Final Flashcards

Explain the duties to the employer standard relating to additional compensation agreements

Candidates must not accept or undertake any situation that may conflict with the employer’s interest, unless written consent from all parties is obtained

What’s an example of poor earnings quality in relation to discretionary decisions?

If, for example, provisions for credit losses were increasing with, or in excess of, the reduction in revenue, this would hide the decline in pretax income, indicating a decrease in earnings quality

For the effect on pension obligation, what is the impact of a reduction of the discount rate on the debt-to-equity ratio?

A reduction of the discount rate means a decrease in pension obligation, meaning additional equity is available, increasing the equity component of the D/E ratio

DDM reminder:

Make sure to include the first period if it’s given

Reminder for FCFE discount model

FCFE for each period is the starting FCFE x g^t, with the adjustments from the financial data made after

Between IG, HY and Government bonds, how would I expect them to perform after the business cycle has peaked and the yield curve has inverted?

If the business cycle has peaked and the yield curve has inverted, this means that the economy is likely heading towards a recession. This means that the HY will likely perform the worst, followed by the IG bonds, and the Government Bond should perform best

A sharp decline in real earnings nearly always coincides with what?

A recession

A leading indicator of the business cycle is the trend in

Corporate profit margins

What are the characteristics of short-biased funds?

They are naturally exposed to greater volatility, and therefore do not make use of significant leverage

What are the characteristics of long/short equity funds?

They buy/sell any stock they deem to be under/overvalued. They may use leverage but it depends on the strategy and risk involved

What are the characteristics of market-neutral strategies?

Take long and short positions in securities with similar characteristics, allowing them to maintain a market neutral position, tend to have a diverse portfolio adjusted over short time horizons with the use of derivatives and indexes to achieve neutral beta

What do distressed securities and merger arbitrage have in common?

They are both event-driven strategies, that have binary outcomes

What do I need to remember for Conditional Factor Risk Models that provide exposures to the normal exposure, and alternative exposure?

The normal exposure is the base case, the alternative exposure is a second part of the same model, so I need to include the base case within the alternative as well

What’s a key point to pathways valuation?

It can be done two ways, forwards and backwards:

• Sequential, path-by-path discounting along a single pathway, or

• Discounting the bond’s cash flows by the spot rate inferred from the 1-period rates

Simple way to think of binominal tree valuation of a FRN with a coupon floor

Essentially works as normally, except that the coupon is the discount rate, unless it is less than the floor, in which case the floor is used as the coupon

What is a busted convertible?

The conversion value is so deep out of the bond that the bond characteristics mimics that of an otherwise identical nonconvertible bond

Formula for conglomerate discount

EV - (Sum of the Parts), where sum of the parts is essentially the EV of the other components

When is a control discount/premium applied?

A control premium is applied when an individual has a controlling interest i.e. they have control over decisions, and vice-versa for discount when noncontrolling

What types of firms should use the excessive earnings valuation method?

Small firms with significant intangible assets and positive normalised earnings

What are the two types of synergies I should be aware of?

Revenue synergies and cost synergies

Golden rule for Ethics

Check every claim - i.e. if they say only CFA institute people work there, make sure that’s true

What is an important concept in relation to representation of the CFA charter?

Members cannot misrepresent or exaggerate the meaning or implication of the CFA charter, for example saying that due to the Charterholders enhanced skillsets, the fund should continue to outperform benchmarks

What is the standard requirements in relation to limitations?

In communication with clients and prospective clients, candidates must discuss all limitations and risks within an investment strategy or process, regardless if they are relevant

What’s Grinold’s Rule?

Active Return = IC * Volatility * Scores

(IC = Success Rate - Failure Rate for that one question)

What does a greater uncertainty of the Information Coefficient (IC) relate to?

Provides a more ambitious managers forecast of active return, and the IC could either increase or decrease depending on superior skill or lack thereof

Price Return, Roll Return, and Collateral Return Formulas:

Price: (P₁ - P₀) / P₀ - (As of today)

Collateral: Yield * Time Period

Roll: (Near-term - Farther-term) / Near-term

Total = Sum of all

What does backwardation mean? is the basis swap positive or negative?

Spot Prices are greater than Futures Prices,

Therefore, the basis between these is positive

What can be said about precious metals (i.e. gold and silver) futures?

Historically they have had negative average roll returns and are associated with contango, due to storage costs and investment appeal

What’s the basis swap for

related for two different commodities

What’s the total return swap for?

return on the commodity index

What’s the excess return swap for?

price of commodity in excess of the reference rate

What’s the variance swap for?

Difference between commodities actual and expected variance

What’s the volatility swap for?

difference of the commodity and its actual volatility

What’s the difference between a variance and volatility commodity swap?

variance = volatility squared, volatility = standard deviation

What’s the effective duration of a zcb?

Approximately it’s maturity

What’s the effective duration of a fixed-rate coupon bond?

< maturity

What’s the effective duration of a callable bond?

<= duration of straight bond

What’s the effective duration of a putable bond?

<= duration of straight bond

What’s the effective duration of a floater bond?

approximately it’s time to next reset

When is one-sided duration the appropriate duration measure?

When you are measuring a upward or doward (parralel) shift in the benchmark yield curve

What does a dickey-fuller test failing to reject the null hypothesis indicate?

error term has a unit root and is not covariance stationary

In terms of shareholder voting rights, what is the standard of an industry leading policy?

Straight voting, over dual-class, because in straight voting, all shareholders have equal say, while as with dual-class is can be disproportionately weighted towards founders etc.

What is vertical integration?

Adding distinct stages into the companys supply chain within its company itself

Credit Rating Transition Matrix

YTM - Sum of(Credit Spread * Duration * Probability)

Why would it be innapropriate to cite as marketing material the track record of a previous employer that you worked at?

Because it might overstate the individuals contribution of that track record, particularly if they were not a significant contributor (i.e. not a decision maker)

Is it a violation for a member or candidate to transact within clients trades in their own fund?

Providing they do not specifically benefit from the clients transactions, they are paying members of the fund, and do not disadvantage the client

What does an increase of dividend likely mean for a companys valuation?

Valuation will likely lower, because while the dividend itself will be higher, the sustainable growth rate will be lower which impacts the rest of the valuation

Do cyclical or noncyclical equity stocks have better consumption hedging properties?

Noncyclical

When calculating discount rates for commercial property tenants, what do I include for Corporate, but not government (fixed nominal)

Credit Premium

When calculating discount rates for commercial property tenants, what do I include for government (fixed nominal), but not for government (inflation-indexed)?

Expected inflation between t and t + s, and Risk premium for inflation uncertainty

What is the Taylor Rule compared against?

Current policy rate

Taylor Rule > Current Policy Rate indicates what?

Positive gap, economomy at risk of overheating if growth expected to continue

Taylor Rule < Current Policy Rate indicates what?

Negative gap, economy at risk of underproducing if growth expected to continue way it is

If Marginal Utility from current consumption is falling, what is the impact on bond yields?

They will decrease, because investors are less willing to consume now, which means more willing to save and invest, which means they will purchase more bonds, which means bonds prices with climb and their yields will decrease

Formula for Taylor Rule Policy Rate

pr = i_{interest rate} + I_{inflation rate} + .5(Inflation Gap) + .5(Output Gap), where:

Gaps are: Actual - Target

What are asset-based valuations typically used for?

Natural resource companies (e.g. mining, oil, and gas), it is innapropriate when there is potentially significant goodwill invovled

What does a lack of marketability discount apply to?

Non-publically traded (private) stocks

What does a blockage factor apply to?

It applies to blocks of shares which often realise lower market prices than smaller amounts of stock

What does a conglomerate discount apply to?

Companys with several unrelated lines of business

Is Net Income being higher than CFO a sign of lower-earnings quality?

If it was over multiple periods, it could be. But in the case of a single period of being higher, it is relatively fine given that timings of cashflows could be recognised in different periods for example. One year of NI being higher is not considered a warning sign

What’s going concern valuation used for?

When the company will continue operations into the future

What’s investment valuation used for?

Value to a specific buyer accounting for synergies

What’s fair market value used for?

Value if asset changed hands between willing buyer and seller with no compulsion

What’s the difference between liquidation and orderly liquidation valuation

Orderly if for when the assets can be sold over a longer period of time

What can be said about the distribution of interest rate on a binomial tree?

Interest rates are approximately lognormally distributed around the forward rates derived from the benchmark yield curve

The Cox-Ingersoll-Ross (CIR) and Vasicek models are what?

Single-factor Equilibrium models based on a short rate

What do the CIR and KWF models not allow for?

Negative interest rates (just remember is the three word names that can be abbreviated)

How to calculate partial goodwill?

Calculate the fair value of the proportion of net assets, then take the difference of the payment

PVGO formula

P₀ - (E₁ / r)

When we are considering the proportion of stock price dervived from PVGO, what do we want to keep in mind?

Essentially find the difference between price and derived value (PVGO), then use that against the market price to see proportion

What can we say about models with more than two months of lag?

If a backtest is run without point-in-time data, it must incorporate reporting lags to counteract look-ahead bias.

In real-life data, after two months of lag, it usually results in such stale data that it understates risk-adjusted performance.

This is based on the bar chart of what Point-in-time (baseline) is used. No lag and 1m lag would likely be above, given the look-ahead bias

How do you simulate portfolio rebalancing?

Use a rolling-window backtesting methodology

Information Ratio using breadth

IR = (TC)(IC)(^sqrtBR)

Formula for Expected Active Return, expanded fundamental law

E(R_A) = (TC)(IC)(^sqrtBR)(o_A), or (IR)(o_A)

Optimal Active Risk of a Constrained Portfolio

o_optimal = (TC) x (IR / SR_B) x o_B

Breadth Formula

N / (1 + (N - 1)p)

What’s another word for active risk?

Aggressiveness

Information Ratio using Active stuff

Active Return / Active Risk

Optimal Sharpe Ratio

sqrt(ST_B² + IR²)

TC is very close or equal to 1.0 when?

unconstrained portfolios

What are the pros and cons to liquid alts vs traditional hedge funds?

Greater liquidity, transparency and lower fees, but tend to underperform and liquidity limits investments

What’s a convertible arbitrage strategy?

Managers exploit mispricing between a firm’s convertible debt and it’s equity,

Tends to have low implied volatility

What are the unique traits of global macro strategies?

Returns exhibit right-tail skewness during periods of market stress (lumpier), and they are cyclical/more volatile

What’s the difference between Time-Series Momentum (TSM) and Cross-Sectional Momentum (CSM)?

TSM is single asset, CSM is multi-asset

What are ‘Insiders’

Shareholders who are also managers and/or board members

What are ‘Interlocking Directoriates’

An individual being a member of a board for multiple companies

In ESG integration, when should the factors of ‘Materiality’ and ‘Time Horizon’ be included?

Materiality: Factor should only be included if it will have a material effect on the company

Time Horizon: Even if the factor is material, if it is outside the meaningful investment horizon then potentially shouldn’t be included

What’s an important reminder when it comes to ownership?

Ownership and Voting Power are quite likely two different things to consider

Three key assumptions of the BSM

Brownian Motion, continuous prices, and European Style

What is the Black Model used to value?

Options where the underlying has no cost, i.e. Futures, swaps, and interest rates

What is the BSM used to value?

Assets with carrying costs (i.e. financing costs, or opportunity cost of capital) so Equities and Currencies

What’s the EffDur Formula, and thing to keep in mind?

(PV_- - PV₊) / (2 * CurveChange * PV₀), where

Curve Change is either way movement so if it’s +0.20% and -0.20%, the Change is 0.20%, not 0.40%

In what circumstance do both putable and callable bonds exhibit positive convexity?

When they are out of the money

When doing floating-bond valuation, do caps/floors affect coupons or interest rates?

Coupons, but you can just do it in reverse and minus the difference too

What’s the difference between an American and Bermudan Option?

American = Callable/Putable any time on or after specific date

Bermudan = Callable/Putable Two or more specified dates only

What does an Authorised Participant (AP) do?

Creates and redeems shares of an ETF in coordination with the Fund Sponsor (FS)

What’s the difference between a creation unit and a creation basket

Creation Unit = Large in-kind transaction occuring only between AP and FS

Basket = Basket of securities that the AP sends when creating an ETF. List is disclosed each day

What is a requirement of trading under the standards?

disclosure of holdings, duplicate transaction confirmations and periodic statements, and preclearance procedures

When unable to adequately perform managerial/supervisor responsiblities, what must a member do?

decline to accept supervisory responsibility in writing

Other than general assumptions, what key assumptions do I need to remember for Arbitrage Pricing Theory (APT)

No arbitrage opportunities exist within well diversified portfolios