DA4675 CFA Level III Smart Sheet 2020 PDF

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Quick Sheet in order to facilitate with many formulas and basic financial concepts such these being tested in CFA curiculum...

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2020

CRITICAL CONCEPTS FOR THE CFA EXAM

CFA® EXAM REVIEW

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WILEY’S CFA PROGRAM LEVEL III SMARTSHEETS FUNDAMENTALS FOR CFA EXAM SUCCESS

WCID184

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Wiley’s CFA Program Exam Review ETHICAL AND PROFESSIONAL STANDARDS StandardS of ProfeSSional ConduCt • ThoroughlyreadtheStandards,alongwithrelated guidanceandexamples.

aSSet Manager Code of ProfeSSional ConduCt • Firm-wide,voluntarystandards • Nopartialclaimofcompliance. • Compliancestatement:“[Insertnameoffirm]claims compliancewiththeCFAInstituteAssetManagerCodeof ProfessionalConduct.Thisclaimhasnotbeenverifiedby CFAInstitute.” • FirmsmustnotifyCFAInstitutewhenclaiming compliance. • CFAInstitutedoesnotverifymanager’sclaimof compliance. • Standardscover: • Loyaltytoclients • Investmentprocessandactions • Trading • Riskmanagement,compliance,andsupport • Performanceandvaluation • Disclosures

gloBal inVeStMent PerforManCe StandardS • Focusonrequireddisclosures,andpresentationand reportingrequirementsandrecommendationsofGIPS.

• Beabletoidentifyandcorrecterrorsinaperformance presentationthatclaimstobeGIPScompliant.

BEHAVIORAL FINANCE BehaVioral finanCe PerSPeCtiVe • Prospecttheory • Assignsvaluetochangesinwealthratherthanlevels ofwealth.

• Underweightmoderate-andhigh-probability outcomes.

• Overweightlow-probabilityoutcomes. • Valuefunctionisconcaveaboveawealthreference point(riskaversion)andconvexbelowawealth referencepoint(riskseeking).

• Valuefunctionissteeperforlossesthanforgains. • Cognitivelimitations • Boundedrationality:decidinghowmuchwillbedone toaggregaterelevantinformationandusingrulesof thumb.

• Satisficing:findingadequateratherthanoptimal solutions.

• Traditionalperspectiveonportfolioconstruction assumesthatmanagerscanidentifyaninvestor’s optimalportfoliofrommean-varianceefficientportfolios. • Consumptionandsavings

• Mentalaccounting:wealthclassifiedintocurrent income,currentlyownedassets,PVoffutureincome.

• Framing:sourceofwealthaffectsspending/saving decisions(currentincomehashighmarginal propensitytoconsume).

• Self-control:long-termsourcesunavailableforcurrent spending.

• Behavioralassetpricingmodels • Sentimentpremiumincludedinrequiredreturn. • Bullish(bearish)sentimentriskdecreases(increases) requiredreturn.

• Behavioralportfoliotheory • Strategicassetallocationdependsonthegoal assignedtothefundinglayer.

• Usesbondstofundcriticalgoalsinthedomainof gains.

• Usesriskysecuritiestofundaspirationalgoalsinthe domainoflosses.

• Adaptivemarketshypothesis • Mustadapttosurvive(biastowardspreviously successfulbehaviorduetouseofheuristics).

• Riskpremiumsandsuccessfulstrategieschangeover time.

BehaVioral BiaSeS • Cognitiveerrors(beliefpersistencebiases) • Conservatism:overweightinitialinformationandfailto updatewithnewinformation.

• Confirmationbias:onlyacceptbelief-confirming information,disregardcontradictoryinformation.

• Representativeness:extrapolatepastinformationinto thefuture(includesbase-rateneglectandsample-size neglect). • Illusionofcontrol:believethatyouhavemorecontrol overeventsthanisactuallythecase. • Hindsightbias:onlyrememberinformationthat reinforcesexistingbeliefs. • Cognitiveerrors(information-processingbiases) • Anchoringandadjustment:developinitialestimate andsubsequentlyadjustitup/down. • Mentalaccounting:treatmoneydifferentlydepending onsource/use. • Framing:makeadecisiondifferentlydependingon howinformationispresented. • Availabilitybias:useheuristicsbasedonhowreadily informationcomestomind. • Emotionalbiases • Lossaversion:stronglypreferavoidinglossesto makinggains(includesdispositioneffect,housemoneyeffectandmyopiclossaversion). • Overconfidence:overestimateanalyticalability orusefulnessoftheirinformation(prediction overconfidenceandcertaintyoverconfidence). • Self-attributionbias:self-enhancingandselfprotectingbiasesintensifyoverconfidence. • Self-controlbias:failtoactintheirlong-terminterests (includeshyberbolicdiscounting). • Statusquobias:prefertodonothingthanmakea change. • Endowmentbias:valueanownedassetmorethanif youweretobuyit. • Regretaversion:avoidmakingdecisionsforfearof beingunsuccessful(includeserrorsofcommissionand omission). • Goals-basedinvesting • Baseofpyramid:low-riskassetsforobligations/needs. • Moderate-riskassetsforpriorities/desires;speculative assetsforaspirationalgoals. • Behaviorallymodifiedassetallocation • Greaterwealthrelativetoneedsallowsgreater adaptationtoclientbiases • Advisorshouldmoderatecognitivebiaseswithhigh standardoflivingrisk(SLR). • Advisorshouldadapttoemotionalbiaseswithalow SLR.

inVeStMent ProCeSSeS • Behavioralbiasesinportfolioconstruction • Inertiaanddefault:decidenottochangeanasset allocation(statusquobias).

• Naïvediversification:exhibitcognitiveerrorsresulting fromframingorusingheuristicslike1/ndiversification.

• Companystockinvestment:overallocatefundsto companystock.

• Overconfidencebias:engageinexcessivetrading

(includesdispositioneffect).

• Homebias:preferowncountry’sassets. • Mentalaccounting:portfoliomaynotbeefficientdue togoals-basedinvestingaseachlayerofpyramidis optimizedseparately.

• Behavioralbiasesinresearchandforecasting • Representativeness:duetoexcessivestructured information.

• Confirmationbias:onlyacceptsupportingevidence. • Gamblers’fallacy:overweightprobabilityofmean reversion.

• Hothandfallacy:overweightprobabilityofsimilar returns.

• Overconfidence,availability,illusionofcontrol,selfattributionandhindsightbiasesalsopossible.

• Marketbehavioralbiases • Momentumeffectsduetoherding,anchoring, availabilityandhindsightbiases.

• Bubblesduetooverconfidence,self-attribution, confirmationandhindsightbiases.

• Valuestockshaveoutperformedgrowthstocks;smallcapstockshaveoutperformedlarge-capstocks.

CAPITAL MARkET ExPECTATIONS CMe fraMeworkS and MaCro ConSiderationS • Goodforecastsare: • Objectiveandunbiased • Internallyconsistent • Efficientwithlowerrors • Uncertaintyanderrorsstemfromchoosingincorrect model,errorsinunderlyingdata,orerrorsin estimatedparameters • Errorscanalsostemfrombehavioralbiasessuchas anchoringbias,availabilitybias,confirmationbias, statusquobias,overconfidencebias,andprudence bias • Aggregateequitymarketvalue:

• Threedistinctapproachestoforecastingeconomic change: • Econometrics • Economicindicators • Checklistapproach • Yieldcurveoverthebusinesscycle • Initialrecovery–Steepyieldcurvewithlowshort-term ratesthatstarttorise • Earlyexpansion–Risingcurvewithsteepshort maturitiesandflatlongmaturities • Lateexpansion–Slowlyrisingandflatteningcurve • Slowdown–Flatorinvertedcurvethatisfalling • Contraction–Fallingcurvethatbeginstosteepen

foreCaSting aSSet ClaSS returnS • Expectedreturnsonfixedincomesecuritiescanbe determinedusing: • ADCFapproach,wherebycurrentpriceandfuturecash flowsinferayieldtomaturity(YTM).Realisedreturn differfromYTMduetogains/lossesfrompre-maturity transactionsandreinvestmenteffects • Abuildingblockapproach,wherebyexpectedreturn isbasedontheshort-termnominaldefault-freerate plusriskpremiumssuchasatermpremium,credit premiumandliquiditypremium • Expectedreturnsonequitiescanbedeterminedusing: • Historicalstatistics Wiley © 2020

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Wiley’s CFA Program Exam Review • ADCF/dividenddiscountapproach,suchasthe Grinold-Kronermodel:

assetallocationsresultsinanoverallstrategicasset allocation).

PrinCiPleS of aSSet alloCation • Abuildingblockapproach,wherebyexpectedreturn isbasedoneithertheshort-or-long-termnominal default-freerateplusriskpremiumssuchasthoseused forfixedincomesecuritiesaswellasanequityrisk premium

• Anequilibriumapproach,wherebyexpectedreturnfor

• Meanvarianceoptimization(MVO) • Producesanefficientfrontierbasedonreturns, standarddeviationofreturnsandpairwise correlations.

• Findsoptimalassetallocationmixthatmaximizes client’sutility.

characteristicsofdifferentassetclasses.

• Timehorizon:assetallocationdecisionsevolve withchangesintimehorizon,humancapital,utility function,financialmarketconditions,characteristicsof liabilityandtheassetowner’spriorities.

• Regulatory:financialmarketsandregulatoryentities oftenimposeadditionalconstraints.

• Taxes • Placelesstax-efficientassetsintax-advantaged accountstoachieveafter-taxportfoliooptimization.

anequitymarketisbasedonitssensitivity( )toglobal marketreturnsanditslevelofintegration( )with globalmarkets(Singer-Terhaarmodel):

• MVOlimitations • Assetallocationsarehighlysensitivetosmallchanges ininputvariables. • Assetallocationscanbehighlyconcentrated.

and

• Onlyfocusesonmeanandvarianceofreturns. • Sourcesofriskmaynotbewelldiversified. • Asset-onlystrategy. • Single-periodframeworkandignorestrading/ rebalancingcostsandtaxes.

• Expectedreturnsonrealestatecanbedeterminedusing: • Capitilizationrates:

• Abuildingblockapproach,wherebyexpectedreturnis basedonriskpremiathatincorporatethoseusedfor bothfixedincomesecuritiesandequities • Anequilibriumapproach,withadjustmentsfor illiquidityandsmoothedreturns • Expectedreturnsforforeignexchangecanbedetermined using: • Amonetaryapproach,wherebyexchangerate movementsreflecttheexpecteddifferencesininflation • Capitalflows,wherebyexpectedchangesinexchange ratesisbasedondifferencesbetweencountriesin default-freeratesandriskpremiums

• Abuildingblockapproach,wherebyexpectedreturnis basedonriskpremiathatincorporatethoseusedfor bothfixedincomesecuritiesandequities • Expectedreturnforemergingmarketsecuritiesislikely toincludeconsiderationsforabilityandwillingnessto pay(fixedincome)andriskstoshareholderprotections (equities) • Expectedvarianceofreturnsandcovariancescanbe determinedusing: • Historicalstatistics • Factormodels,thatseektoreduceproblems associatedwithhistoricalstatistics.Shrinkage estimation,usinghistoricalstatisticsandfactormodel outputscanprovidefurtherprecision • Smoothing,especiallyinthecaseofilliquidmarkets:

• Doesnotaddressevolvingassetallocationstrategies, path-dependentdecisions,non-normaldistributions.

• ApproachestoimprovequalityofMVOassetallocation • Usereverseoptimizationtocomputeimpliedreturns andimprovequalityofinputs,e.g.Black-Litterman model.

• Addingconstraintstoincorporateshort-sellingand otherreal-worldrestrictionsintooptimization. • ResampledMVOtechniquecombiningMVOandMonte Carloapproachestoseekthemostefficientand consistentoptimization. • MonteCarlosimulationandscenarioanalysis • Usedinamultiple-periodframeworktoimprove single-periodMVO.

• Providesarealisticpictureofdistributionofpotential futureoutcomes.

• Canincorporatetrading/rebalancingcostsandtaxes. • Canmodelnon-normaldistributions,serialandcrosssectionalcorrelations,evolvingassetallocations,pathdependentdecisions,non-traditionalinvestments, humancapital. • Riskbudget

• Identifiestotalamountofriskandallocatesriskto differentassetclasses. • Assetallocationisoptimalwhenratioofexcessreturn toMCTRisthesameforallassets.

• Rebalancingrangeforataxableportfolio(Rtaxable)can bewiderthanthoseofanotherwiseidenticaltaxexemptportfolio(Rtax exempt).

• Revisiontoassetanallocation • Changesingoals • Changesinconstraints • Changesininvestmentbeliefs • Tacticalassetallocation(TAA)approaches • DiscretionaryTAA:usesmarkettimingskillstoavoidor hedgenegativereturnsindownmarketsandenhance positivereturnsinupmarkets.

• SystematicTAA:usessignalstocaptureasset-classlevelreturnanomaliesthathavebeenempirically demonstratedasproducingabnormalreturns.

• Behavioralbiasesinassetallocation • Lossaversion:mitigatebyframingriskintermsof shortfallprobabilityorfundinghigh-prioritygoalswith low-riskassets.

• Illusionofcontrol:mitigatebyusingtheglobalmarket portfolioasastartingpointandusingaformalasset allocationprocessbasedonlong-termreturnandrisk forecasts,optimizationconstraintsanchoredaround assetclassweightsintheglobalmarketportfolio,and strictpolicyranges.

• Mentalaccounting:goal-basedinvestingincorporates thisbiasdirectlyintotheassetallocationsolutionby aligningeachgoalwithadiscretesub-portfolio.

• Recencyorrepresentativenessbias:mitigatebyusing aformalassetallocationpolicywithprespecified allowableranges.

• Framingbias:mitigatebypresentingthepossibleasset allocationchoiceswithmultipleperspectivesonthe risk-rewardtradeoff.

• Familiarityoravailabilitybias:mitigatebyusingthe

• Liability-relativeassetallocationapproaches

globalmarketportfolioasthestartingpointinasset allocationandcarefullyevaluatinganypotential deviations.

EQUITY PORTFOLIO MANAGEMENT • Approachestomanagingequityportfolios • Passivemanagement:trytomatchbenchmark performance.

• ARCHmodels,thatseektoaccountforvolatility clusteringofreturns

ASSET ALLOCATION aSSet alloCation aPProaCheS • Asset-only:doesnotexplicitlymodelliabilities • Liability-relative(liability-driveninvesting):aimsatan assetallocationthatcanpayoffliabilitieswhenthey comedue. • Goals-basedinvesting:specifiessub-portfolios alignedwithaspecificgoal(sumofallsub-portfolio

• Goal-basedassetallocations • Creationofdifferentiatedportfoliomodulesbasedon capitalmarketexpectations. • Identifyingclients’goalsandmatchingthegoalsto appropriatesub-portfoliosandmodules.

aSSet alloCation with real-world ConStraintS • Constraintsonassetallocationdueto: • Assetsize:moreacuteissueforindividualratherthan institutionalinvestors.

• Liquidity:liquidityneedsofassetownerandliquidity

• Activemanagement:seektooutperformbenchmark bybuyingoutperformingstocksandselling underperformingstocks. • Semiactivemanagement(enhancedindexing):seek tooutperformbenchmarkwithlimitedtrackingrisk (highestinformationratio). • Approachestoconstructinganindexedportfolio • Fullreplication:minimaltrackingriskbuthighcosts. • Stratifiedsampling:retainsbasiccharacteristicsof indexwithoutcostsassociatedwithbuyingallthe stocks. • Optimization:seekstomatchportfolio’sriskexposures (includingcovariances)tothoseoftheindexbutcan bemisspecifiedifhistoricalriskrelationshipschange Wiley © 2020

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Wiley’s CFA Program Exam Review overtime.

• Valuestyleinvesting:lowP/E,contrarian,highyield. • Growthstyleinvesting:consistentgrowth,earnings momentum.

• Market-oriented(blendorcorestyle)investors:marketorientedwithavaluebias,market-orientedwitha growthbias,growthatareasonableprice,stylerotators. • Marketcapapproach:small-cap,mid-cap,large-cap investors. • Investmentstyleanalysis • Holdings-based:analysescharacteristicsofindividual securityholdings. • Returns-based:regressingportfolioreturnson returnsofasetofsecuritiesindices(betasarethe portfolio’sproportionalexposuretotheparticularstyle representedbyindex). • Priceinefficiencyontheshortside • Restrictionstoshortselling. • Management’stendencytodeliberatelyoverstate profits. • Sell-sideanalystsissuefewersellrecommendations. • Sell-sideanalystsarereluctanttoissuenegative opinions. • Selldisciplines • Substitution:opportunitycostsellanddeteriorating fundamentalssell. • Rule-driven:valuation-levelsell,down-from-costsell, up-from-costsell,targetpricesell. • Semiactiveequitystrategies • Derivative-basedsemiactiveequitystrategies: exposuretoequitymarketthroughderivativesand enhancedreturnthroughnon-equityinvestments,e.g. fixedincome. • Stock-basedenhancedindexingstrategies:portfolio lookslikebenchmarkexceptinthoseareasonwhich themanagerexplicitlywishestobeton(withinrisk limits)togeneratealpha. • Informationratio(GrinoldandKahn)

• Core-satelliteportfolio:indexandsemiactivemanagers constitutecoreholdingwhileactivemanagersrepresent satellites. • Totalactivereturnandrisk • Manager’strueactivereturn=Manager’sreturn– Manager’snormalbenchmark • Manager’smisfitactivereturn=Manager’snormal benchmark–Investor’sbenchmark • Totalactiverisk

sellingparentandbuyingsubsidiary)andmulti-class trading(e.g.sellingclassAsharesincompanyX,while buyingtheirclassBshares).

• Eventdriven: • Mergerarbitrage–Seekreturnsfromthepricevolatility accompanyingtakeoverbidsofacquiringcompany’s stockandtargetcompany’sequityanddebtsecurities

• Distressedsecurities–Buyingsecuritiesofcompanies infinancialdistressandfacingbankruptcytotake advantageoflowpriceandtherestructuringofthe company

• Relativevalue: • Fixedincomearbitrage–Exploitingvariousaspects ofmispricingofriskpremiumsbetweensecurities. Strategymanagerswilltendtohedge/immunize againstmarketriskssuchasduration,sovereignrisk, currencyrisk,creditriskandprepaymentrisk

• Convertiblebondarbitrage–Seekreturnsfromdelta hedgingandgammatradingshortequityhedges againstthepotentiallongequityexposurewithin convertiblebonds • Opportunistic:

• Globalmacro–Seekreturnsthroughtrading ofcurrencies,bondsandderivativesbasedon expectationsoftherelativeeconomichealthof countriesandpotentialeconomicpolicychanges

• Managedfutures–Systematicallyseekreturnsfrom technicalanalysisofmarketsandsignalsofexpected movementsinfuturespricesacrossallglobalmarkets.

• Specialist: • Volatility–Seeksreturnsthroughtheimpliedvolatility capturedinoptionpricesbybuyingcheapvolatility andsellingexpensivevolatility

• Insurance-linked–Seeksreturnsfrominvestingand tradinginreinsurancesecurities(e.g.cat-bonds) orlifesettlements(i.e.purchasingoflifepolicies withattractivesurrendervaluesandmortality characteristics) • Multi-manager: