CFA Mock Exam 1 Session 1

Credit Spread

POD*LGD = POD(1-RR)

BPV 5 yr CDS

effspreaddur 10y / effspreaddur 5y * NP

Excess Spread Return

E[ExcessSpread] = Spread₀ – (EffSpreadDur × Delta spread) – (POD × LGD)

where:

E[ExcessSpread] = Expected excess spread 

Spread₀ = Initial credit spread

EffSpreadDur = Effective spread duration

Delta spread = Change in spread

POD = Probability of default

LGD = Loss given default

Modified Duration of equity capital

D_E^* = (A/E) D_A^* – (A/E – 1) D_L^*(Δi/Δy)

Gifts - Standards

Members and Candidates must not accept gifts, benefits, compensation, or consideration that competes with or might reasonably be expected to create a conflict of interest with their employer's interest unless they obtain written consent from all parties involved

Priority of Transactions - Standards

investment transactions for clients and employers must have priority over investment transactions in which a member or candidate is the beneficial owner.

ETFs vs Mutual Funds - Tax considerations

ETF has greater tax efficiency than a similarly managed mutual fund. Managers of mutual funds must sell their portfolio holdings to fulfill shareholder redemptions, creating a taxable event where gains and losses are realized. ETFs have the advantage of accommodating those redemptions through an in-kind delivery of stock, which is the redemption process. Capital gains are not recorded when a redemption is fulfilled through an in-kind delivery of securities, so the taxable gain/loss passed to the investor becomes smaller.

Delta

Sensitivity of changes in price of stock

Optimal Asset Allocation

ratio of excess return to MCTR is the same for all asset classes and matches the Sharpe ratio of the tangency portfolio

Rolling Yield

Rolling yield = Coupon income (current yield) + Rolldown return

Coupon income = Annual coupon payment / Current bond price 

Rolldown return = Change in bond price over the one-year investment horizon (assuming an unchanged yield curve) / Current bond price 

Dispersion of Strategy with highest convexity

Barbell

Behavioral / Structural Inefficiencies

A behavioral inefficiency is a perceived mispricing (temporary) created by the actions of other market participants. A structural inefficiency (permanent) is a perceived mispricing created by external or internal rules and regulations.

Overweighting Short End of Yield Curve

Curve steepened - short term yields decreased and more attractive to buy

Late Expansion

debt coverage ratios may deteriorate as balance sheets expand and interest rates rise. High-yield bonds are considered a cyclical asset and in an overheating economy, cyclical assets typically underperform

Trough of Cycle

• Countercyclical Slope of the Yield Curve:

  • At the Trough (Late Contraction / Early Recovery): Short-term rates are depressed because the central bank has cut policy rates to stimulate the economy, while inflation and growth are expected to pick up over the long term. This creates a steep, upward-sloping yield curve.

  • At the Peak (Late Expansion): Short-term rates are high as central banks tighten monetary policy to curb overheating and wage/price inflation, while long-term growth/inflation expectations moderate. This leads to a flat or inverted yield curve.

• Countercyclical Horizon Structure of Inflation Expectations:

  • At the trough, near-term inflation is subdued (due to economic slack and downward pressure on wages and prices), but long-term inflation expectations are anchored around the central bank's credible target. Thus, short-term expected inflation is low relative to long-term expected inflation, reinforcing an upward-sloping yield curve.

• Credible Central Bank Policy:

  • Because the central bank's target is credible, economic agents expect monetary policy easing at the trough to successfully restore inflation back to target over the medium-to-long term, ensuring long-term bond yields reflect anchored inflation expectations rather than runaway inflation or permanent deflation.