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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CFA Level 1 Review: Equity Investments

Study session 14 in the CFA Level 1 curriculum concludes the material on equity investments with three readings (49-51). I wanted to hit on this study session before the beginning material in SS13 because it is a little more important and will be the base of what you need for the second exam. Most of the material is conceptual and will be repeat for students of finance. 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 and through your career as an analyst. Much like the introductory material on Financial Statements, this material will act as base knowledge you absolutely must know.

Overview of Equity Securities

The reading is all conceptual so make sure you get the general ideas and the vocabulary. Understand the characteristics of equity and what function they serve. As always, pay special attention anytime the curriculum compares one idea with another and discusses advantages/weaknesses. This kind of list and definitional material is easily testable in a multiple choice format.

Whereas debt securities represent a liability of the issuing company, equity represents a residual ownership on the company’s assets. This implies higher risk but also potentially higher return. There are three types of equity securities; common shares, preferred stock and other. There is some material on preferred stock, i.e. adjusting some of the metrics and its higher status for payments, but you will spend the vast majority of your time learning about common shares.

The material on private equity investments, i.e. venture capital and buyouts is fairly interesting. Understand the objectives of these investors and the summary idea behind the investments. Private equity generally has a lock-up period of 3-5 years, meaning the money is committed for a long-time and illiquid. Understand the difference in exit plans for these groups, i.e. venture capital generally looking to take the company public or sell to another fund; buyouts will recapitalize the company (take on debt) and manage a turnaround to issue shares again or sell to another fund.

The Institute has scaled-back the material on foreign stocks and emerging markets over the last few years but there is still some information you should remember. Understand the reasons a foreign company would issue Depository Receipts and the three levels of sponsored ADRs.

The last section, Equity Securities and Company Value, is probably the most important since it gets you ready for valuation. Understand the different valuation ideas, i.e. book value and market value. Return on equity and the cost of equity are two very important concepts throughout the CFA so make sure fully understand them here.

Return on equity (ROE) is a key measure of profitability and can be calculated as the net income over the book value of equity. How much income is the company able to generate on investor’s equity? You will use the DuPont formula later to look further into ROE but make sure you understand this book value formula and what it implies.

Introduction to Industry and Company Analysis

Another largely conceptual reading and more akin to an MBA course than the CFA curriculum in my opinion. The material on industry analysis revolves around the idea that different industries react differently to the macro-economic environment. Analysis of this helps to assess profitability and leads to an industry or sector rotation strategy.

Businesses can be grouped through their product or service or by the correlation of their sales to the business cycle. Grouping by products or services puts companies in a similar industry and a sector. While grouping by business cycle separates companies into cyclical and non-cyclical stocks.

Cyclical companies have a positive correlation with the business cycle. When the economy is expanding and business/consumer spending is rising, these companies see higher sales. Demand for their product/service is elastic and more discretionary.

Non-cyclical companies do not have as positive a correlation with the business cycle. They sell products/services that are necessities (non-elastic) and demand is more stable. Sales may still rise or fall with the economic cycle, just not as much as cyclical companies.

As always, remember the advantages and weaknesses of business-cycle classifications. The grouping helps to differentiate risk associated with the business cycle but is somewhat arbitrary. Since economic cycles differ across countries, international companies (even cyclical ones) may be able to smooth their revenues. Some industries may have characteristics or products/services that makes it difficult to group them as either cyclical or non-cyclical.

The material on industry classification systems is secondary so just understand the main ideas. Make sure you understand the material on the grouping by sector, then by industry and the steps in constructing a peer group.

Spend a little extra time on the principals of strategic analysis, especially Porter’s Five Forces. The material is highly testable and you will see it again in the CFA Level II exam.

  • Threat of substitutes – the more substitues a product has then the more elastic its demand will be and the lower the company’s ability to increase prices
  • Bargaining power of buyers – when there are fewer buyers that control a large part of the product’s demand then those buyers will be better positioned to bargain for lower prices and concessions
  • Bargaining power of suppliers – similarly if there are only a few suppliers of raw materials, they can more easily demand higher prices or restrict supply. Conversely, if there are many suppliers or it is a commondity material then they will have lower bargaining power
  • Threat of new entrants – this depends on barriers to entry like the cost to start a business, any regulations or laws around the product. If there are high barriers to entry then the existing companies are better protected and face less competition
  • Rivalry among existing firms – the more competitive the industry then the less ability the company will have to raise prices and profits. This tends to happen when the industry is fragmented (many small companies), has high fixed costs and sells an undifferentiated product

Remember the five stages of the industry life-cycle; embryonic, growth, shakeout, mature and decline as well as the basic forces within each stage.

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.

Price-to-Cash Flow Ratios

There are several of these ratios listed in the curriculum but the most attention is given to Free Cash Flow-to-Equity (FCFE). You should already be familiar with FCFE and FCFF from the corporate finance material as well as in other parts of the equity curriculum. For the other P/Cash Flow ratios, just remember some of the adjustments that are typically made like non-cash charges and financing. Cash Flow metrics are preferred because it is not as easily manipulated by management as earnings numbers.

Free Cash Flow-to-Equity (FCFE)

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

Enterprice Value-to-EBITDA

EV is the total value of firm in excess of cash and investments. This is the market value of debt plus common and preferred equity, minus cash and investments. We use the market value of debt because it is a more realistic amount that someone would pay for the firm, when combined with equity. Earnings before interest, depreciation and amortization (EBITDA) measures the potential cash flow to all providers of capital, so by taking a ratio of the two we find a market driven valuation of the firm.

The advantages of the metric are that it is more appropriate when valuing capital-intensive companies or those with differing amounts of leverage (because it is a pre-interest and depreciation measure). The metric is also useful when earnings are negative and P/E cannot be used.

The main disadvantage is that it does not account for several adjustments that should be made for good measures of operational cash flows. Different revenue recognition practices will change results as well as trends in working capital.

We’ll hit study session 13 next week with a review of market structure, indices and efficiency. It is completely conceptual and of secondary importance compared to SS14 so should be a pretty easy week. You might want to plan on reading through SS13 quickly to leave time to review the important material from this week’s SS14 readings.

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

CFA Level 1 Review: Financial Reporting Quality

Study session ten in the CFA Level 1 curriculum concludes the material on FSA with reporting quality and some applications in three readings (33-35). Towards the end of the week, after you’ve read through the study session, it would be a good idea to take a small mock-exam over the FSA topic area. Use the end-of-chapter problems or a question bank to work through 100-200 questions. If you do not score at least 65% or better, you may want to build in some FSA review over the next couple of weeks. The topic is probably the most important in the curriculum and to your career.

Financial Reporting Quality

The reading, and much of the curriculum in FSA, revolves around your ability to understand aggressive and questionable accounting practices. Companies using more conservative accounting practices are more likely to surprise on the upside while those using aggressive assumptions may be signaling weakness.

A lot of the aggressive practices are highlighted elsewhere in the curriculum but are reiterated here. Motivation to artificially increase earnings could be to meet expectations, meet debt covenants or to improve incentive compensation. Understand that management might have an incentive to manipulate earnings lower as well, possibly to smooth higher earnings in the current quarter into weaker quarters.

The list material behind red flags is fairly testable so understand the risks. The curriculum describes the ‘Fraud Triangle’ and three conditions that are generally present when it occurs.

  • Incentives and pressures include pressure on management to meet expectations, financial targets, debt covenants, and their own financial well-being
  • Opportunities include the nature of the industry, a complex organizational structure, ineffective monitoring, a significant number of estimates build into the accounting system, high turnover or ineffective audit staff
  • Attitudes and rationalizations include the use of inappropriate accounting, poor communication channels, failure to correct reportable conditions, and a history of violations

The most important material is the specific warning signs and the measures to spot them.

  • aggressive revenue recognition (bill-and-hold sales, sale-leaseback, swaps and barter to generate sales)
  • operating cash flow out of line with earnings, i.e. if earnings are increasing or positive while operating cash flow is decreasing or negative may be an indication that management is manipulating earnings (CFO/Net Income)
  • Classification of expenses as extraordinary or nonrecurring
  • LIFO liquidations occur when management uses the LIFO method and runs the balance lower to year-end. Watch the LIFO reserve for clues of LIFO liquidation.
  • Margins significantly out of line with peers without other explanations – overstatement of inventory or capitalization of costs is a clue that management is using aggressive accounting with expenses. Check the company’s margins against prior years and quarters as well.
  • Assumptions behind depreciation – using a longer life estimate for machinery than peers will lower depreciation expense and increase earnings but may not appropriately match costs with sales.
  • Assumptions used in pension accounting – Using a higher discount rate or higher expected return on plan assets will decrease pension expense but may lead to a problem down the road when the assumptions are corrected. As with most of the warning signs, compare assumptions with peers in the industry
  • Fourth quarter surprises that cannot be attributable to seasonality
  • Excessive use of operating leases or other off-balance sheet financing – the company may be guaranteeing some contracts or receiving financing that is not accounted for on the balance sheet, this reduces liabilities relative to peers and makes the balance sheet look more healthy than reality.

Accounting Shenanigans on the Cash Flow Statement

Understand that the cash flow statement is less easily manipulated but management can still distort the various accounts.

  • Stretching out payables (look for a trend in days sales payable) – accounts payable increases and may indicate problems paying suppliers
  • Using a third-party to pay payables and then accounting for payment as a financing cash outflow in subsequent periods – this is basically taking out a loan to pay for current expenses. The problem is that it does not appropriately match expenses with sales and later quarters will be affected
  • Securitization of receivables and whether it is through a bankruptcy-remote VIE – The problem here, and with many of the other questionable accounting tactics, is sustainability. Securitizing (selling off your receivables) increases cash flow for the current quarter but the company may still be responsible for collecting those sales. The company may have to pay back some of the proceeds in subsequent periods if default on receivables is higher.
  • Treatment of tax benefit on the cash flow statement and sustainability as an increase in cash from operations
  • Stock buybacks to offset dilution – Since buybacks are listed under financing cash flows, analysts need to reclassify net cash paid to buyback shares from financing outflow to operating cash outflow.

Financial Statement Analysis: Applications

Really nothing new in this reading, just a review of the previous material. The reading gets into a little more detail but remember that the Level 1 exam is all about the basic ideas and reasons. Start with understanding the processes for evaluating past performance and projecting financial performance then move on to ratios.

Remember what accounts you use as the denominator for pro forma financial statements (sales and total assets), using the ratios from past periods is how you will estimate going forward. Remember the accounts and rationale behind analyst adjustments (FIFO balance sheets, LIFO income statements), adjustments to PP&E, goodwill and bringing off-balance sheet financing on the books.

Four general categories for quantitative credit analysis:

  • Scale and diversification: purchasing power from scale and product/geographic diversification
  • Tolerance for leverage:
    • Retained cash flow (RCF)/total debt
    • (RCF – capex)/total debt
    • Total debt/EBITDA
    • (EBITDA – capex)/interest
    • EBITDA/interest is the most well known and used formula of the four
  • Operational efficiency leads to lower costs and higher margins
    • EBITDA margin
    • Operating margin
  • Margin stability is measured through average % change in EBITDA margin

Remember the basic screens for different equity strategies, i.e. growth versus value investing, and the limitations of back-testing.

We are going to skip over some topics and begin our coverage of Equity Investments next week. The topic area is covered in two study sessions and will become increasingly important in the next two exams. Building a good base of knowledge from Level 1 material is absolutely critical to doing well on the other exams.

Only a few months left to the December exam. If you haven’t already, assess how you are doing with a mock exam or some practice problems over the material you have covered. If you are not through at least a few study sessions or are not retaining much of the information, you may need to step up your schedule. Stay strong, we’ll get there.

‘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, 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, 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 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

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

CFA Level 1 Review, Portfolio Management

Study session 12 in the CFA Level 1 curriculum includes four readings (42-45) on portfolio management and sets the basis for further material in the other two exams. While the topic area is only worth about 5% of your Level 1 test score, it makes up about 10% of the second exam and is the core focus on the third exam. The material here is pretty basic and easy to understand if you give it a little time and do the readings.

Portfolio Management: An Overview

The different types of clients, individual and institutional, are important here. Understand the basic return objectives and risk tolerance for individuals and the seven institutional clients (banks, pensions, insurance, endowments, foundations, investment companies, and sovereign wealth funds) as well as their time horizon, liquidity/spending needs and special circumstances for each.

Individual clients objectives and special constraints vary by individual.
Pension plans usually have long time horizons, high risk tolerance, varying income and liquidity needs.
Endowments and foundations usually have very long time horizons, high risk tolerance, with income needs based on that of college or foundation programs.
Banks have shorter time horizons, low risk tolerance, high income needs to pay interest and operational expenses.
Insurance companies have short horizons for P&C and long time horizons for Life companies, while the risk tolerance and income needs vary.

* Memorizing the needs is not nearly as important as knowing why they differ. You will need to understand this and be able to explain in on the Level 3 essay section, GUARANTEED.

The actual steps in the portfolio management process are of less importance than understanding individual sections in the process. Just remember that understanding the client’s needs through an IPS always comes first, followed by putting the portfolio together and then monitoring and rebalancing.

Target asset allocation is an important concept and you absolutely need to get the basics here to go into detail in Level 2. Weights are determined based on capital market expectations and the risk/return analysis of asset classes according to the needs of the specific client.

Understand the basics behind mutual funds, ETFs, hedge funds, and venture capital funds. Pay special attention to the differences between mutual funds and ETFs.

Portfolio Risk and Return (part 1 and 2)

These readings are more quantitatively focused and will set the stage for your quant material in the next exam. All the calculations can be done fairly easily on your calculator.

Understand the difference between arithmetic and geometric return. Geometric return measures the compound return and is appropriate when there are multiple periods. Arithmetic return is the average and is easier to compute and more commonly used.

Understand the IRR and how to work the cash flow functions on your calculator.

Remember, the asset class weights must sum to 1 for a portfolio return. Beyond that, it’s pretty easy. Just take the return of each asset times its weight and add them all up.

The calculations behind gross, net and real return are probably of lesser importance than how they differ. Understand what comes out of gross return (trading expenses, managerial and administrative expenses) to get net.

Variance and covariance, and correlations can seem overly lengthy and complex but you must know how to calculate them (despite the fact that your calculator can do it for you). Put them in some practice problems on flash cards and drill until its natural to run through the formulas.

Remember the three percentages to a normal distribution. +- 1 deviation holds 68% of observations, 95% within two deviations and 99% within three deviations.

The utility function is one of the few formulas in the curriculum that is pretty inconsequential in practical terms but seems to show up on exams because it’s easily testable. Just put it on a flash card and learn it.

Be able to calculate the capital allocation line and understand the idea behind indifference curves and the optimal portfolio. Understand the capital market line and how it relates to the CAL.

The capital asset pricing model will come into the curriculum several times and is the basis for many assumptions and valuation. At this point, just remember the basic formula and the assumptions underlying the model as well as limitations.

Basics of Portfolio Planning and Construction
Used to be, you didn’t start into the IPS until Level 2 and then really got into detail in Level 3. The Institute has moved it up to level 1 so that should give you an idea of its importance. We covered the basics of the IPS (Return Objective, Risk Tolerance, and 5 Constraints) in a previous post on Level 2 so click here for the summary.

Understand the criteria to specifying asset classes and how strategic asset allocation fits into portfolio construction. Understand the difference between SAA and tactical asset allocation. In TAA, the manager deviates from policy weights according to temporary changes in short-term capital market expectations but the long-term policy weights are constant.

Understand the difference and advantages/limitations between top-down and core-satellite.

Study session 13 in the CFA Level 1 curriculum begins the material on equity investments with three readings in equity market structure and efficiency.

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

CFA Level 1 Review Corporate Finance

Study session 11 in the CFA level 1 curriculum is a long one with six readings (36-41) covering Corporate Finance. The good news is that it is almost all conceptual material and anyone with undergraduate-level coursework in Finance will have seen much of it. As with much of the material at Level 1, you need a good base of understanding because you will be expected to know it in the other two exams.

The readings here are good, “what-if,” material as in what if you want to transition into management or corporate finance from investment management but neglected this really core information.

Capital Budgeting
Remember that only incremental cash flows are to be considered in budgeting. These are the additional inflow directly associated with the project. Sunk costs, like spending on impact or research, are not to be included because they are already spent. Financing costs are also not included because they are already factored into the discount rate.

Understand the difference between independent and mutually exclusive projects. Most questions on the exams will be about mutually exclusive projects, only able to go with one project. This is capital rationing in contrast to unlimited funds.

The biggest part of the reading is remembering all the measures: NPV, IRR, Payback & Discounted Payback, AAR, and PI. While NPV and IRR are the most important and will be seen many times in the curriculum, the others are pretty basic and easily remembered. Along with the calculations, you should know advantages/limitations of each method and the decision rule.

Remember, IRR is less subjective and widely accepted but based on the assumption of reinvested cash flows (not always realistic). The method will give multiple IRRs with un-conventional cash flows so the NPV method may be preferable.

NPV directly measures the increase in value to the firm and assumes reinvestment at the opportunity cost of capital, r.

Cost of Capital
Remember the preference continuum for estimating capital structure: target capital structure > current capital structure (weighted by market value) > trends in capital structure and management statements  >  averages of comparable companies’ capital structure

The various methods of estimating cost of debt and equity are probably the most important material in the reading.

Yield to Maturity or Debt-Rating for debt – YTM can be found using your calculator (N, PMT, FV, PVà compute i/Y) but remember to multiply the rate by number of coupons per year. Debt-rating is pretty easy using the yield on comparably rated bonds. ** The cost of debt is NOT the coupon rate.

Cost of equity: Dividend discount, bond yield plus risk, CAPM
Remember, estimated growth equals the retention rate times ROE.

Measures of Leverage
Understand the difference between operating leverage and financial leverage. Operating leverage refers to the fixed costs in operating while financial leverage refers to the debt costs in the capital structure. Remember that the higher the leverage, the higher the volatility and risk in net income.

Be able to calculate DOL, DFL and DTL using income statement items (changes in operating income, units sold, EBIT, Sales) or by the per unit inputs (quantity, price, variable operating cost per unit, fixed operating cost).

Companies with a high degree of financial leverage may be able to exit bankruptcy through restructuring (going concern) while those with high operating leverage have less flexibility and may be liquidated.

Dividends and Share Repurchases

Types of dividends: cash, stock, stock split, and liquidating dividend.
Remember the chronology for dividends: declaration dateàex-dividend dateàrecord date(typically two days after ex-div)àpayment date.

Share repurchase methods: open market, tender offer, dutch auction, and repurchase through direct negotiation.

Remember the advantages/disadvantages of each form of dividend or repurchase plan and how each impacts shareholder wealth.

Working Capital Management
There is some really good corporate finance material here but the specific measures are probably most important for the CFA exams. You’ll see these again in the equity investment material.

Liquidity measures: current and quick ratio (know the difference)

Turnover ratios: accounts receivable, inventory turnover, number of days receivables, number of days payable, number of days inventory (be able to calculate the operating and net operating cycle)

Remember the difference between money market yields, discount basis yield and the bond equivalent yield. You use 360 days for money market and discount yield and 365 days to calculate the BEY.

The cost of trade credit is a very testable formula. Put it on a flash card and learn it.

Corporate Governance
Remember the best-practices information here:

  • A majority of board members should be independent
  • Nominating, compensation, and audit committees should be completely independent members
  • Board should have resources to hire external consultants
  • Annual elections allow quick action by shareholders
  • Independent members of the board should meet regularly without management
  • Board should conduct an annual self-assessment
  • Company should adopt a code of ethics
  • Compensation and the incentive structure should align management-shareholder interests

Study session 12 in the CFA Level 1 curriculum covers the basics of portfolio management.

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

CFA Level I Review Financial Reporting Quality and Shenanigans

Study session ten in the CFA Level 1 curriculum curriculum concludes the material on FSA with reporting quality and some applications in three readings (33-35).

Financial Reporting Quality
The reading, and much of the curriculum in FSA, revolves around your ability to understand aggressive and questionable accounting practices. Companies using more conservative practices are going to have higher earnings quality because the doubt will be on the side of more favorable accounts.

A lot of the aggressive practices are highlighted elsewhere in the curriculum but are reiterated here. Understand that management might manipulate earnings to the downside as well as to the downside.

The list material behind red flags is fairly testable so understand the risks.

  • Incentives and pressures include pressure on management to meet expectations, financial targets, debt covenants, and their own financial well-being
  • Opportunities include the nature of the industry, a complex organizational structure, ineffective monitoring, a significant number of estimates build into the accounting system, high turnover or ineffective audit staff
  • Attitudes and rationalizations include the use of inappropriate accounting, poor communication channels, failure to correct reportable conditions, and a history of violations

The most important material is the specific warning signs and the measures to spot them.

  • aggressive revenue recognition (bill-and-hold sales, sale-leaseback, swaps and barter to generate sales)
  • operating cash flow out of line with earnings (CFO/Net Income)
  • Classification of expenses as extraordinary or nonrecurring
  • LIFO liquidations
  • Margins significantly out of line with peers without other explanations
  • Assumptions behind depreciation
  • Assumptions used in pension accounting
  • Fourth quarter surprises that cannot be attributable to seasonality
  • Excessive use of operating leases or other off-balance sheet financing

Accounting Shenanigans on the Cash Flow Statement
Understand that the cash flow statement is less easily manipulated but management can still distort the various accounts.

  • Stretching out payables (look for a trend in days sales payable)
  • Using a third-party to pay payables and then accounting for payment as a financing cash outflow in subsequent periods
  • Securitization of receivables and whether it is through a bankruptcy-remote VIE
  • Treatment of tax benefit on the cash flow statement and sustainability as an increase in cash from operations
  • Stock buybacks to offset dilution

Financial Statement Analysis: Applications
Really nothing new in this reading, just a review of the previous material. Remember what accounts you use as the denominator for pro forma financial statements (sales and total assets). Remember the accounts and rationale behind analyst adjustments (FIFO balance sheets), adjustments to PP&E, goodwill and bringing off-balance sheet financing on the books.

Study session eleven in the CFA Level 1 curriculum is an extremely lengthy (six readings) on Corporate Finance. Much of it is fairly basic and will be a repeat of your intermediate finance courses from college. If your background is not in finance then you will need to spend some extra time because the concepts will be revisited in the second exam as well.

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

CFA Level 1 Review Financial Reporting and Analysis

Study session nine in the CFA Level 1 curriculum details financial reporting & analysis with four readings (29-32) covering inventories, long-lived assets, taxes and long-term liabilities.

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.

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.

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.

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.

Understand how the financial statement accounts and ratios differ under capitalizing or expensing. 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.

Understand that, as an analyst, you may 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.

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.

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.

Understand the concepts and general rules behind intangible assets and impairment.

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.

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 I Review Understanding the Financial Statements

We started study session eight in the CFA Level 1 curriculum last week with a review of the Income Statement and the Balance Sheet. We will conclude this week with the Statement of Cash Flow and some notes on financial analysis.

Understanding Cash Flow Statements
While the Statement of Cash Flows is just as important, or more so in the practical world of analysis, the CFA curriculum does not spend as much time on it as with the other two financial statements. I don’t think it is a short-coming of the material, only that there is less to cover on the statement. It is relatively less ‘manipulated’ than the income statement and there are not as many adjustments needed as with the balance sheet.

There are some absolutely key concepts and formats that you need to remember about the statement, whether for the tests or for practical analysis. Understand the direct and indirect format and how to arrive at both using the other two statements. This is one of the best ways to understand how the company operates, i.e. how the company uses assets, liabilities and income to generate cash for equity holders.

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

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.
  • 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)
  • 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 (for 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.

Start with Revenues

+/- Change in Accounts Receivable
= Cash collected from customers
+ Investment income in cash

 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

– cash paid for interest
– cash paid for income taxes
= Cash Flow from Operations

Investment income in cash is usually the difference between other income and the gain or sale of property, plant and equipment. Cash paid for interest is the interest expense from the income statement.

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

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 is an immense number of formulas shown, I counted more than 50 in the FinQuiz study notes including multiple ways to get at measures like return on equity. Do not simply try to memorize them for the exam. You need to read this section and understand where the information is coming from on the financial statements, how it is related to other revenue/expense information and how you use it in financial analysis.  Again, take your time and your effort will pay off hugely in the future.

Study session nine in the CFA Level 1 curriculum gets deeper into the FSA material with four readings on inventories, long-lived assets, income taxes and non-current liabilities.

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

CFA Level I Review, Financial Statements Overview

Study session eight in the CFA Level 1 curriculum includes four readings (25-28) and covers the three main financial statements along with financial analysis techniques.

** If you want a career in finance or investment analysis, if this is really what you want to do, then you absolutely must embrace this reading. The four readings present the underlying concepts of how the financial statements represent a firm’s performance. Not only will this material be the core of your study for the CFA exams, your professional career will most likely revolve around it.

The reading is so important and so testable that we will be spending two weeks here for our 21-week study plan. You may want to keep on the one-study session per week schedule if you already have a good grasp of the statements and basic analysis.

So spend a little extra time on this study session if you have not already mastered it from previous courses. The time spent here will pay off this June and in the other exams as well.

Understanding Income Statements

The income statement measures the company’s performance over a period of time. The main point is that revenues and related expenses are matched during the period in which they occur. This is supposed to give a better measure of performance than a cash accounting. The problem is that management often has a strong incentive to manipulate the revenues, expenses and other items to show earnings in a different light.

It’s important to understand the basic structure of the statement and what each line item represents:

  • Net Sales is gross revenue minus any allowances for returns
  • Cost of goods sold is really what it sounds like and is the inventory cost, here it is important to understand inventory accounting procedures like LIFO, FIFO, or average cost to understand how management is expensing it
  • Gross Profit is the difference between net revenue and COGS (also used to find Gross Margin) and is your first measure of profitability
  • Selling, General & Administrative is all direct and indirect expenses that can be linked to operations (salaries, rent, utilities, marketing, pretty much everything that is not associated with the cost of inventory itself)
  • Operating income (profit) is the result of operations and your second measure of profitability (profit margin = operating income/ net revenue)
  • Interest expense is just the interest on debt for the period
  • Nonrecurring items- discussed below
  • Provision for income taxes represents the estimated tax liability and gives an indication of the effective tax rate
  • Net income is your final measure of profitability (net margin = net income/net revenue)

A theme throughout the curriculum is the preference for conservative accounting principles, as opposed to aggressive practices. Conservative principles are those that take the ‘safe’ bet when recognizing revenues or expenses (and usually less favorable to short-term reporting).

Understand how to calculate the two methods for revenue recognition of long-term projects and the SEC’s four criteria for revenue recognition:

  • Legitimate arrangement between buyer and seller
  • Delivered or rendered the product or service
  • Price is or can be determined
  • The seller can be reasonably assured of collection

Nonrecurring items that are unusual or infrequent (but not both) are reported as part of earnings from continuing operations and are often a way for management to take large expenses up front instead of in the future. Examples are: restructuring costs, asset impairment charges, gains or losses on sale of long-lived assets.

Those nonrecurring items that are unusual and infrequent (extraordinary) or discontinued operations are reported net of taxes below income from continued operations. Because these are so out of the ordinary, analysts do not normally consider them against performance. As with those nonrecurring items included in continuing operations, analysts must decide whether they are appropriately reported.

Remember that some items are not reported on the income statement but go “direct to equity” as other comprehensive income. The easiest way to remember these is by the PUFE acronym for:

  • Pensions or additional minimum pension liability
  • Unrealized gains or losses on available for sale securities
  • Foreign currency exchange translations on hedging
  • Effective portion of cash flow hedges

You are not asked to do much with the Statement of Comprehensive Income at level I but just understand the basic relationship and what each of the four items represents.

Understand which changes to accounting standards must be reported retrospectively (changes to accounting principles) and which must be treated prospectively with no adjustments to prior periods (changes to estimates) and that corrections of prior period errors require a restatement of financial statements.

Be able to calculate earnings per share for both a simple (just NI minus preferred dividends over weighted average common shares) and complex capital structure (basic EPS adjusted for After-tax interest on convertible and common share adjustments for assumed conversions).

Understanding Balance Sheets

Unlike the other two statements, the balance sheet is a ‘snapshot’ in time. The figures reflect the state of accounts at that moment, the last day of the quarter or year. The other two statements represent activity over the period. For this reason, and this is very important, when you perform ratio analysis comparing numbers across the statements you will take an average of the beginning and ending figures for balance sheet accounts. For example, the cash debt coverage is cash-flow from operations divided by average total debt from beginning and ending balance sheet date.

You’re going to get tired of people saying, “Assets = Liabilities + Equities.” This is the basic balance sheet equation and around which much of the material will revolve around. Understand what it shows when you change around the equation (i.e. A-L = E) and you’ll get the importance of the concept.

Account Valuations

One of the most important topics on the statement is valuation. Some accounts are shown at historical or amortized price, while others are shown at fair (market) value. Obviously this makes a big difference in overall valuation and when comparing numbers. Further, analysts often will adjust the numbers to arrive at a number they feel is more realistic or comparable. You aren’t asked to do this but just to understand where it might be needed and why. The definitions below will each describe the method of valuation for the account.


Assets represent a future probable economic benefit and could be accumulated items, amounts spent but not yet expensed (matched with revenues) or amounts earned but not yet received (accounts receivable).

Current assets are the most liquid and are accumulated or planned to be used in the ‘current’ operating period. Normally recorded at fair market value.

Cash or cash equivalents- is usually short-term money market, CDs, commercial paper or treasuries that can be converted to cash quickly. This is used in all your liquidity ratios and is (duh) valued at market.

Accounts receivable– Sales made on credit but not collected, usually offset by an allowance for uncollectable (estimated) but shown net realizable (fair) value. Trends in AR are an important indication of performance and estimates.

Inventories- A key item and one you’ll spend a lot of time on through the curriculum. Reported at lower of cost or market on the balance sheet but estimated through different practices (LIFO, FIFO, or average). Could be broken down into three sub-accounts: raw materials, work-in-process, and finished goods.

Prepaid expenses– Where the company has paid in advance for a service or product, i.e. insurance and rent. Valued at market with an adjustment when they are expensed through the income statement.

Long-term assets have a useful life of more than a year (or operating cycle) and are usually not going to be sold to customers. These accounts are usually recorded at cost and then depreciated or amortized over the estimated life.

Property, Plant, & Equipment – valued at cost and depreciated over its estimated useful life, shown as net. These are also referred to as ‘tangible’ assets because they generally have physical substance and are easily counted.

Goodwill & other intangibles– Goodwill is the amount paid for acquisitions above their market value. It is basically a premium paid for things like brand and proprietary technology. It is recorded at cost and tested annually for impairment, which is an estimation of the value that no longer exists.


Liabilities are future probable sacrifices from obligations or transactions and could be: amounts received but not earned yet as revenue, amounts received that must be repaid or amounts expensed on the income statement but not yet paid (accounts payable, accruals, etc).

Current liabilities are those that will be paid or settled in the ‘current’ operating cycle.

Accounts Payable– suppliers have sold something to the company on credit that must be repaid. As with AR, you’ll look for trends in this to see that the company is not taking longer to pay. Valued at market.

Accrued liabilities– Those items expensed in the current period but that will not be paid until the next period, kind of a carry-over effect of timing, i.e. wages and interest owed but not paid yet. Valued at market.

Short-term debt- includes lines of credit and notes with an original maturity of less than a year (negotiated debt).

Current portion of long-term debt – principal portion of long-term notes including any capital lease obligations.

Unearned revenue- sales collected in advance but not yet earned so they sit here until delivered or performed. Settled as revenue on the income statement instead of through a cash adjustment.

Long-term liabilities is often a single line item for debt but can also be broken out into items like: bonds and notes payable, long-term lease obligations, deferred taxes and pension liabilities.

Stockholder’s Equity

Equity is the residual after assets and liabilities and that which is due the owners of the company. It includes: capital contributed by owners through stock, recognized on the income statement but not yet paid out to owners (retained earnings) and adjustments to assets or liabilities that did not go through the income statement (see other comprehensive income in prior post).

Contributed capital– is supplied by stockholders and broken into common, preferred and additional paid-in-capital.

Minority interest – This is the cumulative, noncontrolling ownership held in other companies.

Retained earnings– accumulated net income due to owners but not yet paid out.

Treasury stock – amount paid to repurchase company stock usually shown as a negative number because it decreases equity.

We will conclude the study session next week with the Statement of Cash Flows and some notes on financial analysis.

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

CFA Level 1 Review, Intro to Financial Statement Analysis

Study session seven in the CFA Level 1 curriculum includes three readings (22-24) for an introduction to financial reporting and analysis. How much time you spend here really depends on how well you know basic financial accounting. The material is extremely important as a step to more detailed concepts but will most likely be repeat information for any student of finance.

Financial Statement Analysis

If you’ve had any previous finance classes, most of the reading will be pretty basic and you can probably just skim it for new information. The material on the procedural steps of statement analysis is secondary to the definitions of the major accounts in the financial statements.

If you are unfamiliar with financial statements, spend some time getting the basic role and parts of the statements. This basic understanding and definitions is critical to understanding how the statements work and are related but it will be repeated in study session eight within the readings on the individual statements.

Understand that different entities use the financial statements for different reasons, whether for investment, M&A evaluation, creditworthiness or internal evaluations.

The balance sheet is a point in time measure of the firms assets, liabilities and equity capital. The numbers presented are as of a certain date. This is important because the other statements are presented for activity in the period. For many of the ratios, you will be using an average of the beginning and ending value to get a better representation of the account over the period. Another important thing to remember is that values on the balance sheet do not necessarily reflect fair market value. You will spend a lot of time learning how each line item is recorded and held on the books.

The income statement is a report of the firm’s operations over the period. How many sales they recorded and what it cost to make those sales. The most important thing to remember here is that sales do not mean cash flow. Understand the concept of the accrual method of accounting and how revenues and expenses are matched.

The statement of cash flows is a reconciliation of the other two accounts and reports how the firm’s cash changed over the period. You will be shown how to construct the statement two different ways, direct and indirect. Resist the temptation to just learn one way and hope that you don’t need to use the other.  Understanding how cash payments and receipts are reported is one of the best ways to understand the company and will pay off big time in your analysis.

Financial Reporting Mechanics

This reading covers all the basics of financial accounting and is must know material. It’s hard to point out the important information here because it is almost all key to understanding the financial statements and how they are reported. If you did well in previous finance classes then it may again be repeated information. Read through the material and highlight everything which you do not already have a firm understanding.

Understand the difference between operating, investing and financing activities. This is the key to analyzing how the business works. Operating activities are the core business including sales and how those sales are made. Investing activities relate to the acquisition of long-term assets and investments and help to generate more operations in the future. Financing activities relate to the firm’s capital transactions involving equity or debt.

If you are not familiar with accrual accounting, spend some time running through the scenarios provided by the curriculum. It’s pretty basic at this point but you need to understand how revenue is booked against expenses, how long-term assets are capitalized and expensed over time through depreciation, and how payables and deferred items work.

As part of learning the cash flow statement, remember the difference between a source of cash and a use of cash, and how it relates to the other statements. An increase in liabilities or equity or a decrease in assets is a source of cash because either an asset is being converted to cash or a liab/equity is being accrued in exchange for cash now. On the other hand, an increase in assets or a decrease in liab/equity is a use of cash. Buying an asset or paying off a liability/equity account decreases cash.

Financial Reporting Standards

While you will need to understand how the statements are reported differently under IFRS and GAAP, a lot of this background information is secondary to the mechanics. Understand the relationship between each framework and the private sector organizations that establish rules (FASB and IASB) and the difference in framework between IFRS and GAAP.

Knowing some of the forms will be necessary in your professional life, even if you don’t see a specific question on the exam. 10-K is the annual report to the SEC while 10-Q is a quarterly report. Material events outside of the quarterly or annual reports are required in an 8-K form. Forms 3, 4 and 5 are required to report changes in ownership.

Remember, IFRS does not permit LIFO as an inventory costing method and uses a single-step method for impairment rather than the two-step method used in GAAP. IFRS also requires capitalization of development costs when certain criteria are met.

An important difference between GAAP and IFRS is the difference between a principles-based method, providing a broad reporting framework and more judgment, and a rules-based method which provides specific rules for each transaction and requires less judgment.

Study session eight in the CFA Level 1 curriculum covers the three main financial statements and will make or break your CFA future. Make sure you are ready to spend some time on the readings to get a good base for deeper analysis down the road.

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

CFA Level I Review: Foreign Exchange (with Videos)

Study session 6 in the CFA Level 1 curriculum concludes the economics material with two readings (20-21) on economics in a global context.  Only 19 LOS but is important to set a base (especially forex) for level II

International Trade and Capital Flows
The reading is almost completely conceptual and just a series of lists, theories and competing models. The most testable material is often the comparison between theories or models, so understand basic advantages/disadvantages of each.

Understand the different impacts of tariffs, quotas and subsidies across the economy. Producer surplus increases while the consumer surplus decreases under these trade policies. The effect on the government is mixed with an increase from tariffs, decreasing revenue from an export subsidy and dependent results on import quotas.

Prices in the importing country increase under a tariff and quota system while domestic consumption falls under all three trade policies. Domestic production generally increases though at the expense of national welfare.

Currency Exchange Rates
The material on foreign exchange rates can get tough but you have to build a good understanding. It is not only easily testable on the Level I exam but will also be an important part of the curriculum in the other two exams. Failure to understand the basic concepts here only means that you will need to spend the time to learn them in subsequent years.

Understand the differences between currency futures and forwards. As a exchange product, futures are available only at a fixed contract amount and for settlement on fixed dates. Collateral (margin) must be posted and is marked-to-market on a daily basis. Liquidity is much higher for futures and there is no counterparty risk. Forwards are OTC agreements between private parties so will be much more flexible in terms of amount, settlement and collateral. They are not as liquid and include counterparty risk.

The real points here and through the other two exams is in your ability to do the rate calculations. First understand the difference between a direct and indirect quote. The direct quote will have the domestic currency last (i.e. after the slash) and in terms of one unit of the currency. $1.37/Euro is the direct quote for euros in the US dollar. One euro costs $1.37 dollars.

Be able to calculate and determine depreciation/appreciation in a currency as well as the forward rate.

* Forex was a tough one for me and I really couldn’t get the hang of it until I watched a couple of videos. Work through the curriculum and any study guides you have but don’t be afraid to look on YouTube for a visual interpretation as well.

A good explanation of Bid and Ask quotes is available on YouTube at:

Cross rates and arbitrage are easily testable and will really test whether you understand forex quotes and calculations. A good explanation of triangular arbitrage is available on YouTube at:

Beyond the basic function of the currency regimes, the advantages and disadvantages are the most important part here. A few times drilling yourself on flash cards should be enough to be able to pick these out of a list if questioned on the exam.

The material on capital flows and currency rates is largely theoretical so understand the general concepts. Understand the difference between the elasticities approach and the absorbtion approach.  The basic idea behind the Marshall-Lerner condition is that demand for imports and exports is price sensitive so that increases in relative prices will lead to a changing trade balance that can be managed through devaluations of the domestic currency. Under the absorption approach, a depreciation will improve the trade balance only for a short period through the wealth effect, and that is only under an economy operating under full employment.

Study session 7 begins your introduction to Financial Reporting and Analysis, probably the most important topic within the entire CFA curriculum. Fortunately, the material on the CFA Level 1 exam is pretty basic and you will probably have seen it before in any basic finance course.

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

CFA Level 1 Review, Economics

Study session five in the CFA Level 1 curriculum covers macroeconomic analysis (reading 17-19). Again, the Institute is not expecting you to become a star economist with these readings so do not get bogged down in the details. There are a few basic equations that may be testable but you should focus on the concepts and definitions.

Aggregate Output, Prices and Economic Growth

This is largely a definitional reading to set up for further issues. Understand the components within GDP (household, business, government, and net exports) and the issues with measuring it. Additionally, understand the components of GDP by the expenditure method: consumer spending, business gross fixed investment, change in inventories, government spending, government gross fixed investment, and net exports.

Understand the difference between GDP and National Income and the components of NI: employee compensation, enterprise profits before taxes, interest income, proprietor’s income, rent, and indirect business taxes.

A matrix is helpful to learn the short- and long-run changes in the aggregate supply/demand curve given various changes. Understand the determinants of the curves and which way a shift will occur.

An increase in stock prices, housing prices, consumer or business confidence, capacity util, government spending, bank reserves, or global growth will cause a rightward (higher) shift in aggregate demand.

An increase in labor supply, natural resources supply, human or physical capital, productivity or technology, expectations for future prices, or subsidies will cause a rightward shift in the short-run aggregate supply though expectations and subsidies will not affect the long-run curve (the others will affect both curves). An increase in nominal wages, input prices, and taxes will cause a leftward shift in the short-run aggregate supply curve but will have no impact on the long-run.

Understand the sources of economic growth: labor, human and physical capital, technology, and natural resources (you will need to know how they affect growth according to different theories in a future reading).

Understanding Business Cycles

A matrix chart is again useful here with economic activity on the vertical axis and cycle points on the horizontal.


  • Layoffs slow and net employment turns positive in early expansion (recovery) with businesses first turning to overtime and temp workers
  • Full time hiring picks up and the unemployment rate falls in late expansion
  • The rate of hiring slows but the unemployment rate continues to fall at the peak
  • Hiring freezes and hours are cut followed by outright layoffs in contraction (recession)

Consumer and Business Spending

  • Cyclical sectors start to pick up in early expansion and consumer spending increases
  • Increase in spending is broad-based with construction and capital spending pickup in late expansion
  • Spending continues to expand but the growth rate of spending slows at peak
  • Industrial production, housing, consumer and durable goods fall first in recession


  • Remains moderate and may continue to fall in early expansion
  • Starts to increase in late expansion
  • Accelerates at peak
  • Decelerates but with a lag in recession

This list is abbreviated and you may want to expand it with further detail but remember to stick to the broader concepts.

Understand how an increase/decrease in foreign GDP growth should affect forex rates and trade (i.e. when the domestic currency appreciates then imports should increase through cheaper foreign goods and decrease net exports).

The rest of the reading is devoted to a discussion on the various theories. Again, understand the definitions and how each theory says the economy works as well as basic criticism of each. The most you will see (in my opinion) is definitional and comparison questions on these rather than detailed procedural stuff.

Understand the definitions for unemployment and how it is calculated as well as issues with NARU AND NAIRU. Understand the basic definitions for the components of leading, coincident and lagging indicators.

Monetary and Fiscal Policy

The quantity theory of money is easily testable but a pretty basic calculation. MV = PY or the quantity times the velocity of money equals the average price level times real output. Understand the basic theory and what it means for inflation.

Lists like monetary policy tools are important on the exams because they cover broad conceptual ideas and are easily worked into questions. Central banks have three primary tools: open market operations buying or selling government bonds, changing the policy or discount rate, and changing the reserve requirement for banks. Understand the basic process behind using each of these and the affect on the economy.

Lists of limitations to a policy or measure are also important. Understand the basics of monetary policy tools like problems with the transmission mechanism, bond market vigilantes, deflationary traps and liquidity traps.

Fiscal policy and its affect on aggregate demand is important. Understand the difference between automatic stabilizers and discretionary policy.

The key to the reading is the relationship between monetary and fiscal policy. Build out a chart with easy versus restrictive policy on one axis and monetary/fiscal policy on the other.

  • Easy fiscal/tight monetary: higher output and rates with expansion in public sector
  • Tight fiscal/easy monetary: lower rates and expansion of private sector
  • Easy monetary/easy fiscal: higher aggregate demand and lower rates with both public and private sector growth
  • Tight monetary/tight fiscal: higher rates and lower aggregate demand

Study session six in the CFA Level 1 curriculum concludes economics with two readings on exchange rates and international trade.

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

Embracing the Horror of a CFA exam Fail

By now everyone that took the recent CFA exam in December has received their results and the news was not good for 63% of the 48,981 candidates.

Only 37% of the Level I candidates passed the exam in December, close to the ten-year average of 38% but well under the average pass rates for the other two exams.

While it might be of little solace to those that did not get through this time, try to remember that failing one exam is no big deal in the grand scheme of things. Few people will know or remember that you didn’t pass so resist the trap of being your own worst critic. Believe me, if not passing one of your CFA exams is your biggest regret in life, you are doing exceptionally well!

Many that receive the disappointing news start to question the worth of the designation or wonder if they should register for the next exam. These are valid questions but not to be made lightly or as a knee-jerk reaction to bad news. The industry has been extremely unforgiving over the last few years and you need every advantage to stay competitive. Don’t decide against the designation just because you think it will get you out of some study time. If you want to be successful in the industry, you need to keep your skills strong and the CFA curriculum is the best around.

On the bright side, the curriculum doesn’t change much from year to year and you should do well on the next exam. The additional time studying, especially in the Level I curriculum, will give you a strong base from which to work on the other two exams.

Use the experience to strengthen your resolve and evaluate your study plans. Did you start too late or not spend enough time studying? Every year, successful candidates report an average of 300 hours spent studying for the exam. Did you do well or poorly on any particular topic areas? The topic areas are consistent throughout the three exams and build upon material learned in Level 1. Don’t think that barely squeaking by on a topic is going to help you moving forward.

Take a look at our CFA Level 1 Strategy and at the basic study plan. Use it to improve your own plan and you should have no problem come June. We will continue our 21-week study plan next week with study session five across the three levels.

A failure can be the best teaching tool. Learn from it and be a stronger professional.
Joseph Hogue, CFA

CFA Level I Review, Economics

Study session 4 in the CFA Level I curriculum covers microeconomic analysis and is composed of four readings (13-16). The material on economics concludes in study session 5 with macroeconomic analysis and is worth 10% of your total exam score.

While the material may get detailed at points, larger concepts and ideas are the key for most of your points in the economics section. The Institute isn’t expecting you to become a chief economist at some bank just by virtue of the curriculum. Get the big picture down and how it affects the investment decision-making process and move on to the “core” topic areas like FRA and equity.

Intro to Demand and Supply
Understand the difference between substitutes and complements and how price and demand is affected. A price increase for a substitute causes demand for the other product to increase while an increase for a complement drives down demand for the product.

Shifts versus movement along the supply/demand curves is easily testable and a fundamental concept. Remember that a change in price represents movement along the curves while changes in other variables (income, expectations, technology, number of buyers/sellers, price of related goods) will cause a shift in the curve.

Figuring out the areas under the curve can be a pain but is also something that has shown up on the exams. Remember your basic math: Area = ½ (base * height) and the terminology (consumer and producer surplus, deadweight loss, affects of a ceiling or floor on prices)

Consumer Demand
The terminology and interaction here is probably the more important part. Remember the income effect and substitution effect reacts from a change in price and how the changes are different for normal versus inferior goods.

The Firm
Understanding how the terminology fits together mathematically is a big part of the reading (i.e. Total revenue minus explicit and implicit costs equals economic profit). There is a lot here and figuring out all the curves can be a pain for those that did not get it in their fundamental college course.  For me, reading through the material only put me to sleep. The best way to understand the material was to work through problems and use the answers to understand how everything fit together.

  • Firms will produce as long as their marginal revenue (MR) is greater than marginal costs (MC)
  • The break even price is the point at which economic profit equals the average total cost (P = AR = MR = ATC or where TR = TC)
  • If MR is greater than MC then profit can be increased by increasing output
  • If MR is less than MC then profit can be increased by decreasing output
  • When TR is less than TVC then the firm will shut down (short-run) and exit (long-run)

The differences between long-run and short-run decisions are important.  

In the short-run, the firm can continue to operate even if TR is less than TFC and TVC. However, the industry will contract as existing firms leave over the long-run. If TR is greater than TC then firms will continue to operate in the short-run but the industry will attract competitors in the long-run.

The Firm and Market Structures
The reading is a huge relief after the previous one because the material is largely conceptual and fairly easy to grasp. The differences between the four market structures is key and the best way to see how they compare is to make yourself a table with: number of sellers, degree of differentiation, barriers to entry, pricing power of firm, non-price competition, firm demand, allocative efficiency and long-run profits.

Along with the table, make a quick note on the characterisitics and advantages of each structure.

  • Perfect competition: Free entry and exit to industry with low barriers, homogenous products and a large number of buyers/sellers means sellers are price takers, efficient allocation of resources and only a normal profit
  • Monopolistic competition: many buyers/sellers with some product differentiation but entry/exit is low-cost, firms have some control over price but must advertise
  • Oligopoly: few sellers offering similar or identical products (close substitutes), barriers to entry/exit are high and firms have substantial control of price. Understand the terminology behind duopoly, collusion and cartels
  • Monopoly: single seller and product, high barriers to entry and significant control over resources/price.

While the material in monopolistic competition and oligopoly is important, the curriculum seems to focus more time on the extremes and how they relate to supply/demand analysis.

Study session five concludes the topic area with macroeconomics and is incrementally more important to the other two CFA exams. Let me know if you’ve got any questions or comments.

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