CFA Level 3 Book 5

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1. Account Return if
External Cash Flow
at Beginning of
Evaluation Period
Formula
2. Account Return if
External Cash Flow
at End of Evaluation
Period Formula

3. Algorithmic Trading The use of automated, quantitative systems that utilize trading rules, benchmarks, and constraints to execute
(4 Types) orders with minimal risk and costs.
Classified into:

Simple logical participation - seek to trade with market flow so as to not become overly noticeable to the market
and to minimize market impact. Breaks trade into small pieces and trades throughout the day; small part of
trading volume and low market impact costs. (narrow spread, low urgency, and small relative average daily
volume)

Implementation Shortfall (arrival price strategies) - minimize trading costs defined by the implementation
shortfall measure or total execution costs. Trade heavier early in the day to ensure order completion, reduce
opportunity costs, and minimize the volatility of trading costs. Executes order quickly to Minimize variance of
cost of trading. Similar to portfolio optimization because portfolio value is maximized. (high urgency level)

Opportunistic Participation - trade passively over time but increase trading when liquidity is present

Specialize strategies include passive strategies and other misc. strategies

4. Allocation/Selection (Portfolio Weight of Sector - Benchmark Weight of Sector) * (Portfolio Return on Sector - Benchmark Return of
Interaction = Sector)

5. Appropriate ways to
monitor performance
for Long-Short
Hedge Funds

1.Value Added Return (performance impact)

2. Separate long/short benchmarks and then combine them to their relevant proportions to create an overall
benchmark
3. Sharpe Ratio - compares to risk free return rather than benchmark

it is possible for MV0 to be zero for a long-short portfolio, making return calc. nonsensical
6. Best Execution 1. Depends on value added of the trade versus cost
Characteristics 2. Best execution and value added cannot be known ex ante
3. Best execution and cost can only be calculated ex post. Assessing value added may take even longer to
evaluate if the idea works out.
4. Relationships and practices are integral to best execution. Best execution is ongoing and requires diligence
and dedication to the process.

compared to prudence (selecting most appropriate securities for an investor) whereas best execution refers to
best means to buy/sell those securities
7. Briefly explain the challenges inherent in performance measurement and
performance evaluation for a long-short hedge fund. If traditional performance
measurement and evaluation are not appropriate in a long-short environment, are
there other options that may be useful?

8. Brokered Markets: Investors use brokers to locate counterparty to

trade. Useful when trader has large block to
sell, wants to be anonymous, or when security
market is small or illiquid
9. Buy and Hold (BH) Characteristics and Risk Tolerance -Exposure diagram's slope is equal to one
-Does not rebalance regardless of portfolio
wealth level
-Investor's tolerance for risk is zero if the value
of the investor's assets falls below the floor
value
-Otherwise, passively, risk tolerance increases
proportionately with wealth
10. Buy Side and Sell Side Relationship Both sides must follow word of honor or no one
will take opposite trade.
Two reasons that have increase opportunity and
temptation to act unethically between each
other are:
1. The development of electronic trading
provides more anonymity. a trader who gains
information from another can use this info
against the other.
2. Decline of explicit brokerage commissions,
can lead to greater implicit costs.

Buy side should always act in best interests of

their clients and have duty to maximize their
portfolio and never put sell-side traders before
them.
11. CFA Institute Trade Management Guidelines 1. Processes - firms should have procedures in
place to maximize value using best execution
2. Disclosures - provide disclosures to clients
and potential regarding information on trading
techniques, markets, brokers and conflicts of
interest
3. Record Keeping - maintain documentation
supporting firm's compliance and disclosures
sent to clients. Retains as evidence to regulators
as best execution for clients.
12. Client Circumstances that may cause portfolio rebalance 1. Change in Wealth
2. Change in Time Horizon
3. Change in liquidity Requirements
4. Tax Concerns
5. Laws and Regulations
6. Unique Circumstances/Preferences
13. Compare and contrast macroBoth macro attribution and micro attribution are different facets of performance attribution. The
attribution with micro attribution. basic tenet behind performance attribution is that an account's performance is compared to a
What is the difference between designated benchmark, then the sources of differential returns are identified and quantified. The
using a return metric and using a main difference between macro and micro attribution is the definition of which "account's"
dollar metric? Briefly discuss the performance we are analyzing. Macro attribution is done at the fund sponsor level; that is,
inputs and methodology that analysis is typically done for a grouping of investment managers or investment accounts. Micro
could be used with a macro attribution is carried out at the level of the individual investment manager.
analysis.
There are three main inputs to the macro attribution approach:

policy allocations;

benchmark portfolio returns; and

fund returns, valuations, and external cash flows.

Fund sponsors determine policy allocations, or "normal" weightings, for each asset class and
individual manager. These are typically determined after some sort of asset liability analysis
and/or determination of the risk tolerance of the governing body of the fund.

Benchmark portfolio returns are an important factor in determining the value added by the fund. If
the benchmarks do not adequately match the managers' investment styles, the performance
attribution will have little value. Fund sponsors may use broad market indexes as the benchmarks
for asset categories (the Wilshire 5000 as the benchmark for overall US domestic equities, for
example) and may use more focused indexes to represent managers' investment styles (such as
the Russell 2000 Value Index for a small-cap value manager).

Fund returns, valuations, and external cash flows are all critical elements for determining the
relevant performance for the portfolio as a whole and for each individual investment manager's
account.

A return metric implies that fund returns are used at the level of the individual management
account to allow an analysis of the fund sponsor's decisions regarding manager selection. A
dollar-metric approach uses account valuation and external cash flow data to calculate rates of
return and also to compute the dollar impacts of the fund sponsor's investment policy decision
making.
14. Composites must include new timely and consistent basis after each portfolio comes under management
portfolios on a
15. Constant Mix (CM) Characteristics Concave. represents the sale of portfolio insurance
and Risk Tolerance -Exposure diagram's slope is less than one
-Any procedure that buys when stocks fall or sells when stocks rise is a concave strategy
-If more investors follow concave strategies, the markets will become too stable
-Absolute Risk tolerance varies directly with wealth
-Relative risk tolerance remains constant regardless of wealth level
-Investors using this strategy will hold stocks at all levels of wealth

16. Constant Proportion PortfolioConvex. represents the purchase of portfolio insurance

Insurance (CPPI) Characteristics-Exposure diagram's slope is greater than one
and Risk Tolerance -Any Procedure that buys when stocks rise or sells when stocks fall is a convex strategy
-The more investors follow convex strategies, the more volatile the markets will become
-Investor risk tolerance is similar to that of the BH Methodology
-Investor Risk tolerance drops to zero when total assets drop below the floor value
-However, CPPI assumes that investor risk tolerance is more dramatically affected by changes in
wealth levels than BH
17. Constructing 1. Identify the fundamental factors that will generate systemic returns
Multifactor models 2. Determine the exposures of the portfolio and the benchmark to the fundamental factors at the start of the
to conduct Micro evaluation period
Attributions / 3. Determine the manager's active exposure to each factor
Returns based style 4. Determine the active impact. this is the added return due to the manager's active exposures
analysis
Fundamental factor model micro attribution results will look very similar to returns based analysis (returns are
regressed against the returns to several different indices to determine factor exposures)

The primary difference between them is the use of other fundamental factors (leverage, market timing, sector
rotation, size of the firm) that would not be used in returns based style analysis
18. Construction of 1. Identify important elements of investment process
Customer Security 2. Select securities consistent
Based Benchmark 5 3. Weight the securities (including cash) to reflect manager's process
steps 4. Review and adjust as needed to replicate
5. Rebalance custom benchmark on predetermined schedule
19. Criteria of Market should provide Liquidity, Transparency, and assurity of completion.
Quality
Liquid markets have small bid ask spreads, market depth, and resilience.
Transparent markets allow investors to obtain pre trade (regarding quotes/spreads) and post trade
information (completed trades)
Assurity of completion in markets let investors be confident that the counterparty will uphold its side of the
trade agreement.

Lquidity can be measured by quantitative measurements, while transparency and assurity of completion are
qualitative assessments.

Lower quoted and effective spreads and higher bid and ask sizes indicate greater liquidity and quality
20. Crossing Networksshould not disclose unmatched quantities.

Maintain complete confidentiality not only in regard to the size of the orders and the names of the investors
placing the orders, but also in regard to the unmatched quantities. If a crossing network were to disclose the
unmatched quantities, it would provide useful information to other parties that would affect the supply and
demand of these stocks in which clients want to transact. As a result of the information leakage, transaction
costs for its clients would likely rise.
21. Crossing a trade is relatively large and has large spread in attempt to minimize spread (large volume) calculate spread
System or Broker by (Ask - Bid)/Last Price
should be used
when
22. Determinants of 1. Transaction Costs (higher the costs means greater optimal width of corridor) (illiquid assets mean wider
Optimal Corridor corridor bc higher costs. to minimize transaction costs, corridor should be higher = less rebalance;less
Width in Percentage transaction costs
of Portfolio 2. Risk tolerance (higher tolerance, wider optimal corridor)
Rebalancing 3. Correlation of returns with other asset classes (greater correlation, wider optimal corridor)
Program 4. Volatility of asset class returns (greater volatility, narrower optimal corridor)
5. Volatility of returns on other assets in portfolio (greater volatility, narrower optimal corridor widths)
23. Determining Compare the market capitalizations between the subject portfolio and respective benchmark index (median,
Appropriateness of average, weighted average)
an Index as the
Benchmark to Compare the portfolio beta to the potential benchmark/index
Portfolio
24. Econometric Ex Ante - determining size of the trade
Models can be used ex Ex Post - trading effectiveness can be assessed by comparing actual trading costs to forecasted
ante and ex post by trading costs from the models

Help forecast transaction costs and show they are nonlinearly related to:
Security liquidity - trading volume, market cap, spread, and price
Size of the trade relative to liquidity
Trading Style - more aggressive trading results in higher costs
Momentum - trades that require liquidity Risk

25. Effective and Quoted a purchase took place at the ask price or a sale took place at the bid price
Spreads would be equal if
26. Effective Spread (Buy 2 x (execution price - midquote)
Order) =
27. Effective Spread (Sell 2 x (midquote - execution price)
Order) =
28. Estimated Implicit CostsTrade size × (Trade price - Benchmark price) for a buy

Trade size × (Benchmark price - Trade price) for a sale.

29. Ex Post Alpha

uses SML as benchmark (also uses CAPM for Expected Return on Account) ; systematic risk
30. Four Management Factors 1. Interest Rate Management Effect: ability to predict changes in relevant interest rates
contributing to a fixed-2. Sector/Quality Effect: Ability to select and overweight (underweight) outperforming
income Portfolio's Return:(underperforming) sectors and qualities
3. Security selection effect: ability to select superior securities to represent sectors
4. Trading Activity: residual effect; assume to measure the return to active trading (buying and selling)
over the period
31. Four Types of Trader:

Information Motivated traders - trade based on time sensitive information; prefer market orders
because their trades must take place quickly. Their trades demand liquidity, and they are willing to
bear the higher trading costs

Liquidity motivated traders - transact to convert their securities to cash or reallocate their portfolio
from cash. They utilize market orders and trades on crossing networks and electronic
communication networks (ECNs). Liquidity motivated traders prefer to execute their within a day.

Value-motivated traders - use investment research to uncover misvalued securities. They will use limit
orders because price, not speed, is their main objective

Passive traders - trade for index funds. They favor limit orders and trades on crossing networks.
This allows for low commissions, low market impact, price uncertainty, and possible elimination
of the bid ask spread.
32. GIPS Valuation Hierarchy 1. Quoted Prices from an active market for the same or a similar security.
2. Quoted prices from an inactive market for the same or a similar security
3.Observable market-based inputs other than quoted prices
4. Subjective, unobservable inputs
33. Hybrid Market: Combination of either Quote driven, Order driven, or brokered markets
34. Impact of Strategies on
Risk and Return for BH, CM, and
CPPI

35. Implementation Shortfall Missed Trade (opportunity/unrealized profit or loss) = |CP - DP| * # of shares canceled
Components
Explicit Costs (commission/fees) = cost per share * # of shares executed

Delay (slippage) = |BP` - DP| * # of shares later executed

BP` = revised benchmark price

Market Impact (price impact/realized profit or loss) = |EP - DP or BP`| * # of shares executed
BP* if there is a delay
36. Implementation Shortfall Benchmark is Quoted Price Midpoint
Estimate
Sums of each of the [# of shares * (Benchmark - Cost of Order)

For the number of times issues were purchased

37. Implementation Shortfall (IS)

measures transaction costs as the difference in performance of a hypothetical portfolio in which

the trade is fully executed with no cost and the performance of the actual portfolio.

For a Purchase: - an increase in price is a cost. A decrease in price is an account benefit (negative
cost)

For a Sale: - an increase in price is an account benefit (negative cost). A decrease in price is a
cost.

Disadvantages: may be unfamiliar to traders; Requires considerable data and analysis

38. Implementatio
n Shortfall Key
Terms

Decision Price (DP) - Market Price of security when order is initiated

Often orders are initiated when market is closed and the previous trading day's closing price is used as DP
Execution Price (EP) - Prices at which the order is executed
Revised Benchmark Price (BP*) - market price of security if the order is not completed in a timely manner
as defined by the user.
Cancellation Price (CP) - market price of security if the order is not fully executed and the remaining
portion of the order is canceled.
39. Information Ratio

40. Jenson Alpha

41. M^2 Measure

Total Risk (SD). measures value added/lost relative to the market if the portfolio had same risk as the
market.
42. Macro Attribution carried at the Fund Sponsor Level and uses a value metric that uses account valuation and external cash
Analysis flow data to calculate rates of return and dollar impacts

Three Inputs:
1.Policy Allocations
2. Benchmark Portfolio Returns
3. Fund Returns, valuations, and external cash flows

43. Market Order vs Market Order - execute the trade immediately to get best possible price. emphasis on speed of execution.
Limit Order Has Price uncertainty

Limit Order - order to trade at limit price or better. can expire. emphasis on price of execution. Has
execution uncertainty
44. Median Account As 1. impossible to identify median manager in advance
Benchmark 2. Ambiguous
Drawbacks 3. Benchmark is not investable
4. Impossible to verify appropriateness

5. Have to rely on compiler's representations that the accounts have been screened, input data validated, and
calculation methodology approved
6. Survivor Bias, the median will be biased upwards

45. Micro
Attribution
Analysis

carried out at investment manager level (attribute performance of an individual manager).

Uses a rate of return metric that calculates percentage returns at the level of the individual manager account

Three Inputs:
1. Pure Sector Allocation
2. Allocation selection
3. Within-sector selection
46. Model performance cannot claim compliance if model performance is linked to actual performance.
vs Actual
Performance The GIPS standards state that composites must include only actual assets under management within the
defined firm, and they expressly prohibit linking the performance of simulated or model portfolios with actual
performance
47. Modified
Dietz Method
Formula

48. Money
Weighted Rate of
Return Formula

49. One Factor Model

ap = zero factor value

Bp = beta

R1 = Return on Market Index

Ep = error term
50. Order Driven Markets:Investors trade with each other without the
use of intermediaries. Three Main Types:
1.Electronic Crossing Network (orders batched together and crossed (matched) at fixed points in time
during the day at the average of the bid/ask quotes
2. Auction Markets (trader orders compete for execution)
3. Automated Auctions (computerized auction markets and provide price discovery
51. Original Dietz Method
TWRR Formula

52. Portfolio Return P

Formula (broken into
returns due to Market,
Style, and Active
Management

53. Pure Sector Allocation = (Portfolio Weight of Sector - Benchmark Weight of Sector) * (Benchmark Return of Sector - Return
on Portfolio Benchmark)
54. Quote Driven Markets: Investors trade with Dealers
55. Seven
Primary Types of 1. Absolute
Benchmarks in use: 2. Manager Universe
3. Broad Market Indices
4. Style Indices
5. Factor-Model Based
6. Returns-Based
7. Custom Security-Based
56. Sharpe Ratio

Total Risk (standard deviation). plotted against the CML

57. Switching portfolios to Portfolios must not be switched from one composite to another unless documented changes to a
another composite portfolio's investment mandate, objective, or strategy or the redefinition of the composite makes it
appropriate. The historical performance of the portfolio must remain with the original composite.
58. Terminated Portfolios must be last full measurement period that each portfolio was under management
included in the historical
performance of the composite
up to the
59. Time
Weighted Vs
Money
Weighted
Return
TWRR advantages: not influenced by external cash flow activity; appropriate when managers have little control over
external cash activity
TWRR Disadvantages: Account valuations needed for every date of external cash flow. Admin Costs may be higher
because of this.
MWRR Advantages: appropriate if mgr has control on external cash flows; valuations only needed at start and beg.
of period
MWRR Disadvantages: sensitive to size/timing of external cash flows. Not appropriate if mgr has no control on cash
flows.
60. Trader andPrincipal and Agent. Broke acts as trader's agent and locates liquidity necessary at best price. Broker may even take
Broker position in security to facilitate trade. Trader identity remain anonymous. Broker also may provide record keeping,
Relationship: financing, cash management, and other services.
61. Trader andhave opposing interests. dealers want to maximize trade spread while traders want to minimize it. When trader has
Dealer info that dealer doesn't have, trader profits at dealer's expense, which leads to adverse risk for the dealer. It is the
Relationship: trader's interest to conceal intent, while it is dealer's interest to find out who informed traders are.
62. Trading "the actual costs of buying or selling investments"
Expenses
"These costs typically take the form of brokerage commissions, exchange fees and/ or taxes, and/ or bid-offer
spreads from either internal or external brokers. Custodial fees charged per transaction should be considered
custody fees and not trading expenses."
63. Trading Tacts
(5)

Liquidity-at-any-cost Trading: trader must transact a large block of shares quickly. Mutual fund that must
liquidity shares quickly to satisfy redemption in its fund. Trader ready to pay high price due to market impact,
commissions, or both.

Costs-are-not-important Trading: trader believes exchange markets will operate fairly and efficiently such that
the execution price they transact at is at best execution. Market orders

Need-trustworthy-agent Trading: trader employs broker to skillfully execute a large trade in a security, which
may be thinly traded. The weakness of this strategy is that commissions may be high and the trader may
reveal his trade intentions to the broker.

Advertise-to-draw-liquidity: trade is publicized in advance to draw counterparties to the trade. The weakness of
this strategy is that another trader may front run the trade, buy in advance of a buy order

Low-cost-whatever-the-liquidity: trader places a limit order outside of the current bid-ask quotes in order to
minimize trading costs. Passive and value-motivated traders will often purse this strategy.
64. Tr
eynor
Measure

Related to alpha by using beta ; systematic risk

65. Type I Error Rejecting the null hypothesis when it is true.

Keeping managers who are returning no value added

66. Type II Failing to reject the null when it is false.
Error
Firing good managers who are adding value
67. A Valid1. Specified in Advance
Benchmark 2. Appropriate
Should 3. Measurable
meet the 4. Unambiguous
following 7 5. Reflective of Current Investment Opinions
Criteria: 6. Accountable
7. Investable

S-A-M-U-R-A-I
68. Vol
ume
Weighted
Average
Price
(VWAP)

weighted average of execution prices during a day where the weight applied is the proportion of the day's
trading volume. Best suited for an order that is a low percentage of the average daily volume of the stock.

Shortcomings: not useful if trader is significant part of trading volume. because the activity will significantly affect
the VWAP, trader is essentially comparing trades to herself.

Potential to "game" the comparison - trader could wait until late in the day and then decide which trades to execute

Does not consider missed trades

69. What are One of the problems in estimating missed trade opportunity cost is that the estimate depends upon when the cost is
some of the measured. As the solutions to Parts A and B of this problem indicate, the estimate could vary substantially when a problems
in different interval is used to measure the missed trade opportunity cost. Another problem in estimating the missed trade estimating
opportunity cost is that it does not consider the impact of order size on prices. For example, the estimates above
the missed assume that if the investment manager had bought the 500,000 shares on 8 February, he would have been able to sell
trade these 500,000 shares at $23.60 each on 8 February (or at $21.74 each on 14 February). However, an order to sell opportunity
500,000 shares on 8 February (or on 14 February) would have likely led to a decline in price, and the entire order of
cost? 500,000 shares would not have been sold at $23.60 (or at $21.74). Thus, the missed trade opportunity costs above are
likely to be overestimates.
70. Within (Benchmark Weight of Sector) * (Portfolio Return on Sector - Benchmark Return of Sector)
Sector
Allocation =