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CFA Level III Updated
What are the essential components of an Investment Policy Statement (IPS)?
The IPS contains return objectives, risk objectives, and five constraints (Time horizon, Taxes, Liquidity, Legal, Unique circumstances). The return objective must be stated as required return, adjusted for taxes and inflation, while risk tolerance reflects the lower of ability and willingness.
How is information ratio maximized in practical portfolio construction?
Information ratio maximization combines information coefficient, breadth, and transfer coefficient via the Fundamental Law of Active Management, solved via quadratic programming.
Is there a case for allocating to international small-cap equities?
International small-cap offers lower correlation to US equities (~0.68), historically higher returns, and exposure to domestic economic drivers. Typical allocation is 5–15% of the international equity sleeve.
Why do investors exhibit home-country bias and how do I quantify it?
Home-country bias is measured as the overweight vs global market cap share. Drivers include familiarity, FX aversion, liability matching, and behavioral factors. Typical bias far exceeds rationally justifiable levels.
Calendar rebalancing vs. percent-range rebalancing — pros, cons, and when to use each?
Calendar rebalancing trades on a fixed schedule (simple but inflexible), while percent-range rebalancing uses corridors around target weights (responsive but requires monitoring). Corridor width depends on transaction costs, volatility, correlation, and risk tolerance.
What is Operational Due Diligence in PE fund selection?
ODD checks governance, back-office, compliance, service providers, and operational risk separately from investment merits.
What is CDS basis and how do positive vs negative basis trades work?
CDS-bond basis is the difference between CDS spread and cash bond Z-spread. In theory it should be zero; in practice deviations create arbitrage opportunities...
What is longevity insurance (deferred income annuity) and when is it optimal?
A deferred income annuity (DIA), often called longevity insurance, is purchased at one age with payments beginning at a later age.
Is factor timing a viable strategy?
Factor timing varies exposures to style factors based on predictive signals. Evidence is mixed — valuation spreads predict value factor returns, but most timing signals fail out-of-sample...
How is key rate PV01 computed and what does it tell me that duration doesn't?
KR01 measures dollar change for a 1bp shift at one key rate, holding others constant. Reveals curve-shape exposures that single-number duration hides.
How does importance sampling reduce variance in Monte Carlo?
Importance sampling replaces the original density with a proposal, then weights samples by p/q. Choose the proposal to put probability mass where the integrand matters most...
How do you manage a Friendly Follower client?
The Friendly Follower (FF) has moderate risk tolerance and cognitive biases — availability, recency, framing, hindsight. Example: Rodrigo Alarcón chases hot themes. Advisor approach: EDUCATE and use passive strategies — global index core, concentration caps, pre-committed rebalancing...
How does factor-based asset allocation work?
Factor-based allocation targets systematic factors (growth, inflation, value, momentum) instead of asset classes. Offers cleaner risk decomposition but requires sophisticated tools.
How does the endowment effect distort portfolio construction?
The endowment effect makes clients overvalue assets they already own. Accommodate by segregating legacy positions, diversifying around them, using options overlays, and gradually trimming.
How is a target-date fund glidepath designed?
A target-date fund glidepath is a schedule of equity/fixed-income allocation versus years-to-retirement, balancing accumulation growth with preservation...
What is asset location and how does it fit into tax planning?
Asset location places tax-inefficient assets in tax-advantaged accounts and tax-efficient assets in taxable. Distinct from asset allocation. Can add 30-80 bps after-tax alpha.
When does empirical duration diverge from effective duration, and which should I use?
Effective = model-based parallel shift. Empirical = regression vs yields. HY/MBS empirical is 30-60% lower due to spread-rate negative correlation.
What does fiduciary duty mean in investment management and how is it tested on CFA Level III?
Fiduciary duty requires investment professionals to act in the best interest of clients through two core components: the duty of loyalty (acting in good faith, avoiding conflicts) and the duty of care (exercising prudence and competence in investment decisions).
How does the Treynor-Black model combine active and passive portfolios?
The Treynor-Black model combines a passive market index with an active alpha portfolio weighted by alpha-to-residual-variance ratios, improving Sharpe by information ratio.
How is the Markowitz efficient frontier constructed and interpreted?
The Markowitz efficient frontier plots portfolios maximizing expected return per variance level, traced via quadratic programming on expected returns and covariances.
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