CFA Level II Review, Economics

Study session 4 in the CFA Level II curriculum covers economics for valuation (3 readings: 14-16) and is worth between 5% – 10% of your total exam score. I thought the material was pretty interesting and had to resist the temptation to spend too much time on it. The FRA and Equity material on the second exam is tough and you really need to be spending your time on the core topic areas. Get the concepts and basic formulas down in economics and move on.
Currency Exchange Rates
This reading is the more quantitative of the three and can be tough for some candidates because of the convention for quotes. In a USD/EUR quote, the euro is the base currency and the dollar is the price currency. It reflects how many dollars can be bought for one euro. If the rate goes from 1.456 USD/EUR to 1.33 USD/EUR then the dollar has appreciated because you need fewer dollars for one Euro.
** do not get caught up in actual spot rates on the market (i.e. the current rate on Yen, dollar, etc.). The tests generally quote rates in realistic terms but this does not have to be the case. Do not think that because one of the possible answers is not a realistic quote (i.e. $50 USD/JPY) then it cannot be the correct choice.
Remember that nominal rates represent non-inflation adjusted prices while real rates are adjusted for inflation.
The parity conditions are important and easily testable so learn the equations and implications for each.

  • Covered interest rate parity must  hold because it is enforced by arbitrage
  • Uncovered interest rate parity tends to hold over the long-term but not over shorter periods.
  • Purchase Power Parity does not hold when there are different baskets of goods, goods and services are non-tradable, transportation costs

Be able to work through a carry trade strategy and tell if a arbitrage-profit exists.
Understand how capital flows work to affect exchange rates and the differences between expansionary/restrictive policy with flexible/fixed rates.
Economic Growth and the Investment Decision
The reading, along with that on regulation, is largely terminology and list material. Pick out the key ideas and lists for flash cards.

  • Preconditions for growth: well-functioning/developed markets, defined property rights and rule of law, free flow of capital and trade, public education and health services, policies that encourage entrepreneurialism, adequate infrastructure
  • Classical model: growth rate in real GDP per capita is temporary because an increase in the real wage causes the population to increase and the supply of labor
  • Neoclassical model: growth in real GDP per capita depends solely on exogenous tech progress and diminishing returns
  • Endogenous growth model: technological progress is an endogenous factor and depends on people to innovate. Growth in real GDP can continue if people have the ability and willingness to innovate.

Understand the factors of production and the concept behind the Cobb-Douglas production function (i.e. constant returns to scale and diminishing marginal productivity)
Know how to work through the equation for growth accounting and be able to distinguish an event as growth in labor, capital or technological progress

  • Growth in output equals the rate of tech change plus growth in capital (times the elasticity of output) plus the growth rate in labor (times the elasticity of output  in labor, which is just one minus output elasticity of capital)
  • Growth in TFP is through entrepreneurial activity, education, roads, technology or natural resources

Economics of Regulation
This one is a good one for a quick outline. Start with the definitions and overview then rationale for regulation. Then list out the outcomes and tools for regulation. Probably the least important of the three readings and almost entirely conceptual.
Study session five begins the readings on Financial Reporting and Analysis, arguably the most important topic area to the CFA curriculum. The study sessions can get intense from here so try not to fall behind.
‘til next time, happy studyin’
Joseph Hogue, CFA

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