CFA Portfolio Management and Wealth Planning Syllabus

List the five constraints in an IPS.

Liquidity needs, Time horizon, Tax concerns, Legal and regulatory factors, and Unique circumstances. (Mnemonic: L-T-T-L-U.)

How do ability and willingness to take risk combine to set risk tolerance?

Risk tolerance is the lower of the two when they conflict; ability (based on wealth, time horizon, liquidity, and required return) is generally the binding constraint, while willingness (psychological) must be reconciled through client education. Below-average ability normally governs.

What factors increase an investor's ability to take risk?

A longer time horizon, larger asset base relative to liabilities/needs, low liquidity requirements, stable income, and a low required rate of return. These give greater capacity to absorb losses.

Distinguish an absolute return objective from a relative return objective.

An absolute objective targets a specific return independent of markets (e.g., 8% per year, or CPI + 3%). A relative objective targets performance versus a benchmark or peer group (e.g., exceed the index by 200 bps).

What is the difference between a required return and a desired return in an IPS?

The required return is the return the client must earn to meet essential goals (a needs-based minimum). The desired return is an aspirational level tied to wish-list goals; it may be pursued only if risk tolerance permits.

Why is time horizon a critical IPS constraint, and how can it be multistage?

Time horizon determines risk capacity and appropriate asset allocation; longer horizons permit more risk and illiquid assets. It is multistage when distinct phases exist (e.g., pre-retirement accumulation followed by post-retirement decumulation), each with different objectives.

Define strategic asset allocation (SAA).

The long-term policy allocation of a portfolio across asset classes, chosen to satisfy the IPS objectives and constraints under long-run (equilibrium) capital market expectations. It sets the target (policy) weights and their benchmark.

What are the typical steps in forming a strategic asset allocation?

1) Specify asset classes; 2) form long-run capital market expectations (returns, risks, correlations); 3) optimize (e.g., mean-variance) to derive efficient policy weights; 4) select the allocation matching the IPS; 5) document and periodically review it.

What criteria make a good asset-class specification for allocation?

Assets within a class are relatively homogeneous; classes are mutually exclusive; classes are diversifying (low correlations across classes); classes as a group cover most investable wealth; and each class can absorb a meaningful share of the portfolio while preserving liquidity.

What is a corner portfolio and why is it useful in asset allocation?

A corner portfolio is a point on the efficient frontier where an asset weight changes from zero to positive (or vice versa). Between adjacent corner portfolios, efficient allocations are linear combinations, letting one interpolate weights for a target return.

How does strategic asset allocation relate to a portfolio's benchmark?

The SAA policy weights applied to each asset class's benchmark index define the portfolio's overall policy benchmark. Deviations from these policy weights (tactical or security selection) are what produce active return relative to the benchmark.

Empirically, what portion of return variability is typically attributed to asset allocation policy?

Studies (e.g., Brinson, Hood, Beebower) attribute the large majority — commonly cited around 90% — of the variability of a portfolio's returns over time to the strategic asset allocation policy, rather than to security selection or market timing.

Define tactical asset allocation (TAA).

Short-term, deliberate deviations from the strategic (policy) weights intended to exploit perceived temporary mispricings or shifts in the risk-return outlook across asset classes. It is an active strategy aiming to add value over the SAA.

How does tactical asset allocation differ from strategic asset allocation?

SAA sets long-run policy weights based on equilibrium expectations and is passive/infrequently changed. TAA makes short-run, active shifts around those weights based on near-term forecasts. SAA is the baseline; TAA is a controlled overlay generating active risk and return.

What is the difference between discretionary and systematic (rules-based) TAA?

Discretionary TAA relies on a manager's judgment and forecasting skill to time asset-class shifts. Systematic TAA follows quantitative signals or rules (e.g., value, momentum, carry) to trigger reallocations, removing subjective judgment.

What is rebalancing, and why is it required?

Rebalancing returns portfolio weights to their strategic targets after market movements cause drift. It is required because drift alters the portfolio's risk profile away from the IPS; rebalancing enforces discipline and implicitly sells winners and buys losers.

Contrast calendar rebalancing with percentage-of-portfolio (corridor) rebalancing.

Calendar rebalancing restores target weights at fixed intervals (e.g., quarterly), which is simple but ignores intra-period drift. Percentage-of-portfolio rebalancing acts whenever an asset's weight breaches a tolerance band (corridor) around its target, responding to actual drift regardless of date.

What factors widen the optimal rebalancing corridor (tolerance band) for an asset class?

Higher transaction costs, higher risk tolerance, and lower correlation of the asset with the rest of the portfolio all argue for wider corridors. Higher asset volatility argues for narrower corridors (drift accumulates faster).

Define risk management in the enterprise/portfolio sense.

The process by which an organization or investor defines the level of risk it is willing to take, measures the risk it is taking, and adjusts the actual risk toward the desired level — all in support of the entity's objectives, not simply minimizing risk.

List the core elements of a risk management framework.

1) Risk governance (setting risk tolerance and oversight); 2) Risk identification and measurement; 3) Risk infrastructure (people, systems, data); 4) Defined policies and processes; 5) Risk monitoring, mitigation, and management; 6) Communication; and strategic risk analysis/integration.

What is risk governance and what is its central output?

Risk governance is the top-down, enterprise-level direction of risk management by the board/senior leadership. Its central output is a clearly articulated risk tolerance — a statement of which risks the enterprise will accept, avoid, or transfer to pursue its goals.

Define risk tolerance, risk budgeting, and risk exposure.

Risk tolerance is the total amount and types of risk an entity is willing to bear. Risk budgeting allocates that total risk across assets, strategies, or units. Risk exposure is the actual amount of a given risk currently borne.

Distinguish financial risks from non-financial risks.

Financial risks arise from financial markets: market risk, credit risk, and liquidity risk. Non-financial risks arise from operations and the external environment: operational, model, solvency, settlement, legal/regulatory, tail, and accounting risks.

What are the three principal types of financial market risk?

Market risk (losses from movements in prices, rates, or FX), credit (default) risk (counterparty failing to pay), and liquidity risk (inability to trade at fair value / transaction-cost risk when unwinding a position).

Define Value at Risk (VaR).

VaR is the minimum loss expected over a specified period at a given confidence level. E.g., a one-day 5% VaR of \$1 million means there is a 5% probability of losing at least \$1 million over one day (equivalently, 95% confidence the loss will not exceed that).

Name the three methods for estimating VaR and one feature of each.

Parametric (variance-covariance): assumes a distribution (usually normal), simple but poor for options/fat tails. Historical simulation: reuses actual past returns, no distribution assumption but bound to the sample. Monte Carlo simulation: generates returns from a specified model, flexible but computationally intensive.

What are the main limitations of VaR as a risk measure?

VaR states a threshold but not the magnitude of losses beyond it (no tail size), is sensitive to method and assumptions, can understate risk with fat tails/non-normality, may give a false sense of precision, and is not subadditive in general (can penalize diversification).

What is Conditional VaR (CVaR / expected shortfall) and how does it improve on VaR?

CVaR is the expected loss given that the loss exceeds the VaR threshold — the average of the tail beyond VaR. It improves on VaR by quantifying the size of extreme losses and is a coherent (subadditive) risk measure.

Define the sensitivity risk measures delta, gamma, vega, and duration.

Delta ($\Delta$): sensitivity of an option's price to the underlying's price. Gamma ($\Gamma$): sensitivity of delta to the underlying (rate of change of delta). Vega: sensitivity to volatility. Duration: sensitivity of a bond's price to interest-rate changes.

Contrast scenario analysis with stress testing.

Scenario analysis estimates portfolio impact under specified hypothetical or historical sets of market moves (multiple factors changing together). Stress testing is a form of scenario analysis focused on extreme, adverse moves to reveal vulnerabilities that normal risk measures (like VaR) may miss.

What are the primary methods available for modifying or mitigating risk?

Risk prevention/avoidance (don't take the risk), risk acceptance with self-insurance or a risk budget, risk transfer (insurance), risk shifting (derivatives/hedging to change the payoff distribution), and diversification. Choice depends on cost and the entity's risk tolerance.