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CFA Level III Updated
How do I isolate credit spread effect in fixed income attribution?
Spread effect = Active Weight x Spread Duration x -(Spread Change). Sapphire's +15% BBB overweight during 35bps tightening produced +34.1bps. Requires spread duration distinct from modified duration, plus sector decomposition.
How does herding behavior affect market stability, and what mechanisms trigger informational cascades?
Herding occurs through informational cascades (rational inference from others' trades), reputational concerns (career safety in following the crowd), and correlated information. It amplifies market volatility beyond fundamental levels and creates fragile price dynamics that can reverse suddenly when cascades break.
What ethical considerations arise from using AI and machine learning in investment management, and how should CFA charterholders address them?
AI in investment management raises ethical challenges around explainability, data bias, overfitting, and accountability. CFA Standards assign responsibility to the human professional, require disclosure of AI use to clients, and demand that practitioners understand the limitations of the tools they deploy.
What is spread duration contribution, and how does it help portfolio managers measure and manage credit risk across sectors?
Spread duration contribution (SDC) equals a position's weight times its spread duration, measuring each sector's contribution to total portfolio credit risk. Managers use it for risk budgeting, benchmark comparison, and stress testing across credit sectors.
How should portfolio managers approach emerging market currency risk, and when does EM currency exposure add value?
Emerging market currencies offer a carry premium and growth-linked appreciation potential but carry significant crash risk and negative skewness. Portfolio managers should take EM FX exposure when currencies are undervalued, carry is attractive, and the global environment is risk-on, while hedging during US tightening cycles or fiscal deterioration.
What is thematic investing and how does it differ from traditional sector allocation?
Thematic investing targets long-term structural trends that span multiple sectors, unlike traditional sector allocation which focuses on a single GICS category. Unique risks include theme definition ambiguity, valuation inflation, timing mismatch, and benchmark challenges.
How do fixed income portfolio managers use derivatives to manage interest rate risk?
Fixed income managers use interest rate swaps, Treasury futures, and options to adjust portfolio duration without physical bond trading. These derivatives act as an overlay, saving transaction costs while allowing precise control of interest rate exposure.
What is the CBOE PutWrite Index (PUT) and how does it behave?
PUT sells 1-month ATM SPX puts on T-bill collateral. Harvests vol risk premium. Similar return to SPX with lower vol but capped upside and tail risk.
How do I structure a yield curve slope (steepener/flattener) trade?
Slope trades are DV01-neutral positions isolating curve slope. Steepener = long short maturity, short long maturity; flattener is the reverse. Sizing: for $100M 2Y long, short ~$22M 10Y based on relative DV01.
What is a receive-pay curve trade in swap markets?
'Receive 5s, pay 10s' means receive fixed 5Y swap and pay fixed 10Y swap, duration-neutral. This is a curve flattener — profits when the 10s–5s spread narrows via 5Y rallying more or 10Y selling off more.
PPP vs Interest Rate Parity for forecasting exchange rates — when do I use which?
Exchange rate forecasting appears frequently on the Level III exam. PPP is best for long-term forecasts based on inflation differentials, while Interest Rate Parity models work for medium-term directional guidance based on interest rate differentials.
What is the Modified Dietz method and when is it used?
Modified Dietz approximates TWR by weighting cash flows by the fraction of the period they're present, useful when daily valuations are unavailable...
How do I attribute returns to yield curve slope and curvature changes?
Curve effect attributes non-parallel moves to active partial-duration bets. Covenant's 2Y overweight (+7.6bps) and 10Y underweight (+9.7bps) during steepening produced +17.3bps curve alpha, separate from level/duration effect.
What are the key strategies for using a donor-advised fund (DAF)?
A donor-advised fund provides immediate tax-deductible contributions with flexible grant timing. Key strategies include bunching, donating appreciated securities, and estate simplification...
How does a longevity swap work for pensions?
A longevity swap pays the plan net cash if retirees live longer than expected. Plan pays fixed expected mortality flows, receives actual. For Westmere Larkton with $2B swap, if actual deaths fall short of expected, plan receives the shortfall. Insurance margin adds 3-5% to expected flows.
How does a pension risk transfer buy-in differ from a buyout?
A buy-in has the insurer pay the plan (annuity held as an asset); the plan still pays participants. Legally the sponsor keeps the obligation, unlike a buyout. Useful for phased de-risking, flexibility, and preserving legal recourse if insurer fails.
What are the primary estate tax minimization strategies for high-net-worth clients?
Estate tax tools: annual exclusion, lifetime exemption, GRATs, SLATs, ILITs, charitable trusts, and FLP valuation discounts...
How is the quality factor defined in equity investing and which metrics best capture it?
The quality factor captures companies with strong fundamentals — high profitability, stable earnings, low leverage, and responsible payout policies. While no single definition exists, academic work by Novy-Marx and Asness provides frameworks using gross profitability, growth, and safety metrics.
When should an equity portfolio manager choose active vs passive management?
The active versus passive decision depends on market efficiency, manager skill (information ratio), fees, tax sensitivity, and benchmark availability. CFA Level III provides a framework using the Fundamental Law of Active Management to evaluate when active management is likely to add value.
How do I structure and evaluate OTM put protection on an equity portfolio?
Size OTM puts by beta-adjusted notional. 10% OTM 3-month puts ~3% annual drag. Structure collars to fund premium. Model scenarios explicitly.
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