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CFA Level II Updated
How can residual income still be useful when FCFE is weak or even negative for a few years?
Weak near-term FCFE does not automatically mean the equity is impossible to value. It may mean cash is being absorbed by reinvestment, working-capital buildup, or temporary project spending. Residual income can still be useful if: - current book valu
Why can justified price-to-book be greater than one even if book value already represents shareholder equity?
Investors pay more than book value when they expect management to earn returns on that equity base above the required return. Book value tells you what capital is in place. Justified P/B tells you what that capital is worth given expected profitabili
Where exactly does the equity charge enter a residual income valuation?
The equity charge is the middle step. It converts accounting earnings into economic profit. The sequence is: 1. Start with beginning book value. 2. Multiply beginning book value by the required return on equity. 3. Subtract that equity charge from fo
When should I use a residual income model instead of a dividend discount model on CFA Level II?
Use the dividend discount model when dividends are a credible proxy for what the company can distribute to shareholders over time. Use residual income when payout policy is not telling the full economic story. A good residual-income setup usually has
What changes in my calculations when one leg of a bull spread is short?
The short leg turns part of the upside into a negative payoff for your strategy once that option finishes in the money. Example with **Harbor Vision Media**: - Long call, strike `65`, premium `5` - Short call, strike `75`, premium `2` If the stock en
How should I think about a collar when the stock position and the options seem to push against each other?
Start with the stock because the collar is built around an existing equity position. The put and the short call then reshape that stock payoff. Suppose **Silver Pike Logistics** owns stock at `90`, buys a put with strike `84` for `2`, and sells a cal
Why does a long straddle have two breakeven prices instead of one?
A long straddle owns both upside exposure and downside exposure around the same strike. Because profit can come from a large move in either direction, the strategy has one breakeven above the strike and one below it. Take **Elm Ridge Stores**: - Long
How do I stop mixing up option payoff and option profit on CFA derivatives questions?
Use a two-line routine every time: 1. Solve expiration value from intrinsic payoff only. 2. Then add initial premium inflows and outflows to reach profit. Suppose **Aster Telecom** buys a call with strike `40` for premium `3`. If the stock ends at `4
How do TIPS protect against deflation, and is the protection complete?
TIPS deflation protection is partial: principal floor at maturity guarantees return of original face value, but coupons during deflation are paid on lower indexed principal (no coupon floor). Floor applies per-bond to original face only, not to secondary market purchase prices above par...
How does the second-generation currency crisis model explain self-fulfilling speculative attacks, and what role do multiple equilibria play?
Second-generation currency crisis models show that self-fulfilling speculative attacks can occur when fundamentals are in a 'vulnerable zone' where both crisis and no-crisis equilibria are possible. The attack itself raises defense costs (higher interest rates, unemployment), making devaluation rational and confirming the initial expectation.
How does the first-generation currency crisis model explain speculative attacks, and what fundamental imbalances trigger the collapse of a fixed exchange rate?
First-generation currency crisis models explain speculative attacks as rational responses to unsustainable fiscal deficits financed by money creation. Reserves drain predictably until speculators attack at the moment the shadow exchange rate exceeds the peg, making the crisis inevitable given the policy inconsistency.
What are the advantages and disadvantages of full dollarization, and when might a country choose to abandon its own currency?
Full dollarization provides instant inflation credibility, eliminates currency risk, and reduces transaction costs, but permanently sacrifices monetary policy independence, lender-of-last-resort capability, and seigniorage revenue. Countries typically dollarize after chronic monetary mismanagement when credibility gains outweigh sovereignty costs.
What is the twin deficits hypothesis, and under what conditions does a fiscal deficit lead to a current account deficit?
The twin deficits hypothesis links fiscal deficits to current account deficits through the national accounting identity. The relationship holds when consumers are non-Ricardian and capital markets are open, but breaks down when private savings offset the fiscal deficit or when strong export sectors independently drive current account surpluses.
What is Ricardian equivalence, and why does it predict that debt-financed government spending has no stimulative effect — and does this hold in practice?
Ricardian equivalence predicts that debt-financed spending has zero stimulative effect because rational consumers save tax cuts to pay for future tax increases. In practice, finite lifespans, liquidity constraints, and bounded rationality cause the theory to partially fail, reducing but not eliminating fiscal multipliers.
How is the fiscal multiplier estimated, and what factors determine whether it is greater than, equal to, or less than one?
Fiscal multipliers range from below 0.5 to above 2.0 depending on economic conditions. Multipliers are largest during recessions with accommodative monetary policy and smallest during expansions in open economies where monetary policy offsets fiscal stimulus.
What is yield curve control (YCC), and how does targeting a specific yield differ from quantitative easing in terms of mechanism and risks?
Yield curve control targets a specific bond yield and adjusts purchase quantity as needed, unlike QE which fixes purchase quantity. YCC is efficient when credible (few purchases needed) but creates unlimited balance sheet risk when fundamentals diverge from the target yield.
How do negative interest rate policies work in practice, and what is the 'reversal rate' that limits how negative rates can go?
NIRP charges banks on excess reserves using tiered systems that protect most reserve holdings from the negative rate. The reversal rate — estimated at -1.0% to -1.5% — is the floor beyond which further cuts become contractionary by destroying bank margins and reducing lending capacity.
How does quantitative easing (QE) work through the financial system, and what are the primary transmission channels from central bank asset purchases to the real economy?
QE transmits to the real economy through portfolio rebalancing (strongest channel), signaling, wealth effects, exchange rate depreciation, and credit channels. The central bank purchases bonds to remove duration from private portfolios, forcing investors into riskier assets and compressing yields across the curve.
What is central bank forward guidance, and how do the different types (Delphic vs. Odyssean) affect market expectations and the yield curve?
Forward guidance ranges from Delphic (forecasts without commitment) to Odyssean (binding commitments tied to dates or economic thresholds). State-contingent Odyssean guidance produces the strongest yield curve impact, but effectiveness diminishes with repetition and depends critically on central bank credibility.
How do you value an expansion option embedded in a capital project, and when does it materially affect the NPV decision?
An expansion option lets management scale up a project if demand is strong. Strategic NPV equals the base NPV plus the expansion option value. This option is most valuable under high uncertainty with modular project design.
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