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When should I use geometric mean instead of arithmetic mean for investment returns?
This is one of the most frequently tested distinctions in CFA Level I quant. Use arithmetic mean for forecasting a single future period's return, and geometric mean for measuring actual compound growth over multiple periods.
How is an arbitrage-free binomial interest rate tree calibrated to match market prices?
An arbitrage-free binomial tree is calibrated by adjusting interest rates at each node so that the tree correctly prices all on-the-run benchmark bonds at par. The process uses trial-and-error with a volatility assumption relating up and down rates.
Why does YTM assume coupon reinvestment at the same rate, and when does this assumption fail?
YTM assumes all coupons are reinvested at the YTM rate for the bond's remaining life. When rates change after purchase, reinvestment income differs and realized return deviates from YTM. Zero-coupon bonds eliminate reinvestment risk entirely.
How sensitive is the H-model to changes in the initial high-growth rate assumption?
The H-model approximates a linear decline in growth rate from an initial high rate to a sustainable rate. The growth premium is linear in the spread between high and stable growth, making the model moderately sensitive to the initial growth assumption.
What are dark pools and how does market fragmentation affect equity trading?
Dark pools are private trading venues where orders are matched without publicly displaying quotes before execution. They contrast with lit exchanges where the order book is visible. Institutions use them to execute large block orders without signaling intent to the market.
How are joint ventures accounted for under IFRS 11 using the equity method?
Under IFRS 11, joint ventures use the equity method with several CFA Level II nuances: excess purchase price must be allocated to identifiable assets (amortized) and goodwill (not amortized), unrealized intercompany profits are eliminated proportionally, and the entire investment is tested for impairment as a single asset. Losses cannot reduce the investment below zero unless the investor has additional obligations.
What is the difference between the completed contract method and the percentage-of-completion method for long-term contracts?
These two methods handle long-term contract revenue very differently. Percentage-of-completion recognizes revenue proportionally as work is performed, while completed contract waits until the project is fully finished. The choice has major implications for income smoothing, balance sheet presentation, and tax timing.
What are the components of the balance of payments current account and why does it matter for currency analysis?
The current account records trade in goods, services, primary income (investment returns), and secondary income (transfers). Persistent deficits signal that a country is spending more abroad than it earns, requiring offsetting capital inflows.
How do you create synthetic positions using options, and what is put-call parity?
Synthetic positions replicate the payoff of one instrument using a combination of others. Put-call parity (c + PV(X) = p + S) is the equation that makes this possible, allowing you to create synthetic stock, calls, puts, or risk-free bonds.
How does coupon reinvestment risk affect a bond's realized total return?
Coupon reinvestment risk is the risk that the cash flows you receive from a bond (coupons) will be reinvested at a rate different from the yield to maturity (YTM) that was assumed when you purchased the bond.
How do I implement a three-stage DDM with declining growth in the middle period?
The three-stage DDM has a high-growth phase, a transition phase with linearly declining growth, and a stable mature phase. Calculate dividends in each phase using the declining growth rate, compute terminal value using the Gordon Growth Model at the stable rate, then discount all cash flows back to today.
What is the difference between a market maker and a specialist in equity trading?
Market makers and specialists both provide liquidity, but they operate in different market structures. Market makers compete in dealer/OTC markets like NASDAQ, while specialists (DMMs) are assigned to a single stock on auction exchanges like the NYSE with an obligation to maintain an orderly market.
How do fair value adjustments to PP&E affect the equity method income reported by the investor?
This is one of the most commonly tested equity method mechanics on CFA Level II. The investor must depreciate its share of the fair value adjustment to PP&E over the asset's remaining useful life, which reduces the equity income pickup each period.
What are the main categories of alternative investments and why should traditional portfolio managers care?
Alternative investments encompass any asset class outside of traditional publicly traded equities, fixed income, and cash. For CFA Level I, you need to understand five major categories: hedge funds, private equity, real estate, commodities, and infrastructure, plus the role each plays in portfolio construction.
What are the real-world differences between accrual and cash basis accounting, and why does the CFA curriculum focus on accrual?
Accrual accounting records economic events when they occur, regardless of when cash changes hands. Cash basis accounting records transactions only when cash is received or paid. The CFA curriculum emphasizes accrual because it provides a more accurate picture of a company's financial performance over a period.
How do I decompose implementation shortfall into its components, and what does each piece represent?
Implementation shortfall measures the total cost of executing an investment decision by comparing the paper portfolio return to the actual portfolio return. It decomposes into explicit costs, delay cost, market impact cost, and opportunity cost.
What's the difference between dirty price and clean price, and why do bond markets quote the clean price but settle at the dirty price?
Clean price strips out accrued interest to make bond prices comparable over time, eliminating the sawtooth pattern caused by interest building up between coupon dates. Markets quote clean prices for comparability but settle at dirty prices (clean + accrued interest) because the buyer must compensate the seller for interest earned.
How does the IPO book-building process actually work, and why is it preferred over a fixed-price offering?
In a book-building IPO, the lead underwriter collects non-binding indications of interest from institutional investors before setting the final offer price. This contrasts with fixed-price offerings where the price is set upfront. Book building wins because it extracts information from investors and reduces underpricing.
How do I calculate NPV when the cash flows are unequal each year? I keep getting the wrong answer.
Great question — unequal (or "mixed") cash flow problems are among the most commonly tested TVM concepts on the CFA Level I exam. The key insight is that each cash flow must be discounted individually back to the present, and then you sum them all up.
What are the main portfolio rebalancing strategies and how do you choose between them?
Rebalancing realigns portfolio weights back toward the strategic asset allocation after market drift. The three main approaches are calendar rebalancing, percentage-of-portfolio (threshold) rebalancing, and tactical rebalancing, each with distinct tradeoffs between simplicity, cost, and risk control.
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