CFA Level II cheat sheet

The Code and Standards contain seven standards: Professionalism; Integrity of Capital Markets; Duties to Clients; Duties to Employers; Investment Analysis, Recommendations, and Actions; Conflicts of Interest; Responsibilities as a CFA Institute Member or Candidate.

Standard I(B) Independence and Objectivity prohibits accepting gifts, invitations, or benefits that could reasonably compromise independence; modest client gifts are generally acceptable.

Standard II(A) Material Nonpublic Information: members must not act or cause others to act on material nonpublic information; mosaic theory permits combining public and nonmaterial nonpublic information.

Standard III(A) Loyalty, Prudence, and Care: members must act for the benefit of clients, place client interests ahead of employer and personal interests, and vote proxies prudently.

Standard III(B) Fair Dealing requires members to deal fairly and objectively with all clients when disseminating recommendations; simultaneous dissemination is required but different service levels are permitted.

Standard V(A) Diligence and Reasonable Basis: recommendations must have a reasonable, adequate basis; third-party research need not be independently verified but must be assessed for reasonableness.

Standard VI(A) Disclosure of Conflicts requires members to disclose to employer, clients, and prospective clients any conflicts that could impair independence or objectivity.

GIPS requires composites to include all actual, fee-paying, discretionary portfolios; performance must be shown for at least five years or since inception, then extended annually.

Multiple regression assumptions: linearity in parameters, no perfect multicollinearity, zero conditional mean of errors, homoskedasticity, no serial correlation, and normally distributed errors.

Heteroskedasticity leaves OLS coefficient estimates unbiased and consistent but makes standard errors inconsistent; use White's robust standard errors for inference.

Positive serial correlation underestimates standard errors and inflates t-statistics; Durbin-Watson approximately equals 2(1 − r), with values near 2 indicating no first-order autocorrelation.

Multicollinearity inflates standard errors, producing high R-squared with insignificant t-statistics and unstable coefficient estimates; it does not bias coefficients.

A unit root (random walk) makes a series nonstationary; regressions on nonstationary series can be spurious unless the variables are cointegrated.

An AR(1) model xt = b0 + b1 xt−1 + et is covariance stationary if the absolute value of b1 is less than 1, with mean-reverting level b0/(1 − b1).

ARCH models capture conditional heteroskedasticity, where the variance of errors depends on past squared errors; Engle's test detects ARCH effects.

Qualitative dependent variables are modeled with logit or probit; logit uses the logistic CDF and probit the standard normal CDF, with coefficients estimated by maximum likelihood.

Demand is elastic if the absolute value of price elasticity exceeds 1; total revenue rises with a price cut when demand is elastic and falls when demand is inelastic.

A profit-maximizing firm sets output where marginal revenue equals marginal cost; perfect competition has price equal to marginal revenue and marginal cost in long-run equilibrium.

Covered interest rate parity: forward/spot = (1 + i_price currency)/(1 + i_base currency); deviations create arbitrage when capital is mobile.

Uncovered interest rate parity states the expected exchange rate change equals the interest rate differential; a carry trade earns the differential if the spot rate does not move.

Relative purchasing power parity: percentage change in the exchange rate approximately equals domestic inflation minus foreign inflation.

Mundell-Fleming: under high capital mobility, monetary policy is effective with a flexible exchange rate, while fiscal policy is effective with a fixed exchange rate.

Balance of payments accounts sum to zero: current account + capital account + financial account + official reserve changes = 0.

The simple fiscal multiplier is 1/[1 − MPC(1 − t)]; it is larger when the marginal propensity to consume is higher and the tax rate is lower.

Revenue is recognized when (or as) performance obligations are satisfied, either over time or at a point in time, at the transaction price allocated to each obligation.

IFRS permits the cost model or revaluation model for property, plant, and equipment; US GAAP permits only the cost model, and component depreciation is required under IFRS.

LIFO is prohibited under IFRS but permitted under US GAAP; LIFO liquidation boosts gross profit when older, cheaper inventory layers are sold.

IFRS 9 classifies financial assets by business model and contractual cash flow characteristics into amortized cost, fair value through OCI, or fair value through profit or loss.

Lessees recognize a right-of-use asset and lease liability under both IFRS and US GAAP; US GAAP further distinguishes finance leases from operating leases in the income statement.

Funded status equals plan assets minus the projected benefit obligation; under IFRS it is reported as a net pension asset or liability on the balance sheet.

A valuation allowance reduces deferred tax assets when it is more likely than not that some portion will not be realized.

FCFF = CFO + interest × (1 − t) − fixed capital investment; FCFE = CFO − FCInv + net borrowing.

Under the current rate method, assets and liabilities use the current rate, equity uses historical rates, and translation gains or losses go to OCI; the temporal method uses historical rates for nonmonetary items and gains or losses flow to income.

WACC = wd × rd × (1 − t) + wp × rp + we × re, using target market-value weights and the marginal after-tax cost of each source.

CAPM cost of equity = risk-free rate + beta × equity risk premium; alternative estimates include the dividend discount model and bond yield plus risk premium.

For mutually exclusive projects, NPV is preferred over IRR because IRR can mislead when projects differ in scale or timing of cash flows.

Modigliani-Miller without taxes: capital structure does not affect firm value; with corporate taxes, value rises by the present value of the interest tax shield.

The static trade-off theory balances tax shield benefits against financial distress costs; the pecking order prefers internal funds, then debt, then equity.

Cash conversion cycle = days of inventory + days of receivables − days of payables; a shorter cycle frees up cash.

Dividend irrelevance holds in perfect markets; the residual dividend model pays dividends only from earnings left after funding positive-NPV projects.

Board independence, separate CEO and chair roles, and independent audit and compensation committees are core corporate governance safeguards.

Gordon growth model: V0 = D1/(r − g); it requires g less than r and assumes dividends grow at a constant rate forever.

Sustainable growth rate g = retention ratio × ROE = (1 − payout ratio) × ROE.

FCFF = CFO + interest(1 − t) − FCInv; FCFE = CFO − FCInv + net borrowing; discount FCFF at WACC and FCFE at the cost of equity.

Residual income value = B0 + [(ROE − r) × B0]/(r − g); it is useful when free cash flow is negative or unpredictable.

Justified P/E = (1 − b)/(r − g); justified P/B = (ROE − g)/(r − g).

Enterprise value = market value of equity + market value of debt + preferred stock − cash and short-term investments.

EV/EBITDA is capital-structure neutral and useful for comparing firms with different leverage; P/E is distorted by nonrecurring items.

The H-model approximates a two-stage DDM with linearly declining growth: V0 = [D0(1 + gL) + D0 × H × (gS − gL)]/(r − gL).

Bond prices and yields are inversely related; for a given yield change, price increases exceed price decreases because of positive convexity.

Modified duration approximately equals Macaulay duration/(1 + y/m); approximate percentage price change = −Dmod × Δy + 0.5 × convexity × (Δy)².

Spot rates are derived by bootstrapping from coupon bond prices; forward rates satisfy (1 + z2)² = (1 + z1)(1 + 1f1).

Term structure theories: pure expectations (forward rates are expected future spot rates); liquidity preference (long-term bonds carry a premium); segmented markets (supply and demand by maturity).

Credit spread is the yield difference between a risky bond and a benchmark; spread duration measures sensitivity of price to changes in the spread.

In an MBS, prepayment risk includes contraction risk when rates fall and extension risk when rates rise; tranching redistributes prepayment risk among bond classes.

Floating-rate notes have interest rate duration near the time to the next reset; their coupon equals a reference rate plus a quoted spread.

Yield curve strategies: a bullet portfolio concentrates in one maturity, a barbell in short and long maturities, and a ladder spreads maturities evenly.

Forward price: F = S0(1 + r)^T − FV(benefits) + FV(costs); the forward value at initiation is zero.

Futures differ from forwards by daily mark-to-market, clearinghouse credit risk mitigation, and standardized contracts.

European put-call parity: c + X/(1 + r)^T = p + S0; violations create arbitrage opportunities using the underlying and a risk-free bond.

In binomial option pricing, risk-neutral probability p = (1 + r − d)/(u − d), and the option value is the discounted expected payoff under these probabilities.

Black-Scholes-Merton assumes lognormal stock prices, constant volatility and risk-free rate, no dividends, and continuous trading with no arbitrage.

Option Greeks: delta measures sensitivity to the underlying price, gamma to delta, theta to time decay, vega to volatility, and rho to interest rates.

An interest rate swap can be valued as a portfolio of forward rate agreements or as the difference between the values of a fixed-rate and a floating-rate bond.

A credit default swap pays the protection buyer notional × (1 − recovery rate) upon a credit event in exchange for periodic premium payments.

Hedge fund strategies include equity long/short, event-driven, global macro, relative value, and dedicated short bias; each has distinct return drivers and risk exposures.

Private equity includes venture capital and leveraged buyouts; the J-curve describes negative early returns from fees and unrealized investments.

Real estate valuation uses the income approach (NOI/capitalization rate), the cost approach, and the sales comparison approach.

Commodity futures returns decompose into spot return, roll yield, and collateral yield; roll yield is positive in backwardation and negative in contango.

Hedge fund fees typically include a management fee of 1–2% and an incentive fee of about 20% with a high-water mark.

Alternative investments often exhibit return smoothing, understating volatility and correlations and overstating risk-adjusted performance.

Due diligence for alternatives covers operational, investment, and structural risks, including valuation, leverage, liquidity terms, and manager incentives.

Two-asset portfolio variance = w1²σ1² + w2²σ2² + 2w1w2ρ12σ1σ2; diversification benefits increase as correlation falls.

CAPM: E(Ri) = Rf + βi[E(Rm) − Rf]; beta measures systematic risk and is the relevant risk in a well-diversified portfolio.

Sharpe ratio = (Rp − Rf)/σp; Treynor ratio = (Rp − Rf)/βp; Jensen's alpha = Rp − [Rf + βp(Rm − Rf)].

Investor utility = E(R) − 0.5 × A × σ²; a higher risk aversion coefficient A means a steeper indifference curve.

The capital allocation line combines the risk-free asset with the risky portfolio; the optimal risky portfolio maximizes the Sharpe ratio.

An IPS contains return and risk objectives plus five constraints: liquidity, time horizon, tax concerns, legal and regulatory factors, and unique circumstances.

Cognitive errors stem from faulty reasoning (conservatism, confirmation, anchoring), while emotional biases stem from feelings (loss aversion, overconfidence, regret aversion).

Value at risk estimates the minimum loss over a period at a given confidence level; it does not describe losses beyond the threshold, known as tail risk.