CFA Level 2

Question 1

Explain Durbin watson test

Answer 1

Durbin watson is used testing first order autocorrelation (serial correlation).
DW < 2 indicates positive serial correlation
DW = 2(1-r)

If you have an autoregressive model, then you cannot use DW, then you will have to use Breusch godfrey.

Question 2

Write down the solows growth accounting equation

Answer 2

Solows Growth account equation: growth rate of output = rate of technological change + alpha x growth rate of capital + (1-alpha) x growth rate of labor
It comes from the Cobb douglas production function:
y = A * K^alpha * L ^ (1-alpha) which gives the

Question 3

Write down the labor productivity growth accounting equation

Answer 3

Labor productivity growth account equation:

growth rate in potential gpd = Growth rate of the labor force + growth rate of labor productivity

Question 4

Explain conditional convergence, club convergence

Answer 4

Conditional convergence => convergence is conditional on the countries having the same saving rate, population growth rate and production function.

Club convergence => a group of high and middle income countries, where the middle income countries will converge. Low income can also join the club if the y do the appropriate institutional changes.

Question 5

What is the cash flow based accrual ratio?

Answer 5

Cash-flow-based accruals ratio = [NI - (CFO + CFI)] / [(NOA_t1 + NOA_t2)/2]

Question 6

Describe the different ownership structures: Horizontal, vertical, dispersed and concentrated

Answer 6

Horizontal ownership -> companies with mutual business interests have cross-holding share arrangements with each other

Vertical ownership -> a company or a group owns a holding company who owns operating companies

Dispersed ownership -> many shareholders, none of which has the ability to individually exercise the control of the corporation.

Concentrated ownership -> controlling shareholders can exercise power of the company

Question 7

What are stewardship codes?

Answer 7

Stewardship codes are voluntary codes introduced by a country that encourages investors to use their legal rights as shareholders to increase corporate governance engagement

Question 8

What is shareholder activism?

Answer 8

Shareholder activism refers to strategies used by shareholders to attempt to force a company to act in a desired manner?

Question 9

What are special voting arrangements?

Answer 9

Special voting arrangements is a requirement designed to improve the position of minority shareholders

Question 10

What should you do with non-operating assets when using FCFF?

Answer 10

In valuing a company with FCFF, if there exist non-operating assets (like excess cash or mkt. Securities), then you add those to the valuation. The FCFF valuation creates a valuation of operating assets.

Non-operating assets, such as excess cash and marketable securities, noncurrent investment securities, and nonperforming assets, are usually segregated from the company’s operating assets. They are valued separately and then added to the value of the company’s operating assets to find total firm value.

Question 11

What is pathwise valuation?

Answer 11

Pathwise valuation involves discounting a bond’s cash flows for each likely interest rate path and calculating the average of these values across all paths

Question 12

What is backward induction?

Answer 12

That is what we use to value bonds. We start at the maturity and work our way back to the start, discounting with the forward rates.

Question 13

Describe Ho-lee model

Answer 13

Ho-lee (holy shit unique)
Is the only arbitrage free model.
dr = theta x dt + sigma x dw

Good for options and more accurate. Can be negative together with Vasicek

Question 14

Describe Vasicek

Answer 14

Vasicek is mean reverting and has constant volatility.
dr = alpha (mu - r)dt + sigma x dw

can be negative

Question 15

Describe CR, Cox Ingersoll

Answer 15

COX kaxig, går uppåt
It is mean reverting and do not have constant volatility
dr = alpha (mu - r)dt + sigma x sqrt(r) x dw

since we take the sqrt(r), the interest rate cannot be negative

Question 16

Ethics - ipo approval

Answer 16

Employers should require prior approval for employees participating in ipos. ipo allocations should be done

Question 17

How do you hedge a forward poisition?

Answer 17

When you value a forward currency contract you take the opposite position. So if you went in as “sell AUD against USD”, then the oppostive should be “sell USD against AUD”. When you sell the BASE you do it at Bid, when you buy the BASE you do it at the offer).

Question 18

Name some indicators of a potential currency crisis

Answer 18

• The ratio of exports to imports usually drops before a currency crisis (reduced exports)
• Broad money growth (maybe indicated as M2 / to bank reserves) is an indicator of a potential currency crisis.
• Foreign exchange reserves tend to decline steeply when a crisis is approaching
• A banking crisis usually comes before or coincides with a currency crisis
• Countries with fixed or partly fixed exchange rates are more rpone to crises compared to counties that have floating exchange rates.

Question 19

What is the Grinold-kroner model?

Answer 19

Grinold-kroner model is a macro model used to find the ERP.

Grinold-Kroner (a macro model) says: ERP = Dividend yield + Expected Capital gains +inf - risk free rate.
where Expected capital gains = expected repricing (P/E) + earnings growth per share (g)

so Grinold-Kroner: ERP = DY + Delta(P/E) + i + g + delta(S) - rf

Question 20

How do you calculate the CDS upfront payment? What are the two fixed rates?

Answer 20

CDS upfront payment = (fixed coupon rate - credit spread) * duration * nominal

5% for non-investment grade
1% for investment grade

Question 21

When do you use FCFF instead of FCFE?

Answer 21

FCFF is preferred over FCFE when the capital structure is expected to change. FCFF is often use for levered companies with negative FCFE and levered companies with changing capital structure). You also use FCFF to get a control perspective

If the company’s capital structure is relatively stable, using FCFE to value equity is more direct and simpler.

Question 22

What is a busted convertible?

Answer 22

A busted convertible is a converitble bond that is far out of the money, it behaves more like an option-free bond

Question 23

What is the J-curve effect?

Answer 23

P/E firms usually exhibit J-curve effect, where the returns will be done after some years of negative or 0 returns

Question 24

What is the formula for VWAP?

Volume weighted average price

Answer 24

For buy-orders:
VWAP transaction cost estimate = trade size * (Trade VWAP - Benchmark VWAP)
For sell orders it is reversed.

Question 25

What is the formula for effective spread?

Answer 25

For buy orders:
Effective spread cost estimate = trade size * (trade price - mid-point)

Question 26

What is the covered interest rate parity?

Answer 26

Covered interest rate parity is an arbitrage relation and says that forward rates follow interest rate parity. So nominal interest rate spread equals the percentage forward premium.

Question 27

What is the uncovered interest rate parity?

Answer 27

Uncovered interest rate parity says that the expected future exchange rate follows interest rate parity. It is forecasting EXPECTED FUTURE SPOT RATES. It states that the expected future spot rate is a function of the current spot rate and the interest rates of each currency

Question 28

What happens when both uncovered interest and covered interest rate parity holds?

Answer 28

The forward exchange rate would serve as an unbiased predictor of the future spot exchange rate.

Question 29

What is the international fischer effect?

Answer 29

The internation fisher effect occurs when the nominal yield spread between domestic and foreign markets equals the domestic-foreign expected inflation differential. This assumes that real interest rates are broadly the same across all markets.

So international fischer effect => expected inflation differential.
Exante PPE => expected change in spot rates.

assumes real interest rate is the same, delta i = delta expected inflati

Question 30

What is exante PPE?

Answer 30

Ex ante PPE occurs when the expected change in the spot exchange rate should equal the expected difference between domestic and foreign inflation rates

Question 31

Contrast P/E, P/CFO and EV/EBITDA in terms of vulnerability to manipulation

Answer 31

P/E and EV/EBITDA are generally more affected by manipulation. P/CFO is more stable.

But EV/EBITDA should be used when there is a lot of financial leverage (EV) and financial leverage -> high interest costs so good to look at EBITDA

Question 32

What do you do with preferred shares in P/B?

Answer 32

In P/B, the denominator BVPS is calculated by removing preferred shares.

so B = common shareholder’s equity

Question 33

What does a 3x9 FRA mean? And what happens to the long side when the floating rate increases?

Answer 33

3x9 -> begins in 3 months, ends in 9 months so it covers 6 months. When we calculate the value of a FRA sometime later, we need to discount it back from the maturity of the FRA to the current period.

The long side of the FRA, fixed-rate payer (floating-rate receiver), incurs a gain when rates increase.

Question 34

Contrast IFRS to US GAAP when it comes to contingent liabilities?

Answer 34

US GAAP - the contingent liability must be both probable and reasonably estimated.
IFRS - the contingent liability just need to be reliable estimated

Question 35

Describe how impairment of goodwill is done in US GAAP and IFRS.

Answer 35

IFRS is simple:
You write it down to the recoverable amount. So if carrying value is 2,500 and recoverable amount is 2,300, the impairment is 2,300-2,500 = -200
If impairment is greated than goodwill, you allocate on a prorata basis to the other
non-cash assets within the unit.

US GAAP:
1. First look if write down is needed. Is the fair value of unit < carrying value? If yes, move on=>
2. calculate new good will. Goodwilll = fair value of unit - identifiable net assets.
Example: carrying value 2,500. Goodwill = 400. Fair value of unit 2,300 and net identifiable assets = 2,000. Then 2,300 < 2,500, new goodwill = 2,300-2,000, impairment = 400-300

In US Gaap you cannot do impairment more than the good will.

Question 36

How do you calculate FFO?

Answer 36

Funds from operations, FFO = NI + dep + deferred tax expense +/- loss/gain on sale

Question 37

How do you calculate AFFO?

Answer 37

AFFO = FFO - non-cash rent - recurring maintenance capex

Question 38

How do you calculate NAVPS?

Answer 38

First you take the NOI and cap rate to value the operating assets.
Op. assets = NOI / cap rate (this is the direct capitalization method, cap rate = r- g)

Then you add all non-operating assets to get NAV (and deduct liabilities) and then divide by # of shares.

Usually you remove non cash rent from NOI

Question 39

Elaborate on the five theories that explain the term structure of interest rates:
Unbiased expectations theory
Local expectations theory
Liquidity expectations theory
Preferred habitat theory
Market segmentation theory

Answer 39

Unbiased expectations theory - Every maturity strategy leads to the same expected returns over a given investment horizon. So yield curve are only impacted by the market expectation of future interest rates, no risk premiums for longer maturities.
Local expectations theory - a narrow interpretation of unbiased expectations theory. LEE asserts that expected returns on bonds with varying maturities is the same only over short time periods.
Liquidity expectations theory - Borrowers prefer to borrow long term and lenders prefer to borrow short term, so upward sloping yield curve.
Preferred habitat theory - Different market participants have different maturity preferences, will seek different maturities if extra returns are good enough
Market segmentation theory - Different market participants have different maturity preferences, so supply and demand affect the shape of the yield curve. However, the market participants are unwilling or unable to make any other investments.

Question 40

What are judicial law, statues and administrative law?

Answer 40

Judicial law => courts enforce regulation (tänk usa)
Statues are laws enacted by legislative bodies
Administrative laws are rules issued by government agencies

Question 41

Explain the Mundell-Fleming models when it comes to government policies impact on the exchange rate

Answer 41

In the Mundell-Fleming model, monetary policy is transmitted to the exchange rate through its impact on interest rates and output. Changes in the price level and/or the inflation rate play no role.

Question 42

Draw out the table what happens with the fx under High capital mobility.

Answer 42

top row (left to right) expansionary monetary, restrictive monetary
first column (top to bottom) expansionary fiscal, restrictive fiscal

restrictive monetary and expansionary fiscal is currency appreciation

Question 43

Explain tax imputation system, double taxation system and split-rate taxation system

Answer 43

Tax imputation system -> tax is calculated for the individual, so if the company had a higher tax rate than the individuals tax on income, the individual may get a tax credit
Double taxation system -> first corporate tax, then additional tax on dividend income
Split-rate taxation system -> different tax on capital gains and dividends

Question 44

Name a few good governance practice when it comes to:
- audit committe / renumeration
- tenure
- # of independent directs in the board
- what can cause a director to not be independent

Answer 44

• Audit committee / Renumeration committee => all should be outside directors
• Good corporate governance means that board members should not have too long tenure, >10 years may be bad, it can affect the independence!
• At least 1 and 3 members as a minimum or somewhere between 20% and 50%.
• Independent directors on the board that get appointed to advisors to the CEO are no longer independent.
• Having private / business relationship, being an owner, have worked at the company. Renumeration per say doesn’t have to be a factor, or political involvement.

Question 45

What is the FCFE coverage ratio?

Answer 45

FCFE / (dividends + share repurchases)

Question 46

Name the three returns in a future contract

Answer 46

Price return = (current price - old price) / old price
Roll return = (near term - further term) / near term * % rolled
collateral return = risk free rate * time

Question 47

What is negative calendar spread?

Answer 47

Negative calendar spread is when the futures market is in contango, current price is lower than the future price.

It cannot be explained by the hedging hypothesis which rationalizes backwardation.

Question 48

What is the formula for adjusted R-squared?

Answer 48

adj R2 = 1 - (n-1)/(n-k-1) * (1 - R2)

Question 49

What is the rate of growth of output in the steady state?

Answer 49

delta y / y = theta / (1-alpha) + n
where n = delta L / L, which is the growth of labor

Question 50

What are some strenghtes with the residual income model?

Answer 50

• You can use it when you have negative cash flows.
• The model gives less weight to terminal value.
• RI models use readily available accounting data.
• It can be used to value non-dividend paying companies.

Question 51

Write out the formula for PV of terminal value in a RI model with persistence factor

Answer 51

[ E_t - rB_T-1] / [(1+r - w) x (1+r)^(T-1)]

you have ^(T-1) in the other term of the denominator.

Leading market position and low dividend payout usually mean a high persistence factor when it comes to RoE in the residual income model.

Question 52

How does the Economic value added model work?

Answer 52

EVA = NOPAT - wacc x TC

NOPAT is EBIT after tax, or EBIT x (1-tax) and use beginning book value of total capital.

Question 53

What is the market value added?

Answer 53

MVA = Market value of the company - book value of total company = MVe + MVd - accounting value equity - accounting value debt

Question 54

What is the Excess Earnings Method?

Answer 54

This method basically values a company in two pieces - the tangible value and the intangible value.
The tangible value of the company is simply calculated as the value of the company’s net worth (i.e., working capital + fixed assets).
The intangible part is calculated by capitalizing those earnings that are calculated to be in “excess” of what a reasonable amount of earnings would be on the company’s tangible net worth.
Adding the tangible and intangible values of the company together results in the value of the entire company.

Question 55

What is the G-spread and what does it measure?

Answer 55

G-spread is the bonds YTM - government YTMs

It measure general credit risk for the bond

Question 56

What is the TED-spread?

Answer 56

TED spread is the MRR - treasury bill, it measure the overall credit risk

Question 57

What is the MRR-OIS spread?

Answer 57

It is a perception of the money markets, MRR is up to 1 year (money market) and OIS is just 1 day

Question 58

What is the swap spread?

Answer 58

Yield on swap - government bond yields, it measure counterparty credit risk since the swap is hedged for interest rate risk but you still have some counterparty risk

Question 59

What is the I-spread?

Answer 59

I-spread stands for interpolated spread and it is the yield on a bond - interpolated swap spread.

Question 60

What is the break even inflation rate?

Answer 60

The difference between the yield on non-inflation adjusted (nominal) and inflation-indexed bonds with the same maturity is called the break-even inflation (BEI) rate. The inflation expectations, θ, and the risk premium demanded by investors as compensation for the uncertainty of future inflation, π
, determine the break-even inflation rate. So BEI = θ + π

Question 61

Explain insurance theory, hedging pressure hypothesis & theory of storage when it comes to the future curve

Answer 61

Insurance theory is also called “normal backwardation”. Sellers (commodity producers) want to hedge and can accept a lower price.

Hedging pressure hypothesis - markets can be in both contango and backwardation depending on buyers or sellers have greater wish to remove price uncertainty.

Theory of storage - Commodity futures prices are affected by the cost of storage and convenience yield. Futures price = Spot price + storage costs - convenience yield

Convenience yield is inversely related to general availability of the commodity. So very rare => much convenience yield.

Question 62

Write the formula for OAS and what happens to it when volatility increase?

Answer 62

OAS = Z-spread - option cost
13 10 -3
For putable, OAS >z-spread (the price is lower for the bond without the option)

option value increase with volatility, so for a putable bond the OAS will increase if volatility increase

Question 63

What are some assumptions of the BSM model?

Answer 63

• BSM are used for equities and currency options
• BSM assumes that returns are lognormally distributed
• There are no risk-arbitrage opportunities
• Short selling is permitted
• Risk free rate is constant
• volatility of returns are constant
• Early exercise is not allowed, so BSM only for european options

Question 64

When is the Black option model used?

Answer 64

The Black options valuation model is a modified version of the BSM model used for options on underlying securities that are costless to carry, including options on futures and forward contracts.

Question 65

What is the Dickey-fuller test?

Answer 65

It is a test for an unit root. g = b - 1 and then test if g = 0 (which means b = 1)

Unit root testing involves checking whether the time series is covariance stationary.

A time series with a unit root problem can be modeled by modeling the first differenced series with an autoregressive time series.

Question 66

How can you calculate the periodic pension cost?

Answer 66

Periodic pension cost = Ending Funded Status - Beginning Funded Status + Employer Contributions (contributions increases assets so we need to remove the effect from those)

Periodic pension cost = Current service cost + Interest cost + Past service cost - Actuarial gains/losses - actual return on plan assets

Question 67

What is the NSFR?

Answer 67

NSFR = Net Stable Funding Ratio is calculated as:
Available stable funds / required stable funds and should be >=100%

Question 68

What is the LCR?

Answer 68

LCR = Liquidity coverage ratio
LCR = High quality liquid assets (HQLA) / one month liquidity needs in a stress scenario and should be >= 100%

Question 69

What is the loss and adjustment ratio, underwriting expense ratio and the combined ratio?

Answer 69

• Loss and loss adjustment expense ratio = (loss expense + loss adjustment expense) / net premiums earned
• Underwriting expense ratio = underwriting expense / net premiums written
• combined ratio = loss and loss adjustment expense ratio + underwriting expense ratio

we want the combined ratio < 100%, then we have an underwriting profit.

Question 70

What is greenmail? Dutch auction and open market purchase?

Answer 70

• Greenmail is an effort by the target company to prevent a takeover attempt by offering a substantial premium above the market price to the corporate shareholder trying to take control of the company
• In a Dutch action, the company makes tender offer to its shareholders by stipulating a price range that it will pay per share for a given number of shares. It is a descending price auction in which an auctioneer starts with a very high price, incrementally lowering the price until someone places a bid.
• In an open market purchase, the company simply repurchases its shares at the market price as they become available and as the company believes the conditions for a purchase are favorable.

Question 71

Write out the put-call parity

Answer 71

S0 + p = c + PV(X)

Question 72

What is the formula for conversion adjusted fixed income future price?

Answer 72

Q0 = 1/CF * [FV(B0 + AI_0) - AI_T - FVCI]

The fixed income forward price is the Qo * CF, used for CTD

Question 73

When do you use temporal vs current rate method?

Answer 73

Temporal = same functional currency
Current = different functional currency

Question 74

How do you get to retained earnings in current vs temporal method?

Answer 74

Retained earnings in Current rate => Först beräknas i PnL => Net Income – dividends (at date of declaration) = Retained Earnings

Retained earnings in Temporal => Beräknas i Balance Sheet så att TA = Liabilities + Equity. Retained earnings används sen i PnL för att ta fram translation adjustment

Question 75

Explain how the balance sheet is translated in current rate and temporal method

Answer 75

• For both methods, equity accounts are translated in historical rates
• Current rate => everything (assets + liabilities) is current rate
• Temporal => monetary assets/liabilities is current, non-monetary are historical (wa for inventory)

Question 76

Explain how the PnL is translated in current rate and temporal method

Answer 76

Current rate => everything at average
Temporal => most stuff at average, but dep (historical) and inventory (weighted average historical)

In temporal we also have a translation gain in the PnL. For current it is only in OCI.

Question 77

What do you do in hyperinflation for IFRS / US Gaap?

Answer 77

Hyperinflation if cumulative inflation over 3 years is >100%.

• IFRS, restate for inflation and then use current rate
• US GAAP, just use temporal

Question 78

How do we report foreign transactions that has not been realized?

Answer 78

We report unrealized gain in PnL if we have bought something on credit or have an accounts receivable in a foreign currency as of reporting balance sheet date. (One of the few times we report unrealized gains)

Question 79

Give details on Gamma

Answer 79

Gamma is the highest for at-the-money options and always positive for long puts and calls (it is actually the same)

Gamma can hence be decreased by taking short position.

Question 80

Give details on option Theta

Answer 80

Theta is negative for long positions in options (the decrease in value is more severe for nearly dated options)

Theta is positive for short positions in options

Question 81

Give details on option Vega

Answer 81

Vega (sensitivity to volatility) is always positive and the same for long puts and call.

Vega is high for at or near the money options and when there is long time to maturity

Question 82

Give details on option Rho

Answer 82

Rho (sensitivity to interest rates), positive for call options (you can invest money in the bank), negative for put options

Rho is lower as the experation date nears since interest rates lose much imporance then

Question 83

What does advanced set and settled mean?

Answer 83

Advanced set => reference interest rate is set at the time money is deposited

Advanced settled => settlement is made when the FRA expires so it has to be discounted

Question 84

Explaind Conditional Var, Incremental VaR, Marginal VaR, Relative VaR

Answer 84

Conditional VaR (CVaR / Expected Shortfall) is a tail risk metric that quantifies the amount of the expected losses beyond the VaR cutoff point at a specific confidence level. CVaR is a weighted average of the losses in the tail of the return’s distribution beyond the VaR level.

Incremental VaR is the change in VaR given that you change a position in your portfolio but the size is stayed the same, you just re-weight

Marginal VaR is the change in VaR from removing a position.

Relative VaRmeasures the risk resulting from the underperformance of a portfolio relative to a benchmark portfolio. Assuming a 95% confidence level, a 1-day relative VaR of $5,000 for portfolio B implies that, on average, the portfolio would underperform only for five days in a hundred days, relative to the benchmark by more than $5,000 due to market changes.

Question 85

What is the delta for a call option?

Answer 85

delta = [0, e^(-dividend yield x t)
so if dividend yield = 0, then delta [0, 1]

for a put option, it is just reversed and you have “-“ infront of e^…

Question 86

Write down the hieararchy of quality of financial reports

Answer 86

The hierarchy of quality of financial reports (from high to low):
1. Gaap, decision-useful, sustainable and adequate returns
2. Gaap, decision-useful but unstainable, questionable low earnings
3. Within GAAP, but biased choices
4. Withing GAAP, but earnings management (earnings management below biased choices)
5. Non-compliant accounting
6. Fictitious transactions

earnings management is worse than biased choicses

Question 87

What is one condition needed to make money on a carry trade?

Answer 87

That the uncovered interest rate parity do not hold

Question 88

Elaborate on US Gaap vs IFRS when it comes to goodwill, full/partial?

Answer 88

US GAAP requires full goodwill

IFRS allows both partial and full goodwill

Question 89

Elaborate on differences between principal-principal and principal-agent problems?

Answer 89

• Principal-principal can arise when you have concentrated ownership, the minority may get run over
• Principal-agent can arise when you have dispersed ownership, the management may act in their best interest.

In private companies, overlap in man. and ownership, less agency costs

Question 90

Which two options are used for finding cost of equity for private companies?

Answer 90

1. Expanded CAPM = normal CAPM + size premium + industry premium + company specific premium
2. Build up approach (note Beta=1) = rf + ERP + Size premium + company specific premium

A bit subjective on what premia to add. Dont add IP if already eq. beta

Question 91

What are the three ways of calculating a cost of equity?

Answer 91

• DDMs,
• The bond yield plus risk premium build-up method
• risk-based models.

Question 92

Describe the Bond-yield plus risk premium approach?

Answer 92

Bond yield plus risk premium (BYPRP): re = YTM on company’s long term debt + risk premium

A prerequisite is that the company has public traded debt with YTM available

Question 93

Describe the five factor Fama-French model for calculating the cost of equity

Answer 93

re = rf + β1ERP + β2SMB + β3HML + β4RMW + β5CMA

ERP = equity risk premium
SMB = Small / big, risk premium for small companies (Size premium)
HML = value premium (high vs low)
RMW = Profitable vs least profitable premium (robust vs weak profitability)
CMA = Investment premium, conservative vs agressive investments

The beta for the ERP typically is different between CAPM and the Fama-French five factor model. This is because of the additional factors in the five-factor model that impacts the regression

Question 94

What is the formula for justified trailing P/E?

How do you find justified P/S from justified P/E?

Answer 94

trailing just. P/E = payout ratio (1+g) / (r - g)

If you have justified trailing P/E, you can find justified trailing P/S = P/E * NPM, where NPM is net profit margin)

Question 95

Contrast structural models with reduced form credit risk models

Answer 95

Structural models, they are based on the structure of a company’s balance sheet. In a structural model, owning a (risky) bond is equivalent to owning the company’s assets and having a short position in a call option on the company’s assets. If the value of the assets is higher than the value of the bond, the equity owners will call the assets and the bondholder will be paid the face value

Reduced-form models in credit risk analysis uses historical variables like financial ratios to estimate default intensity.

Question 96

Write the three formula for active return, optimal amount of active risk and best Sharpe ratio

Answer 96

E(Ra) = IC x TC x sqrt(BR) x sigma_a
Optimal amount of active risk sigma_a = TC x IR / SR_b x sigma_b
Optimal SR^2 = SR^2_b + TC^2 x IR^2

Question 97

Explain how to use BIC and AIC

Answer 97

The model with the lowest BIC is the most “parsimonious”, best fitting model

The model with the lowest AIC is the best model for prediction

Individual AIC and BIC stats are meaningless, they are only useful relative to each other.

Question 98

What impact does the savings rate have on growth rate in GDP in endogenoues vs neoclassical model?

Answer 98

In the endogenous model, an increase in the savings rate leads to a permanent increase in the growth rate.

In the neoclassical model, the savings rate has no impact on the steady-state growth rate.

Question 99

What does the credit spread in a bond capture?

Answer 99

The credit spread captures expected loss from default, differences in taxation between corproate and benchmark bonds, liquidity, and uncertainty about these factors

The benchmark yield already captures the expected real return, expected inflation and uncertainty about inflation.

Question 100

Contrast statistical based approach with portfolio based and loan-by-loan when it comes to ABS.

Answer 100

A statistical based approach is appropriate for short-term structured finance vehicles. An ABS backed by a pool of 100,000 consumer credit cards = statistics based approach, they are homogenous and static

Portfolio approach, fewer, higher value assets that are unique and have idiosyncratic risks. If it is not static you have to use the portfolio approach,

Loan by loan, if there are very high value loans and very idiosyncratic

Question 101

Elaborate on key characteristics for appraisal-based indexes

Answer 101

Appraisal-based indexes are often critized for having appraisal lag, which results from appraised valeus tending to lag when there are sudden shifts in the market.

In a down market, the appraised values would not be falling as quick as the transaction prices. So appraisal lag tends to smooth the index, it has less volatility and this in turn overstates sharpe ratios.

Question 102

Write down the key convertible bond ratios:
* conversion price
* Market conversion price
* Market conversion premium
* Market conversion premium ratio
* Conversion value

Answer 102

• conversion price = convertible bond par / converstion ratio
• Market conversion price = convertible bond price / conversion ratio
• Market conversion price premium = market conversion price - underlying share price
• Market conversion price premium ratio = (market conversion price - underlying share price ) / underlying share price
• Conversion value = Underlying share price × Conversion ratio

Question 103

What is the effective duration for a floating rate bond?

Answer 103

The effective duration of a floating-rate bond is close to the time to next reset. If the reset is annual, the effective duration of the bond would be close to 1.

Question 104

Compare divise to agglomorative clustering,

Answer 104

• Divisive hierarchical clustering (top-down) all observations belong to a single cluster in the beginning.
• Agglomerative hierarchical clustering (bottom up), each observation is its own cluster in the beginning.

Question 105

When should you add capital, MPK > r, or MPK < r and what happens in the steady state?

Answer 105

If MPK > r, then you should continue to add capital to you stock

In steady state, MPK = r (rentral price of capital)

MPK stands for marginal productivity of capital

Question 106

What is easier to estimate, health insurance costs or future retirement benefits?

Answer 106

In general, estimating future health care costs (health insurance) is harder than future retirement benefits

Funding of defined benefit pension plans is common and required by law. Funding of other post-retirement benefits are much less common (like post-retirement life insurance and health insurance)

Question 107

What adjustment to CFF and CFO should you do if contribution to the plan is less than the total periodic pension cost?

Answer 107

If the total periodic pension cost is greater than the contribution to the plan, you can make an adjustment to decrease CFO and increase CFF. It is a source of funding. Remember to do after-tax!

Question 108

What is meant with grant date in share based compensation?

Answer 108

Grant date is when the clock starts ticking for vesting, it is also the date at which the fair value of the equity award is often determined for accounting purpose

Share-based compensation expense impacts shareholders’ equity and not the company’s liabilities. It reduced retained earnings and increases paid-in-capital.

Question 109

When does EPS and BVPS increase in share buybacks?

Answer 109

EPS increase if the earnings yield is greater than the after tax cost of funding, so if E/P > after tax cost of debt

BVPS increase is P/B < 1

Question 110

Should you use average book value of equity when calcualtion RoE?

Answer 110

Yes, when calculating RoE (like g= RoE * RR) then use average shareholders equity!

Question 111

What are hedonic and repeat sales indices? How do they compare to repeat sales index?

Answer 111

**Hedonic index **- A hedonic index does not require repeat sales of the same property. It requires only one sale and instead includes variables in the regression that control for differences in the characteristics of the property such as size, age, quality and location

Repeat sales index - focuses on recurring sales of the same property

Both hedonic and repeat sales are “Transaction based indices”

**Appraisal-based index **- based on periodic estimates of property values made by experts. The appraisal based index tends to delay actual transactions so it has lag and it reduces volatility

Question 112

What are net and gross leases?

Answer 112

A gross lease requires the owner to pay for operating expenses

A net lease requires the tentant to be responsible for paying operating expenses.

Triple net leases (NNN leases) are common in US and Canada and require each tentat to pay: 1) common area maintenance, 2) property taxes and 3) building insurance cost

Question 113

What are percentage lease?

Answer 113

A percentage lease means that the tenant have to pay additional rent once their sales reach a certain level.

Question 114

Give a few examples on how the bid-ask spreads for ETF can be kept tight:

Answer 114

• Low creation / redemption fees
• The presence of hedging securities for the AP (authorized participant)
• No underlying securities in other markets
• A higher number of market makers
• A high degree of order flow

Question 115

When can the ETF price be more accurate than NAV or iNAV?

Answer 115

ETF prices may be more accurate reflection than NAVs or iNAVs when:
- the underlying securities are less actively traded
- the underlying market is closed or has time lags

iNAV is the intraday net asset value.

Question 116

How do SROs differ compared to Self Regulation Bodies?

Answer 116

Self-regulatory organizations (SRO) differs from industry self regulatory bodies in that they are given recognition and authority (including enforcement power) by a government body

Self-regulatory bodies obtain their power from constituent members who agree to operate within an organization’s rules and standards. However, the authority of these organizations is not attached to the rule of law, but they can expel the members who breach their rules.

Question 117

Contrats regulatory capture, competition and arbitrage

Answer 117

Regulatory capture -> we capture the good, regulation leads to better environment for companies already in the industry-
Regulatory competition -> regulators compete with eachother trying to make it more beneficial for companies in other countries to relocate
Regulatory arbitrage -> companies trying to exploit differences in regulatory burden, like locating funds in countries with lower reporting requirements.

Question 118

What does dividends irrelevance theory say? And Bird in the hand? Tax theory?

Answer 118

Dividends irrelevance theory => dividends do matter but in what whey they are paid does not, so the dividend policy is irrelevant. “homemade” dividends can replace actual dividends (doesn’t work in reality)

Bird in the hand => better to pay out earnings than invest (since earnings paid out are less risky)

Tax theory => sometimes dividends are taxed higher than capital gains, then the dividend policy do not become irrelevant.

Question 119

To what curve is the Z-spread added?

Answer 119

Z-spread is added to the spot curve.

For a callable or putable bond, the Z-spread is the same as the option-adjusted spread (OAS) in a tree with 0% interest rate volatility (The option cost is 0 in the formula OAS = Z-spread - option cost when voltatility is 0%)

Question 120

1.

Name 4 characteristics of takeover targets in a LBO.

Answer 120

Takeover targets in an LBO usually have:
- Significant physical assets
- Low Debt to equity
- High and strong cash flow
- Undervalued stock

Question 121

What is a fundamental factor model and a macroeconomic factor model?

Answer 121

In a **fundamental factor **model, the factors are attributes of companies or stocks, such as market capitalization or various accounting ratios. So we first specify the factor sensitivies and then the factor returns through regression. The factor betas are calculated directly.

In a macroeconomic factor model, the factors are typically surprises in macroeconomic variables like GDP. In a macroeconomic factor model we develop the factor (surpirses) first and then estimate factor sensitivies (the betas)through regression, so normal way.

fundamental => sensitivities/betas first, then returns (weird)
macroeconomic => factor surprise returns first, then sensitivities (normal)

Question 122

What is the relation between growth rate of potential GDP and real interest rate?

Answer 122

A high growth rate of potential GDP usually means high real interest rate. Faster growth of potential GDP means that consumers expect their real income to rise more rapidly, future consumption is less valuable so you need higher interest rate to be willing to save.

Question 123

What is the relation between a putable bonds value and volatility, exercise price and dividends on stock?

Answer 123

Lower volatility => lower value of put
Lower exercise price => lower value of put
low dividend => lower value of put

Question 124

How is past service cost recognized in IFRS and US GAAP?

Answer 124

Defined benefit plan, US GAAP, is past service costs always OCI and always amortized

In IFRS, past service cost is recognized in PnL!

Question 125

Elaborate on how the profit is bookefd in an intercompany transaction for both up- and downstream sales.

Answer 125

In an upstream sale, the profit on the intercompany transaction is recorded on the associate’s income (PnL) statement. The investor’s share of the unrealized profit is thus included in equity income on the investor’s income statement which must be removed.

In a downstream sale, the profit is recorded on the investor’s income statement.

So in both upstream and downstream, we need to remove the unrealized profit from the equity line of the associate

Question 126

Member with residence in “more strict” and does business in “less strict”, but it states that law of locality where business is conducted governs. To what should you adhere to?

Answer 126

Law of locaility => “less strict”, but we always compare to the code and standards, so the member must adhere to Code and Standards.

Question 127

What do you do in a carry arbitrage?

Answer 127

You buy the underlying and sell a forward contract. Hence you carry the underlying which get sold when the forward expires

Question 128

When should you use a barbell vs a bullet portfolio?

Answer 128

Barbells fall down, bullets shoot up” is how I remember it. Barbell portfolios do better in a flattening yield curve environment. Bullet portfolios do better in a rising yield environment.

Question 129

What are stock appreciation rights?

Answer 129

Stock appreciation rights or phantom stock, compensate an employee on the basis of changes in the value of shares without requiring the employee to hold the shares.

Question 130

What is the formula for effective duration? and one-sided effective duration?

Answer 130

Effective duration = (PV- - PV+) / (2*delta_yield * PV0)

(Down )One-sided effective duration = (PV- - PV0) / (delta_yield * PV0)

(UP) One-sided effective duration = (PV0 - PV+) / (delta_yield * PV0)

Question 131

How does key rate duration differ to effective duration?

Answer 131

Effective duration is calculated by assuming parallel shifts in the benchmark yield curve. Key rate durations reflect the sensitivity of a bond’s price to changes in specific maturities

Question 132

What are one benefit of REITs compared to REOC?

Answer 132

REIT avoids double taxation on dividends received by investors. It does this by avoiding corporate income taxation, leaving the investor to pay taxes on dividends received.

Both REIT and REOCs are publicly traded equity investments and require little Real estate investment knowledge.

Question 133

What are Type 1 and Type 2 errors?

Answer 133

Type 1 error are false positive, you predict 1 but it should have been 0.

Type 2 error are false negative, you predict 0 but it should have been 1.

Question 134

What is precision?

Answer 134

Precision = TP / (TP + FP)

Out of all that we predicited true, how many were actually true?

Question 135

What is recall?

Answer 135

Recall = TP / (TP + FN)
Recall is the True positive rate. Out of all that was true, how many did we get?

Question 136

What is the F1-score?

Answer 136

F1-score is the harmonic mean of precision and recall and is a good accuracy measure when there are class imbalances.

Question 137

Are reclassification of equity or debt investments permitted?

Answer 137

Reclassification of equity instruments is not permitted, the intial classification is irrevocable.

Reclassification for debt instruments is permitted and there is no restatement of prior methods. And reclassification only permitted if the business model / objective of holding the financial asset has changed.

Question 138

If you want to hedge a small change in the stock price, do you add or subtract the call option gamma?

Answer 138

To fully hedge a small change in the stock price, the proper strategy is use call option delta and add the call option gamma,

Question 139

Is implied volatility forward- or backward-looking?

Answer 139

Implied volatility is a measure of estimated future volatility, not historical volatility.

Question 140

What is the F-statistic for testing multiple variables at a time?

Answer 140

F-test statistic for testing multiple variables at a time, e.g. null hypothesis: x3 = x4 = 0

F = (SSE of restricted model - SSE of unrestricted model)/q / [ SSE of restricted model / (n-k-1)]
It is a one-tailed rightside test.

Question 141

What is the Braush Pagan test used for? And what is the test statistic?

Answer 141

BP = n * R2
Tests conditional heteroskedasticity

Question 142

What is the Braush Godfrey test used for? And what is the test statistic?

Answer 142

Breusch Godfrey is for testing serial correlation. It is used for autoregression and can test any lag, we use p-values?

Question 143

What is VIF and what are the thumbrules?

Answer 143

Variance inflation factor (VIF) is a measure for quantifying multicollinearity
* VIF > 10 indicates serious multicollinearity issues requiring correction
* VIF > 5 warrant further investigation
* VIF = 1 means that there are no multicollinearity.

Question 144

What is leverage and outliers?

Answer 144

Leverage means that the point is on a very different X-level and its presence impacts the output. If leverage > 3(k+1)/n then it is potentially influential

Outliers means that the point is on a very different Y-level. If the studentized residuals are greater than the t-statistic then it is potentially influential

Question 145

What are influential points?

Answer 145

Outliers and high-leverage points are not necessarily influential. An observation is considered influential if its exclusion from the sample causes substantial changes in the estimated regression function. Cook’s distance or Cook’s D is a metric for identifying influential data points. If Di > 2 * sqrt(K/n) then it is highly likely to be influential.

Question 146

Is there a cap for the surplus in a Defined Benefit obligation?

Answer 146

When a company has a surplus in a DB pension plan, the amount of assets that can be reported is the lower of the surplus or the present value of future economic benefits.

Question 147

What are the two adjustments you can do to pension expense in US Gaap?

Answer 147

In US GAAP, you can do two adjustments to reclassifying pension components.

Operating income can be adjusted to include only current service cost, the interest component is reclassified as interest expense

The actual return on plan asset can be added as investment income.

Question 148

What does the remeasurement component of the periodic pension cost represent?

Answer 148

The remeasurement component of the periodic pension cost includes both actuarial gains and losses on the pension obligation and the net return on plan assets.

IFRS, it is recognized in OCI
US Gaap, either immediately PnL or more commonly in OCI and amortized to PnL using corridor approach

Question 149

What are credit unions?

Answer 149

Credit unions are depository institutions that function like banks and offer many of the same services, but they are owned by their members rather than being publicly traded as many banks are.

Question 150

What is the benish model?

Answer 150

It produces a M-score which indicates the probability of earnings manipulation. The higher number, >-1.78 the higher probability for earnings manipulation.