My CFA Level 1 Exam Study Sheet

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.

k_ps = D_ps / P₀

k_ce = (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 = R_E = R_F + B(R_M − R_F); WACC = (Equity ÷ Vtotalassets)(R_E) + (Debt ÷ Vtotalassets)(R_D)(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:
cov_1,2 = {Σ[(R_{stock A} − Mean R_A)(R_{stock B} − Mean R_B)]} / (n − 1)
Mean R_A = (10 + 6 + 8) / 3 = 8, Mean R_B = (15 + 9 + 12) / 3 = 12
Here, cov_1,2 = [(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)/(k_e − 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.