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What is distressed debt investing, and how do distressed investors identify the fulcrum security?
Distressed debt investors buy deeply discounted debt of troubled companies, often targeting the fulcrum security — the most senior debt class that won't be fully repaid. This security often converts to equity in the restructured company, offering significant upside.
How do share repurchases affect EPS and shareholder value, and when are buybacks value-creating vs. value-destroying?
Share repurchases are EPS-accretive when earnings yield exceeds after-tax borrowing cost, but only create value when shares are purchased below intrinsic value. EPS accretion and value creation are separate concepts — the exam tests both.
How does the income approach to real estate valuation work, and what determines cap rates?
The income approach values real estate as NOI divided by the cap rate. NOI excludes debt service and depreciation. Cap rates reflect property risk — lower cap rates mean higher values and are driven by property quality, location, tenant strength, and interest rate environment.
How does sector rotation work as an investment strategy, and which sectors outperform in each business cycle phase?
Sector rotation shifts portfolio weights to sectors expected to outperform based on business cycle positioning. Consumer discretionary leads in early recovery, energy in late expansion, and utilities and healthcare in recessions.
How does the carry trade work, and why does it seem to violate uncovered interest rate parity?
The carry trade borrows in low-rate currencies and invests in high-rate currencies to earn the interest differential. Despite uncovered interest rate parity predicting this should not work, the forward premium puzzle shows high-rate currencies depreciate less than expected.
Can someone explain the Fama-French 3-factor model with a worked example showing SMB and HML?
The Fama-French 3-factor model adds SMB (small minus big) and HML (high minus low book-to-market) to the market factor. Positive SMB loading means the stock behaves like small caps, and positive HML loading means it behaves like value stocks.
Why is gamma considered the 'hidden risk' for delta-hedged option sellers?
Gamma is dangerous for option sellers because it forces a buy-high, sell-low rebalancing cycle. Gamma peaks for at-the-money options near expiration and determines how quickly a delta hedge becomes stale and how expensive rebalancing will be.
What qualifies as material nonpublic information (MNPI) for insider trading under Standard II(A)?
Standard II(A) prohibits acting on information that is both material and nonpublic. Information is material if a reasonable investor would consider it important, and nonpublic if not yet disseminated through recognized channels.
Is a trade deficit always bad for a country? What drives it and how should investors interpret it?
A trade deficit isn't inherently bad — it depends on whether it's driven by productive investment or unsustainable consumption. The trade deficit is the mirror image of a capital account surplus, meaning foreigners are investing in the country.
How do interest rate caps, floors, and collars work? Can someone explain with a practical loan example?
An interest rate cap is a series of caplets (call options on rates) that protect a floating-rate borrower from rising rates. A floor is a series of floorlets (put options) that guarantee minimum rate income. A collar combines both to bound rate exposure.
What's the difference between structural and reduced-form credit analysis models?
Structural models (Merton) treat equity as a call option on assets — default occurs when asset value falls below debt. Reduced-form models treat default as a random event driven by a hazard rate estimated from market credit spreads.
Can someone explain correlation vs. causation with a finance example? My professor keeps emphasizing this.
Correlation measures the linear association between two variables but says nothing about whether one causes the other. There are three key reasons: reverse causality, omitted variables (confounding), and spurious correlation.
How do mortgage pass-through securities work and what is prepayment risk?
Mortgage pass-through securities give investors a pro rata share of monthly principal, interest, and prepayments from a pool of residential mortgages. Prepayment risk — the uncertainty about when homeowners will pay off their mortgages — creates both contraction risk and extension risk.
How does a leveraged buyout (LBO) model work, and what drives equity returns for the sponsor?
A leveraged buyout uses primarily debt financing to acquire a company. Sponsor returns come from three levers: EBITDA growth, debt paydown from the company's own cash flows, and potential multiple expansion at exit.
What drives credit spreads on corporate bonds and how do they change through the economic cycle?
Credit spreads represent the additional yield investors demand over risk-free rates to compensate for default risk, credit uncertainty, and illiquidity. They have three components: expected loss, credit risk premium, and liquidity premium, and they fluctuate dramatically through the economic cycle.
How do you value a callable bond and what's the relationship between OAS and the call option?
Callable bonds give the issuer the right to redeem the bond before maturity. The fundamental relationship is: Value(callable) = Value(option-free) - Value(call option). OAS removes the option cost from the Z-spread, leaving only credit and liquidity compensation.
How do you derive a justified P/E ratio from fundamentals, and how is it different from a trailing P/E?
A justified P/E ratio is derived from the Gordon Growth Model: justified leading P/E = (1 - b) / (r - g), where b is retention, r is required return, and g is growth. It tells you what P/E a stock should trade at given its fundamentals, and comparing it to the actual P/E reveals potential mispricing.
How does sum-of-the-parts valuation work and why do conglomerates trade at a discount?
Sum-of-the-parts valuation values each business segment separately using appropriate peer multiples, then sums them and subtracts net debt. Conglomerates typically trade 10-15% below SOTP value due to capital allocation inefficiency, complexity, management dilution, and investor preference for pure-play companies.
How do you assess receivables quality using the allowance for doubtful accounts and turnover ratios?
Receivables quality is assessed by analyzing receivables turnover, DSO, and the allowance for doubtful accounts relative to gross receivables. Key red flags include DSO increasing over time, A/R growing faster than revenue, and the allowance ratio declining despite receivables growth.
FIFO vs. weighted average cost: how do they affect COGS, inventory, and taxes when prices are rising?
Under FIFO, the oldest costs flow to COGS while the newest remain in ending inventory. Under weighted average, all costs are blended. When prices are rising, FIFO produces lower COGS, higher ending inventory, and higher net income compared to weighted average.
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