Community Q&A
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CFA Updated
How do you estimate the appropriate discount for a private company valuation?
Private company discounts include DLOM (lack of marketability, typically 15-35%) and DLOC (lack of control, derived from control premiums). The key is knowing which discounts to apply based on your starting valuation basis.
How does goodwill impairment testing work under IFRS vs. US GAAP?
Under IFRS, goodwill impairment compares CGU carrying amount to recoverable amount (higher of fair value less costs to sell or value in use). US GAAP compares reporting unit carrying amount to fair value. Both test annually, and impairment is irreversible.
What is the J-curve effect in private equity fund returns?
The J-curve describes how private equity funds typically show negative returns in early years (due to management fees, slow deployment, and conservative valuations) before returns improve significantly in later years as portfolio companies are grown and exited.
How do you calculate WACC and why does each component matter?
WACC blends the after-tax cost of debt and cost of equity weighted by their market values: WACC = (E/V) × Re + (D/V) × Rd × (1 - T). The tax adjustment on debt reflects the deductibility of interest expense.
Can someone explain call and put option payoffs with diagrams?
A long call pays max(S - K, 0) with unlimited upside and loss limited to the premium. A long put pays max(K - S, 0) with gain capped at K minus premium. Payoff is the raw exercise value; profit subtracts the premium paid.
How do I calculate portfolio risk for a two-asset portfolio? I keep messing up the formula.
Portfolio variance for two assets uses the formula σ²_p = w₁²σ₁² + w₂²σ₂² + 2w₁w₂ρ₁₂σ₁σ₂. The key insight is that because correlation is typically less than 1, the portfolio's actual risk is lower than the weighted average of individual risks.
How should risk management for individuals consider human capital and financial capital together?
Risk management for individuals recognizes that total wealth includes both human capital and financial capital. The nature of a person's human capital — whether bond-like or equity-like — should drive financial portfolio allocation and insurance decisions.
What is the difference between IRR and MOIC in private equity, and why can IRR be misleading?
IRR measures time-weighted returns and rewards early exits, while MOIC measures total wealth creation regardless of timing. IRR can be misleading because it can be inflated through subscription credit lines, early exits, and timing of capital calls.
When and how should a company adjust its WACC for project-specific or country-specific risk?
The firm's WACC should be adjusted when project risk, capital structure, or country risk differs from the firm's profile. The pure-play method unlevers a comparable company's beta and re-levers it for the project. Country risk premiums are added for international projects.
How do hedge fund fee structures work, and what is the high-water mark provision?
Hedge funds typically charge 2% management fees plus 20% incentive fees. The high-water mark prevents charging performance fees on recovered losses — the fund must exceed its previous peak NAV before earning incentive fees again.
What are the three forms of the Efficient Market Hypothesis, and why do market anomalies seem to contradict them?
The three forms of EMH differ in which information is reflected in prices: weak (past prices), semi-strong (all public info), and strong (all info including insider). Anomalies may reflect risk premiums, data mining, or the joint hypothesis problem.
What drives long-term real exchange rate movements, and what is the Balassa-Samuelson effect?
Real exchange rates can trend persistently due to structural factors. The Balassa-Samuelson effect explains why currencies of fast-growing economies appreciate in real terms: rapid productivity growth in tradeable goods pushes up wages and service prices economy-wide.
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.
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