CSI Portfolio Management Techniques (PMT) Cheat Sheet

Use the tables for a quick pre-exam check. Expand a topic’s notes for explanations, examples, and additional distinctions.

Scope and study context

Item	Reference
Provider	Canadian Securities Institute
Official exam title	CSI Portfolio Management Techniques (PMT®)
Official exam code	PMT
Page purpose	Independent quick reference for final-stage review and practice support

After reviewing this page, move into independent companion practice:

1. Start with topic drills for IPS, risk/return, asset allocation, fixed income, derivatives, and performance measurement.
2. Review every missed question using detailed explanations, not just the correct option.
3. Track mistakes by category: calculation error, concept confusion, missed constraint, wrong metric, or poor reading of the case.
4. Re-drill weak areas with original practice questions until you can explain why each wrong answer is wrong.
5. Finish with mixed timed sets or mock exams to practice switching topics under exam conditions.

Practical next step: choose one weak PMT topic, complete a focused question bank drill, and review the detailed explanations until the decision rule behind each answer is clear.

High-Yield Portfolio Management Flow

IPS Cheat Sheet

Core Return and Risk Formulas

Return Measures

Holding-period return:

\[ HPR=\frac{Ending\ Value-Beginning\ Value+Income}{Beginning\ Value} \]

Arithmetic mean return:

\[ \bar{R}_{arith}=\frac{R_1+R_2+\cdots+R_n}{n} \]

Geometric mean return:

\[ \bar{R}_{geo}=\left[(1+R_1)(1+R_2)\cdots(1+R_n)\right]^{1/n}-1 \]

Expected return:

\[ E(R)=\sum p_iR_i \]

Real return approximation:

\[ Real\ Return \approx Nominal\ Return-Inflation \]

Exact real return:

\[ Real\ Return=\frac{1+Nominal\ Return}{1+Inflation}-1 \]

Risk, Covariance, and Portfolio Variance

Variance:

\[ \sigma^2=\sum p_i(R_i-E(R))^2 \]

Standard deviation:

\[ \sigma=\sqrt{\sigma^2} \]

Covariance:

\[ Cov_{A,B}=\rho_{A,B}\sigma_A\sigma_B \]

Two-asset portfolio expected return:

\[ E(R_p)=w_AE(R_A)+w_BE(R_B) \]

Two-asset portfolio variance:

\[ \sigma_p^2=w_A^2\sigma_A^2+w_B^2\sigma_B^2+2w_Aw_BCov_{A,B} \]

Notes and examples

Risk and Return Formula Review

Know what each measure captures and when it is appropriate.

Core Portfolio Relationships

\[ E(R_p)=\sum_{i=1}^{n} w_iE(R_i) \]\[ \sigma_p^2=w_A^2\sigma_A^2+w_B^2\sigma_B^2+2w_Aw_B\sigma_A\sigma_B\rho_{A,B} \]\[ \beta_p=\sum_{i=1}^{n} w_i\beta_i \]\[ \text{CAPM expected return}=R_f+\beta_i\left(E(R_m)-R_f\right) \]

Metric Selection Table

Metric	Measures	Best Used When	Trap
Standard deviation	Total volatility	Total portfolio risk matters	Penalizes upside and downside volatility equally
Variance	Squared dispersion	Calculation step for volatility	Harder to interpret directly
Correlation	Co-movement between assets	Diversification benefit	Low correlation can change during stress
Covariance	Direction and strength of joint movement	Portfolio variance calculations	Scale is less intuitive than correlation
Beta	Sensitivity to market/systematic risk	Diversified equity portfolio or CAPM	Not a complete risk measure for undiversified portfolios
Tracking error	Active risk versus benchmark	Active manager evaluation	Low tracking error does not mean low absolute risk
VaR	Estimated loss threshold over period/confidence	Tail risk summary	Does not show how bad losses can be beyond the threshold
Downside deviation	Harmful volatility below target	Asymmetric risk preferences	Requires correct target threshold
Duration	Bond price sensitivity to interest rates	Fixed-income risk	Higher duration means greater rate sensitivity
Convexity	Curvature of bond price-yield relationship	Large yield changes	Duration alone is only an approximation

Modern Portfolio Theory and CAPM

Beta, CAPM, and Security Market Line

Beta:

\[ \beta_i=\frac{Cov_{i,m}}{\sigma_m^2} \]

CAPM expected return:

\[ E(R_i)=R_f+\beta_i[E(R_m)-R_f] \]

Alpha:

\[ \alpha_i=R_i-\left(R_f+\beta_i(R_m-R_f)\right) \]

Efficient Frontier Decision Rules

Performance Ratios and Manager Evaluation

Sharpe ratio:

\[ Sharpe=\frac{R_p-R_f}{\sigma_p} \]

Treynor ratio:

\[ Treynor=\frac{R_p-R_f}{\beta_p} \]

Jensen’s alpha:

\[ \alpha_p=R_p-\left[R_f+\beta_p(R_m-R_f)\right] \]

Information ratio:

\[ IR=\frac{R_p-R_b}{Tracking\ Error} \]

Tracking error:

\[ Tracking\ Error=\sigma(R_p-R_b) \]

M-squared:

\[ M^2=Sharpe_p \times \sigma_m + R_f \]

Time-Weighted vs Money-Weighted Returns

Time-weighted chain-linking:

\[ TWRR=(1+r_1)(1+r_2)\cdots(1+r_n)-1 \]

Asset Allocation Techniques

Notes and examples

Asset Allocation

Asset allocation is often the most important determinant of portfolio risk and return. Exam questions may test whether you distinguish policy-level allocation from short-term tilts.

Allocation Type	Meaning	Example
Strategic asset allocation	Long-term target mix based on IPS	60% equity, 35% fixed income, 5% cash
Tactical asset allocation	Short-term deviation from policy weights	Temporarily overweighting equities
Dynamic allocation	Adjusting exposure based on changing conditions or rules	Reducing equity risk as funded status improves
Core-satellite	Passive or low-cost core plus active satellites	Index core with specialist managers
Liability-driven allocation	Assets selected to match liability timing and sensitivity	Pension duration matching

Rebalancing

Rebalancing Method	Strength	Weakness
Calendar-based	Simple and disciplined	May rebalance when not needed
Percentage-of-portfolio	Responds to drift	Requires monitoring and thresholds
Constant mix	Buys after declines and sells after gains	Can underperform in strong trends
CPPI-style approach	Protects floor while allowing upside	Requires assumptions and monitoring

Decision rule: Rebalancing is not just mechanical. Consider transaction costs, taxes, liquidity, client constraints, and whether the IPS has changed.

Rebalancing Decision Table

Risk Types and Controls

Fixed Income Portfolio Techniques

Bond Price and Yield Logic

Notes and examples

Current yield:

\[ Current\ Yield=\frac{Annual\ Coupon}{Market\ Price} \]

Approximate percentage price change using modified duration:

\[ \%\Delta P \approx -Modified\ Duration \times \Delta y \]

Duration with convexity adjustment:

\[ \%\Delta P \approx -D_{mod}\Delta y+\frac{1}{2}Convexity(\Delta y)^2 \]

Measure	Meaning	Exam point
Macaulay duration	Weighted average time to receive cash flows	Often linked to immunization horizon
Modified duration	Price sensitivity to yield change	Directly estimates percentage price change
Dollar duration	Dollar price change for yield change	Useful for hedging and portfolio-level exposure
Convexity	Curvature of price-yield relationship	Positive convexity helps when yields move significantly
Yield to maturity	Discount rate equating price to promised cash flows	Assumes holding to maturity and reinvestment at YTM
Yield spread	Extra yield over benchmark	Compensation for credit, liquidity, optionality, and other risks

Fixed Income Strategy Matrix

Strategy	Objective	Best fit	Main risk
Ladder	Spread maturities over time	Income needs and reinvestment diversification	May not maximize view-based return
Barbell	Short and long maturities, fewer intermediates	Yield-curve view, liquidity plus duration	More convexity but may carry reinvestment risk
Bullet	Concentrated around one maturity	Known future liability	Less diversification across maturity dates
Immunization	Match asset duration to liability horizon	Funding a future obligation	Requires rebalancing as duration changes
Cash-flow matching	Match cash inflows to liability payments	High certainty required	Can be costly or hard to construct
Active duration	Extend duration if rates expected to fall; shorten if rates expected to rise	Interest-rate view	Wrong rate call hurts performance
Credit strategy	Adjust credit quality and spread exposure	Spread or economic cycle view	Downgrade/default risk
Yield-curve strategy	Position for steepening, flattening, twists	Yield-curve views	Curve may move differently than expected

Fixed-Income Portfolio Techniques

Fixed income questions frequently combine return, risk, income, liquidity, and liability matching.

Bond Price and Yield Relationship

If Market Yields…	Bond Prices…	Longer Duration Impact
Rise	Fall	Larger price decline
Fall	Rise	Larger price increase

Duration and Convexity

Concept	What It Tells You	Exam Trap
Macaulay duration	Weighted average time to receive cash flows	Not the same as modified duration
Modified duration	Approximate price sensitivity to yield changes	Approximation is less accurate for large rate moves
Effective duration	Sensitivity when cash flows may change	Useful for callable or option-embedded bonds
Convexity	How duration changes as yields change	Positive convexity is generally beneficial
Negative convexity	Price gains limited when rates fall	Common with callable bonds or mortgage-like structures

Fixed-Income Strategies

Strategy	Best Fit	Key Risk
Ladder	Diversified maturity schedule and liquidity	May not maximize return for a rate view
Barbell	Short and long maturities	Reinvestment and long-duration risk
Bullet	Maturities clustered around target date	Concentration around one maturity point
Immunization	Matching asset duration to liability horizon	Requires rebalancing as rates and durations change
Cash-flow matching	Bond cash flows meet liabilities	Can be costly or hard to construct
Credit strategy	Earn spread through credit exposure	Default, downgrade, liquidity risk
Yield curve strategy	Position for curve shifts	Forecast risk

Trap: A bond with a higher yield may have more credit risk, liquidity risk, call risk, or duration risk. Do not choose it solely because yield is higher.

Equity Portfolio Management

Notes and examples

Equity Style Review

Style	Typical Characteristics	Risks
Value	Lower valuation multiples, often out-of-favour companies	Value traps, slower growth
Growth	Higher expected earnings growth	Valuation risk, sensitivity to expectations
Quality	Strong balance sheets, stable profitability	May become expensive
Momentum	Recent winners	Reversal risk
Dividend/income	Dividend-paying stocks	Sector concentration, dividend cuts
Small-cap	Smaller companies	Liquidity, business risk, volatility

Active vs Passive

Approach	Advantages	Disadvantages
Passive	Low cost, transparent, benchmark exposure	No attempt to outperform, benchmark concentration
Active	Potential alpha, flexibility, risk control	Fees, manager risk, style drift
Enhanced indexing	Small active bets around benchmark	Tracking error still matters
Factor investing	Systematic exposure to rewarded factors	Factor cycles and crowding risk

Exam trap: A manager can outperform because of market beta, sector exposure, style exposure, currency, or luck — not necessarily skill. Performance evaluation must isolate risk-adjusted value added.

Derivatives for Portfolio Management

Notes and examples

Option Payoff Basics

Long call payoff at expiry:

\[ Payoff=\max(0,S_T-K) \]

Long put payoff at expiry:

\[ Payoff=\max(0,K-S_T) \]

Covered call position:

\[ Long\ Stock+Short\ Call \]

Protective put position:

\[ Long\ Stock+Long\ Put \]

Market view	Possible strategy	Result
Bullish	Long call or long asset	Upside participation
Bearish	Long put or reduce exposure	Downside participation/protection
Neutral to mildly bullish	Covered call	Income, capped upside
Wants downside floor and accepts capped upside	Collar	Defined risk range
Wants temporary beta reduction	Short index futures or buy puts	Hedge market exposure
Wants foreign currency certainty	Forward currency hedge	Locks exchange rate

Derivatives and Hedging

Derivatives may be used to hedge, equitize cash, adjust duration, manage currency exposure, or create option-based payoff profiles. The exam may test whether the derivative use is consistent with the client mandate.

Derivative Use Cases

Instrument	Common Use	Key Risk
Futures	Hedge market exposure, adjust beta, equitize cash	Basis risk, margin, contract mismatch
Forwards	Currency or customized exposure hedge	Counterparty risk, liquidity
Options	Downside protection, income generation, asymmetric exposure	Premium cost, complexity
Swaps	Exchange cash flow exposures	Counterparty and valuation risk

Option Strategy Review

Strategy	Position	Objective	Trade-Off
Protective put	Long asset + long put	Downside protection	Pay option premium
Covered call	Long asset + short call	Generate income	Cap upside
Collar	Long asset + long put + short call	Reduce downside with lower net cost	Limit upside
Long call	Right to buy	Upside exposure with limited loss	Premium can expire worthless
Long put	Right to sell	Hedge or profit from decline	Premium cost
Short option	Obligation if exercised	Earn premium	Potentially large risk

Hedge Ratio Reminder

A simple equity futures hedge often depends on portfolio value, beta, futures price, and contract multiplier.

Number of contracts is commonly estimated as:

\[ N \approx \frac{\text{Portfolio value} \times \beta}{\text{Futures price} \times \text{Contract multiplier}} \]

Adjust the direction based on the objective:

• Reduce equity exposure: short futures.
• Increase or equitize exposure: long futures.
• Hedge currency receivable: sell the foreign currency forward.
• Hedge currency payable: buy the foreign currency forward.

Trap: A perfect hedge is rare. Basis risk, beta mismatch, timing mismatch, currency mismatch, liquidity, and transaction costs can cause hedge results to differ from expectations.

Active vs Passive Decision Rules

Alternative Investments in Portfolio Construction

Notes and examples

Alternative Investments

Alternatives are often tested through risk, liquidity, valuation, diversification, and suitability.

Alternative	Potential Role	Key Risks and Traps
Real estate / REITs	Income, inflation sensitivity, diversification	Leverage, liquidity, property cycle risk
Infrastructure	Long-term cash flows, inflation linkage	Regulatory, political, valuation, liquidity risk
Private equity	Growth and illiquidity premium	Long lockups, valuation lag, high dispersion
Private debt	Income and spread	Credit, liquidity, covenant risk
Hedge funds	Absolute return or lower correlation strategies	Fees, leverage, transparency, manager risk
Commodities	Inflation hedge, crisis diversification	No cash flow, volatility, roll yield
Structured products	Customized payoff	Complexity, issuer risk, liquidity

Decision rule: Alternatives may improve diversification, but suitability depends on liquidity needs, time horizon, complexity tolerance, valuation transparency, fees, and IPS constraints.

Tax-Aware Portfolio Logic

Notes and examples

Tax-Aware Portfolio Management

PMT questions may test whether you think in after-tax terms when the client is taxable.

Concept	Review Point
After-tax return	What the client keeps matters more than pre-tax return
Asset location	Place tax-inefficient assets where they are most appropriate, subject to client facts
Turnover	High turnover can increase realized taxable gains and costs
Tax-loss harvesting	Realize losses where appropriate to offset gains, subject to applicable rules
Income type	Interest, dividends, and capital gains may be taxed differently depending on jurisdiction and account type
Unrealized gains	Selling legacy holdings may trigger tax costs
Registered/tax-advantaged accounts	Consider account rules and suitability without assuming facts not provided

Decision rule: If the question says “taxable investor,” “after-tax return,” “large embedded gain,” or “high turnover,” taxes are probably central to the answer.

Behavioural Finance Traps

Notes and examples

Behavioural Finance Cheat Sheet

Bias	Description	Portfolio Risk
Loss aversion	Losses feel worse than equivalent gains	Selling risky assets after declines
Overconfidence	Overestimating skill or information	Excessive trading, concentration
Anchoring	Relying too heavily on initial value	Refusing to sell below purchase price
Confirmation bias	Seeking confirming evidence only	Ignoring contrary data
Recency bias	Overweighting recent events	Chasing performance
Herding	Following the crowd	Buying bubbles, selling panics
Mental accounting	Treating money differently by bucket	Inefficient total portfolio
Framing	Decisions change based on presentation	Inconsistent risk choices
Status quo bias	Preference for current holdings	Failure to rebalance or diversify
Endowment effect	Overvaluing what one owns	Holding unsuitable legacy assets

Exam trap: The remedy may be education, reframing, IPS discipline, automatic rebalancing, diversification rules, or decision checklists — not simply “tell the client the bias is wrong.”

Benchmark and Attribution Reference

Scenario Decision Shortcuts

Common PMT Exam Traps

• Confusing risk tolerance with risk capacity. Capacity can be low even when willingness is high.
• Recommending the highest expected return without checking liquidity, tax, time horizon, and constraints.
• Using standard deviation when the question asks for benchmark-relative risk; use tracking error.
• Using Treynor for a poorly diversified portfolio; beta ignores unsystematic risk.
• Treating duration as maturity. Duration is sensitivity and weighted timing of cash flows.
• Forgetting that bond prices and yields move in opposite directions.
• Assuming a hedge eliminates all risk. Basis risk, counterparty risk, liquidity risk, and implementation risk can remain.
• Choosing active management without identifying why alpha is plausible after costs.
• Evaluating a manager using money-weighted return when cash flows were client-directed.
• Comparing portfolios on pre-tax returns when the investor is taxable.
• Ignoring IPS rebalancing rules during market stress.
• Treating alternative investments as automatically diversifying; correlation can rise in stressed markets.

Final Review Checklist

Before answering a PMT scenario, identify:

1. Client objective: growth, income, preservation, liability funding, after-tax return, or benchmark-relative return.
2. Constraint that dominates: liquidity, time horizon, tax, legal, unique, or risk capacity.
3. Correct risk measure: standard deviation, beta, duration, tracking error, downside risk, or shortfall risk.
4. Correct return measure: time-weighted, money-weighted, arithmetic, geometric, pre-tax, or after-tax.
5. Correct implementation tool: asset allocation, security selection, duration adjustment, derivative hedge, rebalancing, or benchmark change.
6. Trade-off created by the recommendation: cost, liquidity, tracking error, tax impact, capped upside, leverage, or model risk.

PMT Cheat Sheet

This independent quick review is for candidates preparing for the Canadian Securities Institute CSI Portfolio Management Techniques (PMT®) exam, code PMT. Use it as a fast final review before moving into topic drills, mock exams, original practice questions, and detailed explanations.

The exam rewards candidates who can connect portfolio theory to practical portfolio decisions: client objectives, constraints, risk measurement, asset allocation, portfolio construction, implementation, monitoring, and performance evaluation.

High-Yield Exam Mindset

For most PMT-style questions, ask:

1. Who is the client? Individual, pension, foundation, corporation, trust, or other institutional investor.
2. What is the objective? Return requirement, risk tolerance, income need, capital preservation, growth, liability matching, tax efficiency.
3. What are the constraints? Time horizon, liquidity, tax, legal/regulatory, unique circumstances, ethical restrictions, currency, concentration, ESG or mandate limits.
4. What is the portfolio decision? Strategic asset allocation, tactical shift, security selection, hedging, rebalancing, manager selection, benchmark choice.
5. What metric answers the question? Standard deviation, beta, duration, Sharpe ratio, Treynor ratio, tracking error, information ratio, attribution, after-tax return.
6. What is the trap? Confusing risk measures, ignoring constraints, using the wrong benchmark, mixing nominal and real returns, or choosing a technically correct answer that violates the IPS.

Portfolio Management Workflow

    flowchart TD
	    A[Define client situation] --> B[Create or update IPS]
	    B --> C[Set objectives and constraints]
	    C --> D[Choose strategic asset allocation]
	    D --> E[Select implementation approach]
	    E --> F[Monitor portfolio, client, markets]
	    F --> G[Measure performance and risk]
	    G --> H[Rebalance or revise strategy]
	    H --> B

Core PMT Topic Map

Investment Policy Statement Essentials

The IPS is the bridge between client facts and portfolio decisions. In exam questions, the best answer usually aligns with the IPS even if another answer has a higher expected return.

Objectives vs Constraints

Notes and examples

Ability vs Willingness to Take Risk

Situation	Likely Interpretation
High wealth, stable income, long horizon	High ability to take risk
Short horizon, low wealth, high liquidity need	Low ability to take risk
Client panics during volatility	Low willingness to take risk
Client wants aggressive returns but cannot afford losses	Ability usually constrains the portfolio
Client can afford risk but is very conservative	Willingness may constrain the portfolio unless education changes it

Decision rule: When ability and willingness conflict, the prudent portfolio normally reflects the lower effective risk tolerance unless the question gives a reason to educate the client and adjust expectations.

Client Type Cheat Sheet

Required Return: Practical Exam Approach

A required return question often has hidden cash flow and inflation assumptions. Read carefully.

Common Required Return Steps

1. Identify current portfolio value.
2. Identify cash inflows or outflows.
3. Determine whether return is nominal or real.
4. Adjust for inflation if required.
5. Use after-tax amounts if the question asks for after-tax return.
6. Compare required return to risk tolerance.

Trap: A client may require a high return mathematically, but if risk tolerance is low, the correct recommendation may be to adjust goals, spending, retirement date, savings, or constraints rather than simply build a high-risk portfolio.

Modern Portfolio Theory and Efficient Frontier

Concepts to Review

Notes and examples

CML vs SML

Feature	Capital Market Line	Security Market Line
Risk measure	Standard deviation	Beta
Applies to	Efficient portfolios	Individual securities and portfolios
Slope	Market price of total risk	Market risk premium
Key use	Portfolio efficiency	Expected return under CAPM

Trap: If the question involves a well-diversified portfolio and market sensitivity, beta may be appropriate. If the question evaluates total portfolio volatility or Sharpe ratio, use standard deviation.

Currency Management

Currency exposure matters when assets, liabilities, spending, or reporting currency differ.

Trap: The correct currency policy depends on the client’s base currency, liabilities, time horizon, and risk tolerance — not simply on a forecast that a currency may rise or fall.

Performance Measurement

TWRR vs MWRR

Notes and examples

Trap: If cash flows are controlled by the client, use time-weighted return to evaluate the manager. If the question asks what the investor actually earned on invested money, money-weighted return may be relevant.

Risk-Adjusted Performance Metrics

Metric	Plain Formula	Best Use	Trap
Sharpe ratio	(Portfolio return - risk-free rate) / standard deviation	Total risk-adjusted performance	Best for diversified total portfolios
Treynor ratio	(Portfolio return - risk-free rate) / beta	Systematic risk-adjusted performance	Requires meaningful beta
Jensen’s alpha	Actual return - CAPM required return	Value added versus CAPM expectation	Depends on beta and benchmark assumptions
Information ratio	Active return / tracking error	Active manager skill versus benchmark	Requires appropriate benchmark
Sortino ratio	Excess return / downside deviation	Downside-risk focus	Target return must be defined

Benchmark Quality

A good benchmark should generally be:

• Specified in advance
• Investable or replicable
• Measurable
• Appropriate to the mandate
• Unambiguous
• Reflective of manager style and opportunity set

Trap: Comparing a Canadian balanced manager to a pure equity index, or a value manager to a broad growth-heavy index, can produce misleading conclusions.

Performance Attribution

Attribution explains why performance differed from the benchmark.

Decision rule: First identify whether the manager’s active decision was about where to allocate or what to select. Then match the attribution effect.

Manager Selection and Monitoring

Trap: Do not hire or retain a manager based only on recent performance. Look for process, risk, consistency, and mandate fit.

Ethics, Suitability, and Professional Judgment

For the Canadian Securities Institute CSI Portfolio Management Techniques (PMT®) exam, professional judgment questions often come down to putting the client’s objectives, constraints, disclosure, and suitability ahead of return chasing.

Practical Rules

• Recommend only strategies consistent with client facts and the IPS.
• Identify and manage conflicts of interest.
• Use reasonable assumptions and explain limitations.
• Do not ignore liquidity, tax, or legal constraints.
• Do not present forecasts as guarantees.
• Consider costs, risks, and implementation practicality.
• Document major decisions and rationale.
• Revisit the IPS when client circumstances materially change.

Calculation and Decision Checklist

Common Candidate Mistakes

1. Choosing the highest-return answer without checking suitability.
2. Confusing willingness to take risk with ability to take risk.
3. Using standard deviation when the question points to beta, or beta when total risk matters.
4. Ignoring liquidity needs in retirement, foundation spending, or liability-driven cases.
5. Forgetting that duration is a price sensitivity measure, not just “time to maturity.”
6. Assuming alternatives are automatically low risk because they have low correlation.
7. Using the wrong benchmark for performance evaluation.
8. Treating tax as irrelevant for a taxable client.
9. Assuming a hedge eliminates all risk.
10. Calling recent outperformance skill without considering style, factor exposure, or benchmark mismatch.
11. Failing to distinguish strategic asset allocation from tactical tilts.
12. Overlooking embedded gains, concentrated positions, or unique constraints.
13. Ignoring inflation when the question asks for real purchasing power.
14. Assuming the IPS never changes.
15. Answering from market opinion rather than the facts given in the case.

Fast Review: “Best Answer” Decision Rules

IPS and Suitability

• If a strategy violates a stated constraint, it is usually wrong.
• If required return is unrealistic, adjust goals rather than automatically increasing risk.
• If a client has low liquidity tolerance, avoid illiquid alternatives even if expected return is attractive.
• If the client has short horizon and high cash need, capital preservation usually dominates.

Notes and examples

Risk Metrics

• Use standard deviation for total volatility.
• Use beta for market/systematic risk.
• Use tracking error for benchmark-relative active risk.
• Use duration for bond interest rate sensitivity.
• Use downside deviation when the concern is losses below a threshold.

Performance

• Use TWRR to evaluate the manager.
• Use MWRR to evaluate the investor’s actual experience.
• Use Sharpe for total portfolio risk-adjusted return.
• Use information ratio for active return per unit of active risk.
• Use attribution to separate allocation decisions from selection decisions.

Fixed Income

• Rates up, bond prices down.
• Longer duration means greater sensitivity.
• Callable bonds may have negative convexity.
• Immunization requires monitoring and rebalancing.
• Higher yield usually comes with higher or different risk.

Derivatives

• Protective put = downside protection with premium cost.
• Covered call = income now, upside capped.
• Short futures = reduce exposure.
• Long futures = increase exposure.
• Currency hedge direction depends on whether the client will receive or pay the foreign currency.

Mini Self-Check Before Practice

Can you answer these without notes?

1. What are the two parts of risk tolerance?
2. Which IPS constraints are most likely to override a high-return recommendation?
3. When should a manager be evaluated using TWRR instead of MWRR?
4. What is the difference between Sharpe ratio and Treynor ratio?
5. Why can a low-correlation alternative still be unsuitable?
6. How does a rise in interest rates affect a long-duration bond portfolio?
7. What does convexity add beyond duration?
8. What makes a benchmark appropriate?
9. What is the difference between allocation effect and selection effect?
10. When is a protective put preferable to a stop-loss-style approach?
11. Why might a client with high wealth still have low risk tolerance?
12. How can tax considerations change the preferred portfolio strategy?
13. What is style drift, and why does it matter?
14. Why does diversification reduce unsystematic but not systematic risk?
15. What changes would require updating the IPS?

Put the review into practice