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CFA Level II Updated
How do autoregressive models work in time series analysis, and why does stationarity matter so much?
Autoregressive models forecast a variable using its own past values. They require stationarity because non-stationary data produces spurious regression results with misleading statistical significance.
How do real options change capital budgeting decisions? I keep getting the wrong answer on NPV-with-options problems.
Real options recognize that managers have flexibility — they're not locked into a static 'invest or don't invest' decision. The expanded NPV equals the static NPV plus the value of any embedded real options.
How do you price a forward contract using the no-arbitrage framework? I keep mixing up the cost-of-carry components.
Forward pricing rests on one core idea: you should be indifferent between buying the asset today and holding it, or entering a forward contract to buy it later. If these two strategies don't cost the same, an arbitrageur will exploit the gap until they converge.
What is the difference between full goodwill and partial goodwill in business combinations?
Full goodwill measures NCI at fair value and includes goodwill attributable to both parent and NCI. Partial goodwill measures NCI at its share of identifiable net assets and includes only the parent's goodwill. Full goodwill results in higher total assets and higher NCI on the balance sheet.
What is the Black-Litterman model and why is it better than standard mean-variance optimization?
The Black-Litterman model starts with equilibrium returns implied by market cap weights, then blends investor views using Bayesian statistics. This produces much more stable and intuitive portfolio weights compared to standard mean-variance optimization.
How is logistic regression used in finance and how does it differ from linear regression?
Logistic regression predicts binary outcomes (default/no-default) by constraining output to a 0-1 probability range using the sigmoid function. Unlike linear regression, coefficients are interpreted as log odds. Common financial applications include credit scoring and event prediction.
How do you use market multiples for cross-border equity comparisons?
Cross-border multiple comparisons require adjustments for accounting differences (IFRS vs. GAAP), growth rates, risk premiums, tax rates, and capital structure. EV/EBITDA is generally the most comparable metric because it neutralizes many of these distortions.
What are the key differences between IFRS 16 and ASC 842 for lease accounting?
IFRS 16 uses a single model treating all leases as finance-type, with front-loaded depreciation plus interest expense. ASC 842 retains a dual model where operating leases show a single straight-line expense. Both put ROU assets and lease liabilities on the balance sheet.
How do you apply DCF analysis to value a commercial real estate investment at CFA Level II?
CFA Level II real estate DCF involves projecting NOI year by year, calculating terminal value using a terminal cap rate, and discounting all cash flows at an appropriate rate. The terminal cap rate is typically higher than the going-in cap rate.
How do you evaluate an international capital budgeting project when you have to deal with foreign currency cash flows?
International capital budgeting has two equivalent approaches: convert foreign cash flows to home currency using forward rates then discount at home WACC, or discount foreign cash flows at the foreign WACC then convert at spot. Both should yield the same NPV.
What is the difference between absolute and relative purchasing power parity, and does PPP actually hold in practice?
Absolute PPP states the exchange rate equals the ratio of price levels, while relative PPP states exchange rate changes equal inflation differentials. Relative PPP holds roughly over the long run but fails short-term due to capital flows, sticky prices, and non-traded goods.
What are the key extensions of the CAPM and how do they address its limitations?
The standard CAPM has several limitations addressed by extensions. Black's Zero-Beta CAPM replaces the risk-free rate with the return on a zero-beta portfolio, the International CAPM adds currency risk factors, and the Conditional CAPM allows time-varying betas.
How do you use put-call parity to create synthetic positions and spot arbitrage opportunities?
Put-call parity (C + PV(K) = P + S) can be rearranged to create synthetic positions and identify arbitrage opportunities. When the relationship is violated, you can construct a risk-free profit by selling the overpriced side and buying the underpriced side.
Can someone walk through the binomial option pricing model with a two-period example?
The binomial model prices options by building a stock price tree, calculating terminal payoffs, and using backward induction with risk-neutral probabilities. Here's a complete two-period example pricing a European call.
What is key rate duration and why is it better than effective duration for managing bond portfolios?
Key rate duration decomposes a bond's interest rate sensitivity across specific maturities on the yield curve, unlike effective duration which only measures sensitivity to parallel shifts. This distinction matters when yield curves shift non-parallel.
What's the difference between equilibrium and arbitrage-free term structure models?
Equilibrium models (Vasicek, CIR) derive the term structure from economic assumptions and may not match today's yield curve. Arbitrage-free models (Ho-Lee, BDT) are calibrated to exactly fit the current curve and are preferred for pricing securities with embedded options.
When should you use market-based vs. asset-based valuation, and what are the key differences?
The choice between market-based and asset-based valuation depends on the type of company and data availability. Market-based valuation uses multiples from comparables, while asset-based valuation sums individual assets minus liabilities at fair market value.
FCFE vs. FCFF: what's the difference and when should I use each for valuation?
FCFF represents cash available to all capital providers and is discounted at WACC, while FCFE represents cash available to equity holders only and is discounted at the cost of equity. Use FCFF when capital structure is changing; use FCFE for direct equity valuation when leverage is stable.
How does the H-model work for valuation, and how is it different from a two-stage DDM?
The H-model is a simplified DDM that assumes growth declines linearly from a high rate to a stable rate, rather than dropping abruptly. The formula splits value into a stable-growth component and an extra premium for above-normal growth during the transition period.
When do you use the equity method vs. the acquisition method for intercorporate investments?
The classification depends on the degree of influence or control the investor has over the investee. Below 20% ownership is treated as a financial asset at fair value, 20-50% uses the equity method (significant influence), and above 50% requires full consolidation via the acquisition method.
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