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How does the binomial distribution apply to finance? I want a practical example beyond coin flips.
The binomial distribution models two-outcome scenarios. In finance, it directly maps to up/down stock price movements and credit default modeling. The formula P(X=x) = C(n,x) x p^x x (1-p)^(n-x) is used extensively.
Market orders, limit orders, stop-loss — when do you use each type?
Order types are a practical topic tested on the CFA exam. Market orders guarantee execution but not price, limit orders guarantee price but not execution, and stop orders combine elements of both.
How does bond pricing actually work? I keep hearing 'present value of cash flows' but need a concrete example.
Bond pricing is fundamentally about time value of money. You discount every future cash flow — each coupon payment and the final par repayment — back to today using the bond's yield to maturity (YTM) as the discount rate.
How do you handle revenue recognition with multiple performance obligations and variable consideration?
Level II revenue recognition involves variable consideration (estimated and constrained), license classification (right of access vs right to use), and allocation of bundled transaction prices across multiple performance obligations.
When are financial instruments measured at amortized cost vs fair value, and what's the impact?
Financial instruments are classified into three categories under IFRS 9: amortized cost, FVOCI, and FVTPL. Classification depends on the business model test and cash flow characteristics test. Each category treats unrealized gains/losses differently on the financial statements.
When should an equity portfolio manager choose active vs passive management?
The active versus passive decision depends on market efficiency, manager skill (information ratio), fees, tax sensitivity, and benchmark availability. CFA Level III provides a framework using the Fundamental Law of Active Management to evaluate when active management is likely to add value.
How do you handle foreign subsidiary translation in a hyperinflationary economy?
When a subsidiary operates in a hyperinflationary economy (roughly 100% cumulative inflation over three years), IFRS requires restating financial statements for inflation before translating at the current rate, while US GAAP switches to the temporal method using the parent's currency as functional.
How do I structure and evaluate OTM put protection on an equity portfolio?
Size OTM puts by beta-adjusted notional. 10% OTM 3-month puts ~3% annual drag. Structure collars to fund premium. Model scenarios explicitly.
How does Lintner's dividend smoothing model work mathematically?
Lintner's 1956 model: ΔD = α + β(D* - D_prev). Firms use a speed of adjustment β (typically 0.3) to slowly move dividends toward a target payout fraction of EPS. This produces smoothed dividends much less volatile than earnings...
How do endowments manage liquidity given heavy illiquid allocations?
Endowments manage liquidity through tiered asset buckets, credit lines, pacing models, and stress tests to avoid forced illiquid sales.
Why did endowments shift from income-focus to total-return investing?
UPMIFA abolished the income-only rule, letting endowments spend from total return and construct portfolios based on risk-adjusted return.
How do convexity trades work in fixed income?
Convexity trades position the portfolio to profit from expected interest rate volatility. Buy convexity (barbell, STRIPS) when expecting large moves; sell convexity (MBS, callables) to harvest yield pickup in stable environments.
How is a butterfly yield curve trade constructed?
Butterfly trades bet on curvature: positive butterfly (long body, short wings) profits when belly richens; negative butterfly (short body, long wings) profits when belly cheapens. Duration-neutral construction via dollar-duration weighting.
What is a management fee step-down in private equity and why is it important?
A management fee step-down is a contractual reduction in the annual management fee once the fund's investment period ends, typically charged on invested capital rather than commitments.
How does a clawback provision protect LPs in a private equity fund?
A clawback provision requires the GP to return previously distributed carry to LPs if the GP has received more than its contractual share of profits by fund end.
What exactly does Standard VI(A) on disclosure of conflicts require?
Standard VI(A) requires prominent, plain-language disclosure of any conflict (ownership, boards, compensation, relationships) to clients, prospects, and employers.
What are the most common violations of the CFA Code of Ethics that lead to disciplinary action?
Most common violations involve misrepresentation, front-running, undisclosed conflicts, inadequate supervision, and plagiarism — each mapped to specific numbered Standards.
What does Modigliani-Miller say about capital structure irrelevance?
MM Proposition I: in frictionless markets, firm value is independent of capital structure via homemade leverage arbitrage. Real-world deviations (taxes, bankruptcy, agency, asymmetry) are where CFOs create value.
How do I compute individual node values in a binomial bond tree?
V_t = [0.5*(V_up + C) + 0.5*(V_down + C)] / (1 + r_t). Compute backward value, then apply call/put rules. If backward value exceeds call price, cap at call price. Careful with coupon timing conventions — CFA assumes end-of-period coupons...
How is effective convexity computed for a putable bond and why is it positive and higher than straight?
EffConv = (V_plus + V_minus - 2*V_0) / (V_0 * delta_y^2). Putable bond has high positive convexity because the put floors downside while upside participates fully. Callable can have negative convexity. Useful for hedging MBS negative convexity...
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