2018 CFA level 3 study note book3 unprotected

Table of Contents
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Getting Started Flyer
Table of Contents
Page List
Table of Contents
Readings and Learning Outcome Statements
Capital Market Expectations
1. LOS 14.a: Discuss the role of, and a framework for, capital market
expectations in the portfolio management process.
2. LOS 14.b: Discuss challenges in developing capital market forecasts.
3. LOS 14.c: Demonstrate the application of formal tools for setting capital
market expectations, including statistical tools, discounted cash flow
models, the risk premium approach, and financial equilibrium models.
4. LOS 14.d: Explain the use of survey and panel methods and judgment in
setting capital market expectations.
5. LOS 14.e: Discuss the inventory and business cycles and effects that
consumer and business spending and monetary and fiscal policy have on
the business cycle.
6. LOS 14.f: Discuss the effects that the phases of the business cycle have on
short-term/long-term capital market returns.
7. LOS 14.g: Explain the relationship of inflation to the business cycle and the
implications of inflation for cash, bonds, equity, and real estate returns.

8. LOS 14.h: Demonstrate the use of the Taylor rule to predict central bank
behavior.
9. LOS 14.i: Interpret the shape of the yield curve as an economic predictor
and discuss the relationship between the yield curve and fiscal and
monetary policy.
10. LOS 14.j: Identify and interpret the components of economic growth trends
and demonstrate the application of economic growth trend analysis to the
formulation of capital market expectations.
11. LOS 14.k: Explain how exogenous shocks may affect economic growth
trends.
12. LOS 14.l: Identify and interpret macroeconomic, interest rate, and
exchange rate linkages between economies.
13. LOS 14.m: Discuss the risks faced by investors in emerging-market
securities and the country risk analysis techniques used to evaluate
emerging market economies.
14. LOS 14.n: Compare the major approaches to economic forecasting.
15. LOS 14.o: Demonstrate the use of economic information in forecasting
asset class returns.
16. LOS 14.p: Explain how economic and competitive factors can affect


investment markets, sectors, and specific securities.
17. LOS 14.q: Discuss the relative advantages and limitations of the major
approaches to forecasting exchange rates.
18. LOS 14.r: Recommend and justify changes in the component weights of a
global investment portfolio based on trends and expected changes in
macroeconomic factors.
19. Key Concepts
1. LOS 14.a
2. LOS 14.b

3. LOS 14.c
4. LOS 14.d
5. LOS 14.e
6. LOS 14.f
7. LOS 14.g
8. LOS 14.h
9. LOS 14.i
10. LOS 14.j
11. LOS 14.k
12. LOS 14.l
13. LOS 14.m
14. LOS 14.n
15. LOS 14.o
16. LOS 14.p
17. LOS 14.q
18. LOS 14.r
20. Concept Checkers
1. Answers – Concept Checkers
7. Equity Market Valuation
1. LOS 15.a: Explain the terms of the Cobb-Douglas production function and
demonstrate how the function can be used to model growth in real output
under the assumption of constant returns to scale.
2. LOS 15.b: Evaluate the relative importance of growth in total factor
productivity, in capital stock, and in labor input given relevant historical
data.
3. LOS 15.c: Demonstrate the use of the Cobb-Douglas production function in
obtaining a discounted dividend model estimate of the intrinsic value of an
equity market.
4. LOS 15.d: Critique the use of discounted dividend models and
macroeconomic forecasts to estimate the intrinsic value of an equity

market.
5. LOS 15.e: Contrast top-down and bottom-up approaches to forecasting the
earnings per share of an equity market index.
6. LOS 15.f: Discuss the strengths and limitations of relative valuation models.
7. LOS 15.g: Judge whether an equity market is under-, fairly, or over-valued


using a relative equity valuation model.
8. Key Concepts
1. LOS 15.a
2. LOS 15.b
3. LOS 15.c,d
4. LOS 15.e
5. LOS 15.f,g
9. Concept Checkers
1. Answers – Concept Checkers
8. Self-Test – Economic Analysis
1. Self-Test Answers: Economic Analysis
9. Introduction to Asset Allocation
1. LOS 16.a: Describe elements of effective investment governance and
investment governance considerations in asset allocation.
2. LOS 16.b: Prepare an economic balance sheet for a client and interpret its
implications for asset allocation.
3. LOS 16.c: Compare the investment objectives of asset-only, liabilityrelative, and goals-based asset allocation approaches.
4. LOS 16.d: Contrast concepts of risk relevant to asset-only, liability-relative,
and goals-based asset allocation approaches.
5. LOS 16.e: Explain how asset classes are used to represent exposures to
systematic risk and discuss criteria for asset class specification.
6. LOS 16.f: Explain the use of risk factors in asset allocation and their relation
to traditional asset class–based approaches.

7. LOS 16.g: Select and justify an asset allocation based on an investor’s
objectives and constraints.
8. LOS 16.h: Describe the use of the global market portfolio as a baseline
portfolio in asset allocation.
9. LOS 16.i: Discuss strategic implementation choices in asset allocation,
including passive/active choices and vehicles for implementing passive and
active mandates.
10. LOS 16.j: Discuss strategic considerations in rebalancing asset allocations.
11. Key Concepts
1. LOS 16.a
2. LOS 16.b
3. LOS 16.c
4. LOS 16.d
5. LOS 16.e
6. LOS 16.f
7. LOS 16.g
8. LOS 16.h
9. LOS 16.i
10. LOS 16.j
12. Concept Checkers


1. Answers – Concept Checkers
10. Principles of Asset Allocation
1. LOS 17.a: Describe and critique the use of mean–variance optimization in
asset allocation.
2. LOS 17.b: Recommend and justify an asset allocation using mean–variance
optimization.
3. LOS 17.i: Recommend and justify an asset allocation based on the global
market portfolio.

4. LOS 17.c: Interpret and critique an asset allocation in relation to an
investor’s economic balance sheet.
5. LOS 17.g: Discuss the use of Monte Carlo simulation and scenario analysis
to evaluate the robustness of an asset allocation.
6. LOS 17.d: Discuss asset class liquidity considerations in asset allocation.
7. LOS 17.e: Explain absolute and relative risk budgets and their use in
determining and implementing an asset allocation.
8. LOS 17.f: Describe how client needs and preferences regarding investment
risks can be incorporated into asset allocation.
9. LOS 17.h: Describe the use of investment factors in constructing and
analyzing an asset allocation.
10. LOS 17.j: Describe and evaluate characteristics of liabilities that are
relevant to asset allocation.
11. LOS 17.k: Discuss approaches to liability-relative asset allocation.
12. LOS 17.l: Recommend and justify a liability-relative asset allocation.
13. LOS 17.m: Recommend and justify an asset allocation using a goals-based
approach.
14. LOS 17.n: Describe and critique heuristic and other approaches to asset
allocation.
15. LOS 17.o: Discuss factors affecting rebalancing policy.
16. Key Concepts
1. LOS 17.a
2. LOS 17.b, 17.i
3. LOS 17.c
4. LOS 17.d
5. LOS 17.e
6. LOS 17.f
7. LOS 17.g
8. LOS 17.h
9. LOS 17.j

10. LOS 17.k, 17.l
11. LOS 17.m
12. LOS 17.n
13. LOS 17.o
17. Concept Checkers
1. Answers – Concept Checkers


11. Asset Allocation with Real-World Constraints
1. LOS 18.a: Discuss asset size, liquidity needs, time horizon, and regulatory or
other considerations as constraints on asset allocation.
2. LOS 18.b: Discuss tax considerations in asset allocation and rebalancing.
3. LOS 18.c: Recommend and justify revisions to an asset allocation given
change(s) in investment objectives and/or constraints.
4. LOS 18.d: Discuss the use of short-term shifts in asset allocation.
5. LOS 18.e: Identify behavioral biases that arise in asset allocation and
recommend methods to overcome them.
6. Key Concepts
1. LOS 18.a
2. LOS 18.b
3. LOS 18.c
4. LOS 18.d
5. LOS 18.e
7. Concept Checkers
1. Answers – Concept Checkers
12. Currency Management: An Introduction
1. LOS 19.a: Analyze the effects of currency movements on portfolio risk and
return.
2. LOS 19.b: Discuss strategic choices in currency management.
3. LOS 19.c: Formulate an appropriate currency management program given

financial market conditions and portfolio objectives and constraints.
4. LOS 19.d: Compare active currency trading strategies based on economic
fundamentals, technical analysis, carry-trade, and volatility trading.
5. LOS 19.e: Describe how changes in factors underlying active trading
strategies affect tactical trading decisions.
6. LOS 19.f: Describe how forward contracts and FX (foreign exchange) swaps
are used to adjust hedge ratios.
7. LOS 19.g: Describe trading strategies used to reduce hedging costs and
modify the risk–return characteristics of a foreign-currency portfolio.
8. LOS 19.h: Describe the use of cross-hedges, macro-hedges, and minimumvariance-hedge ratios in portfolios exposed to multiple foreign currencies.
9. LOS 19.i: Discuss challenges for managing emerging market currency
exposures.
10. Key Concepts
1. LOS 19.a
2. LOS 19.b
3. LOS 19.c
4. LOS 19.d
5. LOS 19.e
6. LOS 19.f
7. LOS 19.g
8. LOS 19.h


9. LOS 19.i
11. Concept Checkers
1. Answers – Concept Checkers
13. Market Indexes and Benchmarks
1. LOS 20.a: Distinguish between benchmarks and market indexes.
2. LOS 20.b: Describe investment uses of benchmarks.
3. LOS 20.c: Compare types of benchmarks.

4. LOS 20.d: Contrast liability-based benchmarks with asset-based
benchmarks.
5. LOS 20.e: Describe investment uses of market indexes.
6. LOS 20.f: Discuss tradeoffs in constructing market indexes.
7. LOS 20.g: Discuss advantages and disadvantages of index weighting
schemes.
8. LOS 20.h: Evaluate the selection of a benchmark for a particular investment
strategy.
9. Key Concepts
1. LOS 20.a
2. LOS 20.b
3. LOS 20.c
4. LOS 20.d
5. LOS 20.e
6. LOS 20.f
7. LOS 20.g
8. LOS 20.h
10. Concept Checkers
1. Answers – Concept Checkers
14. Self-Test – Asset Allocation
1. Self-Test Answers: Asset Allocation
15. Introduction to Fixed-Income Portfolio Management
1. LOS 21.a: Discuss roles of fixed-income securities in portfolios.
2. LOS 21.b: Describe how fixed-income mandates may be classified and
compare features of the mandates.
3. LOS 21.c: Describe bond market liquidity, including the differences among
market sub-sectors, and discuss the effect of liquidity on fixed-income
portfolio management.
4. LOS 21.d: Describe and interpret a model for fixed-income returns.
5. LOS 21.e: Discuss the use of leverage, alternative methods for leveraging,

and risks that leverage creates in fixed-income portfolios.
6. LOS 21.f: Discuss differences in managing fixed-income portfolios for
taxable and tax-exempt investors.
7. Key Concepts
1. LOS 21.a
2. LOS 21.b
3. LOS 21.c


4. LOS 21.d
5. LOS 21.e
6. LOS 21.f
8. Concept Checkers
1. Answers – Concept Checkers
16. Liability-Driven and Index-Based Strategies
1. LOS 22.a: Describe liability-driven investing.
2. LOS 22.b: Evaluate strategies for managing a single liability.
3. LOS 22.c: Compare strategies for a single liability and for multiple liabilities,
including alternative means of implementation.
4. LOS 22.d: Evaluate liability-based strategies under various interest rate
scenarios and select a strategy to achieve a portfolio’s objectives.
5. LOS 22.e: Explain risks associated with managing a portfolio against a
liability structure.
6. LOS 22.f: Discuss bond indexes and the challenges of managing a fixedincome portfolio to mimic the characteristics of a bond index.
7. LOS 22.g: Compare alternative methods for establishing bond market
exposure passively.
8. LOS 22.h: Discuss criteria for selecting a benchmark and justify the
selection of a benchmark.
9. LOS 22.i: Describe construction, benefits, limitations, and risk–return
characteristics of a laddered bond portfolio.

10. Key Concepts
1. LOS 22.a
2. LOS 22.b
3. LOS 22.c
4. LOS 22.d
5. LOS 22.e
6. LOS 22.f
7. LOS 22.g
8. LOS 22.h
9. LOS 22.i
11. Concept Checkers
1. Answers – Concept Checkers
17. Yield Curve Strategies
1. LOS 23.a: Describe major types of yield curve strategies.
2. LOS 23.b: Explain why and how a fixed-income portfolio manager might
choose to alter portfolio convexity.
3. LOS 23.c: Formulate a portfolio positioning strategy given forward interest
rates and an interest rate view.
4. LOS 23.d: Explain how derivatives may be used to implement yield curve
strategies.
5. LOS 23.e: Evaluate a portfolio’s sensitivity to a change in curve slope using
key rate durations of the portfolio and its benchmark.


18.

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6. LOS 23.f: Construct a duration-neutral government bond portfolio to profit
from a change in yield curve curvature.
7. LOS 23.g: Evaluate the expected return of a yield curve strategy.
8. Key Concepts
1. LOS 23.a
2. LOS 23.b
3. LOS 23.c
4. LOS 23.d
5. LOS 23.e
6. LOS 23.f
7. LOS 23.g
9. Concept Checkers
1. Answers – Concept Checkers
Credit Strategies
1. LOS 24.a: Describe risk considerations in investment-grade and high-yield
corporate bond portfolios.
2. LOS 24.b: Compare the use of credit spread measures in portfolio
construction.
3. LOS 24.c: Discuss bottom-up approaches to credit strategies.
4. LOS 24.d: Discuss top-down approaches to credit strategies.
5. LOS 24.e: Discuss liquidity risk in credit markets and how liquidity risk can
be managed in a credit portfolio.
6. LOS 24.f: Describe how to assess and manage tail risk in credit portfolios.
7. LOS 24.g: Discuss considerations in constructing and managing portfolios
across international credit markets.
8. LOS 24.h: Describe the use of structured financial instruments as an
alternative to corporate bonds in credit portfolios.
9. Key Concepts
1. LOS 24.a
2. LOS 24.b

3. LOS 24.c
4. LOS 24.d
5. LOS 24.e
6. LOS 24.f
7. LOS 24.g
8. LOS 24.h
10. Concept Checkers
1. Answers – Concept Checkers
Self-Test – Fixed-Income Portfolio Management
1. Self-Test Answers: Fixed-Income Portfolio Management
Formulas
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BOOK 3 – ECONOMIC ANALYSIS, ASSET ALLOCATION
AND FIXED-INCOME PORTFOLIO MANAGEMENT
Readings and Learning Outcome Statements
Study Session 7 – Applications of Economic Analysis to Portfolio Management
Self-Test – Economic Analysis
Study Session 8 – Asset Allocation and Related Decisions in Portfolio Management (1)
Study Session 9 – 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


READINGS AND LEARNING OUTCOME STATEMENTS
READINGS
The following material is a review of the Fixed Income Portfolio Management, Fixed
Income Derivatives, and Equity Portfolio Management principles designed to
address the learning outcome statements set forth by CFA Institute.

STUDY SESSION 7
Reading Assignments
Applications of Economic Analysis to Portfolio Management, CFA Program 2018
Curriculum, Volume 3, Level III
14. Capital Market Expectations
15. Equity Market Valuation

STUDY SESSION 8
Reading Assignments

Asset Allocation and Related Decisions in Portfolio Management (1), CFA Program
2018 Curriculum, Volume 3, Level III
16. Introduction to Asset Allocation
17. Principles of Asset Allocation

STUDY SESSION 9
Reading Assignments
Asset Allocation and Related Decisions in Portfolio Management (2), CFA Program
2018 Curriculum, Volume 3, Level III
18. Asset Allocation with Real-World Constraints
19. Currency Management: An Introduction
20. Market Indexes and Benchmarks

STUDY SESSION 10
Reading Assignments
Fixed-Income Portfolio Management (1), CFA Program 2018 Curriculum, Volume 4,
Level III
21. Introduction to Fixed-Income Portfolio Management
22. Liability-Driven and Index-Based Strategies


STUDY SESSION 11
Reading Assignments
Fixed-Income Portfolio Management (2), CFA Program 2018 Curriculum, Volume 4,
Level III
23. Yield Curve Strategies
24. Credit Strategies

LEARNING OUTCOME STATEMENTS (LOS)
The CFA Institute learning outcome statements are listed in the following. These are

repeated in each topic review. However, the order may have been changed in order
to get a better fit with the flow of the review.

STUDY SESSION 7
The topical coverage corresponds with the following CFA Institute assigned
reading:
14. Capital Market Expectations
The candidate should be able to:
a. discuss the role of, and a framework for, capital market expectations in
the portfolio management process. (page 1)
b. discuss challenges in developing capital market forecasts. (page 2)
c. demonstrate the application of formal tools for setting capital market
expectations, including statistical tools, discounted cash flow models,
the risk premium approach, and financial equilibrium models. (page 6)
d. explain the use of survey and panel methods and judgment in setting
capital market expectations. (page 17)
e. discuss the inventory and business cycles and effects that consumer
and business spending and monetary and fiscal policy have on the
business cycle. (page 18)
f. discuss the effects that the phases of the business cycle have on shortterm/long-term capital market returns. (page 19)
g. explain the relationship of inflation to the business cycle and the
implications of inflation for cash, bonds, equity, and real estate returns.
(page 22)
h. demonstrate the use of the Taylor rule to predict central bank
behavior. (page 24)
i. interpret the shape of the yield curve as an economic predictor and
discuss the relationship between the yield curve and fiscal and
monetary policy. (page 27)
j. identify and interpret the components of economic growth trends and

X VY

j. identify and interpret the components of economic growth trends and
demonstrate the application of economic growth trend analysis to the
formulation of capital market expectations. (page 27)
k. explain how exogenous shocks may affect economic growth trends.
(page 29)
l. identify and interpret macroeconomic, interest rate, and exchange rate
linkages between economies. (page 30)
m. discuss the risks faced by investors in emerging-market securities and
the country risk analysis techniques used to evaluate emerging market
economies. (page 31)
n. compare the major approaches to economic forecasting. (page 33)
o. demonstrate the use of economic information in forecasting asset class
returns. (page 34)
p. explain how economic and competitive factors can affect investment
markets, sectors, and specific securities. (page 34)
q. discuss the relative advantages and limitations of the major
approaches to forecasting exchange rates. (page 37)
r. recommend and justify changes in the component weights of a global
investment portfolio based on trends and expected changes in
macroeconomic factors. (page 39)
The topical coverage corresponds with the following CFA Institute assigned
reading:
15. Equity Market Valuation
The candidate should be able to:
a. explain the terms of the Cobb-Douglas production function and
demonstrate how the function can be used to model growth in real
output under the assumption of constant returns to scale. (page 58)

b. evaluate the relative importance of growth in total factor productivity,
in capital stock, and in labor input given relevant historical data.
(page 60)
c. demonstrate the use of the Cobb-Douglas production function in
obtaining a discounted dividend model estimate of the intrinsic value of
an equity market. (page 62)
d. critique the use of discounted dividend models and macroeconomic
forecasts to estimate the intrinsic value of an equity market. (page 62)
e. contrast top-down and bottom-up approaches to forecasting the
earnings per share of an equity market index. (page 65)
f. discuss the strengths and limitations of relative valuation models.
(page 67)
g. judge whether an equity market is under-, fairly, or over-valued using a
relative equity valuation model. (page 67)


STUDY SESSION 8
The topical coverage corresponds with the following CFA Institute assigned
reading:
16. Introduction to Asset Allocation
The candidate should be able to:
a. describe elements of effective investment governance and investment
governance considerations in asset allocation. (page 88)
b. prepare an economic balance sheet for a client and interpret its
implications for asset allocation. (page 91)
c. compare the investment objectives of asset-only, liability-relative, and
goals-based asset allocation approaches. (page 92)
d. contrast concepts of risk relevant to asset-only, liability-relative, and
goals-based asset allocation approaches. (page 93)
e. explain how asset classes are used to represent exposures to

systematic risk and discuss criteria for asset class specification.
(page 94)
f. explain the use of risk factors in asset allocation and their relation to
traditional asset class–based approaches. (page 96)
g. Select and justify an asset allocation based on an investor’s objectives
and constraints. (page 97)
h. describe the use of the global market portfolio as a baseline portfolio
in asset allocation. (page 99)
i. discuss strategic implementation choices in asset allocation, including
passive/active choices and vehicles for implementing passive and active
mandates. (page 100)
j. discuss strategic considerations in rebalancing asset allocations.
(page 102)
The topical coverage corresponds with the following CFA Institute assigned
reading:
17. Principles of Asset Allocation
a. describe and critique the use of mean–variance optimization in asset
allocation. (page 111)
b. recommend and justify an asset allocation using mean–variance
optimization. (page 118)
c. interpret and critique an asset allocation in relation to an investor’s
economic balance sheet. (page 120)
d. discuss asset class liquidity considerations in asset allocation.
(page 121)
e. explain absolute and relative risk budgets and their use in determining
and implementing an asset allocation. (page 122)
f. describe how client needs and preferences regarding investment risks


f. describe how client needs and preferences regarding investment risks

can be incorporated into asset allocation. (page 123)
g. discuss the use of Monte Carlo simulation and scenario analysis to
evaluate the robustness of an asset allocation. (page 121)
h. describe the use of investment factors in constructing and analyzing an
asset allocation. (page 124)
i. recommend and justify an asset allocation based on the global market
portfolio. (page 118)
j. describe and evaluate characteristics of liabilities that are relevant to
asset allocation. (page 125)
k. discuss approaches to liability-relative asset allocation. (page 126)
l. recommend and justify a liability-relative asset allocation. (page 126)
m. recommend and justify an asset allocation using a goals-based
approach. (page 128)
n. describe and critique heuristic and other approaches to asset
allocation. (page 130)
o. discuss factors affecting rebalancing policy. (page 131)

STUDY SESSION 9
The topical coverage corresponds with the following CFA Institute assigned
reading:
18. Asset Allocation With Real-World Constraints
The candidate should be able to:
a. discuss asset size, liquidity needs, time horizon, and regulatory or other
considerations as constraints on asset allocation. (page 140)
b. discuss tax considerations in asset allocation and rebalancing.
(page 146)
c. recommend and justify revisions to an asset allocation given change(s)
in investment objectives and/or constraints. (page 149)
d. discuss the use of short-term shifts in asset allocation. (page 151)
e. identify behavioral biases that arise in asset allocation and recommend

methods to overcome them. (page 153)
The topical coverage corresponds with the following CFA Institute assigned
reading:
19. Currency Management: An Introduction
The candidate should be able to:
a. analyze the effects of currency movements on portfolio risk and return.
(page 166)
b. discuss strategic choices in currency management. (page 170)
c. formulate an appropriate currency management program given
financial market conditions and portfolio objectives and constraints.


X VY

(page 173)
d. compare active currency trading strategies based on economic
fundamentals, technical analysis, carry-trade, and volatility trading.
(page 173)
e. describe how changes in factors underlying active trading strategies
affect tactical trading decisions. (page 178)
f. describe how forward contracts and FX (foreign exchange) swaps are
used to adjust hedge ratios. (page 180)
g. describe trading strategies used to reduce hedging costs and modify
the risk–return characteristics of a foreign-currency portfolio.
(page 186)
h. describe the use of cross-hedges, macro-hedges, and minimumvariance-hedge ratios in portfolios exposed to multiple foreign
currencies. (page 188)
i. discuss challenges for managing emerging market currency exposures.
(page 191)
The topical coverage corresponds with the following CFA Institute assigned

reading:
20. Market Indexes and Benchmarks
a. distinguish between benchmarks and market indexes. (page 203)
b. describe investment uses of benchmarks. (page 204)
c. compare types of benchmarks. (page 204)
d. contrast liability-based benchmarks with asset-based benchmarks.
(page 205)
e. describe investment uses of market indexes. (page 205)
f. discuss tradeoffs in constructing market indexes. (page 206)
g. discuss advantages and disadvantages of index weighting schemes.
(page 207)
h. evaluate the selection of a benchmark for a particular investment
strategy. (page 208)

STUDY SESSION 10
The topical coverage corresponds with the following CFA Institute assigned
reading:
21. Introduction to Fixed-Income Portfolio Management
The candidate should be able to:
a. discuss roles of fixed-income securities in portfolios. (page 224)
b. describe how fixed-income mandates may be classified and compare
features of the mandates. (page 227)
c. describe bond market liquidity, including the differences among market
sub-sectors, and discuss the effect of liquidity on fixed-income portfolio