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CFA Level II Updated
How do I optimize the width of a collar, and what trade-offs am I making between protection and participation?
Collar width optimization balances downside protection (put strike) against upside participation (call strike). Key factors include risk tolerance, return targets, volatility skew, and the zero-cost constraint. Tighter collars provide more protection but cap more upside.
How do recovery rates vary by seniority in the capital structure, and why does this matter for bond investors?
Recovery rates vary dramatically by seniority: senior secured bank loans recover 70-80% on average, senior unsecured bonds recover 40-50%, and subordinated bonds recover only 20-25%. These differences drive significant credit spread differentiation within the same issuer's capital structure.
What are the unique valuation challenges in cross-border M&A that don't exist in domestic deals?
Cross-border M&A introduces currency alignment challenges, country risk premiums, tax regime differences, multiple regulatory approvals, and cultural integration risks that don't exist in domestic deals.
What is rho and when does interest rate sensitivity actually matter for options?
Rho measures an option's sensitivity to a 1 percentage point change in the risk-free rate. Calls have positive rho and puts have negative rho. While often the least significant Greek, rho matters for long-dated options and deep in-the-money positions.
How is past service cost handled differently under IFRS versus US GAAP?
Under IFRS, past service cost from a pension plan amendment is recognized entirely in profit or loss immediately. Under US GAAP, it is initially recognized in OCI and then amortized to pension expense over the average remaining service period of affected employees. The total impact is the same, but timing differs significantly, affecting earnings comparability.
How do you price a European call option using a two-period binomial model?
The two-period binomial model prices a European call by building a stock price tree, calculating terminal payoffs, then using risk-neutral probabilities to work backward through each period, discounting at the risk-free rate.
What are the limitations of the PEG ratio for equity valuation?
The PEG ratio has major limitations: it assumes a linear relationship between P/E and growth (contradicting the DDM), ignores risk and cost of equity, is undefined for zero or negative growth, varies with which growth rate is used, and ignores the payout ratio.
In a step acquisition, what happens to the pre-existing equity interest when you gain control?
In a step acquisition, the previously held equity interest is remeasured to fair value at the date control is achieved. The difference between fair value and carrying amount is recognized as a gain or loss in the income statement.
How does the PSA prepayment model work for mortgage-backed securities, and what does '200 PSA' actually mean?
The PSA prepayment model ramps the conditional prepayment rate (CPR) from 0.2% in month 1 to 6.0% by month 30, then holds flat. '200 PSA' doubles all these rates (CPR peaks at 12%). Faster prepayments create contraction risk (principal returned early at low rates) while slower prepayments create extension risk.
Can someone walk through a two-stage DDM with actual numbers? I keep getting the terminal value calculation wrong.
The two-stage DDM projects high-growth dividends individually, then calculates a terminal value using the Gordon model at the transition point. The key is computing the terminal value using the NEXT dividend after the transition and discounting it back to today. Common mistakes include using the wrong dividend and forgetting to discount.
How does distressed investing work? What's the strategy behind buying bonds of companies in or near bankruptcy?
Distressed investing involves buying deeply discounted debt of troubled companies, profiting through restructuring, recovery trading, or asset liquidation. The key strategies include loan-to-own, fulcrum security identification, and trading around restructuring events.
How is machine learning changing the investment management industry? Are robo-advisors and algo trading making human analysts obsolete?
Machine learning is automating portfolio rebalancing, execution, and compliance while augmenting fundamental analysis and asset allocation. Robo-advisors serve mass-market clients, but complex financial planning still requires human judgment.
What are the main types of corporate restructuring and when does each create value?
Corporate restructuring includes divestitures, spin-offs, equity carve-outs, and leveraged buyouts. Each creates value through different mechanisms — from eliminating conglomerate discounts to improving managerial focus to capturing tax shields.
How do currency options work for hedging FX exposure? When would I use them instead of forward contracts?
Currency options give the holder the right to exchange currencies at a predetermined rate. The key advantage over forwards is participating in favorable moves while being protected against adverse ones, but this flexibility comes at the cost of the option premium.
How should an analyst evaluate changes in the DTA valuation allowance?
The valuation allowance on a DTA signals management's assessment of future profitability. Increases suggest doubt about realizing the DTA; decreases suggest improved outlook. Analysts should evaluate whether VA changes are justified by business fundamentals or used for earnings management.
How do pension assumptions (discount rate, salary growth, expected return) affect reported financials?
The discount rate, compensation growth rate, and expected return on plan assets each have distinct effects on PBO, pension expense, and funded status. Management can influence reported financials through these assumption choices, making pension footnote analysis critical.
Do stock splits create shareholder value or are they purely cosmetic?
Stock splits increase shares proportionally and reduce per-share price without changing market cap. Arguments for real effects: improved retail liquidity, positive signaling (+2-3% return), optimal trading range. Counter-arguments: fractional shares eliminate liquidity gains, institutions are price-agnostic...
What does the trade-off theory say about optimal capital structure?
Trade-off theory balances debt tax shields against distress and agency costs, predicting higher leverage for stable, tangible-asset firms and lower leverage for volatile intangible-intensive firms like biotech.
What's probit regression and how does it differ from logit?
Probit regression uses the inverse standard normal CDF as link function for binary outcomes, vs logit using log-odds. Predictions are nearly identical in most cases...
What is the Capital Allocation Line and how do I derive it?
The CAL shows risk-return combinations from mixing a risky portfolio with the risk-free asset. Slope equals the Sharpe ratio. Every risky portfolio generates its own CAL...
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