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CFA Level II Updated
When do you use the temporal method vs the current rate method for foreign subsidiary translation?
The temporal method (remeasurement) is used when the subsidiary's functional currency equals the parent's, with gains/losses in the income statement. The current rate method (translation) is used when the functional currency is the local currency, with gains/losses in OCI as a CTA.
How does defined benefit pension funded status appear on the balance sheet?
The balance sheet reports the funded status of the pension plan: Fair Value of Plan Assets minus PBO. If the PBO exceeds plan assets, a net pension liability is recorded. Changes each period include service cost, interest cost, actual return on assets, contributions, and benefits paid.
What are the different types of share repurchase programs and their trade-offs?
Four main buyback methods: open-market (most common, flexible, slow), fixed-price tender (premium price, fast), Dutch auction tender (range-based price discovery), and accelerated share repurchase (immediate retirement via investment bank). Each balances speed, flexibility, cost, and signaling...
How does market timing theory explain equity issuance patterns?
Market timing theory: firms issue equity at high valuations, and past timing decisions leave a persistent imprint on current leverage. Baker-Wurgler found cumulative market-to-book weight explains leverage.
What is negative binomial regression and when do I prefer it over Poisson?
Negative binomial regression extends Poisson by adding a dispersion parameter allowing variance to exceed mean, handling overdispersion common in financial count data...
How does adding a risk-free asset change the efficient frontier?
Adding rf transforms the efficient frontier from a curved hyperbola into a straight line. Both E[R] and standard deviation scale linearly with risky-asset weight, producing a line tangent to the old frontier...
What is a vector autoregression (VAR) model?
VAR is a multivariate AR where each variable depends on lags of itself and all others. No theoretical identification required. Foundation of macro policy analysis.
What is an error correction model (ECM)?
ECM models short-run dynamics of cointegrated series with an error correction term pulling back to long-run equilibrium. Lambda must be negative and significant for true cointegration.
What does yield curve normalization look like and when does it occur?
Yield curve normalization typically unfolds through a bull steepener...
What causes the yield curve to invert?
Yield curve inversion results from the interplay of Fed policy, inflation expectations, term premia...
When is it optimal to defer an investment and how is the deferral option valued?
A deferral option is the right to postpone investment — equivalent to an American call on the project...
What are the primary risks investors face with blank check companies, and how does the sponsor incentive structure create misalignment?
The primary risk of blank check companies is sponsor-shareholder misalignment. Sponsors profit even from mediocre deals due to founder shares received for minimal investment. Structural dilution, deadline pressure, and reliance on optimistic projections further disadvantage public investors.
How does the Isolation Forest algorithm detect anomalies in financial data, and why is it preferred over distance-based methods?
Isolation Forest detects anomalies by measuring how few random splits are needed to isolate an observation. Anomalies — being few and different — are isolated quickly with short path lengths. It requires no distributional assumptions, making it ideal for fat-tailed financial data.
How do the components of the Balance of Payments fit together? I need a visual of how the accounts interact.
The Balance of Payments is an accounting identity where the current account, capital account, and financial account must sum to zero. A current account deficit means the country imports more than it exports, which is financed by capital and financial account inflows.
How is the real yield curve constructed, and what economic information does its shape convey compared to the nominal curve?
The real yield curve is constructed from inflation-linked bond yields and reflects compensation above expected inflation. Its shape is driven by monetary policy (short end), institutional demand (belly), and real term premium (long end). Negative real yields indicate investors accept guaranteed purchasing power loss, typically driven by safe-haven demand or monetary policy.
How are employee stock options (ESOs) expensed on the income statement, and what adjustments should analysts make for valuation purposes?
Employee stock options are expensed at grant-date fair value over the vesting period under ASC 718 and IFRS 2. For DCF valuation, analysts must choose either to deduct ESO expense from cash flows (using basic shares) or add it back (using diluted shares) — never both, as this double-counts the cost of equity compensation.
How should a company recognize a provision for a loss-making (onerous) contract, and what costs are included in the assessment?
An onerous contract provision under IAS 37 is recognized when unavoidable costs of meeting obligations exceed expected benefits. Post-2022 amendments clarify that unavoidable costs include both incremental costs and an allocation of directly related costs, not just incremental amounts.
What empirical evidence supports or contradicts the pecking order theory of capital structure?
Empirical evidence for the pecking order theory is mixed. Supporting evidence includes the dominance of internal financing, negative announcement effects for equity issues, and the observation that profitable firms use less debt. Contradicting evidence shows that small firms issue equity frequently, many firms maintain target leverage ratios, and large cash holdings coexist with debt.
How does tokenized real estate work, and what advantages and risks does it present compared to traditional real estate investment?
Tokenized real estate uses blockchain-based tokens to represent fractional ownership in property through a special purpose vehicle. While it lowers minimum investments and enables faster transfers, significant challenges remain in secondary market liquidity, legal complexity, regulatory compliance, and smart contract risk.
Structural vs. reduced-form credit models — what's the real difference and which does the CFA exam emphasize?
The exam is predominantly conceptual for credit models. Structural models (Merton) treat equity as a European call option on firm assets with debt face value as the strike. Reduced-form models treat default as a random event governed by a hazard rate, without modeling firm assets directly.
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