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CFA Level III Updated
What does the forward curve tell us about future rate expectations?
The forward curve is the market-implied future spot curve, assuming no-arbitrage. Under PEH, forward = expected future spot, but empirically there's a positive term premium (~0–100bps) so forwards overstate expected future rates.
What are the required disclosures in a GIPS-compliant presentation?
GIPS requires a specific compliance statement, firm/composite definitions, benchmark rationale, fees, 5-10 years of returns, dispersion, and ex-post standard deviation.
What internal controls does GIPS require for risk measurement?
GIPS internal controls require documented policies on composite inclusion, valuation, calculation, error correction, documentation retention, and ex-post risk measurement.
What is PME (public market equivalent) and how does it measure PE manager skill?
PME compares PE returns against investing same cash flows in a public benchmark. KS-PME >1 means outperformance; accounts for timing and vintage effects...
How does currency selection effect work in global fixed income?
Currency effect = sum of (Active FX Weight x Currency Return vs Base). Atlas's +10% EUR (+3%) and -10% JPY (-2%) produced +50bps total. Separate from local bond returns and hedging P&L; requires Karnosky-Singer framework for proper decomposition.
How does bounded rationality affect market outcomes, and when do heuristic shortcuts lead to systematic pricing errors?
Bounded rationality means investors use heuristics like representativeness, availability, and anchoring instead of full optimization. These shortcuts work well in stable, repetitive environments but create systematic pricing errors when conditions are novel, emotionally charged, or involve small samples.
Why is full replication impractical for bond indices, and how does stratified sampling solve this?
Full bond index replication is impractical because indices contain thousands of illiquid securities with minimum lot size requirements. Stratified sampling solves this by dividing the index into risk cells defined by duration, sector, and quality, then selecting a manageable subset of bonds matching each cell's weight.
What ethical obligations apply to algorithmic trading, and where is the line between legitimate strategies and market manipulation?
Algorithmic trading ethics center on distinguishing legitimate strategies (market-making, statistical arbitrage) from manipulation (spoofing, layering, quote stuffing). CFA Standards prohibit market manipulation and require best execution, while gray areas like latency arbitrage demand professional judgment and documentation.
What are the tradeoffs between barbell, bullet, and ladder strategies for yield curve positioning, and when does each one outperform?
Barbell, bullet, and ladder strategies distribute cash flows differently along the maturity spectrum while targeting the same duration. The barbell has higher convexity and outperforms in flattening environments, while the bullet earns more carry and wins when the curve steepens.
How does a Family Limited Partnership (FLP) enable wealth transfer at a discount through lack of control and marketability adjustments?
A Family Limited Partnership enables wealth transfer at a 25-45% discount by applying lack-of-control and lack-of-marketability adjustments to limited partnership interests gifted to heirs. Parents retain management control through the general partner while reducing the taxable value of transfers.
What is the loss aversion coefficient, and how does the 2:1 ratio of losses to gains impact portfolio construction?
The loss aversion coefficient (lambda approximately equals 2.25) means losses generate roughly 2.25 times the psychological pain of equivalent gains' pleasure. This asymmetry helps explain the equity premium puzzle, under-allocation to stocks, and the popularity of principal-protected products.
When should a portfolio manager use partial versus full currency hedging for international equity allocations?
The optimal currency hedge ratio depends on the correlation between asset and currency returns, hedging costs, and the investor's risk preferences. Partial hedging (50-70%) is most common for developed market equities, while bonds typically warrant full hedging and emerging market currencies are often left unhedged due to prohibitive costs.
What criteria should an analyst use when selecting sector ETFs for a top-down portfolio strategy?
Selecting sector ETFs requires evaluating index methodology, expense ratio, tracking error, liquidity metrics, and holdings concentration. A systematic framework helps ensure the chosen ETF aligns with both the investment thesis and practical portfolio constraints.
How do structured products like CLOs and ABS fit into fixed income portfolio management?
Structured products like CLOs and ABS are created by pooling underlying assets and issuing tranched claims. They offer yield enhancement, diversification, and floating-rate exposure but carry complexity, model, and liquidity risks that require careful analysis.
How effective are VIX call options as a tail hedge?
VIX calls on VIX futures (not spot). Term structure contango causes heavy decay. Pay off big in crises but unreliable carry. Combine with SPX puts.
What signals do managers use to time yield curve positioning?
Managers use signals across Fed cycle stage, breakeven inflation, growth momentum, curve mean-reversion, Treasury supply, central bank balance sheet, and positioning data to time curve steepener/flattener trades.
What are the level, slope, and curvature factors of the yield curve?
PCA decomposes yield curve movements into Level (~85%), Slope (~12%), and Curvature (~3%) factors. Together they explain ~99% of daily curve variation, and hedging them in sequence captures progressively more rate risk.
What are the Fundamentals of Compliance under GIPS?
GIPS Fundamentals of Compliance require defining the firm, identifying discretionary portfolios, building composites, and making required disclosures — all or nothing.
How do you forecast fixed-income returns using the building-blocks approach?
The building-blocks approach for fixed-income returns decomposes the expected return into additive risk premiums layered on top of the risk-free rate: real risk-free rate, inflation premium, term premium, credit premium, and liquidity premium.
Why is IRR used for private equity performance and what are its pitfalls?
IRR is standard in PE because GPs control capital call and distribution timing, making dollar-weighted returns the fair measure. But IRR has reinvestment and gaming pitfalls...
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