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CFA Level II Updated
What are dim sum bonds and why do international issuers choose to issue in the offshore RMB market?
Dim sum bonds are RMB-denominated bonds issued in Hong Kong's offshore market. Non-Chinese issuers use them for cheaper RMB borrowing during appreciation expectations, diversified funding sources, natural currency hedging, and enhanced visibility in China.
How is a variance swap replicated using options, and why is this replication significant for volatility trading?
A variance swap is replicated by a portfolio of OTM options across all strikes, weighted by 1/K-squared. This replication is the theoretical basis of the VIX index and is model-free, meaning it does not depend on any specific option pricing model.
How is the CDX credit index constructed, and how do investors use it for hedging and speculation?
The CDX index is a standardized, equally-weighted portfolio of 125 investment-grade (or 100 high-yield) single-name CDS contracts that rolls semi-annually. Investors use it for macro hedging of credit portfolios, basis trading, and expressing directional views on credit spreads.
What is a squeeze-out merger and what protections do minority shareholders have?
A squeeze-out merger lets a controlling shareholder force minorities to sell their shares after reaching a threshold ownership level (typically 90%+). Minority shareholders are protected by appraisal rights that let them challenge the offered price in court.
When is it optimal to exercise an American call option early, and why do dividends matter?
An American call on a non-dividend stock should never be exercised early because the holder would sacrifice time value and downside protection. For dividend-paying stocks, early exercise is optimal just before the ex-date when the dividend exceeds the remaining time value.
How does the all-current method for foreign currency translation work with a comprehensive example?
The all-current method translates all assets and liabilities at the current exchange rate, common stock at historical rates, and income statement items at the average rate. The cumulative translation adjustment (CTA) is the plug figure in equity that absorbs the exchange rate effects, reported in accumulated other comprehensive income.
Why is an interest rate floor equivalent to a portfolio of put options on interest rates?
An interest rate floor is a series of floorlets, each paying when the reference rate falls below the floor rate. Each floorlet has the payoff structure max(0, K - S), making it equivalent to a put option on the interest rate.
How do I derive and apply the justified P/B ratio from ROE and growth in a Level II context?
At CFA Level II, the justified P/B is derived from the residual income framework: P/B = 1 + PV(future residual income)/Book Value. When ROE exceeds cost of equity, residual income is positive and the justified P/B exceeds 1.0. Multi-period ROE forecasts with fade rates provide more realistic estimates.
What's the difference between partial goodwill and full goodwill methods for NCI, and when do you use each?
The full goodwill method measures NCI at fair value and recognizes goodwill attributable to both parent and NCI. The partial goodwill method measures NCI at its proportionate share of identifiable net assets, recognizing only the parent's goodwill.
How do PAC tranches in a CMO protect against prepayment risk, and what happens to the companion tranche?
PAC tranches receive a fixed principal payment schedule as long as prepayments stay within the PAC collar (e.g., 100-300 PSA). The companion tranche absorbs all prepayment variability, receiving excess principal when prepayments are fast and less when slow. This gives the PAC stability at the cost of a lower yield.
How do you calculate FCFE starting from net income, and why do we add back depreciation but subtract net capex?
FCFE from net income adds back depreciation (non-cash charge), subtracts capex (actual cash investment), adjusts for working capital changes (cash tied up in operations), and adds net borrowing (debt holders share funding burden). Each adjustment converts accrual income into cash available to equity holders.
How do you eliminate unrealized profit on upstream and downstream transactions under the equity method?
For downstream transactions (investor sells to investee), eliminate 100% of the unrealized profit from equity income because it originated on the investor's books. For upstream transactions (investee sells to investor), eliminate only the investor's proportionate share of unrealized profit.
How should digital assets like cryptocurrencies be evaluated as an alternative investment class?
Digital assets don't fit neatly into traditional categories. Institutional evaluation focuses on their diversification benefit, extreme volatility requiring small allocations, and unique valuation challenges since traditional DCF doesn't apply to most crypto assets.
How do AIC and BIC help with model selection, and why can't I just use R-squared?
R-squared always increases with more variables, rewarding overfitting. AIC and BIC add penalty terms for model complexity — AIC penalizes moderately for better predictions, BIC penalizes heavily for a more parsimonious model.
How do you value a target company in an M&A transaction? What are the right multiples to use?
M&A valuation uses three primary methods: comparable company analysis, comparable transaction analysis, and DCF. Practitioners triangulate across all three and explicitly model synergies, applying probability-weighted achievement rates.
How do you trade volatility directly? I keep hearing about straddles and the 'vol surface' but need clarity.
Volatility trading means profiting from changes in implied volatility or from realized volatility differing from what the market expects, regardless of direction. Core strategies include straddles, strangles, and skew trades.
When should an analyst treat a DTL as equity rather than a true liability?
A DTL that grows continuously because of ongoing capital investment effectively never reverses and can be reclassified as equity for analytical purposes. This reduces calculated leverage ratios and provides a more accurate picture of the company's true obligations.
When do you use the temporal method vs. the current rate method for foreign subsidiary translation?
The choice depends on the subsidiary's functional currency. If it's the local currency, use the current rate method with translation adjustments flowing to OCI. If it's the parent's currency, use the temporal method with remeasurement gains/losses hitting the income statement.
What's the real economic difference between stock dividends and cash dividends?
Stock dividends distribute shares (proportional ownership unchanged); cash dividends pay cash. Stock dividends are economically neutral in theory (market cap unchanged, price adjusts). Used for signaling without cash, price range management, and avoiding immediate taxes...
How does MM Proposition II relate cost of equity to leverage?
MM II: cost of equity rises linearly with D/E to offset cheaper debt, keeping WACC constant in a no-tax world. With taxes, WACC falls with leverage via tax shields until bankruptcy costs dominate.
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