Exam (elaborations)
CFA Level 3 Questions and Answers 2024
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Exam of 48 pages for the course CFA at CFA (CFA Level 3)
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CFA Level 3GIPS Input Requirements - answer-All data must be captured and documented based
on fair value, using trade date accounting, and including accrued income for fixed
income securities.
-If market value of a security does not exist, the preferred value approach sequence is
the following:
1) Prices of similar assets in active markets.
2) Prices of similar assets in inactive markets.
3) Observable market inputs other than prices (e.g., PE, div yield)
4) Subjective, unobservable inputs (e.g., discounted cash flow)
-Basic GIPS requires valuing portfolios at least monthly and on the date of all large
external cash flows (ECFs). Large is anything big enough to materially distort the
computation of account or composite return.
GIPS Presentation and Reporting Requirements - answer Initial report must include at
least 5 years unless that composite's strategy has existed for less than 5 years.
Thereafter, add at least 1 year to the composite presentation record until at least a
rolling 10-year history is included.
GIPS Real Estate Reporting Requirements - answer-Liquid marketable securities such
as REITS, MBS, and Evergreen Funds remain under the regular provisions of GIPS.
-Basic GIPS requires monthly valuation and measurement.
-RE valuation is quarterly and can be done internally by the firm.
-At lest every 12 months, the valuation must be done by a qualified external source. The
external valuation can be as infrequent as every 36 months if the client agrees. In that
case, the GIPS report must also disclose the percentage of composite assets valued
externally each year.
-For CEFs, return must be computed and presented since inception of the fund using
IRR (SI-IRR) and continued until the fund is liquidated. ECFs for RE used to calculate
SI-IRR must be at least quarterly.
GIPS Private Equity Reporting Requirements - answer-Basic GIPS requires monthly
valuation and measurement.
-Must be valued annually with return reported both gross and net of fees.
-For CEFs, return must be computed and presented since inception of the fund using
IRR (SI-IRR) and continued until the fund is liquidated. ECFs for PE used to calculate
SI-IRR must be daily.
Behavioral Finance - answer-Descriptive of how investors behave.
-It assumes investors have cognitive limits and emotional biases.
-Therefore, market prices may not be efficient.
,-The focus is how to help investors make decisions that more closely approximate the
"optimal" decisions of traditional finance in spit of the investors biases and feelings.
Traditional Finance - answer-Normative, describing what investors should do.
-Assumes investors are rational, risk-averse, apply utility theory to maximize
satisfaction, and that market prices are efficient.
4 Axioms of Utility Theory - answer1) Completeness: Choices and preferences are
known.
2) Transitivity: Rankings are applied consistently.
3) Independence: Utilities are additive and divisible.
4) Continuity: Indifference curves are smooth and unbroken.
Utility Theory - answerAssumes investors are risk averse and feel diminishing marginal
utility of wealth, which has 2 implications:
1) An investor's indifference curves will be convex. In order to accept additional equal
increments of risk, an investor must expect increasing increments of return. Investors
will vary their risk aversion and those with high risk aversion will select portfolios with
lower risk/return, while investors with low risk aversion will select portfolios with higher
risk/return.
2) Investors will have concave utility functions. As an investor adds equal increments of
wealth, the investors level of satisfaction (utility) increases but at a diminishing rate.
Prospect Theory - answerProposed by behavioral finance may better explain investor
behavior, it assumes:
-Investors focus on perceived gain or loss (change in wealth), not the level of wealth.
-Perception of gain or loss depends on the reference point used (e.g. year-end price or
original cost basis).
-Gain or loss is not "real" until it is realized.
-Subjective decision weights (low probability events are given too much weight) replace
objective probability.
-Decisions are made in stages.
The result is that it assumes investors are risk averse when facing gains (and therefore
sell winners too soon) but are loss averse and risk seeking when facing losses (and
therefore hold losers too long).
BF Details: Decision Making in Two Phases - answer-Editing Phase: Codification,
combination, segregation, cancellation, simplification, and dominance. This can lead to
an anomaly known as the isolation effect.
-Evaluation Phase: Investors probability weight expected outcomes to determine utility.
However, the probabilities are not simple objective probabilities, but adjusted
probabilities.
,Isolation Effect - answerAn anomaly where investors focus on one factor or outcome
while unconsciously eliminating or subconsciously ignoring others. As a result, the
presentation of data can affect the decision made even if the underlying economics are
the same.
Bounded Rationality - answerInvestors have limits in their ability to reach optimal
decisions.
Satisfice - answerInvestors gather enough information and perform enough analysis to
reach an acceptable (but not optimal) decision.
Traditional Finance Conclusion that Markets are Efficient - answerThe Price is Right:
Suggests asset prices reflect all available information and adjust instantaneously to fully
incorporate the value of new information. Therefore, the function of the portfolio
manager is to allocate an investor's portfolio to asset classes that are consistent with
the client's objectives and constraints.
No Free Lunch: Implies managers cannot generate excess return (alpha) consistently.
All information is instantaneously and accurately incorporated into prices, so whether
asset prices change depends on the release of new information. Because information
enters the market randomly, changes in prices must also be random, making excess
returns impossible to forecast consistently.
Weak-Form Efficiency - answerPrices reflect all past price and volume data. Managers
cannot consistently generate excess returns using technical analysis.
Semi-Strong-Form Efficiency - answerPrices reflect all public information. New
information is immediately reflected in asset prices. Managers cannot consistently
generate excess returns using technical or fundamental analysis.
Strong-Form Efficiency - answerPrices reflect all information, public and private. No
analysis based on inside and/or public information can consistently generate excess
returns.
Consumption and Savings - answerThe behavioral life-cycle model says that individuals
are subject to framing, self-control bias, and mental accounting. Therefore, they will not
achieve the optimal balance of short-term consumption and long-term investing.
-Framing
-Self-Conrol Bias
-Mental Accounting
Behavioral Asset Pricing - answerThe required return on an asset is the risk-free rate,
plus a fundamental risk premium, plus a sentiment premium. The sentiment premium
can be estimated by considering analysts' forecasts. The greater the dispersion of
, analysts' forecasts, the greater the sentiment premium. If these sentiment premiums are
random and unpredictable, they complicate asset allocation.
Behavioral Portfolio Theory (BPT) - answerAssumes investors structure their portfolios
in layers according to their goals. The composition of each layer of the portfolio is
determined by the interaction of 5 factors:
-If higher return is the goal, more assets are allocated to the higher return level.
-The higher return layer will hold higher risk assets.
-Lower risk investors will hold more diversified portfolios.
-Investors with a perceived information advantage will hold more concentrated
positions.
-Investors who are highly loss averse will be reluctant to hold risky assets.
Portfolios can appear to be diversified and hold many assets but are sub-optimal from a
TF perspective because the correlation among asset layers is not considered. However,
from a TF perspective, a slightly less efficient portfolio investors can live with is better
than an optimal portfolio they abandon during a market setback.
The Adaptive Markets Hypothesis - answer5 Important Conclusions:
-Investors make decisions to help them survive (satisfice) rather than to maximize utility
(make theoretically optimal decisions).
-Investors must adapt to survive.
-Because participants adapt, no investment strategy can continually outperform.
-Risk premiums will vary over time as (1) the general level of investor risk aversion
increases or decreases and (2) the level of competition in the market decreases or
increases.
-Assets can be temporarily misplaced, allowing active management to add value.
Emotional Biases Definition - answerCaused by individuals' psychological
predispositions. Not deliberate; it is more of a spontaneous reaction and it is more
difficult to overcome.
Emotional Biases List - answer-Loss Aversion Bias
-Overconfidence Bias
-Self-Control Bias
-Status Quo Bias
-Endowment Bias
-Regret-Aversion Bias
Cognitive Errors - answerThe result of mechanical or physical limitations; they result
from the inability to analyze all information or from basing decisions on incomplete
information. Easier to overcome and respond to education.
Cognitive Errors Streaming from Believe Perseverance - answer-Conservatism Bias
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