2017 Level III Formulas

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Graphs, charts, tables, examples, and figures are copyright 2016, CFA Institute.
Reproduced and republished with permission from CFA Institute. All rights reserved.
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 Comments and Instructions
This document is a compilation of what I believe are the most important formulas for Level III. It
does not list the facts which you must know in order to clear the exam. These facts are covered in
our Level III crash course which is available for sale.

No formula sheet can be 100% comprehensive. This formula sheet is no exception. However, it can
serve as a good starting point. Print this document and add your notes/comments. Specifically,
after every practice test look at this sheet and add formulas or comments which you think will be
helpful. This document might start out as an IFT formula sheet but it should end up with many of
your notes. If you have suggestions for improving this document please write to us at:
[email protected]

Do a lot of practice over the last few days and good luck on your exam.

Regards,
Arif Irfanullah, CFA

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 Taxes and Private Wealth Management (1/2)
Future value factor
Returns-based taxes: accrual taxes on interest and dividends FVIFi = [1 + r(1 – ti)]n

Returns-based taxes: deferred capital gains FVIFcgb = (1 + r)n(1 – tcg) + tcgB

Wealth-based taxes FVIFw = [(1 + r)(1 – tw)]n

Blended Tax Environment Formulas

Annual return after realized taxes r* = r (1 – pi ti – pd td – pcg tcg)
Effective capital gains tax rate T* = tcg(1 – pi – pd – pcg)/(1 – piti – pdtd – pcgtcg)
Future after-tax accumulation for each FVIFTaxable = (1 + r*)n(1 – T*) + T* – (1 – B)tcg  
unit of currency in a taxable portfolio
Accrual-equivalent return If we start with 100 and end with an after-tax amount of 139
after 5 years then: 100(1 + RAE)5 = 139
Accrual-equivalent tax rate r(1 – TAE) = RAE

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 Taxes and Private Wealth Management (2/2)
Description Future Value
Taxable Account Contributions are after-tax Discussed previously.
Returns are taxed

Tax-Deferred Contribution are pre-tax 𝐅𝐕𝐈𝐅𝐓𝐃𝐀 = 𝟏 + 𝒓 𝒏 (𝟏 − 𝑻𝒏 )

Accounts (TDAs) Returns accumulate on tax-deferred basis until
funds are withdrawn; taxed at ordinary rates
Tax-Exempt Contributions are after-tax 𝐅𝐕𝐈𝐅𝐓𝐚𝐱𝐄𝐱 = 𝟏 + 𝒓 𝒏

Accounts Returns are not taxed

Investors after-tax risk = ζ (1 - T)

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 Estate Planning in a Global Context (1/2)

𝑵 𝐩 𝐒𝐮𝐫𝐯𝐢𝐯𝐚𝐥 ×𝐒𝐩𝐞𝐧𝐝𝐢𝐧𝐠 𝐣
Core capital = 𝒋=𝟏 𝟏+𝐫 𝐣

If tax is paid by recipient:

If the tax is paid by the donor:

1
Relative value of generation skipping =
(1 − tax rate of capital transferred from 1st to 2nd generation)

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 Estate Planning in a Global Context (2/2)
Methods used to Example: Tax imposed by a residence country on
provide double Tax liability worldwide income is 40%; tax imposed by foreign
taxation relief government on foreign-sourced income is 30%.
Max [40%, 30%]  Tax-payer will pay 40%.

Credit method Max [TResidence, TSource] Out of 40%

• 30% will be paid to foreign-government.
• 10% will be paid to domestic government.
Exemption
TSource 30% collected by foreign government.
method
0.40 + 0.30 – (0.40 × 0.30) = 58%

Deduction Out of 58%

TResidence + TSource – (TResidence × TSource) • 30% will be paid to foreign-government.
method
• 28% [i.e. 0.40 – (0.40 × 0.30)] will be paid to residence or
domestic country.

Double taxation treaties may help resolve residence-source and residence-residence conflicts but not source-source conflict.

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Risk Management for Individuals

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 Managing Institutional Investor Portfolios

DB Plan liquidity requirement: Net cash outflow = Benefit Payments – Pension Contributions

Foundations or endowment long-term return = Spending rate + Admin cost + Inflation

Endowment simple spending rule: Spendingt = Spending rate × Ending market valuet–1

Endowment rolling three-year average spending rule:

Spendingt = Spending rate × (1/3)[Ending market valuet–1 + Ending market valuet–2 + Ending market valuet–3]

Endowment geometric smoothing rule:

Spendingt = Smoothing rate × [Spendingt–1 × (1 + Inft–1)] + (1 – Smoothing rate) × (Spend. rate × Beg. market
valuet–1)

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 Capital Market Expectations (1/3)

Shrinkage estimators: [(weight × historical parameter estimate) + (weight × target parameter estimate)]

DCF model:

Gordon growth model:

Nominal GDP = Real growth rate in GDP + Expected long-run inflation rate

Earnings growth rate = Nominal GDP growth rate + Excess Corporate growth (for the index companies)

Grinold-Kroner model:

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 Capital Market Expectations (2/3)

Risk-premium approach:
• Expected bond return = Real risk-free interest rate + inflation premium + default risk premium + illiquidity
premium + maturity premium + tax premium
• Expected equity return = YTM on a long-term government bond + Equity risk premium

ICAPM: E (Ri) = RF +βi [E (RM) – RF]

With perfect integration: RPi = [(ζi) x (ρi, M) x (Sharpe ratio of GIM)] + Illiquidity premium

With complete segmentation: RPi = [(ζi) x Sharpe ratio of GIM)] + Illiquidity premium

Sharpe ratio = risk premium / standard deviation

Singer-Terhaar approach:
Risk premium = (Degree of integration × risk premium under perfectly integrated markets)
+ ({1 - degree of integration} × risk premium under perfectly segmented markets)

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 Capital Market Expectations (3/3)

Output gap = Trend GDP – Actual GDP

Taylor rule equation: Roptimal = Rneutral + [0.5 × (GDPgforecast – GDPgtrend)] + [0.5 × (Iforecast – Itarget)]

Trend growth in GDP = Growth from labor inputs + Growth from changes in labor productivity

Growth from changes in labor productivity = Growth from capital inputs + Total factor productivity growth

Growth from labor inputs = Growth in potential labor force size + Growth in actual labor force participation

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 Equity Market Valuation

Estimated percentage change in real GDP:

Intrinsic Value of an equity market: and

Fed Model:

Yardeni Model:

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 Asset Allocation

Utility adjusted return: U = E(R) − 0.005RA σ2

Safety-first ratio = (Expected return – threshold level) / σ

Test for adding a new asset class to investor portfolio:

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 Currency Management: An Introduction (1/2)

Domestic-currency return:

Total risk of the domestic-currency returns:

Under uncovered interest rate parity (assuming base currency in the P/B quote as the low-yield
currency): % change in the spot exchange rate = Interest rate on high-yield currency – Interest rate on
low-yield currency

Forward rate bias:

Net delta of the combined position = Option delta + Delta hedge

Size of delta hedge (that would set net delta of the overall position to 0) = Option’s delta × Nominal size
of the contract

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 Currency Management: An Introduction (2/2)

Hedge ratio = Nominal value of hedging instrument / market value of hedged asset

S.D.(RDC )
Minimum or optimal hedge ratio = Correlation (R DC ; R FX ) × S.D.(RFX )

Long position in a risk reversal = Long position in a call option + Short position in a put option

Short position in a risk reversal = Long position in a put option + Short position in a call option

Short seagull position = Long protective put + Short deep-OTM call option + Short deep-OTM put option

Long seagull position = Short protective put + Long deep-OTM call option + Long deep-OTM put option

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 Fixed Income Portfolio Management – Part I (1/3)
Steps to calculate Present value distribution (PVD) of cash flows:

1) % or weight of the index’s total market value attributable to cash flows falling in each period =
PV of cash flows from benchmark index for specific periods (say every 6 months)
PV of Total cash flows from benchmark

2) Contribution of each period’s cash flows to portfolio duration = Duration of each period × Weight of
index cash flows falling in specific period

Contribution of each period’s cash flows to portfolio duration

3) Benchmark’s PVD =
Index duration (i. e. , the sum of all the periods’ duration contributions)

Active Return = Portfolio’s Return – Benchmark Index’s Return

1
Active Return−Mean Active Return 2 2
Tracking Risk = Standard deviation of the Active Returns =
n−1

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 Fixed Income Portfolio Management – Part I (2/3)

𝐓𝐨𝐭𝐚𝐥 𝐅𝐮𝐭𝐮𝐫𝐞 𝐃𝐨𝐥𝐥𝐚𝐫𝐬 𝟏/𝒏

Semi-annual total return = − 𝟏
𝐅𝐮𝐥𝐥 𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐭𝐡𝐞 𝐁𝐨𝐧𝐝

Dollar Duration = Duration × Portfolio Value × 0.01

Portfolio’s Dollar Duration = Sum of dollar durations of the individual securities in the portfolio

Original or Old Dollar Duration

Rebalancing Ratio =
New Dollar Duration

Cash required for the rebalancing = (Rebalancing ratio – 1) × (total new market value of portfolio)

Market value of bond or sector in the Portfolio

Contribution of bond or sector „i‟ to the portfolio duration = ×
Total Portfolio Value
Effective Duration of bond or sector i

Net safety rate of return (Cushion Spread) = Immunized Rate – Minimum acceptable return

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 Fixed Income Portfolio Management – Part I (3/3)

Dollar safety margin = Current value of the bond portfolio – PV of the required terminal value at the new
interest rate

Economic surplus = Market value of assets – Present value of liabilities

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 Fixed Income Portfolio Management – Part II (1/3)
Duration of Assets ×Assets − Duration of Liabilities ×Liabilities
Duration of Equity = Equity

Profit on borrowed funds + Profit on Equity

Rp = Portfolio rate of return = =
Amount of Equity
Amount of borrowed funds × Return on funds invested – Cost of borrowing + Amount of Equity × Return on funds invested
Amount of Equity

Amount borrowed × Repo rate × Repo term

Dollar interest = 360

DT − DI PI
𝐀𝐩𝐩𝐫𝐨𝐱𝐢𝐦𝐚𝐭𝐞 𝐧𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐜𝐨𝐧𝐭𝐫𝐚𝐜𝐭𝐬 = × Conversion factor for the CTD bond
DCTD PCTD

Dollar duration of swap = Dollar duration of a fixed-rate bond – Dollar duration of floating rate bond

Duration of an option = Delta of option x duration of underlying x (price of underlying/price of option)

Duration of the bond to be hedged ×Price of the bond to be hedged
Hedge ratio = Duration of the Cheapest to Deliver bond ×Price of the Cheapest to Deliver bond × (Conversion factor for the
Cheapest to Deliver bond)
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 Fixed Income Portfolio Management – Part II (2/3)

Protective put = long position in the bond + buy a put option on the bond

Covered call = long position in the bond + sell a call option on the bond

Payoff function for in-the-money credit spread call option = (Spread at option maturity – Credit strike
spread) x NP x Risk factor

Payoff function for the buyer of a credit forward contract = (Credit spread at the forward contract maturity
– Contracted credit spread) × Notional amount × Risk factor

Basis = Cash (spot) price – Futures price

Change in foreign bond value (In terms of change in foreign yield only) = Duration × ∆ Foreign yield × 100

Change in foreign bond value (when domestic rates change) = Duration × Yield beta × ∆ Domestic yield × 100

∆ Yield Foreign = α + Yield beta or country beta (β) (∆ yield Domestic) +ε

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 Fixed Income Portfolio Management – Part II (3/3)
Estimated ∆ Yield Foreign = Yield beta × ∆ Domestic yield

short term interest rate in the domestic country−short term interest rate in foreign country
Forward Premium = 𝟏+ short term interest rate in foreign country

≈ Short term interest rate in the domestic country - Short term interest rate in foreign country

Unhedged return (R) = Foreign bond return in local currency terms + Currency return (or FC currency
appreciation)

Hedged return (HR) = Foreign bond return in local currency terms + Forward discount (premium) = id + (rl – if)

Hedged return (HR) = Domestic risk-free interest rate + Bond’s local risk premium

% ∆ Price
Breakeven Spread change = × 100
Duration

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 Equity Portfolio Management (1/2)
Active Return
Information Ratio = Tracking Risk or Active Risk

Risk-adjusted Expected Active Return (UA) = Expected or forecasted Active Return for the Manager
Structure (rA) – [Risk aversion with respect to active risk (λA) × variance of the active return (σ2A)]

Active weight = Stock’s weight in the actively managed portfolio – Stock’s weight in the benchmark

Fundamental Law of Active Management: Information Ratio

≈ Information Coefficient × Information Breadth

Rate of return of equitized market neutral strategy = (Gains/losses on the long & short securities positions +
Gains/losses on the long futures position + Interest earned by the investor on the cash from short sale) ÷
Portfolio Equity
n n

𝐏𝐨𝐫𝐭𝐟𝐨𝐥𝐢𝐨 𝐚𝐜𝐭𝐢𝐯𝐞 𝐫𝐞𝐭𝐮𝐫𝐧 = hAi rAi 𝐏𝐨𝐫𝐭𝐟𝐨𝐥𝐢𝐨 𝐚𝐜𝐭𝐢𝐯𝐞 𝐫𝐢𝐬𝐤 = h2Ai σ2Ai
i=1 i=1

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 Equity Portfolio Management (2/2)

Manager’s True Active return

True information ratio = Manager’s True Active risk

Manager‟s “true” active return = Manager’s return - Manager’s normal benchmark

Manager‟s “misfit” active return = Manager’s normal benchmark return - Investor’s benchmark

Total active risk = True Active Risk 2 + Misfit Active Risk 2

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 Alternative Investments Portfolio Management
Roll return = Change in futures contract price – Change in spot price

n 2
1 min returnt , threshold, 0
𝐃𝐨𝐰𝐧𝐬𝐢𝐝𝐞 𝐝𝐞𝐯𝐢𝐚𝐭𝐢𝐨𝐧 =
n−1

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 Risk Management
Mean portfolio return − Risk free rate
𝐒𝐡𝐚𝐫𝐩𝐞 𝐑𝐚𝐭𝐢𝐨 =
Standard deviation of portfolio return

Expected return on an investment

Risk-Adjusted Return on Capital (RAROC) = Measure of capital at risk

Average annual return

Return over Maximum Drawdown (RoMAD) = Drawdown

(Mean portfolio return – MAR)

Sortino Ratio = Downside deviation

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 Risk Management Applications of Forward and Futures Strategies

𝛽𝑇 − 𝛽𝑆 𝑆
# of futures contracts needed to change a portfolio‟s beta: 𝑁𝑓 =
𝛽𝑓 𝑓

𝑇
𝑉 1+𝑟
# of futures contracts required to create a synthetic equity position: 𝑁𝑓 =
𝑞𝑓

𝑇
𝑉 1+𝑟
Synthetic position in cash can be created by selling futures contracts: 𝑁𝑓 = −
𝑞𝑓

Investing V* in bonds and buying Nf* futures contracts at a price of f is equivalent to buying = Nf*q/(1 + δ)T
units of stock

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 Risk Management Applications of Options Strategies (1/5)
Covered Call = Underlying + short call option Protective Put = Underlying + long put option
 Value at expiration: VT = ST – max(0, ST – X)  Value at expiration: VT = ST + max(0, X – ST)
 Profit: Π = VT – S0 + c0  Profit: Π = VT – S0 – p0
 Maximum profit = X – S0 + c0  Maximum profit = ∞
 Maximum loss = S0 – c0  Maximum loss = S0 + p0 – X
 Breakeven: ST* = S0 – c0  Breakeven: ST* = S0 + p0

Bull Spread = Long call with exercise price X1 + short Bear Spread = Short call with low exercise price
call with higher exercise price X2. X1 + long call with high exercise price X2.
 Value at expiration: VT = max(0, ST – X1) – max(0, ST – X2)  Value at expiration: VT = max(0, X2 – ST) – max(0,
 Profit: Π = VT – c1 + c2 X1 – ST)

 Maximum profit = X2 – X1 – c1 + c2  Profit: Π = VT – p2 + p1

 Maximum loss = c1 – c2  Maximum profit = X2 – X1 – p2 + p1

 Breakeven: ST* = X1 + c1 – c2  Maximum loss = p2 – p1

 Breakeven: ST* = X2 – p2 + p1
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 Risk Management Applications of Options Strategies (2/5)
Butterfly Spread = Bull spread + bear spread
 Value at expiration: VT = max(0, ST – X1) – 2max(0, ST – X2) + max(0, ST – X3)
 Profit: Π = VT – c1 + 2c2 – c3
 Maximum profit = X2 – X1 – c1 + 2c2 – c3
 Maximum loss = c1 – 2c2 + c3
 Breakeven: ST* = X1 + c1 – 2c2 + c3 and ST* = 2X2 – X1 – c1 + 2c2 – c3

Collar = Underlying + long put + short call Straddle = Underlying + long call + long put with the
same exercise price and same expiration
 VT = ST + max(0, X1 – ST) – max(0, ST – X2)  VT = max(0, ST – X) + max(0, X – ST)
 Profit: Π = VT – S0  Profit: Π = VT – (c0 + p0)
 Maximum profit = X2 – S0  Maximum profit = ∞
 Maximum loss = S0 – X1  Maximum loss = c0 + p0
 Breakeven: ST* = S0  Breakeven: ST* = X ± (c0 + p0)

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 Risk Management Applications of Options Strategies (3/5)

Box Spread
 Value at expiration: VT = X2 – X1
 Profit: Π = X2 – X1 – (c1 – c2 + p2 – p1)
 Maximum profit = (same as profit)
 Maximum loss = (no loss is possible, given fair option prices)
 Breakeven: no breakeven

Pay-off of an interest rate call option = (Notional principal) × max (0, Underlying rate at expiration –
Days in underlying rate
Exercise rate) × 360

Pay-off of an interest rate Put Option = (Notional principal) × max (0, Exercise rate - Underlying rate at
Days in underlying rate
expiration) × 360

Effective rate on the loan = {(NP + Effective interest) / effective loan proceeds} 365 / Days in underlying rate – 1

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 Risk Management Applications of Options Strategies (4/5)

Interest Rate Cap with a Floating-Rate Loan

Days in settlement period
Loan interest = Notional Principal × (LIBOR on previous reset date + 100 bps) × 360

Days in settlement period

Cap pay-off = Notional Principal × (0, LIBOR on previous reset date – Exercise rate) × 360

Effective Interest = Interest due on the loan – Caplet pay-off

Interest Rate Floor with a Floating-Rate Loan

Days in settlement period

Loan interest = Notional Principal × (LIBOR on previous reset date + 100 bps) ×
360
Days in settlement period
Cap pay-off = Notional Principal × (0, Exercise rate - LIBOR on previous reset date) × 360
Effective Interest = Interest due on the loan + Floorlet pay-off

Change in option price To delta hedge a call option position, the number of
𝐃𝐞𝐥𝐭𝐚 =
Change in underlying price shares to purchase = 𝑁𝑐 = − 1
𝑁𝑆 ∆𝑐 ∆𝑆
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Risk Management Applications of Options Strategies (5/5)

Delta of option 2
Ratio Spread: Desired quantity of option 1 relative to option 2 = Delta of option 1

Change in delta
𝐆𝐚𝐦𝐦𝐚 =
Change in underlying price

Change in Option price

Vega =
Change in Volatility of the underlying

Risk Management Applications of Swap Strategies

Notional principal of swap = Portfolio value * (Target duration – Original duration) / Swap duration

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 Execution of Portfolio Decisions (1/2)

Mid-quote = (Market Bid + Market Ask) / 2

Quote spread = Ask price – Bid price

Effective spread (for Buy) = 2 × (Execution Price – Midquote)

Effective spread (for Sell) = 2 × (Midquote - Execution Price)

Share Volume Weighted Effective Spread = [(Volume of shares traded for order 1 × Effective spread of
order 1) + (Volume of shares traded for order 2 × Effective spread of order 2) +⋯+ (Volume of shares traded
for order n × Effective spread of order n)]/n

Market-adjusted Implementation Shortfall = Implementation cost – Predicted return estimated using

market model

Trade Size Relative to Available Liquidity =

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 Execution of Portfolio Decisions (2/2)

Realized profit/loss = Execution price – Relevant decision price

Delay costs =

Missed Trade Opportunity Cost =

Implementation Cost = Commissions & Fees as % + Realized profit or loss + Delay costs + Missed trade
opportunity costs

Estimated Implicit Costs for “Buy” = Trade Size × (Trade Price – Benchmark Price)

Estimated Implicit Costs for “Sale” = Trade Size × (Benchmark Price - Trade Price)

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 Monitoring and Rebalancing

Portfolio value = Investment in stocks + Floor value

Portfolio return = Percent in stock × Return on stocks

Cushion = Investment in stocks = Portfolio value – Floor value

Target Investment in Stocks under Constant Mix Strategy = Target proportion in stocks × Portfolio Value

Target Investment in Stocks under Constant Proportion Strategy = Target proportion in stocks ×
(Portfolio Value – Floor value)

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 Evaluating Portfolio Performance (1/2)
Account‟s rate of return during evaluation period „t‟ when a
contribution is received at the start of the period:

Account‟s rate of return during evaluation period „t‟ when a

contribution is received at the end of the evaluation period:

Time-weighted rate of return: rtwr = (1 + rt,1) × (1 + rt,2) × … × (1 + rt,n) – 1  

Style = Manager’s benchmark portfolio - Market index

Active management = Manager’s portfolio – Benchmark

Portfolio return = Market Index + Style + Active Management

Active position = Security weight in portfolio – Weight in benchmark

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 Evaluating Portfolio Performance (2/2)
Value-added return on a long-short portfolio = Portfolio Return – Benchmark Return

Impact = Active weight × return

Pure sector allocation =

Number of sectors
j=1 Portfolio weight of sector j − Benchmark weight of sector j × (Benchmark return of sector j − Retu

Within sector selection =

Number of sectors
j=1 Benchmark weight of sector j × (Portfolio return of sector j − Benchmark return of sector j)

Allocation/selection Interaction =
Number of sectors
j=1 Portfolio weight of sector j − Benchmark weight of sector j × (Portfolio return of sector j − Bench

Treynor‟s measure =
Portfolio average return−Risk free rate 𝐌 𝟐 = Risk-free rate + Portfolio return−risk free rate
Total risk or S.D.of portfolio returns
×
Beta of portfolio return i.e.systematic risk
market return
Portfolio average return−Risk free rate
Sharpe ratio = 𝑅𝐴 ⎯ 𝑅𝐵
Total risk or S.D.pf returns 𝐈𝐧𝐟𝐨𝐫𝐦𝐚𝐭𝐢𝐨𝐧 𝐑𝐚𝐭𝐢𝐨 = IR A =
𝜎𝐴−𝐵
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 Overview of the Global Investments Performance Standards (1/2)

Geometrically link sub-period returns = rtwr = (1 + rt,1) × (1 + rt,2) × ... × (1 + rt,n) − 1  

For periods beginning on or after 1 January 2005

𝑉1 − 𝑉0 − 𝐶𝐹 𝐶𝐷 − 𝐷𝑖
Time-weighted return using Modified Dietz method = 𝑟𝑀𝑜𝑑𝐷𝑖𝑒𝑡𝑧 = 𝑤ℎ𝑒𝑟𝑒, 𝑤𝑖 =
𝑉0 + 𝑛𝑖=1 𝐶𝐹𝑖 × 𝑤𝑖 𝐶𝐷

For periods prior to 1 January 2005

𝑉1 − 𝑉0 − 𝐶𝐹
Time−weighted return = 𝑟𝐷𝑖𝑒𝑡𝑧 =
𝑉0 + (𝐶𝐹 × 0.5)

𝑛
Sum of beginning assets and weighted external cash flows = 𝑉𝑝 = 𝑉0 + 𝑖=1(𝐶𝐹𝑖 × 𝑤𝑖 )

𝑉0,𝑝𝑖
Beginning assets weighting method composite return = 𝑟𝐶 = 𝑟𝑝𝑖 × 𝑛
𝑝𝑖=1 𝑉0,𝑝𝑖

𝑉𝑝𝑖
Beginning assets plus weighted cash flows method composite return = 𝑟𝑐 = 𝑟𝑝𝑖 × 𝑉𝑝𝑖

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 Overview of the Global Investments Performance Standards (2/2)
𝑛 𝑤𝑖
MIRR: EMV = 𝑖=1 𝐹𝑖 1 + R + BMV (1 + R)

EMV −BMV
Daily valuation method = BMV

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Practice, Practice, Practice.

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