Community Q&A
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CFA Level I Updated
Can someone explain correlation vs. causation with a finance example? My professor keeps emphasizing this.
Correlation measures the linear association between two variables but says nothing about whether one causes the other. There are three key reasons: reverse causality, omitted variables (confounding), and spurious correlation.
What drives credit spreads on corporate bonds and how do they change through the economic cycle?
Credit spreads represent the additional yield investors demand over risk-free rates to compensate for default risk, credit uncertainty, and illiquidity. They have three components: expected loss, credit risk premium, and liquidity premium, and they fluctuate dramatically through the economic cycle.
How do you value a callable bond and what's the relationship between OAS and the call option?
Callable bonds give the issuer the right to redeem the bond before maturity. The fundamental relationship is: Value(callable) = Value(option-free) - Value(call option). OAS removes the option cost from the Z-spread, leaving only credit and liquidity compensation.
How do you assess receivables quality using the allowance for doubtful accounts and turnover ratios?
Receivables quality is assessed by analyzing receivables turnover, DSO, and the allowance for doubtful accounts relative to gross receivables. Key red flags include DSO increasing over time, A/R growing faster than revenue, and the allowance ratio declining despite receivables growth.
FIFO vs. weighted average cost: how do they affect COGS, inventory, and taxes when prices are rising?
Under FIFO, the oldest costs flow to COGS while the newest remain in ending inventory. Under weighted average, all costs are blended. When prices are rising, FIFO produces lower COGS, higher ending inventory, and higher net income compared to weighted average.
How do data privacy regulations like GDPR and CCPA affect analytics practices at investment firms, and what are the key compliance requirements?
Data privacy regulations require investment firms to establish legal bases for processing personal data, minimize collection, limit repurposing, and honor deletion requests. Alternative data often contains personal information even when appearing aggregate. CFA ethics standards reinforce confidentiality obligations.
How does GIPS handle error correction, and what determines whether an error is material enough to require restatement?
GIPS requires firms to correct errors and, if material, restate composite performance and notify affected parties. Materiality is determined by each firm's written policy, considering the error's magnitude, duration, and potential impact on investment decisions.
How does the treasury stock method work for calculating the dilutive impact of stock options on EPS?
The treasury stock method assumes in-the-money options are exercised, proceeds are used to repurchase shares at the average market price, and only the net incremental shares (issued minus repurchased) increase the diluted EPS denominator.
What are the key contrarian investing signals, and how do you build a framework for systematically trading against the crowd?
Contrarian investing systematically trades against crowd extremes by combining sentiment indicators (put-call ratio, surveys, fund flows, positioning data) with fundamental checks. The framework requires multiple indicators reaching extreme levels simultaneously, structural confirmation, and disciplined risk management to avoid value traps.
How do step-up coupon bonds work and why would an issuer choose this structure?
Step-up coupon bonds have predetermined coupon increases at scheduled dates. Issuers choose this structure to lower initial interest expense, incentivize calling before coupons rise, and match payments to growing cash flows. Valuation requires discounting each period's unique coupon separately.
How does the par value method for treasury stock differ from the cost method?
The par value method records treasury stock at par value and reverses the original APIC from the initial issuance. Any excess of repurchase price over original issue price reduces retained earnings. Total equity is the same under both methods.
How does the cost method for treasury stock work, and what are the journal entries for repurchase and reissue?
Under the cost method, treasury stock is recorded at repurchase cost as a contra-equity account. Reissues above cost create APIC credits; reissues below cost first reduce APIC from prior transactions, then hit retained earnings. No gains or losses flow through income.
How are restricted stock units (RSUs) accounted for, and how does the expense recognition work over the vesting period?
RSUs are measured at the grant-date stock price (no option pricing model needed) and compensation expense is recognized over the vesting period. The total expense is adjusted for estimated forfeitures, with catch-up adjustments if actual forfeitures differ.
What is the difference between intrinsic value and fair value methods for stock option compensation expense?
The intrinsic value method measures compensation as the difference between stock price and exercise price at the grant date, often resulting in zero expense for at-the-money options. The fair value method uses option pricing models to capture the full economic value, and is now required under ASC 718 and IFRS 2.
What is a butterfly spread, how is it constructed, and when would I use it?
A butterfly spread buys one call at the lowest strike, sells two calls at the middle strike, and buys one call at the highest strike. It profits most when the stock expires exactly at the middle strike, with very limited downside equal to the net premium paid.
Can someone explain credit default swaps at a CFA Level I depth — what they are, how they work, and why they matter?
A credit default swap is a contract where the protection buyer pays periodic premiums to the seller in exchange for a payment if the reference entity defaults. Triggers include bankruptcy, failure to pay, and restructuring.
Why do some companies have multiple share classes with different voting rights, and how should analysts think about this?
Dual-class share structures let founders maintain voting control even after selling a majority of economic interest to public shareholders. This creates governance risks and typically results in a 5-15% valuation discount, as minority shareholders cannot effectively influence corporate decisions.
What is the agency problem with free cash flow, and how can it be mitigated?
The free cash flow agency problem occurs when managers with excess cash invest in value-destroying projects rather than returning capital to shareholders. Mitigation mechanisms include higher leverage, dividends and buybacks, performance-based pay, and hostile takeover discipline.
How should wrap fee accounts be treated under GIPS composite reporting?
Wrap fee accounts should be grouped into separate composites or presented with wrap-fee-specific performance. Returns must be shown net of the entire wrap fee, and the firm must disclose the fee structure and percentage of wrap assets.
How do I decompose an option's price into intrinsic value and time value?
Option premium equals intrinsic value plus time value. Intrinsic value is the exercise-now value and can never be negative. Time value reflects the probability the option gains value before expiration and is highest for at-the-money options.
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