CFA Level III flashcards

32 cards. Read the term and the definition here. The deck at the top of this page is optional.

Mosaic theory

Combining public information with nonmaterial nonpublic information to reach an investment conclusion is permitted; acting on material nonpublic information violates Standard II(A).

Soft dollar standard

Under Standard III(A) Loyalty, Prudence and Care, directed brokerage must benefit the client by producing research or services that assist the investment decision process.

GIPS composite definition

A composite aggregates portfolios managed under a similar strategy, objective and mandate; firms must include all actual, fee-paying, discretionary portfolios that meet the composite definition.

GIPS five-year minimum

Firms must present a minimum of five years of GIPS-compliant performance, or performance since inception if the firm has operated for fewer than five years.

Independence and objectivity gifts

Standard I(B) prohibits accepting gifts or entertainment that could reasonably impair independence or objectivity; modest gifts are permissible only if disclosed to the employer.

Roy safety-first ratio

Formula (E(Rp) - RL)/sigma_p measures excess expected return per unit of downside risk; the highest ratio minimizes the probability of falling below the threshold RL.

Policy portfolio

The strategic asset allocation reflecting the investor's long-term objectives, risk tolerance and constraints; it serves as the benchmark against which tactical deviations are measured.

Surplus optimization

A liability-relative approach that maximizes expected surplus return per unit of surplus risk, where surplus equals asset market value minus liability market value.

Correlation and diversification

Portfolio risk falls most when asset correlations are low or negative; with perfect positive correlation, portfolio standard deviation equals the weighted average of component standard deviations.

Tactical asset allocation

Short-term deviations from the strategic allocation intended to exploit perceived mispricings, kept within the permissible policy ranges stated in the IPS.

Rebalancing corridor width

Permissible rebalancing bands widen when transaction costs are higher, asset-class policy ranges are wider, and the investor's tolerance for tracking deviation is higher.

Fundamental law of active management

Expected information ratio approximately equals the information coefficient times the square root of breadth, where breadth is the number of independent investment decisions per year.

Risk budgeting

Allocating total portfolio risk across managers or factors by measuring each component's contribution to total risk rather than relying on capital weights alone.

Duration matching

Immunization requiring the present value of assets to equal the present value of liabilities and asset duration to equal liability duration; convexity matters for large rate moves.

Tracking error

The annualized standard deviation of the difference between portfolio and benchmark returns; it measures active risk and constrains how far a manager may deviate.

Incremental VaR

The change in portfolio value at risk caused by adding or removing a position; used to judge whether a proposed trade improves the portfolio risk profile.

Time-weighted return

Return computed by geometrically linking subperiod returns around external cash flows, removing cash-flow timing effects; required for GIPS composites except private market investments.

Money-weighted return

The internal rate of return setting the present value of contributions and withdrawals equal to the ending value; it reflects the investor's actual experience including cash-flow timing.

Treynor ratio

Excess return divided by beta, (Rp - Rf)/beta_p; it measures return per unit of systematic risk and suits well-diversified portfolios where only beta matters.

Brinson attribution

Decomposes active return into allocation (weight differences times benchmark returns), selection (benchmark weights times return differences) and an interaction term.

M-squared measure

M-squared = Rf + (Sharpe_p * sigma_m) - Rm; it rescales portfolio return to the benchmark's volatility so portfolio and benchmark returns are directly comparable.

Capture ratio

Upside capture divided by downside capture of benchmark returns; a ratio above one indicates the manager did better in rising markets than in falling ones.

Put-call parity

For European options on a non-dividend-paying stock, c + X/(1+r)^T = p + S0; any deviation from this equality permits a riskless arbitrage.

Forward contract value

At time t the value of a long forward equals St - F0/(1+r)^(T-t); the contract has zero value at initiation and gains value as spot rises.

Delta hedging

The number of options needed to hedge equals portfolio delta divided by option delta; the hedge must be rebalanced because delta changes as the underlying moves.

Parametric VaR

VaR = (mean return - z * standard deviation) * portfolio value; the normal-distribution assumption understates losses for fat-tailed or illiquid portfolios.

Covered call

Writing a call option against a long stock position; it generates premium income in exchange for capping upside, with downside protection limited to the premium received.

Spending rate rule

Endowment spending is often set as a target rate applied to a moving average of market value, smoothing spending and preserving intergenerational equity.

J-curve effect

Early private equity returns are negative because of fees and start-up costs, then rise as portfolio companies mature; performance is reported as a money-weighted IRR.

Cash flow matching

A dedication approach that aligns asset cash inflows with liability outflows period by period, eliminating reinvestment and interest rate risk once the portfolio is established.

Illiquidity premium

The extra expected return investors demand for assets that cannot be sold quickly without a price concession; it underpins allocations to private market investments.

Event-driven strategy

A hedge fund approach exploiting mispricings around corporate events such as mergers, restructurings or bankruptcies, typically carrying limited broad market beta.