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How do Sharpe ratio, Treynor ratio, and information ratio differ as risk-adjusted performance measures?
All three ratios measure risk-adjusted performance, but they differ in what risk they measure and what return they evaluate. Understanding when each is appropriate is critical for the CFA Level III exam.
What is home bias and what behavioral factors drive it?
Home bias is over-allocation to domestic assets relative to global market weights. Partly rational (currency, info, taxes), mostly behavioral (familiarity, ambiguity aversion, patriotism).
How do I use the exponential distribution for default timing?
Exponential models waiting times with constant hazard lambda. Memoryless property makes it standard in reduced-form credit models.
When should I use F1 score instead of accuracy or AUC?
F1 is harmonic mean of precision/recall, essential for imbalanced classes. Bannockwood Credit Union picks Model B (F1=0.52) over Model C on 0.8% fraud dataset...
When should I use the Poisson distribution in finance?
Poisson models independent event counts with constant rate lambda. Useful for default counts, operational losses, and price jumps when events are independent.
Why does improving precision hurt recall, and vice versa?
Precision-recall tradeoff is mathematically forced along a single ROC curve. Heronshaw Insurance optimizes fraud threshold 0.42 (38% precision, 74% recall) to minimize $6.8M/yr expected cost...
What makes a benchmark valid for performance evaluation and what are the key properties a good benchmark must have?
Benchmark selection is foundational to performance evaluation because a poorly chosen benchmark makes all subsequent analysis meaningless. The CFA Level III curriculum identifies seven key properties of a valid benchmark.
How does early-exercise behavior affect the expected-term adjustment for employee options?
Expected term captures early exercise. Three methods: simplified (vesting plus contractual)/2, historical actual-exercise data, or lattice-implied exercise boundary. Shorter terms reduce fair value.
Why does gold futures almost always trade in contango?
Gold is a financial asset with negligible convenience yield. Futures price equals spot times one plus risk-free rate minus lease rate, producing persistent contango.
What is AUC in machine learning classification and how do I interpret it?
AUC measures ranking ability; Voltran Capital's credit default model AUC=0.82 is strong for corporate default prediction with 1.8x lift at 6% threshold...
When is a binomial/lattice model preferred over Black-Scholes for employee options?
Lattice models discretize time into steps and better handle early exercise rules, path-dependent payoffs, graded vesting with different terms, and dynamic volatility.
Why do long VIX futures positions consistently lose money over time?
VIX futures usually trade contango, so long-roll ETFs sell low and buy high each month, losing 8-12 percent annually to roll drag.
How do you decompose alpha to distinguish genuine manager skill from luck and factor exposure?
Alpha decomposition is the process of separating a manager's excess return into its component sources to determine how much (if any) represents genuine investment skill. The key insight is that not all alpha is created equal.
How do I apply Black-Scholes specifically for employee stock option valuation?
Black-Scholes for employee options uses the same equation with adjusted inputs: expected term instead of contractual, historical plus implied volatility, and dividend yield over the term.
How are short-term interest rate (STIR) futures priced and quoted?
STIR futures quote as 100 minus rate. A 95.50 price implies 4.50% rate. Tick is 0.5bp worth $12.50 on a $1M quarterly notional.
Why are executive stock options harder to value than traded options?
Executive options differ from traded options due to non-transferability, service requirements, long duration, and no dividend protection. Expected term adjustments reduce valuation meaningfully.
What is the convexity bias in Eurodollar (now SOFR) futures and how big is it?
Convexity bias arises because futures mark to market linearly while forwards are convex in rates. Adjustment is roughly half sigma squared times T1 times T2.
What is a break clause on a swap and how is the breakage cost calculated?
Break clauses permit optional early termination at predetermined dates. Kestrel Industries pays $1.52M breakage to exit a 4.05% pay-fixed swap when rates fall to 2.95%...
What are Performance Share Units (PSUs) and how are they valued?
PSUs are RSU-like awards where payout depends on performance or market targets, often 0 to 200 percent of target. Non-market conditions use probability estimates; market conditions use Monte Carlo.
How do you calculate the invoice price paid to the short at delivery?
Invoice price equals Futures Settle times CF times Face plus accrued interest. A worked example shows $98,819.90 for a 2040 bond.
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