CFA Level I flashcards

Basic EPS measures the amount of income attributable to each common share, calculated by subtracting preferred dividends from net income and dividing by the weighted average number of common shares outstanding.

• Formula: (Net income − Preferred dividends) / Weighted average common shares
• Preferred dividends are always subtracted, even if not declared, for cumulative preferred stock
• Basic EPS does not consider convertible securities or options (that's diluted EPS)

Memory trick: Subtract preferred, divide by shares — that's basic EPS care.

EAR converts a stated (nominal) annual rate compounded m times per year into an equivalent annual rate reflecting the effect of compounding.

• EAR = (1 + periodic rate)^m - 1
• EAR > stated rate whenever m > 1
• EAR increases as compounding frequency increases

Memory trick: More compounding, more compounding power.

A no-arbitrage condition stating that the forward exchange rate reflects the interest rate differential between two currencies.

• F = S × (1+i_domestic)/(1+i_foreign)
• Higher interest rate currency trades at a forward discount
• Prevents riskless arbitrage between money markets and FX forwards

Memory trick: High-rate currency loses value forward — 'high yield, low future price.'

Counts the number of ways to choose r items from n items when order does not matter, calculated as n!/(r!(n-r)!).

• Use combinations when order is irrelevant (e.g., selecting a portfolio)
• Use permutations when order matters (e.g., ranking top 3 stocks)
• Combinations are always ≤ permutations for the same n and r

Memory trick: Combo doesn't care about the order, Permutation puts it in order

A method for calculating price elasticity of demand that uses the average of starting and ending values as the base, avoiding directional bias.

• %ΔQ uses average of Q1 and Q2 as denominator
• %ΔP uses average of P1 and P2 as denominator
• |E|>1 = elastic; |E|<1 = inelastic; |E|=1 = unit elastic

Memory trick: Midpoint avoids the 'direction bias' — average the base like averaging a road trip's start and end mileage.

The Treynor ratio measures excess return per unit of systematic risk (beta) and is most appropriate for evaluating well-diversified portfolios where unsystematic risk has been eliminated.

• Formula: (Rp − Rf) / βp
• Appropriate when portfolios are well-diversified (no unsystematic risk remains)
• Sharpe ratio is preferred for non-diversified or total portfolios using standard deviation

Memory trick: Diversified? Trust Treynor's beta-based test

A market condition in which security prices fully and quickly reflect all publicly available information, so fundamental analysis of public data cannot generate abnormal returns.

• Includes financial statements, news, and economic data
• Implies technical AND fundamental analysis of public info are unproductive
• Tested via event studies around announcements

Memory trick: Semi-strong: news hits, price shifts instantly.

The no-arbitrage futures price on a dividend-paying index equals the spot price adjusted for the risk-free rate net of the dividend yield.

• F0(T) = S0 × [(1+Rf)/(1+δ)]^T
• Higher dividend yield lowers the futures price relative to spot
• Higher risk-free rate raises the futures price relative to spot

Memory trick: Carry cost = borrow rate minus dividend gain — net it into the futures price.

An annuity due has cash flows at the beginning of each period; its future value equals the ordinary annuity FV multiplied by (1+r).

• FV(ordinary) = PMT x [(1+r)^n - 1]/r
• FV(due) = FV(ordinary) x (1+r)
• Annuity due always has higher FV than ordinary annuity for same terms

Memory trick: Due deposits get one extra ride on interest.

Under IFRS, if the value of previously written-down inventory recovers, the write-down can be reversed, but only up to the original cost; US GAAP prohibits any reversal.

• IFRS allows reversal, capped at original cost
• US GAAP: write-downs are permanent, no reversal allowed
• Reversal is recognized as a reduction in COGS in the period it occurs

Memory trick: IFRS lets you bounce back, but never higher than where you started.

FFO is a REIT performance measure calculated as net income plus depreciation and amortization, minus gains (plus losses) on sales of property, designed to better reflect a REIT's recurring cash-generating operating performance than GAAP net income.

• Depreciation is added back because real estate often appreciates rather than depreciates economically
• Gains/losses on property sales are excluded as non-recurring items
• FFO is a standard REIT industry metric defined by NAREIT

Memory trick: Add back the depreciation myth, strip out the one-time sale gain.

A cognitive bias in which individuals rely too heavily on an initial reference point (anchor) and fail to adjust sufficiently when new information arrives.

• Common in valuation and forecasting revisions
• Leads to under-reaction to new, materially different information
• Distinct from representativeness, which involves overreacting to patterns

Memory trick: The first number drops anchor — new facts can't pull it far.

A Type II error occurs when a hypothesis test fails to reject a null hypothesis that is actually false.

• Type I error: rejecting a true null (probability = significance level, alpha)
• Type II error: failing to reject a false null (probability = beta)
• Power of a test = 1 - beta = probability of correctly rejecting a false null

Memory trick: Type I cries wolf; Type II misses the wolf.

Risk budgeting allocates a portfolio's total risk across positions, identifying which assets contribute disproportionately more or less risk than their capital weight.

• Contribution-to-weight ratio > 1 = disproportionate risk source
• Driven by asset volatility and correlation with rest of portfolio
• Used to rebalance portfolios toward more efficient risk allocation

Memory trick: Small weight, big risk — the tail wagging the portfolio dog.

The duty of loyalty to an employer under Standard IV(A) does not require members to conceal or participate in illegal activity; reporting such conduct, especially after internal channels fail, does not violate the Standard.

• Loyalty applies to employment matters, not covering up fraud
• Internal reporting is usually the first step, but external reporting is justified if ignored
• Protecting client assets and market integrity can override strict employer loyalty

Memory trick: Loyalty doesn't mean silence about fraud.

The fundamental price-to-book ratio derived from the Gordon Growth Model, calculated as (ROE − g) / (r − g), reflecting how much investors should pay per dollar of book value based on profitability, growth, and required return.

• Formula: Justified P/B = (ROE − g) / (r − g)
• Higher ROE relative to required return increases justified P/B
• Comparing justified P/B to actual market P/B indicates over/undervaluation

Memory trick: Profit power minus growth, over cost of capital minus growth.

Quote-driven (dealer) markets rely on designated dealers who continuously post bid/ask quotes and provide liquidity; order-driven (auction) markets match buy and sell orders directly from market participants, often via an electronic limit order book.

• Quote-driven: dealers as intermediaries, e.g., traditional OTC/dealer markets
• Order-driven: direct matching of investor orders, e.g., electronic limit order books
• Order-driven markets can further be call markets (periodic matching) or continuous markets

Memory trick: Dealers quote, orders match — know who moves the market.

A common-size balance sheet presents each line item as a percentage of total assets, enabling comparison across companies of different sizes.

• Each asset item ÷ total assets
• Each liability/equity item ÷ total assets
• Facilitates cross-sectional and trend analysis

Memory trick: Divide every line by total assets to see the size-free picture.

Members must not engage in professional or personal conduct involving dishonesty, fraud, or deceit that reflects adversely on their integrity or competence.

• Applies even to conduct unrelated to investment activities
• Deliberate falsification and fraud are clear violations
• Simple legal infractions unrelated to dishonesty (e.g., minor traffic violations) typically do not violate the standard

Memory trick: Dishonesty anywhere taints everywhere.

Orders are defined by both a price condition (market, limit, stop) and a time-in-force instruction (day, good-till-canceled, immediate-or-cancel).

• Limit orders specify a maximum buy or minimum sell price
• Day orders expire at the end of the trading session if unfilled
• Stop orders become market orders once a trigger price is reached

Memory trick: Price sets the ceiling, time-in-force sets the clock.

GIPS requires that terminated portfolios remain in a composite's historical performance through their last full period under management, preventing survivorship bias.

• Excluding terminated accounts overstates composite returns (survivorship bias)
• Weighted average calc: sum(weight × return)
• Violates both GIPS standards and CFA Standard III(D)

Memory trick: "Don't let losers leave quietly — keep them in the history."

The stock price at which an investor's equity percentage falls to the maintenance margin, triggering a margin call.

• Formula: P0 × (1 − initial margin)/(1 − maintenance margin)
• Loan amount is fixed in dollar terms as price falls
• Lower maintenance margin means price can fall further before a call

Memory trick: As price falls, equity shrinks faster than debt — find the tipping point.

A depreciation method that allocates the depreciable cost of an asset based on actual usage or output rather than time.

• Rate per unit = (Cost − Salvage)/Total estimated units
• Expense = Rate per unit × units produced in period
• Depreciation varies with production activity, unlike straight-line

Memory trick: Depreciate by output, not by the calendar.

An asset is current if expected to be converted to cash, sold, or consumed within one year or the operating cycle, whichever is longer.

• Use the LONGER of 1 year or operating cycle
• Applies mainly when operating cycle exceeds 12 months
• Strategic investments and PP&E are generally noncurrent

Memory trick: Pick the LONGER yardstick — year or cycle

Members must use client brokerage commissions only to benefit clients (e.g., research or execution quality), not for personal gain, as part of the duty of loyalty, prudence, and care.

• Directing trades for personal perks at client expense is a violation
• Best execution and research benefits are legitimate uses of soft dollars
• Excess commission cost = (paid rate − market rate) × share volume

Memory trick: Client's commission, client's benefit only.

An index weighting method that uses only the publicly tradable (float-adjusted) shares of each constituent rather than total shares outstanding.

• Float-adjusted market cap = shares outstanding × float % × price
• Excludes closely held or restricted shares from weighting
• Most major broad market indexes use this method today

Memory trick: Only the shares that can actually trade get to vote in the index.

The order in which creditors and shareholders are paid in liquidation, based on seniority and whether the claim is secured or unsecured.

• Secured debt > unsecured debt > subordinated debt > preferred equity > common equity
• Collateral pledges create priority within the same seniority class
• Bond indentures specify seniority ranking

Memory trick: 'Secured Sits Senior, Subordinated Sits Last'

The three-factor DuPont model breaks ROE into net profit margin, asset turnover, and financial leverage to analyze the sources of equity returns.

• ROE = Net Profit Margin × Asset Turnover × Financial Leverage
• Net Profit Margin = Net Income/Sales
• Financial Leverage = Average Total Assets/Average Total Equity

Memory trick: Margin × Turnover × Leverage = ROE story

Economic variables that tend to change before the overall economy changes direction, used to forecast future business cycle turning points.

• Examples: building permits, stock prices, new orders for capital goods
• Coincident indicators move with the economy (e.g., industrial production)
• Lagging indicators confirm trends after they occur (e.g., unemployment duration)

Memory trick: Leading indicators are the crystal ball; lagging indicators are the rearview mirror.

The compound annual growth rate that accounts for the effects of compounding over multiple periods, calculated as the nth root of the product of (1+return) terms minus 1.

• Geometric mean ≤ arithmetic mean whenever returns vary
• Best measure for reporting historical compound performance
• Formula: [(1+R1)(1+R2)...(1+Rn)]^(1/n) - 1

Memory trick: Geometric mean grows steady, arithmetic mean floats too high

A measure of risk-adjusted return that divides excess return over the risk-free rate by total portfolio risk (standard deviation).

• Formula: (Rp − Rf) / σp
• Uses total risk, appropriate for non-diversified or total portfolios
• Higher Sharpe ratio indicates better risk-adjusted performance

Memory trick: Sharpe shares excess return among total risk takers

An accelerated depreciation method that applies a constant rate (double the straight-line rate) to the declining book value each year, ignoring salvage value until the final years.

• Rate = 2 × (1/useful life)
• Applied to beginning-of-year book value, not depreciable base
• Salvage value only matters as a floor near the end of useful life

Memory trick: Double the rate, shrink the base each year

The anticipated loss on a credit exposure, calculated as Exposure at Default × Probability of Default × Loss Given Default (1 − recovery rate).

• LGD = 1 − Recovery Rate
• Higher PD or lower recovery rate increases expected loss
• Used by lenders and bond investors to price credit risk

Memory trick: Exposure times default odds times what you'll actually lose.

A rule for updating the probability of an event based on new information, combining prior probabilities with conditional likelihoods to produce a posterior probability.

• Updated Probability = [P(new info|event)×P(event)] / P(new info)
• Denominator computed via the total probability rule across all mutually exclusive scenarios
• Widely used in credit risk, diagnostic testing, and Bayesian statistics

Memory trick: Start with your prior belief, update it once new evidence knocks

A bond's price equals the present value of its future coupon and principal payments discounted at the market yield to maturity.

• Coupon < YTM → bond trades at a discount
• Coupon > YTM → bond trades at a premium
• Coupon = YTM → bond trades at par

Memory trick: Discount cash flows to find the true price today.

Members must not copy or use, without acknowledgment, the work, ideas, or specific data of others as though it were their own original work.

• Licensing/subscription rights allow use but not uncredited authorship claims
• Applies to reports, models, and specific data/analysis
• Proper attribution avoids the violation

Memory trick: Paying for content isn't the same as owning the credit.

Capitalizing a lease (recognizing a right-of-use asset and lease liability) increases both total assets and total liabilities, which raises leverage ratios and lowers asset turnover and return on assets, compared to expensing lease payments as incurred.

• Right-of-use asset and lease liability recognized at present value of payments
• Increases total assets and total liabilities symmetrically at inception
• Raises debt-to-equity and debt-to-assets; lowers asset turnover and ROA

Memory trick: Capitalize the lease, both sides of the scale grow heavier.

The LIFO reserve is the difference between LIFO and FIFO inventory values; its change is used to convert LIFO COGS to an equivalent FIFO basis.

• FIFO Inventory = LIFO Inventory + LIFO Reserve
• FIFO COGS = LIFO COGS − Increase in LIFO Reserve
• Used to compare firms using different inventory methods

Memory trick: Reserve grows, COGS shrinks when converting to FIFO

Beta measures an asset's systematic risk relative to the market and can be calculated as correlation with the market times the ratio of the asset's standard deviation to the market's standard deviation.

• Formula: β = ρ(i,m) × (σi/σm) = Cov(i,m)/σm²
• Beta of 1.0 means the asset moves in line with the market
• Beta > 1 indicates higher systematic risk than the market

Memory trick: Correlation times the risk ratio gives you beta

Jensen's alpha measures a portfolio's risk-adjusted excess return relative to the return predicted by CAPM, given its beta.

• Alpha = Actual return − [Rf + β(Rm − Rf)]
• Positive alpha = outperformance vs. CAPM benchmark
• Requires knowing beta, risk-free rate, and market return

Memory trick: Alpha = Actual minus what CAPM said you deserved.

Members must not allow gifts, compensation, or favors from third parties to compromise the independence of their investment analysis or recommendations.

• Issuer-paid travel should be modest and, ideally, self-funded
• Business-class travel and lavish entertainment are red flags
• Standard applies to research analysts, especially issuer-paid research

Memory trick: Pay your own way, keep views your own.

A liquidity ratio measuring a firm's ability to meet short-term obligations using its most liquid assets, excluding inventory and prepaid expenses.

• Quick assets = cash + marketable securities + receivables
• Formula: Quick assets / Current liabilities
• More conservative than the current ratio

Memory trick: Quick assets are cash-like — no inventory allowed

A market condition where security prices fully reflect all past trading information (prices and volume), implying technical analysis cannot generate abnormal returns.

• Weak form: past prices/volume already reflected
• Semi-strong form: all public information reflected
• Strong form: all information, public and private, reflected

Memory trick: Weak beats charts, semi-strong beats news, strong beats even secrets.

When a stock in a price-weighted index splits or a constituent changes, the divisor must be adjusted so the index level does not change due to the mechanical event.

• Index level = sum of prices / divisor
• Splits and constituent changes require divisor recalculation
• Only price changes (not corporate actions) should move the index

Memory trick: Split happens, price drops, divisor shrinks to keep the index steady.

In simple linear regression, R-squared represents the proportion of variation in the dependent variable explained by the independent variable and equals the square of the correlation coefficient between the two variables.

• R^2 = r^2 in simple (one-variable) linear regression
• r = sqrt(R^2), with sign matching the slope coefficient's sign
• R^2 ranges from 0 to 1; higher values indicate better model fit

Memory trick: Square root R-squared, borrow the slope's sign.

Members must not make false or misleading statements about investment performance, qualifications, or services.

• Composite returns must reflect all relevant accounts, asset-weighted
• Cherry-picking best performers to represent the firm is a violation
• GIPS compliance helps prevent this type of misrepresentation

Memory trick: Weight it all, don't pick the tall.

In a symmetric Cournot model with linear demand P=a-Q and marginal cost c, each firm produces q*=(a-c)/3, yielding a market price between the competitive and monopoly outcomes.

• Each firm's output: q* = (a-c)/3
• Total industry output: 2(a-c)/3
• Cournot price lies between competitive (P=MC) and monopoly price

Memory trick: Two rivals split the market pie into thirds — 'Cournot cuts it into three.'

Members must treat all clients fairly when providing investment advice, taking investment action, or allocating limited investment opportunities such as IPOs.

• Oversubscribed IPOs should be allocated pro-rata among suitable clients
• Favoring clients based on fee size or relationship violates fair dealing
• Fair does not mean equal treatment, but consistent and systematic treatment

Memory trick: Slice the IPO pie evenly among diners.

The Z-spread is the constant spread added to every point on the benchmark spot curve that equates the present value of a bond's cash flows to its price, while the nominal spread simply subtracts a single benchmark yield from the bond's YTM.

• Z-spread accounts for the full shape of the yield curve; nominal spread does not
• On an upward-sloping curve, Z-spread typically exceeds nominal spread
• Option-adjusted spread (OAS) = Z-spread minus the value of any embedded option

Memory trick: Z-spread zigzags along the whole curve; nominal spread just picks one point.

The total amount of new capital at which the cost of one or more capital components increases, typically when retained earnings are exhausted and new equity must be issued.

• Break point = Amount of capital at old cost / Weight of that source in target structure
• Marginal cost of capital (MCC) schedule rises at each break point
• Firms should use MCC, not just WACC, for large capital budgets

Memory trick: Divide the cheap pool of cash by its weight to find where costs jump

The t-test for a population mean compares a sample mean to a hypothesized value, standardized by the sample standard error, to determine statistical significance.

• t = (sample mean - hypothesized mean) / (s/sqrt(n))
• Reject H0 if |t-statistic| > critical t-value
• Degrees of freedom = n - 1 for a single mean t-test

Memory trick: Divide the gap by the standard error to gauge how far you strayed.

Each fixed loan payment consists of an interest portion (based on the remaining balance) and a principal portion; early payments are interest-heavy.

• Interest portion = beginning balance × periodic rate
• Principal portion = total payment − interest portion
• Principal portion grows over the life of the loan as balance declines

Memory trick: Early payments feed the bank's interest, later payments shrink your debt

The risk of a portfolio combining two assets depends on each asset's variance, weights, and the correlation between them.

• Formula: σp² = w1²σ1² + w2²σ2² + 2w1w2ρ1,2σ1σ2
• Lower correlation reduces portfolio risk through diversification
• When ρ = 1, portfolio std dev equals the weighted average of individual std devs

Memory trick: Weights, variances, and correlation blend to shrink risk

A cognitive bias in which individuals separate money into distinct mental "buckets" based on source or purpose, rather than treating wealth as fungible.

• Leads to inconsistent risk-taking across accounts
• Common with windfalls treated as 'house money'
• Can cause suboptimal overall portfolio risk management

Memory trick: Money is money — but mental accounting puts it in separate jars.

An emotional bias in which investors overestimate their own abilities or the precision of their information, often leading to excessive trading and underestimation of risk.

• Often follows a string of successful outcomes
• Leads to underdiversification and excessive trading
• Distinct from self-attribution bias, which attributes success to skill and failure to luck

Memory trick: Two good years, ten bad trades — confidence outran competence.

CV is a relative measure of dispersion that expresses standard deviation as a percentage of the mean, useful for comparing risk per unit of return across different assets.

• CV = standard deviation / mean
• Lower CV means less risk per unit of return
• Useful when comparing distributions with different means

Memory trick: CV tells you the risk you pay per percent of return.

Supervisors must make reasonable efforts to detect and prevent violations of laws, regulations, and the Code and Standards by those under their supervision, escalating internally or externally if initial efforts fail.

• Reporting to management is a first step, not a final step
• Escalation to regulators may be warranted if internal action fails
• Supervisors may need to recuse themselves if violations continue unaddressed

Memory trick: "If the first knock goes unanswered, climb the ladder."

A bond indenture clause requiring the issuer to retire a specified portion of the bond issue periodically before maturity, reducing the amount outstanding at final maturity.

• Reduces credit risk to bondholders as a class
• Increases call/reinvestment risk for individual bondholders
• Shortens the bond's average life and duration

Memory trick: Sink the debt, shrink the risk.

When a long-lived asset is sold at a gain or loss, the gain/loss must be removed from net income in CFO (indirect method), and the total cash proceeds are reported as an investing cash inflow.

• Subtract gains / add back losses in CFO to avoid double counting
• Total sale proceeds (not book value) appear in CFI
• This adjustment applies only under the indirect method

Memory trick: Gain out of ops, cash goes to invest.

A duration estimate calculated from bond prices after small upward and downward yield shocks: (V₋ − V₊)/(2 × V₀ × Δy).

• Requires prices at yield up and yield down scenarios
• V₀ is the initial (base) price
• Widely used for bonds without closed-form duration formulas, e.g., callable bonds

Memory trick: Shock it up, shock it down, split the difference.