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FIXED INCOME, DERIVATIVES, ALTERNATIVE INVESTMENTS, AND PORTFOLIO MANAGEMENT CFA® Program Curriculum 2022 • LEVEL I • VOLUME CONTENTS How to Use the CFA Program Curriculum Background on the CBOK Organization of the Curriculum Features of the Curriculum Designing Your Personal Study Program CFA Institute Learning Ecosystem (LES) Prep Providers Feedback ix ix x x xi xii xiii xiv Fixed Income Study Session 14 Fixed Income (2) Reading 43 Understanding Fixed-Income Risk and Return Introduction Sources of Return Macaulay and Modified Duration Macaulay, Modified, and Approximate Duration Approximate Modified and Macaulay Duration Effective and Key Rate Duration Key Rate Duration Properties of Bond Duration Duration of a Bond Portfolio Money Duration and the Price Value of a Basis Point Bond Convexity Investment Horizon, Macaulay Duration and Interest Rate Risk Yield Volatility Investment Horizon, Macaulay Duration, and Interest Rate Risk Credit and Liquidity Risk Empirical Duration Summary Practice Problems Solutions 14 14 19 22 25 26 32 34 36 45 45 47 51 52 53 58 63 Reading 44 Fundamentals of Credit Analysis Introduction Credit Risk Capital Structure, Seniority Ranking, and Recovery Rates Capital Structure Seniority Ranking Recovery Rates Rating Agencies, Credit Ratings, and Their Role in the Debt Markets Credit Ratings Issuer vs Issue Ratings ESG Ratings 69 70 70 72 73 73 74 78 79 80 81 indicates an optional segment ii Contents Risks in Relying on Agency Ratings Traditional Credit Analysis: Corporate Debt Securities Credit Analysis vs Equity Analysis: Similarities and Differences The Four Cs of Credit Analysis: A Useful Framework Credit Risk vs Return: Yields and Spreads Credit Risk vs Return: The Price Impact of Spread Changes High-Yield, Sovereign, and Non-Sovereign Credit Analysis High Yield Sovereign Debt Non-Sovereign Government Debt Summary Practice Problems Solutions 82 87 87 88 105 109 112 113 120 124 126 131 140 Study Session 15 Derivatives 147 Reading 45 Derivative Markets and Instruments Derivatives: Introduction, Definitions, and Uses Derivatives: Definitions and Uses The Structure of Derivative Markets Exchange-Traded Derivatives Markets Over-the-Counter Derivatives Markets Types of Derivatives: Introduction, Forward Contracts Forward Commitments Types of Derivatives: Futures Types of Derivatives: Swaps Contingent Claims: Options Options Contingent Claims: Credit Derivatives Types of Derivatives: Asset-Backed Securities and Hybrids Hybrids Derivatives Underlyings Equities Fixed-Income Instruments and Interest Rates Currencies Commodities Credit Other The Purposes and Benefits of Derivatives Risk Allocation, Transfer, and Management Information Discovery Operational Advantages Market Efficiency Criticisms and Misuses of Derivatives Speculation and Gambling Destabilization and Systemic Risk 149 149 150 153 154 155 158 158 162 166 170 170 178 182 183 184 185 185 185 186 186 186 188 189 189 190 191 191 192 192 Derivatives indicates an optional segment Contents iii Elementary Principles of Derivative Pricing Storage Arbitrage Summary Practice Problems Solutions 194 195 196 201 204 211 Basics of Derivative Pricing and Valuation Introduction Basic Derivative Concepts, Pricing the Underlying Basic Derivative Concepts Pricing the Underlying The Principle of Arbitrage The (In)Frequency of Arbitrage Opportunities Arbitrage and Derivatives Arbitrage and Replication Risk Aversion, Risk Neutrality, and Arbitrage-Free Pricing Limits to Arbitrage Pricing and Valuation of Forward Contracts: Pricing vs Valuation; Expiration; Initiation Pricing and Valuation of Forward Commitments Pricing and Valuation of Forward Contracts: Between Initiation and Expiration; Forward Rate Agreements A Word about Forward Contracts on Interest Rates Pricing and Valuation of Futures Contracts Pricing and Valuation of Swap Contracts Pricing and Valuation of Options European Option Pricing Lower Limits for Prices of European Options Put-Call Parity, Put-Call-Forward Parity Put–Call–Forward Parity Binomial Valuation of Options American Option Pricing Summary Practice Problems Solutions 221 222 222 222 224 228 229 229 230 231 232 Study Session 16 Alternative Investments 287 Reading 47 Introduction to Alternative Investments Introduction Why Investors Consider Alternative Investments Categories of Alternative Investments Investment Methods Methods of Investing in Alternative Investments Advantages and Disadvantages of Direct Investing, Co-Investing, and Fund Investing 289 289 290 291 295 295 Reading 46 234 235 239 240 242 245 248 249 254 258 261 263 268 271 273 279 Alternative Investments indicates an optional segment 296 iv Contents Due Diligence for Fund Investing, Direct Investing, and Co-Investing Investment and Compensation Structures Partnership Structures Compensation Structures Common Investment Clauses, Provisions, and Contingencies Hedge Funds Characteristics of Hedge Funds Hedge Fund Strategies Hedge Funds and Diversification Benefits Private Capital Overview of Private Capital Description: Private Equity Description: Private Debt Risk/Return of Private Equity Risk/Return of Private Debt Diversification Benefits of Investing in Private Capital Natural Resources Overview of Natural Resources Characteristics of Natural Resources Risk/Return of Natural Resources Diversification Benefits of Natural Resources Instruments Real Estate Overview of the Real Estate Market Characteristics: Forms of Real Estate Ownership Characteristics: Real Estate Investment Categories Risk and Return Characteristics Diversification Benefits Infrastructure Introduction and Overview Description Risk and Return Characteristics Diversification Benefits Issues in Performance Appraisal Overview of Performance Appraisal for Alternative Investments Common Approaches to Performance Appraisal and Application Challenges Private Equity and Real Estate Performance Evaluation Hedge Funds: Leverage, Illiquidity, and Redemption Terms Calculating Fees and Returns Alternative Asset Fee Structures and Terms Custom Fee Arrangements Alignment of Interests and Survivorship Bias Summary indicates an optional segment 299 303 303 305 306 310 311 314 319 321 321 322 326 328 329 331 334 334 335 339 342 347 350 350 353 356 359 362 366 366 368 370 372 375 376 376 379 381 387 387 388 392 396 Contents v Portfolio Management Study Session 17 Portfolio Management (1) 403 Reading 48 Portfolio Management: An Overview Introduction Portfolio Perspective: Diversification and Risk Reduction Historical Example of Portfolio Diversification: Avoiding Disaster Portfolios: Reduce Risk Portfolio Perspective: Risk-Return Trade-off, Downside Protection, Modern Portfolio Theory Historical Portfolio Example: Not Necessarily Downside Protection Portfolios: Modern Portfolio Theory Steps in the Portfolio Management Process Step One: The Planning Step Step Two: The Execution Step Step Three: The Feedback Step Types of Investors Individual Investors Institutional Investors The Asset Management Industry Active versus Passive Management Traditional versus Alternative Asset Managers Ownership Structure Asset Management Industry Trends Pooled Interest - Mutual Funds Mutual Funds Pooled Interest - Type of Mutual Funds Money Market Funds Bond Mutual Funds Stock Mutual Funds Hybrid/Balanced Funds Pooled Interest - Other Investment Products Exchange- Traded Funds Hedge Funds Private Equity and Venture Capital Funds Summary Practice Problems Solutions 405 405 406 406 408 Portfolio Risk and Return: Part I Introduction Investment Characteristics of Assets: Return Return Money-Weighted Return or Internal Rate of Return Time-Weighted Rate of Return Annualized Return Other Major Return Measures and their Applications Gross and Net Return 441 441 442 442 445 449 454 456 456 Reading 49 indicates an optional segment 411 412 414 415 415 416 418 419 419 420 425 426 427 427 428 430 430 432 432 433 433 434 434 434 435 435 436 438 440 vi Reading 50 Contents Pre-tax and After-tax Nominal Return Real Returns Leveraged Return Historical Return and Risk Historical Mean Return and Expected Return Nominal Returns of Major US Asset Classes Real Returns of Major US Asset Classes Nominal and Real Returns of Asset Classes in Major Countries Risk of Major Asset Classes Risk–Return Trade- off Other Investment Characteristics Distributional Characteristics Market Characteristics Risk Aversion and Portfolio Selection & The Concept of Risk Aversion The Concept of Risk Aversion Utility Theory and Indifference Curves Indifference Curves Application of Utility Theory to Portfolio Selection Portfolio Risk & Portfolio of Two Risky Assets Portfolio of Two Risky Assets Portfolio of Many Risky Assets Importance of Correlation in a Portfolio of Many Assets The Power of Diversification Correlation and Risk Diversification Historical Risk and Correlation Historical Correlation among Asset Classes Avenues for Diversification Efficient Frontier: Investment Opportunity Set & Minimum Variance Portfolios Investment Opportunity Set Minimum- Variance Portfolios Efficient Frontier: A Risk-Free Asset and Many Risky Assets Capital Allocation Line and Optimal Risky Portfolio The Two-Fund Separation Theorem Efficient Frontier: Optimal Investor Portfolio Investor Preferences and Optimal Portfolios Summary Practice Problems Solutions 457 457 458 459 459 460 461 462 462 463 463 464 466 467 467 468 469 473 476 476 484 485 485 487 487 488 489 Portfolio Risk and Return: Part II Introduction Capital Market Theory: Risk-Free and Risky Assets Portfolio of Risk-Free and Risky Assets Capital Market Theory: The Capital Market Line Passive and Active Portfolios What Is the “Market”? The Capital Market Line (CML) 519 519 520 520 524 524 525 525 indicates an optional segment 491 491 492 494 494 495 497 502 503 505 513 Contents vii Capital Market Theory: CML - Leveraged Portfolios Leveraged Portfolios with Different Lending and Borrowing Rates Systematic and Nonsystematic Risk Systematic Risk and Nonsystematic Risk Return Generating Models Return- Generating Models Decomposition of Total Risk for a Single-Index Model Return-Generating Models: The Market Model Calculation and Interpretation of Beta Estimation of Beta Beta and Expected Return Capital Asset Pricing Model: Assumptions and the Security Market Line Assumptions of the CAPM The Security Market Line Capital Asset Pricing Model: Applications Estimate of Expected Return Beyond CAPM: Limitations and Extensions of CAPM Limitations of the CAPM Extensions to the CAPM Portfolio Performance Appraisal Measures The Sharpe Ratio The Treynor Ratio M2: Risk-Adjusted Performance (RAP) Jensen’s Alpha Applications of the CAPM in Portfolio Construction Security Characteristic Line Security Selection Implications of the CAPM for Portfolio Construction Summary Practice Problems Solutions 528 530 532 532 534 534 536 537 537 539 540 541 542 543 546 547 548 548 549 551 552 552 553 554 557 558 558 560 563 565 571 Glossary G-1 indicates an optional segment ix How to Use the CFA Program Curriculum Congratulations on your decision to enter the Chartered Financial Analyst (CFA®) Program This exciting and rewarding program of study reflects your desire to become a serious investment professional You are embarking on a program noted for its high ethical standards and the breadth of knowledge, skills, and abilities (competencies) it develops Your commitment should be educationally and professionally rewarding The credential you seek is respected around the world as a mark of accomplishment and dedication Each level of the program represents a distinct achievement in professional development Successful completion of the program is rewarded with membership in a prestigious global community of investment professionals CFA charterholders are dedicated to life-long learning and maintaining currency with the ever-changing dynamics of a challenging profession CFA Program enrollment represents the first step toward a career-long commitment to professional education The CFA exam measures your mastery of the core knowledge, skills, and abilities required to succeed as an investment professional These core competencies are the basis for the Candidate Body of Knowledge (CBOK™) The CBOK consists of four components: ■■ A broad outline that lists the major CFA Program topic areas (www.cfainstitute org/programs/cfa/curriculum/cbok); ■■ Topic area weights that indicate the relative exam weightings of the top-level topic areas (www.cfainstitute.org/programs/cfa/curriculum); ■■ Learning outcome statements (LOS) that advise candidates about the specific knowledge, skills, and abilities they should acquire from readings covering a topic area (LOS are provided in candidate study sessions and at the beginning of each reading); and ■■ CFA Program curriculum that candidates receive upon exam registration Therefore, the key to your success on the CFA exams is studying and understanding the CBOK The following sections provide background on the CBOK, the organization of the curriculum, features of the curriculum, and tips for designing an effective personal study program BACKGROUND ON THE CBOK CFA Program is grounded in the practice of the investment profession CFA Institute performs a continuous practice analysis with investment professionals around the world to determine the competencies that are relevant to the profession, beginning with the Global Body of Investment Knowledge (GBIK®) Regional expert panels and targeted surveys are conducted annually to verify and reinforce the continuous feedback about the GBIK The practice analysis process ultimately defines the CBOK The CBOK reflects the competencies that are generally accepted and applied by investment professionals These competencies are used in practice in a generalist context and are expected to be demonstrated by a recently qualified CFA charterholder © 2021 CFA Institute All rights reserved c0 p0 S0 X r S0 c0 p0 X r T X r T T S0 p0 c0 By using the symbols and the signs in these versions of put–call parity, we can see several important interpretations In the equations below, plus signs mean long and minus signs mean short: T long put long call, short asset, long bondd T long call long put, long asset, short bond T c0 p0 X r long asset long call, short put, long bond S0 p0 c0 long bond long asset, long put, short call p0 c0 S0 X r c0 p0 S0 X r S0 T X r You should be able to convince yourself of any of these points by constructing a table similar to Exhibit 15.20 10.1 Put–Call–Forward Parity Recall that we demonstrated that one could create a risk-free position by going long the asset and selling a forward contract.21 It follows that one can synthetically create a position in the asset by going long a forward contract and long a risk-free bond Recall our put–call parity discussion and assume that Investor A creates his protective put in a slightly different manner Instead of buying the asset, he buys a forward contract and a risk-free bond in which the face value is the forward price Exhibit 17 shows that this strategy is a synthetic protective put Because we showed that the fiduciary call is equivalent to the protective put, a fiduciary call has to be equivalent to a protective put with a forward contract Exhibit 18 demonstrates this point Exhibit 17 Protective Put with Forward Contract vs Protective Put with Asset Outcome at T Put Expires In-the-Money (ST < X) Put Expires Out-of-the-Money (ST ≥ X) ST ST X ST Protective put with asset Asset Long put Total X – ST (continued) 20 As a further exercise, you might change the signs of each term in the above and provide the appropriate interpretations 21 You might wish to review Exhibit 6 262 Reading 46 ■ Basics of Derivative Pricing and Valuation Exhibit 17 (Continued) Outcome at T Put Expires In-the-Money (ST < X) Put Expires Out-of-the-Money (ST ≥ X) Protective put with forward contract Risk-free bond Forward contract Long put F0(T) F0(T) ST – F0(T) ST – F0(T) X ST X – ST Total Exhibit 18 Protective Put with Forward Contract vs Fiduciary Call Outcome at T Put Expires In-the-Money (ST < X) Call Expires In-the-Money (ST ≥ X) Protective Put with Forward Contract Risk-free bond F0(T) Forward contract F0(T) ST – F0(T) ST – F0(T) X ST Call Risk-free bond X ST – X Total X Long put X – ST Total Fiduciary Call X ST It follows that the cost of the fiduciary call must equal the cost of the synthetic protective put, giving us what is referred to as put–call–forward parity, T F0 T r p0 T c0 X r (13) Returning to our put–call parity example, a forward contract on ¥90,000 expiring in two months with a 2% interest rate would have a price of ¥90,000(1.02)0.167 = ¥90,298 Rearranging Equation 13, we have p0 c0 T êơX F0 T ẳ r The right-ưhand side is (Ơ100,000 ¥90,298)/(1.02)0.167 = ¥9,670, which is the same answer we obtained using the underlying asset rather than the forward contract Naturally these two models give us the same answer They are both based on the assumption that no arbitrage is possible within the spot, forward, and options markets So far we have learned only how to price options in relation to other options, such as a call versus a put or a call or a put versus a forward We need a way to price options versus their underlying Binomial Valuation of Options 263 EXAMPLE 7 Put–Call Parity Which of the following statements best describes put–call parity? A The put price always equals the call price B The put price equals the call price if the volatility is known C The put price plus the underlying price equals the call price plus the present value of the exercise price From put–call parity, which of the following transactions is risk-free? A Long asset, long put, short call B Long call, long put, short asset C Long asset, long call, short bond Solution to 1: C is correct The put and underlying make up a protective put, while the call and present value of the exercise price make up a fiduciary call The put price equals the call price for certain combinations of interest rates, times to expiration, and option moneyness, but these are special cases Volatility has no effect on put–call parity Solution to 2: A is correct The combination of a long asset, long put, and short call is risk free because its payoffs produce a known cash flow of the value of the exercise price The other two combinations not produce risk-free positions You should work through the payoffs of these three combinations in the form of Exhibit 12 BINOMIAL VALUATION OF OPTIONS n explain how the value of an option is determined using a one-period binomial model; Because the option payoff is determined by the underlying, if we know the outcome of the underlying, we know the payoff of the option That means that the price of the underlying is the only element of uncertainty Moreover, the uncertainty is not so much the value of the underlying at expiration as it is whether the underlying is above or below the exercise price If the underlying is above the exercise price at expiration, the payoff is ST – X for calls and zero for puts If the underlying is below the exercise price at expiration, the payoff is zero for calls and X − ST for puts In other words, the payoff of the option is straightforward and known, as soon as we know whether the option expires in- or out-of-the-money Note that for forwards, futures, and swaps, there is no such added complexity The payoff formula is the same regardless of whether the underlying is above or below the hurdle As a result of this characteristic of options, derivation of an option pricing model requires the specification of a model of a random process that describes movements in the underlying Given the entirely different nature of the payoffs above and below the exercise price, it might seem difficult to derive the option price, even if we could model movements in the underlying Fortunately, the process is less difficult than it first appears 11 ... Implications of the CAPM for Portfolio Construction Summary Practice Problems Solutions 52 8 53 0 53 2 53 2 53 4 53 4 53 6 53 7 53 7 53 9 54 0 54 1 54 2 54 3 54 6 54 7 54 8 54 8 54 9 55 1 55 2 55 2 55 3 55 4 55 7... the CFA Program curriculum, please visit www cfainstitute.org ORGANIZATION OF THE CURRICULUM The Level I CFA Program curriculum is organized into 10 topic areas Each topic area begins with a brief... (www.cfainstitute org/programs /cfa/ curriculum/ cbok); ■■ Topic area weights that indicate the relative exam weightings of the top-? ?level topic areas (www.cfainstitute.org/programs /cfa/ curriculum) ;
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