CFA Level II flashcards

32 cards. Read the term and the definition here. The deck at the top of this page is optional.

Seven Standards of Conduct

The CFA Institute Code and Standards comprise seven categories: Professionalism; Integrity of Capital Markets; Duties to Clients; Duties to Employers; Investment Analysis, Recommendations, and Actions; Conflicts of Interest; and Responsibilities as CFA Institute Members.

Fair Dealing Standard III(B)

Requires members to deal fairly and objectively with all clients when providing investment analysis, recommendations, or taking investment action; dissemination should be simultaneous to all clients who receive recommendations.

GIPS Composite Definition

A composite is an aggregation of one or more portfolios managed according to a similar investment mandate, objective, or strategy; it must include all actual, fee-paying, discretionary portfolios.

Heteroskedasticity Consequence

Conditional variance of errors differs across observations; OLS coefficients remain unbiased but standard errors are inconsistent, so robust (White) standard errors must be used for valid inference.

Durbin-Watson Statistic

Tests first-order serial correlation in regression residuals; DW approximately equals 2(1 − r), where r is residual autocorrelation; values near 2 indicate no serial correlation.

Unit Root Test

Dickey-Fuller test checks whether a time series is nonstationary (has a unit root); if the null of a unit root is not rejected, differencing produces a stationary series.

Covered Interest Rate Parity

Links spot and forward exchange rates to interest rate differentials: forward/spot = (1 + i_price currency)/(1 + i_base currency); arbitrage enforces the relationship when capital flows freely.

Mundell-Fleming Conclusion

With high capital mobility, monetary policy is effective under a flexible exchange rate while fiscal policy is effective under a fixed exchange rate.

Purchasing Power Parity

Absolute PPP states exchange rates equal price level ratios; relative PPP states the exchange rate change approximates the inflation differential between countries.

LIFO Liquidation

Occurs when a firm sells more inventory than it purchases, dipping into older LIFO layers with lower costs; this raises gross profit artificially and is not sustainable.

FCFF Formula

Free cash flow to the firm equals cash flow from operations plus after-tax interest minus fixed capital investment; it is the cash available to all capital providers.

Temporal Method

Translation method used when the foreign subsidiary's functional currency is the parent's currency; monetary assets and liabilities use the current rate, nonmonetary items use historical rates, and translation gains or losses go to income.

Deferred Tax Valuation Allowance

A contra account reducing deferred tax assets when it is more likely than not that some portion will not be realized; its creation increases the effective tax rate in that period.

WACC Formula

Weighted average cost of capital equals wd × rd × (1 − t) + wp × rp + we × re, using market value weights and after-tax cost of debt.

Cash Conversion Cycle

Days of inventory plus days of receivables minus days of payables; measures how long cash is tied up in operations before collection.

Pecking Order Theory

Firms prefer internal financing first, then debt, and issue equity only as a last resort, due to asymmetric information and issuance costs.

Gordon Growth Model

Values a stock as V0 = D1/(r − g), assuming dividends grow forever at a constant rate g that is less than the required return r.

Justified P/E

Fundamental P/E derived from the Gordon growth model: (1 − b)/(r − g), where b is the retention ratio, r the required return, and g the growth rate.

Residual Income Model

Values equity as current book value plus the present value of future residual income, where residual income equals (ROE − r) × beginning book value.

H-Model

A two-stage DDM shortcut assuming growth declines linearly from a high initial rate to a stable rate over a finite horizon; value combines the stable-growth value and a half-life adjustment.

Modified Duration

Measures the percentage price change of a bond for a 1% (100 bp) change in yield; approximately equals Macaulay duration divided by (1 + yield/compounding frequency).

Bootstrapping Spot Rates

Derives spot rates sequentially from par yield curve prices: the spot rate for maturity n solves the equation equating the bond's price to the present value of its cash flows.

Convexity Adjustment

Approximates bond price change as −modified duration × Δy + 0.5 × convexity × (Δy)²; convexity captures the curvature of the price-yield relationship and is positive for option-free bonds.

Put-Call Parity

For European options: c + X/(1 + r)^T = p + S0; a violation permits arbitrage by combining the underlying, a bond, and the two options.

Forward Price Formula

F = S0 × (1 + r)^T − FV(benefits) + FV(costs); for an asset with no carry benefits or costs, F equals the future value of the spot price.

Delta of an Option

Delta measures change in option price per one-unit change in underlying price; calls have positive delta between 0 and 1, puts negative between −1 and 0, and delta approximates the hedge ratio.

Roll Yield

The return from rolling a futures position forward; positive when the futures curve is in backwardation (futures price below spot) and negative in contango.

Hedge Fund Fee Structure

Typically a management fee of 1–2% of assets plus an incentive fee of 20% of profits, often with a high-water mark ensuring fees are paid only on new profits.

J-Curve Effect

Private equity fund returns are negative in early years due to fees and unrealized investments, then rise as portfolio companies mature and are exited.

Sharpe Ratio

Excess portfolio return per unit of total risk: (Rp − Rf)/σp; appropriate when the portfolio represents an investor's entire risky holding.

IPS Constraints

The five constraints in an investment policy statement are liquidity, time horizon, tax concerns, legal and regulatory factors, and unique circumstances.

Utility Function

Investor utility equals expected return minus 0.5 × risk aversion coefficient × variance; higher risk aversion lowers the utility of a given risky portfolio.