Community Q&A
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CFA Level II Updated
How are intercompany transactions eliminated during consolidation?
Intercompany transactions must be fully eliminated during consolidation. For downstream sales (parent to subsidiary), unrealized profit is allocated entirely to the parent. For upstream sales (subsidiary to parent), unrealized profit is shared between parent and NCI proportionally.
What is risk parity and how does it differ from traditional asset allocation?
Risk parity allocates portfolio weights so each asset class contributes equally to total portfolio risk. Unlike a traditional 60/40 portfolio (which derives ~90% of risk from equities), risk parity achieves true diversification across risk sources, often using leverage to reach target returns.
How do decision trees work for financial classification problems?
Decision trees recursively split data at each node using the variable that produces the most homogeneous child groups (measured by entropy or Gini impurity). They are interpretable but prone to overfitting, which is why ensemble methods like random forests are often preferred.
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 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.
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.
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 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.
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 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'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 boosting and how does gradient boosting differ from AdaBoost?
Boosting builds strong learners by sequentially combining weak learners focused on previous errors. AdaBoost reweights examples; gradient boosting fits residuals via gradient descent...
How does venture debt complement equity financing for startups, and what role do warrants play in the lender's return?
Venture debt provides startups with non-dilutive capital between equity rounds. Lenders earn interest plus warrant coverage that provides equity upside. Founders preserve ownership — dilution from warrants is typically one-tenth of what additional equity would cost.
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