Community Q&A
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How does purchasing power parity affect international equity valuation, and should I adjust DCF models for PPP?
PPP provides expected future exchange rates for converting foreign-currency cash flows in international DCF models. Two equivalent approaches exist: value in local currency then convert, or convert each cash flow and discount at domestic rates.
What exactly is 'smart beta' or factor investing, and how does it differ from traditional passive indexing?
Factor investing, or 'smart beta,' uses systematic rules-based approaches to capture specific return drivers like value, momentum, quality, and low volatility — sitting between traditional passive indexing and active management.
How does the private equity secondary market work, and why would an LP sell their fund interest?
The PE secondary market allows limited partners to sell their fund interests before termination. Transactions typically occur at a discount to NAV, with pricing driven by fund quality, age, remaining commitments, and market conditions.
What is the Asset Manager Code of Professional Conduct, and how do firms adopt it?
The Asset Manager Code is a voluntary code for asset management firms, distinct from the individual Code of Ethics. Adoption requires notifying CFA Institute, implementing compliance policies, and publicly committing to six principles centered on client benefit and professional conduct.
How do you adjust the Black-Scholes-Merton model for stocks that pay a continuous dividend yield?
The Merton extension replaces S with S times e to the negative qT in the BSM formula, where q is the continuous dividend yield. This reduces call values and increases put values because dividends reduce the stock's growth rate during the option's life.
Why do we assume asset prices follow a lognormal distribution instead of normal?
If continuously compounded returns are normally distributed, then prices follow a lognormal distribution. This ensures prices can never be negative, which is economically necessary for limited-liability equity.
How does principal component analysis (PCA) decompose yield curve movements into factors?
PCA decomposes yield curve movements into three uncorrelated factors: level (parallel shifts, ~85-90% of variance), slope (steepening/flattening, ~8-10%), and curvature (butterfly, ~2-3%). Together they explain over 95% of yield curve variation.
How does duration matching immunize a portfolio against a single liability?
Duration matching immunizes against rate changes because price risk and reinvestment risk offset each other at the duration point. For a single liability, set the portfolio's Macaulay duration equal to the liability's time horizon and ensure sufficient initial value.
What special adjustments are needed when valuing equities in emerging markets?
Emerging market valuations require adjustments to discount rates (country risk premium, illiquidity), cash flows (political risk scenarios, currency translation), and terminal values. The key is to avoid double-counting risk in both the numerator and denominator.
What is free-float adjustment and why do indexes use it instead of total market cap?
Free-float adjustment excludes shares not available for public trading — insider stakes, government holdings, treasury shares, and strategic cross-holdings. Most major indexes use free-float market cap for weighting to reflect actual investability.
What is the difference between expected return and actual return on pension plan assets?
Under IFRS, the return on plan assets used in pension cost is calculated using the same discount rate applied to the obligation, with any difference from actual returns going to OCI. Under US GAAP, management sets an expected return rate, which directly reduces pension expense, with the actual-vs-expected difference deferred in OCI. This makes GAAP pension expense more susceptible to management assumptions.
How does the specific identification method work for inventory costing?
Specific identification tracks each individual inventory item to its actual purchase cost. When that specific item is sold, its actual cost becomes COGS with no cost flow assumption needed. It is most appropriate for high-value, low-volume items like jewelry or real estate, but it raises manipulation concerns since management can cherry-pick which items to sell.
How do the BSM Greeks (delta, gamma, vega, theta, rho) measure option sensitivity, and which matters most?
The BSM Greeks measure option sensitivity to underlying price (delta), rate of delta change (gamma), volatility (vega), time decay (theta), and interest rates (rho). Together they provide a complete risk profile of any option position.
How do I interpret regression output for CFA Level I? The R-squared, coefficients, and t-stats all blur together.
Regression analysis interpretation follows a systematic four-step sequence: check R-squared for explanatory power, test overall significance with the F-statistic, evaluate individual coefficients with t-statistics, then interpret the slope magnitude.
How are recovery rates estimated and why do they vary so much across different types of debt?
Recovery rate is the percentage of face value that bondholders actually receive when an issuer defaults. It varies significantly based on seniority in the capital structure, collateral quality, industry, and economic conditions.
When should I use forward P/E versus trailing P/E in comparable analysis?
Forward P/E is generally preferred because valuation is inherently forward-looking, and it captures expected earnings changes. Use trailing P/E when analyst coverage is unavailable, forecasts are unreliable, or for historical screening and cycle analysis.
What are the main equity index construction methods and how do they differ?
The three main equity index construction methods are price-weighted (weight based on share price), market-cap weighted (weight based on market capitalization), and equal-weighted (all stocks get equal weight). Each has different biases, rebalancing requirements, and sensitivity to stock splits.
What's the difference between trailing and forward P/E, and when is each more appropriate?
The price-to-earnings (P/E) ratio is the most widely used relative valuation metric. Trailing P/E uses actual last-12-months EPS while forward P/E uses consensus forecast EPS. The choice depends on earnings stability, analyst coverage quality, and whether the company is experiencing an earnings inflection.
How is contingent consideration remeasured after a business combination and where do changes hit?
Contingent consideration classified as a liability must be remeasured to fair value each reporting period, with changes recognized in the income statement. If classified as equity, no remeasurement occurs.
What is a LIFO liquidation, and why does it artificially inflate income?
A LIFO liquidation occurs when a company using LIFO sells more units than it purchases, dipping into older, lower-cost inventory layers. The resulting decrease in COGS artificially inflates gross profit by the difference between old-layer costs and current replacement costs.
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