“I got that email that every candidate waits for saying that I passed the Level 3 exam and was able to submit my application for membership to the CFA Institute and receive my charter. I was so happy I spent the next hour calling and emailing friends and family. My happiness was quickly turned to pain and disappointment a couple of months later when my application was denied!”
This is an excerpt from an email I received last year in December and is pretty typical of ones I get each year. The problem is almost always the same, lack of approved work experience.
Before you receive your charter and are approved for Institute membership, you must:
- Pass all three exams
- Have two sponsors fill out the Institute’s sponsorship application, one supervisor and one member of the local CFA society
- Meet the requirements for 48 months of ‘qualifying’ work experience
- Pay member dues and sign the Professional Conduct Statement
The requirement for 48 months of ‘qualifying’ work experience catches more candidates than you would think. The Institute fairly narrowly defines ‘qualified’ and will deny your application if your experience does not fit the mold.
‘Qualifying’ Work Experience
Below is the guidance from the Institute on what is considered ‘qualifying’ work experience.
- Evaluating or applying financial, economic, and/or statistical data as part of the investment decision-making process involving securities or similar investments (e.g., publicly traded and privately placed stocks, bonds, and mortgages and their derivatives; commodity-based derivatives and mutual funds; and other investment assets, such as real estate and commodities, if these are held as part of a diversified, securities-oriented investment portfolio).
- Engaged in responsibilities and/or producing work or work product that informs or adds value to those decisions.
- Supervising, directly or indirectly, persons who practice these activities.
- Teaching such activities.
The problem is that the definition provided is fairly broad while the actual criteria used in judging applications is more narrow.
In fact, my first application for membership in 2011 was denied for lack of experience. I was denied credit for my three years of work as a financial analyst since my role in the investment decision-making process was not clear.
Follow the Learning Outcome Statements
First, if you are a level one or level two candidate then you’re in luck and still have a few years to get the experience you need. If you are working in a front-office position and you’re job is directly involved in the decision-making process, you’re also in luck and shouldn’t have a problem.
If you do receive that disappointing letter, you can always provide more detail on your job duties. Focus on the learning outcome statements, especially those in the level 3 exam, and how they fit with your job duties. Every company makes investments of resources in projects and most personnel help in the decision-making process in some way. You just have to find your place in the process. After providing more detail on my work experience, including a rewrite of duties more closely related to the exam LOS, I was approved for membership and received my charter.
If you are not approved for membership even after re-applying, it’s not the end of the world. You will be given affiliate member status and will enjoy all the benefits of Institute membership but will not be able to vote. Leverage your ‘charter pending’ status into a job where your duties directly affect the decision-making process and reapply when you meet the 48 months requirement.
‘til next time, countin’ the days to start the 2014 study season
Joseph Hogue, CFA
The changes to the 2014 CFA Level 2 exam are not as extensive as we’ve seen in the past but there are a few important differences. There are seven new readings and a few ones that have been dropped. All the new readings will have new LOS, though they may be similar to past LOS.
If you’re new to the exam, I wouldn’t change my study schedule too much for the curriculum changes but make sure you have a good grasp of the material. Those repeating the exam will want to focus on the new material since most of the old material will be relatively fresh in your mind.
The Standards and ethics material is the same next year as it has been in the past.
The material in quantitative methods (Study Session 3) and economics (Study Session 4) are basically the same, though some of the LOS have been split or combined but this won’t change the ideas or formulas that you need to know.
Study Session 6, Financial Reporting and Analysis, includes the same three readings (19-21) but they have been updated from last year. LOS 21b and 21h-j have been added and require a more detailed understanding of currency transaction exposure and multinational accounting.
Study Session 8, corporate finance, has not changed though some of the LOS have been split, combined or have slightly different wording. Again, these changes really do not affect what you need to study or understand. Focus on the bigger changes.
The Lessons we Learn, reading 22; Study Session 7 has also been updated
Study Session 11, Equity Valuation (Industry and Company Analysis) has seen the most changes with the addition of two new readings; Reading 33, “Your Strategy Needs a Strategy,” and Reading 34, “Industry and Company Analysis.”
The two new readings strike me as very similar to the Five Forces reading, more management-related than the rest of the curriculum. As an analyst, you need to be able to understand business models and management perspective but a lot of this stuff always seemed too theoretical to me. Easy to remember though.
Reading 44, “A Primer on Commodity Investing,” has been added to Study Session 13, Alternative Investments. The material is fairly close to that in the commodities reading that was dropped from the Level 1 curriculum this year. This happens often where the Institute moves the focus of material from one year to another. The LOS in the new reading look fairly basic and it shouldn’t be a problem for candidates.
Fundamentals of Credit Analysis (Reading 42, 2013) in the Fixed Income material has been replaced by Reading 45, Credit Analysis Models in Study Session 14. While the LOS have changed, they appear to cover mostly the same ideas and concepts. If anything, the new LOS are a bit more quantitatively focused.
Credit Derivatives: An Overview (Reading 53, 2013) has been replaced by Reading 56, Credit Default Swaps in Study Session 15. The new material actually looks a little easier because it is more narrowly focused on Swaps rather than all credit derivatives.
Study Session 18, Portfolio Management has also seen some pretty big changes. The Theory of Active Portfolio Management (Reading 55, 2013) has been dropped and two new readings have been added; Reading 58, “Residual Risk and Return: The Information Ratio” and Reading 59, “The Fundamental Law of Active Management.” Both of these new readings turn the focus to a quantitative approach to active management from last year’s focus on theory.
That concludes our review of the changes to the three exams for the 2014 season. We’ve still got a while before you need to start worrying about a study schedule so we’ll probably cover some miscellaneous topics or answer some questions in the coming weeks. Let me know if there’s anything you want covered.
‘til next time, take a break!
Joseph Hogue, CFA
This is the last of three posts covering the must know formulas for the Level 2 CFA exam. In this post we’ll cover study sessions 13 through 18. The other two posts can be found here: part 1 and part 2.
SS13- Alternative Investments
The Learning outcome statements say you need to be able to calculate the value of real estate over all three approaches; income, cost and sales but the focus of the curriculum is clearly on the income approach and understanding net operating income (NOI). The cost and sales approach to valuation are fairly simple. Cost is just the total expense of creating a similar property while the sales approach looks at the square foot value of similar properties that have sold on the open market.
Of the three valuation methods using income, the direct capitalization is the most important though you also need to understand the DCF and multiplier methods. The discounted cash flows method is just like any other DCF where you take the cash flows over the life of the investment along with a terminal value and discount them to a present value. The multiplier method involves multiplying the gross income from a property by a multiple derived from sales data on similar properties.
The direct capitalization approach revolves around finding the net operating income (NOI) and a cap rate which is the rate of return required by investors.
Gross rental income minus vacancy or collection losses is the effective gross income. The effective gross minus (utilities, taxes, insurance, maintenance, management and advertising) equals the NOI.
* Remember –financing costs and federal income taxes are not subtracted for NOI because the value is independent of financing and is a before-tax, unleveraged measure of income. Depreciation is also not removed.
The cap rate will usually be given or you will need to calculate it from sales and NOI data from similar properties. Otherwise, the cap rate can be found by (discount rate minus growth rate) as well.
The property value is then NOI/cap rate.
Understand how to arrive at the NAV of a REIT and calculate the NAV per share as well as the concept of Funds from Operation (FFO) and REIT price multiples. Understand the difference between FFO and bottom-line earnings and why FFO is a better metric for REITs.
NAV per share = (market value of real estate company’s assets – market value of company’s liabilities)/number of shares outstanding.
The private equity section is testable as well with formulas for distributed to paid in (DPI), residual value to paid in (RVPI), and total value to paid in (TVPI). You also need to know the pre-money and post-money valuation as well as the ownership fraction and price per share in venture capital financing.
DPI= sum of distributions/ cumulative capital called down
RVPI = NAV after distributions/ cumulative capital called down
TVPI (also called the investment multiple) is = DPI + RVPI
SS14- Fixed Income Valuation Concepts
Be sure to understand all the financial ratios in credit analysis like: operating profit margin, debt/EBITDA, EBIT or EBITDA to interest expense, and debt/capital.
Understand that the impact on return may be different for small and large yield changes. The impact on return for small, instantaneous changes is (-modified duration)* the change in the spread, while the impact for a large change in yield is (-modified duration*spread change) plus ½ convexity * (change in spread squared).
You may also need to value a callable or putable bond using an interest rate tree.
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
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.
SS15- Structured Securities
Be able to calculate the prepayment amount on a passthrough security given a monthly mortality rate. Remember, the single monthly mortality (SMM) is the prepayment/(beginning mortgage balance – scheduled principal payment)
The annualized SMM is the conditional prepayment rate (CPR) and is 1-(1-SMM)12
SS16- Derivatives: Forwards and Futures
The two study sessions covering derivatives are where the formulas get especially intense. You can’t afford to neglect the material because it is worth between 5% and 15% of your total exam score. Start by understanding the basic concepts behind the formulas to give yourself a chance at an educated guess if you forget the formula itself.
Be able to price equity or fixed-income forward as well as find the value of the contract over its life. Remember, the price of a forward is based on an arbitrage relationship between the contract and the underlying determined by how much it would cost to buy and hold the asset using borrowed funds. Knowing this means that you need the current price, interest rate, any cash flows in or out, and the contract length to be able to calculate the forward contract.
Forward = (S0 – PV(CF))(1+r)t
You should be able to work through an arbitrage scenario given these data points and the price of a forward contract, first understanding if an arbitrage profit is available then calculating the profit.
Forward rate agreements are also very testable so be able to value a contract. FRA are agreements to pay (or receive) a set interest rate and receive (or pay) a floating rate that is determined at contract expiration.
The payoff on a FRA is = Notational times ( underlying rate at expiration – forward contract rate)(days in underlying rate/360) divided by (1+underlying rate at expiration (days in underlying/360))
It may seem like an intimidating formula but it is really just the difference in rates at expiration multiplied by a time factor relative to the contract length. Make sure you use 360 for the days in a year.
SS17- Derivatives: Options, Swaps, and Rate Derivatives
Being able to calculate synthetic positions using options is a matter of knowing the put-call parity formula. The relationship says that the value of a call plus the (strike price divided by (1+risk free rate)t) should be equal to the value of a put and the underlying asset.
C0 + (x/(1+Rf)T) = P0 + S0
Rearranging this formula, you can find the price for synthetic positions by putting C0, P0, or S0 alone on one side of the equation.
Be able to calculate the payment to a cap or floor holder.
Payment to cap is the max of either zero or notational*(index rate – cap strike rate)*(days in settlement period/360)
While the payment to the floor holder is the max of either zero or notational*(floor strike rate – index rate)*(days in settlement period/360)
The swaps material can be lengthy and complicated with formulas for the fixed payment, floating payment and for the pricing. Remember that currency swaps involve two different currencies and the notational principal is usually exchanged at initiation.
SS18- Portfolio Management
Portfolio management becomes the focus on the Level 3 exam, so it really pays to learn the material on the second exam to save time next year. The expected return and standard deviation on a two-asset portfolio is a common question and fairly easy. Remember that the return is just the weighted returns of the assets while you’ll need the variance and correlation coefficient for the standard deviation.
Varianceportfolio = w21*σ21+w22 σ22+ 2w1w2(correlation) σ1 σ2
*Remember to take the square root of the variance to get the standard deviation.
Also be able to calculate the expected return on an asset given factor sensitivities and factor risk premiums, which is basically just a regression-type formula.
The formulas in these three posts should get you started on the list of most likely to show up on the exam. While you cannot take a formula sheet into the test with you, it’s a good idea to write one up just to practice the formulas and commit them to memory.
A little over a week left to the exam.
‘til next week, happy studyin’
Joseph Hogue, CFA
We covered the first five study sessions worth of formulas in last week’s post and will continue with study sessions 6-12 this week. Again, this is not a complete list of every calculation you will need on the Level 2 exam but the formulas in the curriculum that stand out to me as particularly important. At a minimum, you should know these and the conceptual material surrounding their assumptions and strengths/limitations.
SS6- FRA Intercorporate Investments, Post-Employment and Share-based Compensation, and Multinational Operations
Most of the FRA material is more knowing the accounting and procedures rather than complex formulas. Once you know what adjustments or expenses to be made to a beginning entry then the calculations are really little more than addition/subtraction.
The pension material is important here and you’ll see the same accounting in the next exam as well. Be able to calculate the defined benefit pension obligation and the net pension liability or asset. For the ending DBO = Beginning + Service Cost + Interest Cost +/- Past service cost from current amendments +/- actuarial gains or losses in the current period – benefits paid
Be able to calculate the pension expense and economic pension expense as well.
The translation effects on the balance sheet and income statement through the temporal and current rate methods is something that has been in the curriculum for a while and often appears on the exam. Remember, the gains and losses from the use of the temporal method go directly to the income statement whereas the gains/losses from the current rate method go to the CTA in the stockholders’ equity section of the balance sheet. The balancing ‘plug’ number for the current rate method is the cumulative translation adjustment while the plug number for the temporal method is retained earnings and the gain from translation on the income statement.
SS7 – FRA Earnings Quality Issues and Ratio Analysis
This is mostly a conceptual reading with some basic ratios and no real formula work
SS8- Corporate Finance
Economic profit is a fairly important formula here with the other formulas (i.e. market value added, residual income) also easily testable and seen in other sections of the exam. Economic profit is the excess earned over the dollar cost of capital invested.
- EP = NOPAT – SWACC
- NOPAT = Net operating profit after tax, EBIT (1-tax rate)
- SWACC = dollar cost of capital, WACC* Capital
- Market Value Added (MVA) is the NPV calculation of Economic Profit
Be able to calculate dividends under three dividend policies: Stable, constant dividend payout ratio, and residual.
- Under the stable dividend policy, a payout is set for long term and the target payout ratio is used to find the expected increase. The expected increase is the increase in earnings times the target ratio times an adjustment factor (the reciprocal of the number of years to adjust the dividend)
- Under the constant payout ratio policy, the dividend fluctuates with net income and may be volatile.
- Under the residual policy, dividends = earnings – (capital budget*equity % in capital structure)
SS9- Corporate Finance: Financing and Control
The post-merger EPS is the acquirer’s pre-merger earnings plus the target’s pre-merger earnings divided by the post-merger shares outstanding. Remember that the acquirer may have to issue new shares equal to the target’s market cap divided by the acquirer’s stock price.
The Herfindahl-Hirshman Index is something that comes up frequently but really isn’t too difficult. Just take each firm’s market share times 100 and then squared, then add them all up. Realistic numbers are usually above 500 up to 3,000 so make sure you check your answer. You’ll need to remember the three levels of concentration and the likelihood of an antitrust challenge (i.e. < 1,000, 1,000- 1,800, >1,800)
You may need to calculate the free cash flows for a target company through NOPLAT. NOPLAT is the unlevered net income plus any change in deferred taxes. FCF = NOPLAT + Noncash charges – changes in net working capital – capex. Don’t forget to discount the FCF to a present value using the appropriate rate.
SS10- Equity Valuation
The weighted average cost of capital is a fairly easy calculation but can cost you points if you rush through it. Don’t forget to use the after tax cost of debt, rate (1-tax rate). It is usually preferred to use the target weights for capital structure rather than the current market value weights when finding WACC.
SS11- Industry and Company Analysis
There are some extremely important and testable formulas in this reading. You should be able to work the dividend discount model solving for any one of the variables in case they ask for the discount rate or the dividend growth rate. Remember, the Gordon growth model is a DDM under the constant growth assumption while the H-model or the multi-stage models assume different growth rates.
Under the Gordon growth, value = (current dividend * (1+growth rate)) divided by the required rate minus growth
The H-model is taking a basic DDM (initial dividend rate divided by rate minus long-term growth) but multiplies in a bonus because of supernormal growth (the difference in rates times half the years plus the long-term growth rate). The second part of the equation is a mathematical attempt at estimating a linear (straight line) decline in growth.
Be able to decompose the return on equity in a DuPont Analysis down to its most basic pieces.
ROE = NI/Sales * Sales/Total Assets * Total Assets/Shareholders’ Equity
If you forget, just remember that ROE is NI/Equity so all the other variables must cancel out (i.e. sales is denominator in NI/Sales and numerator in Sales/Assets). Remember that these are also net profit margin * asset turnover* leverage.
SS12- Valuation models
Free cash flow is an extremely important measurement and you will need it extensively in the equity section of the exam, especially at level II. It represents the cash available to either equity investors or all capital providers after all working capital and fixed capital needs have been accountable. Basically, it is the extra cash available to owners (of debt or equity) after the company’s future operations have been funded.
Free Cash Flow to the Firm (FCFF) is the cash flow available to all capital providers (debt and equity) and equals:
Net income + Net noncash Charges (depreciation and amortization) – Investment in working capital – Investment in Fixed capital + after tax interest expense
Free Cash Flow to Equity (FCFE) is the cash flow available to common shareholders and equals:
Net income + Net noncash Charges (depreciation and amortization) – Investment in working capital – Investment in Fixed +/- net borrowing
- Notice that FCFE is FCFF except without adding back interest expense and taking net borrowing into account.
- Understand how to arrive at FCFE or FCFF with CFO
- FCFF = CFO + INT (1-t) – invest fixed capital
- FCFE= CFO – invest fixed capital +/- net borrowing
Be able to understand and calculate price multiples like price/earnings, price/book, price/sales, and price/earnings to growth on a trailing and forward basis.
Enterprise value multiples like EV/EBITDA or EV/Sales are important along with the other price multiples. Remember, Enterprise Value is market value equity + market value preferred + market value debt – cash & investments.
In its most basic form residual income is net income minus an equity charge or just the income remaining after a theoretical cost of the equity used. Net Income – (equity capital*cost of equity)
You may see the calculation including NOPAT which is Net Income + the after tax interest expense so be ready for RI = NOPAT- (WACC*Total Capital) as well.
The valuation model using residual income and book value can be lengthy but is absolutely necessary to learn. Go through a couple of examples until you are sure you have it down for the test.
We’ll conclude the Level 2 must know formulas on Friday with study session 13-18. Let me know if you have any questions or think I missed an important formula.
‘til next time, happy studyin’
Joseph Hogue, CFA
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:
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:
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
Study session 18 in the CFA Level 2 curriculum concludes the material with three readings (54-56) in Portfolio Management.
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
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
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