CFA 2017 level 3 schweser notes book 3

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Table of Contents Getting Started Flyer Contents Readings and Learning Outcome Statements Capital Market Expectations Exam Focus Formulating Capital Market Expectations LOS 15.a Problems in Forecasting LOS 15.b LOS 15.c The Use of Surveys and Judgment for Capital Market Expectations LOS 15.d Economic Analysis 10 LOS 15.e 11 LOS 15.f 12 Inflation and Asset Returns 13 LOS 15.g 14 The Taylor Rule 15 LOS 15.h 16 The Yield Curve 17 LOS 15.i 18 Economic Growth Trends 19 LOS 15.j 20 LOS 15.k 21 Links Between Economies 22 LOS 15.l 23 Emerging Market Economies 24 LOS 15.m 25 Economic Forecasting 26 LOS 15.n 27 Economic Conditions and Asset Class Returns 28 LOS 15.o 29 LOS 15.p 30 Forecasting Exchange Rates 31 LOS 15.q 32 Reallocating a Global Portfolio 33 LOS 15.r 34 Key Concepts LOS 15.a LOS 15.b LOS 15.c LOS 15.d LOS 15.e LOS 15.f LOS 15.g LOS 15.h LOS 15.i 10 LOS 15.j 11 LOS 15.k 12 LOS 15.l 13 LOS 15.m 14 LOS 15.n 15 LOS 15.o 16 LOS 15.p 17 LOS 15.q 18 LOS 15.r 35 Concept Checkers 36 Answers – Concept Checkers Equity Market Valuation Exam Focus Cobb-Douglas Production Function LOS 16.a LOS 16.b LOS 16.c LOS 16.d LOS 16.e Relative Equity Market Valuation LOS 16.f 10 LOS 16.g 11 Key Concepts LOS 16.a LOS 16.b LOS 16.c LOS 16.d LOS 16.e LOS 16.f LOS 16.g 12 Concept Checkers 13 Answers – Concept Checkers Self-Test: Economic Analysis Asset Allocation Exam Focus Strategic Asset Allocation LOS 17.a Tactical Asset Allocation LOS 17.b LOS 17.c LOS 17.d Dynamic and Static Asset Allocation LOS 17.e 10 LOS 17.f 11 Specifying Risk and Return Objectives 12 LOS 17.g 13 Specifying Asset Classes 14 LOS 17.h 15 LOS 17.j 16 LOS 17.k 17 Risk in International Assets 18 LOS 17.l 19 LOS 17.m 20 LOS 17.n 21 22 23 24 25 26 27 28 29 30 31 32 33 Steps in Asset Allocation LOS 17.o Approaches to Asset allocation LOS 17.p Constraints Against Short Sales LOS 17.q LOS 17.i LOS 17.r Strategic Asset Allocation Issues LOS 17.s Tactical Allocation LOS 17.t Key Concepts LOS 17.a LOS 17.b LOS 17.c LOS 17.d LOS 17.e LOS 17.f LOS 17.g LOS 17.h LOS 17.i LOS 17.r 10 LOS 17.j 11 LOS 17.k 12 LOS 17.l 13 LOS 17.m 14 LOS 17.n 15 LOS 17.o 16 LOS 17.p 17 LOS 17.q 18 LOS 17.s 19 LOS 17.t 34 Concept Checkers 35 Answers – Concept Checkers Currency Management: An Introduction Exam Focus Introduction Effects of Currency on Portfolio Risk and Return LOS 18.a Calculating Portfolio Return for Multiple Investments in Foreign Assets Risk Strategic Decisions LOS 18.b LOS 18.c 10 Tactical Currency Management 11 LOS 18.d 12 LOS 18.e 13 Currency Management Tools 14 LOS 18.f 15 Roll Yield 16 Strategies to Modify Risk and Lower Hedging Costs 17 LOS 18.g 18 19 20 21 22 Hedging Multiple Currencies LOS 18.h Managing Emerging Market Currency LOS 18.i Key Concepts LOS 18.a LOS 18.b LOS 18.c LOS 18.d LOS 18.e LOS 18.f LOS 18.g LOS 18.h LOS 18.i 23 Concept Checkers 24 Answers – Concept Checkers Market Indexes and Benchmarks Exam Focus Benchmarks vs Indexes LOS 19.a Investment Uses of Benchmarks LOS 19.b Types of Benchmarks LOS 19.c LOS 19.d Use of Market Indexes 10 LOS 19.e 11 Index Construction 12 LOS 19.f 13 The Pros and Cons of Approaches to Index Weighting 14 LOS 19.g 15 LOS 19.h 16 Key Concepts LOS 19.a LOS 19.b LOS 19.c LOS 19.d LOS 19.e LOS 19.f LOS 19.g LOS 19.h 17 Concept Checkers 18 Answers – Concept Checkers 10 Self-Test: Asset Allocation 11 Fixed-Income Portfolio Management—Part I Exam Focus Bond Portfolio Benchmarks LOS 20.a Bond Indexing Strategies LOS 20.b Selecting a Benchmark Bond Index LOS 20.c 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 LOS 20.d LOS 20.e Scenario Analysis LOS 20.f Immunization LOS 20.g Warm-Up: Duration as a Measure of Bond Portfolio Risk Duration Contribution Adjusting Dollar Duration LOS 20.h Spread Duration LOS 20.i Extensions to Classical Immunization LOS 20.j Immunization Risks LOS 20.k Immunizing Single Liabilities, Multiple Liabilities, and General Cash Flows LOS 20.l Risk Minimization vs Return Maximization LOS 20.m Cash Flow Matching LOS 20.n Key Concepts LOS 20.a LOS 20.b LOS 20.c LOS 20.d LOS 20.e LOS 20.f LOS 20.g LOS 20.h LOS 20.i 10 LOS 20.j 11 LOS 20.k 12 LOS 20.l 13 LOS 20.m 14 LOS 20.n 31 Concept Checkers 32 Answers – Concept Checkers 12 Relative-Value Methodologies for Global Credit Bond Portfolio Management Exam Focus Relative Value Analysis LOS 21.a Cyclical and Secular Changes LOS 21.b Liquidity LOS 21.c Rationales for Secondary Bond Trades LOS 21.d 10 Duration Management 11 Relative Value Analysis 12 LOS 21.e 13 14 15 16 17 Measuring Spread Spread Analysis Bond Structures Credit Analysis Key Concepts LOS 21.a LOS 21.b LOS 21.c LOS 21.d LOS 21.e 18 Concept Checkers 19 Answers – Concept Checkers 13 Fixed-Income Portfolio Management—Part II Exam Focus Leverage LOS 22.a Repurchase Agreements LOS 22.b Bond Risk Measures LOS 22.c Futures Contracts Advantages of Interest Rate Futures 10 LOS 22.d 11 Dollar Duration 12 Duration Management 13 LOS 22.e 14 LOS 22.f 15 Managing Default Risk, Credit Spread Risk, and Downgrade Risk With Derivatives 16 LOS 22.g 17 International Bond Excess Returns 18 LOS 22.h 19 International Bond Durations 20 LOS 22.i 21 The Hedging Decision 22 LOS 22.j 23 Breakeven Spread Analysis 24 LOS 22.k 25 Emerging Market Debt 26 LOS 22.l 27 Selecting a Fixed-Income Manager 28 LOS 22.m 29 Key Concepts LOS 22.a LOS 22.b LOS 22.c LOS 22.d LOS 22.e LOS 22.f LOS 22.g LOS 22.h LOS 22.i 10 LOS 22.j 14 15 16 17 11 LOS 22.k 12 LOS 22.l 13 LOS 22.m 30 Concept Checkers 31 Answers – Concept Checkers Self-Test: Fixed-Income Portfolio Management Formulas Copyright Pages List Book Version BOOK – ECONOMIC ANALYSIS, ASSET ALLOCATION AND FIXED-INCOME PORTFOLIO MANAGEMENT Readings and Learning Outcome Statements Study Session – Applications of Economic Analysis to Portfolio Management Self-Test – Economic Analysis Study Session – Asset Allocation and Related Decisions in Portfolio Management (1) Study Session – Asset Allocation and Related Decisions in Portfolio Management (2) Self-Test – Asset Allocation Study Session 10 – Fixed-Income Portfolio Management (1) Study Session 11 – Fixed-Income Portfolio Management (2) Self-Test – Fixed-Income Portfolio Management Formulas C default risk, and this can be most effectively managed with binary credit options or credit spread options The type of credit-related risk most closely associated with the actions of a third party is downgrade risk In this case, a major rating agency reduces its assessment of the issue/issuer’s credit quality, and the value of the bond is adversely affected This type of credit risk can be best managed with binary credit options or swaps In the case of both instruments, the specified credit event is a downgrade below some level 13 When considering potential sources of excess return for an international bond portfolio manager, which of the following statements is most correct? A Market selection refers to nations in which investments are to occur, currency selection refers to whether or not currency exposures are actively managed or hedged, and sector selection refers to industries, ratings categories, maturity ranges, et cetera B Sector selection refers to nations in which investments are to occur, currency selection refers to whether or not currency exposures are actively managed or hedged, and market selection refers to industries, ratings categories, maturity ranges, et cetera C Currency selection refers to nations in which investments are to occur, and sector selection refers to industries, ratings categories, maturity ranges, et cetera There are at least six potential sources of excess return Market selection concerns determining which national bond markets may afford the best opportunities Currency selection concerns currency exposure management: should we hedge our exposures or should we actively manage our exposures? Duration management refers to managing interest rate risk and exposure so as to take advantage of any anticipated changes in rates Sector selection involves seeking out the best performing industries, ratings categories, maturity ranges and other sector classifications Credit analysis concerns the evaluation of credit qualities in an attempt to identify securities that may experience positive credit quality changes The degree to which we are willing to deviate from our benchmark, which is often referred to as enhanced indexing 14 A Canadian bond represents 10% of an international bond portfolio It has a duration of and a yield beta of 1.2 If domestic interest rates change by 50 basis points, what is the estimated percentage price change for the bond, and what is its duration contribution to the portfolio? Price change ; Duration contribution A 3.5% ; 0.70 B 4.2% ; 0.84 C 8.4% ; 0.42 The estimated price change is: %Δprice = duration × Δy × β = × 0.005 × 1.2 = 4.2% The duration contribution is: DC = weighting × duration × β = 0.10 × × 1.2 = 0.84 15 An international bond portfolio manager is considering two bonds for investment The bonds are comparable in terms of risk characteristics, and the following information applies: Country Nominal Return Risk-Free Rate Exchange Rate #/D A 9.75% 8.50% 3.00 B 4.75% 3.25% 5.00 Domestic n/a 5.75 n/a You expect Currency A to depreciate against the domestic currency by 2.6%, and you expect Currency B to appreciate against the domestic currency by 2.6% On a fully hedged basis, which bond should be selected, and, assuming that this bond is selected, should the bond’s currency exposure be hedged? A Bond A; hedge B Bond A; not hedge C Bond B; not hedge Assuming a comparable level of risk and a fully hedged position, the bond selection is based upon the bond’s excess return: Bond A excess return = 9.75 – 8.50 = 1.25% Bond B excess return = 4.75 – 3.25 = 1.50% Bond B should be selected under the assumption that the position will be fully hedged Once Bond B has been selected, if the hedging decision is revisited, the decision will depend upon the change in currency values implied by the differential in the risk-free rates, relative to the portfolio manager’s expectations Change in Currency B implied by the interest rate differential = 5.75 – 3.25 = +2.50% Because you expect Currency B to appreciate by 2.60%, you should not hedge 16 A portfolio manager with investable funds is considering two alternatives: Bond Nominal Yield Duration Australian Bond 7.65% 6.5 New Zealand Bond 6.85% 5.3 If the target holding period is six months, by how much would either of the yields on these two bonds have to change to offset the current yield advantage of the Australian Bond? A Australian increase by bp, New Zealand decrease by bp B Australian decrease by bp, New Zealand increase by bp C Australian increase by 12 bp, New Zealand decrease by 15 bp The current yield advantage to the Australian Bond is 7.65 – 6.85 = 0.8% or 80 bp Because the target holding period is six months, this represents 40 bp over the investment horizon Next, we calculate the required change for each bond: → The yield would need to increase by bp → The yield would need to decrease by bp In either case, the yield advantage is offset by the spread widening 17 From the perspective of an international bond portfolio manager, which of the following is the least likely rationale for an allocation to emerging market debt (EMD) securities? A EMD credit quality has been improving B Holding EMD issues results in reduced currency risk exposure C EMD issuers are recovering from adverse events more quickly than in the past Emerging market currencies can be extremely volatile, especially during negative market events Thus, even if the choice is between a bond in a developed country/currency and an EMD issue, the currency risk is most likely to be greater for the EMD issue The other points are valid rationales for an allocation to EMD 18 With respect to emerging market debt (EMD), one of the main risks to the foreign bondholder is political risk Which of the following is least likely to be a type of political risk? A Potential changes in tax and/or regulatory policy B A lack of standardized debt covenants for EMD securities C The possibility that investment capital cannot be repatriated to the investor’s home country A lack of standardized debt covenants is certainly an issue, and creates risks for the EMD holder If the covenants were changed arbitrarily, that could constitute political risk However, the lack of standardization itself is not political risk The other points are all forms of political risk 19 Factors that should be evaluated during the due diligence process when selecting a fixedincome portfolio manager include: A style analysis, selection ability, investment process, and beta correlations B style analysis, selection ability, investment process, and alpha correlations C style analysis, selection ability, risk management process, and alpha correlations Four principal factors that should be evaluated during the due diligence process surrounding the selection of a fixed-income portfolio manager are (1) style analysis (which includes portfolio management policy), (2) security selection ability, (3) investment process (which includes how research is conducted and decisions are made), and (4) the correlation of the manager’s alpha with other current and prospective managers SELF-TEST: FIXED-INCOME PORTFOLIO MANAGEMENT You have now finished the Fixed-Income topic area To get immediate feedback on how effective your study has been for this material, log in to your Schweser online account and take the self-test for this topic area Questions are more exam-like than typical Concept Checkers or QBank questions; a score of less than 70% indicates that your study likely needs improvement These tests are timed and allow three minutes per question FORMULAS market volatility: factor model based market return: factor model based market variance: covariance of returns between two markets, C and D: variance of a market, C: price of a stock at time 0: Grinold-Kroner expected return on equity: expected bond return: ICAPM: beta for stock i: = correlation of stock i with the market: equity risk premium for market i: where: ρi = 1.0 for a fully segmented market target interest rate to achieve neutral rate: Cobb-Douglas function (% change): Solow residual = %ΔTFP = %ΔY – α(%ΔK) – (1 – α)(%ΔL) H-model: constant growth model: Fed model: Yardeni model: P/10-year MA(E): Roy’s Safety-First Measure (RSF): Foreign Asset Return and Risk: RDC = (1 + RFC)(1 + RFX) – = RFC + RFX + (RFC)(RFX) σ 2(RDC) ≈ σ 2(RFC) + σ 2(RFX) + 2σ(RFC)σ(RFX)ρ(RFC,RFX) σ(RDC) = σ(RFX)(1 + RFC) where: RFC = the return on a foreign currency denominated risk-free asset portfolio effective duration: contribution of bond or sector i to the portfolio duration = wiDi dollar duration of a bond or portfolio: DD = ($Δvalue) = (effective duration)(0.01)(value) portfolio dollar duration: return of a leveraged portfolio: RP = Ri + [(B / E) × (Ri – c)] leveraged equity duration (may also be referred to as portfolio duration): number of contracts to adjust portfolio duration: if yield beta is given include it as a multiplier in the previous calculation OV = max [(strike – value), 0] OV = max [(actual spread – strike spread) × notional × risk factor, 0] payoff to a credit spread forward: FV = (spread at maturity – contract spread) × notional × risk factor forward premium or discount: breakeven spread analysis: % change in relative price = –DS ∆S ∆S = % change in relative price / –DS return on a bond denominated in a foreign currency: Rb = Rl + Rc ≈ Rl + (id – if) ⇒ id + (Rl – if) All rights reserved under International and Pan-American Copyright Conventions By payment of the required fees, you have been granted the non-exclusive, non-transferable right to access and read the text of this eBook on screen No part of this text may be reproduced, transmitted, downloaded, decompiled, reverse engineered, or stored in or introduced into any information storage and retrieval system, in any forms or by any means, whether electronic or mechanical, now known or hereinafter invented, without the express written permission of the publisher SCHWESERNOTES™ 2017 LEVEL III CFA® BOOK 3: ECONOMIC ANALYSIS, ASSET ALLOCATION AND FIXED-INCOME PORTFOLIO MANAGEMENT (EBOOK) ©2016 Kaplan, Inc All rights reserved Published in 2016 by Kaplan, Inc Printed in the United States of America ISBN: 978-1-4754-4125-3 If this book does not have the hologram with the Kaplan Schweser logo on the back cover, it was distributed without permission of Kaplan Schweser, a Division of Kaplan, Inc., and is in direct violation of global copyright laws Your assistance in pursuing potential violators of this law is greatly appreciated Required CFA Institute disclaimer: “CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by Kaplan Schweser CFA and Chartered Financial Analyst are trademarks owned by CFA Institute.” Certain materials contained within this text are the copyrighted property of CFA Institute The following is the copyright disclosure for these materials: “Copyright, 2016, CFA Institute Reproduced and republished from 2017 Learning Outcome Statements, Level I, II, and III questions from CFA® Program Materials, CFA Institute Standards of Professional Conduct, and CFA Institute’s Global Investment Performance Standards with permission from CFA Institute All Rights Reserved.” These materials may not be copied without written permission from the author The unauthorized duplication of these notes is a violation of global copyright laws and the CFA Institute Code of Ethics Your assistance in pursuing potential violators of this law is greatly appreciated Disclaimer: The Schweser Notes should be used in conjunction with the original readings as set forth by CFA Institute in their 2017 Level III CFA Study Guide The information contained in these Notes covers topics contained in the readings referenced by CFA Institute and is believed to be accurate However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam success The authors of the referenced readings have not endorsed or sponsored these Notes PAGES LIST BOOK VERSION 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 Cover i iii iv v vi vii viii ix x 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 151 152 153 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 154 155 156 157 158 159 160 161 162 163 164 165 166 167 168 169 170 171 172 173 174 175 176 177 178 179 180 181 182 183 184 185 186 187 188 189 190 191 192 193 194 195 196 197 198 199 200 201 202 203 204 205 144 145 146 147 148 149 150 151 152 153 154 155 156 157 158 159 160 161 162 163 164 165 166 167 168 169 170 171 172 173 174 175 176 177 178 179 180 181 182 183 184 185 186 187 188 189 190 191 192 193 194 195 206 207 208 209 210 211 212 213 214 215 216 217 218 219 220 221 222 223 224 225 226 227 228 229 230 231 232 233 234 235 236 237 238 239 240 241 242 243 244 245 246 247 248 249 250 251 252 253 254 255 256 257 196 197 198 199 200 201 202 203 204 205 206 207 208 209 210 211 212 213 214 215 216 217 218 219 220 221 222 223 224 225 226 227 228 229 230 231 232 233 234 235 236 237 238 239 240 241 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Conditions and Asset Class Returns 28 LOS 15.o 29 LOS 15.p 30 Forecasting Exchange Rates 31 LOS 15.q 32 Reallocating a Global Portfolio 33 LOS 15.r 34 Key Concepts LOS 15.a LOS 15.b LOS 15.c LOS 15.d... LOS 22.k 12 LOS 22.l 13 LOS 22.m 30 Concept Checkers 31 Answers – Concept Checkers Self-Test: Fixed-Income Portfolio Management Formulas Copyright Pages List Book Version BOOK – ECONOMIC ANALYSIS,
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