Category Archives: Level II

Which formulas are the most important for the CFA Level 2?

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There are a ton of formulas you need to know for the Level 2 exam. For me, as with others, it is the most quantitatively intensive test I’ve ever taken.

But do you really need all those formulas, and how do you memorize so much in such a quick time?

In this post and continued through the next two Tuesdays, we’ll look at the most important formulas in the second exam and how to approach the massive amount of material. The usual disclaimer applies, while I have been writing on the exams for quite a while and took them myself, no one knows what will actually show up on the exam. All the curriculum is testable. I can only tell you what I have seen through my own experience and what I have seen on successive versions of the curriculum over the last four years.

We’ll start with a general approach to the formulas then look at each study session to pick out the most important formulas.

Remembering every single calculation from the curriculum is not practical for most candidates and it does seem that the Institute targets some material as more important than others. That said, it is extremely easy to get into the punter’s trap. I call the punter’s trap where you find a tough formula and decide to skip it and focus on easier points instead. Something like punting in football instead of going for the extra yardage. The problem is, once you start doing this it gets easier to do it again and again. Pretty soon, you are skipping a good portion of the curriculum and you are guaranteed some lost points on the exam. Spend the time and get these formulas down.

There’s two things you can do to help get through the tough formulas.

  • First, you need to understand what is conceptually happening in the formula. Trying to understand the myriad of symbols is crazy. If  WACC = (Vd/(Vd +Vce))rd (1-t) + (Vce/(Vd+Vce))rce) doesn’t make you go cross-eyed you are a stronger person than I am. Think about it intuitively and it makes sense. The overall cost of a firm’s funding capital is the cost and proportion of equity and debt. The percentage of each funding type relative to the total is multiplied by its cost. Debt is tax advantaged, so you need the after-tax cost.
  • Secondly, you have to work these formulas through practice and repetition. One of the most popular posts here shows that active learning (engaging the material through practice and conversation) allows you to remember much more than passive learning. The best way to approach tough formulas is to put them on flash cards. Write out a full practice question like those at the end of the chapters. Then work the questions each day. When you are able to do one easily, put it aside so the time necessary each day decreases. You will want to review them all every couple of weeks to make sure you haven’t forgotten any.

We’ll go through each study session to look at the high level important questions but make sure you are doing the end-of-chapter and blue-box questions in the curriculum. If the Institute is taking the time to write out a problem, then they want you to know the formula and you could see it on the exam.

There are no calculations in the first two study sessions, just ethics material but this is extremely important to your overall grade so you may want to review our posts on ethics and standards.

SS2/3 – Quantitative Methods
You need to know how to calculate the sample covariance and correlation coefficient. Learn the basics of the formula but you can do both of these on your calculator so learn how to input the data and you’ll save a lot of time.

You need to know how to calculate a value for a regression model, which is pretty easy by just plugging the numbers into the variables in the formula. The correlation coefficient is just the covariance divided by the standard deviations of each variable. Ryx = COVyx/sysxwith the covariance being the sum of the differences (y- average y)(x – average x) divided by the sample size minus one.

Remember, the slope estimate (b1) is the covariance divided by the variance. What gets most candidates is the various statistics on the ANOVA chart so learn the parts and be able to interpret their meaning.

Predicting the value of a time series or the autoregressive model is similar to the regression model, just plug in the numbers. Be sure you can work a formula with a seasonal lag as well. You may also need to calculate a mean reverting level.

SS4 – Economics
Forex can be tough, especially with the confusion around direct and indirect quotes. You need to be able to calculate the bid-ask spread as well as calculate the profit on a triangular arbitrage. I have included two video explanations to get you started.

A good explanation of Bid and Ask quotes is available on YouTube at:
http://www.youtube.com/watch?v=PmjUx8ZcsoY

Cross rates and arbitrage are easily testable and will really test whether you understand forex quotes and calculations. A good explanation of triangular arbitrage is available on YouTube at:
http://www.youtube.com/watch?v=FElk-K1vb_I

The forward premium or discount on a currency is just the relative difference between the forward and spot price (Fxy – Sxy)/ Sxymultiplied by the annualized time in the contract (12/# of months until settlement)

Interest rate parity is an important concept and the formula is fairly easy. It’s just the relative interest rates (1+rx/1+ry) times the spot price.

SS5 – FRA Inventories and Long-term Assets
You’re required to calculate the effect of inflation or deflation on inventory costs and ratios but I see this as more a conceptual problem. Understand what affect inflation or deflation has on the LIFO or FIFO methodologies and you’ll be fine.

We’ll cover study sessions 6-12 in the post next Tuesday and the remaining sessions in the post after that. We’ll be using the other posts through the next couple of weeks to review strategies for the exams and how to prepare.

‘til next time, happy studyin’
Joseph Hogue, CFA

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CFA Level 2 Review, Portfolio Management

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Study session 18 in the CFA Level 2 curriculum concludes the material with three readings (54-56) in Portfolio Management.

Portfolio Concepts
A lot of the quantitative stuff here you’ve already seen in the quant methods section so be ready to calculate the return and variance on a portfolio. Remember, the portfolio return is just the asset weights times the asset returns while the variance calculation involves standard deviation and correlations.

Understand the theory behind the efficient frontier and how the CAL and CML incorporate into the idea.

  • The capital allocation line (CAL) is a straight line from the risk-free rate to any portfolio in the risk/return area. The optimal portfolio is where the CAL lies on the efficient frontier.
  • The line between the risk-free rate (intercept point) and the optimal portfolio (the tangency of the efficient frontier) is the capital market line (CML). All points on this line are portfolios consisting of different proportions risk-free asset and risky assets. Where the portfolio falls on this line depends on the risk tolerance of the client.

Understand the assumptions used in the CAPM (i.e. optimal portfolios can be built from just expected returns, variances and covariances; identical expectations about returns and variances; ability to borrow and lend at risk-free rate; no trading costs or taxes) and be able to calculate with a historical or adjusted beta.

The material on APT and multifactor models is mostly conceptual so focus on the basic ideas as well as the differences between the two methods. Multi-factor models are basically just a simple regression so don’t get confused by all the terminology.

The Theory of Active Portfolio Management
The reading is almost entirely Treynor Black model with some quick conceptual stuff as an introduction. The Treynor-Black model is a portfolio optimization model that combines market inefficiency with MPT.

Understand the steps in Treynor-Black

1)      Estimate expected return and standard deviation for the passively managed portfolio

2)      Identify limited set of mispriced securities

3)      Determine weights for the mispriced securities

4)      Group securities with non-zero alpha into an active portfolio

5)      Allocate funds between the passive and active portfolio

Understand the use of R2 in Treynor-Black alpha forecasts and analyst accuracy

The Portfolio Management Process
The easiest reading, and possibly the most important, is on the portfolio management process. This material is really the focus of the level III CFA exam but is shown here in a summary version. Learning this material at level II will make next year all that much easier for you.

  • The ‘steps’ in the process (planning, execution, and feedback) are secondary to the other material and fairly obvious anyway. Understanding the pieces within each step will make it intuitive as to where in the process they occur and the overall flow.
  • Understand that the IPS benefits both the client (through a formalized and portable plan) and the advisor (showing fulfillment of duty to client).
  • At the second level, you are really only asked to remember the basic structure of the IPS and what each objective or constraint means. The acronym that always helped me was  R-R-TUTLL. Risk, Return, Taxes, Unique Circumstances, Time Horizon, Legal, Liquidity.
    • Risk tolerance is made up of willingness and ability to tolerate risk. Ability is usually a quantitative concept where a lower proportion of spending to total assets equals higher risk tolerance. Willingness is much more qualitative and comes from the client’s fears and hopes.
    • Return requirement and objective (simplified) is what the client wants to do with their money and what kind of return they need to get there.
    • Taxes is fairly explanatory
    • Liquidity is the spending needs the client needs, within the next year or during retirement
    • Time horizon- the material approaches this in terms of ‘stages’ around life events. Usually something like pre-retirement or pre-college spending and post-retirement.
    • Legal usually doesn’t factor into individual IPS expect with trusts and other legal documents
    • Unique Circumstances is a catch-all not addressed elsewhere, usually something like client prohibitions against investing in vice assets (smoking, alcohol, gambling, etc) or Socially-responsible investing

The tax material is fairly lengthy, but again time spent here will save you next year. Start with the basic formulas and concepts behind the different tax regimes. Pay attention to the concepts under tax loss harvesting or deferral within taxed accounts and the compare/contrast material with retirement accounts.

Wow, we’ve made it through the entire curriculum. Hopefully, you have been able to keep up and have been doing well on practice problems and using other resources. You’re not done just yet. There’s still three weeks left to the exam and they can be the most important three weeks of your preparation. We’ll cover what to expect on test day in Friday’s post and other tips and strategies in subsequent posts all the way up to test day.

‘til next time, happy studyin’
Joseph Hogue, CFA

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CFA Level 2 Review: Options, Swaps and Rate Derivatives

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Study session 17 in the CFA Level 2 curriculum concludes the material on derivatives with four readings (50-53) on options, swaps, and rate derivatives.

Option Markets and Contracts
If you’re familiar with the options markets, the material is pretty basic and will be easy points. For those without prior experience, you’ll need to spend a little more time because it is fairly testable stuff. Understand the difference between European-style and American Options but all the formulas and quant material is based on expiration so there won’t be a difference.

Start with the put-call parity equation and be able to solve for any of the variables; call price, put price or stock price. This will get you through any questions on synthetic positions.

Understand how to create a delta hedge through the number of calls to sell or the total number of shares to purchase. The number of calls to sell equals the number of shares you want to hedge divided by the delta of the option. The total shares to purchase is the number of options you are short times their delta.

You won’t need to do the math for the Black-Scholes Merton equation but you may need to know the assumptions and limitations.

  • Lognormal distribution skewed to the right side but limited to zero on the left side of the distribution
  • Continuous risk-free rate is constant and known
  • Volatility of the underlying asset is constant and known
  • Markets are frictionless (no taxes, transaction costs, or restrictions on short sales)
  • Underlying asset has no cash flows
  • Options valued are European and cannot be exercised early

Know the Greeks and their respective measures. You will need to know how to delta hedge an asset but the rest of the Greeks are just conceptual. Three of the Greeks start with the same letter as the definitional word which is how I remembered them.

  • Delta- sensitivity to price change
  • Gamma- sensitivity to delta change
  • Rho – sensitivity to rate change
  • Theta – sensitivity to time change
  • Vega – sensitivity to volatility

Swap Markets and Contracts

This was probably one of the most difficult readings for me when studying for the Level 2 exam. There are some lengthy and detailed calculations here and you will probably need to spend some time to get them down. I would start with getting the underlying concept first which will help to remember how to put the formulas together. Flash cards work well for drilling the specific equations until you can remember them.

The fixed rate (swap rate) is determined at the contract initiation date and makes the present value of the fixed rate component equal to the present value of the floating rate component. Determining this rate is called “pricing” the swap. The floating rate is reset at the beginning of each settlement period and is based on the short-term rates (LIBOR).

The market value of the swap at any time is equal to the difference between the value of the float-rate side and the value of the fixed-rate side.

A rate swap is an agreement between two parties to exchange fixed for floating rate payments. There is no exchange of principal at initiation. Since currency swaps are for two notional principals, there is usually an exchange at the beginning and end of the swap.

Payer swaptions are the right to enter into a specific swap as the fixed rate payer while receiver swaptions are the right to enter into a swap as the fixed rate receiver.

Interest Rate Derivative Instruments
Caps or ceilings are agreements where one party pays another the when a reference rate exceeds a contracted point. Basically, the buyer needs to limit their risk that rates will increase and enters into a call option on rates (possibly someone paying on floating-rate debt).

Conversely, Floors are agreements where one party pays another when a reference rate drops below a contracted point. A floor is similar to a put option on rates. The calculations for caps and floors are not too difficult, just tedious because you often need to do calculations for multiple periods. Just remember, the payoff is either (0) where the market rate is higher than the floor or lower than the ceiling, or the payoff is the difference between the market rate and the contract rate times the notational and the time fraction (i.e. 90/360).

Credit Derivatives: An Overview
Like the title says, this is really just an overview and there isn’t too much detail. Make sure you get the concepts along with the terms.

Credit default swaps transfer the default risk of an asset to another party. The protection buyer makes a fixed periodic payment to the seller during the term. If the default ‘event’ occurs then the seller pays the buyer according to the contract. Note- this involves counterparty risk that the seller can deliver.

Defalt triggers on CDS instruments can be a number of events including; failure to make a debt payment, bankruptcy, restructuring, moratoriums, or any technical defaults. The settlement of the CDS may be in delivery or a cash settlement.

Understand the various participants in the CDS market and why they might need protection.

Study session 18 in the CFA Level 2 curriculum covers three readings in portfolio management.

‘til next time, happy studyin’
Joseph Hogue, CFA

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CFA Level 2 Review, Forwards and Futures

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Study session 16 in the CFA Level 2 curriculum starts the material on derivatives with two readings (48-49) on forwards and futures. The topic is worth between 5% to 15% on both the Level 2 and Level 3 exams so you will definitely see at least one item set and possibly more.

Forward Markets and Contracts
The forward price is based off of a no-arbitrage assumption that you shouldn’t be able to earn a riskless return above the risk-free rate. The price is a function of the spot price, the risk-free rate and the term of the contract = S0*(1+Rrf)T

You need to understand this simple equation to be able to calculate a cash and carry arbitrage, which often finds its way onto the exams.  This is where you borrow at the risk free rate, buy the bond and simultaneously short/long the forward contract to profit on the difference.

Example: You calculate the no arbitrage price on a four-month contract of $813.10 with a risk-free rate of 5% but the forward is priced in the market at $850. The cash and carry is borrow $800 at the risk-free and buy the bond while shorting the forward contract. At the settlement date, the short forward is satisfied by delivering the bond for a payment of $850 and used to repay the $800 loan. The total amount to repay the loan over the four month term is $800*(1.05).333 = $813.10 with an arbitrage profit of $850 – $813.10 or $36.89 (try several practice problems for this until you can easily do it for under- or over-priced forwards)

Once you have the basic formula down and can do a cash/carry example, the rest of the iterations on forward pricing are fairly easy. The forward rate agreement (FRA) is a little harder, but it is another highly testable item and you need to practice it until you know it. Remember to use 360 for the annual term in the denominator.

Futures Markets and Contracts
Make sure you understand the differences between futures and forward markets and products. Futures are marked to market, traded on organized exchanges, standardized, involve a third-party clearinghouse, and are regulated. Forwards are between private parties, not marked to market, customized and not regulated. Understand how this affects counter-party risk, liquidity, price and margin.

The futures price is also built on the same no-arb assumption so be ready to calculate it and work a cash/carry example.

Backwardation and contango are two important terms on which the curriculum has focused. Backwardation is where the futures price is less than the spot while the spot is less than the future price in Contango. Understand the basics of how these two phenomenon affect market participants for futures (growers and speculators).

Study session 17 in the CFA Level 2 curriculum concludes the material on derivatives with four readings on options, swaps, and rate derivatives.

‘til next time, happy studyin’
Joseph Hogue, CFA

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CFA Level 2 Review, Structured Securities

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Study session 15 in the CFA Level 2 curriculum concludes the fixed income material with three readings (45-47) on structured securities. As it is with much of the topic areas in the Level 2 curriculum, the formulas can get pretty intense but you need to spend some time and master them. The topic area is worth about 10% of your exam score and another 15% in the Level 3 exam.

 Mortgage-Backed Bonds
The reading starts out pretty basic with a glossary of MBS terms and differences between types of structure. Be able to calculate the mortgage payment, an easy task on the PV function of your calculator.

The two types of prepayment risk are important and you should know the difference between them. Contraction risk is that a security’s life will decrease when rates come down and borrowers prepay their loan. This means the investor will need to reinvest proceeds at a lower rate. Extension risk, that the security’s life will increase, is when rates increase and prepayments decrease. The price of the security will decline and the investor will be stuck in the lower rate longer.

Be able to calculate the single monthly mortality (SMM) and the conditional prepayment rate (CPR) assuming a PSA. The two formulas may seem inconsequential but they are probably the most easily testable part of the reading which is largely conceptual.

SMM = prepayment in month i/(beginning mortgage balance for month i – scheduled principal pmt month i)
CPR = 1- (1-SMM)12

The rest of the reading is fairly conceptual. Understand the tranche structure of CMO and the different classes of stripped MBS.

Asset-Backed Bonds
Understand the basic process of securitization and the parties involved. Types of credit enhancements is fairly testable, as much of the list material is.

External enhancements like a third-party guarantee, letter of credit or corporate guarantee expose the investor to third-party risk. Internal enhancements like reserve funds, excess spreads, overcollateralization, and senior-subordinate structures do not have the third-party risk.

The structure is similar for most of these securities, the differences in prepayment risk is probably the most important area. Credit cards and mobile homes do not have prepayment risk. Student loan prepayments are not sensitive to rates.

Know the concepts and structure for CDOs. There is a some quantitative material around an arbitrage transaction that you should do a few practice problems to understand but I’m not sure it is as testable as the other formulas in the topic.

Valuing Mortgage and Asset-Backed Securities
Understand the three assumptions (prepayment rate, reinvested at yield, held to maturity) of cash flow yield and be able to calculate the bond equivalent yield, BEY = 2((1+im)6 – 1)

As is the case throughout the curriculum, pay attention to the limitations on each yield measure (usually based around the assumptions).

Know the basic idea behind the five steps to valuation using Monte Carlo simulation:

  • simulate interest rate      path and cash flow using rates, volatility, and spread assumptions;
  • calculate the PV of cash      flows along 1,000 paths;
  • calculate theoretical      value of MBS as the average PV along all paths;
  • calculate OAS as the      spread that makes PV equal to market price;
  • calculate the option cost      as the zero-volatility spread minus the OAS

Duration is probably the most testable material in the reading, especially since you will need it in other topics. The formula may look intimidating at first but it is pretty intuitive. The price sensitivity to changes in rates is the (value at the lower rate minus value at the higher rate) divided by( twice the initial price times the change in rates)

Understand the different types of duration methods (cash flow, effective duration, coupon curve, empirical duration) and their limitations. The major criticism of cash flow duration is that it is based on the assumption of a single prepayment rate over the life of the security.

Study session 16 in the CFA Level 2 curriculum starts the material on derivatives with two readings on forwards and futures.

‘til next time, happy studyin’
Joseph Hogue, CFA

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CFA Level 2 Review, Fixed Income

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Study session 14 in the CFA Level 2 curriculum begins the material on fixed income with three readings (42-44) on valuation concepts. The material is not as recognizable for many candidates as the stuff on equity investments and can get tough at times. The first reading is fairly basic and secondary to the more practical information in the second reading. The topic is worth 10% of your Level 2 exam and you’ll need the concepts for Fixed Income in the next exam.

Fundamentals of Credit Analysis

The reading is like a 101 on credit analysis and good for your general knowledge of the industry. There are a few important concepts but they are all overall general concepts.

Understand the forms of credit risk:

  • Spread risk is the loss of value from an increase in yield spread over other bonds due to the perceived increase in default risk of the issuer, notice it is from the perception of risk but not necessarily an actual downgrade
  • Downgrade risk is the loss when an issuer is downgraded by an agency due to creditworthiness
  • Market liquidity risk is the loss due to lack of sufficient participation to buy/sell the bonds in the quantity desired

Understand the difference between equity and credit analysis, and the four Cs of Credit

  • Capacity is the ability of the borrower to meet debt obligations
  • Collateral is the quality and value of the assets supporting the debt
  • Covenants are the terms and conditions in a bond agreement
  • Character is the quality of management and willingness to satisfy debt obligations

The different ratios and ratio analysis in the reading are extremely important but reviewed in other sections. You can address them here or in the other sections, but you must know them.

Know the difference between affirmative covenants (obligations the company must hold like paying interest, taxes and submitting audited statements) and negative covenants (limitations on the company like debt ratios and the amount of cash that can be paid out to equity holders).

Term Structure and Volatility of Interest Rates

Know the basis and implications behind the shapes of the yield curve (normal, flat, inverted, and humped). Understand the types of yield curve shifts (parallel and non-parallel) and what it means for relative value of bonds.

The curriculum spends a lot of time explaining how to construct the theoretical spot rate curve for treasuries. Other than bootstrapping, it is still fairly conceptual so understand the basis behind each methodology (coupon strips, on-the-run treasuries, on-the-run plus select off-the-run, all treasury coupons and bills) as well as advantages or limitations.

Bootstrapping is a methodology that can be used to construct the spot curve when using securities with different maturities. The defined process is easily testable so put an example on a flashcard and drill it.

Example: 6-month U.S. Treasury bill has an annualized yield of 5% and the 1-year Treasury STRIP has an annualized yield of 4.5%. The yields are spot rates since these are discount securities. Assume that the 1.5 year Treasury is priced at $98 and its coupon rate is 5% ($2.5 every six months).

The 1.5-year spot rate is:
Price = $2.5/ (1+ (5%/2)) + $2.5/ (1/ 4.5%/2))2 + $102.5/(1+(18month spot /2))3
18-month spot rate = 6.464%

The four theories of the term structure of rates are also fairly testable but you really only need to know the basics.

1)      Pure expectations says that forward rates represent expected future spot rates and are not based on other systematic factors. It predicts that the expected spot rate in one year is equal to the implied 1-year forward, implying that expectations are unbiased and the shape of the yield curve depends on expectations.

2)      Liquidity preference states that long-term rates not only reflect expectations but also include a premium for investing in the long-term bonds, a liquidity premium. Rates are biased as holding long-term maturity requires the premium and that a yield curve may have any shape because the size of the liquidity premium is positively related to investor risk aversion.

3)      Preferred habitat states that rates are set by expectations  and a risk premium to compensate investors for buying bonds outside their “preferred” maturity.

4)      Market segmentation states that the slope of the curve depends on supply and demand conditions in the long and short-term markets. An upward-sloping curve indicates that there is less demand for short-term relative to long-term while a downward sloping curve would imply the opposite.

The quant material used to measure curve risk (rate duration, effective duration, and key rate duration) is extremely important and you will need it again in the third exam. Learn it now and save yourself the time next year.

Valuing Bonds with Embedded Options

The reading starts out fairly conceptual and easy with the interpretation of different spread measures. Understand the main differences between nominal, zero volatility, and option-adjusted spread.

The rest of the reading gets pretty intense with different methodologies for valuation of bonds with options. If nothing else, make sure you understand the concepts behind all the methods and the detail for constructing a binomial interest rate tree.

1)      Given the coupon rate and maturity, use the yield on the current 1-year on-the-run issue for today’s rate.

2)      Assume the level of rate volatility

3)      Given the coupon rate and market value of the 2-year on-the-run issue, select a value of the lower rate and compute the upper rate. R1,u= r1,l * e2volatility

Where:
R1,u is the upper rate (1 reflects the interest rate starting in year 1 and u reflects the higher of the two rates in year 1)
Volatility is the assumed volatility of the 1-period rate
e is the natural antilogarithm, 2.71828

4)      Compute the bond’s value one year from now using the interest rate tree

5)      If the value calculated using the model is greater than the market price, use the higher rate of r1,l and recomputed r1,u and then calculate the new value of the on-the-run issue using new rates. If the value is too low, decrease the interest rates in the tree.

6)      The five steps are repeated with a different value for the lower rate until the value estimated by the model is equal to the market price.

It’s a tough exercise to work through but often shows up on the exam so you need to get an understanding of it.  

Study session 15 in the CFA Level 2 curriculum concludes the fixed income material with three readings on structured securities.

‘til next time, happy studyin’
Joseph Hogue, CFA

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CFA Level 2 Review, Alternative Investments

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Study session 13 in the CFA Level 2 curriculum includes four readings (38-39) on alternative investments. The material is quite a bit more detailed and quantitatively focused than that seen in the first exam and worth between 5% and 15% of your total exam score. Most of the readings are fairly conceptual with only some basic valuation calculations.  

Private Real Estate Investments
Understand the forms of investment (direct, lending, and public securities) and how they differ. Understand the basics behind REITs and how they differ from normal stocks (tax advantaged structure).

The characteristics of the different ‘alternative’ investments are important throughout the readings. Understand that real estate is not homogeneous (each one differs in size, location, age, quality, etc.), are indivisible and may be prohibitively expensive for smaller investors, are management intensive, subject to depreciation, and have high transaction costs.

Understand the basics behind the different property types, i.e. residential, office, retail, industrial and how they differ. Pay attention to the income approach to valuation and be able to calculate NOI and capitalization rate. Understand that the cap rate is positively related to the discount rate and interest rates, but negatively related to the growth rate.

Publicly Traded Real Estate Securities
Here you will need to get more detail on REITs, the different types,  advantages and disadvantages to privately held real estate. REIT structure (upREITs versus DownREITs) is of secondary importance to basic investment characteristics.

Understand the basic economic drivers and factors for the group and each property type. The Institute does not expect you to become a REIT analyst or Donald Trump from the curriculum. Focus on the basics and don’t get bogged down in detail. Look for advantages/limitations as well as list material.

Pay attention to the NAV approach to valuation.

Pro forma cash NOI = NOI minus non-cash rents plus adjustments for impact of acquisitions
Estimated future expected cash NOI = pro forma NOI plus expected growth in NOI
Est. gross asset value =  estimated value of operating real estate plus BV of cash plus book value of land plus BV of receivables plus BV of prepaid and other assets
Net asset value = estimated gross asset value minus total debt minus other liabilities
NAVPS = NAV divided by shares outstanding

Understand that normal price multiples (P/E) are not appropriate for REITs and know the basic idea behind the FFO multiples.

Private Equity Valuation
Understand the differences between private equity and public equity and the various forms of PE (LBO and VC).

Beyond the vocabulary and general concepts, the NPV method of valuation is fairly testable. To be honest, this is one of the formulas/calculations that I skimmed when I was taking the test. Being that the entire topic area is worth about 10% of the exam and this PE valuation is such a small part of the topic, I didn’t really want to commit the time to get the lengthy process (especially when multiple rounds of financing are used). Unless it comes easily to you or you want to go into PE, I would focus on concepts and vocabulary.

Investing in Hedge Funds: A Survey
The differences between Hedge Funds and other investments is most important here, including fee structure, lock-up periods, and regulation. Understand the basic difference between the types of strategies as well as performance biases.

Self selection bias arises because losing funds simply do not report to a database, skewing average returns upwards.
Survivorship bias occurs because managers with poor performances drop out of the business and the results are removed from databases, overstating average returns.

Study session 14 in the CFA Level 2 curriculum begins the material on fixed income and includes some tough detail on term structure and valuation. Make sure you plan to spend some time on practice problems.

‘til next time, happy studyin’
Joseph Hogue, CFA

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CFA Level 2 Review, Equity Valuation

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Study session 12 in the CFA Level 2 curriculum concludes the material on equity investments with four readings (34-37) and could be some of the most important readings for your career as an equity analyst. These are really the basic concepts that you are going to be using and you need to master them to be able to handle the greater detail you’ll see in your professional roles.

Free Cash Flow Valuation
Free cash flow to the firm is available to all suppliers of capital and should use the WACC for a discount rate. Free cash flow to equity is only applicable to equity suppliers so the required return on equity is used as the discount rate.

The most difficult part in FCF calculations, for me, was the adjustments to net income to arrive at FCFF. Remember: depreciation, amortization, restructuring expenses, losses on fixed asset sales, deferred tax liabilities, after-tax interest expenses and preferred stock dividends are all added back to net income. Any gains on the sale of fixed assets, the amortization of long-term bond premiums, deferred tax assets, and investments in FC and WC are all subtracted from net income.

It’s a pain but you absolutely have to understand and be able to calculate all the approaches of FCF estimation: net income, net cash flow, EBIT, EBITDA, and FCFE from FCFF. Start with the calculation from net income to get a good feel for the adjustments and what is being built into FCF, this should make the other equations more intuitive.

Market-Based Valuation
Remember that these are relative valuations and do not necessarily mean that an asset is intrinsically under- or over-valued. The advantage is that they are simple, intuitive and well-known.

Understand the difference between trailing- and leading- price multiples. Trailing earnings need to be adjusted for cyclicality, accounting differences, dilution, and non-recurring items. This is why many use normalized earnings through the ROE method or historical average.

Be able to calculate all the price multiples with inputs,
Trailing P/E = (retention rate * growth)/ (return common equity – growth)
P/B = (ROE – growth)/ (return common equity – growth)
P/S =( (current earnings/current sales)*(retention rate)* growth)/ (return common equity – growth)

Remember that Enterprise Value equals: Market value of equity, preferred stock, and debt minus cash and investments. From here it is fairly simple to get the EV/EBITDA and EV/Sales multiples.

Residual Income Valuation
Residual income is a firm’s net income minus the required return of shareholders. The advantage over the dividend discount model is that more of the intrinsic value is captured upfront in the book value rather than through an estimated terminal value.

The RI model is only appropriate with clean surplus accounting, when there are no changes in the book value except for earnings and dividends. The book value used in the RI model should be adjusted for off-balance sheet items.

The disadvantages of the RI model are that it relies on easily manipulated financial statement data, clean surplus must hold, and the amount of adjustments that may be needed. The model is most appropriate with companies that do not pay a dividend, when there are negative FCF, or the terminal value is difficult to estimate.

Be able to calculate RI from net income or NOPAT
RI= Net Income – Capital Charge
= Net Income – (Equity capital * cost of equity)
RI = NOPAT – Total Capital Charge
= NOPAT – ((after-tax cost of debt * debt capital) – (cost of equity * equity capital))

Private Company Valuation
Understand the company specific (life cycle, size, markets, management) and stock specific (liquidity of equity, concentration of control, agreements on liquidity restrictions) factors for valuation.

Most of the valuation calculations (FCFF) have been used in other sections so focus on the idea behind each valuation method as well as advantages/limitations.

The discount equation for lack of control and marketability is fairly testable so understand how to perform the calculation and ideas around it. The lack of control discount (DLOC) is the percentage deducted from the pro rata share of an equity interest to reflect absence of control (when valuation is being done for a minority interest in the target). The lack of marketability discount (DLOM) reflects the absence of marketability (liquidity, share and transfer restrictions, concentration of ownership).

DLOC = 1- (1/(1+control premium))
DLOM = Value of at-the-money puts/Value of stock before any DLOC

Study session 13 in the CFA Level 2 curriculum covers alternative investments. The material is quite a bit more complex than what you saw at Level 1 so don’t fall behind.

‘til next time, happy studyin’
Joseph Hogue, CFA

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CFA Level 2 Review Equity Investments

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Study session 11 in the CFA Level 2 curriculum continues the material on equity investments with two readings (32-33).

Five Competitive Forces
Porter’s five forces is an extremely popular industry analysis tool. If you ever go for your MBA, and many of you will without realizing it yet, you will see this material again. At the CFA curriculum level, it is pretty basic and your really only need to remember the underlying concept behind each force.

  • Threat of entry- barriers to entry on the supply and demand side, customer switching costs, access to distribution channels, government regulation, and capital requirements
  • Bargaining power suppliers- number of suppliers and switching costs, and differentiation among supplied materials
  • Bargaining power buyers – number of buyers and switching costs, and whether one buyer accounts for a significant share of revenue
  • Threat of substitutes- relative value of substitutes and buyer switching costs
  • Rivalry among competitiors- product cycle and introductions, marketing, price discounting

Understand the difference between factors affecting the industry structure (growth rate, tech innovation, government, complementary products) and the five forces that shape strategy.

Discounted Dividend Valuation
While the five forces is pretty basic and can be some easy points, this is the more important reading by far. You absolutely must know all the different iterations of dividend discount models.

Besides being able to plug data and calculate valuation, you are expected to understand the differences between the models and decide which model to use given different scenarios. As with many of the formulas in the CFA curriculum, you should start with the concept behind the calculation and understand what it means. This will help you get the conceptual points on the exams, which I would say are easily more than half of total points, and will help you memorize the formula.

We covered the free cash flow formulas and residual income model as inputs to dividend discount models in a prior post here.

Remember, FCFF is pre-debt cash flow while FCFE is post-debt so FCFF is preferable when the company has a volatile capital structure, is highly leveraged, or has negative FCFE.

The residual income model is only valid under Clean Surplus Accounting and is preferable when the company is not paying dividends and when expected free cash flows are negative.

Understand and be able to calculate the Gordon Growth Model and the different iterations of the dividend discount models.

The H-Model is an intimidating formula and many candidates neglect it and ‘hope’ that it doesn’t show up on the exam (but it often does). It is easier if you reason through the pieces. The formula is really just the Gordon growth with a “compromise” estimate of growth based on the two periods. The estimate for growth is just the long-term rate plus half of the difference between the supernormal period and the long-term rate.

Study session 12 in the CFA Level 2 curriculum could be the most important across the three exams for an equity analyst. The four readings cover four different methods of valuation: FCF, Relative Valuation, Residual Income, and Private Company Valuation.

‘til next time, happy studyin’
Joseph Hogue, CFA

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