding and why would you choose each
    • A simple spending rule is just a percentage rate times the portfolio’s market value. This rule can lead to volatile spending and would necessitate a lower risk tolerance to avoid volatility in the portfolio value.
    • A rolling three-year average rule is the percentage rate times the portfolio’s average value over the last three years. The rule helps to decrease volatility and can increase risk tolerance.
    • A geometric smoothing rule is the weighted average of the prior year’s spending (adjusted for inflation) and the product of the percentage rate times the portfolio’s market value. This rule also increases risk tolerance but places more emphasis on the recent market value of the portfolio.
  • Difference between endowments/foundations. A foundation may be the sole source of funding whereas endowments are usually a smaller part of overall funding. Foundations may have a limited time horizon whereas endowments are usually indefinite. Endowments do not have legally required spending levels.

Part A-

i. Most endowments and foundations, unless explicitly stated in vignette, are going to want to maintain REAL VALUE OF ASSETS. This means they must earn a return high enough to satisfy spending needs and inflation. The first two points in the vignette give you everything you need for the objective (maintain real value, long-term, fund 25% of annual op expenses)

ii. The institute will give you points for a geometric or arithmetic return (but you should know how to do the geometric return because it is technically correct).

Required return is going to be= spending rate * inflation rate * management expenses.

                * remember- the correct inflation rate is that applicable to spending (this case higher education) not necessarily general inflation = (1+ spending rate)*(1+inflation rate)*(1+mgmt. expense rate)
   * Know how to calculate your spending rate from the three spending rules

Part B-

Worth six points: one point for circling the correct answers in middle box, two points for ONE REASON stated in third column. ** Remember- graders are only going to look at your first response. Don’t waste your time putting down more than one response.

The guideline answer shows two possible responses, only one was asked for.

- For endowments, generally as funding increasesà risk tolerance increases because spending needs are lower proportion of total assets.

- As inflation increases, risk increases as well because it becomes harder to protect REAL VALUE of assets in portfolio and also satisfy spending needs

Part C-

Remember TUTLL, IPS constraints are just as important for institutionals as for individuals

Time- will generally be infinite for most institutional types or the vignette will say otherwise
Unique- usually explicit in case as well (endowments and foundations often have prohibitions against investing in ‘vice’ stocksà Socially-Responsible Investing)
Taxes- Endowments/Foundations are tax exempt, Banks and Insurance are Taxable
Liquidity- Annual spending needs for Endowment/Foundations, Very important for Banks/Insurance to fund claims and withdrawals.
Legal- UMIFA for Endowments/Foundations, Highly-regulated Banks/Insurance on the state level

Part D-

i. primary goal for endowment is usually spending with protection of real value- reducing portfolio risk will also reduce expected return and make it harder to cover spending and inflation

ii. LEARN THE SPENDING RULES! Three-year average rule will smooth needs thus lowering volatility

Part E-

Again, ONLY WRITE WHAT IS ASKED FOR. The questions asks for 3 factors (don’t write six and hope the grader will look for the best 3, they don’t do this)

For differences in risk tolerance, think about the IPS constraints that affect tolerance.

  • Time – Longer or infinite horizons will have longer to make up portfolio shortfalls
  • Liquidity – The need to fund a larger percentage of total institutional spending is an important one and makes for lower ability to tolerate risk. Spending rules that lower volatility (smoothing or the 3-yr average rule) will increase ability to tolerate risk.
  • Legal – remember foundations must spend a certain percentage to maintain tax status while endowments do not have this requirement
  • Additionally, other sources of funding and the yearly increase (inflationary or otherwise) in operating expenses are always important to needs

Guideline answer provided by Institute shows 7 possible answers, you only need 3

We’ll cover study session 14 in the CFA Level 3 curriculum next week. The readings start Risk Management, an extremely important topic in the Level 3 exam and definitely worth a couple of questions on the test.

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

CFA Level 3 Review, Alternative Investments



Study session 13 in the CFA Level 3 curriculum includes three readings (31-33) on Alternative Investments and is worth between 5% and 15% of your total exam score.

Alternative Investments Portfolio Management
Remember the common features to alternative investments:
1)      Illiquidity and longer time horizon- investors demand a return premium
2)      Diversification from low correlation with traditional investments
3)      High due diligence costs because of complex structures and lack of transparency
4)      Difficulty in establishing a valid benchmark and performance appraisal
5)      Informationally less efficient with possibility of adding value through skill and information

Know the specific characteristics and limitations to each investment type within alternatives. Much of the material has been seen in the curriculum to the previous two exams so it should not be too difficult to pick up.

Real estate: Adds diversification and an inflation hedge but high transaction costs. REITs are highly liquid and more accessible but are correlated with stocks.
Private Equity/Venture Capital: illiquid and relatively high risk but high returns expected. May have lock-up periods or involve long time horizons. Remember the financing stages for private equity and characteristics of each. A few vocabulary here like clawback provision and carried interest.
Commodities: Understand the difference and characteristics of direct versus indirect investment. Direct investment entails carrying and storage costs while indirect investment in the companies may not provide sufficient exposure because of company hedging programs.
Hedge Funds: Understand the basics behind the different strategies (equity neutral, fixed income arbitrage, distressed securities, convertible arb, merger arb, hedged equity, global macro). Remember the advantages/disadvantages of funds of funds. Remember that a high water mark provision requires that incentive fees are only based on returns above the highest value over the life of the fund (i.e. once fees have been paid for achieving that level, the manager must exceed it to earn more incentive fees).

The Level 3 exam places some emphasis on the indexes as well, so remember the basics behind each index to alternative investments as well as strengths/weaknesses to each.

Swaps
You need to be able to work through a simple swap for the exam. Working through a couple of examples on flash cards will help and will allow you to review it quickly.

Example:  Find the price of a two long forward swaps to guarantee the cost of buying 100,000 barrels of oil in each of the next two years.
The forward price of oil for delivery in one year is $20/barrel.
The forward price for delivery in two years is $21/barrel.
The one-year zero coupon bond yields 6% while the two-year zero yields 6.5%

Present value of the cost per barrel would be: $20/1.06 + $21/1.0652 = $37.383
The two-year swap price would be:  x/1.06 + x/1.0652 = $37.383 à $20.483

Rate swaps are a weighted average of implied forward interest rates. They are less risky relative to commodity swaps because of the fewer number of inputs. The market value is the difference in the present value of payments between the original and the new swap rates. The value of the swap is always zero at initiation and changes as the interest rate changes.

Commodity Swaps are a weighted average of the forward commodity price and is the difference in the present value of payments.

Commodity Forwards and Futures
The math can seem a little intimidating on commodity forwards but you have to be able to work through it because it does show up on the exam. Understand the difference between a commodity that can and cannot be stored.

The lease rate represents a return required to buy and lend a commodity. It is similar to a dividend yield but is not directly observable.
The convenience yield is the non-monetary benefits associated with holding a commodity but is only earned when the commodity is held by a commercial user.

Understand the concept behind the hedging strategies but the calculation is probably secondary to being able to work through the forwards calculation. A few vocabulary items are important like the crush and crack spread.

Study session 14 begins the readings on Risk Management, an extremely important topic in the Level 3 exam and definitely worth a couple of questions on the test.

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

CFA Level 3 Review, Equity Investments



Study session 12 in the CFA Level 3 curriculum concludes the material on equity investments with three readings (28-30) on governance and international investments. You need to go through the material at least once to get the general idea behind the concepts and pick up the vocabulary but the study session is of secondary importance against the other material in equity investments.

Corporate Performance, Governance and Business Ethics
The reading is completely conceptual and not of huge importance (my opinion). Understand the basic concept of the different stakeholders (stockholders, customers, suppliers, creditors, governments, unions, communities, general public) and their expectations for the company. Understand that a stakeholder group’s expectations may contrast with another group. There is a school of thought that says all stakeholder groups should have a place at the table to affect corporate control but it is not practical or efficient. The general idea is that the company should maximize profits, within regulatory and ethical principals, and this will take care of various stakeholder needs.

The various theories and philosophical approaches are of less than secondary importance. Skim through it and get a basic idea for each of the concepts.

International Equity Benchmarks
This is a pretty short reading with only a few key points to remember. Understand home-country bias and the benefit of international investing (diversification, difference in industrial mix and economic cycles).  Remember that there are also some disadvantages, i.e. shares are often closely held by the government or private individuals and cross-holding may be an issue.

Understand the concept and tradeoff for international indexes: breadth versus investability, liquidity versus reconstitution effects, precise float adjustments versus transaction costs, objectivity/transparency versus judgement.

Emerging Markets Finance
Understand the effect of liberalization and market integration on dividend yields (lower), expected returns and cost of capital (decrease), liquidity and volume (increase), political risk (decrease), correlation with other markets (increase), and capital flows (increase). The drop in expected returns can be hard to understand but remember, an efficient market prices risk with higher expected returns so if volatility and risk is reduced then so will expected returns.

The material on contagion is basically list stuff but pretty interesting if you follow your EM history. The five effects of currency contagion (trade, income, wake up, credit crunch, and liquidity) are fairly testable.

The rest of the material just outlines the difference in market structure between emerging and developed markets (liquidity, price discovery, credit, etc) and possible differences in governance. As with most of the study session, read through it to get the general idea, vocabulary and list material.

Study session 13 in the CFA Level 3 curriculum covers alternative investments in portfolio management with three readings.

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