5 Things I Wish I Knew about the CFA Level I Exam

Last week, I listed out the things I wish I knew before each level of the CFA exams. For the most part, these were the general ideas that relate well across all three levels. This week, I am reminiscing back to those bygone days of the Level I CFA exam.
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CFA Level 1 Curriculum Review: Financial Statement Analysis

Reading 28 in the CFA curriculum combines the financial statements with key ratios and analysis

This is the fifth week of our CFA Level 1 review of the financial statement material. Reading 28 is your first look into the financial statement analysis and techniques that will make up a big portion of your CFA level 2 exam. In all, financial reporting and analysis accounts for 20% of your level 1 points and up to 20% of the second exam.

Check out the introduction to CFA Level 1 Financial Statements
Check out the CFA Level 1 Income Statement Review
Check out the CFA Level 1 Balance Sheet Review
Check out the CFA Level 1 Statement of Cash Flows Review

Some of the ratios and financial analysis techniques you’ll see in reading 28 have already been discussed in the separate readings on each financial statement. Besides specific techniques used in analysis, pay attention to assumptions used in different techniques and the limitations of each method.

Ratios and Common-Size Financial Statement Analysis

Ratios in financial statement analysis offer a way to standardize information and compare results across companies. It can be used to compare current results with past performance as well. Ratio analysis is limited across companies because each might operate in a slightly different product category or market. Differences in accounting practices can distort ratios and there’s no definite set of ratios that will tell you all you need about a company.

Activity ratios measure management efficiency in day-to-day operations. I’ve included some of the most common ratios used below. Activity ratios are also called asset utilization ratios. Notice that when you use Balance Sheet data in a ratio with another financial statement, you need to take the average of the beginning and ending number reported on the Balance Sheet.

cfa activity ratiosSolvency ratios measure the firm’s ability to meet long-term obligations. Liquidity ratios measure the firm’s ability to meet short-term obligations. Pay attention to the Cash Conversion Cycle which reflects the number of days a company’s cash is tied up in the operating cycle. The conversion cycle equals the number of days inventory plus days receivable outstanding minus the number of days accounts payable outstanding.

Understand the difference between operating leverage and financial leverage. Operating leverage comes from using fixed costs in the company’s business and magnifies the effect of sales growth on operating income. Financial leverage comes from the use of debt and magnifies the effect of changes in EBIT on net income.

cfa debt and liquidity ratiosProfitability ratios measure overall performance and margins. Gross, operating and net margin are used often to show different ideas of profitability.

cfa profitability ratiosIt may seem like a lot of ratios to memorize but they are fairly easy to remember after some repetition. Write the ratios and a brief explanation on some flash cards and review them each day until you’ve mastered the concept.

Common-size financial statement analysis is helpful in spotting trends within a company’s results as well as comparing accounting line items across firms. A horizontal common-size statement compares an accounting item like sales or operating expenses against itself from another year. It’s helpful in finding growth across time in each line item. A vertical common-size statement compares an accounting item against another line in the same year, usually against sales or total assets. It’s helpful in comparing the proportion of a line item in one company against another.

For common-size analysis on the balance sheet, you’ll use total assets as the common item. For analysis on the income statement, sales are used as the common item for comparison.

There’s quite a bit more in reading 28 including DuPont Analysis and some important ratios for equity analysis. All the ratios in the reading could easily show up on the CFA exam since they’re pretty easy to test in a quick question. The best way to approach the material is to understand the concept of the ratio. Instead of just rote memorization of the equation, understand what the components are and how they relate to each other. You’ll find it much easier to remember the mountain of ratios and equations for the exam.

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

CFA 2016 Review: Level I Statement of Cash Flows

This is the fourth week of our CFA Level 1 review of the financial statement material. We look at the Statement of Cash Flows this week, a statement that shows the inflows and outflows of cash over the period. Actual cash flow is much harder to manipulate compared to the income statement so analysts use this statement heavily in their work. Make the Statement of Cash Flows your new best friend.

Check out the introduction to CFA Level 1 Financial Statements

Check out the CFA Level 1 Income Statement Review

Check out the CFA Level 1 Balance Sheet Review

Understanding the Statement of Cash Flows

Like the Income Statement, the Statement of Cash Flows shows activity over the period. Remember, this is different from the Balance Sheet which shows assets, liabilities and equity only at one point in time. To compare Cash Flow numbers with Balance Sheet data, you’ll need to take an average of the beginning and ending balance sheet number for an appropriate comparison.

Understand also that cash flow is not the same as net income. Income is an accounting idea based on revenue earned and matched expenses but may not mean the company is generating cash.

A company’s cash flows are separated into one of three sections; operating, investing and financing.

Cash Flow from Operations is the cash generated from normal day-to-day operations. Throughout the cash flow statement, it will be important to distinguish between inflows and outflows of cash. Cash inflows for operations include: collection on sales and accounts receivable, receipt of interest or dividends. Cash outflows for operations include: payments to suppliers and accounts payable, payments to employees, interest payments and payment of income taxes.

Cash Flow from Investing Activities is the purchase or sale of long-term assets, assets like PP&E or long-term investments that will help generate sales for years to come. Cash inflows for investing include sales of non-current assets. Cash outflows here include the purchase of non-current assets.

Cash Flow from Finance is the borrowing and repayment of debt, issuing stock or paying dividends. Cash inflows include issuing stock or bonds. Cash outflows include paying debt or dividends and buying back shares.

The Statement of Cash Flows is connected to the balance sheet through cash. The sum of the three cash sections on the statement, plus the beginning balance of cash from the balance sheet will equal the ending cash balance for the end of the period.

cfa level 1 review statement of cash flows formatYou are going to be spending a lot of your time working through cash flow statements as a new analyst. The Statement of Cash Flows can be constructed from information given on the other two financial statements. The best way to understand the statement, and a must-know topic for the CFA exams, is mastering the two methods for calculating and reporting the statement: the Direct and Indirect methods.

I’m not going to write out the methods here. It’s something you need to write out and study in detail and both methods are shown in the curriculum and in the Finquiz Notes. It can seem tedious to practice through the methods but you need to do it to learn how the statement is constructed through cash changes. Practice with real company financial statements to see if you come out with the same numbers.

Cash Flow Analysis

Performance ratios used with the Statement of Cash Flows include: cash flow to sales, cash return to assets or equity, and cash flow per share. These are all pretty easy to remember and not nearly as important as two other concepts in the reading.

Other than a basic understanding of the cash flow statement, the most important section in the reading is on Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE). You will use these two concepts throughout the curriculum and absolutely must master them.

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

The calculation for FCFE is fairly easy but you need to make sure not to get the components confused with FCFF. FCFE is CFO minus investments in fixed capital plus net borrowing, or the cash flow available to common equity holders without placing a burden on operations.

FCFE can be more volatile than other cash flow measures because of the capital expenditures spending, so you might have to use a multi-year average if the test question mentions it. Though you will probably not be asked to do so on the test, some analysts adjust CFA for nonrecurring expenses before calculating FCFE. A big focus in the CFA curriculum is conservative practices, almost always favored when a choice is given. Adjusting items for non-recurring events and taking the average of volatile accounts over a period of time are more conservative and provide a more stable estimate.

Make sure you can go from FCFF to FCFE or can get there from multiple routes. Thinking through the various accounts and why they are included will help get these concepts down. PRACTICE, PRACTICE, PRACTICE.

FCFF = CFO + interest(1-tax rate) – Fixed Capital Investment

FCFF = EBITDA(1-tax rate)+depreciation expense(tax rate) + (increase in deferred tax) – (investments in fixed and working capital)

FCFE = FCFF – interest(1-tax rate) + net borrowing

Most CFA candidates haven’t had as much experience with the Statement of Cash Flows or haven’t taken time to really master the direct and indirect method so spend some time on the reading to really understand the statement.

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

CFA 2016 Review: Level I Balance Sheet

Master this introductory material on the balance sheet in the 2016 CFA Level 1 curriculum to breeze through tougher concepts later

This is our third week of reviewing the CFA Level 1 Financial Statement material, following the introductory reading and income statement analysis last week.

We begin on our review of the Balance Sheet, reading 26 of the CFA Level 1 curriculum, this week. The balance sheet is not quite as talked about among investors as the income statement but is no less important. Understand how the balance sheet relates to the other two statements, especially how assets are depreciated and expensed.

Understanding the Balance Sheet

The Balance Sheet financial statement is different from the other statements in that it is a snapshot in time rather than a presentation of activity over the period. The Balance Sheet shows assets, liabilities and owner’s equity as of the last day in the reporting period.

Assets represent economic resources of the company, resources that can be used to generate cash or sales. Liabilities are current or future obligations of the company, representing an outflow of economic benefit. Owner’s equity represents the remaining assets or economic resources after all creditors (liabilities) are paid. This gives rise to the balancing of the Balance Sheet with Assets equaling liabilities and equity.

Assets and liabilities are presented in terms of liquidity. Assets that are highly liquid like cash or those that can be converted to cash are show first. Those liabilities that are expected to be paid within a year are shown first in short-term liabilities. The remaining assets and liabilities are shown in long-term accounts because they are expected to be used or paid out over more than a year.

cfa level 1 review balance sheetUnderstand that some of the assets on the Balance Sheet will have a contra-asset and the difference between historical value and net. Accounts receivable is offset by the allowance for doubtful accounts for Net Receivables. Property, Plant and Equipment is offset by depreciation for its net value.

There is a lot of accounting concepts on the balance sheet but you must know them to be a good analyst. You’ll go into more detail on how inventories, long-term assets and other accounts are depreciated, expensed and recorded in other readings. If you don’t have a strong background in accounting, it’s imperative that you spend the time necessary to master this introductory material so you can understand the more detailed readings.

The differences between U.S. GAAP and IFRS reporting can be tedious and confusing. It’s best if you put together a table for each financial statement. Label the different accounting items (inventory, PP&E, etc) down the left-side column followed by columns for GAAP and IFRS. This makes for a quick review of the differences that you can use a few times a day until you’ve got them committed to memory.

An important distinction on the Balance Sheet is the classification of financial assets. Financial assets (liquid assets in stocks and other securities) are either classified as Held-to-Maturity, Held-for-Trading, or Available-for-Sale. How the asset is classified will affect how it’s value is recorded and how the gains/losses show through to the income statement.

  • Held-to-Maturity assets are measured at amortised or historical costs and no unrealized gains/losses are reported.
  • Held-for-Trading assets are recorded at fair value and marked to market with unrealized gains/losses recognized as profit/loss on the income statement and in retained earnings.
  • Available-for-Sale assets are recorded at fair value with unrealized gain/loss recognized on Other Comprehensive Income and accumulated within owner’s equity.

Balance Sheet Analysis

As with the reading on the Income Statement, the analysis here is fairly light with just some ratios. The reading is focused more on the accounting concepts for the Balance Sheet while other readings will go deeper into the analysis.

In ratio analysis, you must remember to adjust your Balance Sheet numbers when using them with numbers from the other financial statements. It’s easier than it sounds, you just need to take the average of the beginning and ending values for the Balance Sheet number.

For example, the Days Sales Outstanding ratio is found by taking the average of the beginning and ending receivables on the balance sheet and then dividing by sales or credit sales from the income statement.

Make sure you understand and remember the liquidity ratios and the solvency ratios. These are very basic and will be used throughout the CFA exams and your job as an analyst.

Liquidity Ratios: Current, Quick (acid-test), Cash
Solvency Ratios: Long-term Debt to Equity, Debt to Equity, Financial Leverage

We’ll continue with the Statement of Cash Flows next week and then a week for financial statement analysis. Make sure you are scheduling enough study time to read through the curriculum, work practice problems and then review study notes. It’s only this repetitive system of studying that will allow you to commit the material to memory.

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

CFA Level 1 Review: Fixed Income

Study Session 16 in the CFA Level 1 curriculum concludes the Fixed Income topic area with two readings, one on risk and return concepts and another on basic credit analysis. The credit analysis reading is completely conceptual and probably secondary to the first reading.

When I took the Level 1 exam, I was surprised by how conceptually-focused it was and how many of the formulas that I had studied for hours were not tested. They say the Level 1 exam is a mile wide and an inch deep because the curriculum touches a seemingly endless number of areas but does not go into much detail. For this reason, I always recommend to Level 1 candidates to focus on getting the main ideas and reasoning behind the concepts then to work on learning formulas.

This is especially true in SS16 with quite a few new formulas on duration and convexity. You will definitely need the basic duration and convexity formulas for the level 2 exam, so spend a little extra time here. You may or may not need to remember the formula for Macaulay duration, I would consider it of secondary importance to the others. Whatever you do, make sure you understand the concept of duration and convexity above all else.

Understanding Fixed Income Risk and Return

There are three sources of return for a bond; coupons, reinvestment and the return of face value. It is imperative that you understand how rising or falling rates affect the value of coupons and reinvestment opportunities.

If rates increase, the value of a bond decreases to make the yield competitive (i.e. since the coupons do not change, new investors/demand for the bond will require a market competitive yield so the price must change). If rates fall, the value of the bond increases but investors are exposed to reinvestment risk because of lower rates.

Understand how the time to maturity affects these concepts as well. The value of a long-term bond will rise and fall more with changes in interest rates because the change in reinvestment return has longer to affect the value.

This idea of rate risk on a bond’s price is known as Yield Duration (or just Duration). There are four measures: Macaulay, Modified, Effective, dollar and Price value of a basis point. The modified, effective, and dollar duration and PVBS are probably the most important to remember for the exam.

Modified Duration is the price of the bond at the lower rate minus the price of the bond at the higher rate (PVlow –Pvhigh) divided by two times the change in yield times the initial price (2*Yieldchg*PV0). It is a fairly easy formula to remember if you think about the concept first. You are measuring rate sensitivity so the numerator is the change in value with a change in rates. The denominator is the initial price times how much the rate change caused yield to change and multiplied by two. It may take a few practice problems but make a flash card and you’ll get it.

Effective Duration is basically the same formula but using the yield curve instead of the change in the bond’s yield. Understand that the Modified and Effective Duration will be different but will move closer together when: yield curve is flatter, maturity is shorter, price of bond is closer to par.

Understand the advantages and limitations to each method of measure for portfolio duration.

You will definitely need dollar duration for the second and third exam. Fortunately, once you have the basic duration formulas down then dollar duration is easy to remember.

The price value of a basis point is an estimate of the change in price when YTM changes one basis point. It’s a pretty quick and easy formula; the change in price with high and low rates (PVlow –Pvhigh) divided by two. Don’t forget that a basis point is one-hundreth of a percent (0.0001).

Convexity is also a very important concept in the reading. While duration only estimates the change in price from changes in rates, convexity measures the difference in that estimate on rate changes. Convexity will differ from duration the most when rates are much higher or much lower. Understand that callable bonds have negative convexity at lower rates because of the call option.

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 curriculum throws a ton of ratios at you to measure liquidity and financial strength but they are all discussed in more detail in other sections. Quickly understand how the ratio shows higher or lower credit risk but I wouldn’t spend too much time here. Study them in the equity and FRA topic areas where more detail is provided.

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).

Just a month and a half left to the exam. You should be well on your way to finishing your first pass through the curriculum and ready for a review of the more difficult/important topics. Start taking mock exams built off of question banks and end-of-chapter questions as well to start getting ready for the long 6-hour exam. These mock exams will help measure how you do when you have to sit down and test every topic area at once instead of individually.

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

CFA Level 1 Review: Equity Markets

Study session 13 in the CFA Level 1 curriculum begins the material on equity investments with three readings (46-48). The material is almost completely conceptual and likely not worth a ton of points but still worth your time. Since it is all basic-level and conceptual, it is pretty easy to understand and you only need the basic idea to get any points on the exam. Make sure you understand the vocabulary and concepts, including any lists and advantages/limitations on comparisons given.

Market Organization and Structure

This is almost entirely a vocabulary lesson on the market and participants. It is important that you know the information for general knowledge but it is not as testable as some of the other readings. The key terms are good for flashcards with a quick rundown until you’ve got them.

Understand the difference between assets; i.e. fixed-income, equities and pooled investment vehicles. You likely won’t need much other than the brief definitional material for futures, options, swaps and commodities. Most of these assets are covered in much more detail in other parts of the curriculum.

Understand how to calculate returns on leveraged positions, maintenance margin requirement and the margin call price. If a buyer will receive a margin call when the value of equity drops below 25% of the maintenance margin requirement, with an initial stock price of $20 leveraged with 60% margin: the margin call price is ($8 +Price – $20) / Price = $16.

While the likelihood of seeing much of this one the exam is pretty low, make sure you have a basic grasp of the material. Understanding how the markets are organized and the primary players is an absolutely basic requirement to understanding how the markets operate. It should be repeat information for Finance students but will get you up to speed if you are from a different educational background.

Security Market Indices

The differences and calculations for the indices (price-weighted, equal-weighted, market cap, and fundamentally-weighted) are important information and have shown up on the exam. It’s really not difficult information, just understand how they are constructed and how to calculate returns.

Price-weighted indices are based on the price of each stock. This means that higher-priced stocks will have more influence on the index. It is simply calculated but biased to the higher-priced stocks and may involve a downward bias. Stock splits, spinoffs and constituent changes will all affect the divisor.

Equally-weighted indices are based on an equal-dollar amount in each stock. The advantage is that it is also easily calculated but it may bias towards small-cap firms because there are more of these in the market. It also requires frequent rebalancing (higher transaction costs) and contains potentially illiquid stocks.

Market-cap weighted indices are based on the value of each stock company in the index. Advantages include a better representation of each company’s value in the market though the index will be biased to larger firms. The index may overweight stocks that have seen their value increase (overvalued) against those that have decreased in value.

Understand the uses of indices; i.e. measuring market sentiment, as a proxy for asset classes, as benchmarks for managed portfolios and as the bases for new products.

They construction and limitations of alternative asset indices shows up several times in the curriculum, so spend some time on this section. Pay special attention to the possible biases within each index.

Market Efficiency

The efficient markets theory is a huge concept in the industry and for the exams. You do not necessarily need to know all the data and details that support it, but you should know the implications of each level of efficiency. Understand what it means for technical analysis and transaction costs in trading.

Know the difference between market value (the current price in the market) and intrinsic value (value based on investment characteristics). Depending on the efficiency of the market, these two values may differ widely.

The Institute does not ask you to take a position on the efficient market hypothesis but regardless of how you believe the markets behave, when you are taking the exam the curriculum is the ultimate truth. Know that there is considerable evidence supporting the semi-strong form of efficiency and some evidence to support the strong form. Understand the implication this has on active portfolio management, i.e. that gross performance will likely mirror the market but will underperform after fees.

Remember the factors contributing to or impeding efficiency in market prices:

  • Greater number of participants should contribute to market efficiency through consensus
  • Information availability and financial disclosure should promote fairness and efficiency
  • Limits to trading like restrictions on short-selling and operational inefficiencies (high transaction costs, difficulties in execution) impede market efficiency

The list of market anomalies is testable vocabulary and can be fun to read through. Again, mostly a flashcard exercise until you can recognize the terms and their basic idea. Understand that most of these anomalies are limited due to market knowledge that they exist and front-running.

Understand the basic idea behind the eight behavioral biases, which will be even more important in your Level 3 exam.

  • Loss aversion is bias that investors dislike losses much more than the want gains and will hold on to losers to avoid losses much longer than they should.
  • Overconfidence is the tendency to overestimate your own ability to predict/forecast prices and other market indicators. Often leads to undiversified portfolios.
  • Representativeness is the bias that investors give greater weight of probability to the current situation, i.e. investors overweight current information and trends and tend to neglect new information or trends.
  • Gambler’s fallacy is the bias to project long-term reversion to the mean, i.e. that falling stocks will reverse direction based on no fundamental change
  • Mental accounting is the bias to mentally track gains and losses for different investments within separate ‘buckets’ rather than as a whole portfolio view
  • Conservatism is the bias to under-react to new information and tendency to stick to prior views
  • Disposition effect is the tendency to avoid regret by selling winners too early and holding on to losers too long
  • Narrow framing is the tendency to analyze a situation in isolation, ignoring the larger context and forces

Again, most of this stuff is perfect for flash cards and a quick understanding of basic ideas. Just make sure you have the concepts and move on to spend more time on more important study sessions.

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

December CFA Exam Must-Know Strategy

Following our discussion last week on taking the December and June exams, we thought it would be a good time to start a series of posts to prepare December candidates for the exam. This week we will cover the basic strategy and helpful tips for the first CFA exam. Over the next couple of months, we will cover specific topic-level information within the first exam.

Follow those topic weights

The CFA Institute does not disclose the minimum passing score on any exam but has said that no one with a score of 70% or greater has ever failed. The Institute does release a topic-level breakdown of the question weights you will see on the exam, shown in the graphic below. While you cannot afford to neglect any particular topic, one of the best things you can do while studying is focus on the high-point areas on each exam.

It will do you no good to spend half your time studying Corporate Finance, even if that is what it takes to master the information, if it means performing poorly in other areas.

cfa topic weights

Looking at the chart, it should be clear that you need to focus on three or four topic areas for the first exam.

You absolutely must master the material in Ethical and Professional Standards. Not only is it carry the second most questions on the exam but it will be 10% of your next two exams as well. You’ll see additional material in the other two exams but the Code and Standards do not change so learn them early. The most challenging aspect for most candidates is that they underestimate the difficulty of the exam questions. Candidates reason that they are more or less honest people and so will intuitively know the answers to the ethics questions.

WRONG! You only need to read through a few of the end-of-chapter questions in the curriculum to see how difficult and confusing the Institute can make these questions. My suggestion, make flashcards for each professional standard for quick review. Then spend most of your time practicing questions. The best resource will be your curriculum book or those from prior years. Try getting the book from last year or the year before for another set of questions. Test bank questions are also a good resource. By practicing as many questions as possible, you will start to get a feel for how they might appear on the actual exam.

Financial Reporting & Analysis is likely the most important topic area in the curriculum across all three exams. You are testing for the designation of Chartered Financial Analyst, so you better master the topic to pass the exams and succeed in your career. There are four study sessions covering FRA for the first exam. I would say SS8, the material on the financial statements, is probably the most important.

A few keys to passing the FRA material

  • Understand how items are recorded on the financial statements – Are they historical costs or market values, are they point-in-time values or for the entire period
  • Understand the relationships between the financial statements – These are absolutely critical to your success as an analyst. Building your first proforma model will mean linking the three financial statements to your projections flow through and tell you where the company is going.
  • Understand how to adjust and analyze the financial statements through ratios, earnings quality and backing out different items. This is really the Holy Grail of the analyst’s job and you won’t be expected to do it on your first CFA exam but you will be expected to understand the very basics.

We’ll cover FRA in more detail through our topic-level breakdowns. Just remember to leave yourself plenty of study time for the topic when you are planning your schedule.

The time you spend on Quantitative Methods will depend on your prior experience with statistics. While the points in the topic are not huge over the first two exams, understanding the Level 1 material can make the material on the second exam much easier. For this reason, I would suggest spending a little more time to get it down. Study Session 2 is relatively basic material but absolutely fundamental to our industry so you need to understand it.

While Equity Investments is only 10% of your first exam, I would recommend spending more time here as well because it will save you a lot of time on the next exam. Study Session 14 is the more important but SS13 is relatively basic and should be easy enough to get the general ideas. In particular, the material on Industry and Company Analysis (reading 50) and Equity Valuation (reading 51) are extremely important and very testable.

If you do not have a background in debt instruments, you’ll need to spend a little extra time in Fixed Income as well even if it is not a lot of points on the first exam. The basics on pricing and valuation that you learn on the first exam will be needed to understand the material in the other two exams.

Key Resources

While the curriculum is the last word for exam prep, it is simply too long to make it your only resource.

I would recommend you read through a study guide for each topic before you read through the curriculum. This is going to help you quickly get the basic ideas and will help speed your reading through the long curriculum readings. A lot of the curriculum is academic and a little dense so without a quick primer, you could find yourself re-reading passages just to understand what you’re looking at.

Flash cards are another key resource. These are a great resource to carry around with you and get a little extra studying in whenever you have down-time. Don’t buy your flashcards though. Half the benefit is from writing the problems out so you will want to make your own. I talk through how to make a set of quality flash cards in a prior post.

Practice problems, whether from the end-of-chapters or a study bank, are likely the number one reason candidates pass the exam or not. Sitting there reading the curriculum, and other passive learning techniques, will only help you retain about 20% of the material. Actively working through practice problems can help you retain at least 80% and get you well on your way to passing the exam.

As in the ethics material, a lot of candidates underestimate the difficulty of exam questions. You really need to study the practice problems to see what you will be up against for those six hours in December. I usually recommend doing at least 900 practice problems throughout your study plan.

A basic strategy

It is said that the human brain needs to see/experience something upwards of six or seven times to assimilate it into long-term memory. You’ve likely seen this in your daily life. Do you usually remember a phone number by just seeing it one time? No, you need to say it and see it a couple of times before you are able to remember it later.

The same can be said for preparing for the CFA exams. Plan on seeing or practicing the material at least 5-7 times before the exam. If you are breaking the study sessions into a weekly plan, it may look something like this:

Monday: Read study guide material
Tuesday: Practice problems and flash cards
Wednesday: Read curriculum and 30 minutes practice problems
Thursday: Finish curriculum and 30 minutes practice problems
Friday: Test over the material and flash cards
Saturday: Review study guide material and 30 minutes practice problems

By combining study guides, flash cards, practice problems and the curriculum you will be able to cover the material multiple times. By using multiple resources, you avoid getting bored looking at the exact same material every time. Notice, even on the reading days, I have added some practice problems. This is to reinforce the material you learned with active engagement.

I was quite surprised how general the questions were when I took the Level 1 exam. The first exam is an indoctrination into the industry and you are not expected to know all the details. Start by understanding the reasoning and basic ideas within each topic area and then move on to get the details. Understanding the basic reasoning in each Learning Outcome Statement (LOS) will usually help you eliminate at least one of the three answers provided.

Next week, we will start working through some of the topic areas on the Level 1 exam. We will spend most of our time focusing on core topics like Ethics, Financial Reporting, Quantitative Methods and Equity Investments but will try to touch on each topic over the next couple of months.

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

CFA Level 1 Review, Alternative Investments

Study session 18 concludes the CFA Level 1 curriculum with two readings (66-67) covering alternative investments.

Introduction to Alternative Investments
The reading really focuses on the commonalities of alternative investments and how they differ from traditional bonds/stocks. You’ll get more detail into each type of alternative in the other two exams.

Understand the five common characteristics of alternatives:

  • Illiquidity – do not have as many buyers or open market transactions so may have to offer a premium
  • Lack of current market value – because of illiquidity, transactions are not continuous and the current value may need to be estimated
  • Data limitations – less risk and return data may be available because of infrequent trading
  • Asymmetric information – valuations may differ greatly depending on geographic characteristics and there may be considerable information asymmetries
  • Difficulty of analysis – since market transactions are less frequent and data limitations are higher the analysis work may be more difficult and have a lower degree of confidence

Understand the forms of real estate investment and advantages/limitations to each. Direct ownership can be prohibitively expensive and transaction costs are high but it is the most directly tied to prices. An indirect investment in equity or mortgages may have less transaction costs and limited liability. REITs are a hybrid between stock and real estate ownership that carry tax-advantages.

Remember the basic components of the NOI approach to real estate valuation and be able to do a calculation. 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.

Venture capital firms raise funds to invest in private companies or investments. The timeline is probably the most important material here but also understand some of the additional limitations and characteristics. The investment stages are broken into two groups: Formative stage (seed, startup, and first stage financing) and Later-stage (second stage, third stage, mezzanine, and IPO financing). Understand which stage of the production process coincides with each stage.

Hedge funds use a group of strategies for absolute returns, often through hedging or leverage. Understand the basic idea behind the most common strategies: long/short, market neutral, arbitrage, global macro, and event driven. Hedge funds normally charge a percentage of assets fee and an incentive fee of a percentage of profits over a benchmark return. Funds of funds are a single mutual fund or ETF that invests in hedge fund for smaller investors but has the disadvantage of adding another layer of fees.

Understand the problems in hedge fund performance measurement: self-selection, survivorship, smoothed pricing, option-like strategies, and fee structure gaming.

Investing in Commodities
The concept of backwardation and contango often seems to get candidates. The interplay between producers and other participants in the market can cause the future price of a commodity to be higher or lower than its spot. Generally, the future or forward price is lower than the spot (backwardation) because of carrying costs and is referred to as natural backwardation. Producers are willing to sell their expected inventory forward to lock in a price at the end of the season.

When prices are volatile, contango may occur where the future or forward price is above the spot price. This occurs because commodity buyers come into the market to hedge their future price risk.

The actual formula for cost-of-carry is not as important as the theory and the costs that go into it. The idea puts a theoretical max price on commodities referred to as ‘full carry’ and includes storage, insurance, transportation and financing costs.

Understand the three sources of return: collateral yield, roll yield and price return. Roll yield is not related to changes in the spot price but the return derived from selling expiring contracts and buying into longer dated contracts. The roll yield is positive for an investor in backwardation.

Beyond the first section, the commodities reading is largely conceptual and some fairly easy material. Understand the controversy around commodities as an asset class (i.e. do not generate cash flows, return may result from rebalancing instead of increase in asset price, roll yield may disappear). Also, understand the general principal behind the two types of commodity investment approaches: index funds and index-plus strategy.

An index fund involves buying an ETF or an index swap for exposure while the index-plus strategy may involve a collateral return strategy, roll management, rebalancing, or maturity management.

We’ve made it through each of the study sessions. Hopefully, you’ve been able to keep up and do practice problems and review for each topic as well as the readings.

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

Last updated: July 18, 2016 at 16:13 pm

CFA Level 1 Review, Valuation of Debt Securities

Study session 16 in the CFA Level 1 curriculum concludes the topic area with three more readings in fixed income (56-59) covering analysis and valuation.

Introduction to Valuation of Debt Securities
Conceptually, there is little here that you haven’t seen in the equities section. The value of any financial asset is just the present value of expected cash flows. The cash flow function and the Present Value function on your calculator can do most of the work for you but you need to understand the concept and the ‘why’. *Important: Always remember that most bond problems will be semiannual coupons so you need to double the years and divide the rate and the payment by two for your PV calculator work.

The relationship between the coupon rate, discount rate (i.e. current rates in the market) and the price (relative to par) is an important note and will come back throughout the other two exams.

  • If the coupon rate is above the current rate for similar instruments in the market, the bond will be priced higher than par. If you can get a higher rate, you would expect to pay more than the face value.
  • If the coupon rate is less than the current rate in the market, the bond will be priced at a discount. You wouldn’t pay face value for something to get less than offered in the market.

Understand the process behind the binomial model and Monte Carlo simulation for valuation, as well as advantages/limitations but you really do not need to know much more than a conceptual basis just yet.

Yield Measures, Spot Rates, and Forward Rates

Don’t confuse the current yield with the coupon rate. The current yield is the coupon divided by the bond price, the actual yield given the price. The coupon rate is the coupon divided by par, the stated yield.

Understand Yield to Maturity and that it is only realized if the bond is held and under the assumption of reinvestment. If the security is sold earlier than maturity, the investor faces interest rate risk.

Understand how to work through a bond equivalent yield problem and converting it to an annual-pay YTM. The conceptual material on yield-to-call and yield-to-put is important. Understand the assumptions and what it means for an investor holding the debt. The calculations are fairly basic and can be done on the PV function.

Introduction to the Measurement of Interest Rate Risk
Understand both the full valuation and duration/convexity approach with a focus on advantages/disadvantages to each. The full valuation approach is appropriate for a parallel and non-parallel change in the yield curve but is very time consuming with a large portfolio. The duration/convexity approach is simpler but is not appropriate for non-parallel shifts in the yield curve.

The concept behind options is very important, especially call options and negative convexity. Understand the difference between  the price of a security at high or low rates when there is a call or put option. You’ll see this again on the Level 2 exam so learn it now.

Duration is another topic that I could just copy/paste from the Level 2 notes. You need to understand the concept and the formula. Start with the standard formula before you worry about modified duration or the Macaulay formula.

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).

Study session 17 in the CFA Level 1 curriculum consists of six readings covering derivatives. The material is still fairly conceptual but is pretty lengthy.

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

Last updated: July 18, 2016 at 15:51 pm

CFA Level 1 Review, Fixed Income Overview

Study session 15 in the CFA Level 1 curriculum begins the fixed income topic area with four readings (52-55) covering the basic concepts in debt securities. The topic is worth 12% of your Level 1 score but you really need these core concepts to understand the later material the other two exams. The topic will be worth about 10% and 15% of your Level 2 and Level 3 exams.

Looking back on the Level 1 curriculum for these posts, it strikes me how effectively the Institute manages to work candidates into a topic with basic concepts and ideas. I’ve heard the Level 1 exam described as a mile wide and an inch deep because of the breadth of information involved but the difficulty is offset by not requiring too much detail.

This is a key point you need to remember when studying for the first exam. Get the key concepts and vocabulary first. Not getting caught up in too much detail is going to help you cover the curriculum as many times as possible. Going over the material multiple times helps to commit it to memory and helps you pick out the correct answer out of three choices. You’ll still need a fair amount of detail, but the first exam is definitely a bird’s eye view of the material.

Features of Debt Securities
Understand the basic types of affirmative and negative covenants like paying interest & taxes, meeting financial ratios, limitations on additional debt, and restrictions on asset sales.

Definitions and just knowing the lingo is always important. Know what a coupon is and understand what happens to the price if the coupon rate is higher or lower than current market rates. Think about it intuitively. If a bond offers a higher coupon rate than you can find in the market, you are going to be willing to pay a premium on the price, and the opposite is true for a coupon rate below the current market yield.

Understand the basic idea behind call and put provisions, sinking funds, repurchase agreements and prepayment. Remember, the full or dirty price is the agreed price plus all accrued interest.

Risks Associated with Investing in Bonds
There are 11 basic risks listed with bonds: interest rate, call and prepayment, yield curve, reinvestment, credit, liquidity, exchange-rate, volatility, inflation, event, and sovereign risk. Some (interest rate, prepayment, yield curve) are extremely important and you will be seeing a lot of the curriculum focus on detail but you need to have an understanding of the basic factors within each.

The inverse relationship between rates and price underlies interest rate risk. As rates increase, the price of a bond decreases because investors can get a better rate in other products. Understand how maturity of the bond affects the change in price, i.e. longer time left means bigger price swings because you could be earning more/less for a longer time. Duration is the measure of rate risk and you need to remember the formula for the exam = (Price at lower rate – Price at higher rate)/ (2*initial price* change in yield)

Prepayment risk is when the bond issuer (or mortgage holder) has the option to buy back the product. Remember, all options have value and the value of this call feature will be more valuable as rates decrease.

Reinvestment risk is associated with the need to reinvest payments of interest and principal at lower rates than the bond offers. Zero coupon bonds have no reinvestment risk because they have no payments until maturity while amortizing securities have more risk because they pay off principal and interest.

Understand the three types of credit risk: default, credit spread, and downgrade risk.

Understand the threat that inflation poses to bonds as fixed-income products. This means that even as the value of the currency depreciates, the investor only receives the set coupons and principal so the bond is worth less in real terms.

Overview of Bond Sectors and Instruments
This reading is of secondary importance and you really only need a basic idea of the seven sectors of the bond market and an overview of their characteristics.

Sovereign bonds: Government issued and relatively lower risk. They can be issued in local or foreign currencies. Understand the basic differences of the U.S. debt like T-notes, T-bonds, Strips and TIPS.

Semi-government: These are issued by a quasi-government agency and often carry an implicit guarantee. The focus is on agency mortgage debt and the types of CMO and MBS, think Fannie Mae and Freddie Mac a few years ago.

Municipal or province: Like sovereign bonds but issued by smaller authorities like towns and cities. Understand the difference between tax-backed and revenue bonds and the effect on risk. The interest is often tax-advantaged for taxes owed to the issuing municipality or state.

Corporate Bonds: Understand the four factors used by credit rating agencies (character, capacity, collateral, and covenants). This section has a few formulas and is probably one of the more testable in the reading.

Mortgage backed securities: Understanding structure and prepayment risk is the important material here and will be used for more detail in the Level 2 exam.

Asset backed securities: Understand the types of internal and external credit enhancements as well as the role of special purpose vehicles.

Collateralized debt obligations: These are basically the same as asset-backed debt but the backing for the bond is a diversified pool of different debts, i.e. domestic/foreign bonds, bank loans, distressed debt, ABS, and MBS.

Understanding Yield Spreads
An extremely important reading and the setup for many formulas in the Level 2 exam. Understand the effect of monetary policy (open market operations, discount rate, reserve requirements, and verbal notes) on rates.

Understand the theory behind the four shapes to the yield curve and what they say about the outlook for rates and the economy: positively-sloped (normal), flat, inverted (downward-sloping), and humped.

Understand the three theories of term structure: pure expectations, liquidity preference, and market segmentation.

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)      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.

Study session 15 in the CFA Level 1 curriculum concludes the topic area with four more readings in fixed income.

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

Last updated: July 18, 2016 at 16:45 pm

CFA Level 1 Review, Equity Investments

Study session 13 in the CFA Level 1 curriculum begins the material on equity investments with three readings (46-48) in equity market structure and efficiency. The material is almost completely conceptual and any student of finance will already have seen it. If you are new to the industry, spend a little time to get the vocabulary and concepts. The topic area is only worth about 10% of your first exam but is extremely important in the other two tests.

Market Organization and Structure
This is almost entirely a vocabulary lesson on the market and participants. It is important that you know the information for general knowledge but it is not as testable as some of the other readings. The key terms are good for flashcards with a quick rundown until you’ve got them.

Understand how to calculate returns on leveraged positions, maintenance margin requirement and the margin call price. If a buyer will receive a margin call when the value of equity drops below 25% of the maintenance margin requirement, with an initial stock price of $20 leveraged with 60% margin: the margin call price is ($8 +Price – $20) / Price = $16

Pay special attention to the information on orders as you will need it for attribution analysis in the Level 3 exam and it is highly testable in the first exam.

Security Market Indices
The differences and calculations for the indices (price-weighted, equal-weighted, market cap, and fundamentally-weighted) are important information and have shown up on the exam. It’s really not difficult information, just understand how they are constructed and how to calculate returns.

They construction and limitations of alternative asset indices shows up several times in the curriculum, so spend some time on this section. Pay special attention to the possible biases within each index.

Market Efficiency
The efficient markets theory is a huge concept in the industry and for the exams. You do not necessarily need to know all the data and details that support it, but you should know the implications of each level of efficiency. Understand what it means for technical analysis and transaction costs in trading.

The Institute does not ask you to take a position on the efficient market hypothesis but regardless of how you believe the markets behave, when you are taking the exam the curriculum is the ultimate truth. Know that there is considerable evidence supporting the semi-strong form of efficiency and some evidence to support the strong form.

The list of market anomalies is testable vocabulary and can be fun to read through. Again, mostly a flashcard exercise until you can recognize the terms and their basic idea.

Study session 14 in the CFA Level 1 curriculum continues the equity topic area with three readings on valuation of equity securities.

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