CFA Study Guide

Semivariance & Target Semivariance

2009-04-04T09:00:00.001-05:00

Quantitative Methods: Statistical Concepts

Regular variance telsl you the probability of both greater and lesser outcomes compared to the mean. Since most investors are more heavily influenced by downside risk of their investments than the possible upside gains, often times it will be imperative to show the variance only below the mean instead of around both sides of it. Obviously the mean is still an important factor. Although, since you will be using only some the variance data (the lower bounded), you'll have to work only with the subset of values that fall below the mean, and this is where it gets the designation "Semi", or part of.

Semivariance of a normal curve is essentially figured as equal to its regular variance. You can see in the illustration that the lower bounded subset (negative variance) is a mirror image of the upper bound. Semivariance becomes more complicated to compute when the distribution is skewed and those pieces are not mirror images. Even when the distribution is still normal, if the target at which the lower bound is set below the mean, you cannot rely on semivariance equaling the variance. For these two instances you'd have to measure the dispersion below the mean or target by squaring the differences of those observations below that point.

I've not seen any problems in the curriculuum asking for a computation of a skewed or target semivaiance. You should probably get by just knowing the effect of skewness and targets on the variance in relation to a normal instance.

Absolute Measures of Risk

2009-04-03T09:00:00.002-05:00

Quantitative Methods: Statistical Concepts

There are two categories of risk measurements: Absolute and Relative. I've spoken earlier about CV and Sharpe Ratios which measure risk in relation to expected returns (risk÷return; return÷risk). As you might guess, those methods would fall under the Relative category. Absolute measures of risk don't account for any returns. The two Absolute measures are Variance and Mean Absolute Deviation and they only measure a deviation compared to the number of observations (Dev÷N **). The difference between the two is how they handle negative errors.

Variance:
Notice that the deviations from the mean (errors) are squared before summing so that no negative numbers are incorporated. This amplifies the effect of any outliers.

MAD:
Accounts only for the absolute value of the errors and keeps the dispersion results closer to the mean than variance does.

Key Point:
Variance is more sensitive to outliers in the observations.

** Please be aware of the actual equations for these two formulas. Dev÷N is an oversimplification for illustration purposes.

Summary of Elasticity Curves

2009-04-02T09:00:00.008-05:00

Economics: Elasticity Curves

Elastic Curve
Like a rubber band, it is very sensitive to price - a small change in price equals a much larger change in qty. numerically this produces a Numerator that is larger than the denominator, so the answer will be greater 1 and Visually this produces and horizontal line.

Key Point:
Quantity is larger, Numerator Larger, Elasticity of Demand, Larger than 1. Also Infinity is larger than 1.

Inelastic Curve
Not as sensitive to price - even a large change in Price has little effect on qty. Price changed is larger than Qty changed, the Numerator is smaller than denominator, and the answer will be smaller than one. Visually this produces a vertical line.

Key Point:
Quantity is smaller, Numerator smaller, Elasticity of Demand Smaller than 1, and 0 is always smaller than 1.

Price Elasticity of Demand

2009-04-01T09:00:00.000-05:00

Economics: Price Elasticity of Demand

When you start putting the curves into numbers and a formula you can get the specific Price Elasticity of Demand (or Supply depending on what you are charting). The answer that is figured from this equation is used to measure just how much the price of an item can be manipulated before demand will change.

The perfect instances are obviously ∞ or 0 as I covered before. For the imperfect instances, the answers obviously aren't as restrictive, but they can be seen as answers that are either greater than one or less than one. The actual answer is found by dividing the percent change in price into the percent change of quantity. Looking at it theoretically, if the Numerator of a fraction is smaller than the denominator the answer is less than 1 and if reversed, the answer is greater than 1 for example 1 divided by 2 is one half and two divided one is two. So if you look a bit further into to this concept you may be thinking to yourself, "if the change in quantity is negative then that numerator will be negative, so the answer will always be less than one", that is a completely true observation, but in this case we're just going to be looking at the absolute value of the changes and answers. because either way it's the same effect.

Elasticity: Inelastic Curves

2009-03-31T09:50:00.013-05:00

Economics: Elastic & Inelastic Curves

Price vs. Quantity is a common chart for most economics curves. There are two basic curve shapes you will need to know that can be made with a chart like this. What they both illustrate is the general concept of demand/supply. The two types of elasticity curves are called either an Elastic curve or an Inelastic curve which by nature of their names you can tell are the exact opposites of each other in terms of how quantity is affected. The basic underlying fact is that, in terms of demand, as a price increases, quantity demanded decreases. Furthermore the shape of the curve (elastic or inelastic) tells you to what extent price has an effect on demand.

In an INelastic curve:
a large change in price really only affects the quantity demanded very little. Examples of this kind of curve are most often Gasoline, Cigarettes and Home heating oils - things that people need or will pay for no matter how the price fluctuates, and remember this also holds true to price decreases because a person only has so many cars to fill tanks on and so many cigarettes he can smoke in one day, so demand really stays more or less constant with these kinds of items and this is what makes the Inelastic curve more vertical. A large change in price really doesn’t make much movement in quantity demanded on the X axis.

Key Point:
A vertical curve = INelastic curve

You can see that it almost even looks like the chart could be made into the letter "N" if you try real hard.

Dispersion of Risk

2009-03-22T04:35:00.011-05:00

Quantitative Methods: Statistical Concepts

Measuring the risk of error in any set of values incorporates basic statistical equations to find the variance. The variance, in terms of financial analysis, measures how wide or narrow your margin of risk will be from the normally expected values. The larger that variance, the larger the risk, which means investors will expect a significant opportunity for gains with such a risky venture.

The two equations for measuring risk in portfolios are the Coefficient of Variation, and the Sharpe Ratio. Both of these formulas include the component of risk , standard deviation (√variance), compared to the expected return. It should be noted that investors will always want risk to be as low as possible and return to be as high as possible. The important fact to realize is where (numerator or denominator) those factors are placed.

Coefficient of Variation (CV): Risk is found in the numerator; when you want the numerator smaller than the denominator, this means you want the answer of your equation to be as low as possible

Sharpe Ratio: Risk is found in the denominator; when you want the denominator as small as possible, this means you want the answer of your equation to be as large as possible.

Key Point:
CV: Smaller numerator: Smaller Answer is better
Sharpe: Smaller denominator: Larger answer is better

Protecting Confidentiality

2009-03-20T22:01:00.003-05:00

Ethics & Professional Standards: Code of Standards

Confidential information of clients must be protected by CFA members in most all cases.

Exceptions:

Anytime you are cooperating with the CFA Institute's Professional Conduct Program, or the SEC it is acceptable to share this information. It is also acceptable, and actually required to divulge information, without being asked, if you think a client is engaging in illegal activities.

One of the tricky exam question may ask about divulging information in relation to lawsuits: It is not a violation to cooperate with criminal lawsuits; It is a violation to cooperate in civil lawsuits.

Mean Median Mode

2009-03-20T20:37:00.004-05:00

Quantitative Methods: Statistical Concepts

These are measures of central tendency, more plainly: expected value
The differences between them lie in what each of the functions highlight or fail to account for. These strengths and weaknesses of every statistical equation affect the value expectations and are used to gain multiple perspectives on a set of data. Mean, Median and Mode are the most basic of these concepts.

Mean (Arithmetic) - because it accounts for all values in it's arithmetic calculation (sum of values in set ÷ total number of values) - it can be skewed by outliers
Median - has no equation, simply the middle number - therefore not affected by outliers
Mode - also has no equation and is not affected by outliers, it is simply the number that appears most frequently; a set of numbers can have no mode or more than one: bimodal, trimodal...

side note: Geometric Mean - always more conservative (less than) the Arithmetic Mean. Only when the returns for each period are identical will it even be equal to AM

Superior Results

2009-03-19T13:39:00.000-05:00

Ethical & Professional Standards: Code of Standards

CFA Charterholders can never claim superior results simply because they hold the designation. A claim of superior results would have to be accompanied by GIPS compliant data.

Actions on Fully & Overvalued Stocks

2009-03-19T01:45:00.001-05:00

Ethical & Professional Standards: Code of Standards

Anytime an analyst acts to purchase fully or overvalued stocks, it is looked upon as un-beneficial because those stock should be either held or sold, respectively. If an analyst acts on these stocks, he is likely violating the Code. Depending on the reason given for acting on these stocks he could be violating Loyalty Prudence & Care, or Market Manipulation.

Insider Trading

2009-03-18T13:35:00.002-05:00

Ethical & Professional Standards: Code of Standards

There are a few procedures that members are supposed to employ to prevent insider trading, but it is important to remember the precedence of those procedures.

Methods of Prevention:

Firewall
Trading Restrictions
Watch Lists

The primary and most effective method is the "Firewall" approach because it is proactive in preventing insider information from reaching individuals who could possibly act upon it. The second two methods are successively used to prevent and monitor the actions of people who may or may not have that information.

EAR & APR

2009-03-13T11:56:00.004-05:00

Quantitative Methods: TMV

The first thing you should know is that APR (Annual Percentage Rate) goes by a few names. It is also called SAIR (Stated Annual Interest Rate) os sometimes just Stated Rate, and last but not least, Nominal Rate.

APR:
The ultimate difference in the answers EAR and APR formulas give you is that the simple APR, does not include the effects of compounding, where EAR does. Because of this, you can imagine that the equation for figuring APR is simpler as well.

EAR:
Since EAR does account for compounding periods, it is used when comparing investments that have different compounding periods. It takes the apples and oranges of periodic monthly, quarterly, semiannually compounding rates and transforms them into apples and apples on a yearly basis. It is also used to compare investments with different time horizons like for example 3 years @ 7% compared to 5 @ 4%.

In the paper formulas you'll see that each equation uses m to denote the period. There is also another time period called n the difference being that m is the number of periods/year, and n is the total number of periods for the investment. So if you invest money for 3 years compounding quarterly, m=4 ; n=[4*3]=12

What you should also keep in mind is that the TMV programs in the calculators use an input called N. The calculator doesn't care or keep track of whether you are actually inputting n or m, it's up to you to figure out your time period, but remembering this can actually save you a little time and frustration while using the calculator.

Since the EAR equation looks at the whole investment horizon, and interpolates an annualized return for that whole time frame, when using the calculator, you don't need to account for however many compounding periods there are, just the length of the investment horizon in years. N in your calculator would be 3 (years).

Although APR seems simpler on paper [i*m] when you use the calculator inputs to figure i you use the total amount of compounding periods [4*3=12 periods]. This means that i has been calculated as a periodic rate, and not an annualized rate. There is actually one more step you would need to put into your calculator which would be to make that periodic rate equal to a year's worth - multiplying it by the number of periods in just one year.

Key Point:
Not all i are created equal. Depending on which i you want your calculator to give you, you'll need to use the corresponding N.

when i = EAR ; N = total years
when i = APR ; N = total compounding periods - then multiply by m (periods/year) to get an annualized number.

Posterior Probabilites

2009-03-12T12:42:00.011-05:00

Quantitative Methods: Probabilities

This name kind of literally means, "probability from the back end", or more plainly, working from back to front. It's proper name is the Bayes Theorem, or an updated probability, and involves an event diagram, just like the other probability approaches. The difference is that the question will tell you that one of the secondary events, those further to the right, has already happened, and you are expected to find the probability that one of the primary events on the left of the diagram has happened as well. Of course this is made a little difficult because there are only two kinds of secondary events which means that each secondary event can also be attributed to each primary event. It sounds more complicated than it really is, I promise. Most of the CFA study books will give you formulas the look like P(R|C)=P(C|R)/P(C), which is even more confounding.

Example: If C happens, what's the probability that A has happened as well?

My method:
You will only be working with numbers on the far right of the diagram. The key here is to realize that you need to add the two secondary "If" instances that the question has stated already happened. That number will then be divided into the one instance where both probabilities happen.

The beauty is that obviously one of either the Numerator or Denominator will be bigger, and what you are looking for is a probability, which will always be less than 1 ~ .31/.28 = 1.107%. If you get an answer bigger than one then you need to switch the Numerator and Denominator.
Answer:

P (A|C)

P(A|C)+P(B|C)

.28

(.28+.03)

=90.32%

FIFO & LIFO

2009-03-11T09:48:00.003-05:00

Financial Statement Analysis:

First off, both methods assume that in general, the cost of inventory as well as the cost of the products you make with that inventory are rising, so that as your production costs rise, so do your revenues.

The very definition of FIFO means that, the very oldest (and relatively the cheapest) items are those being sold first, leaving the more expensive items in your inventory.

LIFO then would mean that the most expensive items have been sold first, leaving the items which had lesser costs.

Key difference: how these methods interact with the balance sheet and income statements

Balance Sheet
The balance sheet is like a "snapshot" in time, where assets and liabilities available are valued at the market value at that point in time. Again, using FIFO means that the oldest items are being sold first, and the newest items are being held in inventory. The older the item is, the more volatile it's market value may become - it could go up, it could go down (somewhat similar to maturity risk premium). The reality is that the cost you paid for a specific input obviously never changes, but the finished goods you make with the inventory is generally trending upward. The closer the cost of your inputs are to the market value if the finished goods you make, the more accurate (and more highly valued) your inventory numbers will be.

Income Statement:
You want that volatility and larger difference that LIFO inherently has in the income statement because that difference can lend to improve your bottom line. Since you account for the costs of an item sold only in the period in which that item is sold, in order to boost your revenue, you'd like to be able to report the lowest associated costs.

Since inventory costs generally trend upward, you'd have to associate the oldest (lowest) historical cost to the current selling price. This difference increases the margins in your COGS.

Key Point:
FIFO minimizes the market value to historical cost difference, LIFO enhances it.

IRR & NPV

2009-03-10T11:35:00.000-05:00

Quantitative Methods: Discounted Cash Flows

When given a a list of either uneven cash flows or a single sum of money, and told figure out if it is an acceptable investment for a client you will need to check for two things:

if the CF IRR is higher than the client's required rate of return
if NPV is positive; if NPV is less than what the client is wiling/capable to pay.

In one sum of money, you could be asked,

at what value should a client purchase an item that will be worth FV in M years ?

(where the variables are actual numbers), or the client could have an available amount of money to spend today etc. Any of the variables PV, FV, IRR, m could be left to solve for, but it will most likely involve discounting a future value back to the present value, or compounding the present value into the future.

With uneven cash flows, you'll likely be asked to compare a required rate of return to the actual IRR of the payments.

Compounding Interest: Periodic vs. Annual

2009-03-09T14:11:00.006-05:00

Quantitative Methods: TMV

You will almost never answer a question by giving the periodic rate. You may be given variables that compound in monthly, quarterly, daily terms, but the initial values you use with those variables will only give you the periodic rate (ip).

The test questions will most likely always ask for either APR/SAIR (Annual Percentage Rate/Stated Annual Interest Rate) or EAR (Effective Annual Rate). What you must do is memorize the equations for each and be able to incorporate the periodic rate you already solved for in order to convert that answer into 1 year's worth of compounding periods. The key difference in these equations is how the periodic rate is entered.

For APR you can leave it as the percentage which you first solved for with the TMV equation. For EAR, you'll need to enter it as a decimal point by dividing into 100.

Independence & Objectivity

2009-03-08T15:39:00.000-05:00

Ethics: Standards
Independence and objectivity must always be kept in mind while doing business with a CFA designation. These factors most often are thought to be negatively effected when a person takes or gives a gift that is either actually in connection with, or could be seen as being in connection with a business matter. The circumstances usually revolve around whether the member accepts a gift or service from influential people of companies that could sway his opinion. The CFA member does not have to act in a biased manner in order to violate the Standards, the instance of accepting a gift that could potentially bias a member is can also be seen as a violation. There is no formal list Comprised by the CFA that enumerates these kinds of gifts because the list it could be added to on a regular basis depending on the circumstances and there could also be exceptions in may cases. Many firms enact policies and more specific lists on what items are unacceptable or which companies are restricted from receiving opinions or coverage, but in most cases it is up to the CFA member to use his best judgment at all times and act accordingly.

Gifts are allowed in some cases from clients and business partners, where it can be considered modest (less than $100), but the member should still fully disclose these kinds of gifts.

Exceptions are allowed when the member is given/copmed gifts or services that are necessary and unavailable from anyone other than an influential party. This could include a free hotel stay from a client, but only if there are no other hotels in the area that a member could have chosen in order to remain objective. It would have been the only practical and available choice.

Discounting Vs. Compounding

2009-03-07T09:55:00.002-06:00

Quantitative Methods: Interest Rates

Discount Rates are referred to when analysis needs to be done between future and present values of a stream of cash flows. When referring to the act of taking the difference, the noun is converted to a verb and is called either Compounding or Discounting. You'd take a present value and compound it into the future using the given Discount Rate to find what the end sum will be. If you're targeting a specific future value, you would discount it back the present to find out what the amount put in today would would need to be in order to reach that future amount.

Key Point:
Compound payments into the Future
Discount payments into the Past

Required Interest Rate

2009-03-06T11:11:00.001-06:00

Quantitative Methods: Interest Rates

Making an investment to be repaid over time and concluding the price at which you would break even includes looking at the many factors involved in forgoing purchasing power today for being able to collect a larger sum in the future. The Required Interest Rate, or Required Return (in reference to equity), is the comprehensive number that accounts for all of those factors which include:

Real Risk-Free Rate: As the name implies it accounts for no uncertainty. Only accounts for the difference in timing between spending your real dollars now or later.

Expected Inflation: Over time the purchasing power of a dollar today will be reduced by normal future inflation (generally assumed to be about 2-3%).

Default-Risk Premium: Accounts for the possibility that the borrower will make late payments or possibly go under and not be able to make any payments. It's dependent on the due diligence done on the borrower including credit health.

Liquidity Premium: Some types of securities, like stocks or treasuries are freely traded on a day to day basis, others, like equity securities can have trading restrictions based on quantity or time. The opportunity to sell in these cases is called liquidity; the harder it is to sell a security, the less liquidity it has. A higher rate must then be paid to buyers of securities who have little liquidity as compensation for the constraints. It serves as more of an incentive to buy them when compared to other more liquid securities.

Maturity Premium: The longer a security is held, there is a higher chance that it could be subjected to any or all of the above risks. This effect leads to a higher volatility in repayment probabilities and again, there must be an incentive paid to buyers for this kind of transaction.

Inferior, Normal & Luxury Goods

2009-03-04T20:24:00.002-06:00

Economics: Income Elasticity of Demand

This equation is used mostly to categorize items and their purchase patterns in relation to In. A negative or positive answer can tell you something about the item, the relative answer of Income Elasticity, be it , greater than one, less than one less than 0, can tell you whether the items are inferior goods or normal goods (less than or greater than 0 respectively), furthermore, if it's a normal good, it's subdivided into necessity and luxury (less than or greater than 1 respectively).

Inferior Goods:
As a person's income rises, then the less demand there will be for inferior goods. As your income rises you'll switch from brewing inferior instant coffee at home to getting that store-bought latte down the street. The relationship of inferior goods is therefore inverse to a rise in income, and as you might be able to guess, inferior goods fall in the category whose Income Elasticity of Demand is less than zero.

Non-inferior (normal & luxury) goods:
These goods correlate with a rise income, and therefore can be seen as greater than zero. And as you look at those non-inferior goods they can be divided into the categories of necessity and luxury by testing if the answer is either greater than or less than 1. Common sense might again tell you that if the inferior goods answer is on the far end of the spectrum and is less than zero, then the luxury item will have the largest answer of greater than one, which leaves normal goods to fall between zero and one.

Key Point:
The relation between Inferior and goods and Income is Inverse
The relation between Non-Inferior goods and Income is Correlative

IFRS vs. FASB Qualitative Characteristics

2009-03-03T16:42:00.000-06:00

Financial Reporting & Analysis: Differences in Reporting Frameworks

IFRS calls for all qualitative characteristics to be equally important when preparing financial statements.

FASB call into effect a hierarchy: (from most to least important)

Relevance & Reliability
Comparability
Understandability

Income Statement Format

2009-03-02T10:20:00.001-06:00

Financial Reporting & Analysis: Financial Statements

In the income statement, revenues and expenses both have further subdivisions. The general reasoning for these divisions is specifically to aide in analysis.

In the revenues section there are Revenue, from sales of goods (self explanatory), and Other Revenues (dividends from investments, income from the sale of equipment, etc.). The pivotal point here is if the revenue was generated from operational output or not. Any analyst, either internal or external, wants to be able to see if a company's operating margins are comparable to it's competitors - if the company needs to improve or is ahead of the curve.

In the expenses section, financing expenses are subdivided because it is possible that a new owner or partner could significantly change this account. If a large corporation with an accompanying large bank-roll is looking to make an acquisition, it could easily remove the cost of a line of credit, or outstanding loans, which again would improve a company's margins. Whereas the operating expenses may take more effort or a change in management to see significant reductions.

There might also be an account for losses in this section since they intrinsically reduce revenue. This is where something like damage to equipment or a decline in value of inventory would be reported, again because these are items on which a company has no operational effect, and they should not be included when looking into future performance analyses.

Key point: subdivided accounts can be classified as operational or non-operational and these divisions lead to better synthesis of finance and operating margins.

IFRS vs. FASB in Valuation

2009-03-01T20:40:00.000-06:00

Financial Reporting & Analysis: Differences in Frameworks

In FASB, Long Term Assets (PP&E and Intangibles) must be listed at Historic Cost less Accumulated Depr.

In IFRS these accounts can be listed at fair market value, or otherwise known as Mark-to-Market terms.
The issues:

Reliability - Historic cost is easily accounted for, yet fair market value is a subjective assessment if a secondary market doesn't exist for the asset.
Relevance - Historic cost is out of date as soon as inflation is applied and therefore doesn't represent the actual or economic value. Fair market value can theoretically put a more accurate value on the asset account if the judgment of those assets' market figures are accurate.

Key Point: Reliability vs. Relevance

side note: Because of these differences, Valuation Measurements act as a barrier to a single framework. Combining the two frameworks would mean reconciling valuation rules.

Constraints of Financial Stmts

2009-03-01T10:39:00.000-06:00

Financial Reporting & Analysis: IFRS Prep & Presentation of Statements

The IFRS calls for statements to have certain qualitative characteristics so that the people relying on them can be assured the assumption they make on these statements are as accurate as possible.

The Problem:
Assessing certain accounts such as Acct Receivable and Bad Debts Provisions involves some estimations. If you wanted completely accurate information in these accounts you'd have to wait until all collections have been received, but the nature of most statements is that they are published at specific times: monthly quarterly, year-end.

The Issue:
There is a point of diminishing returns in waiting for the most accurate information when analysts or governing bodies need the statements by a certain time.

The trade off is in Relevance vs. Reliability
quickly published statements may have less accurate info, but completely accurate statements will not be published in time for most applications.

Elasticity: Perfect Curves

2009-02-28T19:10:00.004-06:00

Economics: Elastic & Inelastic Curves

There are theoretically perfect versions of both of these curves as, where the Elastic curve is perfectly horizontal and the Inelastic curve is perfectly vertical.

So if you remember much from calculus you might know that perfect curves on charts like this either have a value of ∞ or 0. The easiest way to remember this point is to think of elasticity in a very literal sense. Imagine a rubber band. If it were very elastic it could stretch from here to the other end of the earth, if it were Inelastic, you couldn’t stretch it at all, hence ∞ and 0.

Perfectly Elastic curve = ∞
Perfectly INelastic curve = 0