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CFA Level II Updated
How do CMO tranches redistribute prepayment risk, and what are PAC vs. support tranches?
CMOs redistribute pass-through prepayment risk among tranches. Sequential-pay structures direct principal to tranches in order. PAC tranches maintain a predictable schedule within a PSA band, while support tranches absorb all prepayment variability, bearing the highest risk.
What discounts apply when valuing a private company, and how do you estimate DLOC and DLOM?
Private company valuations require two key discounts: DLOC (Discount for Lack of Control) and DLOM (Discount for Lack of Marketability). DLOC adjusts for minority stakes lacking control rights, while DLOM adjusts for the inability to quickly sell at fair value. They are applied multiplicatively.
How do industry life cycle stages affect equity valuation approach and assumptions?
Industry life cycle stages — embryonic, growth, shakeout, mature, and decline — each imply different growth rates, margins, and cash flow profiles. This determines the appropriate valuation approach: early-stage companies require revenue multiples or option-based models, while mature firms suit stable DDM and peer multiples.
What are the main methods for estimating the equity risk premium and which should I use?
The equity risk premium can be estimated using historical averages (5.5-8.0%), forward-looking GGM approaches (3.5-5.0%), surveys (3.0-6.0%), or macroeconomic models (3.5-5.5%). Each method has trade-offs, and even small differences in ERP dramatically change equity valuations.
When and how do you impair an equity method investment?
Equity method investments can be impaired when objective evidence of decline exists (IFRS) or when the decline is deemed other-than-temporary (US GAAP). The carrying amount is written down to recoverable amount or fair value, with a key difference being that IFRS allows reversals while US GAAP does not.
How do TIPS (Treasury Inflation-Protected Securities) mechanically work?
TIPS adjust principal daily using CPI-U. Indexed Principal = Original × (Current CPI / Base CPI). Coupons are paid on indexed principal, so both coupons and maturity repayment rise with inflation. Deflation floor at maturity guarantees return of original face value...
How do splines work in regression and what's the difference between natural vs cubic splines?
Spline regression joins polynomial pieces at knots to create smooth flexible curves. Natural cubic splines add linearity constraints at boundaries for stable extrapolation...
What do investor utility functions look like for different risk aversion levels?
Risk aversion A in mean-variance utility shapes indifference curves. Low A gives shallow parabolas; high A gives steep ones. Typical A values range 1-2 for aggressive to 6-10 for conservative investors...
How does royalty financing work as an alternative funding mechanism, and what types of assets generate suitable royalty streams?
Royalty financing provides capital in exchange for a percentage of revenue from a specific asset — a drug, patent, or mineral resource. Unlike revenue-based financing on total company sales, royalties are tied to a named product's performance over its commercial life.
What are the differences between filter, wrapper, and embedded feature selection methods for financial factor models?
Filter methods rank features by statistical metrics independently of any model. Wrapper methods evaluate subsets by training the actual model. Embedded methods perform selection during training. A cascaded approach — filter first, then embedded, then wrapper — is most practical.
What determines the shape of the credit spread term structure, and under what conditions can it invert?
The credit spread term structure normally slopes upward because cumulative default probability, forecast uncertainty, and liquidity premiums all increase with maturity. Inversion occurs when near-term default risk is elevated relative to long-term survival probability — typically for distressed issuers facing imminent refinancing risk or covenant triggers where surviving the near term materially improves long-term prospects.
How does the securitization waterfall work? I need to understand the cash flow priority structure.
Securitization creates a waterfall structure where cash flows from an underlying asset pool are distributed in priority order: senior tranches first, then mezzanine, then equity. Losses are absorbed in reverse order, with the equity tranche taking the first hit.
How do UK inflation-linked gilts work mechanically, and how does the 3-month indexation lag affect pricing and analysis?
UK inflation-linked gilts adjust principal and coupons using the RPI with a 3-month indexation lag, meaning the Reference RPI for any settlement date comes from three months prior. This lag causes investors to miss the final period's inflation at maturity and creates partially known near-term cash flows that affect duration and pricing.
How can option pricing theory be used to value equity in a distressed company, and what is the Merton model's practical application?
The Merton model treats equity as a call option on firm assets with the face value of debt as the strike price. For distressed companies where assets are near or below debt levels, this framework captures the option value of potential asset recovery that traditional balance sheet analysis assigns as zero.
What are the revenue disaggregation requirements under IFRS 15 and ASC 606, and how should analysts use this information?
IFRS 15 and ASC 606 require disaggregation of revenue into categories reflecting how economic factors affect the nature, timing, and uncertainty of revenue. Categories include product type, geography, transfer timing, and customer type. Analysts should use this data to assess revenue quality, concentration risk, and mix shifts.
Under what conditions is capital structure irrelevant to firm value according to Modigliani-Miller, and why do these conditions matter?
Modigliani-Miller Proposition I shows that firm value is independent of capital structure when there are no taxes, bankruptcy costs, agency costs, information asymmetry, or transaction costs. Relaxing each condition systematically explains why real-world firms have optimal capital structures and forms the foundation of modern capital structure theory.
FCFE vs. FCFF: when should I use each, and how do I avoid double-counting debt effects?
This is one of the highest-yield topics for CFA Level II. Use FCFF when leverage is expected to change significantly because it is independent of capital structure. Use FCFE when leverage is stable and you want to value equity directly.
How does a leveraged risk parity portfolio work, and why does it use leverage on bonds to match equity-like returns?
Leveraged risk parity applies borrowing to amplify the returns of a bond-heavy, equal-risk-contribution portfolio. Since bonds historically have higher Sharpe ratios, leveraging the portfolio can achieve equity-like returns with better diversification, but introduces interest rate, liquidity, and margin risks.
How does a Dutch auction share repurchase work, and why might a company prefer it over a fixed-price tender offer?
A Dutch auction repurchase lets shareholders name their minimum selling price within a firm-specified range, and the clearing price is set at the lowest level needed to acquire the target number of shares. All accepted tenders receive the same clearing price.
What is the difference between fair value less costs of disposal and value in use when determining recoverable amount under IAS 36?
Recoverable amount under IAS 36 is the higher of fair value less costs of disposal and value in use. FVLCD reflects market-based selling price minus transaction costs, while VIU is the present value of expected future cash flows from continued use.
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