CFA Level II: Portfolio Management and Ethical & Professional Standards

Vocabulary practice flashcards covering Economics and Investment Markets, Active Portfolio Management, ETFs, Multifactor Models, Market Risk Measurement, Backtesting & Simulation, and Ethical & Professional Standards.

Inter-temporal Rate of Substitution

The ratio of an investor's marginal utility of consuming $1$ unit of real consumption in the future at time $t$ ($u_t$) to the marginal utility of current real consumption of $1$ unit ($u_0$), expressed as $m_t = \frac{u_t}{u_0}$.

Taylor Rule

A central bank policy formulation linking policy interest rates to inflation and output gaps: $r = R_n + \pi + 0.5(\pi - \pi^*) + 0.5(y - y^*)$, where $R_n$ is the neutral real policy rate, $\pi$ is current inflation, $\pi^*$ is the target inflation rate, $y$ is the log of current output, and $y^*$ is the log of target sustainable output.

Break-Even Inflation Rate (BEI)

The difference between the yield of a non-inflation-indexed risk-free bond and an inflation-indexed risk-free bond of the same maturity, consisting of expected inflation ($\pi$) and a risk premium for uncertainty about actual inflation ($\theta$): $\text{BEI} = \pi + \theta$.

Term Spread

The difference between the yield on a longer-term bond and the yield on a short-term bond, reflecting growth and inflation expectations as well as a risk premium for inflation uncertainty ($\theta$).

Credit Spread

The additional yield required on a credit-risky bond over a default-free bond of the same maturity, representing a risk premium ($\gamma$) that rises during economic downturns and narrows during expansions.

Shiller's CAPE

The cyclically adjusted price-to-earnings ratio that uses real (inflation-adjusted) stock prices in the numerator and a $10$-year moving average of real earnings in the denominator to smooth short-term earnings volatility over the business cycle.

Active Return

The value added by active management, measured ex-ante or ex-post as the difference between the return of an actively managed portfolio and the return of its benchmark portfolio ($R_A = R_P - R_B$).

Active Weight

The difference between an individual security's weighting in an actively managed portfolio ($w_{Pi}$) and its corresponding weighting in the benchmark portfolio ($w_{Bi}$), where the sum of active weights across all portfolio assets equals zero.

Information Ratio (IR)

A risk-adjusted performance measure defined as active return divided by active risk: $IR = \frac{R_P - R_B}{\sigma_{(R_P - R_B)}} = \frac{R_A}{\sigma_A}$, representing excess return generated per unit of benchmark tracking risk.

Closet Index Fund

A purportedly actively managed fund that closely mirrors its underlying benchmark index, resulting in a Sharpe ratio close to the benchmark, very low active risk, and an information ratio near zero or negative after management fees.

Information Coefficient (IC)

A measure of an investment manager's forecasting skill, defined ex-ante as the risk-weighted correlation between forecasted active returns and realized active returns.

Transfer Coefficient (TC)

The cross-sectional correlation between forecasted active returns and risk-adjusted actual active portfolio weights, measuring the degree to which portfolio constraints prevent the implementation of unconstrained optimal weights (equal to $1.0$ for unconstrained portfolios).

Breadth (BR)

The number of independent active investment decisions or bets made by a portfolio manager per year.

Authorized Participant (AP)

A large broker-dealer that serves as a primary market participant with the exclusive ability to create or redeem ETF shares in-kind directly with the ETF sponsor in large blocks known as creation units.

Arbitrage Gap

The price band surrounding an ETF's net asset value (NAV) within which the ETF trades on secondary markets without triggering arbitrage by authorized participants, determined by transaction costs, creation/redemption fees, and carry risk.

Tracking Error (ETF)

The annualized standard deviation of the daily tracking difference between the total return of an ETF and the return of its tracked benchmark index.

Exchange-Traded Note (ETN)

An unsecured, unsubordinated debt instrument issued by a financial institution that promises to pay the return of a designated index less management fees, exposing the investor directly to the issuer's counterparty credit risk.

Arbitrage Pricing Theory (APT)

An asset pricing model that relates expected returns on well-diversified portfolios to multiple systematic risk factors, based on three assumptions: returns follow a factor model, unsystematic risk can be diversified away, and no arbitrage opportunities exist.

Macroeconomic Factor Model

A multifactor model in which asset returns are modeled as a linear function of unexpected surprises (deviations of realized values from consensus forecasts) in macroeconomic variables, such as GDP growth, inflation, and interest rate spreads.

Fundamental Factor Model

A multifactor model where asset returns are explained by firm-specific fundamental attributes (e.g., P/E, market capitalization, leverage) through standardized sensitivities and factor-mimicking portfolio returns.

Standardized Sensitivity

The factor exposure in a fundamental factor model, measured as the number of standard deviations an asset's attribute deviates from the cross-sectional mean: $b_{i} = \frac{\text{Attribute}_i - \overline{\text{Attribute}}}{\sigma_{\text{Attribute}}}$.

Active Specific Risk

The portion of active risk (tracking error variance) attributable to asset selection within asset classes rather than factor exposures, calculated as $\sum_{i=1}^n (w_{Pi} - w_{Bi})^2 \sigma_{\varepsilon i}^2$.

Active Factor Risk

The component of active risk squared resulting from differences between a portfolio's factor sensitivities and the benchmark's sensitivities to systematic factors, calculated as total active risk squared minus active specific risk.

Factor Portfolio

A portfolio deliberately constructed to have a sensitivity of $1.0$ to a single specified risk factor and sensitivities of zero to all other risk factors in the model, used for hedging or targeted factor bets.

Tracking Portfolio

A portfolio designed to replicate the systematic factor exposures of a specific target benchmark while holding a different combination of individual securities.

Carhart Four-Factor Model

A multifactor extension of the Fama-French three-factor model that adds momentum (WML: winners minus losers) to market risk (RMRF), size (SMB: small minus big), and value (HML: high minus low book-to-market).

Value at Risk (VaR) on a Return Distribution

The threshold value ($X$) defining the left-hand tail boundary of a return distribution, representing the minimum dollar or percentage loss expected to occur over a specific period at a given probability level (such as $5\%$).

Parametric VaR Method

An approach to estimating Value at Risk (also known as the variance-covariance method) that computes portfolio downside risk using estimated means, variances, and covariances of underlying risk factors, typically assuming a normal distribution.

Conditional VaR (CVaR)

A downside risk measure (also called expected tail loss or expected shortfall) that computes the expected loss given that the loss equals or exceeds the Value at Risk threshold.

Incremental VaR (IVaR)

The change in a portfolio's total Value at Risk that occurs when an existing portfolio position size is adjusted or a new security is introduced.

Marginal VaR (MVaR)

The partial derivative (slope) of portfolio Value at Risk with respect to a security's weight, providing an estimate of the change in portfolio VaR for a $1\%$ incremental change in asset allocation.

Active Share

A measure of active management calculated as half the sum of absolute differences between the portfolio weights and benchmark weights across all securities in the investment universe.

Surplus-at-Risk

A risk metric used by defined benefit pension funds that calculates the Value at Risk of the fund's surplus, where surplus equals plan assets minus the present value of projected liabilities.

Risk Budgeting

A continuous risk management framework in which an organization establishes an aggregate acceptable level of risk and subsequently allocates that risk across various business units, strategies, or asset classes.

Stop-Loss Limit

A risk management rule requiring that an investment position or portfolio exposure be reduced, hedged, or liquidated if cumulative losses surpass a designated amount over a defined time frame.

Rolling Window Backtesting

A walk-forward testing framework where factor signals and model parameters are continuously calibrated across a moving historical data window and evaluated against subsequent out-of-sample periods to simulate real-world trading.

Survivorship Bias

A distortion in backtesting and historical analysis that arises from evaluating only those companies, securities, or funds that have persisted until the end of the sample period, excluding those that became defunct, merged, or delisted.

Look-Ahead Bias

A backtesting error that occurs when an investment simulation uses data or information that was not yet known or available at the exact point in time when the simulated trade was executed.

Point-in-Time Data

A historical dataset recording the exact information, financial statements, and prices as they were originally known to market participants on a given historical date, excluding subsequent revisions, restatements, or survivorship filters.

Bootstrapping (Simulation)

A non-parametric statistical resampling technique in historical simulation where sample observations are drawn repeatedly at random with replacement from the historical return series.

Tail Dependence Coefficient

A statistical parameter that measures the propensity of two random variables to experience extreme co-movements within their distribution tails, helping prevent underestimation of joint downside risk.

Mosaic Theory

The framework under Standard II(A) permitting financial analysts to formulate investment conclusions and trade without violating insider-trading rules by synthesizing public information with nonmaterial nonpublic information.

Soft Dollars (Client Brokerage)

Commissions generated from client transactions that are directed to a broker-dealer to obtain research or brokerage services that must directly benefit the client rather than the investment manager.

Investment Policy Statement (IPS)

A formal written document between an advisor and client outlining the client's investment objectives (return and risk tolerance) and constraints (liquidity, time horizon, tax, legal, and unique circumstances) used to assess investment suitability.

Front Running

The unethical and prohibited practice of entering personal transactions in advance of pending client or employer trades, violating Standard VI(B) Priority of Transactions.