The discussion of diversification benefits focused on a portfolio consisting of risky assets; when a risk-free asset is incorporated, diversification is still prevalent but a linear trade-off between risk and return is established. The introduction of a risk-free asset does not change the construct of the minimum variance frontier graphical structure (y-axis = expected return; […]

# CFA Exam Level 2

## Diversification Benefits

A diversification benefit exists when a portfolio’s standard deviation can be reduced without reducing expected return. The diversification benefit is possible when return correlations between portfolio assets is less than perfect positive correlation (<+1.0). If assets have less than a +1.0 correlation, then some of the random fluctuation around the expected trend rates of return […]

## The Minimum Variance Frontier & Efficient Frontier

Two asset classes (stocks and bonds for example) can be combined with varying proportions to create an infinite number of portfolios. An investor can calculate the expected returns and variances of a two asset portfolio and plotting these on the Y (returns) and X (variances) axis of a graph. Global Minimum Variance Portfolio: The portfolio […]

## Expected Return and Variance for a Two Asset Portfolio

Expected Return for a Two Asset Portfolio The expected return of a portfolio is equal to the weighted average of the returns on individual assets in the portfolio. Rp = w1R1 + w2R2 Rp = expected return for the portfolio w1 = proportion of the portfolio invested in asset 1 R1 = expected return of […]

## Mean-Variance Analysis Assumptions

Mean-variance analysis gives investors a framework to assess the tradeoff between risk and return as mean-variance analysis quantifies the relationship between expected return and portfolio variance (or standard deviation). Mean-variance analysis is the theoretical foundation of Modern Portfolio Theory established by Professor Harry Markowitz and much of the material covered in this module traces its […]

## CFA Level 2: Portfolio Management – Introduction

The portfolio management section contains a lot of material and much of it might never appear on the actual Level 2 test. Consider that this is one of the most in-depth study sessions from the official curriculum, but a candidate may only see one item set (six questions). That said much of this session’s content […]

## Credit Derivative Trading Strategies

Basis Trades: Made based on the difference between a bond’s yield and the CDS premium. Curve Trades: Flattener: Buy the short term CDS and sell the long term CDS Steepener: Sell the short term CDS and buy the long term CDS Index Trades: An investor can buy or sell a credit index CDS Basket Trades […]

## Credit Default Swaps (CDS)

What are Credit Default Swaps (CDS)? A Credit Default Swap is an agreement between two parties in which a protection buying party pays a premium to a protection selling party; in return for this premium the protection selling party will pay the protection buying party a specified notional amount if a specified credit event takes […]

## Interest Rate Derivatives – Caps and Floors

Interest rate caps and floors are option like contracts, which are customized and negotiated by two parties. Caps and floors are based on interest rates and have multiple settlement dates (a single data cap is a “caplet” and a single date floor is a “floorlet”). Like other options, the buyer will pay a premium to […]

## Swap Credit Risk and Swap Spread

Current Credit Risk: The situation where one swap party is owed a payment now and the other party cannot make the payment. Potential Credit Risk: The possibility that the other party may default in the future. The amount at risk for default is equal to the swap’s market value at any given point in time. […]