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CFA Level II Updated
How does an interval fund operate mechanically, and what investor protections are built into its structure?
Interval funds operate under SEC Rule 23c-3, requiring periodic share repurchases at NAV with at least 21 days notice. When redemption requests exceed the repurchase amount, they are prorated proportionally. Investor protections include mandatory repurchase schedules, minimum 5% offers, and NAV-based pricing.
How do you value a stock using the residual income model, and when is it better than DCF?
The residual income (RI) model is a powerful valuation tool, especially useful when dividends are unpredictable or free cash flow is negative. Residual income is the earnings a company generates above and beyond what investors require on their equity capital.
What is equal risk contribution (ERC) in risk budgeting, and how do you calculate each asset's risk contribution?
Equal risk contribution allocates portfolio weights so each asset contributes the same amount to total portfolio risk. Risk contribution is calculated as weight times marginal contribution to risk, and ERC requires numerical optimization since closed-form solutions rarely exist.
What are the differences between a fixed-price tender offer and an open-market stock repurchase, and when would a company choose each?
A fixed-price tender offer involves buying shares at a set premium within a short window, sending a strong undervaluation signal. Open-market repurchases buy shares gradually at market prices with no completion obligation, offering maximum flexibility.
How do you identify a cash-generating unit under IAS 36, and what are the practical criteria for grouping assets?
A cash-generating unit under IAS 36 is the smallest group of assets generating largely independent cash inflows. Identification depends on revenue independence, management reporting, and whether the asset group could be sold as a going concern.
How does the APV method separate the unlevered firm value from financing side effects?
APV separates firm value into the unlevered value (discounted at the unlevered equity cost) plus the present value of tax shields. This decomposition is ideal when debt levels change over time, such as in LBOs or project finance.
How does ridge regression use an L2 penalty to handle multicollinearity, and how do you choose the penalty parameter?
Ridge regression adds an L2 penalty (sum of squared coefficients times lambda) to the OLS objective, shrinking coefficients toward zero to stabilize estimates under multicollinearity. The penalty parameter lambda is chosen via cross-validation.
What are the main economic effects of immigration on labor markets, wages, and long-term growth?
Immigration increases total GDP through labor force expansion, has modest and mixed effects on native wages depending on skill complementarity, and contributes positively to innovation and fiscal balances over the long run. For aging economies, immigration is a critical lever for sustaining potential GDP growth.
How do you create a synthetic long stock position using options, and why would you use it instead of buying actual shares?
A synthetic long stock combines a long call and short put at the same strike and expiration, replicating share ownership with dollar-for-dollar tracking. It offers capital efficiency and leverage advantages but sacrifices dividends, voting rights, and permanence.
How does theta decay vary across different times to expiration, and why does it accelerate near expiry?
Theta decay follows a square-root-of-time relationship, meaning options lose time value at an accelerating rate as expiration approaches. ATM options experience the most dramatic acceleration, which is why option sellers target the 30-45 DTE window for optimal theta capture.
What exactly are equity-linked notes and why would an investor choose them over direct equity exposure?
An equity-linked note is a structured debt instrument whose return is tied to equity performance. It typically combines a zero-coupon bond with an embedded equity derivative, offering downside protection in exchange for capped upside participation.
How are variable lease payments accounted for under IFRS 16, and what is the difference between index-linked and performance-based variable payments?
Variable lease payments linked to an index or rate are included in the lease liability and remeasured when the index changes. Performance-based or usage-based variable payments are excluded from the liability and expensed as incurred, potentially understating reported leverage.
What are the specific criteria for recognizing revenue on a bill-and-hold arrangement, and why is it considered a red flag?
Bill-and-hold arrangements allow revenue recognition while the seller retains physical possession of goods. Four strict criteria must be met: substantive business reason, goods separately identified as the customer's, ready for transfer, and not available for other customers.
How are customer loyalty programs accounted for under IFRS 15, and how does the deferred revenue calculation work?
Loyalty points represent a separate performance obligation under IFRS 15. The transaction price is allocated between the delivered product and the points based on relative standalone selling prices. Revenue on points is deferred and recognized as redeemed or upon expiration.
What does the LIBOR-OIS spread tell us that the TED spread doesn't?
The LIBOR-OIS spread isolates pure bank credit and liquidity risk by comparing term interbank rates to expected overnight rates, avoiding the flight-to-quality distortion that inflates the TED spread during crises.
What is the Abnormal Earnings Growth (AEG) model and how does it differ from residual income?
The Abnormal Earnings Growth model anchors on capitalized forward earnings rather than book value, adding value for earnings growth that exceeds the cost of equity. AEG is preferred over residual income when book values are unreliable.
What is the difference between CPR and SMM in MBS prepayment modeling, and how do you convert between them?
CPR is the annualized prepayment rate; SMM is the monthly equivalent. Convert using SMM = 1 - (1-CPR)^(1/12). SMM is applied to the balance after scheduled payments to project monthly prepayments in MBS cash flow models.
What is a dollar roll in the MBS market and how does it work as a financing tool?
A dollar roll is an MBS financing transaction where the investor sells MBS for current delivery and buys back a similar (not identical) MBS for future delivery. The price difference (drop) plus reinvestment income can make this cheaper than repo financing.
Can I use the residual income model when book value of equity is negative?
The residual income model can work with negative book value because future RI adds value on top of the negative anchor. When book value is negative, the equity charge becomes an addition to RI. However, the model becomes unstable and alternative approaches may be preferred.
How do I compute FCFE when the company is actively changing its capital structure?
When a company is deleveraging, net borrowing is negative, reducing FCFE significantly during the transition period. Model each year explicitly, then use the stable target capital structure for terminal value. Consider using FCFF/WACC when leverage is actively changing.
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