CFA Level I flashcards

Gross profit is revenue minus cost of goods sold, representing the profit before operating expenses are deducted.

• Gross profit = Revenue − COGS
• Appears above SG&A on a multi-step income statement
• Used to compute gross profit margin (Gross profit / Revenue)

Memory trick: Revenue minus Cost of goods = Gross profit, everything else comes later.

A capital structure in which different classes of common stock carry different voting rights, often allowing founders or insiders to retain control with a minority economic stake.

• Superior-voting shares (e.g., 10 votes) are typically held by founders/insiders
• Public shares often carry only one vote each
• Structure separates ownership (cash flow rights) from control (voting rights), a key governance risk factor

Memory trick: Small stake, big say — founders keep the castle keys

Members must act for the benefit of clients, placing client interests before their employer's and their own, and exercise prudent judgment consistent with the applicable investment mandate.

• Duty of loyalty runs primarily to the client, not the employer
• Undisclosed self-dealing (e.g., higher-fee proprietary products) breaches this duty
• Full disclosure of costs and rationale is required

Memory trick: Client comes before the firm's fund lineup.

Capitalizing a cost spreads the expense over future periods via depreciation, whereas expensing recognizes the full cost immediately, affecting net income, total assets, and related ratios differently in the year of expenditure.

• Capitalizing: higher net income and total assets in year one
• Expensing: lower net income and total assets immediately, but higher expense volatility avoided later
• Capitalizing generally produces higher ROA/ROE and smoother earnings in early years, reversing over the asset's life

Memory trick: Capitalize now, depreciate later — assets and earnings both look bigger today

Members must disclose to clients and employers any compensation or benefit received for referring clients to other service providers.

• Applies to both cash and non-cash benefits
• Disclosure must be made before the client acts on the referral
• No minimum dollar threshold triggers the disclosure duty

Memory trick: "Every referral dollar must be disclosed, not withheld."

A negative shift in short-run aggregate supply caused by rising input costs, leading simultaneously to higher price levels and lower real output.

• Classic trigger: sharp rise in oil/commodity prices
• Combines inflation with recession/stagnation — 'stagflation'
• Contrasts with demand-pull inflation, which raises both price and output

Memory trick: Oil shock = Stag(nation) + (in)flation = Stagflation.

The Capital Market Line relates expected return to total risk for efficient portfolios; the Security Market Line relates expected return to systematic risk (beta) for any asset or portfolio.

• CML: x-axis is standard deviation, applies only to efficient portfolios
• SML: x-axis is beta, applies to all assets/portfolios
• SML is the graphical representation of CAPM

Memory trick: Capital line for the efficient crowd, Security line for everyone

A solvency ratio measuring a company's ability to meet interest payments from operating earnings, calculated as EBIT divided by interest expense.

• Interest coverage = EBIT / Interest expense
• Higher ratio indicates lower default risk on debt
• Also called times interest earned ratio

Memory trick: EBIT covers interest — divide earnings by the interest bill.

Diluted EPS reflects the potential dilution from convertible securities using the if-converted method: adding back after-tax interest saved to net income and adding the as-if-converted shares to the denominator.

• Numerator adds back interest expense × (1 − tax rate)
• Denominator adds shares issuable upon conversion
• Security is dilutive only if it reduces EPS below basic EPS

Memory trick: If it converts, add back interest after tax and add the new shares.

The P/E ratio implied by the Gordon growth model, linking payout ratio, required return, and growth rate to a fair valuation multiple.

• Forward justified P/E = (1-b)/(r-g)
• Trailing justified P/E = (1-b)(1+g)/(r-g)
• Sustainable growth g = ROE × retention ratio b

Memory trick: Payout over the growth-adjusted return gives the fair forward multiple.

A behavioral tendency to sell winning investments too early and hold losing investments too long, driven by loss aversion and reference-point (purchase price) anchoring.

• Rooted in prospect theory's loss aversion concept
• Can lead to poor tax efficiency and suboptimal portfolio composition
• Investors treat break-even point as a psychological anchor

Memory trick: Sell the winners fast, hug the losers too long

The implicit annualized interest rate a firm pays by forgoing a supplier's early payment discount and paying at the end of the credit period instead.

• Formula: [d/(1−d)] × [365/(days paid − discount days)]
• Forgoing discounts often implies a very high effective borrowing cost
• Terms like '2/10, net 45' mean a 2% discount if paid within 10 days, otherwise full amount due in 45 days

Memory trick: Skip the discount, pay a steep hidden interest rate

A measure of the dispersion of actual observed values around the regression line, reflecting the average size of the regression's residuals.

• SEE = √[SSE/(n − k − 1)]
• k = number of independent variables in the regression
• Smaller SEE indicates a better model fit relative to the data's scale

Memory trick: Divide leftover error by leftover freedom, then root it out

When a futures account balance falls below the maintenance margin, the holder must deposit variation margin to bring the balance back up to the initial margin level.

• Margin call triggered when balance < maintenance margin
• Deposit required = initial margin - current balance
• Daily mark-to-market settles gains/losses in futures accounts

Memory trick: Fall below maintenance, top back up to initial — not just to the floor.

The weighted-average time (in years) until a bond's cash flows are received, with weights equal to the present value of each cash flow as a fraction of the bond's total price.

• For a zero-coupon bond, Macaulay duration equals maturity
• Higher coupons reduce Macaulay duration versus maturity
• Used as the basis for modified duration = MacDur/(1+YTM/m)

Memory trick: Duration is the time-weighted balance point of cash flows.

The identity MV = PY relates money supply (M), velocity (V), price level (P), and real output (Y); in growth-rate form, %ΔM + %ΔV ≈ %ΔP + %ΔY.

• MV = PY is the equation of exchange
• Growth-rate form: %ΔM+%ΔV=%ΔP+%ΔY
• Assumes velocity is often treated as stable, but not always constant

Memory trick: 'MV=PY': More money or faster spending (V) pushes prices up unless output keeps pace.

A cognitive bias where individuals attribute successes to their own skill and failures to external factors, often fueling overconfidence.

• Leads to overconfidence and excessive trading
• Can result in underestimating true portfolio risk
• Common cause of the disposition effect and poor diversification

Memory trick: Win? It's me. Lose? It's the market.

Client and employer transactions must be given priority over transactions in securities in which the member or the member's family has a beneficial ownership interest.

• Personal trades should not precede client trades in the same security
• Applies to accounts of immediate family if the member has beneficial ownership
• Firms often use trade rotation systems to prevent front-running

Memory trick: "Clients cross the finish line first — personal trades wait."

The lowest potential yield an investor could receive among all possible redemption scenarios (maturity or various call dates) on a bond.

• Calculated by comparing YTM to YTC at each call date
• Used as a conservative yield measure for callable bonds
• Reflects the issuer's incentive to call when advantageous to them, not the investor

Memory trick: 'Assume the worst case — pick the lowest yield among all exits'

A market structure with many sellers offering differentiated products, low barriers to entry, and downward-sloping individual demand curves.

• Long-run economic profit = 0 due to entry
• Firms have some pricing power from differentiation
• Excess capacity exists relative to perfect competition

Memory trick: Think 'MC' = Many Competitors with slightly different products.

The PEG ratio (Price/Earnings-to-Growth) adjusts the P/E ratio for expected earnings growth, calculated as P/E divided by the expected growth rate (expressed as a whole number); a lower PEG generally suggests a stock is more attractively valued relative to its growth.

• Formula: PEG = P/E ÷ expected EPS growth rate (%, as whole number)
• Lower PEG suggests better value relative to growth (rule of thumb, PEG < 1 is often seen as attractive)
• Ignores risk differences, so should be used alongside other measures

Memory trick: Cheap growth wins: lower PEG, better deal.

In an inflationary environment, FIFO matches old low costs to COGS, leaving high recent costs in inventory, which raises reported inventory and net income compared to LIFO.

• FIFO: low COGS, high ending inventory, high net income in inflation
• LIFO: high COGS, low ending inventory, low net income (tax benefit) in inflation
• Effects reverse in deflationary periods

Memory trick: FIFO Flatters Financials when prices climb

Members and candidates must not misrepresent or overstate the meaning of the CFA charter, including implying it guarantees performance or ensures superior analytical ability.

• Charter denotes adherence to a rigorous curriculum and ethics, not guaranteed returns
• Cannot claim charter ensures superior investment results
• Proper references to candidacy must state exact status (e.g., 'Level II candidate')

Memory trick: The charter is a credential, not a crystal ball.

When issuing new common equity, flotation costs reduce net proceeds, which raises the effective cost of equity above the cost implied by the current market price.

• Formula: re = D1/[P0(1-F)] + g
• F is flotation cost as a percentage of issue price
• Flotation costs increase the required cost of new external equity relative to internal equity (retained earnings)

Memory trick: Fees shrink the pot — divide by what's left after flotation.

A term structure theory stating that forward rates are unbiased predictors of future spot rates, so the shape of the yield curve reflects the market's expectations for future short-term rates.

• Upward-sloping curve implies expected rising short-term rates
• Downward-sloping curve implies expected falling short-term rates
• Ignores liquidity/risk premia, unlike liquidity preference theory

Memory trick: 'The curve is the crowd's crystal ball for future rates'

SYD is an accelerated depreciation method that allocates a decreasing fraction of the depreciable base to each year, based on the sum of the years' digits of the asset's useful life.

• SYD denominator = n(n+1)/2, e.g., for 4 years = 4+3+2+1=10
• Numerator decreases each year (4,3,2,1 for a 4-year life)
• Front-loads depreciation expense more than straight-line but less abruptly than double-declining balance

Memory trick: Add the years, then count them down for each year's crown.

A future interest rate implied by the current spot rate curve under no-arbitrage, calculated by comparing compounded returns over different horizons.

• (1+S_long)^n = (1+S_short)^m × (1+forward)^(n-m)
• Used to back out market-implied future short rates
• Basis of bootstrapping and relative value trades

Memory trick: 'Long rate compounds short rate plus the forward gap'

The rate at which a company can grow its equity (and dividends/earnings) without external equity financing, calculated as ROE multiplied by the retention ratio (g = ROE × b, where b = 1 − payout ratio).

• Formula: g = ROE × (1 − payout ratio)
• Used as the long-term growth input in DDM models
• Assumes constant ROE, payout ratio, and no new equity issuance

Memory trick: Keep more, grow more: retention times ROE.

GIPS requires firms to calculate portfolio returns using time-weighted methodology (or acceptable approximations like Modified Dietz) to neutralize the effect of external cash flow timing on performance.

• Modified Dietz weights cash flows by the fraction of the period they were invested
• Formula: R = (EMV − BMV − CF) / (BMV + CF × weight)
• GIPS mandates such methods to ensure fair, comparable performance reporting across firms

Memory trick: Weight the cash by the days it stayed.

The yield a taxable bond must offer to provide the same after-tax return as a given tax-exempt (e.g., municipal) bond, for an investor in a specific tax bracket.

• Formula: tax-exempt yield / (1 − marginal tax rate)
• Higher tax brackets make municipal bonds relatively more attractive
• Used to compare bonds with different tax treatments on an equal basis

Memory trick: 'Gross up the tax-free yield by dividing out the tax bite'

Values a stock as the present value of a perpetuity of dividends growing at a constant rate: V0 = D1/(r-g).

• Requires r > g for the model to be valid
• Use next period's dividend D1, not the current dividend D0
• Sensitive to small changes in g or r

Memory trick: Grow the dividend one year forward, then divide by the growth-adjusted return.

A bond whose principal is repaid gradually over its life through scheduled payments, rather than as a single lump sum at maturity.

• Each payment includes both interest and principal, like a mortgage.
• Fully amortizing bonds have zero principal remaining at maturity.
• Contrasts with bullet bonds, which repay all principal at maturity.

Memory trick: Amortizing = 'a mortgage-like' bond — principal melts away over time.

Transaction-based manipulation involves trades or orders (e.g., wash trades, matched orders) intended to mislead market participants about volume or price without genuine economic purpose.

• Distinguished from information-based manipulation (false statements/rumors)
• Wash trades and matched orders are classic examples
• Gain calculation: price change × shares transacted at the manipulated price

Memory trick: "Fake trades, fake tape — transaction-based manipulation escapes no cape."

Members must maintain records supporting investment analyses, recommendations, and communications with clients to substantiate compliance with the Code and Standards, retaining them for a minimum of seven years absent a longer legal or firm requirement.

• Seven years is the CFA Institute default minimum
• If law requires longer, follow the law
• Records support defensibility of research and recommendations

Memory trick: When in doubt, keep it seven years about.

The cost-of-carry model prices a futures contract as the spot price adjusted for the net cost of holding the underlying asset: financing/storage costs increase the futures price, while convenience yield (a non-cash benefit of physical ownership) decreases it.

• F = S × (1 + r + storage cost − convenience yield)
• High convenience yield can push a market into backwardation
• Storage costs are more relevant for physical commodities than financial assets

Memory trick: Carrying costs add up, convenience yield knocks it back down.

NOI is gross income adjusted for vacancy losses minus operating expenses (excluding financing costs and capex). Property value = NOI ÷ Capitalization rate.

• NOI excludes debt service and capital expenditures
• Cap rate reflects market required return for similar properties
• Lower cap rates imply higher property values for a given NOI

Memory trick: Gross income shrinks by vacancy and expenses before it becomes NOI.

The blended required return on a firm's capital, weighted by the market value proportions of debt and equity, using after-tax cost of debt.

• WACC = wd×rd×(1−t) + we×re
• Weights should reflect target/market values, not book values
• Used as the discount rate for average-risk projects

Memory trick: Weigh Debt (after tax) and Equity to get the WACC average

Approaches to financing current assets that range from aggressive (max short-term debt) to conservative (max long-term financing), with maturity matching in between.

• Aggressive: short-term debt finances part of permanent assets too, higher risk/lower cost
• Conservative: long-term financing covers permanent assets plus part of seasonal assets, lower risk/higher cost
• Maturity matching: asset and liability maturities are aligned

Memory trick: Conservative = Cushioned with long-term cash.

A monopolist maximizes profit where marginal revenue equals marginal cost (MR=MC), then sets price from the demand curve at that quantity.

• MR curve has twice the slope of a linear demand curve
• Monopolist prices above marginal cost (P>MC)
• Output is lower than the competitive equilibrium

Memory trick: Double the slope, halve the output — MR falls twice as fast as demand.

Members who possess material nonpublic information must not trade, cause others to trade, or communicate the information to others who might trade on it.

• Materiality: would affect price or investment decision
• Nonpublic: not yet disseminated to marketplace
• Mosaic theory does NOT cover clearly material nonpublic facts obtained directly

Memory trick: Overheard secrets are still secrets — don't trade on them.

The option-adjusted spread removes the value of an embedded option from the Z-spread, isolating pure credit/liquidity compensation; the difference reflects the option's cost.

• Callable bond: OAS < Z-spread (option costs the bondholder)
• Putable bond: OAS > Z-spread (option benefits the bondholder)
• Option cost (bp) = Z-spread − OAS for callable bonds

Memory trick: 'Z-spread minus OAS unmasks what the call option is costing you'

A monetary policy guideline that recommends a central bank's target interest rate based on deviations of inflation and output from their targets.

• Formula: i = r* + π + 0.5(π-π*) + 0.5(output gap)
• r* is the neutral real interest rate
• Positive output gap or inflation gap raises the recommended rate

Memory trick: Neutral rate plus inflation plus half of each gap — Taylor's simple recipe.

Values a stock by discounting an initial high-growth phase of dividends explicitly, then adding a discounted terminal value based on stable long-term growth.

• Terminal value uses next-period dividend: D(n+1)/(r-g)
• Terminal value must be discounted back to present at r
• Explicit-period dividends grow at the high initial rate

Memory trick: Sprint fast for three years, then settle into a steady long-term jog.

The two-asset combination that minimizes overall portfolio variance, weighting more heavily toward the lower-volatility asset given their correlation.

• Formula: w1 = (σ2² − σ1σ2ρ) / (σ1² + σ2² − 2σ1σ2ρ)
• Lower-volatility asset typically receives a higher weight
• Sits at the leftmost point of the efficient frontier

Memory trick: Least risk lives left — lean weight toward the calmer asset.

In a fixed-for-fixed currency swap, each party pays interest in its own notional currency; net settlement requires converting one leg to a common currency using the spot rate.

• Each leg's interest is calculated on its own currency notional
• Convert one currency's cash flow using the prevailing spot rate to net
• Currency swaps typically also exchange notional principal at initiation and maturity

Memory trick: Two currencies, one settlement — convert, then net the difference.

A board structure in which directors are divided into classes with staggered multi-year terms, so only a subset is elected each year.

• Reduces shareholders' ability to replace the board quickly
• Considered an anti-takeover defense
• Contrasts with a unitary board where all directors face annual election

Memory trick: Staggered = Shielded — one group at a time, hard to overturn.

The annualized return an investor earns if a callable bond is held until its first (or a specified) call date and redeemed at the call price.

• Uses call price as FV and call date as N instead of maturity
• Investors compare YTM and YTC(s) to find yield to worst
• Callable bonds often trade closer to call price when rates fall

Memory trick: 'Call it early, price it early — swap FV and N for the call date'

Put-call parity shows that a fiduciary call (long call + risk-free bond) and a protective put (long stock + long put) produce identical payoffs at expiration.

• Fiduciary call = c + PV(X)
• Protective put = S0 + p
• Both strategies have the same payoff, hence the same price by no-arbitrage

Memory trick: Fiduciary call and protective put are twins — same payoff, different wrapper.

The profit to a put buyer equals the option's payoff at expiration minus the premium paid.

• Put payoff = max(Strike − Spot, 0)
• Profit = Payoff − Premium paid
• Maximum loss to a put buyer is limited to the premium paid

Memory trick: Puts pay when prices plummet — profit is payoff minus premium.

Liquidity constraints identify the client's need for cash to meet spending needs, either anticipated (e.g., tuition, weddings) or unanticipated (e.g., emergencies).

• IPS constraints: liquidity, time horizon, taxes, legal/regulatory, unique circumstances
• Liquidity needs are typically expressed as a dollar amount and timeframe
• Distinct from time horizon, which reflects the investment holding period

Memory trick: Cash needed soon? Think Liquidity, not Long-term horizon.

An economic variable that changes direction after the overall economy has already turned, confirming a trend rather than predicting it.

• Unemployment rate is a classic lagging indicator
• Lagging indicators confirm cycle turning points
• Contrasts with leading indicators (e.g., permits, stock prices)

Memory trick: Jobs are the last to know — unemployment lags the recovery.

Members must understand and comply with all applicable laws, rules, and the Code and Standards, following whichever is stricter.

• Applies globally regardless of where the member is located
• Members must disassociate from known violations
• Stricter of local law vs. Code always governs

Memory trick: Strictest rule wins the race.

A valuation model that discounts free cash flow to equity, growing at a constant rate, using the required return on equity minus the growth rate: V0 = FCFE1 / (r − g), analogous to the Gordon Growth DDM but using FCFE instead of dividends.

• Must use FCFE1 (next period), not FCFE0, in numerator
• Appropriate for stable, mature companies with constant FCFE growth
• Requires r > g for the model to produce a meaningful finite value

Memory trick: Grow the cash first, then divide by the gap between return and growth.

Members must exercise diligence and have a reasonable and adequate basis, supported by appropriate research, for any investment analysis, recommendation, or action.

• In-sample backtests alone are insufficient; out-of-sample/walk-forward testing is needed
• Overfitting risk must be assessed before relying on quantitative models
• Reasonable basis requirement applies regardless of how strong backtested statistics appear

Memory trick: "A shiny backtest isn't proof — test it out-of-sample for the roof."

GIPS verification is a firm-wide engagement assessing compliance with composite construction requirements and policy design; a performance examination is a separate, additional engagement testing a specific composite's calculation accuracy.

• Verification is firm-wide, not composite-specific
• Performance examination tests accuracy of a specific composite's presentation
• Verification does not guarantee accuracy of any single composite's returns

Memory trick: Verification checks the recipe book, not each individual dish.

When a component of a price-weighted index undergoes a stock split, the divisor must be adjusted downward so that the index level remains unchanged immediately after the split.

• Stock splits reduce a stock's price but not its economic value, requiring divisor recalculation.
• New divisor = New sum of prices ÷ Pre-split index level.
• Divisor decreases whenever a stock split lowers a high-priced stock, since price sum falls but index level must stay constant.

Memory trick: Split the price, shrink the divisor — the index stays put like a see-saw balancing.

Unsystematic (firm-specific) risk can be eliminated through diversification; systematic (market) risk cannot and is the only risk compensated with a risk premium.

• Total risk = systematic + unsystematic risk
• Adding uncorrelated securities reduces unsystematic risk toward zero
• CAPM prices only systematic risk (beta)

Memory trick: Don't put all eggs in one basket — but the whole market still shakes.

Members must keep client information confidential unless disclosure is required by law, related to illegal client activity, or authorized by the client.

• Legal subpoenas/court orders override confidentiality
• Illegal client activity is an exception to confidentiality
• Confidentiality survives the end of the client relationship

Memory trick: "Law trumps lock — a valid subpoena opens the vault."

Interest cost incurred during the construction period of a qualifying long-lived asset is added to the asset's cost rather than expensed on the income statement.

• Applies only during the construction/development period
• Increases asset cost and future depreciation expense
• Once construction ends, further interest is expensed normally

Memory trick: Build first, expense later — capitalize while under construction

The number of days a company takes to convert its investments in inventory and other resources into cash flows from sales, net of payment period to suppliers.

• CCC = DIO + DSO − DPO
• Shorter CCC generally indicates more efficient working capital management
• A negative CCC means the firm collects cash before paying suppliers

Memory trick: Inventory in, Sales out, minus Payables held gives the Cycle