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CFA Level II Updated
How do you decompose a corporate bond's yield spread into its component parts, and what drives each one?
A corporate bond's yield spread over Treasuries decomposes into credit spread (expected loss plus credit risk premium), liquidity premium, optionality adjustment, and tax effects. The credit risk premium -- compensation beyond expected loss -- typically accounts for 60-80% of the total credit spread.
How do you calculate the justified P/E ratio from the Gordon Growth Model, and when would you use trailing vs. leading P/E?
The justified P/E ratio is derived directly from the Gordon Growth Model. The leading version equals (1 - b)/(r - g) and the trailing version equals (1 - b)(1 + g)/(r - g). Unlike market P/E, the justified P/E reflects fundamental value and helps identify over- or undervaluation.
How do you value a REIT? The standard P/E ratio doesn't seem to work because of depreciation.
Traditional P/E understates REIT profitability because real estate depreciation is largely non-economic. REITs use FFO, AFFO, and NAV-based valuation metrics that adjust for this accounting distortion.
How do neural networks work at a high level, and what are the risks of using them in investment decisions?
Neural networks learn complex non-linear relationships through layers of connected nodes trained via backpropagation. Key risks in finance include overfitting, black-box opacity, and non-stationarity of financial relationships.
What are agency costs and how do they affect corporate financing decisions?
Agency costs arise when the interests of agents don't align with principals. In corporate finance, there are agency costs of equity (shareholder-manager conflict) and agency costs of debt (shareholder-bondholder conflict), each with specific mitigation mechanisms.
How do credit default swaps actually work? What happens when a credit event is triggered?
A credit default swap is essentially insurance on a bond issuer's credit risk. The protection buyer makes periodic payments to the protection seller, who compensates the buyer if a credit event such as bankruptcy, failure to pay, or restructuring occurs.
What are the key differences between IFRS and US GAAP pension accounting?
Key differences: IFRS uses a single net interest approach with no expected return assumption, while US GAAP uses separate interest cost and expected return. IFRS never recycles actuarial gains/losses from OCI, while US GAAP amortizes them via the corridor method.
What is the Fundamental Law of Active Management and what does it tell us?
The Fundamental Law states IR ≈ IC × √BR, meaning active portfolio performance depends on forecast skill (IC) multiplied by the square root of independent bets (BR). The transfer coefficient (TC) adjusts for constraints that prevent full translation of skill into positions.
How do you detect and prevent overfitting in machine learning models?
Overfitting is detected by comparing training vs. validation performance — a large gap signals the model memorized noise. Prevention techniques include cross-validation, regularization (L1/L2), ensemble methods, early stopping, and feature reduction.
Gordon growth model vs. exit multiple — which terminal value method should I use?
The Gordon growth model assumes perpetual FCF growth and is theoretically rigorous but highly sensitive to inputs. The exit multiple method uses market-based multiples and is easier to benchmark. Best practice is to use both and reconcile differences.
What are the key red flags for detecting earnings manipulation?
Key red flags include revenue growing faster than operating cash flow, rising DSO, capitalizing operating expenses, declining depreciation-to-asset ratios, and persistent gaps between accruals and cash flows. The Beneish M-Score is a quantitative tool for detection.
What makes timberland unique as an investment, and how does harvest flexibility create an option-like payoff?
Timberland returns come from biological growth (2-6% annual volume increase), timber price changes, and land appreciation. Harvest flexibility acts as an embedded real option — investors can delay harvest when prices are low while trees continue growing.
What are the key corporate governance mechanisms that protect shareholders, and how do governance failures destroy value?
Key governance mechanisms include independent boards, separation of CEO/Chair roles, and strong shareholder rights. Governance failures like empire building, related-party transactions, and entrenched management can destroy significant shareholder value.
How do sterilized and unsterilized central bank interventions differ in their effect on exchange rates?
Unsterilized intervention changes the money supply and is more effective at moving exchange rates because it alters monetary conditions. Sterilized intervention offsets the money supply impact and relies mainly on signaling and portfolio balance channels.
How does the Brinson-Hood-Beebower performance attribution model separate allocation from selection effects?
The Brinson model decomposes active returns into allocation (sector weighting decisions), selection (stock picking within sectors), and interaction effects. The allocation effect measures whether the manager overweighted outperforming sectors.
How do interest rate caps, floors, and collars work for hedging floating-rate debt?
Interest rate caps protect floating-rate borrowers from rising rates by paying out when rates exceed the cap strike. Floors protect lenders from falling rates. Collars combine a long cap with a short floor to reduce the net premium cost.
What drives swap spreads and what does a negative swap spread mean?
Swap spreads represent the difference between the fixed swap rate and the matching-maturity Treasury yield. They're driven by credit risk, Treasury supply, balance sheet constraints, and hedging demand. Negative swap spreads can occur when Treasury supply overwhelms dealer capacity.
What are covered bonds and how are they different from regular asset-backed securities?
Covered bonds differ from ABS primarily through dual recourse: investors have claims on both the segregated cover pool and the issuer itself. Additionally, the cover pool is dynamic — the issuer must replace defaulted or prepaid assets.
How does a credit default swap (CDS) work and how is the spread determined?
A credit default swap is a bilateral contract providing credit protection. The protection buyer pays a periodic spread in exchange for compensation at a credit event. The CDS spread is set so PV of premiums equals PV of expected loss, approximately equal to PD times LGD.
How does the venture capital method work for valuing early-stage companies?
The venture capital method values early-stage companies by projecting an exit value, discounting it at a high rate to get post-money valuation, then subtracting the investment to get pre-money valuation. The VC's ownership equals the investment divided by post-money valuation.
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