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
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
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
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