CFA Level II Exam flashcards

The Liquidity Preference Theory states that investors prefer short-term bonds because they are more liquid. To persuade them to hold longer-term bonds, a liquidity premium must be added to the expected future short-term rates, resulting in an upward-sloping yield curve.

• Investors demand a premium for holding less liquid, longer-term bonds.
• This premium increases with maturity.
• It implies that forward rates are upward-biased estimates of future spot rates.

Memory trick: Liquidity's flow makes long yields grow.

Industry cyclicality refers to the sensitivity of an industry's revenues and profits to the business cycle. Companies in highly cyclical industries face greater earnings volatility and thus higher credit risk due to less predictable cash flows for debt servicing.

• Cyclical industries (e.g., technology, automotive) are sensitive to economic swings.
• Non-cyclical industries (e.g., utilities, consumer staples) are more stable.
• Higher cyclicality leads to greater business risk, which contributes to higher credit risk.
• Stable cash flows are crucial for meeting debt obligations.

Memory trick: Cyclical waves bring credit woes.

Using put options to protect an investment against a decline in value. The put option gains value as the underlying asset price falls, offsetting losses in the asset.

• Provides downside protection while retaining upside potential (less the premium).
• Costs a premium, which is the maximum loss on the option position.
• Suitable for investors who want to limit losses but remain invested.

Memory trick: Derivatives: Your Financial Safety Net.

The return generated by rolling over a futures contract from one maturity to the next. It arises from the difference between the expiring futures price and the price of the new, longer-dated futures contract.

• Positive in backwardation (expiring > new).
• Negative in contango (expiring < new).
• Component of total commodity futures return.

Memory trick: Rolling out of futures can either cost or pay.

Trade creation occurs when the formation of a free trade area or customs union leads to imports shifting from a higher-cost domestic producer to a lower-cost producer within the trade bloc.

• Increases economic efficiency and welfare.
• Occurs when internal production is replaced by cheaper imports from a partner.
• Results in a net gain for the importing country and the bloc.
• Driven by comparative advantage within the trade bloc.

Memory trick: Creation brings better buys, diversion makes you pay the price.

The liquidity constraint in an IPS dictates the need to hold sufficient liquid assets to meet anticipated and unanticipated cash outflows without disrupting the long-term investment strategy.

• High liquidity needs require a larger allocation to cash and short-term instruments.
• Low liquidity needs allow for greater allocation to illiquid, higher-return assets.
• Influenced by income stability, spending habits, and anticipated large expenses.
• Must be balanced with return objectives.

Memory trick: When cash is tight, and needs are near, short-term assets quell all fear.

Specific risks associated with investing in infrastructure assets, including construction risk, demand risk, regulatory risk, political risk, and operational risk.

• Long-term nature of assets.
• Often subject to government regulation.
• High upfront capital expenditure.

Memory trick: Infrastructure faces many hurdles from ground to governance.

The pure expectations theory posits that forward rates are unbiased predictors of future spot rates, implying that the expected return for holding a long-term bond is the same as rolling over short-term bonds.

• Long-term rates are an average of current and expected future short-term rates.
• Assumes investors are risk-neutral and have no preference for liquidity.
• Implies that the shape of the yield curve is determined solely by expectations of future spot rates.
• Forward rate = expected future spot rate.

Memory trick: Expectations 'predict' the future, making forward rates 'reflect' the spot.

A central bank's intervention in the foreign exchange market to buy or sell foreign currency, where the monetary impact of the intervention is offset through simultaneous open market operations.

• Aims to influence the exchange rate without affecting the domestic money supply.
• Involves matching foreign exchange transactions with offsetting domestic bond transactions.
• Effectiveness can be limited if capital mobility is high and intervention is prolonged.

Memory trick: Sterilize the flow, trim the spend, keep the economy stable.

The disposition effect (selling winners too early, holding losers too long) is a manifestation of loss aversion. Mitigation often involves implementing rules-based strategies to remove emotional decision-making.

• Systematic rebalancing is a powerful tool.
• Using stop-loss orders can help with losing positions.
• Focusing on long-term goals can reduce short-term emotional reactions.

Memory trick: Bias Fixes: Rules, Goals, and Automation.

A theory that attributes long-term economic growth to internal factors such as human capital, innovation, and knowledge, rather than exogenous factors like technological progress.

• Emphasizes the role of policies that foster R&D, education, and institutional quality.
• Suggests that growth rates can be sustained over long periods due to increasing returns to knowledge.
• Contrasts with neoclassical models where growth eventually converges to a steady state.

Memory trick: Institutions, Knowledge, and People drive endless growth.

Operating leverage measures how sensitive a company's operating income is to changes in sales volume. A higher proportion of fixed costs leads to higher operating leverage, making earnings more volatile and increasing credit risk, especially during downturns.

• Operating leverage = % Change in Operating Income / % Change in Sales.
• High fixed costs = high operating leverage.
• High variable costs = low operating leverage.
• Lower operating leverage generally indicates lower credit risk due to more stable earnings.

Memory trick: Fixed costs are a Fixed burden, Variable costs allow you to Vary.

Planned Amortization Class (PAC) tranches in CMOs are designed to have a more predictable cash flow stream by reducing exposure to both contraction and extension prepayment risk within a specified prepayment range.

• Protected by companion/support tranches.
• Offers stability within a prepayment collar.
• Lower prepayment risk than plain-vanilla MBS.

Memory trick: PACs are like a shielded car, within a speed limit.

K-fold cross-validation is a technique used in machine learning to estimate the generalization performance of a model and mitigate overfitting by repeatedly splitting the dataset into k folds, using k-1 folds for training and one fold for validation, and averaging the results.

• Provides a more robust estimate of model performance than a single train-test split.
• Helps in hyperparameter tuning by evaluating different settings.
• Reduces variance in performance estimation compared to a single split.
• Each data point serves as both training and validation data.

Memory trick: Cross-validation helps you validate without over-fitting.

Multicollinearity is a phenomenon in multiple regression where two or more independent variables are highly correlated with each other, making it difficult to estimate the individual impact of each variable on the dependent variable.

• Leads to inflated standard errors of coefficients.
• Results in insignificant t-statistics (high p-values) for individual coefficients.
• The overall model (R-squared, F-statistic) may still appear significant.

Memory trick: Regression problems are like a tangled web.

The maximum output an economy can produce over a sustained period without generating inflationary pressures.

• Determined by the quantity and quality of factors of production (labor, capital, natural resources).
• Also influenced by technology and institutional factors.
• Represents the economy's long-run productive capacity.

Memory trick: Capital, Labor, Tech, and Institutions power growth.

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'.

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.

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.

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.

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.

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!

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'.

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.

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.

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.

Forward rates are implied future spot rates derived from the current term structure of spot rates, reflecting the market's expectation of future interest rates.

• The formula is (1 + Sn)^n = (1 + Sk)^k * (1 + kfn-k)^(n-k).
• Investors should be indifferent between investing for 'n' periods at the 'n'-period spot rate or for 'k' periods at the 'k'-period spot rate and then for 'n-k' periods at the 'kfn-k' forward rate.
• Forward rates are not necessarily predictors of future spot rates, but rather reflect breakeven rates.

Memory trick: Spot rates 'stack' up to imply 'future' forward rates.

A cognitive bias where individuals feel the pain of a loss more intensely than the pleasure of an equivalent gain, leading to irrational decision-making.

• Often results in holding losing investments too long (disposition effect).
• Can also lead to selling winning investments too early.
• Impacts risk-taking behavior: more risk-averse for gains, more risk-seeking for losses.

Memory trick: Biases: The Brain's Investment Bugs.

Debt seniority dictates the order in which creditors are paid in the event of issuer default or bankruptcy.

• Senior debt has higher priority than subordinated debt.
• Higher priority generally leads to higher recovery rates.
• Secured debt generally has higher priority than unsecured debt within the same seniority class.

Memory trick: Seniors get the first slice, subs get the crumbs.

An acquisition strategy where a significant amount of borrowed money (leverage) is used to buy a company. The target company's assets often serve as collateral for the loans.

• Targets mature, stable companies.
• High debt-to-equity ratio.
• Focus on operational improvements and value creation.

Memory trick: Private equity plays many roles: from seeds to buyouts.

A monetary policy where a central bank purchases large quantities of government bonds or other financial assets to increase the money supply and lower interest rates.

• Used when conventional monetary policy (e.g., lowering policy rates) is ineffective.
• Aims to stimulate economic activity by lowering long-term interest rates and increasing liquidity.
• Can lead to currency depreciation, as it increases the supply of domestic currency.

Memory trick: QE floods market, currency sinks.

The Treynor measure (or reward-to-volatility ratio) is a risk-adjusted measure of return that calculates the excess return per unit of systematic risk (beta).

• Uses beta as the risk measure (systematic risk).
• Higher values indicate better performance.
• Formula: (Portfolio Return - Risk-Free Rate) / Portfolio Beta.

Memory trick: Sharpe is for total, Treynor for beta's call, Jensen for alpha's thrall.

The basic Solow Growth Model predicts that economies with similar parameters (production function, savings, depreciation) will converge to the same steady-state capital-to-labor ratio, with poorer countries (lower capital-to-labor ratio) growing faster in the short run.

• Assumes exogenous technological progress (or none, as in this question).
• Predicts conditional convergence: countries with similar fundamentals converge.
• Poorer countries grow faster if they are further below their steady state.
• Steady state is where investment equals depreciation.

Memory trick: Same rules, same end; starting low means faster ascend.

The IPS outlines the client's investment goals, risk tolerance, and constraints, providing a framework for investment decisions. Objectives typically balance risk and return.

• Primary objective defines the main goal (e.g., capital preservation, growth, income).
• Secondary objective supports the primary one.
• Must align with client's specific circumstances, time horizon, and risk tolerance.

Memory trick: IPS: Your Personal Investment Compass Setting.

Modified duration measures the price sensitivity of a bond to a change in its yield to maturity, assuming the cash flows do not change.

• It is derived from Macaulay duration.
• It requires coupon payments, YTM, and periods to maturity.
• It does not directly use credit rating or market price as inputs for its calculation.

Memory trick: My Duration Needs Yield and Coupons, Not Credit.

Natural Language Processing (NLP) is a branch of artificial intelligence that enables computers to understand, interpret, and generate human language, allowing for the analysis and processing of unstructured text data.

• Key for analyzing sentiment, extracting entities, summarizing text.
• Transforms unstructured text into structured features for ML models.
• Applications: chatbots, spam detection, language translation, text analytics.

Memory trick: Big Data analysis: Regress, Cluster, NLP, and Time.

Liquidity ratios measure a company's ability to meet its short-term financial obligations using its current assets.

• Current Ratio: Current Assets / Current Liabilities.
• Quick Ratio (Acid-Test Ratio): (Current Assets - Inventory) / Current Liabilities.
• Higher ratios generally indicate better short-term liquidity.

Memory trick: Liquidity 'flows' to cover 'short' needs.

Companies may repurchase shares to signal to the market that management believes the stock is undervalued, conveying confidence in future performance.

• Signals management's confidence.
• Can be more tax-efficient for shareholders than dividends (capital gains vs. ordinary income).
• Increases EPS and ROE due to fewer outstanding shares.

Memory trick: Dividends Delight, Repurchases Reflect.

In an acquisition, cash held by the target company can be used to finance part of its own purchase, reducing the acquirer's required cash outlay.

• Reduces acquirer's cash burden.
• Can be seen as 'bootstrapping' the acquisition.
• Affects the pro forma balance sheet of the combined entity.

Memory trick: Funding Fusions: Cash, Stock, or Smart Moves.

Distressed investing involves acquiring the debt or equity of financially troubled companies with the goal of restructuring and turning them around for profit.

• Targets companies in or near bankruptcy.
• Often involves acquiring debt at a discount and converting to equity.
• Requires deep operational and restructuring expertise.

Memory trick: PE Power Plays: Start, Grow, Fix, Buy.

Ideal LBO targets typically have stable cash flows, low existing debt, strong management, and potential for operational improvements, rather than high CapEx growth.

• Strong, stable cash flows are essential for debt service.
• Low existing leverage allows for new debt capacity.
• Identifiable operational efficiencies or cost reduction opportunities.
• Mature industries, rather than high-growth, high-CapEx industries.

Memory trick: LBO's Logic: Cash, Control, Clean Debt.

The act of a company buying back its own shares, often interpreted by investors as a positive signal that management believes the stock is undervalued.

• Can convey management's confidence in future prospects.
• Tender offers at a premium send the strongest signal.
• Open market repurchases are less impactful as signals.

Memory trick: Premium tender shouts 'undervalued' loudest.

The pecking order theory suggests that companies prioritize financing sources, preferring internal funds first, then debt, and finally external equity.

• Internal funds (retained earnings) are preferred due to no flotation costs or adverse signaling.
• Debt is preferred over equity because it has lower information asymmetry costs.
• New equity issuance is a last resort, especially when management believes the stock is undervalued (adverse selection).

Memory trick: Capital's Core: Trade-offs & Pecking.

Modigliani-Miller Proposition II with corporate taxes states that the cost of equity increases linearly with the debt-to-equity ratio, adjusted for the tax shield.

• Re = R0 + (R0 - Rd)(1 - t)(D/E)
• Cost of equity increases with leverage.
• Tax shield benefits debt holders and increases firm value, but also increases equity risk.

Memory trick: Leverage Lifts Equity's Load, but also its cost.

A poison pill (shareholder rights plan) is a defensive tactic used by a target company to make a hostile takeover more difficult or expensive by diluting the acquiring party's ownership.

• Grants existing shareholders (excluding the acquirer) the right to buy new shares at a discount.
• Triggers when an acquirer accumulates a certain percentage of shares (e.g., 10-20%).
• Makes the target significantly more expensive to acquire.

Memory trick: Defending Deals: Deter, Delay, Deny.

The Discounted Cash Flow (DCF) model is a robust valuation method for M&A, particularly when future cash flows and synergy benefits can be reliably estimated.

• Directly values future Free Cash Flow to Firm (FCFF) or Free Cash Flow to Equity (FCFE).
• Allows for explicit modeling of synergies, operational improvements, and growth rates.
• Sensitive to assumptions about discount rate (WACC) and terminal value.

Memory trick: Valuing Ventures: Cash, Comparables, Assets.

The static trade-off theory suggests an optimal capital structure exists where the marginal benefit of the debt tax shield equals the marginal cost of financial distress.

• Balances tax benefits of debt against costs of financial distress.
• Predicts an optimal debt-to-equity ratio that maximizes firm value.
• Costs of financial distress include direct (legal, administrative) and indirect (lost sales, employee turnover) costs.

Memory trick: Capital's Core: Trade-offs & Pecking.

A corporate share structure where different classes of common stock carry different voting rights, typically allowing founders or insiders to retain control despite owning a minority of the economic equity.

• Often used by technology companies and family-controlled businesses.
• Class A shares typically have fewer votes (or none) and are sold to the public.
• Class B (or other) shares have superior voting rights and are held by founders/insiders.
• Can lead to agency problems and lower governance ratings.

Memory trick: Two classes of stock, one for votes, one for wealth.

Modigliani-Miller Proposition I with corporate taxes states that WACC decreases as leverage increases due to the tax deductibility of interest payments.

• VL = VU + tD (Value of Leveraged firm = Value of Unleveraged firm + Tax * Debt)
• The tax shield makes debt cheaper than equity.
• As debt increases, the proportion of cheaper financing increases, lowering WACC.

Memory trick: Taxes Trim WACC's Total.

States that the cost of equity for a leveraged firm is a linear function of the debt-to-equity ratio, reflecting the increased financial risk borne by equity holders.

• Assumes no taxes, no transaction costs, and perfect capital markets.
• Cost of equity increases with financial leverage.
• WACC remains constant regardless of leverage.

Memory trick: Leverage's rise makes equity's slice price.

A committee of the board of directors responsible for overseeing the company's financial reporting process, internal controls, and the appointment and performance of external auditors.

• Composed entirely of independent directors.
• Ensures the integrity of financial statements.
• Acts as a liaison between the board and external auditors.

Memory trick: Audit checks the books, compensation pays the chiefs, nominee picks the board, risk spots the threats.

A stable dividend policy aims to maintain a consistent dividend payment per share, often with gradual increases, to provide predictability to investors.

• Prioritizes a steady dividend stream over a fixed payout ratio.
• Favored by investors seeking predictable income.
• Allows companies to smooth dividends despite earnings volatility.

Memory trick: Dividends Deliver: Stable, Steady, or Leftover.

This board committee oversees board composition, director independence, succession planning for directors, and overall corporate governance practices.

• Ensures board effectiveness and independence.
• Identifies and recommends new directors.
• Addresses issues like CEO/Chairman duality and conflicts of interest.

Memory trick: Committees Keep Companies Clean.

A dividend policy where a company pays out a fixed percentage of its net income as dividends to shareholders.

• Dividends per share will fluctuate with earnings.
• Signals management's confidence in future earnings.
• Can lead to volatile dividends, which some investors dislike.

Memory trick: Ratio for percentage, stable for growth, residual for leftovers, constant for fixed cash.

A valuation method for early-stage companies that incorporates scenario analysis by valuing the company under different possible future outcomes (e.g., best case, worst case, most likely case) and then calculating a probability-weighted average of these valuations.

• Addresses high uncertainty inherent in startups.
• Typically uses discounted cash flow (DCF) or market multiple approaches within each scenario.
• Requires estimation of probabilities for each scenario.

Memory trick: Early stage needs scenarios, not just one flow.

The calculation of FCFE starting from net income, adjusting for non-cash items, investment in fixed capital, and investment in working capital, and considering net borrowing.

• FCFE = Net Income + Depreciation - Capital Expenditures - ΔWorking Capital + Net Borrowing.
• Represents cash flow available to equity holders.
• Alternative formula: FCFF - Net Debt Payments + Net Borrowings.

Memory trick: Net Income, Add Dep, Subtract Capex & WC change.

The earnings of a company that exceed the investors' required rate of return on the company's equity capital. It represents the profit generated after covering the cost of equity.

• RI = Net Income - (Equity Capital * Cost of Equity).
• Used in the Residual Income Model for equity valuation.
• Can be positive (value creation) or negative (value destruction).

Memory trick: Earnings MINUS Cost of Equity equals Residual Income.

A market-based valuation approach for private companies that uses valuation multiples (e.g., P/E, EV/EBITDA) derived from publicly traded companies similar to the target private company.

• Relies on the principle that similar businesses should have similar valuation multiples.
• Requires careful selection of comparable public companies and adjustments for differences.
• Common adjustments include size, growth, risk, marketability, and accounting.

Memory trick: Comparables need a 'CALM' adjustment.

A single-stage dividend discount model that assumes dividends grow at a constant rate indefinitely and discounts these future dividends back to the present to determine the intrinsic value of a stock.

• Formula: V0 = D1 / (r - g), where D1 is next year's dividend, r is the required return, and g is the constant growth rate.
• Assumes g < r for a finite value.
• Most suitable for mature, stable companies with predictable dividend growth.

Memory trick: Dividend next, over rate minus growth, for value best.

The cash flow available to equity holders after all operating expenses and debt obligations have been paid and necessary investments in working capital and fixed capital have been made.

• Represents the cash available for distribution to shareholders.
• Often used in valuation models, especially when dividends are not stable or predictable.
• Calculated as Net Income + Depreciation - Capital Expenditures - Change in Working Capital + Net Borrowing (or similar variations).

Memory trick: Cash Flow grows forward, year by year.