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Why do callable bonds exhibit negative convexity and what does that mean for investors?
Callable bonds exhibit negative convexity at low yields because the issuer's call option caps the bond's price upside. As yields fall, the callable bond's price gets compressed near the call price while a non-callable bond continues to rise.
What is the pull-to-par effect and how does it work for premium and discount bonds?
The pull-to-par effect describes how a bond's price converges toward par value as maturity approaches. Premium bonds decline toward par while discount bonds rise toward par, because fewer remaining coupon payments reduce the premium or discount.
How do large working capital swings affect FCFF and what adjustments should I make?
Large working capital swings can make FCFF volatile even when the underlying business is stable. Normalize by averaging WCInv over multiple years, using WC-to-revenue ratios, or separating one-time items from structural changes.
How do you handle a multi-stage DDM when one phase has negative earnings growth?
A negative growth phase means dividends decline during that period. Use the same DDM framework with negative growth rates. The key is ensuring dividends remain positive and carefully computing the terminal value once growth stabilizes.
How does ADR pricing parity work and what creates arbitrage opportunities?
An ADR price should equal the foreign share price multiplied by the exchange rate and adjusted for the ADR ratio. When the ADR trades at a premium or discount to this parity, arbitrage opportunities arise through the creation and cancellation mechanism.
How does high-frequency trading affect market quality and what should CFA candidates know about it?
High-frequency trading refers to algorithmic strategies that execute thousands of orders in microseconds, profiting from tiny price discrepancies. HFT firms use co-located servers and ultra-low-latency connections. The CFA curriculum presents a balanced view of benefits and concerns.
What is a bargain purchase and how is it accounted for in acquisitions?
A bargain purchase occurs when the acquisition price is less than the fair value of net identifiable assets. After mandatory reassessment of all fair values, the remaining excess is recognized as a gain in profit or loss immediately. No goodwill is recorded. This typically occurs in distressed sales or forced liquidations.
How does the installment sales method work for revenue recognition?
The installment sales method recognizes profit proportionally as cash is collected rather than all at once at the point of sale. You calculate a gross profit rate (total gross profit divided by total sales price) and multiply each period's cash collection by that rate to determine the profit recognized.
How does Purchasing Power Parity (PPP) explain exchange rate movements, and does it actually work?
Purchasing Power Parity predicts that exchange rates adjust to equalize the price of goods across countries. Relative PPP, the more useful version, says the exchange rate change equals the inflation differential between two countries.
What do ITM, ATM, and OTM mean, and how do they relate to intrinsic and time value?
Moneyness describes the relationship between an option's strike price and the underlying asset price. An option's premium is decomposed into intrinsic value (what it's worth if exercised now) and time value (the speculative component).
How do interest rate risk and reinvestment risk create an offsetting tradeoff for bond investors?
Interest rate risk and reinvestment risk create a natural tug-of-war for bond investors. Understanding this tradeoff is fundamental to fixed income and leads directly to the concept of immunization.
How do I calculate FCFF starting from EBITDA?
FCFF from EBITDA equals EBITDA times (1 - tax rate) plus the depreciation tax shield minus capital expenditures minus change in working capital. The key is computing taxes on EBIT (not EBITDA) because depreciation provides a tax shield.
How does a limit order book work and what determines which orders get filled first?
A limit order book collects all outstanding buy and sell limit orders and matches them using price-time priority. The best-priced orders execute first, and among orders at the same price, the earliest order fills first.
Can someone break down the main hedge fund strategies and when each is used? I keep mixing them up.
Hedge fund strategies fall into four broad families based on what drives returns: equity hedge, event-driven, relative value, and global macro. Here is a decision framework with a flowchart to classify them and understand when each is used.
How do you build an amortization schedule for the excess purchase price under the equity method?
Building an amortization schedule for excess purchase price under the equity method requires three steps: compute the excess over book value, allocate it to identifiable intangibles and goodwill, then amortize finite-lived items over their useful lives while tracking the investment account balance.
How do corporate issuers decide between debt and equity financing, and what's the trade-off?
Capital structure decisions are central to Corporate Issuers at CFA Level I. Three frameworks help explain how companies choose between debt and equity: Modigliani-Miller propositions, trade-off theory, and pecking order theory.
How does percentage-of-completion revenue recognition work, and when should a company use it instead of recognizing at a point in time?
Revenue recognition over time applies when a customer simultaneously receives and consumes the benefits as the seller performs. The cost-to-cost method divides costs incurred to date by total estimated costs to determine percentage complete, then multiplies by contract price.
How do I construct an Individual Investment Policy Statement using the RRTTLLU framework?
The RRTTLLU framework covers Return, Risk, Time horizon, Taxes, Liquidity, Legal/regulatory, and Unique circumstances. Each factor must be addressed with specific client facts and quantified where possible, especially the return requirement and liquidity needs.
Why do NPV and IRR sometimes give different rankings for mutually exclusive projects, and which should I trust?
NPV and IRR can produce conflicting rankings for mutually exclusive projects due to differences in project scale, cash flow timing, or reinvestment rate assumptions. When they disagree, always follow NPV because it directly measures the dollar value added to the firm.
How do I handle situations where a client pressures me to change a recommendation under Standard I(B) Independence and Objectivity?
Standard I(B) requires that your investment recommendations reflect your honest professional opinion, not the preferences of clients, issuers, or employers. The line is crossed when external pressure causes you to issue a recommendation that does not reflect your genuine analysis.
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