This is a fairly random list of all
the little odds and ends that cause me to miss points when taking CFA level 1 practice tests (I’ll be sitting for the exam in December). I’ve tried to
arrange them by the session they fall into as best I can, but they’re pretty
scattered. I’m not really posting these for anyone’s benefit but my own. I just
intend to push the post to Instapaper, because it is just the best way to read
on my phone before passing out at night.
My Level One Stickies – Tuesday,
Oct 29
Session 1 – Ethical and Professional Standards
Proxies should be completed by
members. Proxies for pension plans should be voted by the member, in the best
interests of the beneficiaries, not the plan sponsor.
Concerning conflicts of interest,
personal relationships with company management trumps a relative’s low level
employment.
Plagiarism: Fed Reserve Chairman Quotes
need to be cited. Materials like charts, graphs, and algorithms developed at a
member’s firm need to be cited for the firm, but not for the individual that actually developed them.
Under Standard IV(A) Loyalty: making
preparations to leave are not a violation as long as they do not interfere with
you acting in the best interests of your current employer.
Under Standard IV(A) Loyalty:
Contacting old clients after employment has officially ended is not a
violation, if you did not misappropriate their contact information from the
former employer.
The nine sections of GIPS standards
are Fundamentals of Compliance, input data, calculation Methodology, Composite
Construction, Disclosure, Presentation and Reporting, Real Estate, Private
Equity, and Wrap Fee/Separately Managed Account Portfolios.
GIPS does not require managers to
include non-fee-paying accounts in composites.
Belief of a friend’s ownership of less
than $1000 worth of a company’s stock would not be considered a potential
conflict of interest.
Standard V Record Retention:
Recreating reports from memory after leaving an employer is acceptable if the
member can recreate ALL supporting information through sources available to him
after leaving.
Session 2 – Quantitative Methods: Basic Concepts
The multiplication rule is used to
determine the probability of two (or more?) events both occurring.
The addition rule is used to determine
the probability of at least one (or more?) event out of two (or more?) events occurring.
Total probability is used to determine
the unconditional probability of an event occurring.
The coefficient of variation is the standard deviation divided by the
mean.
To calculate the present value of an
annuity due, you can reduce N by one, but DON’T FORGET to add one payment to
your calculated present value.
Geometric Return of the following data
set: 20, 15, 0, -5, -5 would be calculated as [(1 + 0.20) × (1 + 0.15) × (1 +
0.0) (1 − 0.05) (1 − 0.05)]^(1/5) – 1
Probability Types: For a stock, based
on prior patterns of up and down days, the probability of the stock having a
down day tomorrow is an example of an Empirical
Probability.
EAY = (1 + HPY)^365/t - 1; HPY = (1 +
EAY)^t/365 - 1
Session 3 – Quantitative Methods: Application
T-bill yields contain an inflation premium. The yield is
considered a nominal risk-free rate because they contain a premium for expected
inflation.
Type 1 error: Rejecting the null
Hypotheses when it is true (false positive).
Type 2 error: Failing to reject a null
hypothesis that is false (false negative)
The probability of a type 1 error is
the significance level of the test.
The power of a test is one minus the
probability of a type 2 error.
P-value is the SMALLEST level of
significance at which the null hypothesis can be rejected.
The F-distributed test statistic is used to compare the variances
of two normally distributed populations. F = s12 / s22
Standard error of the sample mean equals the standard
deviation of the population divided by the square root of the sample size
Sampling error is the difference between a sample statistic
and its corresponding population parameter.
The table of areas under the normal
curve shows the percent of observations that lie to the left of the mean plus x
amount of standard deviations from the mean.
With smaller samples, use the t-table.
To construct a confidence interval be careful: mean +- Number of Sdevs from
t-table (Sdev/(number of samples)^0.5)
Degrees of freedom is equal to number of samples minus one.
test statistic = (sample mean –
hypothesized mean) / (population standard deviation / (sample size)1/2)
The safety first ratio is identical to
the Sharpe ratio, but it replaces the risk free rate with a predetermined
determined threshold rate.
Depending upon the
author there can be as many as seven steps in hypothesis testing which are:
1.
Stating the hypotheses.
2.
Identifying the test statistic and its
probability distribution.
3.
Specifying the significance level.
4.
Stating the decision rule.
5.
Collecting the data and performing the
calculations.
6.
Making the statistical decision.
7.
Making the economic or investment decision.
Session 4 – Economics: Microeconomic Analysis
Supply curves for products are
typically more elastic over a long time period than over a shorter period.
The long run supply curve for constant
cost industries is horizontal.
The long run supply curve for
decreasing cost industries slopes downward to the right.
Marginal product is at a maximum when
marginal cost is at a minimum.
Producer Surplus is best described as
the excess price over the opportunity cost of production.
Utility theory explains consumers’
behavior based on their preferences for various combinations of goods, in terms
of the level of satisfaction each combination provides. In other words utility
measures the satisfaction consumers receive from consuming a specific
combination of goods.
Price Discrimination: The
practice of charging different consumers different prices for the same product
or service. Think Agoda and users of PCs or Mac. Counterintuitive: you would think it is discriminatory pricing, but
apparently it isn’t.
A monopolist will expand production until MR=MC The price of the
product will be determined by the demand curve.
Session 5 – Economics: Macroeconomic Analysis
Interest rates only affect the demand
for money.
Only monetary authorities determine
the supply of money.
Long-run Aggregate Supply (LAS) can be
thought of as the potential real output of the economy.
LAS is positively related to the
quantity of labor, quantity of capital, and technology.
The level of real output (real GDP) on
the LAS curve is the economy’s level of production at full employment.
Full employment does NOT equal zero
unemployment.
The components of GDP are consumption,
investment, government spending, and net exports (exports-imports).
Core Inflation vs. Headline Inflation:
Core inflation does not include food and energy prices, which makes it a better
measure of the underlying trend in prices.
The neutral interest rate = trend rate
of real economic growth + the target inflation rate.
Monetary policy is expansionary if the
policy rate < the neutral interest rate; Monetary policy is contractionary
if the policy rate > the neutral interest rate
The one-year forward exchange rate =
spot rate(1 + one-year forward rate)
The GDP deflator = nominal / real x
100; rate of decrease = (deflator / 100)^(1/t) – 1
Automatic stabilizers are built-in
fiscal devices that ensure deficits in a recession and surpluses during booms.
They limit the problem of proper timing.
Velocity of money is the GDP of a
country divided by its money supply.
Potential Real GDP < Actual Real GDP, the economy is probably
in an inflationary phase.
Potential Real GDP = Actual Real GDP, the economy is at full
employment.
Potential Real GDP > Actual Real GDP, the economy is in a
recessionary phase.
The labor force population rate = people working or actively
seeking employment / working age population
Session 6 – Economics in a Global Context
With formal dollarization or a monetary union, a country does not
have its own currency.
GNP includes goods and
services produced outside the country (by labor and capital)
Marshall-Lerner condition: A country’s ability to narrow a trade
deficit by devaluing its currency depends on the elasticity of demand for
imports and exports.
Aggregate output is also known as
Gross Domestic Product.
Aggregate income and aggregate output
must be equal for an economy as a whole.
The nominal exchange rate is simply
the price of one currency relative to another.
In the currency markets, traders quote
the nominal exchange rate.
Economic Unions and common markets
remove all barriers to the movement of labor and capital among their members. Customs
unions do not.
Imports > Exports: There is a
current account deficit. To make up the difference the country becomes a net
borrower, creating a capital account surplus in the process.
The Ricardian model of trade only
considers labor as a factor of production. Comparative advantage results from
differences in labor productivity.
The Hecksher-Ohlin model of trade
considers both capital and labor productivity.
A country’s comparative advantage
arises from its ability to produce a specific good with lower opportunity cost
than other countries.
Session 7 – Financial Reporting and Analysis: An Introduction
USA-FASB-GAAP-SEC
EU-IASB-IFRS-ESC
The FASB framework lists revenues,
expenses, gains, losses, and comprehensive income as elements related to performance.
The IASB framework lists elements related to
performance as income and expenses, only.
Cash collections include sales revenue
and changes in unearned revenue
Cash expenses include wages expense,
changes in wages payable, insurance expense, changes in prepaid insurance,
interest expense, and changes in interest payable.
Convergence is defined as moving
towards a single set of accounting standards.
A proxy statement before an annual
shareholder meeting, or other shareholder vote, is filed with the SEC on form
DEF-14A
Options and diluted EPS: (# of contracts) – [($ExPrice)(# of
contracts) / ($AvgSharePrice)]
Return on equity (ROE) = net profit
margin × asset turnover × leverage
sustainable growth = (1 – dividend
rate)(ROE)
quick assets = current assets -
inventory
Session 8 – Financial Reporting and Analysis: Income Statements,
Balance Sheets, and Cash Flow Statements
Depreciation is a non-cash expense.
IFRS uses component depreciation. GAAP
does not.
Although Notes are always audited,
MD&A isn’t.
Session 9 – Financial Reporting and Analysis: Inventories, Long
Lived Assets, Income Taxes, and Non-current Liabilities
A Tax Loss Carryforward
is a net taxable loss that can be used to reduce taxable income in the future.
Adjusting asset values from historical
cost to reflect current values is simply a valuation adjustment, NOT
accumulated depreciation. Changes to owners equity is often reflected in
changes to “other comprehensive income.”
By definition differences that result
in deferred taxes are expected to reverse in the future.
Under IFRS, investment property is
defined as an asset owned for the purpose of earning income from rentals and/or
capital appreciation. Be careful: although the purchase/sale of a factory or
warehouse is classified as an investing cash flow, the property is not
considered an investment property.
If a firm redeems a bond before
maturity for a price that is different from the carrying value of the bond
liability, the firm will recognize the difference as a gain or loss. At
maturity the carrying value of the bond liability is equal to the face value of
the bond, so there is no gain or loss recorded.
Securities with market value <
carrying value: If classified as held to maturity, reported at amortized cost.
If classified as available-for-sale, reported at fair value.
kps
= Dps / P0
kce
= (D1 / P0) + g
Session 10 – Financial Reporting and Analysis: Evaluating
Financial Reporting Quality and Other Applications
FIFO ending inventory = LIFO ending
inventory + LIFO reserve
FIFO after-tax profit = LIFO after-tax
profit + (change in LIFO reserve)(1 − t)
Session 11 – Corporate Finance
Financial Leverage: reduces taxes, has
no effect on operating income (although interest paid is a CFO), but it does
affect Net Income and, in turn, EPS.
The marginal cost of capital (MCC) and the weighted average cost
of capital (WACC) are the same thing.
Project Sequencing refers to the
opportunity to decide to invest in a
related project in the future due to the performance of a previously started
project.
For independent projects: NPV and IRR
will lead to the same decision.
For mutually exclusive projects:
Higher NPV projects should be accepted for projects with similar IRRs.
IRR assumes that periodic cash flows
are reinvested at the IRR rate, not the cost of capital. NPV assumes that cash
flows are reinvested at the cost of capital. This is why NPV is preferred to
IRR.
An investor may find multiple IRRs if
there are negative cash flows after the initial investment.
Payback periods ignore the time value
of money.
Counterintuitive: A firm’s target
capital structure is NOT based on existing book values of debt, equity and
preferred stock. It’s based on market
values.
Business Risk can be defined as the
uncertainty inherent in a firm’s return on assets.
The cash conversion cycle measures the
length of time required to convert a firm’s investment in inventory back into
cash.
The cash conversion cycle = average
days of receivables + average days of inventory – average days of payables
Primary sources of liquidity: ready
cash balances, short-term funds like trade credit and bank lines of credit, and
cash flow management
Secondary sources of liquidity:
negotiating debt contracts, liquidating assets, bankruptcy, and reorganization.
“Borne by” Apparently financial
risk is “borne by” common shareholders, NOT creditors (which is bullshit), and
certainly not managers.
Flotation cost is a cash outflow that
occurs at the initiation of a project. The correct way to account for it when
issuing new equity to finance a project is to adjust cash flows in the
computation of the projects NPV. You do not account for flotation cost by
adjusting the cost of equity.
Corporate Governance defines the appropriate rights, roles and
responsibilities of a corporation’s management, board of directors, AND SHAREHOLDERS.
Just 2-3 years for a board member is plenty long.
CAPM = RE = RF + B(RM
− RF); WACC = (Equity ÷ Vtotalassets)(RE) + (Debt ÷
Vtotalassets)(RD)(1 − t)
DTL = (Sales − Variable Costs) / (Sales −
Variable Costs − Fixed Costs − Interest Expense)
Degree of operating leverage (DOL) = (Sales –
Variable Costs) / (Sales – Variable Costs – Fixed Costs)
Degree of financial leverage (DFL) = EBIT /
(EBIT – I) = 875,000 / 807,500 = 1.08
Session 12 - Portfolio Management
An “Asset Class” should be defined by type of security, like
stock, bond, etc… So consumer cyclical is not a valid asset class, but consumer
cyclical equities is a valid asset
class.
The formula
for the covariance for historical data is:
cov1,2
= {Σ[(Rstock A − Mean RA)(Rstock B − Mean RB)]}
/ (n − 1)
Mean RA
= (10 + 6 + 8) / 3 = 8, Mean RB = (15 + 9 + 12) / 3 = 12
Here, cov1,2
= [(10 − 8)(15 − 12) + (6 − 8)(9 − 12) + (8 − 8)(12 − 12)] / 2 = 6
A defined benefit pension plan typically has a long investment
time horizon, low liquidity needs, and high risk tolerance.
Insurance companies and banks typically have low risk tolerance
and high liquidity needs.
Banks and property and casualty insurers typically have short
investment horizons.
An investment policy for a firm’s short-term
cash management fund is highly unlikely to include a list of permissible
securities, because it would be too limited and restrictive. However, a list of
permissible security TYPES is appropriate.
In the context of the CML, the market
portfolio contains all the stocks, bonds,
and risky assets in existence.
The Markowitz efficient frontier lists
portfolios with the highest return (Y-axis) for given levels of risk (X-axis).
The optimal portfolio in the Markowitz
framework occurs when the investor achieves the diversified portfolio with the
highest utility.
Portfolios on the right (“up”) of the
market portfolio on the capital market line are only created by borrowing more
funds to own more than 100% of the market portfolio.
The optimal portfolio for an investor
is the highest indifference curve that is tangent to the efficient frontier. It
is not simply the highest point up the line because of the associated increase
in risk, and individuals’ appetite for risk.
Covariance-ab = (correlation
coefficient)(Sa)(Sb)
If two assets have a perfect negative
correlation it is possible to reduce the overall portfolio variance to zero.
The Capital Market Line (CML) is a
straight line drawn from the risk free rate of return through the market
portfolio. Risk is the x-axis and rate of return is the y-axis. The market
portfolio is determined as the point where the straight line is exactly tangent
to the efficient frontier.
Session 13 – Equity: Market Organization, Market Indices, and
Market Efficiency
The target market of an index is the securities market or portion of a
securities market that the index will be designed to represent.
The securities from the target market
that are included in the index are called its constituent securities.
Initial Margin is defined as the
minimum amount of funds that must be supplied with purchasing a security on
margin.
Margin Call Tipping Point = (initial
share price) x (1-initial margin requirement) / (1-maintenance margin
requirement)
Market-cap weighted index with two
stocks value = [(Current ShareA Price)(Number Of ShareA shares outstanding) +
(Current ShareB Price)(Number of ShareB shares outstanding)] / [(Previous
ShareA Price)(Number of shares of ShareA outstanding) + (Previous ShareB
price)(Number of ShareB shares outstanding)](100)
Private equity firms might not offer
the transparency of those that are publicly traded, but the reduced short term
minded pressures of public shareholder should result in better long term
performance.
Continuous markets are markets where
trades occur at any time the market is open, not necessarily 24 hours/day.
Call markets are markets in which the
stock is only traded at specific times.
Setting one negotiated price to clear
the market is a method used to set opening prices, NOT closing prices, in major
continuous markets.
Market efficiency does not assume that
individual market participants correctly estimate asset prices, but does assume
that some agents will over-estimate and some will under-estimate, but they will
be correct, on average.
Session 14 - Equity Analysis and Valuation
The
simple DDM: Stock Value = Dividend Per Share / (Discount Rate “k”) – (Dividend
Growth Rate “g”)
Use
the CAPM to find the Discount Rate. CAREFUL, use next year’s Expected dividend,
not last year’s
The
Earnings Multiplier Model: P0/E1 = (D1/E1)/(ke
− g)
The relationship
between "k" and "g" is critical - small changes in the
difference between these two variables results in large value fluctuations.
ke
is the required rate of return for the stock
g = (earnings
retention rate)(ROE)
A low capacity level
is associated with higher pricing power. With a low capacity levels there is a
higher chance that supply in the short run will be less than demand at current
prices. Think: “new iPhones”
Firms operating in
industries with low barriers to entry and low industry concentration typically
experience very limited pricing power.
When book values are
stable calculating ROE based on beginning book values is acceptable. If book
values are not stable, divide beginning and ending book values by two to
calculate ROE.
The free cash flow to
equity model is a type of present value model, or discounted cash flow model.
It estimates a stock’s value as the present value of cash available to common
shareholders.
The enterprise model
is an example of a multiplier.
Session 15 – Fixed Income: Basic Concepts
In times of higher than normal demand
for bonds, yield spreads tend to narrow.
Higher supply and higher liquidity
premiums tend to widen yield spreads.
The duration of a zero coupon bond is
approximately equal to its time to maturity.
Duration = (PV after yield
decrease)(PV after yield increase) / (2)(FV)(Change in Yield)
Revenue bonds, issued by
municipalities, are serviced by the income generated from specific projects.
Cap risk occurs with floating rate
bonds that have a cap placed on how high the coupon rate can go.
The London Interbank Offered Rate is
the interest rate paid on negotiable CDs by banks with operations in London,
not necessarily “British” banks. It is determined every day by the British
Bankers Association.
The relationship of duration to
maturity is direct. Shorter time to maturity => shorter duration.
The relationship of coupon size is
indirect. Bonds with larger coupons => shorter duration.
Call risk is composed of three
components: the unpredictability of the cash flows, the compression of the
bond’s price, and the high probability that when the bond is called the
investor will be faced with less attractive investment opportunities, AKA
reinvestment risk.
Bond covenants are classified as
positive and negative. A performance promise, like a minimum current ratio, is
considered a positive covenant. A prohibitive agreement, like no more
borrowing, is considered a negative covenant.
Effective convexity accounts for
embedded options.
The four C’s of credit analysis are
capacity, collateral, covenants, and character.
Session 16 – Fixed Income: Analysis and Valuation
The option adjusted spread for a
putable bond is the Z-spread plus
the put option cost in percent.
Modified Duration: assumes that all
the cash flows on a bond will not change
Effective Duration: considers changes
in cash flow that may occur due to embedded options.
Although rare, negative convexity
occurs with callable bonds.
Annual Yield to Maturity (YTM) is
easy. Just plug and chug for I/Y. To find the Bond Equivalent Yield (BEY): BEY
= 2 x [(1 + YTM)^(0.5) – 1]
When estimating the potential return
on a callable bond, it is better to use the Yield to Call rate than the
standard Yield to Maturity rate.
Eurodollar Time Deposits: U.S. dollar
(USD) denominated deposits at large banks in London, Tokyo, and elsewhere
outside the US, are Eurodollar accounts. By convention the rates are quoted as
an add-on yield.
Following the convention of quoting
Eurodollar account rates as add on yields, euro-denominated deposits held
outside of the EU would be called “Euroeuro” deposits.
Session 17 - Derivatives
Angel Investment: Planning and
establishment of a firm.
Seed Stage Investment: market
research, product development, and marketing.
Early Stage Investment: Large scale production,
and sale of product.
Although payoffs on futures options
are related to the spot price of the underlying commodity, spot price doesn’t
factor into the payoff amount equation. When the option holder exercises the
futures option they receive an underlying futures position. The cash payoff =
exercise price – futures contract price.
Although a protective put and covered
call are both ways to insure against impending downside, the payoff diagram of
a protective put is nearly identical to a long call, shifted upward by the
exercise price of the put.
European put options suck. Remember
that all things equal American options are always worth more up to the point of
expiration, because they can be exercised anytime before their expiration.
European options cannot.
“American” options are not necessarily
traded in the US. The term refers to the option to exercise the contract before
its expiration.
I’m having issues with calculating
margin balances.
In US futures markets the clearing
house acts as counterparty to every contract and guarantees performance of
contract obligations. The exchange
decides which assets will have futures contracts and the contract
specifications.
Forwards dealers are not end users of
forward contracts. Governmental agencies and non-profit organizations both are
end users.
Forwards carry counterparty risk.
Futures do not.
Both forwards, and futures may be
either cash-settlement or deliverable contracts.
Call Value = Stock Price +
Corresponding Put Value – Strike / [(1+Rate)^(t/360)]
At the Chicago Board of Trade foreign
currency contract sizes are fixed in foreign currency units, and priced in
dollars per foreign currency unit.
Session 18 – Alternative Investments
An issuer of floating rate debt can
create an interest rate collar by buying an interest rate cap and selling an
interest rate floor.
The money added to a margin account to
bring the account to the required level is called the variation margin.
The minimum allowed in the account is
called maintenance margin.
The daily settlement process requires
marking-to-market each day.
Maintaining privacy is a valid reason
for a swap contract.
A positive roll yield results from a
backwardated market, whereas a negative yield is produced in a contango market.
In backwardated (contango) markets, futures prices are lower (higher) than spot
prices. Futures markets that are dominated by long (short) hedgers tend to be
in contango (backwardation).
The futures price curve of
backwardated markets slopes down. Contango markets slope upward.
Futures price ≈ Spot price (1 +
risk-free rate) + storage costs − convenience yield. If convenience yield is
low and storage costs are high, it is likely that the futures price is greater
than the spot price, or in contango.
Use of derivatives introduces
operational, financial, counterparty, and liquidity risk.
The income approach to valuing real
estate properties estimates values by calculating the present value of expected
future cash flows from property ownership, OR by dividing the net operating
income for a property by a capitalization rate.
The cost approach to valuing real
estate properties is based on the estimated cost to replace an existing
property.
The comparable sales approach to
valuing real estate properties estimates property values based on recent sales
of similar properties.
