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 – Download Free Formula Sheet – PDF

Reading through the LinkedIn group lately, someone was asking about the difficulty of the CFA Level 1 exam and how it related to another professional exam. A couple of candidates commented how tough the material was and how much there was of it.

I just had to smile.
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When should I Start Studying for the December CFA Exam

While the June CFA exams are just behind us, I’m already getting emails from CFA Level 1 candidates asking when they should start studying for the December CFA exam. It’s a common question, whether ahead of the December or June exam, and really depends on your own schedule and study style.

The easiest (and probably best) answer I can give you is…start studying right now! I have been a big advocate on the blog of making your CFA study schedule a part of continuous and life-long professional development. As a professional, you don’t get summer break or extended vacations. You need to constantly be learning and building your skills as an analyst, or face the chopping block the next time job cuts hit the office. The CFA curriculum is the best in the industry and it doesn’t hurt to start early and really master the material.

But if you’ve already got other projects on your schedule then it’s a relevant question to ask when you need to start studying for the December CFA exam.

How much time do you need to study for the December CFA exam

The average of 300 hours spent by most successful candidates to pass a CFA exam is a pretty good metric from which to start. Your own experience of how quickly you learn new material might guide you higher or lower but I would caution candidates against thinking they need less than 200 hours of study time. This will be your first CFA exam and most are surprised at the level of difficulty. Looking at the 10-year average pass rate of just 39% for the level one exam should give you an indication of how many are caught off-guard by its difficulty.

Most candidates for the June CFA exam start mid-February which leaves about three and a half months to study. That still means about 20 hours of studying each week over 15 weeks to reach 300 hours, a pace that most probably would have trouble keeping. For the December CFA exam, I have heard a lot of candidates wait until sometime in August to start their study schedule.

Realistically though, can you really fit more than 10 to 15 hours of studying into your weekly schedule? Even full-time students have to contend with their university exam schedule. Adult CFA candidates have to balance family-life, work and everything else with studying for the CFA. Budgeting 15 hours a week for studying means you’ll need to start in a few weeks to get 20 weeks of studying in before the exam.

You might be able to make up some lost time with a few days or even a week of intense studying. Taking off work the last week before the exam can net you upwards of 50 hours or more for studying. A lot of candidates plan on studying large blocks of time over the weekends but who wants to work all week and then study all weekend?

I would say plan on starting your December CFA study schedule by the second or third week of July, at the latest. That will give you 20 weeks before the exam. You may not need all the time but it’s far better to overstudy than to not study enough.

As for How to Pass the CFA Level 1 Exam, check out some of the posts here on the blog. The first exam is extremely broad-based but you do not need much detail in each topic area. Make sure you read the curriculum and supplement it with a quick reference guide like the FinQuiz Notes. This strikes a balance between getting the detail you need and the ability to cover the material multiple times through notes.

We’ll start covering topics specific to the CFA Level 1 exam in the coming weeks. Let me know if you have any questions on how to prepare for the exam or what to study.

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

Last updated: July 18, 2016 at 16:01 pm

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

CFA Level 1 Review: Balance Sheet

Study Session 9 is really your first look into the detail in the financial statements. There are four readings, covering inventories, income taxes, non-current liabilities and non-current assets. The material may seem a little boring at times and is largely a review of accounting issues. Resist the urge to just go through the motions and memorize enough to pass the test on these topics, here and in the other readings on the financial statement accounts. Learning the intricacies within the individual line items in the financial statements is your life as an analyst and really separates the good from the great.

It may be easy to fall into a trance-like state while reading through the material. You really need to stop every once in a while to think back on what you’ve read and review the important points.


The material revolves around the choices for inventory accounting (FIFO, LIFO, Weighted Average, and Specific ID). You absolutely must know the FIFO AND LIFO concepts as well as how the choice affects ratios and the income statement. You will need this going into the CFA level 2 exam so don’t ignore it.

FIFO expenses the first items purchased for cost of goods sold, which are usually cheaper given inflation. This will lead to higher earnings from the lower expense. Ending inventory, working capital, shareholders’ equity, earnings, current ratio, ROA, ROE and the profit margin are usually higher using FIFO accounting. The advantage of FIFO is that the ending inventory will represent current replacement costs.

LIFO expenses newer inventory first so ending inventory will usually be lower in an environment of increasing prices. Understand what happens in an inventory liquidation and what it means for taxes, cash flow and earnings. After-tax cash flow, debt-to-equity, and asset turnover are usually higher under LIFO accounting. The advantage of LIFO is that it better matches current costs in goods sold with revenues.

The weighted average costing method is fairly straight forward and just the total cost of units available for sale divided by the total number of units available for sale in the period. It is not quite as commonly used and the Institute does not spend nearly as much time on it as the other two methods. The advantage of average costing is that it smoothes any price changes.

Understand how to convert LIFO to FIFO statements. Add the ending LIFO reserve to inventory. Subtract the change in LIFO reserve from the COGS for FIFO cost of goods sold. Adjust the LIFO net profit by the change in LIFO reserve and the tax rate for the FIFO net profit.

For the exam, you need to understand how the inventory costing methods result in different valuations in other accounts (i.e. gross/operating/net profits, ending inventory, cost of goods, taxes). The table below shows the costing method affects in a (normal) rising price environment. You may be asked how this would differ when prices are falling which would mean that the opposite would happen. More important that memorizing the table is understanding what is happening.

A table with LIFO and FIFO across the top and all the relevant ratios/financial statement line items down the side makes it easier to see how the two methods can cause differences in your analysis. Rather than just writing higher or lower, understand why the effect happens (i.e. shareholders’ equity is usually higher with FIFO because earnings and inventories are higher).

Long-lived Assets

Much of the reading revolves around the capitalizing/expensing debate. Understand the rules for capitalizing and how/why managers might want to bend them.

On acquisition, all tangible assets (physical assets) are recorded at cost on the balance sheet. This is capitalization because the company creates a capital asset that will be used in the business. It appears as an increase in the asset and shareholder’s equity (balance sheet) and a cash outflow in investing (Statement Cash Flows). The company will then depreciate the value of the asset by expensing a certain amount on the income statement each quarter and increasing the accumulated depreciation account on the balance sheet.

The company may also choose to expense an asset if its usefulness is used entirely in the current period. This means no change on the balance sheet and higher expenses on the income statement. Since this results in lower net income (in the current period) and lower assets, management may choose to capitalize an asset when it can.

Your job as an analyst will be to decide if the decision was appropriate and adjust the financial statements if necessary. The material on the adjustments is important and you should remember how to adjust the interest coverage ratio (add depreciation expense to EBIT and the capitalized interest to interest expense) and the net profit margin.

You may also want to adjust the statements for capitalized interest by: add capitalized interest back to interest expense, reclassify capitalized interest from investing to operations on the cash flow statement, remove capitalized interest from depreciation expense.

Understand how the financial statement accounts and ratios differ under capitalizing or expensing. A table makes it easy to remember with capitalization on one side and expensing on the other. Return on equity, ROA, profit margin, pretax cash from operations, earnings, and shareholders’ equity will be higher under capitalization. Cash from investing, asset turnover, and debt-to-equity will be higher under expensing.

Remember the difference and how to calculate the methods of depreciation: straight-line, accelerated, and units-of-production and be able to estimate the age of fixed assets.

Straight-line depreciation is relatively easy and just the original cost minus salvage value, divided by useful life. The biggest hurdle is remembering to reduce by salvage value because many candidates forget the step.

Accelerated depreciation for each year is = (2/asset life) multiplied by the year’s beginning book value of the asset. The method books higher depreciation expense earlier in the asset life.

Debt-to-equity and asset turnover will be higher under an accelerated method of depreciation while ROE, ROA, profit margin, shareholders’ equity, and earnings are higher under straight-line.

The units-of-production method is = (number of units produced/number of total units asset will produce over useful life) times the cost minus salvage value.

Intangible assets are those like patents and goodwill that do not have a physical nature. The most important material here is the difference between IFRS and GAAP in the recognization and accounting for intangible assets. There are separate rules for an internally-generated asset (i.e. through R&D) and an acquired asset. Again, a table with IFRS and GAAP next to each other makes it easiest to compare and remember the material.

Income Taxes

You will need to know the difference between accounting profit and taxable income and how to calculate deferred tax assets and liabilities. A deferred tax liability is taxes that will be paid in the future because the company reported lower taxable income than profits, while a DTA is taxes that will be saved in the future. The material can be a little confusing so you may need to spend a little extra time.

On these more difficult concepts, I like to look for a YouTube video that may help explain things. If you are a visual learner like me, it may help to see the material from a different perspective. Allen Mursau provides a good overview of deferred taxes at https://www.youtube.com/watch?v=45PARid_erY

Understand the concept behind temporary and permanent differences. Tax-exempt interest, allowable tax credits and life insurance premiums are the usual examples for permanent differences.

Be able to determine the income tax expense under the liability method: Taxes payable + change in DTL – Changes in DTA net of valuation allowance.

Non-Current Liabilities

You need to be able to work through the calculation for interest expense, coupon payment and the ending carrying value of a bond. It can be a pain at first isn’t too difficult once you understand what is happening.

The interest expense is just the ending carrying value times the market rate times ½ for semiannual bonds. Reduce this by the interest payment (face value * coupon rate*1/2) for the change in the liability. The prior ending carrying value plus the change in liability is your new carrying value.

Understand how a change in interest rates affects the market value of debt and economic gains. An increase in rates will decrease the value of debt and lead to an economic gain.

Remember the five main debt covenants: limitations on asset disposal, restrictions on debt issuance, limits on use of borrowed funds, collateral maintenance, and dividend restrictions.

Study session ten in the CFA Level 1 curriculum concludes the material on FSA with reporting quality and some applications.

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

CFA Level 1 Review: Cash Flows and Financial Analysis

We covered the first half of study session eight last week with a review of the Balance Sheet and Income Statement. We wrap up our review this week with the Statement of Cash Flows and Financial Analysis Techniques.

Cash Flows are an Analyst’s Best Friend

The Statement of Cash Flows is where you will likely spend much of your time in your first years as an analyst. This reconciliation of cash in and out of a business over a period can be constructed completely from the other two statements. It is also less easily manipulated than the income statement and provides a powerful check against aggressive accounting assumptions on the income statement.

There are two methods of constructing the Statement of Cash Flows, direct and indirect. While it may be tempting to pick one method of cash flow statement construction, you absolutely must know both methods. There is no better practice to understand how the company operates, i.e. how the company uses assets, liabilities and income to generate cash for equity holders. Knowing the power of cash flows over reported income will make you a superb analyst.

Cash versus Accrual Accounting

While the other two statements follow an accrual method of matching expenses and revenues made during the period, the Statement of Cash Flows shows the cash receipts and payments during the period. It is a reconciling statement in the company’s cash and cash equivalents during the period. Because it shows actual inflows and outflows, it is much more difficult to manipulate by management and widely used by analysts.

The general structure for the statement is that,

  • Change in Cash = Cash from operations (CFO) + Cash from Investing (CFI) + Cash from Financing (CFF) + any effects of exchange rates

There is a lot of material here but the first thing you need to master is distinguishing between a cash outflow and a cash inflow. It is all about whether an account is a source of cash or a use of cash. Once you’ve got that understood, everything else is intuitive and more easily understood.

Assets are sources of cash, if you see a decrease in an asset (on the balance sheet) that means the company converted that asset to cash, i.e. cash inflow.

Liabilities are a use of cash, a decrease in a liability account means the company used cash to pay for that decrease, i.e. cash outflow.

Cash Flow from Operations

Besides cash from sales of goods or services, an important part of CFO is the adjustments from items on the balance sheet and income statement. These adjustments happen because of the accounting difference between accrual-based and cash accounting.

  • Depreciation for assets, expensed on the income statement as a use of a capital asset, is not a use of cash so must be added back to net income. This account is extremely important for a lot of capital-intensive sectors like energy and real estate. The company’s continual investment in new equipment or depreciable assets will be an important check against depreciation.
  • Change in operating assets and liabilities that have already been accounted for on the balance sheet but had not yet settled in cash, i.e. accounts receivable, inventories, accounts payable, etc. This is the company’s ‘working capital’ and is important in analyzing the true efficiency of operations. These are all short-term assets and liabilities used in the day-to-day operation of the enterprise.
  • One confusing aspect of the statement is remembering how dividends and interest are shown. Dividends received and interest received and paid are shown as cash flow from operations, while dividends paid are shown as financing.

Cash Flow from Investing

While operating assets and liabilities, or working capital, is shown as cash flow from operations, cash flows for the purchase or sale of long-term assets is shown as investing. This makes intuitive sense if you think of these assets as an investment in long-term production. Items include fixed assets, long-term investments and business acquisitions or divestitures.

Cash Flow from Financing

Financing includes borrowing or repaying debt principal but not interest which is taken as a cost of operations and shown under CFO. Similarly, since equity capital (common and preferred stock) is raised as a financing vehicle, issuing or repurchasing shares and paying dividends is shown as CFF.

Converting the Statement to Direct Method

Most firms use the indirect method to prepare cash flows so the most common need is to convert the statement to the direct method. Firms reporting under the direct method must also present a reconciliation to the indirect method ( U.S. GAAP). The direct method details the firm’s operating cash receipts and payments from customers, suppliers, employees, etc. while removing a lot of the effects of accrual accounting. CFI and CFF are the same for both methods.

You must be able to arrive at CFO using the direct method.

The general formula for the direct method is:

Net Cash from Operations =
Cash Collected from Customers
– Cash paid to suppliers
– Cash paid to employees
– Cash paid for operating expenses
– Cash paid for interest
+ Cash received from dividends and interest

Start with Revenues
+/- change in unearned revenue
+/- Change in Accounts Receivable
= Cash collected from customers

Cost of goods sold
+/- change in inventory
+/- change in accounts payable
= Cash paid to suppliers

Salaries and wages expense
+/- change in wages payable
= Cash paid to employees

Other operating expenses
+/- change in prepaid expenses
+/- change in accrued liabilities
= Cash paid for other operating expenses

Interest expense
+/- change in interest payable
= Cash paid for interest

Dividend and interest income
+beginning interest receivable
– Ending interest receivable
= Cash received from dividends and interest

The Indirect Method

Since most statements use this method, you will not usually have to do the work but it is important to know how to put it together. The method starts with net income and adjusts for cash and non-cash items.

Net Income
+ Non-cash charges (depreciation, amortization, depletion expense)
+ increases in current operating liabilities
+ decreases in current operating assets
+ increases in deferred income tax liability
– increases in current operating assets
– decreases in current operating liabilities
– decreases in deferred tax liability

+ any losses on investing or financing activities (loss on sale or write-downs, loss on debt retirement)
– any gains on investing or financing activities

= Net cash from operations

Free Cash Flow

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

There are a few performance and coverage ratios you should remember as well. Most are relatively simple, just the CFO over an account from one of the other statements. Remember that any account from the balance sheet must be averaged between the beginning and ending value since the balance sheet is a point-in-time estimate rather than activity over the period.

GAAP and IFRS Differences

The difference in cash flow reporting for GAAP and IFRS are extremely testable so you must remember them for the exam. The material is relatively brief and lends itself easily to a flash card.

Interest paid – can be classified as operating or financing cash flows in IFRS but only as operating cash flows under GAAP.

Interest and dividends received – can be classified as operating or investing cash flows under IFRS but only as operating cash flows under GAAP.

Dividends paid – can be classified as operating or financing cash flows under IFRS but only as financing cash flows under GAAP.

Companies reporting under IFRS need to separate their income tax account if possible under operating, investing or financing while all income taxes are reported under operating cash flows in GAAP.

The direct method is preferred under both IFRS and GAAP but the indirect method may also be used. Under GAAP, a company must also provide a reconciliation to the indirect method if the direct method is used in the statements.

Financial Analysis Techniques

The introductory material on ratios, common-size techniques, regression analysis and the use of graphs is probably secondary to actually understanding the formulas that follow and what they mean. Understand the basic concept behind the broad range of techniques and any advantages/limitations to each.

There are an immense number of formulas shown, I counted more than 50 in the FinQuiz study notes including multiple ways to get at the same idea. The likelihood of seeing any individual formula on the exam is relatively small so I would spend more time on the bigger picture and the three financial statements. Make a flash card for each formula and run through them until you are familiar with the concept and inputs to each formula. Once you’ve got a particular formula, put the card in your secondary pile which you may only need to review every month or so. This should be enough to reproduce it on the exam if needed.

Study Session 9 digs deeper into the balance sheet with readings on inventories, income taxes, and non-current assets and liabilities.

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

CFA Level 1 Review: Quant Methods, Building Blocks going Forward

This week we begin our review of some of the most important topic areas for the Level 1 exam. We may not cover every study session before the December exam but we will hit the most important areas and try to make sure you get all the points possible.

You’ll notice that we are skipping over one of the most important topic areas in the exam, Ethics and Professional Standards. If you’ve been following the blog, you know how important this topic is but also that it does not change much from year to year. We’ve covered the Ethics section several times and you can find the most recent post by clicking here. Remember, don’t just read through the material on Ethics and the Standards. You really need to be practicing those end-of-chapter and test bank problems to get a feel for how it will be tested on the exam.

Quantitative Methods: Lower points but absolutely essential

The Quant Methods topic area may represent one of the secondary topics by points on the first exam, only accounting for 12% of your total score, but the material is absolutely critical to your success across the exams and as a professional. You may be able to get through the exams and your career with just a basic understanding of other topics (i.e. derivatives) but try being an analyst without mastering discounted cash flows and statistical concepts and it will be a short career.

Unfortunately, the section is avoided by many candidates. As someone who never really liked math in school, I can relate to the desire to avoid quant methods. Realize as I did though, you are in an analytical field and you need to embrace mathematics. Trust me, math can actually be enjoyable and you can learn to love it. Spend a little time and you will be amazed at how quickly you start understanding more complex concepts. A little effort to break an old perspective will go a long way and will help you immensely.

Quant methods are covered in two study sessions in the Level 1 exam, Basic Concepts and Application, with four readings in each study session. The first study session will be repeat material for anyone with an educational background in finance and should be fairly easy to understand for just about anyone else. Study Session 3 is a little more difficult but still manageable. Of the readings, I would say all but technical analysis are equally important and testable. Ideas like time value of money, probability and quant testing are fundamental to the curriculum and you’ll need to be able to do the math in just about every other topic area.

Make sure you have a basic understanding of technical analysis but it is probably the least important. The Institute has never really put much faith in technical analysis so you will likely only see basic questions on the exam, if at all.

Time Value of Money

The most important thing here is be able to use your calculator to solve for any one of the missing variables. Note that the Institute usually keeps problems within the realm of possible reality so if you get an answer that seems extremely high or low then you need to go back through the calculation to make sure you did it correctly.

Make sure you divide the annual rate by the number of times it is compounded within your formula. (i.e. $100 at 8% compounded quarterly for two years = $100 (1.02)8 is different than simply $100 (1.08)2

Most calculators calculate cash flows as an ordinary annuity, where payments come at the end of the period. Make sure you set the “begin” key for any annuity due problems where payments come at the beginning of the period. Also, remember that the payment and present value inputs will have opposite signs (i.e. since the payment represents an outflow use a negative sign).

**Important** Get in the habit of clearing out your calculator before or after you work a problem. It is as easy as two quick keystrokes (2nd and Clr Wk) and can save you points on the test.

The future value of cash flows is

i.e. if your savings account earns interest at a 5% rate and you have $100 deposited, how much will it be worth in 20 years?


This is a fairly basic calculation with no payments and you’re more likely to see something more difficult on the exam. It is relatively easy to work through but learn to do it on your time value buttons,

PV = 100
I/Y = 5
PMT = 0
N = 20

Whether you input the present value as a negative or not doesn’t matter much here since there are no payments. For other problems, just remember that outflows (deposits and payments into an investment or account) should be negative while inflows (money you receive or value) should be positive. One of the cash flows must be negative (outflow).

The future value of a series of cash flows is only slightly more difficult but easily understandable if you think of each payment as a single future value calculation. Don’t forget the note on changing your calculator for an annuity due.

Example: The same savings account as above has $100 deposited but you plan on depositing an additional $100 per year at the end of the year. What will the balance be at the end of 20 years?

PV= -100
PMT = -100
N = 20
I/Y = 5
FV = $3,333

Make sure you understand how to solve for each variable in the equation when given the other variables.

Note: I set my calculator to four decimal places which is usually more than you will need for the exam.

Discounted Cash Flow

This is arguably the most important reading in the study session and you will see the concepts across all three exams.The first section covers NPV and IRR which are really two sides of the same coin. NPV is the value today of the series of cash flows at a discount rate. IRR is the discount rate at which NPV is zero. Either one can be used in a budgeting decision. As with much of the material, understand the situations where each is more appropriate and the strengths/weaknesses of each concept.

Both NPV and IRR are found easily with the calculator. Remember that a key assumption of IRR is that cash flows are reinvested at the rate, which may not be realistic. Also, if there are multiple cash outflows, there will be multiple IRRs or none at all. There may be a conflict between NPV and IRR when projects are mutually exclusive or when there are multiple cash outflows. In this case, NPV is preferred.

Using the calculator is relatively easy,
The initial project cost or investment is a negative (outflow) as CF0
CO1 through x are the stream of cash flows and entered as a positive (inflow)
If cash flows are an equal amount, you can enter them as F (frequency)
Press the NPV button and enter the interest rate
Down arrow
For IRR, just press the IRR button and CPT

Time-weighted returns measure the rate of growth over a defined period between cash flows. It should be used when the portfolio manager does not control cash in and out of the account (as is usually the case). Money-weighted returns can be done easily using the cash flow function on your calculator but may not be as applicable unless you have discretion on cash flows.

Know the difference and how to calculate the material in money market yields section (i.e. money market yield, bond equivalent yield, and HPY). These are good formulas for flash cards if you’re having problems.

Statistical Concepts and Market Returns

As with much of the quant methods material, you should start with an understanding of the basic concepts before worrying too much about the different variations. It is much more important to master the concept of standard deviation than to work through the material too quickly trying to get a vague idea of everything.

Geometric and Arithemetic averages are important. The arithmetic mean is simply the sum of observations divided by the number of observances while the geometric mean is the compound return by taking the nth root of the product.

The material on measures of dispersion is extremely important and will feed into the concept of risk. Even though you will be able to calculate variance and standard deviation on your calculator, spend the time to learn the formulas.

The Sharpe ratio is a key concept throughout the curriculum and you need to understand what it means as well as how to calculate it. It measures the excess return on an investment or portfolio and can be used to rank opportunities. You will use iterations of this formula in many other concepts (i.e. Roy’s Safety First). The drawback is that, since it uses standard deviation as a measure of risk, it is most applicable for symmetric distributions and may overstate risk-adjusted performance.

Understand that the mean, median and mode are the same in a normal distribution but different with skewness. Don’t worry too much about calculating kurtosis or skewness, just understand the their implication. (i.e. how it affects dispersion and returns)

Probability Concepts

The most important material here is covariance, correlation and being able to do the calculations for expected value, variance and standard deviation for a two-asset portfolio. The formulas can get kind of long but they are pretty basic. This is the material that will be used most through the other levels of the exams as well.

Remember, the expected return is just the weights of each asset times their respective expected returns.

Correlation between two assets is the covariance divided by the product of the two standard deviations.
Correlation = COV(X,Y) / STDev (x) STDev (y)

Correlation ranges from -1 (perfect negative relationship) and +1 (perfect positive relationship).

Common Probability Distributions

Most of the introductory material here is fairly unimportant as it isn’t used much in other parts of the curriculum. The binomial distribution is a little more important because it relates to some of the derivatives material. The normal distribution is really where you want to spend your time.

Remember that 90% of the distribution will be between 1.65 standard deviations, 95% within 1.96 deviations and 99% within 2.58 deviations. You will be given a z-table but need to know the formula and the applicable number of standard deviations. You need to pay attention to the question and look for which part of the curve you are being asked to measure. Do you need an interval around the mean or just one side? All the stuff around the z-score (the formula and finding probabilities) is fairly basic so spend some time and master it.

The information covering Monte Carlo simulations is important but just definitional and advantages/disadvantages against other analytical methods.

Sampling and Estimation

Again, fairly unimportant material but it is mostly conceptual so it should be easier to remember. You won’t need much in the way of formulas but will want to understand the ideas and differences between the different sampling plans. Remember that a good estimator is unbiased, efficient and consistent.

  • Understand the difference between simple random, systematic and stratified sampling as well as advantages/disadvantages around each.
  • A carryover from the previous reading, be able to calculate and interpret confidence intervals for the different distributions. Remember, if the sample size is larger than 30 then the z-score can be used as a proxy for the t-score.
  • Probably the most important material in the reading is that on data mining, sample selection, survivorship, look-ahead and time-period biases. Understand these and the different situations in which they might occur.

Hypothesis Testing

  • Understand the difference between the null and alternative hypothesis and be able to calculate the test statistic. The p-value is the lowest level of significance at which the null hypothesis is rejected.
  • Understand the difference between a Type I and Type II error
    • Type I is where you reject the true null hypothesis (i.e. saying that the statistic falls outside of the confidence interval in a normal distribution when it does not)
    • Type II is where you do not reject a false null hypothesis (i.e. saying that the statistic lies within the confidence interval when it does not)
    • Remember the rules for setting a low or high level of significance (1% or 10%) depending on the penalty for committing either error (i.e. 1% significance if you do not want to make Type I error, 10% significance if you do not want to make Type II error)

Technical Analysis

Again, not as important as the other readings but make sure you have a basic understanding in case you see something on the exam. Understand the assumptions, especially how they relate to the theory of efficient markets, and the comparison to fundamental analysis. It does look like the Institute is putting in more charting information in the curriculum so understand the basic definitional ideas around the vocabulary (i.e. head and shoulders, double tops, neckline, etc.)

Understand what volume says about technical analysis, i.e. intensity of confidence in an up or down move.

The technical indicators are of relatively more importance than the material on charting. Understand the concept behind the price-based indicators, momentum oscillators, sentiment and flow-of-funds indicators and whether an indicator is giving a bullish or bearish signal.

That is a lot to take in for one week so you will probably want to cover one study session per week. It is pretty basic stuff if you have at least an understanding of basic statistics and algebra. We’ll start on the Financial Reporting material next week.

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

Last updated: July 18, 2016 at 17:08 pm

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, Derivatives

Study session 17 in the CFA Level 1 curriculum consists of six readings (60-65) covering derivatives. The material is still fairly conceptual but is pretty lengthy. While the topic is only worth 5% of your Level 1 score, you will need it as a base for the 5% to 15% in each of the next two exams. As with most of the CFA Level 1 curriculum, focus first on the basic concept and differences, advantages and limitations of each type of derivative.

Derivative Markets and Instruments
Derivatives are called such because they are instruments that ‘derive’ their value from the value of an underlying asset. The value of an option, futures contract or swap depends on the price of the asset on which it is written. How much you would pay for an option on a share of Apple depends on how much a share of Apple stock is worth.

Derivatives are traded either over-the-counter or on an exchange. The distinction is important and very testable. Over-the-counter is between two private parties while exchange traded is usually through a clearinghouse (a third party that takes both sides with each party). Exchange-traded derivatives usually have less transaction costs, are standardized and expire on regular calendar dates. The do not carry counterparty risk because of the clearinghouse and are usually marked –to-market with a margin. OTC derivatives have counterparty risk because you don’t really know if the other party can deliver but they are completely customizable to your needs.

Forwards and futures are basically the same instrument except futures are exchange traded while forwards are OTC. Swaps are an OTC agreement between two parties to exchange principal, i.e. an interest rate, currency or commodity.

An option gives the party the right to buy/sell an asset but not the obligation. The buyer can pay a small premium now for the privilege of locking-in the buy/sell price on a later date but does not have to worry about the obligation to deliver. Besides the derivatives material, options will be important in bonds and asset-backed securities as well.

Forward Markets and Contracts
Besides the basic concepts of a forward, the payoff calculation of a FRA is the most important and testable material here. The payoff for a Forward Rate Agreement is:

((Expiration rate – Contract rate) (days in rate/360)) divided by ((1+epiration rate) (days in rate/360))
Multiplied by the principal on the contract.

Think about it logically and the formula becomes easier to remember. You are looking for the difference in rates (adjusted for the term of contract since rates are quoted on an annual basis) as a percentage of the expiration rate. This factor is then multiplied by the contract principal (the notional) to get the payoff. *remember to use 360 days

Futures Markets and Contracts
Mostly conceptual stuff here with the focus on advantages of futures over forwards and the different participants in the futures market.

Option Markets and Contracts
Know the basic concepts behind a put and call as well as how to calculate the payoff at expiration. Most options are pretty easy to calculate but rate options get a little more complicated.

The payoff on a rate option is: (principal) *((exercise rate – rate at expirate)(days in rate/360))
*Remember, a rate option isn’t paid at expiration, it is paid the number of days in rate after the expiration (i.e. an option on 180-day LIBOR that expires in 90 days would be paid in 270 days but the payoff amount is calculated at expiration.

The put-call parity formula can be a pain but you will need it here and it will appear again in the second exam, so spend the time to learn it. Understand how puts and calls can be used to create a synthetic position.

Know the Greeks and their respective measures. Again, something were you just need the basics here but more detail in subsequent exams.  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

Most swaps do not include an exchange of principal at initiation and the payments are netted but currency swaps do because the notionals are in different monies. Be able to calculate the amounts exchanged at initiation as well as on settlement dates.

Be able to calculate the basic payments for an equity swap for both parties and the reasons one would enter into a swap (i.e. protect capital gains while avoiding taxes or to hedge volatility)

Risk Management Applications of Options Strategies
I’m pretty active in the options market, both as a hedge and for investment, so I found this material interesting when I took the exam. The two main strategies are covered calls and protective puts (also called portfolio insurance). You’ll need to understand the basics of each, why investors might use them and to calculate the payoff at expiration.

  • Protective put: buying a      put option against a long position has limited downside but maintains      upside potential.
  • Covered call: Selling call      options against a long position has more downside risk and limited upside      potential but involves collecting a premium instead of paying for      protection. The strategy is best if rates/prices do not change.

Study session 18 concludes the CFA Level 1 curriculum with two readings covering alternative investments.

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

CFA Level 1 Review, Equity Investments

Study session 14 in the CFA Level 1 curriculum concludes the equity topic area with three readings (49-51) on valuation of equity securities. The topic area is arguably one of the single most important in the entire curriculum. It is worth 10% of your Level 1 exam, about 25% of your Level 2 test and 10% of your last exam. As with most of the curriculum throughout the first exam, you will need a strong base to be able to move into deeper detail for the other exams.

Overview of Equity Securities
This is a very basic reading and almost entirely conceptual. Look for the list material and any comparisons with other types of investments, i.e. the differences between debt and equity.

Understand the differences between common and preferred shares like: payment order of dividends, distribution of net assets in a liquidation, and voting rights.

The characteristics of a depository receipt and the types of ADRs is important. You probably won’t need the full detail on types of ADRs but remember that Level  II and III are traded on the exchanges. Level I ADRs are subject to limited reporting requirements and only trade on the OTC market. Regulation S depository receipts are not subject to registration requirements and are only privately placed.

Understand the basic return and risk characteristics of equities, pay attention to standard deviation.

The material on ROE, the cost of equity and investors’ required rates of return is probably the most important in the reading. These will be fundamental concepts across the three exams. Understand how to use the DuPont formula to analyze the sources of changes in a company’s ROE.

Introduction to Industry and Company Analysis
Writing blog entries for the 18 study sessions across the three exams, I am struck with a sense of déjà vu because the same concepts reappear so many years. You will revisit industry and company analysis in both the Level 2 and 3 exams. I know you are tired of studying and trying to find time as it is but spending a little extra time on the Level 1 curriculum to absolutely master the material will pay off big time in the next two years.

Understand the differences between cyclical and non-cyclical companies like stability of demand for products/services and variability in profits due to fixed costs. Understand the basic differences between the sectors, i.e. basic product category and demand stability. If it helps, you might try looking at the fact sheet to the Select Sector SPDRs ETF funds which provide descriptions of each sector.

Porter’s Five Forces Framework is something you will see again so you need to understand it in detail. Understand each of the five forces and how it relates to industry analysis. Beyond the exam, the concept is pretty well known in the business world and you’ll need to know it sooner or later.

  • Greater rivalry (competition) within the industry means lower profitability as companies compete on price and brand identification.
  • The higher the threat of new entrants the lower profitability will be as companies lower prices to avoid attracting competitors. Barriers to entry like high capital expenses or regulation important here.
  • The lower the threat of substitutes the higher the profitability as companies can exercise more control on prices. Pay attention to switching costs for consumers.
  • Bargaining power of buyers is relative to the number of consumers and relative size of each for the product.
  • Bargaining power of suppliers is relative to the number of suppliers for an input and how easily it is to switch suppliers.

The Industry Life Cycle model is also pretty testable so understand the stages (embryonic, growth, shakeout, mature, and decline) and characteristics of each.

Equity Valuation: Concepts and Basic Tools
Understand the differences and advantages/limitations of each of the three major categories of valuation models:

1)      Present value or DCF models provide an intrinsic value estimate of the shares as the sum of future cash flows.

  1. Understand the Gordon growth model and its assumptions, i.e. growth remains constant indefinitely, dividends grow at a constant rate, and the growth rate is less than the required rate of return. A multi-stage DDM is necessary when growth is not constant.
  2. Pay attention to the FCFE model and how it can be used on non-dividend paying stocks

2)      Market multiple models estimate value through a multiplier with earnings, sales, enterprise value or asset-values. These can be applied on a trailing or forward basis.

  1. These are fairly easy to understand but you need to know the limitations, i.e. the multiples are based on trailing (past) data and may not be a good predictor of the future, the multiples reflect relative valuation compared to peers or the index but not intrinsic value.
  2. Understand the difference between the trailing multiple (past data) and the justified (forward) multiple which is based on forecasted data.

Enterprise value is the market cap plus market value of preferred and debt minus any cash and short-term investments. It reflects the real economic value of the company and is helpful when comparing companies with different capital structures.

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

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