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CFA Level II Updated
How do calendar spreads harvest theta, and what conditions make them most profitable?
Calendar spreads harvest theta by selling a near-term option that decays faster and owning a longer-term option at the same strike. Maximum profit occurs when the underlying stays near the strike at front-month expiry with stable or rising implied volatility.
How does cash flow matching work in liability-driven investing, and when is it preferred over duration matching?
Cash flow matching constructs a bond portfolio whose coupon and principal payments exactly coincide with future liability payments, eliminating both reinvestment and interest rate risk. It is preferred over duration matching when liabilities are fixed, certain, and the cost of shortfall is very high.
What is a dividend capture strategy, and how does tax arbitrage drive its profitability?
Dividend capture strategies buy shares before the ex-date and sell after, profiting when the after-tax dividend exceeds the after-tax capital loss from the ex-date price drop. Tax-exempt investors capture the spread because stock prices typically drop less than 100% of the dividend.
How does classifying a disposal group as held for sale affect the income statement under IFRS 5?
Under IFRS 5, a disposal group meeting held-for-sale and discontinued operations criteria is shown as a single line below continuing operations on the income statement. Depreciation ceases, and the group is carried at the lower of carrying amount and fair value less costs to sell.
What does Market Value Added (MVA) tell us about cumulative value creation, and how does it relate to EVA?
MVA equals market value minus total invested capital, measuring cumulative wealth creation. It is the present value of all expected future EVAs. Positive MVA means the market values the firm above what investors have put in, indicating sustained value creation.
How does principal component regression reduce dimensionality, and what are its limitations for prediction?
PCR replaces correlated predictors with uncorrelated principal components and regresses the response on those. Its main limitation is that PCA maximizes X-variance, not correlation with Y, so the most important prediction signal may reside in low-variance components.
What is the secular stagnation hypothesis, and why do some economists believe developed economies are stuck in a low-growth equilibrium?
The secular stagnation hypothesis argues that structural excess saving and deficient investment push the natural interest rate below zero, trapping developed economies in persistent below-potential growth. Aging populations, income inequality, and cheaper capital goods are key drivers, with implications for lower long-term asset returns.
How do you analyze the true cost of a protective put, and when does portfolio insurance become too expensive?
The true cost of a protective put includes the premium paid, the annualized drag on portfolio returns from continuous rolling, and the opportunity cost of the breakeven gap. Insurance becomes too expensive when the annualized cost exceeds the stock's expected return or when implied volatility substantially exceeds realized volatility.
How is a variance swap replicated using a strip of options, and why is this replication important?
A variance swap is replicated using a strip of out-of-the-money options across all strikes, weighted by 1/K^2. This replication is model-free and forms the basis for VIX calculation and variance swap pricing by dealers.
What framework governs green bonds and how do investors verify that proceeds are used for environmental purposes?
Green bonds are governed by the ICMA Green Bond Principles with four pillars: use of proceeds, project evaluation, proceeds management, and reporting. Verification includes second-party opinions, CBI certification, and post-issuance audits to prevent greenwashing.
In a dual-listing setup, which market leads price discovery and how can you tell?
In dual-listed stocks, price discovery is typically led by the market with higher trading volume, the home exchange, and the venue with better microstructure. Researchers measure this using Hasbrouck Information Shares and Gonzalo-Granger Component Shares.
How should analysts approach pro forma (non-GAAP) financial metrics, and what adjustments are appropriate for ratio analysis?
Pro forma adjustments exclude items management considers non-representative. Analysts should scrutinize these by checking if excluded items are truly non-recurring, whether they represent real economic costs (like SBC), and whether GAAP and non-GAAP trends diverge significantly.
How can companies manipulate earnings through pension assumptions, and what adjustments should analysts make?
Companies can manipulate earnings through pension assumptions — primarily the expected return on plan assets, discount rate, and salary growth rate. Analysts should compare these to peers and market conditions, then normalize assumptions for comparability.
What is a risk reversal, and how does it express a view on both direction and volatility skew?
A risk reversal sells an OTM put and buys an OTM call (for a bullish view), expressing both a directional bet and a view on volatility skew. By selling the expensive put and buying the cheaper call, you profit from both upside moves and skew normalization.
How does the Merton structural model calculate distance-to-default, and what are its practical limitations?
The Merton model treats equity as a call option on firm assets, with debt as the strike price. Distance-to-default measures how many standard deviations asset value is above the default point, with higher DD meaning lower default risk.
How does purchasing power parity affect international equity valuation, and should I adjust DCF models for PPP?
PPP provides expected future exchange rates for converting foreign-currency cash flows in international DCF models. Two equivalent approaches exist: value in local currency then convert, or convert each cash flow and discount at domestic rates.
How do you adjust the Black-Scholes-Merton model for stocks that pay a continuous dividend yield?
The Merton extension replaces S with S times e to the negative qT in the BSM formula, where q is the continuous dividend yield. This reduces call values and increases put values because dividends reduce the stock's growth rate during the option's life.
How does principal component analysis (PCA) decompose yield curve movements into factors?
PCA decomposes yield curve movements into three uncorrelated factors: level (parallel shifts, ~85-90% of variance), slope (steepening/flattening, ~8-10%), and curvature (butterfly, ~2-3%). Together they explain over 95% of yield curve variation.
What special adjustments are needed when valuing equities in emerging markets?
Emerging market valuations require adjustments to discount rates (country risk premium, illiquidity), cash flows (political risk scenarios, currency translation), and terminal values. The key is to avoid double-counting risk in both the numerator and denominator.
What is the difference between expected return and actual return on pension plan assets?
Under IFRS, the return on plan assets used in pension cost is calculated using the same discount rate applied to the obligation, with any difference from actual returns going to OCI. Under US GAAP, management sets an expected return rate, which directly reduces pension expense, with the actual-vs-expected difference deferred in OCI. This makes GAAP pension expense more susceptible to management assumptions.
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