study session 2 – quantitative web viewcfa level 2 study tips 2004. examination weights and...

2004 CFA L 2 – S tudy T ips

Schweser CFA Level 2 Study Tips 2004

Examination Weights and StructureThe morning session of the Level 2 exam (3 hours and 50 percent of the exam) is entirely essay format. The

afternoon session (3 more hours and another 50 percent) is in multiple choice, item set format. For the 2004

exam, expect any topic (financial statement analysis, equity valuation, etc.) in either format. The 2004

examination guideline topic area weights, as developed by AIMR, are:

TopicGuideline Topic

Area Weight

Ethical and Professional Standards 10%

Economics 0 to 10%

Quantitative Analysis 0 to 10%

Financial Statement Analysis and Corporate Finance 25 to 35%

Asset Valuation (Equity, Debt, and Derivatives) 35 to 45%

Portfolio Management 5 to 15%

Total 100%

Ethics Study Tips – Study Session 1 & 2Ethics is worth 10 percent of the exam, and is one of the keys to your success on exam day, so make it a top

priority. Although you can fail ethics and still pass the exam, I wouldn’t recommend it. Study the details. As

you know from Level 1, the ethics questions can be tricky, and nitpicky little details can be important on some

ethics questions. Don’t assume that just because you’ve already seen the material at Level 1 you don’t need

to study this time around. Level 2 ethics will be more difficult, more detailed, and more challenging than Level

1, so be prepared. In addition to starting early, study the ethics material more than once. It would be optimal if

you could study ethics in January and once again in May.

Standards of Practice HandbookI recommend that you buy and read the original Standards of Practice Handbook. Although we are very

proud of our summaries of the ethics material, there are two reasons why we recommend that you buy the

original Standards of Practice Handbook. (1) You are a CFA® candidate. As such, you have pledged to

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abide by the AIMR® Standards. (2) The ethics questions on the actual exam can be an exercise in minutia.

You will be much better off if you read our summaries of the Standards and the original Handbook.

Old Ethics Exam QuestionsPlease note that the Level 2 ethics questions from 2000 through 2003 are not available to the public, so

preparing for Level 2 ethics requires a complete and thorough reading of the Standards of Practice Handbook

in addition to the study of old exam questions.

In Book 1 of our Level 2 Study Notes we have taken all the old ethics essay questions from 1995 to 1999 and

revised them to conform to the item-set format by creating a “vignette” followed by a set of related multiple

choice questions. As I noted already, AIMRÒ has changed its policy on exam topic formats for 2004, and now

says “…any of the assigned topics may be tested in either format.” However, I think it’s likely that Level 2

ethics will continue to be tested in item-set format for 2004. Reviewing those old questions in item-set format

will help you prepare for the ethics portion of the 2004 exam.

Quantitative Methods – Study Session 3I’ve got good news, bad news, and extra good news for you. The good news is that two of the three topics in

the Level 2 quant material are repeats of material you encountered at Level 1: hypothesis testing and simple

linear regression (with only one independent variable). The bad news is that the new material on multiple

linear regression (with more than one independent variable) is the most important of the three.

The extra good news is that if you have a firm grasp of hypothesis testing and simple linear regression, you

can handle the multiple regression and anything you might see on the 2004 Level 2 exam. Hypothesis testing

will most likely be tested as part of multiple regression; you will be asked to test the statistical significance of

a regression parameter estimate. In addition, ALL of the important concepts in simple linear regression are

repeated in the context of multiple regression (e.g., testing regression parameters and calculating predicted

values of the dependent variable), and you’re most likely to see these tested as part of a multiple regression

question.

The following are the must know quant topics:

Conducting a hypothesis test of a population mean using a z-test or t-test.

Testing the statistical significance of regression parameter estimates.

Interpreting regression parameter estimates.

Calculating confidence intervals for regression parameter estimates.

Calculating predicted values for the dependent variable in a multiple regression.

Interpreting the F-statistic, R-squared, and adjusted R-squared in multiple regression.

Interpreting the data in an ANOVA table.

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In addition, make sure you are familiar with these concepts:

Conducting hypothesis tests of differences of means and mean differences.

Conducting hypothesis tests of variances and the equality of variances.

Identifying, testing for, and correcting for heteroskedasticity, serial correlation (the Durbin-Watson

statistic), and multicollinearity.

Quant has been tested exclusively in item set format since 2001, which means the most recent quant

questions that are publicly available come from the 2000 exam. AIMR® says quant will be 0 to 10 percent (0

to 36 points) on the 2004 exam. Expect two 6-question item sets that cover quant. However, don’t be

surprised if instead you see a quant question in essay form in the morning section, either as a stand-alone

question or as part of economics or equity valuation.

Economics: Study Session 4If you’re following our suggested Level 2 weekly study schedule, you’ve probably started working on the

economics material. According to AIMR®, economics will be zero to ten percent of the Level 2 exam (0 to 36

points). Historically, economics has been about ten percent of the exam, so I would expect to see 30 to 36

points this year. This material will be tested in either item set or essay format. In 2003 there were two

economics essay questions worth a total of 18 points, plus an unknown number of item sets and points in the

afternoon session.

Economics could be tested as part of a question that integrates economics with another topic area, such as

quantitative methods and asset valuation. Be prepared to apply the investment tools you learn in this section

to the analysis of equity, debt, and derivative securities.

Here are the concepts you must understand in order to be successful on this section of the exam:

Foreign exchange parity relations

There are three ways to forecast future expected spot rates: (1) using inflation rates and purchasing

power parity, (2) interest rates and the uncovered interest parity, and (3) forward rates and the

unbiased forward rate relationship. Know all three! Also make sure you can use interest rate parity to

calculate the no-arbitrage forward exchange rate. This topic also shows up in Study Session 16 on

pricing forward and futures contracts. Finally, you should be able to put these concepts together and

use the asset market approach to determine the short-and long-run effects on exchange rates of an

unexpected increase in the money supply. Parity conditions are the most popular Level 2 economics

topic; they were tested in 2003.

International asset pricing

This is a lengthy topic with lots of learning outcome statements, and several concepts are very

important. The first is the international capital asset pricing model (ICAPM). Understand the

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components of the model, including currency exposures and currency risk premiums, and be able to

calculate the expected return on a stock given a specific formulation of the ICAPM. You should also

be able to analyze the impact of currency risk on a company’s valuation (this topic was tested in

2003). Finally, don’t forget about calculating expected and realized domestic currency returns on

foreign bonds, given changes in exchange rates.

Analyzing the firm’s environment

This is an old favorite with links to other places in the curriculum. Predicting industry sales using

GDP as the independent variable is an application of regression analysis from quant in Study

Session 3. Analyzing company performance throughout the stages of the business cycle and

analyzing the product life cycle are also important topics in the equity valuation material in Study

Sessions 10 and 11.

Economic growth theory

You should be able to contrast the implications of the two theories of economic growth (the neo-

classical model and the endogenous growth theory), and discuss the factors that are likely to

promote economic growth. This material provides a nice link to the credit analysis of sovereign debt

in Study Session 14.

Economics Part 2

In last week’s tip I provided you with an overview of the most important topics in the Level 2 economics

material. This week we’ll focus on one of those topics: foreign exchange parity relations, including relative

purchasing power parity (PPP), uncovered interest rate parity, the international Fisher effect, foreign

exchange expectations relation, and covered interest rate parity.

PPP says that the expected spot rate in one year (defined as FC per unit of DC) is:

expected spot rate = current spot rate × (1 + inflation in FC)/(1 + inflation in DC)

One of the most confusing things about using relative PPP is deciding which inflation rate to put in the

numerator and which to put in the denominator. If you mix them up in a multiple choice question, your answer

will be wrong, but it will almost certainly be included among the choices.

The key is to pay attention to how the exchange rates are quoted. In the formula above, the spot rate is

quoted in FC per unit of DC, the FC inflation rate is in the numerator, and the DC inflation rate is in the

denominator. So whichever rate is on the top in the spot quote is also on the top in the inflation ratio. For

example, if the spot rate is quoted as USD/JPY, the U.S. inflation rate should be in the numerator and the

Japanese inflation rate should be in the denominator.

Uncovered interest rate parity says the expected spot rate in one year (defined as FC per unit of DC) is:

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expected spot rate = current spot rate × (1 + interest rate in FC)/(1 + interest rate in DC)

Covered interest rate parity says the no-arbitrage one-year forward rate (defined as FC per unit of DC) is:

forward rate = current spot rate ×(1 + interest rate in FC)/(1 + interest rate in DC)

Do the same thing for both uncovered and covered interest rate parity: if the spot rate is quoted as FC/DC,

put the FC interest rate in the numerator and the DC interest rate in the denominator. For example, if the spot

rate is quoted as CAD/AUD, put the Canadian interest rate in the numerator and the Australian interest rate in

the denominator.

My advice is to forget about DC and FC, and simply take the spot rate quote as given (e.g., EUR/CHF), and

use our simple rule to apply the appropriate formula (e.g., EUR on top and CHF on the bottom). If you’d like

some practice with this, take a look at question 3 from the 2003 Level 2 exam.

Financial Statement Analysis: Study Session 5-7This is the first of four emails regarding financial statement analysis and corporate finance. Level 2 is

sometimes called “the accounting level” because 25 to 35 percent of the exam will come from financial

statement analysis (and corporate finance, which is part of financial statement analysis at Level 2). Although

the majority of the material will probably appear in the afternoon session in item set format, don’t be surprised

if you see an essay accounting question in the morning session as well. In 2003 there was an 18 point

accounting question in the morning portion of the exam. This material has always been challenging for Level

2 candidates, but you face even more uncertainty this year because the financial statement analysis

curriculum has changed the most of any at Level 2 in 2004.

We’ll focus this week on the topics in Study Session 5. First let’s talk about what’s new in the study session.

The biggest change is the addition of readings that you first encountered last year at Level 1: inventories,

long-lived assets, income taxes, financing liabilities, and leases. However, the Level 2 learning outcome

statements (LOS) are significantly different from those at Level 1. The Level 2 LOS use command words, like

“compare and contrast,” “evaluate,” and “analyze,” that require a higher level of knowledge of the material.

Don’t simply assume you know this material because it’s a repeat of Level 1—you need to spend some time

studying it. Look for links with more traditional Level 2 topics. You’re likely to see this material tested as part

of a question that requires you to make adjustments to the financial statements (see “Analysis of Financial

Statements: A Synthesis” in Study Session 7.

Study Session 5 also includes a new reading on variable interest entities (VIE), which have been a hot topic

in financial markets because of the role they played in recent, well-publicized accounting scandals.

Don’t forget about the traditional accounting topics, however: intercorporate investments, business

combinations, and pension accounting. These three (along with currency translation, earnings quality, and

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financial statement adjustments) represent the heart and soul of the Level 2 accounting material, so expect to

see all three of them on the 2004 exam. You can’t be successful at Level 2 without knowing those topics

inside and out.

As you review this material, keep in mind that you are being tested on your skills as an analyst (a user of

financial statements), not an accountant (a financial statement preparer). Focus on how accounting choices

and methods affect the financial statements and ratios, and how the financials can be adjusted so that they

more accurately reflect economic reality.

Analysis of Intercorporate Investments

Make sure you know how the choice of the cost, equity, consolidation, or proportionate consolidation methods

affects the company’s financial statements and ratios. Remember that the equity method usually reports

better results than any of the other methods, so companies will often attempt to justify the equity method to

consolidate subsidiaries. Also pay attention to the similarities and differences between reportable segments

as defined by U.S. GAAP and business segments as defined by IASB GAAP.

Analysis of Business Combinations

There are three accounting methods to keep track of: (1) U.S. GAAP purchase, (2) IASB GAAP purchase,

and (3) IASB GAAP pooling. Focus your attention on the two variations of the purchase method. LOS 2.B.d

says “construct” consolidated financial statements using both the U.S. and IASB purchase methods, so your

emphasis here should be on constructing and analyzing the financial statements to account for business

combinations. Know how amortization of goodwill, restructuring cost provisions, and in-process purchased

R&D are treated under both methods, and the resulting difference in reported results.

Pension Accounting

This is a complicated topic, but don’t be intimidated! There are two key areas for you to master. The first is to

understand how reported results are affected by management’s assumptions regarding the discount rate, the

rate of compensation increase, the rate of return on plan assets, and the healthcare inflation rate. The second

is to be able to adjust the reported accounting results to reflect economic reality: calculate economic pension

expense and the underlying economic liability (or asset) based on footnote disclosures, and make the

appropriate adjustments to the balance sheet and income statement.

Currency Translation

You should know how the various financial statement items are translated and how to calculate the

translation gain or loss under the temporal and all-current methods. You should also know under what

circumstances each method is applied, and how the firm’s financial ratios are affected by the choice of

method. Take a close look at Question 4 from the 2003 exam (page 368 in Schweser’s Level 2 Study Notes)

for an example of how this material was tested last year. This is the only example of a Level 2 financial

statement analysis question from the last three years that is publicly available.

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Study Session 7

Study Session 7 is the third of five sessions devoted to financial statement analysis and corporate finance,

and one of the most important. Here is where all the accounting concepts from Level 2 are integrated. The

emphasis is on detecting misleading accounting methods, adjusting the firm’s financial statements to better

reflect economic reality, and determining the effect on the financial ratios and reported results. For example,

you might see a bond or equity valuation question in which you make adjustments to the financial statements

and use those adjusted statements to make an investment or valuation decision. Remember that financial

statement analysis (including corporate finance) represents 25 to 35 percent of the 2004 exam.

White et. al., Chapter 17

The analysis of financial statements, or synthesis material, is the important topic review in this session. Here

is where you put everything together by making the appropriate adjustments to the balance sheet and

computing normal operating earnings and comprehensive income, based on your analysis of management’s

choice of accounting methods and assumptions. Make sure you can determine and interpret the effects of

these choices on the reported financial results and ratios.

Schilit, Chapters 2, 3, 7, 8, and 12

The Financial Shenanigans book is new to the Level 2 curriculum for 2004. It’s a qualitative treatment of

earnings quality and a nice compliment to the “synthesis” material. According to AIMR: “Financial

Shenanigans identifies techniques that may be used to distort a company’s financial statements while

Chapter 17 provides methods for adjusting financial statements for perceived defects. Taken together, these

readings provide a useful framework for addressing these issues but are certainly not all inclusive.” That

means you should use Financial Shenanigans as a source of recent examples of accounting fraud and

management manipulation of the financial statements, and use Chapter 17 as the manual for how to make

the appropriate adjustments.

Reilly and Brown, Chapter 12

This topic review is your source for the calculation of most of the ratios that you will be analyzing. This

reading is a repeat from Level 1, so you’re probably already well on your way to memorizing the important

ratios: current ratio, debt/equity, asset turnover, interest coverage, return on equity, and profit margin, just to

name a few. Memorize the three- and five-part DuPont breakdown of return on equity, as well as the

sustainable growth rate formula, and be prepared to use them on the exam. The DuPont ratios are as close

to a sure thing as you’ll find on the Level 2 exam: they’ve shown up every year since 2000 (usually in the

equity section of the exam).

Corporate Finance: Study Session 8-9

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Corporate finance is part of financial statement analysis at Level 2. Financial statement analysis will account

for 25 to 35 percent of the exam, and most of that will come from the accounting material in Study Sessions 5

through 7. However, expect a few questions specifically devoted to corporate finance. Financial statement

analysis is usually tested in item-set format, but you might see an essay question on corporate finance in the

morning.

The corporate finance material in Study Sessions 8 and 9 is new to Level 2 in 2004. Study Session 9 includes

four new topic reviews on special topics in corporate finance: warrants and convertibles, mergers, corporate

control and governance, and “what we know and don’t know about finance.”

Study Session 9

The warrant and convertible bond assignment discusses these securities from the point of view of the issuer;

in Study Session 14, in the topic review on bonds with embedded options, we cover them from the point of

view of the investor. LOS 1.A.c is a link to the option valuation material in Study Session 17 because we can

adjust the Black-Scholes-Merton option pricing model to price warrants.

The mergers material is the most important topic review in corporate finance. Mergers have been part of the

Level 2 curriculum in the past, but this is a new and more complex treatment of the subject. Remember that

accounting for mergers and acquisitions is also addressed in Study Session 5. Here the emphasis is on how

value is created through mergers, how that value is distributed between bidder and target, and how mergers

are valued. Make sure you can estimate the net present value (NPV) and cost of a stock or cash merger. You

should also be able to critique the justifications for a merger proposed by management, including the

“bootstrap effect.”

Corporate control and governance is a new topic in the Level 2 curriculum, so don’t overlook it. In particular,

make sure you understand the differences between control and governance practices among the U.S.,

Germany, and Japan.

Study Session 8

Study Session 8 is a repeat of the Level 1 corporate finance material that you wrestled with last year. The

Level 2 learning outcomes statements (LOS) are almost identical to the Level 1 LOS, so there is no new

material in Study Session 8. I think the purpose of including this material at Level 2 this year is to remind you

of the important corporate finance topics that show up in valuation and analysis:

Calculate cost of equity and project required return with the capital asset pricing model (CAPM).

Calculate the weighted average cost of capital (WACC).

Estimate beta with the pure-play and accounting beta methods.

Calculate and analyze the effects of operating and financial leverage.

Discuss the major capital structure and dividend policy theories.

Discuss how managers use changes in dividend policy to signal earnings forecasts.

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Equity Investments: Study Session 11-13This week is the first of four email tips regarding equity investments, which is the subject of four study

sessions. Equity investments is one of the most important topics at Level 2 (along with financial statement

analysis). It’s part of the general topic of “asset valuation,” which also includes debt and derivatives. AIMR®

says that asset valuation in total will represent 35 to 45 percent of the Level 2 exam. Historically, equity

valuation has made up about 20 percent (or 72 points). It’s usually tested in essay format in the morning

section, but don’t be surprised if you see a six-question item set on equity valuation in the afternoon session

as well.

Take a look at the old essay equity exam questions to see how this material has been tested in the past.

Typically, the morning session includes a multi-question “case” on the various equity topics that focuses on

one company. For example, in 2003, Questions 5 through 10 in the morning session were all equity questions

involving “Rio National Corp” and were worth a total of 72 points.

Spend this week on Study Sessions 10 and 11, which are more qualitative treatments of the topic. Many of

the topic reviews are new for 2004. The only topic reviews remaining from last year include those concerning

the foreword to and the review of equity valuation, the review on competitive strategy, and the review on

industry analysis.

Porter, Chapter 1

The most important of these is the Porter material, which has been tested just about every year. Although it

appears that AIMR takes a year off from this topic review once in a while, you need to be prepared to see it

and deal with it this year. Old exam questions are the best way to study for Porter questions, so take a look at

Question 8 from 2003 (page 321 in Book 4 of Schweser’s Level 2 Study Notes), Question 2 from 2002 (page

332), and Question 6 from 2001 (page 348). Memorize Porter’s five forces and the generic competitive

strategies. Also make sure you can analyze a company’s competitive advantage and the risks of its chosen

competitive strategy.

Hooke, Chapter 6

The Hooke topic review has a number of links to the economics material in Study Session 4, so be prepared

for an exam question that asks you to analyze an industry using the concepts found in both equity and

economics. Industry life cycles and the effect on industries of business cycles are also important.

New Topic Reviews

There are also six new equity topic reviews in Study Sessions 10 and 11. Because these are new, it’s more

difficult to know exactly what might be important on the exam, but here are some areas that you definitely

shouldn’t ignore:

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Calculate alpha and link the concept of alpha to the use of the security market line (SML) in

identifying undervalued assets in Study Session 18.

Conduct global industry analysis and global financial analysis (i.e., DuPont analysis). This is a very

broad topic that really encompasses all of financial statement analysis and equity valuation.

Estimating cost of capital for non-U.S.-based companies, including those in emerging markets,

which is a link to Study Session 12 and the material on the international CAPM in Study Session 4.

Study Session 12

This week we’re going to move on to Study Session 12, which covers dividend discount and free cash flow

valuation models. This is very important Level 2 material, since the application of equity valuation models is

on the Level 2 exam every year, and the two most important and useful valuation models are the dividend

discount and free cash flow models. Spend plenty of time on these models, and make sure you know them

inside and out on exam day. The trend on the exam in recent years is to pack more content into fewer exam

points: a dividend discount question that might have been worth ten points a few years ago is now worth six.

That means you must be able to do these questions quickly and accurately without a lot of wasted time and

effort.

This material has historically been tested in essay format in the morning section, so make sure you review the

old exam questions from recent years to get an idea of how AIMR® writes equity valuation questions. On

pages 309-310 in Book 4 of Schweser’s Level 2 Study Notes you’ll find a table that identifies in what year

major equity topic areas have been tested in recent years. Dividend discount and free cash flow models have

each appeared every year since 2000.

The “must-know” topics from Study Session 12 are:

Know the advantages and disadvantages of each type of model, and determine under what

circumstances each is appropriate.

Use the capital asset pricing model (CAPM) and arbitrage pricing theory (APT) to estimate the

required rate of return on an equity investment.

Calculate the value of a stock using the Gordon growth model, the two-stage dividend discount

model, and the H-model.

Calculate the present value of growth opportunities (PVGO).

Calculate the sustainable growth rate using the DuPont model.

Calculate free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) given the firm’s

financial statements.

Calculate the value of a company using a single-stage or two-stage FCFF and FCFE model.

However, because of the high allocation of points usually given to the topics in this study session, be

prepared for just about any of the learning outcome statements to be tested. There will be a few surprises!

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Study Session 13

The focus in Study Session 13 is on alternatives to the more popular dividend discount and free cash flow

models, including price multiple, residual income, and economic value added (EVA®) models. Don’t be

surprised if you see one or more of these alternative models on the 2004 exam, in addition to the old

favorites. Also, don’t forget that equity is usually tested in essay format in the morning section. However, you

shouldn’t be surprised if you see a six-question item set on equity valuation in the afternoon session as well.

Price multiple models are probably the most important of the three types in this study session. They have

been tested in the morning section of the exam in three of the last four years. The key to understanding these

models is to remember that the justified price multiples are derived from some other type of valuation model,

so it is actually just another, perhaps more intuitive, way to identify under- and overvalued assets. For

example, the justified price-to-earnings (P/E) multiple is derived by rearranging the Gordon growth model and

solving for P/E. Focus most of your attention on the P/E ratio, the price-to-book (P/B) ratio, and the price-to-

cash flow (P/CF) ratio. Make sure you can do each of the following:

Calculate each multiple and the justified value of each multiple.

Calculate underlying and normalized earnings as inputs to the P/E ratio.

Evaluate a stock by the method of comparables using each multiple. To do this, you need to know

the fundamental factors that affect each multiple.

Residual income models were new to the curriculum last year, but they are really just a new and improved

version of the more traditional EVA® models. Residual income models did not show up in the morning section

of the 2003 exam, so be prepared to see them this year. Specifically, you should know how to:

Calculate the intrinsic value of a stock with a multi-stage residual income model using an estimate of

continuing residual income.

Identify situations in which the residual income model is more appropriate than dividend discount,

free cash flow, or market multiple models.

EVA® and market value added (MVA) models have been in the curriculum for a number of years, but have

not been tested in the morning session since 2001. You should know how to calculate EVA® and MVA given

the basic inputs, but don’t spend your valuable study time trying to memorize the long version of EVA®. Also

remember that, according to the empirical evidence, EVA® and MVA are not particularly effective tools for

stock selection, which means they’re of limited value in equity analysis.

Debt Investments: Study Session 14-15The debt valuation material on the Level 2 exam is perhaps the most difficult section to prepare for. Although

there are 2 study sessions, 8 readings, and 83 learning outcome statements (LOS), debt has historically

constituted about 10 percent of the exam, or 36 minutes. That means your study strategy for debt is to make

sure you know the important material, but don't spend so much time on the fine details that you waste

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valuable study time better spent on other topics with higher "exam weight to LOS count" ratios, such as

portfolio management.

Study Session 14

Here's an overview of the "must-know" topics in Study Session 14 on debt valuation. (Next week’s tip will

cover Study Session 15.) If you're prepared for these topics, you should do reasonably well on the debt

section. Be prepared, however, to expect some surprises from the more obscure material.

Have a basic understanding of the unique issues that are important in each type of credit analysis:

corporate bonds (both investment-grade and high-yield bonds), asset-backed securities, municipal

bonds, and sovereign debt. On the 2003 exam, the topic was sovereign debt; in 2002, it was the

credit analysis of high-yield issuers. Asset-backed securities, and the pertinent credit issues, are

also treated extensively in Study Session 15.

Compute the ratios that are most useful in analyzing credit risk.

Calculate effective duration and convexity, and use those measures to estimate the percentage

change in the price of a bond for a given change in yield.

Understand key rate duration, which is an extension of traditional effective duration. It has shown up

regularly on the Level 2 exam in recent years, so make sure you know how to apply it to the analysis

of yield curve risk of fixed-income securities and portfolios.

Calculate the values of callable and puttable bonds using the binomial model.

Interpret an option-adjusted spread (OAS).

Analyze the risk-return characteristics of convertible bonds.

Remember: 83 Debt LOS (total for both study sessions) will be covered in approximately 36 minutes. Know

the most important debt concepts, but don't get lost in the details and neglect the other sections of the exam.

Review the old debt exam questions to get a sense of how this material has been tested in the past.

Study Session 15

The focus of Study Session 15 is structured securities, particularly mortgage-backed securities (MBS) and

asset-backed securities (ABS). Take a look at the old debt exam questions to get a sense of which topics

AIMR® likes to test, and how it likes to test them.

The first two topic reviews on mortgage-MBS and ABS are difficult, time-consuming reading, even though

several learning outcome statements (LOS) from 2003 have been removed. Use your study time wisely by

concentrating on the risk-return characteristics of the various types of MBS and ABS. In particular, focus on

the level of prepayment risk (both extension and contraction risk) inherent in each and be able to identify the

factors that affect the level of prepayment on the underlying securities.

Remember that for this exam, you are an analyst, not an investment banker, so you need to understand how

these securities react to changes in yields and prepayment speeds. You won't be designing complex CMO

structures, however. For example, PAC I tranches have less prepayment risk (both contraction and extension

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risk) than the support tranches, while high-quality home-equity ABS have more prepayment risk than

automobile receivable-backed ABS. Also, remember that principal-only strip (PO) prices are negatively

related to yields, while interest-only strip (IO) prices are positively related to yield changes over a certain

range.

In the topic review on valuing MBS and ABS, know how to interpret the option-adjusted spread (OAS), and

how to apply it to identify rich and cheap securities. You should also be able to identify which type of spread

should be used to value any specific fixed income security and why (e.g., OAS from a Monte Carlo simulation

model for MBS).

The last topic review is a brief treatment of commercial MBS and the difference between these securities and

the more traditional MBS that are backed by retail home mortgages. Don’t overlook this material, because it

might form the basis of a three or four point question to supplement a more traditional question on retail MBS.

Finally, remember what I said last week about debt: 83 debt LOS will be covered in approximately 36

minutes. Know the most important debt concepts, but don't get lost in the details and neglect the other

sections of the exam.

Derivatives: Study Session 16-17For the next two weeks, the topic is DERIVATIVES, which is a word that strikes fear into the heart of many a

Level 2 candidate. Although I wish I had some comforting words of wisdom for you, the fact is that with a new

derivatives textbook in the Level 2 curriculum, this already difficult material is probably going to be even more

challenging in 2004. Not only has the textbook changed, but so has the treatment of the topic. It used to be

true that if you knew how to do payoff diagrams, use the cost-of-carry model, and diagram swap cash flows,

you could sneak through derivatives without significantly damaging your chances of passing.

That’s no longer the case. The emphasis now is on pricing and valuing forwards, futures, options, and

swaps. Although option valuation models are not new to Level 2, valuing forwards, futures and swaps is new

material that can be challenging and time-consuming to master. Pricing a derivative contract means

determining the forward price, for example, that makes the contract value to both parties equal to zero at the

initiation of the contract. It’s sometimes called the “no-arbitrage” price, and we can calculate the no-arbitrage

forward and futures price using the traditional cost-of-carry model that you probably remember from Level 1.

However, once a contract is initiated and the market price of the underlying asset changes, one side gains

and the other side loses. In other words, the value of the contract is positive to one party and negative to the

other. Calculating the value of forward and swaps contracts to each side after the contract is initiated is a little

tricky. Futures contracts that are marked-to-market everyday, however, are basically repriced so that the

value is zero to both sides at the beginning of the trading day. Over-the-counter forwards and swaps,

however, are not typically marked-to-market.

13


Study Session 16

Study Session 16 covers forward and futures contracts. Here are the “must-know” topics:

Calculate the price and value of a forward contract on a fixed-income security and a currency, as

well as the price and value of a forward-rate agreement (FRA). Pricing currency forward contracts

using “interest rate parity” was also covered in Study Session 4.

Explain how to conduct futures arbitrage.

Price Treasury bill futures, Treasury bond futures, stock index futures, and currency futures.

Derivatives will most likely be tested in essay format in the morning section of the 2004 exam. Historically,

derivatives has accounted for about 10 percent (36 points) of the Level 2 exam. However, in 2003, there were

only 18 points in the morning essay section, so be prepared for a derivatives item set.

One note of warning: Over the past few weeks, I’ve encouraged you to look at the old equity and debt exam

questions to help you prepare for 2004. That advice is not as useful for derivatives, because although there

are old questions available, they are less relevant now because of the changes in the derivatives curriculum.

Study Session 17

Last week we focused our attention on forward and futures derivative contracts. This week we’re going to

move on to options and swaps, which are the topics of Study Session 17. As we discussed last week, the

emphasis in the new Level 2 derivatives curriculum is on pricing and valuation of options and swaps. Option

pricing and valuation has always been a part of the Level 2 curriculum, as has swap contracts pricing, but

valuing swap contracts is new.

You may have to go back and review some of the Level 1 options material before you begin your study of

Level 2 derivatives. I suggest that, rather than pulling out your 2003 Level 1 materials, which are less relevant

because of the change in the derivatives text, you should read the “Review of Options Basics” starting on

page 269 in Book 5 of Schweser’s Level 2 Study Notes.

There are quite a few learning outcome statements in this study session, but here’s where you want to focus

your attention:

Calculate the payoff to an interest rate cap and floor.

Understand the distinction between options on interest rates and options on fixed income securities.

Interpret the payoff and profit diagrams of caps and floors when combined with long and short

positions in fixed-income securities.

Calculate the value of an option on assets (stocks and bonds) and interest rates (caps and floors)

using the binomial model.

Calculate the value of an option on a stock or equity index using the Black-Scholes-Merton model,

including those that pay a continuous dividend yield.

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Explain and interpret the option Greeks (delta, gamma, vega, rho, and theta).

Explain how swaps are equivalent to portfolios of other securities, including fixed-income securities

and forward rate agreements (FRAs).

Calculate the fixed rate on a plain-vanilla (interest rate and currency) swap.

Calculate the market value of a plain-vanilla (interest rate and currency) swap prior to expiration.

The material on structured notes hasn't been tested since 2000, so it may be time for AIMR® to revisit it.

Look at Question 19 from the 2000 exam, on page 400 in Book 5 of Schweser’s Level 2 Study Notes.

Portfolio Management – Study Session 18The portfolio management material on the Level 2 exam represents an opportunity to gain some ground and

boost your confidence on exam day. Much of this material is a review from Level 1, so you should be able to

get back up to speed quickly and earn most of the points on this section of the exam.

Historically, portfolio management has been tested in essay format in the morning section of the exam, but for

2004 be prepared for it to show up in essay and/or item set format. Take the time to review the old portfolio

management essay questions and our professor’s commentary in Book 2, page 220, of the Level 2 Schweser

Study Notes. This is one area of the exam where most (if not all) of recent exam questions are publicly

available, so you can expect fewer unpleasant surprises on exam day.

Portfolio management has the highest ratio of exam weight to number of Learning Outcome Statements of

any topic in the Level 2 curriculum, so each and every LOS is a candidate for testing. On past exams,

portfolio management has been about 10 percent and 36 points, although AIMR says it could be anywhere

from 5 to 15 percent (or 18 to 54 points). Here’s the absolute must-know material:

Identify measures of risk and explain when each is useful.

Calculate portfolio expected return and variance.

Calculate and interpret correlation.

Describe the efficient frontier.

Explain the process of selecting the optimal risky portfolio with no risk-free asset (Markowitz Portfolio

Theory).

Know the difference between systematic and unsystematic risk.

Know the difference between the CML and the SML.

Calculate and interpret beta.

Use the SML to identify over- and under-valued stocks.

Explain benchmark error and Roll’s critique of the CAPM.

Discuss the portfolio objectives and constraints for individual and institutional investors.

Identify the steps in the asset allocation process (including the effect of taxes).

15


The last time AIMR® asked Level 2 candidates to calculate the expected return and standard deviation of a

two-asset portfolio was Question 8 of the 2001 exam (morning session). This problem does pop up from time

to time, and if you are expecting it, you can quickly answer it and move on to the more complicated questions.

Here’s a practice problem to sharpen your skills. You should be able to do this problem in eight minutes on

exam day. Don’t peek at the answer until you’ve given it your best effort.

Review & Catch-upThis week I’d like you to start thinking about how the various topics in the Level 2 curriculum are related to

each other. One big difference you’ll notice from Level 1 is that at Level 2, the topics are sometimes tested

together in the same question (e.g., economics and quantitative methods). In order to be successful at Level

2 you have to see the links in the curriculum and anticipate how various topics might be integrated and tested

together.

For example, linear regression (a quant topic) is an analysis tool that can be applied in both economics and

portfolio management. Regression is used to predict company or industry sales (the dependent, or y,

variable) with gross domestic product (GDP) as the independent, or x, variable. It is relatively easy to extend

that to a multiple regression model by adding other independent variables that also explain industry sales to

the model.

Question #4 from the 2000 exam (page 291 in Book 1 of our Study Notes), Question #23 from 1998 (page

295 in Book 1), and Question #6 from 1997 (page 298 in Book 1) are examples of how multiple regression

and economics have been integrated and tested together on the Level 2 exam. For example, Question #23

from 1998 uses a regression model with sales of a particular prescription drug as the dependent variable and

the population of U.S. women over age 60, average income of U.S. women over age 60, and advertising

dollars spent on the drug as the independent variables.

Linear regression models also show up in the application of asset pricing models like the CAPM, the

international CAPM (ICAPM), and the arbitrage pricing theory (APT). In fact, asset pricing models are also

integrated across topics: they appear in both economics and portfolio management.

A multifactor pricing model like the ICAPM, in its empirical formulation, is a multiple regression model with

expected return as the dependent variable and equity and foreign currency risk premiums as the independent

variables. The betas, or sensitivity factors, are the slope coefficients. LOS 3.j in Study Session #4 is simply an

application of LOS 1.C.f from Study Session #3: predicting the dependent variable (expected return) given the

regression model (the ICAPM) and assumed values for the independent variables (the risk premiums).

The lesson today is to look for links in the curriculum! Finding them and using them to integrate the material

“shrinks” the Level 2 curriculum from a mass of seemingly unrelated learning outcome statements to a

coherent treatment of financial analysis, and helps you use your limited study time most efficiently.

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Sample QuestionNorman Johnson has a portfolio consisting of two diversified equity mutual funds. Data on each fund is

presented in the table.

InvestmentExpected Annual

Return

Expected

Standard

Deviation of

Annual Returns

Panther Fund $1,200,000 18% 32%

Patriots Fund $800,000 12% 24%

The expected correlation between returns on the two funds is 0.25.

Calculate the expected annual return on the portfolio.

Calculate the expected covariance between the returns of the two funds.

Calculate the expected standard deviation of the portfolio.

Johnson prefers a portfolio with an expected return of 17 percent. Determine the trade necessary to

achieve this result. Assume Johnson continues to only invest in some combination of Panther and

Patriots.

Answer

Weight on Panther Fund = $1,200,000 / ($1,200,000 + $800,000) = 0.60.

Weight on Patriots Fund = $800,000 / ($1,200,000 + $800,000) = 0.40.

Expected portfolio return = (0.6)(18%) + (0.4)(12%) = 15.6%.

Expected covariance = (0.25)(32)(24) = 192.0.

Portfolio standard deviation = [(0.62)(322) + (0.42)(242) + (2)(0.60)(0.40)(192.0)]0.5 = 23.5%.

(New weight on Panther)(18%) + (1 – new weight on Panther)(12%)

= 17%.

Solve for new weight on Panther = 0.8333 = 83.33%.

New weight on Patriots = 1 – 0.8333 = 0.1667 = 16.67%.

New investment in Panther = (0.8333)($2,000,000) = $1,666,600.

New investment in Patriots = (0.1667)($2,000,000) = $333,400.

The trade required is to sell $466,600 of Patriots ($800,000 – $333,400) and purchase $466,600 of Panther

($1,666,600 – $1,200,000).

The portfolio management material is not necessarily easier than other parts of the Level 2 curriculum, but it

is more predictable. There are few surprises because AIMR has to squeeze up to 54 points out of 26 LOS,

17


almost all of the old exam questions are publicly available, and most of the material is a repeat from Level 1.

Your goal on this section is to get all the points!

Sample QuestionAs we said last week, you should expect to see a dividend discount model on the exam. Here’s another

example of a two-stage DDM to help you sharpen your skills. Try working through the problem before you

peek at the answer. Use this as an opportunity to test yourself. You should be able to answer this question in

eight minutes.

Question

Arnie Weston, CFA, is analyzing MicroImages, Inc. The company recently paid an annual dividend of $1.35

per share. Over the next three years, Weston expects MicroImages to grow at a rate of 25 percent per year.

After year 3, he forecasts a long-term growth rate of 3 percent. Weston also estimates the firm’s beta to be

1.5. The risk-free rate is 4 percent and the market risk premium is 8 percent. What is the value of MicroImage

shares today?

Answer

First we have to compute the required return:

Required return = 4% + (8% × 1.5) = 16%

Next, we have to forecast the dividends over the next three years:

Dividend in year 1 = $1.35 × 1.25 = $1.69

Dividend in year 2 = $1.69 × 1.25 = $2.11

Dividend in year 3 = $2.11 × 1.25 = $2.64

Next, we forecast the terminal value using the constant growth DDM:

Dividend in year 4 = $2.64 × 1.03 = $2.72

Terminal value in year 3 = $2.72 / (0.16 – 0.03) = $20.92

Finally, we calculate the present value today of the dividends in years 1 through 3 at 16 percent, plus the

terminal value in year 3:

PV = ($1.69 / 1.16) + ($2.11 / 1.162) + [($2.64 + $20.92) / 1.163)] = $18.12

Time-saving exam hint: To save time on the exam, use the CF (cash flow) function on your Texas

Instruments BAII Plus to solve this type of multistage equity valuation question. Using the cash flow

worksheet (the CF button on your TI BAII Plus), enter $0.00 as the cash flow in time 0 (CF0 = $0.00), $1.69

as the cash flow in time 1 (C01 = $1.69), $2.11 as the cash flow in time 2 (CF2 = $2.11), and $2.64 + $20.92

= $23.56 as the cash flow in year 3 (CF3 = $23.56). Then go into the NPV worksheet (the NPV button), and

18


enter 16 percent as the discount rate (I = 16), hit the down arrow, and compute NPV (CPT). You should get

$18.12 for an answer.

Every minute counts on exam day! Use your time wisely.

For more information on how to use the cash flow function on your calculator, please download our free

calculator help files, which are available in the download section of our website, or can be directly accessed

by the links below.

TI BA II Plus Help File (PDF)

HP 12C Help File (PDF)

19

http://www.schweser.com/downloads/hp12c_help.pdf

http://www.schweser.com/downloads/ti_ba2_plus_help.pdf

http://www.schweser.com/downloads/downloads.php

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