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CFA Level II Updated
Can someone explain the Ohlson model and the persistence factor in residual income valuation?
The Ohlson model extends residual income valuation by adding a persistence factor (omega) that captures how quickly abnormal earnings fade toward zero. Higher omega means a stronger competitive moat and significantly higher intrinsic value.
How is the option-adjusted spread (OAS) calculated for callable bonds and what does it represent?
OAS is the spread added to every rate in a binomial tree that equates the model price of a callable bond to its market price, after accounting for the embedded call option. It isolates credit and liquidity compensation and enables fair comparison across bonds.
How does backward induction work for pricing bonds on a binomial tree?
Backward induction starts at maturity and works backward. At each node, take the probability-weighted average of the next period's values plus coupon, then discount at the current node's rate. Always discount by the rate at the node you're computing.
How do large working capital swings affect FCFF and what adjustments should I make?
Large working capital swings can make FCFF volatile even when the underlying business is stable. Normalize by averaging WCInv over multiple years, using WC-to-revenue ratios, or separating one-time items from structural changes.
How do you handle a multi-stage DDM when one phase has negative earnings growth?
A negative growth phase means dividends decline during that period. Use the same DDM framework with negative growth rates. The key is ensuring dividends remain positive and carefully computing the terminal value once growth stabilizes.
What is a bargain purchase and how is it accounted for in acquisitions?
A bargain purchase occurs when the acquisition price is less than the fair value of net identifiable assets. After mandatory reassessment of all fair values, the remaining excess is recognized as a gain in profit or loss immediately. No goodwill is recorded. This typically occurs in distressed sales or forced liquidations.
How do I calculate FCFF starting from EBITDA?
FCFF from EBITDA equals EBITDA times (1 - tax rate) plus the depreciation tax shield minus capital expenditures minus change in working capital. The key is computing taxes on EBIT (not EBITDA) because depreciation provides a tax shield.
How do you build an amortization schedule for the excess purchase price under the equity method?
Building an amortization schedule for excess purchase price under the equity method requires three steps: compute the excess over book value, allocate it to identifiable intangibles and goodwill, then amortize finite-lived items over their useful lives while tracking the investment account balance.
How do you analyze a real estate investment? What's the role of cap rates, NOI, and DCF?
Real estate valuation centers on Net Operating Income and uses three main approaches: capitalization rate for quick valuation, DCF for comprehensive analysis, and cash-on-cash return for leveraged equity analysis.
What are ARMA models and when should I use AR vs MA vs ARMA for CFA Level II?
ARMA models combine autoregressive and moving average components. AR models use past values, MA models use past errors, and ARMA captures both. Model selection relies on ACF and PACF plot patterns.
Can someone clearly explain both Modigliani-Miller propositions — with and without taxes — and when each applies?
Modigliani-Miller is the foundation of capital structure theory. Without taxes, firm value is independent of leverage and WACC is constant. With taxes, the tax shield makes leveraged firms more valuable and lowers WACC.
How do you value an interest rate swap at initiation vs. during its life? The two approaches confuse me.
Swap valuation is one of the most tested topics in CFA Level II Derivatives. At initiation, the swap has zero value because the fixed rate is set to equalize present values. During its life, you can value it using bond replication or FRA replication methods.
What is a variable interest entity and when must it be consolidated?
A VIE is an entity that lacks sufficient equity at risk or whose equity holders lack controlling rights. The primary beneficiary -- the entity with power over significant activities and exposure to significant losses or benefits -- must consolidate the VIE.
What are factor tilts and how do portfolio managers use them?
Factor tilts systematically overweight stocks with desirable characteristics (value, momentum, quality, size, low volatility) to capture documented return premiums. Implementation ranges from benchmark-aware tilts to pure long-short factor portfolios and smart beta ETFs.
How do random forests improve on single decision trees?
Random forests combine many decision trees trained on bootstrap samples with random feature selection at each split. This decorrelates the trees, dramatically reducing overfitting (variance) compared to a single tree, at the cost of interpretability.
What is a 'football field' valuation chart and how is it used in equity analysis?
A football field chart is a horizontal bar chart showing value ranges from multiple valuation methods (DCF, comparables, precedent transactions) side-by-side, allowing analysts to visualize where values converge and how the current stock price compares.
What are the key requirements for segment reporting under IFRS 8?
IFRS 8 requires segment identification based on the management approach — how the CODM views the business internally. Reportable segments must exceed at least one 10% threshold (revenue, profit/loss, or assets), and together must cover at least 75% of external revenue.
What is distressed debt investing, and how do distressed investors identify the fulcrum security?
Distressed debt investors buy deeply discounted debt of troubled companies, often targeting the fulcrum security — the most senior debt class that won't be fully repaid. This security often converts to equity in the restructured company, offering significant upside.
How do share repurchases affect EPS and shareholder value, and when are buybacks value-creating vs. value-destroying?
Share repurchases are EPS-accretive when earnings yield exceeds after-tax borrowing cost, but only create value when shares are purchased below intrinsic value. EPS accretion and value creation are separate concepts — the exam tests both.
How does the carry trade work, and why does it seem to violate uncovered interest rate parity?
The carry trade borrows in low-rate currencies and invests in high-rate currencies to earn the interest differential. Despite uncovered interest rate parity predicting this should not work, the forward premium puzzle shows high-rate currencies depreciate less than expected.
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