CFA Level II Exam flashcards

Long-lived assets that provide essential public services, often characterized by stable, predictable, and inflation-linked cash flows, and high barriers to entry.

• Long operating lives.
• Stable and predictable cash flows.
• Often inflation-indexed contracts.
• High capital requirements.

Memory trick: Real assets build a stable foundation with predictable flows.

Heteroskedasticity is when the variance of the error term in a regression model is not constant across observations. Its main consequence is unreliable standard errors.

• OLS coefficient estimates remain unbiased and consistent.
• Standard errors of coefficients are incorrect (usually underestimated).
• Hypothesis tests (t-tests, F-tests) are invalid.
• Confidence intervals are unreliable.

Memory trick: Uneven errors make our 'errors' in judgment.

The ease and speed with which an asset can be converted into cash at a fair market value. A lack of liquidity can restrict investment choices and rebalancing opportunities.

• High liquidity needs require more cash or easily marketable assets.
• Illiquid assets (e.g., private equity, real estate) reduce portfolio flexibility.
• Must consider both current and future liquidity requirements.

Memory trick: Constraints: TULRS are your IPS limitations.

A Planned Amortization Class (PAC) tranche in a CMO is structured to provide a more stable and predictable stream of principal repayments.

• Achieves stability by absorbing prepayments within a 'collar' of speeds.
• Shifts prepayment risk to 'companion' or 'support' tranches.
• Offers protection against both contraction (fast prepayments) and extension (slow prepayments) risk.

Memory trick: PACs Provide Prepayment Predictability.

The speed at which data is generated, collected, and processed, often in real-time or near real-time.

• Refers to streaming data, rather than static datasets.
• Requires rapid processing to extract value.
• Examples include sensor data, online transactions, social media feeds.

Memory trick: Big data has a lot of V's to see!

Financial ratios used to assess a company's ability to meet its short-term obligations.

• Current Ratio: Current Assets / Current Liabilities.
• Quick Ratio: (Current Assets - Inventory) / Current Liabilities.
• Cash Ratio: Cash / Current Liabilities.
• A large gap between current and quick ratios implies reliance on inventory.

Memory trick: CRitical Quick Cash Checks Company's Capability.

A long-term asset allocation approach that sets target weights for various asset classes based on the investor's long-term objectives, risk tolerance, and investment horizon.

• Focuses on long-term goals and risk-return characteristics.
• Provides broad diversification across asset classes and regions.
• Generally involves periodic rebalancing back to target weights.

Memory trick: Asset Allocation: How to Slice the Investment Pie.

Cointegration describes a long-run equilibrium relationship between two or more non-stationary time series (typically I(1)) such that a linear combination of them is stationary (I(0)), implying that they move together in the long run despite short-term deviations.

• Applies to non-stationary series (e.g., I(1)).
• Residuals from their regression must be stationary (I(0)).
• Indicates a stable long-run relationship.
• Leads to the use of Error Correction Models (ECM) for short-run dynamics.

Memory trick: Cointegration: Non-stationary series, stationary residuals, long-run link.

For investors with a long time horizon and high-risk tolerance, an asset allocation strategy typically emphasizes growth-oriented assets, primarily equities, to maximize long-term capital appreciation.

• Equities offer the highest long-term return potential but also higher volatility.
• Long horizons allow time to recover from market downturns.
• High-risk tolerance means comfort with short-term fluctuations.

Memory trick: Client Profile: Your Investment Recipe.

A situation where a country's economic growth stalls after reaching middle-income status, failing to transition to high-income status.

• Often characterized by an inability to compete with both low-wage economies and advanced economies.
• Requires a shift from factor accumulation-driven growth to productivity-driven growth.
• Overcoming it involves innovation, human capital development, and institutional quality.

Memory trick: Innovate, Educate, Productivity Elevate!

Look-ahead bias in backtesting occurs when a trading strategy uses information that would not have been available to an investor at the time the investment decision was made, leading to inflated and unrealistic backtest performance.

• Uses future data to make past decisions.
• Common examples: using restated financials, using future prices, using data released with a lag.
• Leads to overoptimistic backtest results.

Memory trick: Backtests can be biased by looking ahead or picking winners.

Macaulay duration is the weighted average time until a bond's cash flows are received, while modified duration is a measure of a bond's price sensitivity to yield changes, derived from Macaulay duration.

• Macaulay duration is expressed in years.
• Modified duration is Macaulay duration divided by (1 + YTM/frequency).
• Modified duration is used to estimate percentage price change for a given yield change.
• For bonds with embedded options, effective duration is more appropriate.

Memory trick: Macaulay comes 'before' Modified, like 'M' before 'M' in the alphabet.

Simple linear regression models the relationship between a dependent variable and one independent variable using a linear equation, which can then be used to predict values.

• Equation: Y_hat = b0 + b1*X
• b0 is the intercept, b1 is the slope coefficient
• X is the independent variable, Y_hat is the predicted dependent variable

Memory trick: Predicting Sales with a Simple Line

A benefit from an economic activity that accrues to a third party not directly involved in the transaction.

• Leads to underproduction from a social perspective.
• Examples include basic research, vaccinations, education.
• Can be addressed with subsidies or public provision.

Memory trick: Externalities: Good gets a boost, Bad gets a tax.

The pure expectations theory states that forward rates exclusively represent expected future spot rates, and the yield curve shape is determined by these expectations.

• No liquidity premium or risk premium is assumed.
• Long-term rates are geometric averages of expected short-term rates.
• Implied forward rates can be derived from existing spot rates.

Memory trick: Expect pure future spots, geometrically averaged.

Investment constraints are limitations or restrictions that influence the investment strategy within an Investment Policy Statement (IPS).

• Common constraints include liquidity, time horizon, legal/regulatory, tax situation, and unique circumstances.
• Constraints help tailor the investment strategy to the client's specific situation.
• The relative importance of each constraint varies by client.

Memory trick: LTTLU - Liquidity, Time, Tax, Legal, Unique - all in a row!

An options strategy involving holding a long position in a stock and simultaneously selling (writing) a call option on that same stock. It's used to generate income (from the premium) and offers limited downside protection.

• Reduces volatility and generates income.
• Limits upside profit potential if the stock price rises substantially.
• Suitable for investors who expect moderate price movements or slight declines.

Memory trick: Covered Call: Shielding your stock, but capping your climb.

A hedge fund strategy that involves taking both long and short positions in equity securities. The goal is to profit from both rising and falling stock prices, often with a net market exposure.

• Takes both long and short positions.
• Aims to profit from relative mispricings.
• May have a net long or net short market exposure.

Memory trick: Equity funds play both sides, seeking mispricings.

Effective duration measures the interest rate sensitivity of bonds with embedded options, accounting for how changes in interest rates affect the option's value and thus the bond's cash flows.

• Callable bonds have lower effective duration than comparable option-free bonds when rates fall.
• Call option limits upside price potential.
• Effective duration can change significantly with interest rate levels.

Memory trick: Call limits upside, shortens duration.

A measure of risk-adjusted return that indicates the excess return (or risk premium) per unit of total risk (standard deviation) in an investment.

• Formula: (Portfolio Return - Risk-Free Rate) / Portfolio Standard Deviation.
• Higher Sharpe Ratio indicates better risk-adjusted performance.
• Uses total risk (standard deviation) and is appropriate for well-diversified portfolios.

Memory trick: Risk-Adjusted Ratios: How much bang for your buck of risk.

A no-arbitrage condition stating that the difference in interest rates between two countries is equal to the difference between the forward exchange rate and the spot exchange rate.

• Suggests that investors should be indifferent to investing in either country's assets if IRP holds.
• Predicts the relationship between spot and forward exchange rates.
• Often holds in the short term for highly liquid currencies.

Memory trick: Interest Rates Lure Funds, Boosting Currency Value.

Expected Loss Given Default (LGD) represents the proportion of a bond's principal that an investor expects to lose if the issuer defaults. It is a key component in credit risk analysis.

• LGD = (1 - Recovery Rate) × Exposure at Default (Notional Principal).
• The recovery rate is the percentage of the principal amount that can be recovered after a default.
• It is distinct from the probability of default and the CDS spread, though related.

Memory trick: Loss is (1 - Recovery) times Notional's story.

A class of statistical models used to model time-series data with changing variance (heteroskedasticity) where the variance of the current error term is a function of the squares of the previous error terms.

• Captures volatility clustering.
• The conditional variance depends on past squared errors.
• Used extensively in financial time series analysis.

Memory trick: Errors cluster like stormy weather.

The Information Ratio (IR) measures the active return of a portfolio divided by its tracking error (active risk), indicating the consistency of a manager's outperformance.

• Focuses on active management skill.
• Formula: (Portfolio Return - Benchmark Return) / Tracking Error.
• Higher IR indicates better performance per unit of active risk.
• Used to evaluate managers against a specific benchmark.

Memory trick: Info Ratio shows active skill, Sharpe for total thrill, Treynor for beta's will.

Credit risk factors are variables that influence a borrower's ability or willingness to meet its financial obligations, thereby affecting the probability of default.

• Financial leverage (debt-to-equity) is a key indicator.
• Profitability and cash flow generation are crucial for debt servicing.
• Industry cyclicality and competitive landscape impact revenue stability.
• Access to capital markets and refinance options are critical liquidity considerations.

Memory trick: Debt's tight grip makes default slip.

In a Collateralized Debt Obligation (CDO), tranches are layers of securities with different seniority levels, allocating risk and return from the underlying collateral pool. Junior tranches absorb losses first, bearing higher credit risk.

• Senior tranches have the lowest credit risk and lowest yields.
• Mezzanine tranches have moderate credit risk and moderate yields.
• Equity/Junior tranches have the highest credit risk and highest potential yields.

Memory trick: Junior's first to fall, senior stands tall.

The Merton model (a structural credit model) views a company's equity as a call option on its assets and its debt as a risk-free bond minus a put option on its assets. Default occurs if asset value falls below the debt's face value at maturity.

• Company assets follow a geometric Brownian motion (log-normal distribution).
• Equity is a call option on assets; debt is a put option on assets.
• Default is endogenous, occurring when asset value < debt value at maturity.
• Debt is a single zero-coupon bond.

Memory trick: Equity's a call, on assets, standing tall.

A hedge fund strategy that seeks to profit from temporary price discrepancies between related financial instruments, often by taking offsetting long and short positions to minimize market risk.

• Exploits mispricings between related securities.
• Aims for market neutrality.
• Common examples: convertible arbitrage, fixed income arbitrage, equity pairs trading.

Memory trick: Arbitrage finds hidden value in price gaps.

Valuing a callable bond using a binomial interest rate tree involves building the tree of possible interest rates and then working backward from maturity, accounting for the issuer's call option.

• Arbitrage-free interest rate tree is essential.
• Backward induction is used.
• At each node, compare callable value to 'stay-alive' value.

Memory trick: Tree first, then backward, checking calls.

Duration is a measure of a bond's price sensitivity to changes in interest rates. Bonds with longer durations exhibit greater price volatility.

• Zero-coupon bond duration equals its time to maturity.
• Coupon bond duration is less than its time to maturity.
• Higher duration implies higher interest rate risk (price volatility).

Memory trick: Longer duration 'rides' the rate changes 'harder'.

An active asset allocation strategy that involves making short-term, opportunistic adjustments to the strategic asset allocation to capitalize on perceived temporary inefficiencies or mispricings in the market.

• Deviates from long-term strategic weights.
• Aims to add value through market timing or sector rotation.
• Requires active management and a belief in market predictability.

Memory trick: Allocation: S.T.A.N.D. for how you cut the pie.

A form of private equity financing that is provided by venture capital firms or funds to small, early-stage, emerging firms that have been deemed to have high growth potential or which have demonstrated high growth.

• Focuses on early-stage, high-growth companies.
• Often invests in unprofitable companies with significant potential.
• Provides funding for development, market entry, and scaling.

Memory trick: Private equity funds grow companies from seed to maturity.

Strategic asset allocation for endowment funds emphasizes long-term growth and capital preservation, often featuring higher allocations to alternative, less liquid assets due to their perpetual time horizon and high risk tolerance.

• Perpetual time horizon.
• High risk tolerance due to long-term objectives.
• Focus on real return (inflation-adjusted).
• Often includes significant allocations to alternative investments (e.g., private equity, hedge funds, real estate).

Memory trick: Endowments Grow Long, Cash is Low, Alternatives Strong.

Regret aversion is a cognitive bias where individuals make decisions to avoid the pain of regretting a past action or inaction.

• Can lead to holding onto losing investments too long (to avoid realizing the loss).
• Can lead to selling winning investments too early (to avoid regret of potential future loss).
• Often linked to the disposition effect.

Memory trick: Regret Aversion: Don't want to feel bad, so I'll just sit still, sad.

The F1-score is the harmonic mean of precision and recall, providing a balanced measure of a model's accuracy, particularly useful for classification problems with imbalanced datasets where both false positives and false negatives are important.

• F1 = 2 * (Precision * Recall) / (Precision + Recall)
• Ranges from 0 to 1, with 1 being perfect.
• Penalizes models with poor performance on either precision or recall.
• Especially relevant for minority class evaluation.

Memory trick: Balance your evaluation with F1.

Trade creation occurs when FTA members shift from high-cost domestic production to lower-cost imports from a partner. Trade diversion occurs when FTA members shift from lower-cost imports from a non-member to higher-cost imports from a partner.

• Trade creation generally improves welfare; trade diversion generally reduces welfare.
• The net effect of an FTA on welfare (and trade balance) depends on the relative magnitude of these two effects.
• Factors like comparative advantage and initial trade patterns influence the outcome.

Memory trick: FTA: Create or Divert? The balance is key.

A real estate valuation technique that estimates the value of an income-producing property by dividing its Net Operating Income (NOI) by an appropriate capitalization rate (cap rate).

• Value = NOI / Cap Rate.
• Used for stable, seasoned properties.
• Cap rate is derived from comparable sales.

Memory trick: Value is found in income, costs, or comps.

The seniority and security of a bond determine its priority of claims on a company's assets and cash flows in the event of default or liquidation, directly impacting its credit risk.

• Senior secured debt has the highest claim priority and lowest credit risk.
• Unsecured debt has general claims on assets, lower priority than secured.
• Subordinated debt has the lowest claim priority (after senior and unsecured) and highest credit risk.

Memory trick: Seniority is the 'ladder' of claims, higher rung means lower risk.

Embedded options (call, put) significantly alter a bond's price sensitivity to interest rate changes compared to option-free bonds.

• Callable bonds have capped upside appreciation when rates fall.
• Putable bonds have floored downside depreciation when rates rise.
• Call options are beneficial to the issuer; put options are beneficial to the investor.

Memory trick: Options Offer Or Obstruct Outcomes.

The fair price of a bond can be determined by discounting each of its future cash flows (coupon payments and principal) by the appropriate spot rate corresponding to the timing of that cash flow. Spot rates can be derived from the forward rate curve.

• Spot rates are the yields of zero-coupon bonds maturing at different points in time.
• Forward rates are implied future spot rates, indicating the rate for a future period.
• The relationship between spot and forward rates is (1+Zn)^n = (1+Z1)(1+1f1)...(1+n-1f1).
• Bond price = Σ (CFt / (1 + Zt)^t).

Memory trick: Spot rates are the 'now' rates, Forwards are the 'future' rates.

Key rate duration measures the sensitivity of a bond's price to a 1 basis point change in a specific spot rate (key rate) on the yield curve, holding all other spot rates constant.

• Used for non-parallel yield curve shifts.
• Sum of key rate durations approximates total duration.
• Useful for managing yield curve shape risk.

Memory trick: Key rates unlock curve shape insights.

The slope of the yield curve, and how it changes (steepening, flattening), significantly impacts the returns of bonds with different durations.

• Long-duration bonds are more sensitive to long-term rate changes.
• Short-duration bonds are more sensitive to short-term rate changes.
• Steepening (long rates up): bad for long-duration bonds.
• Flattening (long rates down): good for long-duration bonds.

Memory trick: Steep hurts long, Flat helps long.

Extension risk is the risk that the average life of a mortgage-backed security (MBS) will lengthen due to a decrease in the rate of prepayments by borrowers, typically occurring in a rising interest rate environment.

• Occurs when interest rates rise, making refinancing less attractive.
• Causes the effective maturity of the MBS to extend.
• Detrimental to MBS investors as cash flows are received later than anticipated, often at below-market rates.

Memory trick: Rates rise, loans extend, prepayments suspend.

The position of a debt claim in the event of an issuer's bankruptcy or liquidation, which directly impacts its recovery rate.

• Senior secured debt has the highest claim priority.
• Higher seniority typically leads to higher recovery rates.
• Higher recovery rates result in lower expected loss, all else equal.

Memory trick: Security and Seniority Secure Superior Settlements.

A regulatory approach that sets broad objectives and outcomes, rather than detailed prescriptive rules, allowing firms flexibility in how they comply.

• Focuses on 'what' needs to be achieved, not 'how'.
• Aims to be more adaptable to change and foster innovation.
• Requires strong supervision and judgment from regulators.

Memory trick: Rules, Results, or Free Reign: Pick your path.

When valuing a callable bond using a binomial interest rate tree, the bond's value at each node is capped at its call price, reflecting the issuer's option to redeem.

• Start from the final maturity nodes and work backward.
• At each node, calculate the value if not called (discounted expected future values).
• Compare this 'if not called' value with the call price.
• The bond's value is the lower of the two (min(value_if_not_called, call_price)).

Memory trick: Callable bonds are 'capped' by the call price, always 'choosing' the lower value.

A negative outcome of a regional trade agreement where trade shifts from a more efficient, lower-cost producer outside the bloc to a less efficient, higher-cost producer within the bloc.

• Occurs because internal tariffs are eliminated, while external tariffs remain.
• Reduces global efficiency and overall economic welfare.
• Is a potential downside of preferential trading agreements.

Memory trick: Blocs either Create new paths or Divert old ones.

Convexity measures the curvature of a bond's price-yield relationship. For bonds with positive convexity, the price appreciation from a yield decrease is greater than the price depreciation from an equivalent yield increase, making higher convexity generally desirable.

• Higher convexity is more beneficial when interest rates fall, leading to larger price gains.
• Higher convexity is also beneficial when interest rates rise, leading to smaller price losses.
• Investors generally prefer bonds with higher convexity, all else being equal.

Memory trick: High convexity's curve, for gains and protection, it serves.

Modified duration estimates the percentage change in a bond's price for a 1% (100 basis point) change in its yield to maturity. It quantifies interest rate risk.

• Formula: %ΔP ≈ -Modified Duration × ΔYTM
• Higher modified duration implies greater price sensitivity to yield changes.
• It is a linear approximation and works best for small yield changes.

Memory trick: Duration's percentage dip shows price's quick flip.

ARIMA model parameters (p, d, q) are identified by analyzing the Autocorrelation Function (ACF) and Partial Autocorrelation Function (PACF) of a stationary time series, where 'p' is the AR order, 'd' is the differencing order, and 'q' is the MA order.

• AR(p) process: PACF cuts off after lag p, ACF decays gradually.
• MA(q) process: ACF cuts off after lag q, PACF decays gradually.
• ARIMA(p,d,q): 'd' is determined by differencing to achieve stationarity.

Memory trick: ACF for MA, PACF for AR, and differencing for Integrated.

Structural models, like the Merton model, view a company's equity as a call option on its assets and debt as a risk-free bond minus a put option, with default occurring when asset value falls below debt value.

• Equity value = Call option on company assets (strike = debt face value).
• Default occurs when asset value < debt value at maturity.
• Asset volatility is a key input for default probability.
• Assumes a specific capital structure and discrete default event.

Memory trick: Assets are the 'engine', debt the 'barrier', equity the 'option'.

The phenomenon where a country's trade balance initially worsens following a currency devaluation or depreciation, before eventually improving.

• Occurs due to time lags in the adjustment of export and import volumes.
• Import prices rise immediately, while demand/supply responses are slower.
• Requires the Marshall-Lerner condition to hold for the eventual improvement.

Memory trick: Devalue, Dip, then Dash up!

A modeling error that occurs when a function is too closely aligned to a limited set of data points, resulting in poor performance on new, unseen data.

• High accuracy on training data.
• Low accuracy on validation/test data.
• Model learns noise and specific patterns of training data.

Memory trick: Training too hard makes a model too specific.

Convexity measures the curvature of a bond's price-yield relationship, providing a more accurate estimate of price changes than duration alone, especially for large yield changes.

• It is a second-order measure.
• Option-free bonds typically have positive convexity.
• Callable bonds can exhibit negative convexity.

Memory trick: Convexity curves the duration, making it more precise.

The Durbin-Watson test is a statistical test used to detect the presence of autocorrelation (specifically, first-order serial correlation) in the residuals from a regression analysis. Its value ranges from 0 to 4.

• Hypothesis: H0: no positive autocorrelation; Ha: positive autocorrelation.
• Test statistic 'd' around 2 indicates no autocorrelation.
• d < dL: positive autocorrelation.
• 4 - d < dL: negative autocorrelation.

Memory trick: DW: Low means positive, High means negative, Middle is inconclusive.

A foreign exchange intervention where the central bank conducts an offsetting open market operation to neutralize the impact of the intervention on the domestic money supply.

• Central bank acts in the foreign exchange market (buys/sells foreign currency).
• Simultaneously acts in the domestic bond market (sells/buys domestic bonds).
• Goal is to influence the exchange rate without affecting the domestic money supply.
• If foreign currency is sold, domestic currency is absorbed; sterilization requires injecting domestic currency (buying bonds).

Memory trick: FX move, then bond countermove, money supply stays in its groove.

Collateralized Debt Obligations (CDOs) divide the cash flows and risk of an underlying asset pool into multiple tranches with varying levels of seniority and risk.

• Equity/unrated tranches absorb first losses.
• Mezzanine tranches absorb losses after equity.
• Senior tranches have the lowest risk and highest credit rating.

Memory trick: Equity first, Mezzanine next, Senior last in line for loss.

A theory of economic growth that emphasizes that technological progress and long-term growth rates are determined within the economic system itself, driven by factors like investment in human capital, innovation, and R&D.

• Technological progress is endogenous, not exogenous.
• Investment in R&D, human capital, and innovation are key drivers.
• Can explain persistent differences in growth rates between countries.
• Policy interventions can influence long-term growth rates.

Memory trick: Growth's internal spark, not just external mark.

A tranche in a structured finance product, particularly CMOs, designed to have a stable and predictable cash flow schedule within a defined prepayment collar, achieved by redirecting prepayment and extension risk to support tranches.

• Offers protection against both contraction (prepayment) and extension risk within its collar.
• Achieves stability by shifting excess prepayment/extension risk to companion or support tranches.
• Has a more predictable average life and cash flow compared to other tranches.

Memory trick: PACs Protect Against Chaos, but Support takes the Strain.

Prepayment risk is the risk that mortgage borrowers will pay off their loans earlier than expected, often due to falling interest rates or home sales, which negatively affects MBS investors.

• Occurs when homeowners refinance or sell their homes.
• Most significant when interest rates decline.
• Results in reinvestment risk for MBS investors at lower yields.

Memory trick: Prepayments 'rush in' when rates 'drop down'.