CFA Level III · Cheat Sheet
| Concept | Definition / Key Point | ||
|---|---|---|---|
| Efficient Frontier | Set of portfolios with max return per unit risk; represents optimal risk-return tradeoff | ||
| Error Maximization | MVO's primary weakness: small input errors → extreme concentration. Solution: Black-Litterman, resampling, constraints | ||
| Black-Litterman | Bayesian blend of CAPM equilibrium prior + investor views → balanced, diversified portfolios | ||
| Resampling | Monte Carlo: simulate many input sets → compute optimal portfolio for each → average results → stable weights | ||
| Capital Market Line (CML) | Line from risk-free rate to tangency portfolio; dominates efficient frontier when borrowing/lending available | ||
| Tangency Portfolio | Risky portfolio with highest Sharpe ratio; optimal risky holding when risk-free asset exists | ||
| Asset-Only MVO | Minimize portfolio variance; for investors with no liabilities | ||
| Asset-Liability MVO | Minimize surplus volatility (Var(Assets − Liabilities)); appropriate for pensions, insurers, liability-bearing investors | ||
| Method | Trigger | Pros | Cons |
| Calendar | Fixed interval (monthly, quarterly, yearly) | Simple, predictable | Over-rebalances when drift small; misses large drift between reviews |
| Threshold (% of Portfolio) | Asset class drifts beyond tolerance band (e.g., ±5% from target) | Responsive to market moves; avoids unnecessary costs | Monitoring required; complex implementation |
| Corridor (Range) | Rebalance when upper/lower bound breached | Combines simplicity with cost-efficiency | Corridor width is critical parameter |
| Driver | Effect on Corridor Width | ||
| ↑ Transaction costs | Widen corridor (reduce rebalancing frequency) | ||
| ↑ Asset volatility | Widen corridor (reduce false triggers from normal drift) | ||
| ↑ Correlation among assets | May narrow corridor (lower diversification loss from drift) | ||
| Account Type | Rebalancing Approach | ||
| Tax-deferred (401k, IRA, Roth) | Narrow corridors, frequent rebalancing (no tax cost) | ||
| Taxable | Widen corridors; redirect dividends/contributions to underweights; cross-account rebalancing; tax-loss harvesting | ||
| Scenario | Correct Answer | ||
| "Portfolio is 70% concentrated in one asset" | MVO error maximization (estimation error amplification) | ||
| "Pension fund choosing optimization method" | Asset-liability MVO (minimizes surplus volatility, not asset variance) | ||
| "Risk-free asset introduced" | Optimal is tangency portfolio + risk-free asset (CML dominates) | ||
| "Minimize tax impact of rebalancing" | Redirect new flows to underweights; harvest losses; cross-account rebalance | ||
| "High transaction costs; high volatility assets" | Wider rebalancing corridor justified | ||
| Pair | Distinction | ||
| Asset-Only vs Asset-Liability MVO | Asset-only minimizes portfolio variance; asset-liability minimizes surplus variance (Var(A−L)) | ||
| Black-Litterman vs Resampling | BL: Bayesian blend of equilibrium + views; Resampling: Monte Carlo averaging across simulated input sets | ||
| Calendar vs Threshold Rebalancing | Calendar: fixed schedule; Threshold: event-driven when weight band breached | ||
| CML vs Efficient Frontier | CML includes risk-free asset; dominates frontier when borrowing/lending available | ||
| Tangency Portfolio vs Min-Variance Portfolio | Tangency: highest Sharpe ratio (with risk-free asset); Min-variance: lowest variance only |
Aligned to the CFA Institute Level III curriculum.
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