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What is the M-squared (M2) measure, and how does it make the Sharpe ratio easier to interpret?
M-squared transforms the Sharpe ratio into percentage return units by asking: if this fund were levered to match the benchmark's volatility, what return would it earn? The difference from the benchmark return is M2, making it much more intuitive to communicate than the Sharpe ratio.
What is a butterfly spread, how is it constructed, and when would I use it?
A butterfly spread buys one call at the lowest strike, sells two calls at the middle strike, and buys one call at the highest strike. It profits most when the stock expires exactly at the middle strike, with very limited downside equal to the net premium paid.
What does the LIBOR-OIS spread tell us that the TED spread doesn't?
The LIBOR-OIS spread isolates pure bank credit and liquidity risk by comparing term interbank rates to expected overnight rates, avoiding the flight-to-quality distortion that inflates the TED spread during crises.
Can someone explain credit default swaps at a CFA Level I depth — what they are, how they work, and why they matter?
A credit default swap is a contract where the protection buyer pays periodic premiums to the seller in exchange for a payment if the reference entity defaults. Triggers include bankruptcy, failure to pay, and restructuring.
What is the Abnormal Earnings Growth (AEG) model and how does it differ from residual income?
The Abnormal Earnings Growth model anchors on capitalized forward earnings rather than book value, adding value for earnings growth that exceeds the cost of equity. AEG is preferred over residual income when book values are unreliable.
Why do some companies have multiple share classes with different voting rights, and how should analysts think about this?
Dual-class share structures let founders maintain voting control even after selling a majority of economic interest to public shareholders. This creates governance risks and typically results in a 5-15% valuation discount, as minority shareholders cannot effectively influence corporate decisions.
What is the agency problem with free cash flow, and how can it be mitigated?
The free cash flow agency problem occurs when managers with excess cash invest in value-destroying projects rather than returning capital to shareholders. Mitigation mechanisms include higher leverage, dividends and buybacks, performance-based pay, and hostile takeover discipline.
How should wrap fee accounts be treated under GIPS composite reporting?
Wrap fee accounts should be grouped into separate composites or presented with wrap-fee-specific performance. Returns must be shown net of the entire wrap fee, and the firm must disclose the fee structure and percentage of wrap assets.
How do I decompose an option's price into intrinsic value and time value?
Option premium equals intrinsic value plus time value. Intrinsic value is the exercise-now value and can never be negative. Time value reflects the probability the option gains value before expiration and is highest for at-the-money options.
What is the practical difference between the Sharpe ratio and the Sortino ratio?
The Sharpe ratio penalizes all volatility equally, both upside and downside, while the Sortino ratio only penalizes volatility below a target. This distinction matters most when returns are skewed.
What is the difference between CPR and SMM in MBS prepayment modeling, and how do you convert between them?
CPR is the annualized prepayment rate; SMM is the monthly equivalent. Convert using SMM = 1 - (1-CPR)^(1/12). SMM is applied to the balance after scheduled payments to project monthly prepayments in MBS cash flow models.
What is a dollar roll in the MBS market and how does it work as a financing tool?
A dollar roll is an MBS financing transaction where the investor sells MBS for current delivery and buys back a similar (not identical) MBS for future delivery. The price difference (drop) plus reinvestment income can make this cheaper than repo financing.
Why do floating rate notes still have price risk even though the coupon resets?
FRNs eliminate most interest rate risk through coupon resets, but they still face credit spread risk. If the market demands a wider spread than the FRN's fixed spread, the price falls. Credit spread duration equals the remaining maturity, not the reset period.
How does a put option create a floor price for putable bonds?
A putable bond gives the holder the right to sell back to the issuer at a specified price, creating a price floor. When yields rise and the bond falls below the put price, the holder exercises the option, preventing further decline.
Can I use the residual income model when book value of equity is negative?
The residual income model can work with negative book value because future RI adds value on top of the negative anchor. When book value is negative, the equity charge becomes an addition to RI. However, the model becomes unstable and alternative approaches may be preferred.
How do I compute FCFE when the company is actively changing its capital structure?
When a company is deleveraging, net borrowing is negative, reducing FCFE significantly during the transition period. Model each year explicitly, then use the stable target capital structure for terminal value. Consider using FCFF/WACC when leverage is actively changing.
How do dividend reinvestment plans (DRIPs) work and what are their advantages and disadvantages?
A Dividend Reinvestment Plan automatically uses cash dividends to purchase additional shares of the issuing company. Some DRIPs offer shares at a discount. Key exam point: dividends are taxable even when reinvested, creating a tax liability without cash flow.
How do you calculate buyback yield and total payout yield for equity valuation?
Buyback yield measures the percentage of market capitalization returned through share repurchases. Total payout yield combines dividends and net buybacks. A company with a low dividend yield but significant buybacks may actually be returning substantial cash to shareholders.
What are measurement period adjustments in acquisition accounting?
The measurement period allows up to one year after an acquisition for the acquirer to refine provisional fair values of acquired assets and liabilities. Adjustments are made retrospectively, affecting goodwill and requiring restatement of comparative information. Only information about conditions existing at the acquisition date qualifies.
Can someone explain the cost recovery method and when it applies?
The cost recovery method is the most conservative revenue recognition approach where no profit is recognized until the seller has recovered the entire cost of the goods sold. Only after cumulative cash collections exceed total cost does any profit appear on the income statement.
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