CFA Level II Exam flashcards

Using interest rate futures contracts to offset the interest rate risk (duration exposure) of a bond portfolio.

• Nf = (PV_portfolio * D_portfolio) / (PV_futures * D_futures).
• Sell futures to hedge against rising rates (protect against falling bond prices).
• Buy futures to hedge against falling rates (protect against rising bond prices of a short position).

Memory trick: Portfolio Value and Duration, Over Futures Value and Duration.

An options strategy involving holding an underlying asset, buying a protective put, and selling a covered call, typically to limit downside risk while sacrificing some upside potential.

• Limits both potential gains and losses.
• Can be established for a net cost, net credit, or zero cost.
• Used by investors who want to protect their holdings but also generate some income.

Memory trick: Stock's Range, Put's Floor, Call's Ceiling.

The no-arbitrage price of a forward contract on an underlying asset that does not pay dividends, reflecting the cost of carrying the asset.

• Calculated as S0 * e^(rT) for continuous compounding.
• Reflects the future value of the spot price at the risk-free rate.
• Ensures no immediate arbitrage profits.

Memory trick: Spot to Future, Risk-Free Growth.

The theoretical minimum value (lower bound) for a European call option on a non-dividend-paying stock is the greater of zero or the current stock price minus the present value of the strike price.

• Formula: c >= max(0, S0 - Xe^(-rT)).
• S0 = Current stock price, X = Strike price, r = Risk-free rate (continuously compounded), T = Time to expiration.
• This bound ensures no arbitrage opportunities exist.

Memory trick: Bounds: No Option is Cheaper Than Its 'Bare Minimum' Value!

The no-arbitrage exchange rate for a future date, determined by the spot exchange rate and the interest rate differentials between the two currencies.

• F = S * (1 + r_price_currency * T) / (1 + r_base_currency * T).
• The currency with the lower interest rate trades at a forward premium (appreciates).
• The currency with the higher interest rate trades at a forward discount (depreciates).

Memory trick: Spot Times (One Plus Price Rate) Over (One Plus Base Rate).

Interest rate futures can be used to adjust the duration of a bond portfolio without altering the underlying bond holdings. The number of contracts depends on the desired duration change, portfolio value, and futures contract characteristics.

• To increase duration, buy futures contracts.
• To decrease duration, sell futures contracts.
• Number of contracts = (Target Duration - Portfolio Duration) * (Portfolio Value / (Futures Duration * Futures Price per contract)).
• Futures Price per contract is typically the futures price multiplied by its face value (e.g., $98,000 for a $100,000 face value contract at 98).

Memory trick: Duration Hedge: Change Duration = Futures Contracts * Dollar Duration Ratio!

Using equity index futures contracts to offset the systematic (market) risk of an equity portfolio.

• Number of contracts = (Portfolio Value / (Futures Price * Multiplier)) * Portfolio Beta.
• Sell futures to hedge against a downturn (long portfolio).
• Buy futures to hedge against an upturn (short portfolio).

Memory trick: Value Over Futures, Times Beta's Shield.

A fundamental relationship between the prices of European call and put options with the same underlying asset, strike price, and expiration date, ensuring no arbitrage opportunities.

• C + Xe^(-rT) = S + P
• Applies to European options only.
• Requires same underlying, strike, and expiration.

Memory trick: Call plus Discounted Strike Equals Stock plus Put.

The maximum profit for a covered call strategy occurs when the stock price is at or above the strike price of the call option.

• It is calculated as the difference between the strike price and the stock purchase price, plus the premium received.
• The investor owns the underlying stock.
• The call option is sold against the owned stock.

Memory trick: Covered Call: Stock + Sold Call, Profit Caps at Strike!

Adjusting the interest rate sensitivity (duration) of a bond portfolio using interest rate futures contracts.

• Nf = (Target Duration - Portfolio Duration) * Portfolio Value / (Futures Duration * Futures Price).
• Buy futures to increase duration; sell futures to decrease duration.
• Futures duration is often approximated by the duration of the cheapest-to-deliver bond.

Memory trick: Duration Gap, Value's Weight, Futures' Lever.

Covered Interest Parity is a no-arbitrage condition that links spot exchange rates, forward exchange rates, and interest rates in two different currencies.

• It implies that the return on a hedged foreign investment should equal the return on a domestic investment.
• The formula is F = S * (1 + r_domestic * (T/360)) / (1 + r_foreign * (T/360)).
• It assumes perfect capital mobility and no transaction costs.

Memory trick: CIP: Spot * (1 + Domestic) / (1 + Foreign) for Forward!

The decision to exercise an American call option prior to its expiration date for an underlying asset that does not pay dividends.

• Never optimal for American calls on non-dividend-paying stocks.
• Exercising early forfeits the option's time value.
• Exercising early means paying the strike price sooner, giving up interest on that capital.

Memory trick: No Dividends, No Early Call.

Key distinctions between forward and futures contracts, primarily related to trading venue, standardization, and settlement.

• Forwards: OTC, customized, private, settled at expiration.
• Futures: Exchange-traded, standardized, public, marked to market daily.
• Both are agreements to buy/sell an asset at a future date for a predetermined price.

Memory trick: Forward's Private, Future's Public.

The maximum loss for a protective put strategy is limited and occurs if the stock price falls below the put option's strike price.

• It is calculated as the initial stock purchase price minus the put option's strike price, plus the premium paid for the put.
• The strategy involves owning the underlying stock and buying a put option.
• It provides downside protection below the strike price.

Memory trick: Protective Put: Stock + Bought Put, Loss Stops at Strike + Premium!

Free Cash Flow to Firm (FCFF) represents the total cash flow generated by a company's operations that is available to all capital providers (debt and equity holders) after accounting for all operating expenses and investments in working capital and fixed assets.

• FCFF = Net Income + Non-Cash Charges + Interest Expense(1-T) - FCInv - WCInv (or various other starting points).
• From EBIT: FCFF = EBIT(1 - Tax Rate) + Depreciation & Amortization - Capital Expenditures - Change in Working Capital.
• Depreciation and Amortization are added back as they are non-cash expenses.
• Capital Expenditures (FCInv) are subtracted as they are cash outflows for long-term assets.

Memory trick: EBIT's after-tax, add back the non-cash, subtract the real cash investments in growth and working capital.

A valuation model that projects Free Cash Flow to Equity (FCFE) for an explicit forecast period and then estimates a terminal value for the period beyond, discounting all values back to the present.

• Appropriate for companies with varying growth rates over time.
• Combines an explicit forecast period with a stable growth period.
• Terminal value often calculated using the Gordon Growth Model.

Memory trick: Forecast Cash Flows, Then Grow, Discount for Value Now!

Under the temporal method, inventory carried at historical cost is translated using the historical exchange rate that prevailed when the inventory was acquired.

• Monetary assets/liabilities are translated at the current rate.
• Non-monetary assets/liabilities (like historical cost inventory) are translated at historical rates.
• This preserves the historical cost principle in the parent's reporting currency.
• Translation gains/losses are recognized in net income.

Memory trick: Temporal's History, Current's Now, Currency's Dip, Value's How.

Under the current rate method, when the functional currency depreciates against the reporting currency, a net asset exposure leads to a negative Cumulative Translation Adjustment (CTA), while a net liability exposure leads to a positive CTA.

• All assets and liabilities translated at the current rate.
• Equity (except retained earnings) translated at historical rates.
• Income statement items at average rates.
• Translation gains/losses go to CTA, a component of Other Comprehensive Income (OCI).

Memory trick: Current Rate: Depreciating currency makes net liabilities a gain for CTA, while assets are a pain.

A valuation model that estimates the intrinsic value of equity by discounting future Free Cash Flow to Equity (FCFE) during multiple distinct growth stages, typically high growth, transition, and stable growth.

• Assumes FCFE grows at different rates over several periods.
• Commonly used for companies with varying growth prospects over time.
• Requires estimation of FCFE for each stage and a terminal value.

Memory trick: Calculate FCFE growth, stage by stage, then discount.

Under the equity method, the initial investment is an investing cash outflow. The investor's share of the associate's net income is a non-cash item. Dividends received from the associate are cash inflows, typically classified as operating activities (U.S. GAAP) or operating/investing (IFRS).

• Acquisition of investment: Investing cash outflow.
• Share of investee's net income: Non-cash, affects income statement and investment account.
• Dividends received: Cash inflow.
• U.S. GAAP: Dividends from equity method usually operating cash flow.

Memory trick: Buy it (investing), earn it (no cash), get dividends (operating cash).

Delta measures the sensitivity of an option's price to a $1 change in the underlying asset's price.

• Call option delta ranges from 0 to 1.
• It represents the probability of the option expiring in-the-money.
• Out-of-the-money calls have delta < 0.5; in-the-money calls have delta > 0.5.

Memory trick: Delta 'Drives' option price changes from 'Dollars' in stock price.

Differences in depreciation expense between IFRS and U.S. GAAP can arise from variations in rules regarding residual value, useful life reviews, component depreciation, and the point at which depreciation commences.

• Residual Value/Useful Life Review: IFRS requires annual review; U.S. GAAP does not mandate annual review.
• Component Depreciation: IFRS requires; U.S. GAAP permits.
• Revaluation Model: IFRS permits (not for cost model); U.S. GAAP does not permit for most PP&E.
• Depreciation Start: IFRS when available for use; U.S. GAAP generally when placed in service.

Memory trick: IFRS reviews life annually, components are required; GAAP is more 'set it and forget it'.

Accounting decisions, estimates, and methods that tend to increase reported earnings or assets, or decrease reported liabilities or expenses, often pushing the boundaries of generally accepted accounting principles.

• Often involves subjective estimates like useful lives, salvage values, or bad debt provisions.
• Can inflate current period income at the expense of future periods.
• May be a red flag for earnings management or financial statement manipulation.
• Differs from fraudulent reporting in intent, but can still mislead users.

Memory trick: MASK Fraud's Intent, but Choices Can Still Rent.

Under the equity method, an investor recognizes its proportionate share of a foreign associate's net income, translated at the average exchange rate for the reporting period.

• Applicable for significant influence (20-50% ownership typically).
• Share of net income increases the investment account and is reported on the investor's income statement.
• Dividends received reduce the investment account but do not affect income statement recognition of the share of net income.
• Average exchange rate is used for income statement items.

Memory trick: Equity shares good times (income) at the average party rate, but dividends just reduce the tab.

A foreign currency translation method used when a foreign subsidiary's functional currency is different from the parent company's reporting currency.

• All assets and liabilities are translated at the current exchange rate.
• Equity accounts (except retained earnings) are translated at historical rates.
• Income statement items are translated at the average exchange rate.
• Translation adjustments are reported in Other Comprehensive Income (OCI).

Memory trick: Functional Currency Drives the Translation Choice.

Low-quality financial reporting is characterized by accounting choices and disclosures that obscure the true economic performance or financial position of a company, often involving aggressive accounting, earnings management, or insufficient transparency.

• Divergence of net income and operating cash flow.
• Aggressive revenue recognition policies.
• Complex ownership structures or off-balance sheet financing.
• Frequent changes in accounting policies or estimates.

Memory trick: Cash lags revenue, policies are aggressive, and complex structures hide the mess.

A private company valuation method that estimates equity value by adjusting the book values of assets and liabilities to their fair market values, including any unrecorded assets or liabilities.

• Often used for asset-heavy companies or those facing liquidation.
• Requires fair market valuation of all balance sheet items.
• Accounts for unrecorded intangible and contingent assets/liabilities.

Memory trick: Assets Minus Liabilities, Fair Value Is Key!

Free Cash Flow to Equity (FCFE) represents the cash flow available to equity holders after all expenses and reinvestment needs have been met.

• Formula: FCFE = Net Income + Non-cash Charges - Investment in Working Capital - Investment in Fixed Capital + Net Borrowing.
• Non-cash charges typically include depreciation and amortization.
• Investment in fixed capital is usually capital expenditures (CapEx).
• Net borrowing is the net change in debt (new debt issued - debt repaid).

Memory trick: Net Income's Cash Flow, Add Back Non-Cash, Subtract Growth's Dash, Debt's No Crash.

The choice between LIFO (Last-In, First-Out) and FIFO (First-In, First-Out) inventory costing methods significantly impacts reported COGS, inventory value, and net income, especially during periods of changing costs.

• Rising Costs: FIFO results in lower COGS, higher net income, higher inventory value.
• Rising Costs: LIFO results in higher COGS, lower net income, lower inventory value.
• LIFO is permitted under U.S. GAAP but prohibited under IFRS.
• Impacts profitability ratios and working capital measures.

Memory trick: Rising Costs: FIFO's First, Leaves Profit Burst; LIFO's Last, Makes Income Past.