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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.
Can someone explain the main hedge fund strategies — long/short equity, event-driven, and relative value — with concrete examples?
The three major hedge fund strategies differ in their return sources: long/short equity profits from stock selection, event-driven strategies profit from corporate events like mergers and bankruptcies, and relative value strategies exploit pricing discrepancies between related securities.
How do you test for a unit root and what does the Dickey-Fuller test actually tell you?
The Dickey-Fuller test detects unit roots by testing whether the AR(1) coefficient equals 1. Crucially, it uses special critical values more negative than standard t-values because the test statistic follows a non-standard distribution under the null.
How does a firm find its optimal capital structure? The trade-off between tax shields and financial distress costs confuses me.
The static trade-off theory says every firm has an optimal debt-to-equity ratio where the marginal benefit of additional debt from tax shields exactly equals the marginal cost from increased financial distress risk.
What are the practical differences between futures and forwards beyond 'exchange-traded vs OTC'?
You're right that the exchange-vs-OTC distinction is just the surface. The real differences that matter for CFA Level II revolve around daily settlement, credit risk, and pricing divergence driven by the convexity adjustment.
How are intercompany transactions eliminated during consolidation?
Intercompany transactions must be fully eliminated during consolidation. For downstream sales (parent to subsidiary), unrealized profit is allocated entirely to the parent. For upstream sales (subsidiary to parent), unrealized profit is shared between parent and NCI proportionally.
How do FIFO, LIFO, and weighted average affect financial statements differently?
FIFO, LIFO, and weighted average are cost flow assumptions that affect COGS, gross profit, ending inventory, and taxes differently. In a rising-price environment, FIFO produces the highest net income and balance sheet inventory, while LIFO produces the lowest.
What is risk parity and how does it differ from traditional asset allocation?
Risk parity allocates portfolio weights so each asset class contributes equally to total portfolio risk. Unlike a traditional 60/40 portfolio (which derives ~90% of risk from equities), risk parity achieves true diversification across risk sources, often using leverage to reach target returns.
How do decision trees work for financial classification problems?
Decision trees recursively split data at each node using the variable that produces the most homogeneous child groups (measured by entropy or Gini impurity). They are interpretable but prone to overfitting, which is why ensemble methods like random forests are often preferred.
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