This independent Quick Reference is for candidates preparing for the Canadian Securities Institute CSI Advanced Investment Strategies (AIS) exam, code AIS. Use it to review strategy selection, risk controls, derivatives payoffs, portfolio calculations, alternative investments, and applied suitability traps.
High-Yield Strategy Map
| Client objective or problem | Common strategy tools | What the exam may test | Key trap |
|---|
| Enhance income | Covered calls, dividend equities, preferred shares, credit bonds, income funds, REITs | Income stability, tax character, call risk, credit risk | Higher yield usually means higher risk, lower liquidity, or embedded leverage |
| Protect downside | Protective puts, collars, diversification, duration management, cash equivalents, guaranteed/structured products | Difference between hedging and eliminating risk | A covered call is not meaningful downside protection |
| Reduce volatility | Asset allocation, low-correlation assets, options collars, market-neutral strategies | Correlation, beta, standard deviation, VaR limits | Correlations can rise in stressed markets |
| Hedge equity market risk | Index futures, index options, inverse exposure, beta adjustment | Number of contracts, basis risk, partial hedge | A hedge may reduce upside as well as downside |
| Hedge currency exposure | FX forwards/futures, currency-hedged funds, natural hedges | Direction of hedge, interest-rate differential, basis risk | Hedging currency does not hedge the underlying investment |
| Generate tactical exposure | Futures, ETFs, swaps, options, tactical asset allocation | Leverage, liquidity, mark-to-market, margin calls | Low initial capital does not mean low risk |
| Manage interest-rate risk | Duration matching, immunization, barbell/bullet/ladder, swaps, bond futures | Price-yield relationship, convexity, yield curve shifts | Duration works best for small, parallel yield changes |
| Improve tax efficiency | Asset location, capital gains orientation, loss harvesting, registered accounts | After-tax return, income character, timing | Tax strategy must not override suitability |
| Add alternative return drivers | Hedge funds, private equity, real estate, commodities, infrastructure | Illiquidity, valuation, leverage, due diligence | Low reported volatility can reflect stale pricing |
| Transfer credit risk | Credit derivatives, diversification, quality upgrades | Counterparty and credit-event risk | Hedging one risk can introduce another |
Use formulas as decision tools, not memorized decoration. Know what each input means and what assumption is being made.
Return, Risk, and Diversification
\[
E(R_p)=\sum_{i=1}^{n} w_iE(R_i)
\]\[
\sigma_p^2=\sum_{i=1}^{n}w_i^2\sigma_i^2+\sum_{i=1}^{n}\sum_{j\ne i}w_iw_j\operatorname{Cov}(R_i,R_j)
\]\[
\operatorname{Cov}(R_i,R_j)=\rho_{ij}\sigma_i\sigma_j
\]
| Concept | Exam meaning | Watch for |
|---|
| Standard deviation | Total volatility around mean return | Penalizes upside and downside volatility equally |
| Variance | Standard deviation squared | Less intuitive but used in portfolio math |
| Correlation | Degree to which returns move together | Low or negative correlation drives diversification benefit |
| Covariance | Direction and magnitude of co-movement | Scale-dependent; correlation is easier to compare |
| Systematic risk | Market-wide, non-diversifiable risk | Measured by beta for equity-market exposure |
| Unsystematic risk | Security-specific risk | Can be reduced through diversification |
| Tracking error | Volatility of active return versus benchmark | Low tracking error does not guarantee positive alpha |
| Drawdown | Decline from peak to trough | Often more intuitive for clients than standard deviation |
| VaR | Estimated loss threshold at a confidence level and horizon | Not a maximum loss; tail losses can exceed VaR |
Beta, CAPM, and Alpha
\[
\beta_i=\frac{\operatorname{Cov}(R_i,R_m)}{\sigma_m^2}
\]\[
E(R_i)=R_f+\beta_i[E(R_m)-R_f]
\]\[
\alpha_p=R_p-\left[R_f+\beta_p(R_m-R_f)\right]
\]
| Measure | Plain-English use | Formula in words | Better for | Weakness |
|---|
| Sharpe ratio | Excess return per unit of total risk | Excess return / standard deviation | Diversified portfolios | Can be distorted by non-normal or smoothed returns |
| Treynor ratio | Excess return per unit of market risk | Excess return / beta | Well-diversified portfolios | Not useful when beta is unstable or inappropriate |
| Jensen’s alpha | Return above CAPM-required return | Actual return minus CAPM return | Manager skill review | Depends on benchmark and beta estimate |
| Information ratio | Active return per unit of active risk | Active return / tracking error | Active management | High value may reflect benchmark mismatch |
| Sortino ratio | Excess return per unit of downside risk | Excess return / downside deviation | Asymmetric return strategies | Requires a defined target or minimum acceptable return |
Suitability Framework for Advanced Strategies
Advanced strategies are rarely tested as “good” or “bad.” They are tested as suitable or unsuitable for a specific client.
| Suitability factor | Questions to ask | Strategy implications |
|---|
| Objective | Income, growth, preservation, hedging, speculation, tax efficiency? | Match payoff profile to objective |
| Risk tolerance | What volatility and loss can the client emotionally accept? | Avoid naked short options or leverage for low tolerance |
| Risk capacity | What loss can the client financially withstand? | Capacity may be lower than stated tolerance |
| Time horizon | When will funds be needed? | Illiquid alternatives and long lockups need long horizons |
| Liquidity needs | Are withdrawals predictable or uncertain? | Avoid illiquid products for near-term cash needs |
| Knowledge and experience | Does client understand leverage, derivatives, liquidity, margin? | Complex products require extra explanation |
| Tax position | Registered or non-registered? Income or capital gains preference? | Consider asset location and after-tax return |
| Concentration | Existing employer stock, sector, currency, real estate exposure? | Hedging or diversification may be higher priority |
| Constraints | Ethical, legal, regulatory, family, estate, borrowing limits? | Strategy must respect stated constraints |
| Costs | Commissions, spreads, embedded fees, performance fees, financing? | Gross strategy return may not survive total costs |
Advanced Strategy Approval Checklist
Before choosing a derivative, alternative investment, or structured product, confirm:
- The client can explain the basic payoff in plain language.
- Maximum loss, liquidity limits, and margin or funding obligations are understood.
- The strategy addresses a documented objective, not just a product feature.
- The recommendation considers tax character, costs, and account type.
- The strategy does not create hidden concentration, currency, counterparty, or leverage risk.
- The benchmark used to evaluate the strategy matches the strategy’s risk exposures.
Options Quick Reference
Option Position Payoffs
| Position | Market outlook | Maximum gain | Maximum loss | Breakeven at expiry | Main use |
|---|
| Long call | Bullish, wants leverage | Unlimited | Premium paid | Strike + premium | Upside participation with limited loss |
| Short call, uncovered | Neutral to bearish | Premium received | Unlimited | Strike + premium | Income/speculation; high risk |
| Long put | Bearish or wants insurance | Strike minus premium if asset goes to zero | Premium paid | Strike - premium | Downside protection or bearish view |
| Short put | Neutral to bullish | Premium received | Strike - premium if asset goes to zero | Strike - premium | Income or potential entry strategy |
| Covered call | Neutral to mildly bullish | Strike - stock cost + premium | Stock downside less premium | Stock cost - premium | Income enhancement on owned stock |
| Protective put | Bullish but wants floor | Upside less premium | Stock cost - strike + premium | Stock cost + premium | Portfolio insurance |
| Collar | Wants downside floor and accepts upside cap | Limited by short call | Limited by long put floor | Depends on net premium | Cost-controlled protection |
| Bull call spread | Moderately bullish | Strike width - net debit | Net debit | Lower strike + net debit | Defined-risk bullish exposure |
| Bear put spread | Moderately bearish | Strike width - net debit | Net debit | Higher strike - net debit | Defined-risk bearish exposure |
| Long straddle | Expects large move or high volatility | Large upside or downside | Total premiums paid | Strike plus/minus total premium | Volatility purchase |
| Short straddle | Expects little movement | Total premiums received | Large or unlimited | Strike plus/minus total premium | Volatility sale; high risk |
Put-Call Parity
For European-style options with the same underlying, strike, and expiry:
\[
C-P=S_0-\operatorname{PV}(K)-\operatorname{PV}(\text{expected dividends})
\]
| If this changes | Typical effect |
|---|
| Underlying price rises | Call value rises; put value falls |
| Strike price rises | Call value falls; put value rises |
| Time to expiry increases | Usually increases option time value, especially for long options |
| Volatility rises | Calls and puts generally increase in value |
| Interest rates rise | Calls tend to rise; puts tend to fall, all else equal |
| Expected dividends rise | Calls tend to fall; puts tend to rise |
Option Strategy Selection
| View | Lower-risk expression | Higher-risk expression | Avoid if |
|---|
| Strong bullish | Long call, bull call spread | Leveraged stock or uncovered short put | Client cannot lose full premium or handle leverage |
| Mild bullish / income | Covered call, cash-secured short put | Uncovered short options | Client needs full upside |
| Strong bearish | Long put, bear put spread | Short sale, uncovered short call | Client cannot tolerate fast losses |
| Wants protection | Protective put, collar | Stop-loss order only | Client requires guaranteed floor at a specific level |
| Expects high volatility | Long straddle/strangle | Dynamic trading | Premiums are expensive or time decay is misunderstood |
| Expects low volatility | Covered call, short spread | Short straddle | Client cannot withstand gap risk |
Options Exam Traps
| Trap | Correct exam logic |
|---|
| “Buying options is always speculative.” | Long puts may be conservative insurance; long calls can define risk. |
| “Covered calls protect the portfolio.” | They provide limited premium cushion but leave most downside risk. |
| “Short options are low risk because probability of expiry is high.” | Loss severity can be large or unlimited. |
| “A collar is free protection.” | A zero-cost collar gives up upside through the short call. |
| “Stop-loss order equals protective put.” | A stop order may execute at a worse price; a put gives a contractual strike-based payoff at expiry. |
| “High implied volatility is good for option buyers.” | It raises premiums; buyers need a large enough move to overcome cost and time decay. |
Futures, Forwards, and Swaps
Futures and Forwards
| Feature | Futures | Forwards |
|---|
| Trading venue | Exchange-traded | Over-the-counter |
| Terms | Standardized | Customized |
| Settlement | Daily marking to market | Usually settled at maturity or by agreement |
| Counterparty risk | Reduced by clearinghouse structure | Direct counterparty exposure |
| Liquidity | Often higher for standard contracts | Depends on dealer and contract |
| Best use | Standard hedges, tactical exposure | Tailored currency, commodity, or rate exposure |
Equity Index Futures Hedge
\[
N=\frac{(\beta_T-\beta_P)V_P}{V_F}
\]
Where:
- \(N\) = number of futures contracts.
- \(\beta_T\) = target portfolio beta.
- \(\beta_P\) = current portfolio beta.
- \(V_P\) = portfolio market value.
- \(V_F\) = futures contract value.
| Desired result | Futures action |
|---|
| Reduce equity beta | Sell index futures |
| Increase equity beta | Buy index futures |
| Equitize cash | Buy index futures |
| Hedge a long equity portfolio | Sell index futures |
| Hedge a short equity exposure | Buy index futures |
Hedge Risk Terms
| Risk | Meaning | Example |
|---|
| Basis risk | Hedge instrument and exposure do not move perfectly together | Hedging Canadian equities with a broad global index future |
| Cross-hedge risk | Hedging with a related but different asset | Hedging one currency with another correlated currency |
| Rollover risk | New contract price differs when extending hedge | Replacing an expiring futures hedge |
| Liquidity risk | Hedge cannot be adjusted or closed efficiently | Thinly traded contract |
| Margin risk | Mark-to-market losses require cash funding | Futures hedge moves against client before exposure gains are realized |
| Over-hedging | Hedge size exceeds exposure | Portfolio becomes net short market risk |
| Under-hedging | Hedge size is too small | Residual risk remains larger than intended |
Swaps and Credit Derivatives
| Instrument | Cash-flow logic | Common use | Main risks |
|---|
| Interest rate swap: pay fixed, receive floating | Pays fixed rate, receives floating rate | Benefit from rising floating rates or convert floating liability to fixed economics | Counterparty, basis, valuation |
| Interest rate swap: receive fixed, pay floating | Receives fixed rate, pays floating rate | Benefit from falling rates or convert fixed asset exposure | Counterparty, basis, valuation |
| Currency swap | Exchanges interest and often principal in different currencies | Long-term currency funding or hedge | FX, counterparty, liquidity |
| Total return swap | One party receives total return on asset; other receives financing rate | Synthetic exposure without owning asset | Leverage, counterparty, collateral |
| Credit default swap buyer | Pays premium for protection | Hedge credit deterioration or default | Counterparty, basis, contract definition |
| Credit default swap seller | Receives premium, assumes credit risk | Earn spread-like income | Large loss if credit event occurs |
Fixed-Income Strategy Reference
Price, Yield, Duration, Convexity
\[
\frac{\Delta P}{P}\approx -D_{\text{mod}}\Delta y+\frac{1}{2}C(\Delta y)^2
\]
| Concept | Exam meaning | Strategy relevance |
|---|
| Modified duration | Approximate percentage price change for a yield change | Higher duration means higher rate sensitivity |
| Macaulay duration | Weighted average timing of cash flows | Used in immunization concepts |
| Convexity | Curvature of price-yield relationship | Positive convexity improves price behavior for large rate moves |
| Yield to maturity | Discount rate equating price to promised cash flows | Assumes reinvestment and holding to maturity |
| Current yield | Annual coupon / price | Ignores capital gain/loss and reinvestment |
| Credit spread | Extra yield over comparable government bond | Compensation for default, downgrade, liquidity, and risk appetite |
| Real return | Return after inflation | Important for purchasing-power objectives |
Bond Portfolio Strategies
| Strategy | Use when | Benefit | Main risk |
|---|
| Ladder | Need regular maturities and reinvestment discipline | Diversifies reinvestment and rate risk | May lag if active positioning would help |
| Barbell | Want short liquidity plus long yield/duration | Can benefit from certain curve changes | More reinvestment risk at short end and duration at long end |
| Bullet | Target a specific liability date | Concentrates cash flows around need | Less diversified maturity exposure |
| Immunization | Need to fund a future liability | Matches asset sensitivity to liability | Requires monitoring and rebalancing |
| Riding the yield curve | Expect stable or downward-sloping realized yields along holding period | Potential rolldown return | Fails if curve shifts adversely |
| Credit upgrading | Reduce default risk | Higher quality and lower spread volatility | Lower yield |
| Credit spread strategy | Seek income from spread compression or carry | Enhanced yield | Loss from widening spreads or downgrade |
| Callable bond strategy | Accept call risk for extra yield | Higher stated yield | Reinvestment risk when called after rates fall |
| Inflation-linked exposure | Protect purchasing power | Inflation sensitivity | Real yield and duration still matter |
Fixed-Income Traps
| Trap | Correct exam logic |
|---|
| “Longer maturity always means higher risk.” | Rate risk is better measured by duration; coupon and cash-flow timing matter. |
| “Higher yield means better bond.” | Yield may compensate for credit, liquidity, call, or structural risk. |
| “Holding to maturity eliminates risk.” | It may reduce price-realization risk but not credit, inflation, reinvestment, or liquidity risk. |
| “Callable bonds benefit investors when rates fall.” | Issuers are more likely to call, forcing reinvestment at lower rates. |
| “Duration hedge is exact.” | Duration is an approximation and weakens for large or non-parallel yield shifts. |
Alternative Investments
Alternative Asset Classes
| Alternative | Return drivers | Potential role | Key risks |
|---|
| Hedge funds | Manager skill, leverage, arbitrage, event outcomes, market direction | Diversification, absolute return, volatility management | Liquidity, leverage, opacity, valuation, fees |
| Private equity | Operational improvement, leverage, multiple expansion, growth | Long-term growth premium | Illiquidity, capital calls, valuation lag, manager dispersion |
| Private debt | Credit underwriting, illiquidity premium | Income and diversification | Default, liquidity, covenant, valuation |
| Real estate | Rental income, cap-rate changes, occupancy, financing | Income, inflation sensitivity | Interest rates, leverage, vacancy, appraisal lag |
| Infrastructure | Contracted cash flows, regulation, economic usage | Income stability and inflation linkage | Political, regulatory, concentration, liquidity |
| Commodities | Spot price, collateral yield, roll yield | Inflation/geopolitical hedge | No income, high volatility, futures curve risk |
| Managed futures / CTA | Trend following and systematic futures exposure | Crisis diversification potential | Whipsaw risk, model risk, leverage |
| Structured products | Bond component plus derivative payoff | Customized exposure or protection | Issuer credit, caps, participation limits, liquidity |
Hedge Fund Strategy Matrix
| Strategy | Core idea | Market exposure | Typical exam issue |
|---|
| Long/short equity | Long undervalued stocks, short overvalued stocks | Net long, neutral, or net short | Net exposure and short-selling risk |
| Equity market neutral | Offset long and short equity exposures | Low intended beta | Model and short-borrow risk |
| Event-driven | Invest around mergers, restructurings, spin-offs | Event-specific | Deal break or litigation risk |
| Merger arbitrage | Buy target, sometimes short acquirer | Spread capture | Deal failure risk |
| Distressed securities | Buy securities of troubled issuers | Credit/event risk | Legal process and valuation uncertainty |
| Global macro | Express macro views across rates, FX, equity, commodities | Directional | Leverage and wrong-way macro bets |
| Relative value | Exploit pricing differences between related securities | Intended low net exposure | Convergence may take time or fail |
| Convertible arbitrage | Long convertible, short underlying equity | Credit, vol, rate, equity factors | Liquidity and complex hedging |
| Fixed-income arbitrage | Exploit yield curve or spread mispricing | Rate/spread exposures | Leverage and liquidity risk |
| Managed futures | Systematic long/short futures trends | Varies by model | Trend reversal and margin risk |
Alternative Investment Due Diligence
| Area | Questions to answer |
|---|
| Strategy | What risk premia or inefficiencies drive return? |
| Process | Is the process repeatable or dependent on one person? |
| Leverage | How is borrowing, derivatives, or embedded leverage used? |
| Liquidity | What are lockups, gates, redemption windows, and side-pocket risks? |
| Valuation | Are prices observable, model-based, or manager-estimated? |
| Transparency | Can holdings and risk exposures be understood? |
| Fees | Management fee, performance fee, hurdle, high-water mark, expenses? |
| Benchmark | Is the benchmark appropriate for the strategy? |
| Operations | Custody, audit, administrator, controls, conflicts? |
| Stress behavior | How did or could the strategy behave in liquidity crises? |
Structured Products and Packaged Strategies
| Product or structure | Basic construction | Suitable when | Unsuitable when |
|---|
| Principal-protected note | Debt-like component plus derivative exposure | Client wants downside protection and accepts capped/limited upside | Client needs liquidity, transparent pricing, or issuer-risk avoidance |
| Market-linked note | Return tied to index, basket, commodity, rate, or formula | Client wants defined exposure without direct ownership | Client does not understand payoff formula |
| Reverse convertible | Enhanced coupon with downside linked to reference asset | Client accepts equity-like downside for income | Client believes it is bond-like safe income |
| Split share structure | Separates income-priority and capital-growth claims | Client understands priority and leverage | Client cannot tolerate structural complexity |
| Covered-call fund | Portfolio plus systematic call writing | Income-focused client with moderate upside expectations | Client expects full participation in strong bull markets |
| Leveraged ETF or inverse ETF | Daily reset leveraged or inverse exposure | Short-term tactical use by knowledgeable investor | Long-term buy-and-hold without understanding compounding |
| Fund-of-funds | Allocates across underlying managers/funds | Diversification and manager access | Fee layering or lack of transparency is unacceptable |
Structured Product Traps
| Trap | Correct exam logic |
|---|
| “Principal protected means no risk.” | Protection depends on product terms and issuer/guarantor strength. |
| “Higher participation is always better.” | Look for caps, averaging, barriers, fees, and dividend exclusion. |
| “Enhanced coupon equals low risk.” | Extra income often compensates for embedded option risk. |
| “Back-tested payoff proves suitability.” | Back-tests may not reflect real liquidity, costs, taxes, or stress periods. |
| “Daily leveraged ETF matches long-term multiple.” | Daily reset and compounding can cause long-term divergence. |
Tax-Aware Strategy Selection
Do not rely on tax rules alone for suitability. For exam scenarios, focus on relative tax character, account type, timing, and after-tax objective rather than memorizing changing rates.
| Return type | General tax-aware consideration | Strategy implication |
|---|
| Interest income | Often less tax-efficient in non-registered accounts than capital gains or eligible dividends | Consider registered account placement where suitable |
| Dividends | Tax treatment depends on dividend type and investor situation | Compare after-tax yield, not headline yield |
| Capital gains | Often more tax-efficient than fully taxable income and tax is generally realization-based | Deferral and turnover matter |
| Capital losses | May be useful for offsetting taxable capital gains subject to applicable rules | Tax-loss selling must avoid rule violations and portfolio distortion |
| Return of capital | May defer tax but reduces adjusted cost base | Not the same as earned income |
| Foreign income | May face withholding and currency effects | Evaluate account type and after-tax net return |
| High-turnover strategies | Can accelerate taxable income or gains | Consider tax drag in non-registered accounts |
| Derivative strategies | Tax character can depend on intent, structure, and account | Do not assume every option result is a capital gain |
Asset Location Logic
| Asset or strategy | Often preferred account logic | Caveat |
|---|
| Interest-bearing investments | Registered or tax-sheltered/deferred accounts may reduce annual tax drag | Liquidity and withdrawal needs still matter |
| Broad equity exposure | Non-registered may allow capital gains deferral | Concentration and risk must be suitable |
| High-turnover active strategies | Registered accounts can reduce annual tax reporting drag | Costs and suitability remain central |
| Foreign dividend exposure | Account type can affect withholding and net return | Product structure matters |
| Illiquid alternatives | Long horizon accounts may fit liquidity profile | Valuation and eligibility must be reviewed |
| Options for hedging | Account must permit the strategy and match risk profile | Margin, approval, and liquidity constraints matter |
Currency and Global Investing
| Issue | Meaning | Strategy response |
|---|
| Translation risk | Foreign asset value changes when converted to Canadian dollars | Hedge foreign currency exposure |
| Transaction risk | Known future foreign cash flow changes in CAD terms | Use forward or money-market hedge |
| Economic exposure | Business value affected by currency competitiveness | Diversify or choose firms with natural hedges |
| Interest-rate differential | Forward rates reflect relative interest rates | Hedging cost/benefit is embedded in forward pricing |
| Partial hedge | Hedge less than full exposure | Reduces but does not eliminate currency impact |
| Natural hedge | Liability or expense in same currency as asset/income | Aligns cash flows without derivative overlay |
Currency Hedge Direction
| Canadian investor exposure | Concern | Typical hedge |
|---|
| Owns USD asset | USD weakens versus CAD | Sell USD forward/future |
| Will buy USD asset later | USD strengthens versus CAD before purchase | Buy USD forward/future |
| Will receive foreign currency | Foreign currency weakens before receipt | Sell foreign currency forward |
| Must pay foreign currency later | Foreign currency strengthens before payment | Buy foreign currency forward |
Rebalancing, Allocation, and Manager Review
Allocation Approaches
| Approach | Description | Best use | Risk |
|---|
| Strategic asset allocation | Long-term policy mix based on objectives and constraints | Core portfolio design | May lag in unusual market regimes |
| Tactical asset allocation | Shorter-term deviations from policy weights | Express valuation or macro views | Market timing error |
| Dynamic allocation | Rules-based adjustment to market conditions | Risk control or trend response | Whipsaw and model risk |
| Core-satellite | Passive or low-cost core plus active satellites | Balance cost and alpha pursuit | Satellite concentration |
| Liability-driven investing | Assets selected to meet liabilities | Pension or specific future obligation | Model and rate assumptions |
| Risk parity | Allocate by risk contribution, not capital | Diversify risk drivers | Often uses leverage; correlation instability |
Rebalancing Rules
| Method | How it works | Advantage | Disadvantage |
|---|
| Calendar rebalancing | Rebalance on fixed dates | Simple and disciplined | Ignores size of drift |
| Tolerance bands | Rebalance when allocation breaches range | Responds to material drift | Requires monitoring |
| Cash-flow rebalancing | Direct contributions/withdrawals to under/overweight assets | Low transaction cost | May be too slow |
| Tax-aware rebalancing | Considers gains, losses, account type | Improves after-tax efficiency | More complex |
Manager Evaluation
| Question | Good answer should address |
|---|
| Did the manager outperform? | Relative to correct benchmark and after fees |
| Was return due to skill or risk exposure? | Factor exposures, beta, sector, duration, credit, currency |
| Was risk appropriate? | Drawdown, volatility, tracking error, liquidity, leverage |
| Is performance repeatable? | Process, team, capacity, discipline |
| Did style drift occur? | Holdings and exposures compared with mandate |
| Are fees justified? | Net-of-fee value added and access to scarce skill |
Risk Controls for Advanced Strategies
| Risk type | Warning sign | Control |
|---|
| Leverage risk | Small market move creates large loss | Position limits, stress tests, margin liquidity |
| Liquidity risk | Redemption delays, wide spreads, gates | Match product liquidity to client horizon |
| Counterparty risk | OTC derivative or issuer-dependent payoff | Credit review, collateral, diversification |
| Basis risk | Hedge and exposure diverge | Use closer hedge instrument or accept partial hedge |
| Model risk | Strategy depends on assumptions | Scenario analysis and independent review |
| Operational risk | Weak controls, unclear custody, poor reporting | Due diligence and monitoring |
| Concentration risk | Large exposure to one issuer, factor, sector, currency | Diversification or hedge |
| Tail risk | Rare events dominate losses | Stress testing, option protection, lower leverage |
| Valuation risk | Infrequent or subjective pricing | Conservative sizing and transparency |
| Tax risk | Unexpected income character or timing | Confirm treatment before implementation |
Scenario Decision Rules
| Scenario wording | Likely best answer direction |
|---|
| “Wants income and is willing to sell stock if it rises modestly” | Covered call |
| “Wants to protect concentrated stock position but keep some upside” | Protective put or collar |
| “Expects large move but uncertain direction” | Long straddle or strangle |
| “Wants to reduce market exposure temporarily without selling holdings” | Short index futures or index put |
| “Has foreign asset and fears foreign currency depreciation” | Sell that foreign currency forward |
| “Needs certainty of funding a future liability” | Duration matching/immunization, high-quality fixed income |
| “Wants alternative diversification but needs monthly liquidity” | Avoid illiquid private funds; consider liquid alternatives only if suitable |
| “Needs capital protection and can accept capped return” | Structured product may fit, subject to issuer and liquidity risk |
| “Low risk tolerance but attracted by high coupon reverse convertible” | Likely unsuitable; embedded downside risk |
| “Portfolio has high return but high tracking error” | Evaluate information ratio and mandate fit, not return alone |
| “Sharpe ratio looks excellent for illiquid assets” | Question smoothed returns and valuation lag |
Exam Calculation Checklist
When a calculation appears, slow down and identify the structure before computing.
- Write the position first. Long or short? Call or put? Hedge or speculation?
- Use contract multiplier. Option and futures questions often require multiplying quoted price by contract size.
- Check sign. Long futures profit when price rises; short futures profit when price falls.
- Separate payoff from profit. Profit equals payoff minus premium or cost.
- Use net premium for spreads. Debit spreads have max loss equal to net debit.
- Identify target beta. For futures hedges, current beta and target beta determine buy versus sell.
- Match currency direction. Own foreign currency exposure and fear depreciation: sell foreign currency.
- Convert percentage changes carefully. Duration approximation uses yield change in decimal form.
- Compare after-tax or after-fee results if asked. Headline yield is not enough.
- State residual risk. A hedge can leave basis, liquidity, counterparty, or opportunity-cost risk.
Final Rapid Review
| Topic | Must-know distinction |
|---|
| Hedging vs speculation | Same instrument; intent and exposure determine purpose |
| Risk tolerance vs risk capacity | Emotional willingness versus financial ability |
| Diversification vs hedging | Diversification reduces unsystematic risk; hedging offsets a defined exposure |
| Futures vs forwards | Standardized and marked-to-market versus customized OTC |
| Option buyer vs seller | Buyer has right and limited premium loss; seller has obligation and potentially large loss |
| Protective put vs stop-loss | Put provides contractual option payoff; stop order execution is uncertain |
| Covered call vs collar | Covered call sells upside for income; collar adds downside floor |
| Sharpe vs Treynor | Total risk versus systematic risk |
| Duration vs maturity | Duration measures rate sensitivity; maturity is final payment date |
| Yield vs return | Yield is one component; total return includes price change and reinvestment |
| Alternative volatility | Reported volatility may be understated by illiquidity or appraisal pricing |
| Principal protection | Reduces market downside only as specified; issuer and liquidity risk may remain |
Next Step
Use this Quick Reference as a checklist for timed scenario practice: identify the client objective, choose the strategy, calculate the payoff or hedge size, and state the remaining risks in one or two sentences.