www.thetestpreps.com

CRITICAL CONCEPTS FOR THE 2014 CFA®
Approximation formula for nominal required rate:

ExAM
Exprctrd return, variance of2-S1ock portfolio:

THICAL AND PROFESSIONAL ANDARDS
Professionalism Knowledge of the Law, Independence and Objectiviry Misrepresentation. Misconduct. Inregrity of Capiml Markers Material Nonpublic Information. Market Manipulation. Duties to Clients Loyalty. Prudence. and Care. Fair Dealing. Suitability, Performance Presentation. Preservation of Confidenrialiry, Duties to Employers Loyalty. Additional Compensation Arrangements. Responsibilities of Supervisors. Investment Analysis, Recommendations, and Action Diligence and Reasonable Basis. Communication wirh Clients and Prospective Clients. Record Rereruion. Conflicts of Interest Disclosure of Conflicrs. Priority of Transacrions. Referral Fees, Responsibilhies as a CFA lnstirute Member Or CFA Candidate Conduct as Members and Candidates in the CFA Prograrn. Reference to CFA Institute. the CFA Designation. and the CFA Program. Performance Standards

E(R) ~ RFR + fP + RP
Means Arithmetic mean: sum of all observation values in sample/population. divided by II of observations. Geometri« "mill: used when calculating investment returns over multiple periods or ro measure compound growth rates. Geonmrir /liMn return:

E(Rp) = w"E(RA)

+ wBE(Rs)

I

(A) (B) I (C) (D)
(A)

,.ar(Rp)= wl\u!(R\)+w~u2(R8)
+2w \ w8(7{RA )U(RR)P(R Normal Distributions Norma] distribution i~ completely mean and variance. 68% of observations fall within 90% fall within t 1.650 95% fall within t 1.960. 990" fall within ;t 2.58(7. Computing Z-Scores \.Ra) by irs

described t (B) (A)
(B)

R •. 1(I+R)x harmonic mean

•.

(I.R,)]-1 N

1(1.

(C) (D) (E) (A) (6) (C)

t[l]
,I

X,

L-scol7: "standardizes"
Variance and Standard Deviation l17riallc~:avcrage of squared deviations
N

from mean.

observarion from normal distribution; represents /I of standard deviations a given observation is from population mean.
Z

l)Xi-ld population variance: (12_-'i-"'I _

= observation

- population standard deviation

m~-an = x -I'

a

(A)
(B)

N

(C) (A) (6) (C)

f)x, sample variance _ c;2 S","dard Holding .i_I -n

-x)l

_

deoimion: square root of variance.
Period Return
I. I 1',

(IIPR)

Binomial Models Binamia! distribution: assumes a variable can take one of tWO values (success/failure) or. in the case of a stock, movements (up/down). A binomial model C:1I1 describe changes 111 the value of an asset or portfolio; it can be used to compute it~ expected value over several periods. Sampling Distribution

(A) (B)

R _ P, P, , Coefficient

D, or 1'.

+ DJ. -I
1',
I

SampllIIg distribution.

of Variation

Co4Jirirllf of variation (CV): expresses how much dispersion exists relative to mean of a distribution; allows for direct comparison of dispersion across different data sets. CV is calculated by dividing standard deviation of a distribution by the mean or expected value of the distribution: CV=~

probability distribution of all possible sample S{d{IStlC computed from a set of equal-size samples randomly drawn from the same population. The samplillg distribution of'''~ mean is the distribution of estimates of the mean.

bal Investmenr PS®)

"[Insert name of firm) has repared and presented rhis reporr in compliance with rhe Global lnvesrmene Performance tandards (GIPS)." Compliance must be applied n a firm-wide basis. Nine S~CliOTU:fundamenrals of compliance, nput data. calculation methodology. composite onstruction. disclosures. presentation and eponing, real estate, private equity. and wrap ee/separately managed account ponfolios.

Compliallcntatnllmr:

X
Sharpe Ratio Sbarp« ratio: measures O:fm return per unit of risk. Sharpe ratio

Central limit Theorem Central limit theorem: when selecting simple random samples of size 11from POp"lntiOIl with mean II and finite variance CT1, the sampling distriburion of sample mean approaches normal probability distribution with mean It and variance equal to 0'1/11 as the sample size becomes large. Standard Error Sl,l1ItUlrd fTTOr of II" wmpl~ mean i, the srandard devurion of disrriburion of the sample means.
(1

known population

variance:

(1,

UANTITATIVE

METHODS

Roy i slIfi'ty-fim

ratio: -'---"IS

rp

Tn s, rtJr~ct

CTp

unknown Confidence

population Intervals

variance:

Value of Money Basics UNlr( Ult/'IL (FV): amount to which investment rows after one or more compounding periods. Future ualu«: FY = PV(J + I/Y)'. Present ualu« (PV): current value of some future ash Aow PV = FY/(I + I/Y)N. nnuities: series of equal cash Aows that OCCurat venly spaced intervals over time. Ordinary annuity: cash Aow at md-of-time period. l1IlIIity due: cash Aow at brginnillg-of-rime period. t'rpel1liliff: annuities with infinite lives. PVI"". PMT/(discount rate).

For both rarios, larger Expected Exprcud

berrcr, Deviation

Return/Standard return: = P(xi

CollfitUncr interual: gives range of values the mean value will be between. with a given probability (say 90% or 95%). With known variance. formula for a confidence interval is: _ (1

E(X)

E(X) = 2::P(Xi) x. )xl + P(X2)X2 + ... + P(x.}x.

Probabilistic uariance:

(12(X)= 2::P(x,)lx,

- E(X)t = P(X')[:. and restructuring COSts. • lntcgration expenses associared wim b~inesses

ding price (EngIisIJ): Highest bid wins. pays nt bid; all bids known to .11 bidders.

bid: Highest bid wins. pays amount bid; bids nknown to other bidders. d price unkd bid (Vickrry): Highest bid wins, amount bid by second.high bidder. mdil1g priu (DllulJ): Price declines until .tll can be M)ld; each bidder PJYS price bid. fid Dlileh: Price declines until all units can be all bidders pay last bid price.

fiscal multiplier = where MPC = m:uginal

I-MPC

1-[

nues

and Costs

propensiry

to consume,

www.thetestpreps.com linal assn, fi:'(td-ass~t, and tl!orking capnal tumatxr unusual ordinary

priation ordinary

Items (U.S. GAAP only) and mfrequcnt (e.g., losses from of assets). IFRS does not allow items. ratios: total asset turnover = r_ev_c_n_u_c _ average total net assets r:_:ev=en:_:u::_e:::_ __ avcrage net fixed assets revenue average working capital

Held-to-maturity: amortized cost on balance sheet: interest, realized GfL recognized on income statement. ontinued Operations e accounted for as a discontinued operation, 3 ess-assets, operations, investing, financing ties-s-musr be physically/operationally distinct rest of firm. Incomellosses are reported ner of fter ner income from continuing operations.

fixed asset turnover

=

Inventory Accounting In periods of rising pnces and stable or increasing inventory quantities: UFO TTSUltsill: HigberCOGS Lower gross profit Lower inventory balances Basic and Dilured EPS FIFO results ill: Lower COGS Higher gross profit Higher invenrory balances

working

capital turnover =
IW

Gross, operating; and

projiT IIInrghlJ:

pute

Cash Flows From Operations (CFO) ct method: Start with cash collections (cash alent of sales): cash inputs (cash equivalent of of good, sold); cash operating expen5CS; cash st expense: cash taxes. u/lI/~tlJod: ~tart with net income, subtracting gains and adding back losses resuhing from cing or investment cash flow~, adding back .111 ash charges. and adding and subtracting asset liability accounts that result from operations.

. gross profit gross profit margin = .!2....:.:..:...!~.:.: revenue . operallng fi pro
II margin

&"IIi( EPS calculadon does not consider effects of any dilutive sccuriries in computation of Frs:

.

=

EBIT opemling profil revc;uc = -n-c,-s-a1-es-

basic EPS _

nct income preferred dividends WId. avg. no. of common shs, outstanding adj. income avail. for common shares

. net income net profit margin - .:..:..:.:....:.:.;.::.= revenue
Remr»

diluted EPS (ROTC)]: Therefore. net [. income

on flsms [return

011/0111/ (IIpiltll

wtd, avg. common shares plus potential common shares outsranding EPS is: convertible [COnvertible] preferred + debt (I-t) dividends interest

Cash Flow cashflow (FCF) measures cash available for etionary purposes. It is equal to operating cash less net capital expenditures.

return on assets EBIT (rotal capital) = average roral capital Debt to tqllity ratio and tota! deb, ratio: . debc-ro-equiry . rallo = total debr . roral eqwty

diluted

-~. + iv fd]

al Ratios mon-size finO/wal statement analysIs: ommon-size balance sbut expresses all balance eer accounts 3S 3 percentage of rotal assets. ommon-size income statement expresses all come statement items as ;1 percentage of sales. ommon-size cash Aow statement expresses each ne item as a percentage of tOIJI cash inAows utflows). or as a percclll.lge of net revenue.

[~:~e~f~~~f +[iss~i~m] [:;).,. sh s ]-[:~~er;;:n] cony. pfd. sh s cony. ebt d stock opnons Long-Lived Assets lowers increases near-term Exptllsillg: opposite
Caplfaftzmg:

roral debr roral-debr-rario ~ ----

total assets /1lIt7'Nf eOIJrrag~and ford t"llOrg~ cOI'mlg~:

. EBIT mteresl coverage - -.-mterest fixed charge coverage

Capitalizing VB. Expensing income variability and profits. Increase assets, eqUlI)'. effect. residual value

Depreciation

zontal common-size jil/lll/cilll statemenr analysis:

= -.--'-'-'-'-''---'- payment~ ' + lease mterest + lease payments
EBIT
X

sses each line item relaeivc to its value inJ mon base period.
MilOS:

Growth rate (g): g. RR retmtion raft' = 1-

ROE dividends declared income after taxes

Sml1glll-lill~: -------useful life [)ollbl,. dtdillillg balanc«
( 2. )(cost-accum.

COSt

idity

nt

current assets ratio = -----current liabilities . cash rano =

--==:..:.:.:=-===-operating

depreciation)

useful life
.

k

+ marketable

securilies + receivables current liabilities

uquldity short-term ratios indicate company's ability to pay its liabilities. operates the business.

Units of 'production:
COSt- salvage value useful life in units Revaluation of Long-Lived Assets IFRS: revaluation gain recognized in net income only to the extent it reverses previously recognized impairment loss; further gains recognized in equity JS revaluation surplus. (For unvstmrnt prop"'Y' all gains and losses from marking 10 fuir value arc recognized as income.l U.S. GMP: revaluarion is not permitted. Deferred Taxes • Created when taxable income (on lax return) '" prctax income (on financial statements) due to tempowy differences. • Dif""d tax liflbilitlN are created when taxable income < pretax income. Treat DTL as equity if nor expected [0 reverse. • Dif""d lax IlSStIS are created when taxable income > pretaX income. Musr recognize valulltion alkrwallct if mOre likely than noc Ihat DTA will nor be realized. Long-Term i~uance. Liabilities x ourput ururs

Oputlfing p"formana ratios indicate how well management DuPont Analysis Traditional DIIPolll eqtmtion: . return on equIty You may

ratio = cash

+ maskerable

securities current liabiliries

nsive

interval = cash + mkt. sec. + receivables daily cash expenditures

=

lblrs. IfIWIlIOry. pa)'ab/~s IlIrI10'~r, and tlnys' ly ratios- -.1Ilolu-hieh are used ill th~ (fish nion rydrannual sales average receivables cosr of goods sold . average Inventory

(net income J(--salesJ[ --.assets) sales assets eqUlry as: lu~,::er][ m::~~~cr net

31\0

see it presented

vables turnover

return on equiry - [n::;~tl(

1

llory

turnover =

Exlmded /)1I?OI/l equation furrher decomposes profit margin: ROE = (net incomeJx( EBT

bles

turnover

. rauo =

--...£..~==-purchases

average rrade parables

EBT Jx( EBIT J EBIT revenue

of sales outstanding

=

365 receivables turnover

g revenue J [av . total assers J x [ avg. tOtal assetS x avg. equity You may also see it presented as: ROE ~ tax burden x inrerest burden x EBIT margin x asset turnover x leverage Marketable rallo Security Classifications

of inventory

on hand = -. ----'---mventory turnover

365

• PrrmiulII bOlld:coupon rate> market rate al • DiJeoll1l(bOlld:coupon ratc
"Suancc.
• IlIuml n.PtllJf equals book value at the begrnning of Ihe year multiplied by the market rate of interesl at the lime the bonds were issued. < markct

ber

of days of payables = I eye e •

365

parables lurnover

.

H~M-for-trt/(Iillg: fair value on 1,.I.lllcc sheet; dividend" inrcrl"il, rC-Jlil.ed and ullreali,ed GIl. recognized on i,,,omc ~13temCIll. Al'Oilnb/~-for-sa/t: fair ";!Iue on balance \hect; dividends, inrcr~'St, realized GIL recognized on income statement; unrealized GIL is other

rate JI

. conversIon

(days of inventOry] on hand

+[days of ~es]_[number of daYS] outstanding of parables

www.thetestpreps.com
Working Capital Management

ses

Pnmary sourcesofli'llildity. cash balances. shortterm funding. cash Row management of collections and payment. !XCOlldary sourcesofli'lllldity. liquidaring assets, negotiating debt agreements. bankruptcy protection. CAPM:

E(R,)

RFR·

J.IE(RII'~')

RfR

anrialstnrementimno impact of I~ unting from the lessee perspective. capital es resulr in: Hig/m: assets, liabilities, CFO. debt/equity LoI/J~r: net income (early years), CFF. current atio, working capital, asser turnover, ROA,

\l

Cosr of trade credit: % discount) (1+ 1-% discount

ROE. Same: (Oral cash Aow.

..,
........
diorou ..

;7
E(R..J

-I

r------(0\' L!

t

sions ned rontrtbutian: employer contriburion ensed in period incurred. lltd bmq;r overfunded plan recognized as , underfunded plan recognized as liabiliry.

, ,
:
(1 + k.) dividend D, in calculation.

sure co use aprrud

nite

Period Dividend Discount Models mlOrllllll groll'l" model (1III1fti-Siagr) DM: D VoDI (I"'k.}'" D. ...... + (I+k.t;-

p.
(I+k.)"

h were:

Pn

D•.
-( --)

I

k. - g.,

lS11I1JI rowr/, 1II0dld: g Vo Do(1+g.} =~

www.thetestpreps.com difference berw een market price of the 3SSCtand contract price at settlement date. • Early termination can be achieved by entering into a new forward contract with the opposite position, at the then-current expected future price. This will fix the amount of payment to be made/received at settlement dare, • • • • Buyer of a call option-long position. Writer (seller) of a call option-short position. Buyer of a put option-long poslrlon. \'('riter (seller) of a PUI option-short position. intrinsic value of a call option = MaxIO. S - X] intrinsic value of a put option = Max[O. X-51

he horizon at which market price risk and invesrmenr risk jl15t offser is a bond's Macal/fay ration. This is the weighted average of times til a bond's ash Aows arc scheduled to be paid. i~d duration is the approximate change in a s price given a 1% change in itsYTM: Macaulay duranon (V_)-(V_l (I +r) :::::2Vo(Ay) is required if a bond has options:

=

Forward Rate Agreements {FAA} Can be viewed as a forward conrraer to borrowl lend moncy at a certain rate at some future date. Formula for payment to the long at settlement is:
. nollonal ( principal ) (floating 1+ ys rate - forward rate)( da 60 3

ALTERNATIVE
Hedge Funds slral~il'>: Eoeut-drioen

INVESTMENTS

i/)~ duration

dded

1

(V )-(V+) only arc

restructuring; situations.

me:rger arbirrage: distressed/ activist shareholder; special

x

2Vo (~curve) Futures vs. For-wards Fon...,rth Privare contracts Unique contracts Default risk Latle or no regulanon

(A' }(days) oanng rate 360

change estimates based on duration ved by adjusting for COIIIJI'X;ty: = -dur:lIion(~y) and Credit

FUIIIW

%~price

+ .!.convexity(~y)2
2

teral

Enhancement

ed bOlldsare backed by specific collateral and to unsecured and assets. credit enhancement:

Exchange-traded Standardized conrracrs Guaranteed by clearinghouse Regulated

bonds. to CII",d hOlltit are general claims

issuer's cash

Excess spread, waterfall srrucrure. nal credit enhancement: Surety bonds. letters of , bank guarantees.

al

ollareralizarion,

American vs. European Options American optiO/l.S let the owner exercise the option any time before Or at expiration. European options an be exercised Ollly at expiration. Value of the American option will equal/exceed value of the European option. Lower and Upper Opnon European all (c) American all (C) European put {p} American pur (P) Nate: t R~fJlln't: I'O/II~ slraugin: convertible arbitrage; asset-backed fixed income; gencrallixccl income: volatility; multi-strategy. Eqlllty stralq,i~s: marker neutral; fundamental growth; fund.lIllcntai value; quantitative directional; shorr bias. Macro ttra/~gi~s:based on global economic trends. Hedge: fund fees: • "2 and 20": 2% management fce plus 200/0 incentive fee. • Hard hurdle rare: incentive fee only on rerum above hurdle rate. • Sofr hurdle rate: incentive fee on whole rerum, bur only paid if rerum is grealer than hurdle rate. • High Water mark: no incentive fee until value exceeds previous high.

Bounds J/""",ulII

for Options
VII/U~ J\.lnxWIIIIII

Analysis JfIIWII gmd~: Baa3f8BBor above inoestmou gmd~: Ba I/BB+ or below orate Gmily rating (CFR): issuer rallng. orate credit rating (CCR): security rating. Cs": capacity, collateral, covenants, character. lef.wlt ri spot price. Barkumrdatknr: futures price < spot price. Sources of investment return: • Collatem! yi~fd: return on T-bill, posted as margin. • Pnr« "'11m/: due to change in lpot price. • Rofl JMd: positive for backwardation. negative for contango. furures price se spot price{1 + R,) + storage costs - convenience yield

ul'n-ilgl'd buyouts: management

RIVATIVES

es vs. Forwards rward COflImCI: one party agrees to buy. ounrerparry sells) a physical asser/securiry at ecific price on specific fi'tllrl' date. If 3S""t'S ure price increases, buyer (at the older. lower ce) has a gain and seller has a loss. lm contmrt. standardized, exchange-traded ward contract. Ditrercn! from forwards in l fUlLlre; trade in active secondary market. arc gulated. backed by clearinghouse, and require ly settlement of gains/losses.

= time 10 expiration.

Pm-Call Parity Put-call parity holds lhat portfolios with identical payo(fs must sell for the same price to pre-.·ent arbitrage. The put-call parity relationship: X C+ S+I' (1+ RFR)' Each security in the pur-call parity relationship be expressed as: S-C+ X (I +RFR)t X S P X can

rage w of 0111' pnce: rwo assets with idenucal cash

(I+RFR)t
X =S+P-C

ws in the furure, regardless of future events, ould have the same price. If A and B have ntical future payoffs, and A is priced lower n B. buy A and sell B. cond typl' of aTbitrag~:tWO assets with uncertain urns an be combined in 3 portfolio that will ve a certain payoff If a portfolio of A and B s a certain payotr. the portfolio should yield the k-free rate.

p=c+

(I + RFR)I

(1+ RFR)'

PPN: 32004021 ISBN-13: 9781427749208 ISBN-IO: 1427749205

ard Contracts ong InU,! p.lY ~ certain amount at specific future re to short, who will deliver the underlying et. cash settlement forward contract does nor quire actual delivery of the underlying asset. but