Last Revised: 05/10/2022

2023
Level 3 - Formula Sheet

SID115570034.

This document should be used in conjunction with the corresponding readings in the 2023 Level 3 CFA® Program curriculum.
Some of the graphs, charts, tables, examples, and figures are copyright 2022, CFA Institute. Reproduced and republished with
permission from CFA Institute. All rights reserved.

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 Last Revised: 05/10/2022

BOOK 1: Behavioural Finance, Capital Market Expectations, and

Asset Allocation

Capital Market Expectations, Part 1: Framework and Macro

Considerations
(Note: there are no calculate LOS, however, the following formulas may help with
‘describe’, ‘explain’, and ‘discuss’ keywords)

Aggregate trend growth =

• Growth from labour inputs, consisting of:
o Growth in potential labour force size
o Growth in actual labour force participation
• Growth from labour productivity, consisting of:
o Growth from increasing capital inputs
o Growth in total factor productivity

Aggregate market value of equity:

𝑉!" = 𝐺𝐷𝑃! × 𝑆!# × 𝑃𝐸!

𝐸(𝑅" ) = 𝑉!" + 𝐷!

where:
𝑉!" = Aggregate market value of equity
GDPt = the level of nominal GDP
𝑆!# = the share of profits in the economy (earnings/GDP)
PEt = the P/E ratio
Dt = dividends

SID115570034. The Taylor Rule:

𝑖 ∗ = 𝑟%"&!'() + 𝜋" + 0.54𝑌6" − 𝑌6!'"%* 8 + 0.5(𝜋" − 𝜋!('+"! )

In terms of the real, inflation-adjusted, target rate:

𝑖 ∗ − 𝜋" = 𝑟%"&!'() + 0.54𝑌6" − 𝑌6!'"%* 8 + 0.5(𝜋" − 𝜋!('+"! )

where:
i* = the target nominal policy rate
rneutral = the real policy rate that would be targeted if growth is expected to be at trend and inflation on target
𝑌6" = expected GDP growth rate
𝑌6!'"%* = the observed GDP trend growth rate
𝜋" = the expected inflation rate
𝜋!('+"! = the target inflation rate

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 Last Revised: 05/10/2022
National Accounting identity:

(X – M) = (S – I) + (T – G)

where:
(X – M) = net exports
S = savings
I = investment
(T – G) = government surplus

Capital Market Expectations, Part 2: Forecasting Asset Class

Returns
Forecasting Fixed Income Returns:

Discounted Cash Flow Approach:

YTM = PV(CF) = P0

MacDur = ModDur(1 + YTM)

If investment horizon < MacDur E(RB) < YTM if rates ­ Capital g/L dominates
E(RB) > YTM if rates ¯
= MacDur E(RB) » YTM
> MacDur E(RB) > YTM if rates ­
reinvestment dominates
E(RB) < YTM if rates ¯

Building Block Approach:

SID115570034.
E(Rb) = Real risk-free interest rate + Inflation premium + Term premium + Credit premium+
Liquidity Premium

Forecasting Equity Returns:

Discounted Cash Flow Approach:

-$ (/0+)
𝑃, = '2+
where: g = the growth rate in nominal GDP

Solving for r:
-%
𝑟= 3$
+𝑔 r = dividend yield + capital appreciation

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 Last Revised: 05/10/2022
Grinold-Kroner model:

𝐷
𝐸(𝑅" ) ≈ + (%∆𝐸 − %∆𝑆) + %∆𝑃𝐸
𝑃
where:
E(Re) = the expected rate of return on equity
D/P -%DS = the expected cash flow return
%ΔS = the expected %’age change in number of shares outstanding
%ΔE = the expected nominal earnings growth rate
%ΔPE = the expected repricing return

Risk Premium Approach:

E(Ri) = RF + (Risk Premium)1 + (Risk Premium)2 + … + (Risk premium)K

Financial Market Equilibrium Model: Singer-Terhaar approach

All global markets and asset classes are fully integrated

𝜎4 𝑅𝑃56
𝑅𝑃456 = 𝛽4∙56 ∙ 𝑅𝑃56 = 𝜌4∙56 ∙ @ B ∙ 𝑅𝑃56 = 𝜌4∙56 ∙ 𝜎4 ∙ @ B
𝜎56 𝜎56

All global markets and asset classes are completely segmented

93&'
𝑅𝑃48 = 𝛽46 ∙ 𝑅𝑃48 = 𝜎4 ∙ @ :&
B

Combining both:
𝑅𝑃4 = 𝜔 ∙ 𝑅𝑃456 + (1 − 𝜔) ∙ 𝑅𝑃48

where:
𝑅𝑃()* = Risk premium on asset class i in a fully integrated market
SID115570034. 𝑅𝑃( = Risk premium on asset class i in a fully segmented market
σi = standard deviation of asset class i
ρi,GIM = correlation between asset class i and the global investable market
+,
% !"& = SRGIM = Sharpe ratio of the global investable market (estimated at about 0.28)
-!"
𝜔 = the degree of global integration

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Forecasting Real Estate Returns:

Capitalization Rates:
Long-term
𝐸(𝑅'" ) = 𝐶𝑎𝑝 𝑅𝑎𝑡𝑒 + 𝑁𝑂𝐼 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 = 𝑁𝑂𝐼P𝑃 + 𝑔
,
Short-term
𝐸(𝑅'" ) = 𝐶𝑎𝑝 𝑅𝑎𝑡𝑒 + 𝑁𝑂𝐼 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 = 𝑁𝑂𝐼P𝑃 + 𝑔 − %∆ Q𝑁𝑂𝐼P𝑃 R
, ,

Forecasting a cap rate:

• Procyclical with interest rates
o Rates ­, cap rates ­
• Positively related to credit spreads, which are countercyclical with economy and interest rates
o Rates ­, cap rates ¯
• Therefore, offset to some degree

Forecasting Exchange Rates:

PPP (does not hold)

%∆𝑆;< ≅ 𝜋; − 𝜋*
*

where:
𝜋. = inflation if foreign country
𝜋/ = inflation in domestic country

UIRP (does not hold)

%∆𝑆*"< ≅ 𝑟* − 𝑟;
;
• The higher yielding currency should depreciate by (rd – rf)

SID115570034. Capital Flows:

%∆𝑆/"0 ≅ (𝑟 / − 𝑟 . ) + (𝑇𝑒𝑟𝑚/ − 𝑇𝑒𝑟𝑚. ) + (𝐶𝑟𝑒𝑑𝑖𝑡 / − 𝐶𝑟𝑒𝑑𝑖𝑡 . ) + (𝐸𝑞𝑢𝑖𝑡𝑦 / − 𝐸𝑞𝑢𝑖𝑡𝑦 . ) + (𝐿𝑖𝑞/ − 𝐿𝑖𝑞 . )
.
• If d offers higher-risk-adjusted expected return, 𝑆*< expected to ­
;
where:
(𝑟 / − 𝑟 . ) = money markets return differential
(𝑇𝑒𝑟𝑚/ − 𝑇𝑒𝑟𝑚. ) = government bonds risk premium return differential
(𝐶𝑟𝑒𝑑𝑖𝑡 / − 𝐶𝑟𝑒𝑑𝑖𝑡 . ) = corporate bonds risk premium return differential
(𝐸𝑞𝑢𝑖𝑡𝑦 / − 𝐸𝑞𝑢𝑖𝑡𝑦 . ) = publicly traded risk premium equity return differential
(𝐿𝑖𝑞/ − 𝐿𝑖𝑞 . ) = private assets risk premium return differential

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 Last Revised: 05/10/2022
Forecasting Volatility:

No formula is required.
Major points:

• Sample VCV matrix is an unbiased estimate of the true VCV structure (it will be correct
on average but requires large samples to become precise)
o Sample VCVs cannot be used for large numbers of asset classes
o Subject to substantial sampling error
• Linear factor model-based VCVs use a smaller set of factors (as opposed to asset classes)
o VCV is biased and inconsistent, but estimated with precision
• Shrinkage estimation is a weighted average of a sample VCV and a target VCV that
reflects assumed prior knowledge of the true VCV structure
• ARCH models are used for time series with non-constant volatility

Principles of Asset Allocation

MVO objective function (total return):
>
𝑈= = 𝐸(𝑅= ) − 0.005𝜆𝜎=

where:
Um = the investor’s utility for asset mix (allocation) m
Rm = the return for asset mix m
λ = the investor’s risk aversion coefficient
2
𝜎1 = the expected variance of return for asset mix m

Marginal contribution to risk (MCTR) = Asset beta relative to portfolio × Portfolio standard
SID115570034.
deviation

Absolute contribution to risk (ACTR) = Asset weight in portfolio × MCTR

Ratio of excess return to MCTR = (Expected return – Risk-free rate)/MCTR

MVO objective function (surplus return):

?9
𝑈= = 𝐸4𝑅@,= 8 − 0.005𝜆𝜎 > (𝑅@,= )

where:
3+
𝑈1 = the surplus objective function’s expected value for a particular asset mix m
Rs,m = the expected surplus return for asset mix m
Such that Rs,m = (Change in asset value – Change in liability value)/(Initial asset value)

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 Last Revised: 05/10/2022

Risk parity:
1 >
𝑤4 × 𝐶𝑜𝑣(𝑟4 , 𝑟3 ) = 𝜎
𝑛 3
where
wi = the weight of asset i
Cov(ri,rP) = the covariance of asset i with the portfolio
n = the number of assets
𝜎,2 = the variance of the portfolio

Asset Allocation with Real-World Constraints

Expected after-tax return:

rat = pdrpt(1 – td) + parpt(1 – tcg)

where:
pd = the proportion of rpt attributed to dividend income
pa = the proportion of rpt attributed to price appreciation
td = the dividend tax rate
tcg = the capital gains tax rate

Expected after-tax standard deviation:

σat = σpt(1 – t)

where:
σat = the expected after-tax standard deviation
SID115570034. σpt = the expected pre-tax standard deviation

Equivalent rebalancing range for a taxable investor:

Rat = Rpt/(1 – t)

where
Rat = the after-tax rebalancing range
Rpt = the pre-tax rebalancing range

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 Last Revised: 05/10/2022

BOOK 2: Derivatives, Currency Management, and Fixed Income

Option Strategies
Covered Calls:

Value at expiration: VT = ST – max(0, ST – X)

Profit: Π = VT – S0 + c0
Maximum profit = X – S0 + c0
Maximum loss = S0 - c0
Breakeven: ST* = S0 - c0

Protective Put:

Value at expiration: VT = ST + max(0, X - ST)

Profit: Π = VT – S0 - p0
Maximum profit = ∞
Maximum loss = S0 + p0 - X
Breakeven: ST* = S0 + p0

Bull Spread:

Value at expiration: VT = max(0, ST – X1) - max(0, ST – X2)

Profit: Π = VT – c1 + c2
Maximum profit = X2 – X1 – c1 + c2
Maximum loss = c1 – c2
Breakeven: ST* = X1 + c1 – c2

SID115570034.

Bear Spread:

Value at expiration: VT = max(0, X2 - ST) - max(0, X1 - ST)

Profit: Π = VT – p2 + p1
Maximum profit = X2 – X1 – p2 + p1
Maximum loss = p2 – p1
Breakeven: ST* = X2 - p2 + p1

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Straddle:

Value at expiration: VT = max(0, ST - X) + max(0, X - ST)

Profit: Π = VT – (c0 + p0)
Maximum profit = ∞
Maximum loss = c0 + p0
Breakeven: ST* = X ± (c0 + p0)

Zero-Cost Collars:

Value at expiration: VT = ST + max(0, X1 - ST) – max(0, ST – X2)

Profit: Π = VT – S0
Maximum profit = X2 – S0
Maximum loss = S0 – X1
Breakeven: ST* = S0

𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑜𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒

𝐷𝑒𝑙𝑡𝑎 =
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑢𝑛𝑑𝑒𝑟𝑙𝑦𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒

𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑑𝑒𝑙𝑡𝑎
𝐺𝑎𝑚𝑚𝑎 =
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑢𝑛𝑑𝑒𝑟𝑙𝑦𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒

𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑜𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒

𝑉𝑒𝑔𝑎 =
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑣𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦

Volatility:
>E>
𝜎(%%&() (%) = 𝜎=B%!C)D (%)_ >/
SID115570034.

>E>
𝜎=B%!C)D (%) = 𝜎(%%&() (%)/_ >/

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 Last Revised: 05/10/2022

Swaps, Forwards, and Futures Strategies

Calculating the notional amount of a swap:

6-F94 26-F95
𝑁8 = Q 6-F9'
R (𝑀𝑉3 )

where:
NS = Notional amount of the swap
MDUR = modified duration
T = target
P = portfolio
S = Swap
MV = market value

Swap BPV = ModDurSwap x Swap Notional/10,000

Swap payments:

Fixed payment: rfx ´ NA ´ (days/360)

Floating payment: rfl ´ NA ´ (days/360)

Fixed Income Futures:

-4 2-5 G3H4 2G3H5

𝑁; = Q -647
R (𝐶𝐹) or 𝑁; = Q G3H647
R (𝐶𝐹) and BPV = (ModDur ´ MV) ´ 0.0001

where:
BPV = basis point value
DT = Target duration
SID115570034. DP = Portfolio duration
DCTD = Cheapest to deliver duration
CF = conversion factor

Currency Forwards:
89:;<=
/045 I J
>?$
𝐹3< = 𝑆3< c 89:;<= d
G G /04@ I J
>?$

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 Last Revised: 05/10/2022
Number of equity futures:
8
𝑁; = K

where:
Nf = number of futures contracts
S = Market value to be hedged
F = Value of a futures contract = F0 ´ q
(q = multiplier)

Changing the beta of a portfolio:

L4 2L' 8
𝑁; = @ LA
B QK R

where:
b = beta
T = target
S = stock portfolio
f = futures contract

Cash equitization:

L 8
𝑁; = @L4 B QK R since bcash = 0
A

Variance swaps:
! "(!
SID115570034. 𝑉𝑎𝑟𝑆𝑤𝑎𝑝! = 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑁𝑜𝑡𝑖𝑜𝑛𝑎𝑙 × 𝑃𝑉𝐹 × 4" (𝑟𝑒𝑎𝑙𝑖𝑧𝑒𝑑 𝑣𝑜𝑙($,!) )' + "
(𝑖𝑚𝑝𝑙𝑖𝑒𝑑 𝑣𝑜𝑙(!,") )' − 𝑆𝑡𝑟𝑖𝑘𝑒 ' >

where:
)*+, ./!0/.,1
𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑛𝑜𝑡𝑖𝑜𝑛𝑎𝑙 = '×3!405*
and the strike is expressed as volatility, not variance

/
𝑃𝑉𝐹 = B<CD
/0'A M N
>?$

Settlement amount = variance notional ´ (realized variance – strike variance)

Fed Funds futures contract price = 100 – expected FFE rate

O;;"P!4Q" KK '(!" 4=S)4"* TD ;&!&'"@ PB%!'(P!2U&''"%! KK '(!"

𝑃(𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐹𝐹 𝑟𝑎𝑡𝑒) = KK '(!" (@@&=4%+ ( '(!" C4#"2U&''"%! KK '(!"

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 Last Revised: 05/10/2022

Currency Management: An Introduction

Domestic currency return:
J

𝑅EF = A 𝑤( C1 + 𝑅GF,( EC1 + 𝑅GI,( E − 1

(KL

The variance of the domestic-currency returns (RDC):

𝜎 > (𝑤/ 𝑅/ + 𝑤> 𝑅> ) ≈ 𝑤/> 𝜎 > (𝑅/ ) + 𝑤>> 𝜎 > (𝑅> ) + 2𝑤/ 𝜎(𝑅/ )𝑤> 𝜎(𝑅> )𝜌(𝑅/ , 𝑅> )
where:
RDC = the domestic currency return (in percent)
RFC,i = the foreign-currency return on the i-th foreign asset
RFX,i = the appreciation of the i-th foreign currency against the domestic currency
wi = the portfolio weights of the foreign-currency assets such that ∑J(KL 𝑤( = 1

Introduction to Fixed-Income Portfolio Management

Decomposing returns:
E(R) ≈ Yield Income
+/- Rolldown return
+/- E(ΔPrice based on investor’s views of benchmark yield)
+/– E(ΔPrice based on investor’s views of yield spreads)
+/- E(ΔPrice due to investor’s view of currency value changes)

Where:
Yield Income (or Current Yield) = Annual coupon payment/Current bond price

-𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒!"#$%&$'%()*%" − 𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒,-.)"")".$%&$'%()*%" 3

𝑅𝑜𝑙𝑙𝑑𝑜𝑤𝑛 𝑅𝑒𝑡𝑢𝑟𝑛 =
SID115570034. 𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒,-.)"")".$%&$'%()*%"

Note that the rolldown return assumes zero interest rate volatility – assumes an unchanged yield curve over the
strategy horizon.

Rolling Yield = Yield Income + Rolling Return

E(ΔPrice based on investor’s views of benchmark yield or in yield spreads) = [-MD × ΔYield] + [½ ×
Convexity ×(ΔYield)2]

E(Credit losses) = PD × LGD

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 Last Revised: 05/10/2022
Using Leverage:

𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑟𝑒𝑡𝑢𝑟𝑛 [𝑟V × (𝑉O + 𝑉G ) − (𝑉G × 𝑟G )] 𝑉G

𝑟S = = = 𝑟V + (𝑟V − 𝑟G )
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑉O 𝑉O

Note:
1) if rI > rB, then the second term is positive and leverage increases returns
2) if rI < rB, then the second term is negative and leverage decreases returns

where:
rp = return on the levered portfolio
rI =return on the invested funds (investment returns)
VE = value of portfolio’s equity
VB = borrowed funds
rB = borrowing rate (cost of borrowing)
______________________________________________________________________________

Futures Contracts (leverage):

𝑁𝑜𝑡𝑖𝑜𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 − 𝑀𝑎𝑟𝑔𝑖𝑛

𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒K&!&'"@ =
𝑀𝑎𝑟𝑔𝑖𝑛

Repurchase agreements:
Dollar interest = Principal amount × Repo rate × (Term of repo in days/365)

Securities lending:
Rebate rate = Collateral earnings rate – Securities lending rate

SID115570034. Liability-Driven and Index-Based Strategies

Basis point value (aka Present value of a basis point, price value of a basis point):

𝐵𝑃𝑉 = (𝑀𝑜𝑑𝐷𝑢𝑟 ∗ 𝑀𝑉T ) × 0.0001

where:
We have ModDur .
MVb = Market Value of the bond (or portfolio)

𝑀𝑎𝑐𝐷𝑢𝑟
𝐵𝑃𝑉SB'!;B)4B = m o × 𝑀𝑉S × 0.0001
(1 + 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑦𝑖𝑒𝑙𝑑 𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑)

where:
The term in brackets converts MacDur to ModDur

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Required number of futures contracts:

𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝐵𝑃𝑉 − 𝐴𝑠𝑠𝑒𝑡 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝐵𝑃𝑉

𝑁; =
𝐹𝑢𝑡𝑢𝑟𝑒𝑠 𝐵𝑃𝑉
where:
Nf = number of futures contracts

Notional Principal for a Swap:

𝑆𝑤𝑎𝑝 𝐵𝑃𝑉
𝐴𝑠𝑠𝑒𝑡 𝐵𝑃𝑉 + m𝑁𝑃 × o = 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝐵𝑃𝑉
100

Essential relationship for full interest rate hedging:

Asset BPV × ΔAsset yields + Hedge BPV × ΔHedge yields

≈ Liability BPV × ΔLiability yields

where:
ΔAsset yields, ΔHedge yields and ΔLiability yields are measured in bps

BOOK 3: Fixed Income and Equity Portfolio Management

Yield Curve Strategies
SID115570034.
Butterfly spread = -(short-term yield) + (2 * medium-term yield) – long-term yield

/ ∆3H
𝐾𝑒𝑦𝑅𝑎𝑡𝑒𝐷𝑢𝑟# = − 3H × ∆'M

∑%#X/ 𝐾𝑒𝑦𝑅𝑎𝑡𝑒𝐷𝑢𝑟# = 𝐸𝑓𝑓𝐷𝑢𝑟

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Fixed-Income Active Management: Credit Strategies

Yield Spread: risky bond YTM – nearest risk-free bond YTM

G-Spread: Risky bond YTM – interpolated risk-free bond YTM

I-Spread: Risky bond TYM – interpolated swap rate

ASW (asset swap spread): (Corporate bond coupon – swap fixed rate) + MRR

CDS basis: CDS spread – Z-spread

Average OAS – portfolio credit quality

Average SD – portfolio spread sensitivity
DTS = duration * spread

XS ≈ (s × t) – (ΔS × SD)
EXS ≈ (s × t) – (ΔS × SD) – (t × POD × LGD)

where:
XS = annualized excess spread (return)
EXS = annualized expected excess spread (return)
s = the spread at the beginning of the holding period
t = holding period expressed in fractions of a year
Δs = the change in the credit spread during the holding period
SD = spread duration
POD = annualized expected probability of default
LGD = expected loss severity

CDS Price per $1 ≈ 1 + ((Fixed Coupon – CDS Spread) x EffDpreadDurCDS)

SID115570034.

Upfront payment to buyer = [(Fixed Coupon – CDS Spread) x EffDpreadDurCDS] x NA

%DCDS price ≈ -(SDCDS x DCDSspread) X NA

Upfront Premium:
None when CDS Spread = Fixed coupon
Buyer receives when CDS Spread < Fixed Coupon (premium)
Seller receives when CDS Spread > Fixed coupon (discount)

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Passive Equity Investing

Calculating the concentration of an index:

1
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘𝑠 = = 1/𝐻𝐻𝐼
∑%4X/ 𝑤4>

where:
wi = the weight of stock I in the index/portfolio
HHI = Herfindahl-Hirschman Index

Active Equity Investing: Strategies

Returns-based style analysis:
=

𝑟! = 𝛼 + w 𝛽 @ 𝑅!@ + 𝜀!
@X/

where:
rt = the fund return within the period ending at time t
𝑅!N = the return of style index s in the same period
βs = the fund exposure to style s (with constraints ∑1 N N
NKL 𝛽 = 1 𝑎𝑛𝑑 𝛽 > 0 for a long-only portfolio)
α = a constant often interpreted as the value added by the fund manager
εt = the residual return that cannot be explained by the styles used in the analysis

Active Equity Investing: Portfolio Construction

Note: There is no calculate in any LOS

Active Return From Level II Portfolio Management:

SID115570034.

𝑅Y = w 𝛥𝑊4 𝑅4
4X/

where:
Ri = the return on security i
ΔWi = the active weight (Wpi – Wbi)

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Three sources of active return:

𝑅Y = w4𝛽S# − 𝛽T# 8 × 𝐹# + (𝛼 + 𝜀)

where:
∑C𝛽O# − 𝛽P# E × 𝐹# = exposure to reward factors
(α + ε) = alpha + luck (the part of the return that cannot be explained by exposure to rewarded factors)
βpk = the sensitivity of the portfolio (p) to each rewarded factor (k)
βbk = the sensitivity of the benchmark to each rewarded factor
Fk = the return of each rewarded factor

%
1
𝐴𝑐𝑡𝑖𝑣𝑒 𝑆ℎ𝑎𝑟𝑒 = w |𝑊𝑒𝑖𝑔ℎ𝑡SB'!;B)4B,4 − 𝑊𝑒𝑖𝑔ℎ𝑡T"%PC=('#,4 |
2
4X/

Active risk:

𝜎98 = _𝜎 > Qw(𝛽S# − 𝛽T# ) × 𝐹# R + 𝜎[>

Active risk of a portfolio is a function of the variance attributed to the factor exposures and of the variance attributed
to the idiosyncratic risk

Total portfolio variance:

% %

𝑉S = w w 𝑥4 𝑥\ 𝐶4\
4X/ \X/
SID115570034.

Contribution of each asset to portfolio variance:

%

𝐶𝑉4 = w 𝑥4 𝐶4S
4X/

where:
xj = the asset’s weight in the portfolio
Cij = the covariance of returns between asset i and asset j
Cip = the covariance of returns between asset i and the portfolio

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The segmentation of portfolio variance into two components: variance attributed to factor
exposure and variance unexplained:
%

𝑉S = 𝑉𝑎𝑟 }w4𝛽4S × 𝐹4 8~ + 𝑉𝑎𝑟(𝜀S )

4X/

Variance of the portfolio’s active return:

% %

𝐴𝑉S = w w(𝑥4 − 𝑏4 )(𝑥\ − 𝑏\ )𝑅𝐶4\

4X/ \X/

Contribution of each asset to portfolio active variance:

𝐶𝐴𝑉4 = (𝑥4 − 𝑏4 )𝑅𝐶4S

where:
xi = the asset’s weight in the portfolio
bi = the benchmark weight in asset i
RCij = the covariance of relative returns between asset I and asset j
RCip = the covariance of relative returns between asset i and the portfolio

BOOK 4: Alternative Investment, Portfolio Management, and

Private Wealth management

Hedge Fund Strategies

Conditional Factor-Risk Model:
SID115570034.
CAPM

(𝑅]K& )! = 𝛼4 + 𝛽4 (𝐸𝑅𝑃)! + 𝐷! 𝛽4 (𝐸𝑅𝑃)! Can be expanded to any number of risk-factors

where:
RHF = return to hedge fund i
Dt = dummy variable for time period t – the conditional

Asset Allocation to Alternative Investments

De-smoothing an appraisal-based return series
': 2@':Q%
𝑟-8: = /2@

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where:
rDS = de-smoothed return
rt = return in period t
s = serial correlation measure

Overview of Private Wealth Management

Nominal pre-tax return × (1 – t) = Nominal after-tax return

Nominal after-tax return – Inflation = Real after-tax return

Therefore:

Nominal pre-tax return = (Real after-tax return + Inflation)/(1 - t)

Topics in Private Wealth Management

Pre-tax holding period return:

(Q()&"2 Q()&"$ ) 0 4%PB="

𝑅= Q()&"$

After-tax holding period return:

(Q()&"2 Q()&"$ ) 0 4%PB="2!(_ !(_
𝑅^ = Q()&"$
=𝑅− Q()&"$

Geometric (average) return over n holding periods:

/<
𝑅5^ = [(1 + 𝑅/^ )(1 + 𝑅>^ ). . (1 + 𝑅%^ )] % −1
SID115570034.

Post liquidation Geometric (average) return over n holding periods:

/<
^ )4`&4*(!4B% !(_ %
𝑅3? = •(1 + 𝑅/^ )(1 + 𝑅>^ ). . (1 + 𝑅%^ ) − ;4%() Q()&"
€ −1

After-tax excess return: 𝑋 ^ = 𝑅^ − 𝐵^ (B = benchmark)

Tax alpha: 𝛼!(_ = 𝑋 ^ − 𝑋
^
Tax efficiency Ratio: 𝑇𝐸𝑅 = 𝑅 P𝑅 higher = more efficient

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 Last Revised: 05/10/2022
Accumulation:

Tax-exempt: FV = (1 + R)n
Taxable: 𝐹𝑉 = (1 + 𝑅’)%
Tax-deferred: FV = (1 + R)n(1 – t)

For mutual funds:

%"! +(4%@()B@@"@)
𝑝𝑜𝑡𝑒𝑛𝑡𝑖𝑎𝑙 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛𝑠 𝑒𝑥𝑝𝑜𝑠𝑢𝑟𝑒 = !B!() %"! (@@"!@

Tax-Free Gift:

𝐹𝑉54;! [1 + 𝑟+ 41 − 𝑡+ 8]%
𝑅𝑉a(_K'""54;! = =
𝐹𝑉G"`&"@! [1 + 𝑟" (1 − 𝑡" )]% (1 − 𝑇" )

where:
rg = pre-tax return to the gift recipient
tg = effective tax rate on investment for the gift recipient
re = pre-tax return to the estate making the gift
te = effective tax rate on investment for the estate making the gift
Te = estate tax if asset is bequeathed at death

Taxable Gifts (tax liability borne by the recipient):

%
𝐹𝑉54;! „1 + 𝑟+ 41 − 𝑡+ 8… (1 − 𝑇+ )
𝑅𝑉a(_(T)"54;! = =
𝐹𝑉G"`&"@! [1 + 𝑟" (1 − 𝑡" )]% (1 − 𝑇" )

where:
SID115570034.
Tg = the tax rate applicable to gifts

Risk Management for Individuals

Estimating the value of an individual’s human capital today, at Time 0:

Z
𝑝(𝑠! )𝑤!2/ (1 + 𝑔! )
𝐻𝐶, = w
(1 + 𝑟; + 𝑦)!
!X/

p(st) = the probability of surviving to year (or age) t

wt = the income from employment in period t
gt = the annual wage growth
rf = the nominal risk-free rate
y = occupational income volatility
N = the length of working life in years

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The mortality-weighted net present value of future pension benefits:

Z
𝑝(𝑠! )𝑏!
𝑚𝑁𝑃𝑉, = w
(1 + 𝑟)!
!X/

where:
mNPV0 = the mortality-weighted net present value at Time 0
bt = the future expected vested benefit
r = a discount rate - should vary based on the relative riskiness of the future expected benefit payment

BOOK 5: Institutional Investors, Other Topics in Portfolio

Management and Cases

Portfolio Management for Institutional Investors

Spending rule:

Hybrid Rule: (Yale Spending Rule)

Spendingt+1 = w(Constant Growth rule) + (1 – w)(Market Value rule)

Spendingt+1 = w[Spendingt ´ (1 + infl.)] + (1 – w)(Spending Rate ´ AUM)

w = 0 ® Market Value rule

w = 1 ® Constant Growth rule
SID115570034.

Banks and Insurers—Balance Sheet Management:

Y ∆4
𝐷O = 𝐷Y QO R − 𝐷? Q∆DR QO R
? Over modest yield changes, the volatility of equity capital
is a function of the degree of leverage, modified duration
of the assets and liabilities, and the correlation of changes
where: in yields of assets and liabilities
DE = duration of equity
DA = duration of assets
DL = duration of liabilities
i = interest rate on liabilities
y = yields

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 Last Revised: 05/10/2022
expressed as volatilities:
> >
>
𝜎∆S = 4𝐴P𝐸 8 𝜎∆8
>
+ 4𝐿P𝐸 8 𝜎∆T
>
− 24𝐴P𝐸 84𝐿P𝐸 8𝜌𝜎∆8 𝜎∆T
S 8 T 8 T

>
Note, if r = 1, 𝜎∆S shrinks to a minimal amount, even for high leverage
S

Trade Strategy and Execution

Implementation Shortfall

IS = Paper return – Actual return

Paper return = (Pn – Pd)S

𝐴𝑐𝑡𝑢𝑎𝑙 𝑅𝑒𝑡𝑢𝑟𝑛 = 4∑ 𝑠\ 8(𝑃% ) − ∑ 𝑠\ 𝑝\ − 𝐹𝑒𝑒𝑠

𝐸𝑥𝑝𝑎𝑛𝑑𝑒𝑑 𝐼𝑆 = 𝐷𝑒𝑙𝑎𝑦 𝐶𝑜𝑠𝑡 + 𝑇𝑟𝑎𝑑𝑖𝑛𝑔 𝐶𝑜𝑠𝑡 + 𝑂𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦 𝐶𝑜𝑠𝑡 + 𝐹𝑒𝑒𝑠

𝐷𝑒𝑙𝑎𝑦 𝐶𝑜𝑠𝑡 = 4∑ 𝑠\ 8𝑝, − 4∑ 𝑠\ 8𝑝*

𝑇𝑟𝑎𝑑𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 = ∑ 𝑠\ 𝑝\ − 4∑ 𝑠\ 8𝑝,

Delay + Trading = Execution cost.

𝑂𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦 𝐶𝑜𝑠𝑡 = 4𝑆 − ∑ 𝑠\ 8(𝑃% − 𝑃* )

where:
SID115570034. sj = number of shares executed
pj = price for the jth trade
S = total order shares
Pd = decision price
Pn = current price
p0 = arrival price (the price at the time the order was released to the market for execution)

Evaluating Trade Execution

(3b 23 ∗ )
𝐶𝑜𝑠𝑡 (𝑏𝑝𝑠) = 𝑆𝑖𝑑𝑒 × 3∗
× 10,000 𝑏𝑝𝑠

where:
Side = -1 for a sell, +1 for a buy
𝑃N = average price
P* = reference price

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 Last Revised: 05/10/2022

Market-adjusted cost (bps) = Arrival cost (bps) - b ´ Index Cost (bps)

(V%*"_ HcY32V%*"_ (''4Q() S'4P")

𝐼𝑛𝑑𝑒𝑥 𝐶𝑜𝑠𝑡 (𝑏𝑝𝑠) = 𝑆𝑖𝑑𝑒 × V%*"_ (''4Q() S'4P"
× 10,000 𝑏𝑝𝑠

Portfolio Performance Evaluation

Selection: (rp – rB)Bw

Interaction: (Pw – Bw)(rp – rB)

or Selection + Interaction: (rp – rB)Pw

Allocation:
Brinson-Hood-Beebower: (Pw – Bw)rB
Brinson-Fachler: (Pw – Bw)(rB - RB)
SID115570034.
where:

rB = benchmark return on the asset class

RB = overall benchmark return

True Active Return: Manager return – Normal portfolio return

Misfit Active Return: Normal portfolio return – IPS benchmark return

Investor Active return = True active return + misfit active return

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 Last Revised: 05/10/2022
P=M+S+A

P = portfolio
M = market
S = style
A = active return

Note: You are not expected to calculate the attributions – you are only expected to be able to
interpret the output of an attribution analysis.
9V 2'A
Sharpe Ratio = :V

9V 2'A
Treynor ratio = LV

9 29
Information Ratio = :('V 2'@ )
5 @

Appraisal Ratio
d
𝐴𝑅 = :W

where:
a = Jensen’s alpha
se = standard error of the regression

9V 2'4
Sortino Ratio = :7

SID115570034. where:
sD = semideviation
rT = target rate of return

Capture Ratios

Upside Capture = R(m,t)/R(B,t) when R(B,t) > 0

Downside Capture = R(m,t)/R(B,t) when R(B,t) < 0

Capture ratio = UC/DC

where:
R(m,t) = return for manager m in time period t
R(B,t) = return on the benchmark for time period t

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 Last Revised: 05/10/2022

X#$ Y X# ∗
𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝐷𝑟𝑎𝑤𝑑𝑜𝑤𝑛 = S X# ∗
$
, 0U
$

Vpt = portfolio value at time t

Vpt* = peak portfolio value

BOOK 6: Ethics and Professional Standards

Overview of the Global Investment Performance Standards

Time-weighted return: no external cash flows

H% 2H$ 𝑉/
𝑟! = H$
= P𝑉 − 1
,

Modified Dietz:
H 2H$ 2UK
𝑟! = H 0∑%[
$ &\%(UK& ×g& )

V1 = ending portfolio value

V0 = beginning portfolio value
CF = cash flow
U-2 -
w = weight where 𝑤4 = U- &
CD = calendar days
D = days since beginning of period

SID115570034.
Modified IRR:

𝑉/ = ∑%4X/[𝐶𝐹4 × (1 + 𝑟)g& ] + 𝑉, (1 + 𝑟)

25