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How does Arbitrage Pricing Theory differ from CAPM, and how do you apply a multifactor model?
APT differs from CAPM by using multiple risk factors instead of just the market, and relies on a no-arbitrage argument rather than market equilibrium. The model allows flexibility in factor selection but doesn't specify which factors to use.
How does delta hedging work in practice, and why does it need constant rebalancing?
Delta hedging involves taking an offsetting stock position to neutralize the delta of an options portfolio. Because delta changes as the stock price moves (gamma), the hedge must be continuously rebalanced — buying shares when prices rise and selling when they fall.
How should an analyst handle conflicts of interest under the CFA Standards?
Standard VI(A) requires full and fair disclosure of all matters that could impair independence and objectivity, including personal holdings, firm relationships, compensation arrangements, and board memberships. Disclosure must be prominent, plain language, and timely.
What are the different exchange rate regimes and why do countries choose fixed vs. floating rates?
Exchange rate regimes range from hard pegs (dollarization, currency boards) to free floats. The impossible trinity framework explains why countries can't simultaneously have fixed rates, free capital flows, and independent monetary policy.
What are the Black-Scholes model assumptions, and which ones are most violated in real markets?
The Black-Scholes model assumes constant volatility, no dividends, continuous trading, no transaction costs, constant rates, and no arbitrage. The most commonly violated is constant volatility — evidenced by the volatility smile/skew observed in options markets.
Why do mortgage-backed securities have negative convexity, and how does it affect effective duration?
Mortgage-backed securities exhibit negative convexity because prepayments accelerate when rates fall (shortening duration and capping price gains) and slow when rates rise (extending duration and amplifying losses). This creates an asymmetric payoff profile.
What's the correct way to interpret a confidence interval? I keep losing marks on practice exams.
The most common mistake is saying 'there is a 95% probability that the population mean is in the interval.' The population mean is fixed — the correct interpretation is that 95% of similarly constructed intervals would contain the true mean.
What's the practical difference between OAS and Z-spread, and when should I use each?
Z-spread is the constant spread over the spot curve for bonds with fixed cash flows. OAS removes the embedded option cost, providing a pure credit spread comparison. Use OAS whenever comparing bonds with different option features; use Z-spread for option-free bonds.
What adjustments are needed to go from enterprise value to equity value, and what are the common traps?
The enterprise-value-to-equity bridge requires subtracting all non-equity claims from EV: total debt net of cash, preferred stock, minority interest, unfunded pension obligations, and operating lease liabilities. Equity method investments should be added back if not reflected in operating EBITDA.
Why do we need a convexity adjustment and how does it improve the duration-based price estimate?
Duration gives a straight-line estimate of price changes, but bond prices actually move along a curve. Convexity captures that curvature and corrects duration's error, providing a more accurate price estimate especially for large yield changes.
How do I calculate Macaulay duration and modified duration step by step?
Duration is the single most important risk measure in fixed income. Macaulay duration is the weighted-average time to receive a bond's cash flows, while modified duration adjusts it to estimate the percentage price change for a given yield shift.
P/E vs. EV/EBITDA: when should I use each multiple and what are the pitfalls?
P/E measures equity value per dollar of earnings and works best for similarly leveraged companies. EV/EBITDA measures total firm value relative to operating cash flow and is capital-structure neutral. Use EV/EBITDA when comparing companies with different leverage, depreciation policies, or tax regimes.
How do you calculate residual income continuing value and what assumptions drive it?
Residual income continuing value captures excess returns beyond the forecast period. Three approaches exist: RI drops to zero (ROE converges to cost of equity), RI persists forever, or RI decays via a persistence factor (omega between 0 and 1). The persistence factor reflects how long a company can sustain its competitive advantage.
How do the three depreciation methods compare, and when would a company choose each one?
The three depreciation methods — straight-line, double-declining balance, and units-of-production — all result in the same total depreciation over an asset's life but differ in timing. The choice affects reported earnings, tax cash flows, and key ratios differently each year.
How does IFRS 16 change lease accounting and why does it matter for ratio analysis?
IFRS 16 fundamentally changed lease accounting by requiring lessees to recognize nearly all leases on the balance sheet as a right-of-use asset and lease liability. This affects key ratios like D/E, EBITDA, and interest coverage, making it one of the most testable topics in CFA Level I FRA.
How do upstream and downstream transactions affect equity method accounting?
Downstream transactions occur when the investor sells to the investee, while upstream transactions go the other direction. In both cases, unrealized intercompany profit must be eliminated proportionally, though US GAAP requires full elimination for downstream transactions.
What is the endowment model of diversification?
Endowment model (Yale/Swensen): heavy alternatives (PE, VC, HF, real assets), illiquidity premium, active management in inefficient markets. Hard to replicate at small scale.
What's the difference between real yield and nominal yield, and why does real yield go negative?
Real yield = nominal yield net of inflation. Fisher: (1+Nom)=(1+Real)(1+Infl). Negative real yields occur during QE, flight to safety, regulatory buying, and elevated inflation uncertainty. In COVID era, 10Y TIPS reached -1.0% real yield — investors paid for inflation protection and safe-haven status...
What is the step-by-step process for creating an Investment Policy Statement for a private client?
The IPS creation process follows a systematic eight-step flow: client discovery, objectives setting, constraint identification, asset allocation, drafting, client approval, implementation, and ongoing monitoring. The key exam focus is the interaction between return and risk objectives and the five constraints.
What is tax-efficient asset location and how do I apply it to a client portfolio?
Tax-efficient asset location optimizes which assets are held in taxable versus tax-deferred versus tax-exempt accounts to maximize after-tax wealth...
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