CFA 2012 Study Notes - Level 1 :
How to Pass the CFA exams After Studying for Two Weeks Without Anxiety
T. SMITH
Copyright 2012 By T.SMITH
Smashwords Edition
The author successfully passed the CFA (Chartered Financial Analyst), CPA (Certified Public Accountant), and FRM (Financial Risk Manager) exams "WITHOUT ANY RETAKES".
Based on a true experience, the author also wrote how to pass the CFA exams after studying for two weeks.
These materials may not be copied without written permission from the author. The unauthorized duplication of these notes is a violation of global copyright laws and the CFA Institute Code of Ethics.
Required CFA Institute disclaimer: “CFA and Chartered Financial Analyst are trademarks owned by CFA Institute. CFA Institute (formerly the Association for Investment Management and Research) does not endorse, promote, review, or warrant the accuracy of the products or services.
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reading 1: Code of Ethics and Standards of Professional Conduct
a. describe the structure of the CFA Institute Professional Conduct Program and the process for the enforcement of the Code and Standards;
b. state the six components of the Code of Ethics and the seven Standards of Professional Conduct;
c. explain the ethical responsibilities required by the Code and Standards, including the multiple sub-sections of each Standard.
reading
2: Guidance for Standards I–VII
a. demonstrate and explain the application of the Code of Ethics and Standards of Professional Conduct to situations involving issues of professional integrity;
b. distinguish between conduct that conforms to the Code and Standards and conduct that violates the Code and Standards;
c. recommend practices and procedures designed to prevent violations of the Code of Ethics and Standards of Professional Conduct.
reading
3: Introduction to the Global Investment Performance Standards (GIPS)
a. explain why the GIPS standards were created, what parties the GIPS standards apply to, and who is served by the standards;
b. explain the construction and purpose of composites in performance reporting;
c. explain the requirements for verification.
reading
4: Global Investment Performance Standards (GIPS)
a. describe the key features of the GIPS standards and the fundamentals of compliance;
b. describe the scope of the GIPS standards with respect to an investment firm’s definition and historical performance record;
c. explain how the GIPS standards are implemented in countries with existing standards for performance reporting and describe the appropriate response when the GIPS standards and local regulations conflict;
d. describe the nine major sections of the GIPS standards.
reading
5 The Time Value of Money
reading 5: The Time Value of Money
a. interpret interest rates as required rates of return, discount rates, or opportunity costs;
b. explain an interest rate as the sum of a real risk-free rate, expected inflation, and premiums that compensate investors for distinct types of risk;
c. calculate and interpret the effective annual rate, given the stated annual interest rate and the frequency of compounding;
d. solve time value of money problems for different frequencies of compounding;
e. calculate and interpret the future value (FV) and present value (PV) of a single sum of money, an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows;
f. demonstrate the use of a time line in modeling and solving time value of money problems.
reading
6: Discounted Cash Flow Applications
a. calculate and interpret the net present value (NPV) and the internal rate of return (IRR) of an investment;
b. contrast the NPV rule to the IRR rule, and identify problems associated with the IRR rule;
c. calculate and interpret a holding period return (total return);
d. calculate, interpret, and distinguish between the money-weighted and timeweighted rates of return of a portfolio, and evaluate the performance of portfolios based on these measures;
e. calculate and interpret the bank discount yield, holding period yield, effective annual yield, and money market yield for a U.
S. Treasury bill;
f. convert among holding period yields, money market yields, effective annual yields, and bond equivalent yields.
reading
7: Statistical Concepts and Market Returns
a. distinguish between descriptive statistics and inferential statistics, between a population and a sample, and among the types of measurement scales;
b. define a parameter, a sample statistic, and a frequency distribution;
c. calculate and interpret relative frequencies and cumulative relative frequencies, given a frequency distribution;
d. describe the properties of a data set presented as a histogram or a frequency polygon;
e. calculate and interpret measures of central tendency, including the population mean, sample mean, arithmetic mean, weighted average or mean (including a portfolio return viewed as a weighted mean), geometric mean, harmonic mean, median, and mode;
f. calculate and interpret quartiles, quintiles, deciles, and percentiles;
g. calculate and interpret 1) a range and a mean absolute deviation and 2) the variance and standard deviation of a population and of a sample;
h. calculate and interpret the proportion of observations falling within a specified number of standard deviations of the mean using Chebyshev’s inequality;
i. calculate and interpret the coefficient of variation and the Sharpe ratio;
j. explain skewness and the meaning of a positively or negatively skewed return distribution;
k. describe the relative locations of the mean, median, and mode for a unimodal, nonsymmetrical distribution;
l. explain measures of sample skewness and kurtosis;
m. explain the use of arithmetic and geometric means when analyzing investment returns.
reading
8: Probability Concepts
a. define a random variable, an outcome, an event, mutually exclusive events, and exhaustive events;
b. explain the two defining properties of probability and distinguish among empirical, subjective, and a priori probabilities;
c. state the probability of an event in terms of odds for and against the event;
d. distinguish between unconditional and conditional probabilities;
e. explain the multiplication, addition, and total probability rules;
f. calculate and interpret 1) the joint probability of two events, 2) the probability that at least one of two events will occur, given the probability of each and the joint probability of the two events, and 3) a joint probability of any number of independent events;
g. distinguish between dependent and independent events;
h. calculate and interpret an unconditional probability using the total probability rule;
i. explain the use of conditional expectation in investment applications;
j. explain the use of a tree diagram to represent an investment problem;
k. calculate and interpret covariance and correlation;
l. calculate and interpret the expected value, variance, and standard deviation of a random variable and of returns on a portfolio;
m. calculate and interpret covariance given a joint probability function;
n. calculate and interpret an updated probability using Bayes’ formula;
o. identify the most appropriate method to solve a particular counting problem, and solve counting problems using the factorial, combination, and permutation notations.
reading 9 Common Probability Distributions
a. define a probability distribution and distinguish between discrete and continuous random variables and their probability functions;
b. describe the set of possible outcomes of a specified discrete random variable;
c. interpret a cumulative distribution function;
d. calculate and interpret probabilities for a random variable, given its cumulative distribution function;
e. define a discrete uniform random variable, a Bernoulli random variable, and a binomial random variable;
f. calculate and interpret probabilities given the discrete uniform and the binomial distribution functions;
g. construct a binomial tree to describe stock price movement;
h. calculate and interpret tracking error;
i. define the continuous uniform distribution and calculate and interpret probabilities, given a continuous uniform distribution;
j. explain the key properties of the normal distribution;
k. distinguish between a univariate and a multivariate distribution, and explain the role of correlation in the multivariate normal distribution;
l. determine the probability that a normally distributed random variable lies inside a given interval;
m. define the standard normal distribution, explain how to standardize a random variable, and calculate and interpret probabilities using the standard normal distribution;
n. define shortfall risk, calculate the safety-first ratio, and select an optimal portfolio using Roy’s safety-first criterion;
o. explain the relationship between normal and lognormal distributions and why the lognormal distribution is used to model asset prices;
p. distinguish between discretely and continuously compounded rates of return, and calculate and interpret a continuously compounded rate of return, given a specific holding period return;
q. explain Monte Carlo simulation and describe its major applications and limitations;
r. compare Monte Carlo simulation and historical simulation.
reading
10: Sampling and Estimation
a. define simple random sampling and a sampling distribution;
b. explain sampling error;
c. distinguish between simple random and stratified random sampling;
d. distinguish between time-series and cross-sectional data;
e. explain the central limit theorem and its importance;
f. calculate and interpret the standard error of the sample mean;
g. identify and describe desirable properties of an estimator;
h. distinguish between a point estimate and a confidence interval estimate of a population parameter;
i. describe the properties of Student’s t-distribution and calculate and interpret its degrees of freedom;
j. calculate and interpret a confidence interval for a population mean, given a normal distribution with 1) a known population variance, 2) an unknown population variance, or 3) an unknown variance and a large sample size;
k. describe the issues regarding selection of the appropriate sample size, datamining bias, sample selection bias, survivorship bias, look-ahead bias, and time-period bias.
reading
11: Hypothesis Testing
a. define a hypothesis, describe the steps of hypothesis testing, describe and interpret the choice of the null and alternative hypotheses, and distinguish between one-tailed and two-tailed tests of hypotheses;
b. explain a test statistic, Type I and Type II errors, a significance level, and how significance levels are used in hypothesis testing;
c. explain a decision rule, the power of a test, and the relation between confidence intervals and hypothesis tests;
d. distinguish between a statistical result and an economically meaningful result;
e. explain and interpret the p-value as it relates to hypothesis testing;
f. identify the appropriate test statistic and interpret the results for a hypothesis test concerning the population mean of both large and small samples when the population is normally or approximately distributed and the variance is 1) known or 2) unknown;
g. identify the appropriate test statistic and interpret the results for a hypothesis test concerning the equality of the population means of two at least approximately normally distributed populations, based on independent random samples with 1) equal or 2) unequal assumed variances;
h. identify the appropriate test statistic and interpret the results for a hypothesis test concerning the mean difference of two normally distributed populations;
i. identify the appropriate test statistic and interpret the results for a hypothesis test concerning 1) the variance of a normally distributed population, and 2) the equality of the variances of two normally distributed populations based on two independent random samples;
j. distinguish between parametric and nonparametric tests and describe the situations in which the use of nonparametric tests may be appropriate.
reading
12: Technical Analysis
a. explain the principles of technical analysis, its applications, and its underlying assumptions;
b. describe the construction of and interpret different types of technical analysis charts;
c. demonstrate the uses of trend, support, and resistance lines, and change in polarity;
d. identify and interpret common chart patterns;
e. describe common technical analysis indicators: price-based, momentum oscillators, sentiment, and flow of funds;
f. explain the use of cycles by technical analysts;
g. describe the key tenets of Elliott Wave Theory and the importance of Fibonacci numbers;
h. describe intermarket analysis as it relates to technical analysis and asset allocation.
reading 13: Demand and Supply Analysis: Introduction
a. distinguish among types of markets;
b. explain the principles of demand and supply;
c. describe causes of shifts in and movements along demand and supply curves;
d. describe the process of aggregating demand and supply curves, including the concept of equilibrium and mechanisms by which markets achieve equilibrium;
e. distinguish between stable and unstable equilibria and identify instances of such equilibria;
f. calculate and interpret individual and aggregate inverse demand and supply functions and individual and aggregate demand and supply curves;
g. calculate and interpret the amount of excess demand or excess supply associated with a non-equilibrium price;
h. describe the types of auctions and calculate the winning price(s) of an auction;
i. analyze the causes of a demand or supply imbalance that affects a good or service;
j. describe the impact of government regulation and intervention on demand and supply;
k. forecast the effect of the introduction and removal of a market interference (e.g., a price floor or ceiling) on price and quantity;
l. calculate and interpret consumer surplus, producer surplus, and total surplus;
m. calculate and interpret price, income, and cross-price elasticities of demand, including factors that affect each measure.
reading 14: Demand and Supply Analysis: Consumer Demand
a. describe consumer choice theory and utility theory;
b. describe the use of indifference curves, opportunity sets, and budget constraints in decision making;
c. calculate and interpret a budget constraint;
d. determine a consumer’s equilibrium bundle of goods based on utility analysis;
e. compare substitution and income effects;
f. distinguish between normal goods and inferior goods, and explain Giffen goods and Veblen goods in this context.
reading
15: Demand and Supply Analysis: The Firm
a. calculate, interpret, and compare accounting profit, economic profit, normal profit, and economic rent;
b. calculate and interpret total, average, and marginal revenue;
c. describe the firm’s factors of production;
d. calculate and interpret total, average, marginal, fixed, and variable costs;
e. describe breakeven and shutdown points of production;
f. explain how economies of scale and diseconomies of scale affect costs;
g. describe approaches to determining the profit-maximizing level of output;
h. distinguish between short-run and long-run profit maximization;
i. distinguish among decreasing-cost, constant-cost, and increasing-cost industries and describe the long-run supply of each;
j. calculate and interpret total, marginal, and average product of labor;
k. describe the phenomenon of diminishing marginal returns and calculate and interpret the profit-maximizing utilization level of an input;
l. describe the optimal combination of resources that minimizes cost.
reading
16: The Firm and Market Structures
a. describe the characteristics of different market structures: perfect competition, monopolistic competition, oligopoly, and pure monopoly;
b. explain the relationships between price, marginal revenue, marginal cost, economic profit, and the elasticity of demand under each market structure;
c. describe the firm’s supply function under each market structure;
d. describe and determine the profit-maximizing price and output for firms under each market structure;
e. explain the effects of demand changes, entry and exit of firms, and other factors on long-run equilibrium under each market structure;
f. describe the use and limitations of concentration measures in identifying market structure;
g. identify the type of market structure within which a firm is operating.
reading
reading 17: Aggregate Output, Prices, and Economic Growth
a. calculate and explain gross domestic product (GDP) using expenditure and income approaches;
b. compare the sum-of-value-added and value-of-final-output methods of calculating GDP;
c. compare nominal and real GDP and calculate and interpret the GDP deflator;
d. compare GDP, national income, personal income, and personal disposable income;
e. explain the fundamental relationship among saving, investment, the fiscal balance, and the trade balance;
f. explain the IS and LM curves and how they combine to generate the aggregate demand curve;
g. explain the aggregate supply curve in the short run and long run;
h. describe the causes of shifts in and movements along aggregate demand and supply curves;
i. describe how fluctuations in aggregate demand and aggregate supply cause short-run changes in the economy and the business cycle;
j. describe the sources, measurement, and sustainability of economic growth;
k. describe the production function approach to analyzing the sources of economic growth;
l. distinguish between input growth and growth of total factor productivity as components of economic growth.
reading
18: Understanding Business Cycles
a. describe the business cycle and its phases;
b. describe what typically happens to inventory levels and labor and physical capital utilization levels as an economy moves through the business cycle;
c. describe theories of the business cycle;
d. explain the types of unemployment and describe measures of unemployment;
e. explain inflation, disinflation, and deflation;
f. explain the construction of indices used to measure inflation;
g. compare inflation measures, including their uses and limitations;
h. describe factors that affect price levels;
i. describe economic indicators, including their uses and limitations;
j. identify the past, current, or expected future business cycle phase of an economy based on economic indicators.
reading
19: Monetary and Fiscal Policy
a. compare monetary and fiscal policy;
b. explain the definition, qualities, and functions of money, and the money creation process;
c. describe theories of the demand for and supply of money;
d. describe the Fisher effect;
e. describe the roles and objectives of central banks;
f. describe the implementation of monetary policy;
g. describe the qualities of effective central banks;
h. explain the relationships between monetary policy and economic growth, inflation, interest, and exchange rates;
i. determine whether a monetary policy is expansionary or contractionary;
j. describe the limitations of monetary policy;
k. describe the roles and objectives of fiscal policy; Study Session 5 Study Session 5
l. describe the tools of fiscal policy including their advantages and disadvantages;
m. describe the arguments for and against being concerned with the size of a fiscal deficit (relative to GDP);
n. explain the implementation of fiscal policy and the difficulties of implementation;
o. determine whether a fiscal policy is expansionary or contractionary;
p. explain the interaction of monetary and fiscal policy.
20: International Trade and Capital Flows
a. describe the benefits and costs of international trade;
b. distinguish between comparative advantage and absolute advantage;
c. explain the Ricardian and Heckscher–Ohlin models of trade and the source(s) of comparative advantage in each model;
d. compare types of trade and capital restrictions and their economic implications;
e. explain motivations for and advantages of trading blocs, common markets, and economic unions;
f. describe the balance of payments accounts including their components;
g. explain how decisions by consumers, firms, and governments influence the balance of payments;
h. describe functions and objectives of the international organizations that facilitate trade, including the World Bank, the International Monetary Fund, and the World Trade Organization.
reading
21: Currency Exchange Rates
a. define an exchange rate, and distinguish between nominal and real exchange rates and spot and forward exchange rates;
b. describe functions of and participants in the foreign exchange market;
c. define direct and indirect foreign exchange quotations, and convert direct (indirect) foreign exchange quotations into indirect (direct) foreign exchange quotations;
d. calculate and interpret the percentage change in a currency relative to another currency;
e. calculate and interpret currency cross-rates;
f. convert forward quotations expressed on a points basis or in percentage terms into an outright forward quotation;
g. calculate and interpret a forward discount or premium;
h. calculate and interpret the forward rate consistent with the spot rate and the interest rate in each currency;
i. describe exchange rate regimes;
j. explain the impact of exchange rates on countries’ international trade and capital flows.
reading 22: Financial Statement Analysis: An Introduction
a. describe the roles of financial reporting and financial statement analysis;
b. describe the roles of the key financial statements (statement of financial position, statement of comprehensive income, statement of changes in equity, and statement of cash flows) in evaluating a company’s performance and financial position;
c. describe the importance of financial statement notes and supplementary information—including disclosures of accounting policies, methods, and estimates—and management’s commentary;
d. describe the objective of audits of financial statements, the types of audit reports, and the importance of effective internal controls;
e. identify and explain information sources that analysts use in financial statement analysis besides annual financial statements and supplementary information;
f. describe the steps in the financial statement analysis framework.
reading 23: Financial Reporting Mechanics
a. explain the relationship of financial statement elements and accounts, and classify accounts into the financial statement elements;
b. explain the accounting equation in its basic and expanded forms;
c. explain the process of recording business transactions using an accounting system based on the accounting equation;
d. explain the need for accruals and other adjustments in preparing financial statements;
e. explain the relationships among the income statement, balance sheet, statement of cash flows, and statement of owners’ equity;
f. describe the flow of information in an accounting system;
g. explain the use of the results of the accounting process in security analysis.
reading 22 Financial Statement Analysis: An Introduction by Elaine Henry, CFA and Thomas
R. Robinson, CFA
reading 23 Financial Reporting Mechanics International Financial Statement Analysis, by Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CFA, Elaine Henry, CFA, and Michael
A. Broihahn, CFA
reading 24 Financial Reporting Standards by Elaine Henry, CFA, Jan Hendrik van Greuning, CFA, and Thomas
R. Robinson, CFA Study Session 7
reading 24: Financial Reporting Standards
a. describe the objective of financial statements and the importance of financial reporting standards in security analysis and valuation;
b. describe the roles and desirable attributes of financial reporting standard-setting bodies and regulatory authorities in establishing and enforcing reporting standards, and describe the role of the International Organization of Securities Commissions;
c. describe the status of global convergence of accounting standards and ongoing barriers to developing one universally accepted set of financial reporting standards;
d. describe the International Accounting Standards Board’s conceptual framework, including the objective and qualitative characteristics of financial statements, required reporting elements, and constraints and assumptions in preparing financial statements;
e. describe general requirements for financial statements under IFRS;
f. compare key concepts of financial reporting standards under IFRS and U.
S. GAAP reporting systems;
g. identify the characteristics of a coherent financial reporting framework and the barriers to creating such a framework;
h. explain the implications for financial analysis of differing financial reporting systems and the importance of monitoring developments in financial reporting standards;
i. analyze company disclosures of significant accounting policies.
reading 25 Understanding Income Statements by Elaine Henry, CFA and Thomas
R. Robinson, CFA
reading 26 Understanding Balance Sheets by Elaine Henry, CFA and Thomas
R. Robinson, CFA
reading 27 Understanding Cash Flow Statements by Elaine Henry, CFA, Thomas
R. Robinson, CFA, Jan Hendrik van Greuning, CFA, and Michael
A. Broihahn, CFA
reading 28 Financial Analysis Techniques by Elaine Henry, CFA, Thomas
R. Robinson, CFA, and Jan Hendrik van Greuning, CFA LEARNING OUTCOMES
reading 25: Understanding Income Statements
a. describe the components of the income statement and alternative presentation formats of that statement; Study Session 8
b. describe the general principles of revenue recognition and accrual accounting, specific revenue recognition applications (including accounting for long-term contracts, installment sales, barter transactions, and gross and net reporting of revenue), and the implications of revenue recognition principles for financial analysis;
c. calculate revenue given information that might influence the choice of revenue recognition method;
d. describe the general principles of expense recognition, specific expense recognition applications, and the implications of expense recognition choices for financial analysis;
e. describe the financial reporting treatment and analysis of non-recurring items (including discontinued operations, extraordinary items, and unusual or infrequent items) and changes in accounting standards;
f. distinguish between the operating and non-operating components of the income statement;
g. describe how earnings per share is calculated and calculate and interpret a company’s earnings per share (both basic and diluted earnings per share) for both simple and complex capital structures;
h. distinguish between dilutive and antidilutive securities, and describe the implications of each for the earnings per share calculation;
i. convert income statements to common-size income statements;
j. evaluate a company’s financial performance using common-size income statements and financial ratios based on the income statement;
k. describe, calculate, and interpret comprehensive income;
l. describe other comprehensive income, and identify the major types of items included in it.
reading 26: Understanding Balance Sheets
a. describe the elements of the balance sheet: assets, liabilities, and equity;
b. describe the uses and limitations of the balance sheet in financial analysis;
c. describe alternative formats of balance sheet presentation;
d. distinguish between current and non-current assets, and current and non-current liabilities;
e. describe different types of assets and liabilities and the measurement bases of each;
f. describe the components of shareholders’ equity;
g. analyze balance sheets and statements of changes in equity;
h. convert balance sheets to common-size balance sheets and interpret the common-size balance sheets;
i. calculate and interpret liquidity and solvency ratios. Study Session 8
reading 27: Understanding Cash Flow Statements
a. compare cash flows from operating, investing, and financing activities and classify cash flow items as relating to one of those three categories given a description of the items;
b. describe how non-cash investing and financing activities are reported;
c. contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and U.
S. generally accepted accounting principles (U.
S. GAAP);
d. distinguish between the direct and indirect methods of presenting cash from operating activities and describe the arguments in favor of each method;
e. describe how the cash flow statement is linked to the income statement and the balance sheet;
f. describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data;
g. convert cash flows from the indirect to the direct method;
h. analyze and interpret both reported and common-size cash flow statements;
i. calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios.
reading 28: Financial Analysis Techniques
a. describe the tools and techniques used in financial analysis, including their uses and limitations;
b. classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios;
c. describe the relationships among ratios and evaluate a company using ratio analysis;
d. demonstrate the application of the DuPont analysis of return on equity, and calculate and interpret the effects of changes in its components;
e. calculate and interpret ratios used in equity analysis, credit analysis, and segment analysis;
f. describe how ratio analysis and other techniques can be used to model and forecast earnings. LEARNING OUTCOMES
reading 29: Inventories
a. distinguish between costs included in inventories and costs recognized as expenses in the period in which they are incurred;
b. describe different inventory valuation methods (cost formulas);
c. calculate cost of sales and ending inventory using different inventory valuation methods and explain the impact of the inventory valuation method choice on gross profit;
d. calculate and compare cost of sales, gross profit, and ending inventory using perpetual and periodic inventory systems;
e. compare cost of sales, ending inventory, and gross profit using different inventory valuation methods;
f. describe the measurement of inventory at the lower of cost and net realisable value;
g. describe the financial statement presentation of and disclosures relating to inventories;
h. calculate and interpret ratios used to evaluate inventory management.
reading 30: Long-lived Assets
a. distinguish between costs that are capitalised and costs that are expensed in the period in which they are incurred;
b. compare the financial reporting of the following classifications of intangible assets: purchased, internally developed, acquired in a business combination;
c. describe the different depreciation methods for property, plant, and equipment, the effect of the choice of depreciation method on the financial statements, and the effects of assumptions concerning useful life and residual value on depreciation expense;
d. calculate depreciation expense;
reading 29 Inventories by Michael
A. Broihahn, CFA
reading 30 Long-lived Assets by Elaine Henry, CFA and Elizabeth
A. Gordon
reading 31 Income Taxes International Financial Statement Analysis, by Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CFA, Elaine Henry, CFA, and Michael
A. Broihahn, CFA
reading 32 Non-current (Long-term) Liabilities by Elizabeth
A. Gordon and Elaine Henry, CFA Study Session 9
e. describe the different amortisation methods for intangible assets with finite lives, the effect of the choice of amortisation method on the financial statements, and the effects of assumptions concerning useful life and residual value on amortisation expense;
f. calculate amortisation expense;
g. describe the revaluation model;
h. explain the impairment of property, plant, and equipment, and intangible assets;
i. explain the derecognition of property, plant, and equipment, and intangible assets;
j. describe the financial statement presentation of and disclosures relating to property, plant, and equipment, and intangible assets;
k. compare the financial reporting of investment property with that of property, plant, and equipment.
reading 31: Income Taxes
a. describe the differences between accounting profit and taxable income, and define key terms, including deferred tax assets, deferred tax liabilities, valuation allowance, taxes payable, and income tax expense;
b. explain how deferred tax liabilities and assets are created and the factors that determine how a company’s deferred tax liabilities and assets should be treated for the purposes of financial analysis;
c. determine the tax base of a company’s assets and liabilities;
d. calculate income tax expense, income taxes payable, deferred tax assets, and deferred tax liabilities, and calculate and interpret the adjustment to the financial statements related to a change in the income tax rate;
e. evaluate the impact of tax rate changes on a company’s financial statements and ratios;
f. distinguish between temporary and permanent differences in pre-tax accounting income and taxable income;
g. describe the valuation allowance for deferred tax assets—when it is required and what impact it has on financial statements;
h. compare a company’s deferred tax items;
i. analyze disclosures relating to deferred tax items and the effective tax rate reconciliation, and explain how information included in these disclosures affects a company’s financial statements and financial ratios;
j. identify the key provisions of and differences between income tax accounting under IFRS and U.
S. GAAP.
reading 32: Non-current (Long-term) Liabilities
a. determine the initial recognition, initial measurement, and subsequent measurement of bonds;
b. describe the effective interest method and calculate interest expense, amortisation of bond discounts/premiums, and interest payments;
Study Session 9
c. explain the derecognition of debt;
d. describe the role of debt covenants in protecting creditors;
e. describe the financial statement presentation of and disclosures relating to debt;
f. explain the motivations for leasing assets instead of purchasing them;
g. distinguish between a finance lease and an operating lease from the perspectives of the lessor and the lessee;
h. determine the initial recognition, initial measurement, and subsequent measurement of finance leases;
i. compare the disclosures relating to finance and operating leases;
j. describe defined contribution and defined benefit pension plans;
k. compare the presentation and disclosure of defined contribution and defined benefit pension plans;
l. calculate and interpret leverage and coverage ratios. This study session covers evaluating financial reporting quality and shows the application of financial statement analysis to debt and equity investments. The most frequently used tools and techniques to evaluate companies include common-size analysis, cross-sectional analysis, trend analysis, and ratio analysis. Beyond mere knowledge of these tools, however, the analyst must recognize the implications of accounting choices on the quality of a company’s reported financial result
s. Then the analyst can apply financial analysis techniques to analytical tasks including the evaluation of past and future financial performance, credit risk, and the screening of potential equity investment
s. The
readings also explain analyst adjustments to reported financial
s. Such adjustments are often needed to put companies’ reported results on a comparable basis.
reading 33 Financial Reporting Quality: Red Flags and Accounting Warning Signs Commercial Lending Review, by Thomas
R. Robinson, CFA and Paul Munter
reading 34 Accounting Shenanigans on the Cash Flow Statement The CPA Journal, by Marc A. Siegel
reading 35 Financial Statement Analysis: Applications International Financial Statement Analysis, by Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CFA, Elaine Henry, CFA, and Michael
A. Broihahn, CFA LEARNING OUTCOMES
reading 33: Financial Reporting Quality: Red Flags and Accounting Warning Signs
a. describe incentives that might induce a company’s management to overreport or underreport earnings; 0
b. describe activities that will result in a low quality of earnings;
c. describe the three conditions that are generally present when fraud occurs, including the risk factors related to these conditions;
d. describe common accounting warning signs and methods for detecting each.
reading 34: Accounting Shenanigans on the Cash Flow Statement The candidate should be able to analyze and describe the following ways to manipulate the cash flow statement: _ stretching out payables; _ financing of payables; _ securitization of receivables; and _ using stock buybacks to offset dilution of earnings.
reading 35: Financial Statement Analysis: Applications
a. evaluate a company’s past financial performance and explain how a company’s strategy is reflected in past financial performance;
b. forecast a company’s future net income and cash flow;
c. describe the role of financial statement analysis in assessing the credit quality of a potential debt investment;
d. describe the use of financial statement analysis in screening for potential equity investments;
e. explain appropriate analyst adjustments to a company’s financial statements to facilitate comparison with another company.
reading 36: Capital Budgeting
a. describe the capital budgeting process, including the typical steps of the process, and distinguish among the various categories of capital projects;
b. describe the basic principles of capital budgeting, including cash flow estimation;
c. explain how the evaluation and selection of capital projects is affected by mutually exclusive projects, project sequencing, and capital rationing;
d. calculate and interpret the results using each of the following methods to evaluate a single capital project: net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, and profitability index (PI);
e. explain the NPV profile, compare the NPV and IRR methods when evaluating independent and mutually exclusive projects, and describe the problems associated with each of the evaluation methods;
f. describe and account for the relative popularity of the various capital budgeting methods and explain the relation between NPV and company value and stock price;
g. describe the expected relations among an investment’s NVP, company value, and share price.
reading 37: Cost of Capital
a. calculate and interpret the weighted average cost of capital (WACC) of a company;
b. describe how taxes affect the cost of capital from different capital sources;
c. explain alternative methods of calculating the weights used in the WACC, including the use of the company’s target capital structure;
d. explain how the marginal cost of capital and the investment opportunity schedule are used to determine the optimal capital budget;
e. explain the marginal cost of capital’s role in determining the net present value of a project;
reading 39 Dividends and Share Repurchases: Basics by George
H. Troughton, CFA and Gregory Noronha, CFA
reading 40 Working Capital Management by Edgar
A. Norton, Jr., CFA, Kenneth
L. Parkinson, and Pamela Peterson Drake, CFA
reading 41 Financial Statement Analysis by Pamela Peterson Drake, CFA
reading 42 The Corporate Governance of Listed Companies: A Manual for Investors by Kurt Schacht, CFA, James
C. Allen, CFA, and Matthew Orsagh, CFA, CIPM 1
f. calculate and interpret the cost of fixed rate debt capital using the yield-tomaturity approach and the debt-rating approach;
g. calculate and interpret the cost of noncallable, nonconvertible preferred stock;
h. calculate and interpret the cost of equity capital using the capital asset pricing model approach, the dividend discount model approach, and the bond-yield-plus risk-premium approach;
i. calculate and interpret the beta and cost of capital for a project;
j. explain the country equity risk premium in the estimation of the cost of equity for a company located in a developing market;
k. describe the marginal cost of capital schedule, explain why it may be upwardsloping with respect to additional capital, and calculate and interpret its breakpoints;
l. explain and demonstrate the correct treatment of flotation costs.
reading 38: Measures of Leverage
a. define and explain leverage, business risk, sales risk, operating risk, and financial risk, and classify a risk, given a description;
b. calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage;
c. describe the effect of financial leverage on a company’s net income and return on equity;
d. calculate the breakeven quantity of sales and determine the company’s net income at various sales levels;
e. calculate and interpret the operating breakeven quantity of sales.
reading 39: Dividends and Share Repurchases: Basics
a. describe regular cash dividends, extra dividends, stock dividends, stock splits, and reverse stock splits, including their expected effect on a shareholder’s wealth and a company’s financial ratios;
b. describe dividend payment chronology, including the significance of declaration, holder-of-record, ex-dividend, and payment dates;
c. compare share repurchase methods;
d. calculate and compare the effects of a share repurchase on earnings per share when 1) the repurchase is financed with the company’s excess cash and 2) the company uses funded debt to finance the repurchase;
e. calculate the effect of a share repurchase on book value per share;
f. explain why a cash dividend and a share repurchase of the same amount are equivalent in terms of the effect on shareholders’ wealth, all else being equal.
reading 40: Working Capital Management
a. describe primary and secondary sources of liquidity and factors that influence a company’s liquidity position; 1
b. compare a company’s liquidity measures with those of peer companies;
c. evaluate working capital effectiveness of a company based on its operating and cash conversion cycles, and compare the company’s effectiveness with that of peer companies;
d. explain the effect of different types of cash flows on a company’s net daily cash position;
e. calculate and interpret comparable yields on various securities, compare portfolio returns against a standard benchmark, and evaluate a company’s short-term investment policy guidelines;
f. evaluate a company’s management of accounts receivable, inventory, and accounts payable over time and compared to peer companies;
g. evaluate the choices of short-term funding available to a company and recommend a financing method.
reading 41: Financial Statement Analysis The candidate should be able to demonstrate the use of pro forma income and balance sheet statements.
reading 42: The Corporate Governance of Listed Companies: A Manual for Investors
a. define corporate governance;
b. describe practices related to board and committee independence, experience, compensation, external consultants, and frequency of elections, and determine whether they are supportive of shareowner protection;
c. describe board independence and explain the importance of independent board members in corporate governance;
d. identify factors that an analyst should consider when evaluating the qualifications of board members;
e. describe the responsibilities of the audit, compensation, and nominations committees and identify factors an investor should consider when evaluating the quality of each committee;
f. explain the provisions that should be included in a strong corporate code of ethics;
g. evaluate, from a shareowner’s perspective, company policies related to voting rules, shareowner sponsored proposals, common stock classes, and takeover defenses.
reading 43 Portfolio Management: An Overview by Robert
M. Conroy, CFA and Alistair Byrne, CFA
reading 44 Portfolio Risk and Return: Part I by Vijay Singal, CFA
reading 45 Portfolio Risk and Return: Part II by Vijay Singal, CFA
reading 46 Basics of Portfolio Planning and Construction by Alistair Byrne, CFA and Frank
E. Smudde, CFA 2 PORTFOLIO MANAGEMENT 2 LEARNING OUTCOMES
reading 43: Portfolio Management: An Overview
a. describe the portfolio approach to investing;
b. describe types of investors and distinctive characteristics and needs of each;
c. describe the steps in the portfolio management process;
d. describe mutual funds and compare them with other investment products.
reading 44: Portfolio Risk and Return: Part I
a. calculate and interpret major return measures and describe their appropriate uses;
b. describe the characteristics of the major asset classes that investors consider in forming portfolios;
c. calculate and interpret the mean, variance, and covariance (or correlation) of asset returns based on historical data;
d. explain risk aversion and its implications for portfolio selection;
e. calculate and interpret portfolio standard deviation;
f. describe the effect on a portfolio’s risk of investing in assets that are less than perfectly correlated;
g. describe and interpret the minimum-variance and efficient frontiers of risky assets and the global minimum-variance portfolio;
h. describe the selection of an optimal portfolio, given an investor’s utility (or risk aversion) and the capital allocation line.
reading 45: Portfolio Risk and Return: Part II
a. describe the implications of combining a risk-free asset with a portfolio of risky assets;
b. explain the capital allocation line (CAL) and the capital market line (CML);
c. explain systematic and nonsystematic risk, including why an investor should not expect to receive additional return for bearing nonsystematic risk;
d. explain return generating models (including the market model) and their uses;
e. calculate and interpret beta;
f. explain the capital asset pricing model (CAPM), including the required assumptions, and the security market line (SML);
g. calculate and interpret the expected return of an asset using the CAPM;
h. describe and demonstrate applications of the CAPM and the SML.
reading 46: Basics of Portfolio Planning and Construction
a. describe the reasons for a written investment policy statement (IPS);
b. describe the major components of an IPS; 2
c. describe risk and return objectives and how they may be developed for a client;
d. distinguish between the willingness and the ability (capacity) to take risk in analyzing an investor’s financial risk tolerance;
e. describe the investment constraints of liquidity, time horizon, tax concerns, legal and regulatory factors, and unique circumstances and their implications for the choice of portfolio assets;
f. explain the specification of asset classes in relation to asset allocation;
g. describe the principles of portfolio construction and the role of asset allocation in relation to the IPS.
reading 47 Market Organization and Structure by Larry Harris
reading 48 Security Market Indices by Paul
D. Kaplan, CFA and Dorothy
C. Kelly, CFA
reading 49 Market Efficiency by W. Sean Cleary, CFA, Howard
J. Atkinson, CFA, and Pamela Peterson Drake, CFA 3 MARKET ORGANIZATION,
MARKET INDICES, AND MARKET EFFICIENCY LEARNING OUTCOMES
reading 47: Market Organization and Structure
a. explain the main functions of the financial system;
b. describe classifications of assets and markets;
c. describe the major types of securities, currencies, contracts, commodities, and real assets that trade in organized markets, including their distinguishing characteristics and major subtypes;
d. describe the types of financial intermediaries and the services that they provide;
e. compare the positions an investor can take in an asset; 3
f. calculate and interpret the leverage ratio, the rate of return on a margin transaction, and the security price at which the investor would receive a margin call;
g. compare execution, validity, and clearing instructions;
h. compare market orders with limit orders;
i. describe the primary and secondary markets and explain how secondary markets support primary markets;
j. describe how securities, contracts, and currencies are traded in quote-driven markets, order-driven markets and brokered markets;
k. describe the characteristics of a well-functioning financial system;
l. describe the objectives of market regulation.
reading 48: Security Market Indices
a. describe a security market index;
b. calculate and interpret the value, price return, and total return of an index;
c. describe the choices and issues in index construction and management;
d. compare the different weighting methods used in index construction;
e. calculate and analyze the value and return of an index given its weighting method;
f. describe rebalancing and reconstitution of an index;
g. describe uses of security market indices;
h. describe types of equity indices;
i. describe types of fixed-income indices;
j. describe indices representing alternative investments;
k. compare types of security market indices.
reading 49: Market Efficiency
a. explain market efficiency and related concepts, including their importance to investment practitioners;
b. distinguish between market value and intrinsic value;
c. explain factors affecting a market’s efficiency;
d. contrast the weak-form, semi-strong form, and strong-form market efficiency;
e. explain the implications of each form of market efficiency for fundamental analysis, technical analysis, and the choice between active and passive portfolio management;
f. describe identified market pricing anomalies and explain possible inconsistencies with market efficiency;
g. contrast the behavioral finance view of investor behavior to that of traditional finance.
s. The first
reading discusses various types and features of equity securities and their roles in investment managemen
t. The second
reading explains how to conduct industry and company analyses; the
reading’s major focus is on understanding a company’s competitive positio
n. The first two
readings constitute necessary background knowledge for the third
reading, which introduces the subject of equity valuation.
Y ANALYSIS AND VALUATION LEARNING OUTCOME
reading 50: Overview of Equity Securities
a. describe characteristics of types of equity securities;
b. describe differences in voting rights and other ownership characteristics among different equity classes;
c. distinguish between public and private equity securities;
d. describe methods for investing in non-domestic equity securities;
e. compare the risk and return characteristics of types of equity securities;
f. explain the role of equity securities in the financing of a company’s assets; 4
g. distinguish between the market value and book value of equity securities;
h. compare a company’s cost of equity, its (accounting) return on equity, and investors’ required rates of return.
reading 51: Introduction to Industry and Company Analysis
a. explain the uses of industry analysis and the relation of industry analysis to company analysis;
b. compare methods by which companies can be grouped, current industry classification systems, and classify a company, given a description of its activities and the classification system;
c. explain factors that affect the sensitivity of a company to the business cycle and the uses and limitations of industry and company descriptors such as “growth,” “defensive,” and “cyclical”;
d. explain the relation of “peer group,” as used in equity valuation, to a company’s industry classification;
e. describe the elements that need to be covered in a thorough industry analysis;
f. describe demographic, governmental, social, and technological influences on industry growth, profitability, and risk;
g. describe product and industry life cycle models, classify an industry as to life cycle phase (e.g., embryonic, growth, shakeout, maturity, or decline) based on a description of it, and describe the limitations of the life-cycle concept in forecasting industry performance;
h. explain effects of industry concentration, ease of entry, and capacity on return on invested capital and pricing power;
i. describe the principles of strategic analysis of an industry;
j. compare characteristics of representative industries from the various economic sectors;
k. describe the elements that should be covered in a thorough company analysis.
reading 52: Equity Valuation: Concepts and Basic Tools
a. evaluate whether a security, given its current market price and a value estimate, is overvalued, fairly valued, or undervalued by the market;
b. describe major categories of equity valuation models;
c. explain the rationale for using present-value of cash flow models to value equity and describe the dividend discount and free-cash-flow-to-equity models;
d. calculate the intrinsic value of a non-callable, non-convertible preferred stock;
e. calculate and interpret the intrinsic value of an equity security based on the Gordon (constant) growth dividend discount model or a two-stage dividend discount model, as appropriate;
f. identify companies for which the constant growth or a multistage dividend discount model is appropriate;
g. explain the rationale for using price multiples to value equity and distinguish between multiples based on comparables versus multiples based on fundamentals; 4
h. calculate and interpret the following multiples: price to earnings, price to an estimate of operating cash flow, price to sales, and price to book value;
i. explain the use of enterprise value multiples in equity valuation and demonstrate the use of enterprise value multiples to estimate equity value;
j. explain asset-based valuation models and demonstrate the use of asset-based models to calculate equity value;
k. explain advantages and disadvantages of each category of valuation model.
IXED INCOME: Basic Concepts LEARNING OUTCOMES
reading 53: Features of Debt Securities
a. explain the purposes of a bond’s indenture and describe affirmative and negative covenants;
b. describe the basic features of a bond, the various coupon rate structures, and the structure of floating-rate securities;
c. define accrued interest, full price, and clean price; 5
d. explain the provisions for redemption and retirement of bonds;
e. identify common options embedded in a bond issue, explain the importance of embedded options, and identify whether an option benefits the issuer or the bondholder;
f. describe methods used by institutional investors in the bond market to finance the purchase of a security (i.e., margin buying and repurchase agreements).
reading 54: Risks Associated with Investing in Bonds
a. explain the risks associated with investing in bonds;
b. identify the relations among a bond’s coupon rate, the yield required by the market, and the bond’s price relative to par value (i.e., discount, premium, or equal to par);
c. explain how a bond maturity, coupon, embedded options and yield level affect its interest rate risk;
d. identify the relation of the price of a callable bond to the price of an option-free bond and the price of the embedded call option;
e. explain the interest rate risk of a floating-rate security and why its price may differ from par value;
f. calculate and interpret the duration and dollar duration of a bond;
g. describe yield-curve risk and explain why duration does not account for yieldcurve risk;
h. explain the disadvantages of a callable or prepayable security to an investor;
i. identify the factors that affect the reinvestment risk of a security and explain why prepayable amortizing securities expose investors to greater reinvestment risk than nonamortizing securities;
j. describe types of credit risk and the meaning and role of credit ratings;
k. explain liquidity risk and why it might be important to investors even if they expect to hold a security to the maturity date;
l. describe the exchange rate risk an investor faces when a bond makes payments in a foreign currency;
m. explain inflation risk;
n. explain how yield volatility affects the price of a bond with an embedded option and how changes in volatility affect the value of a callable bond and a putable bond;
o. describe sovereign risk and types of event risk.
reading 55: Overview of Bond Sectors and Instruments
a. describe features, credit risk characteristics, and distribution methods for government securities;
b. describe the types of securities issued by the U.
S. Department of the Treasury (e.
g. bills, notes, bonds, and inflation protection securities), and distinguish between on-the-run and off-the-run Treasury securities; 5
c. describe how stripped Treasury securities are created and distinguish between coupon strips and principal strips;
d. describe the types and characteristics of securities issued by U.
S. federal agencies;
e. describe the types and characteristics of mortgage-backed securities and explain the cash flow and prepayment risk for each type;
f. state the motivation for creating a collateralized mortgage obligation;
g. describe the types of securities issued by municipalities in the United States and distinguish between tax-backed debt and revenue bonds;
h. describe the characteristics and motivation for the various types of debt issued by corporations (including corporate bonds, medium-term notes, structured notes, commercial paper, negotiable CDs, and bankers acceptances);
i. define an asset-backed security, describe the role of a special purpose vehicle in an asset-backed security’s transaction, state the motivation for a corporation to issue an asset-backed security, and describe the types of external credit enhancements for asset-backed securities;
j. describe collateralized debt obligations;
k. describe the mechanisms available for placing bonds in the primary market and distinguish between the primary and secondary markets for bonds.
reading 56: Understanding Yield Spreads
a. identify the interest rate policy tools available to a central bank;
b. describe a yield curve and the various shapes of the yield curve;
c. explain the basic theories of the term structure of interest rates and describe the implications of each theory for the shape of the yield curve;
d. define a spot rate;
e. calculate and compare yield spread measures;
f. describe a credit spread and the suggested relation between credit spreads and the well-being of the economy;
g. describe how embedded options affect yield spreads;
h. explain how liquidity and issue-size affects the yield spread of a bond relative to other similar securities;
i. calculate the after-tax yield of a taxable security and the tax-equivalent yield of a tax-exempt security;
j. define LIBOR and explain its importance to funded investors who borrow short term.
reading 57 Introduction to the Valuation of Debt Securities Fixed Income Analysis for the Chartered Financial Analyst® Program, Second Edition, by Frank
J. Fabozzi, CFA
reading 58 Yield Measures, Spot Rates, and Forward Rates Fixed Income Analysis for the Chartered Financial Analyst® Program, Second Edition, by Frank
J. Fabozzi, CFA
reading 59 Introduction to the Measurement of Interest Rate Risk Fixed Income Analysis for the Chartered Financial Analyst® Program, Second Edition, by Frank
J. Fabozzi, CFA 6 FIXED INCOME: Analysis and Valuation LEARNING OUTCOMES
reading 57: Introduction to the Valuation of Debt Securities
a. explain the steps in the bond valuation process;
b. describe types of bonds for which estimating the expected cash flows is difficult;
c. calculate the value of a bond (coupon and zero-coupon);
d. explain how the price of a bond changes if the discount rate changes and as the bond approaches its maturity date;
e. calculate the change in value of a bond given a change in its discount rate;
f. explain and demonstrate the use of the arbitrage-free valuation approach and describe how a dealer can generate an arbitrage profit if a bond is mispriced. 6
reading 58: Yield Measures, Spot Rates, and Forward Rates
a. describe the sources of return from investing in a bond;
b. calculate and interpret traditional yield measures for fixed-rate bonds and explain their limitations and assumptions;
c. explain the reinvestment assumption implicit in calculating yield to maturity and describe the factors that affect reinvestment risk;
d. calculate and interpret the bond equivalent yield of an annual-pay bond and the annual-pay yield of a semiannual-pay bond;
e. describe the calculation of the theoretical Treasury spot rate curve and calculate the value of a bond using spot rates;
f. distinguish the relations among the nominal spread, the zero-volatility spread, the option-adjusted spread, and option cost;
g. explain a forward rate and calculate spot rates from forward rates, forward rates from spot rates, and the value of a bond using forward rates.
reading 59: Introduction to the Measurement of Interest Rate Risk
a. distinguish between the full valuation approach (the scenario analysis approach) and the duration/convexity approach for measuring interest rate risk, and explain the advantage of using the full valuation approach;
b. describe the price volatility characteristics for option-free, callable, prepayable, and putable bonds when interest rates change;
c. describe positive convexity, negative convexity, and their relation to bond price and yield;
d. calculate and interpret the effective duration of a bond, given information about how the bond’s price will increase and decrease for given changes in interest rates;
e. calculate the approximate percentage price change for a bond, given the bond’s effective duration and a specified change in yield;
f. distinguish among the alternative definitions of duration and explain why effective duration is the most appropriate measure of interest rate risk for bonds with embedded options;
g. calculate the duration of a portfolio, given the duration of the bonds comprising the portfolio, and explain the limitations of portfolio duration;
h. describe the convexity measure of a bond and estimate a bond’s percentage price change, given the bond’s duration and convexity and a specified change in interest rates;
i. distinguish between modified convexity and effective convexity;
j. calculate the price value of a basis point (PVBP), and explain its relationship to duration;
k. describe the impact of yield volatility on the interest rate risk of a bond.
reading 60: Derivative Markets and Instruments
a. define a derivative and distinguish between exchange-traded and over-thecounter derivatives;
b. define forward contracts, futures contracts, options (calls and puts), and swaps and compare their basic characteristics;
c. describe the purposes and criticisms of derivative markets;
d. explain arbitrage and the role it plays in determining prices and promoting market efficiency.
reading 61: Forward Markets and Contracts
a. explain delivery/settlement and default risk for both long and short positions in a forward contract;
b. describe the procedures for settling a forward contract at expiration, and how termination prior to expiration can affect credit risk;
c. distinguish between a dealer and an end user of a forward contract;
d. describe the characteristics of equity forward contracts and forward contracts on zero-coupon and coupon bonds;
e. describe the characteristics of the Eurodollar time deposit market, and define LIBOR and Euribor;
f. describe forward rate agreements (FRAs) and calculate the gain/loss on a FRA;
g. calculate and interpret the payoff of a FRA and explain each of the component terms of the payoff formula;
h. describe the characteristics of currency forward contracts.
reading 62: Futures Markets and Contracts
a. describe the characteristics of futures contracts;
b. compare futures contracts and forward contracts;
c. distinguish between margin in the securities markets and margin in the futures markets, and explain the role of initial margin, maintenance margin, variation margin, and settlement in futures trading;
d. describe price limits and the process of marking to market, and calculate and interpret the margin balance, given the previous day’s balance and the change in the futures price;
e. describe how a futures contract can be terminated at or prior to expiration;
f. describe the characteristics of the following types of futures contracts: Treasury bill, Eurodollar, Treasury bond, stock index, and currency. 7
reading 63: Option Markets and Contracts
a. describe call and put options;
b. distinguish between European and American options;
c. define the concept of moneyness of an option;
d. compare exchange-traded options and over-the-counter options;
e. identify the types of options in terms of the underlying instruments;
f. compare interest rate options with forward rate agreements (FRAs);
g. define interest rate caps, floors, and collars;
h. calculate and interpret option payoffs and explain how interest rate options differ from other types of options;
i. define intrinsic value and time value, and explain their relationship;
j. determine the minimum and maximum values of European options and American options;
k. calculate and interpret the lowest prices of European and American calls and puts based on the rules for minimum values and lower bounds;
l. explain how option prices are affected by the exercise price and the time to expiration;
m. explain put–call parity for European options, and explain how put–call parity is related to arbitrage and the construction of synthetic options;
n. explain how cash flows on the underlying asset affect put–call parity and the lower bounds of option prices;
o. determine the directional effect of an interest rate change or volatility change on an option’s price.
reading 64: Swap Markets and Contracts
a. describe the characteristics of swap contracts and explain how swaps are terminated;
b. describe, calculate, and interpret the payments of currency swaps, plain vanilla interest rate swaps, and equity swaps.
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