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What is the Loss Distribution Approach for operational risk, and how do Key Risk Indicators fit in?
The Loss Distribution Approach models operational risk by separately estimating frequency (how many loss events per year) and severity (how large each loss is), then combining them via Monte Carlo simulation. Key Risk Indicators complement LDA by providing forward-looking early warning signals that help management intervene before losses materialize.
How can a pension plan hedge longevity risk?
Longevity swaps, buy-ins, and reinsurance hedge the risk that pensioners live longer than actuarial assumptions predict.
What are the three main VaR calculation methods and when should each be used?
Value at Risk can be calculated using three methods: parametric (variance-covariance), historical simulation, and Monte Carlo simulation. Each has distinct strengths — parametric is fast for linear portfolios, historical simulation captures fat tails, and Monte Carlo handles non-linear instruments like options.
Parametric VaR vs. Historical Simulation VaR — when does each method fail?
Excellent question — understanding when VaR methods break down is arguably more important than knowing the formulas, and GARP loves testing this on the exam. Parametric VaR fails with non-normal returns, non-linear positions, and unstable correlations. Historical simulation suffers from ghost effects, backward-looking bias, and limited tail data.
What are the pros and cons of direct vs. indirect real estate investment? When should I use each?
Direct real estate offers control, tax benefits, and leverage but requires high capital and is illiquid. Indirect investment through REITs and funds provides liquidity and diversification but sacrifices control and may have higher market correlation.
What's the difference between supervised and unsupervised learning, and how are they used in finance?
Supervised learning uses labeled data to predict outcomes like defaults or returns. Unsupervised learning finds hidden patterns in unlabeled data, useful for clustering stocks or detecting market regimes. Finance uses both extensively.
How does pecking order theory differ from trade-off theory in explaining how firms actually raise capital?
Trade-off theory says firms target an optimal debt ratio balancing tax shields against distress costs. Pecking order theory says firms follow a financing hierarchy — internal funds first, then debt, then equity — driven by information asymmetry rather than a target ratio.
What is a swaption and how does the payer vs. receiver distinction work in practice?
A swaption is an option on an interest rate swap. The holder has the right, but not the obligation, to enter into a swap at a predetermined fixed rate on a future date. Payer swaptions benefit from rising rates while receiver swaptions benefit from falling rates.
What does Standard I (Professionalism) actually require? How does Knowledge of the Law work in practice?
Standard I covers professionalism requirements. The critical rule for Knowledge of the Law: always follow the stricter requirement when there's a conflict between local law, firm policy, and CFA Standards.
Can someone explain pension accounting -- PBO, plan assets, and funded status?
Pension accounting involves tracking the PBO (present value of earned benefits), plan assets (investments to pay benefits), and funded status (plan assets minus PBO). Pension expense components are split between the income statement and OCI depending on the reporting standard.
How do deferred tax assets and liabilities arise, and what is a valuation allowance?
Deferred taxes arise because financial reporting and tax rules use different timing for income and expenses. A DTL forms when book carrying value exceeds tax base for an asset, while a DTA forms when future deductible amounts exist. A valuation allowance reduces a DTA if future profitability is uncertain.
What is active share and how does it help detect closet indexing?
Active share measures the percentage of holdings that differ from the benchmark, calculated as half the sum of absolute weight differences. Values below 40% suggest closet indexing; above 60% indicates truly active management. It complements tracking error in evaluating manager style.
How is Natural Language Processing (NLP) applied in finance?
NLP in finance involves analyzing unstructured text (earnings calls, news, filings) using techniques like sentiment analysis, topic modeling, and named entity recognition to generate investment signals. Key preprocessing steps include tokenization, stop word removal, and TF-IDF feature extraction.
How do you conduct a DCF sensitivity analysis and which inputs matter most?
DCF sensitivity analysis tests how valuation changes when key inputs vary. WACC and terminal growth rate are typically the most impactful — a 1% change in WACC can shift value by 15-25%. Two-way tables and scenario analysis provide ranges rather than point estimates.
When must a company consolidate a Special Purpose Entity (SPE) or Variable Interest Entity (VIE)?
Companies must consolidate SPEs/VIEs when they are the primary beneficiary — having power to direct the entity's significant activities AND obligation to absorb losses or right to receive benefits. This applies even without majority ownership.
What is a hedge fund lock-up period and why do they have gate provisions?
Lock-up periods prevent investors from withdrawing capital for a set time (usually 1-3 years), allowing the fund to pursue illiquid strategies. Gate provisions limit redemptions per period (typically 10-25% of NAV) to prevent fire sales that would harm remaining investors.
What are the main theories on dividend policy and do dividends actually matter?
The main dividend theories are: M&M irrelevance (dividends don't matter in perfect markets), bird-in-hand (investors prefer certain dividends), tax preference (capital gains are tax-advantaged), signaling (dividend changes convey information), and agency theory (dividends reduce free cash flow waste).
How does a protective put work as portfolio insurance?
A protective put involves owning a stock and buying a put option on it, creating a floor on losses. Your maximum loss is capped at (purchase price minus strike) plus the premium, while upside remains unlimited.
What are the key components of an Investment Policy Statement (IPS)?
An IPS has two main sections: objectives (return and risk) and constraints (time horizon, taxes, liquidity, legal/regulatory, and unique circumstances — remember TTLLU). It serves as the blueprint governing portfolio management decisions.
What strategies are available for managing concentrated stock positions?
Concentrated stock position strategies include outright sale, exchange funds, equity collars, prepaid variable forwards, and charitable giving. Each has different tax, liquidity, and upside retention trade-offs that must be matched to the client's specific situation.
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