2011年CFA 考試 study guides

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The readings in this study session present a framework for ethical conduct in

the investment profession by focusing on the CFA Institute Code of Ethics and

Standards of Professional Conduct as well as the Global Investment Performance

Standards (GIPS®).

The principles and guidance presented in the CFA Institute Standards of

Practice Handbook (SOPH) form the basis for the CFA Institute self-regulatory

program to maintain the highest professional standards among investment

practitioners. “Guidance” in the SOPH addresses the practical application of the

Code and Standards. The guidance reviews the purpose and scope of each

standard, presents recommended procedures for compliance, and provides

examples of the standard in practice.

The GIPS facilitate efficient comparison of investment performance among

investment managers and across country borders by prescribing methodology and

standards that are consistent with a clear and honest presentation of returns.

Having a global standard for reporting investment performance minimizes the

potential for ambiguous or misleading presentations.

READING ASSIGNMENTS

Reading 1 Code of Ethics and Standards of Professional Conduct

Standards of Practice Handbook, Ninth Edition

Reading 2 Guidance for Standards I–VII

Standards of Practice Handbook, Ninth Edition

Reading 3 Introduction to the Global Investment Performance Standards

(GIPS®)

Reading 4 Global Investment Performance Standards (GIPS®)

STUDY SES

Study Session 1

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LEARNING OUTCOMES

Reading 1: Code of Ethics and Standards of Professional Conduct

The candidate should be able to:

a. describe the structure of the CFA Institute Professional Conduct Program and the

process for the enforcement of the Code and Standards;

b. state the six components of the Code of Ethics and the seven Standards of

Professional Conduct;

c. explain the ethical responsibilities required by the Code and Standards, including

the multiple subsections of each Standard.

Reading 2: Guidance for Standards I–VII

The candidate should be able to:

a. demonstrate a thorough knowledge of the Code of Ethics and Standards of

Professional Conduct by applying the Code and Standards to situations involving

issues of professional integrity;

b. distinguish between conduct that conforms to the Code and Standards and

conduct that violates the Code and Standards;

c. recommend practices and procedures designed to prevent violations of the Code

of Ethics and Standards of Professional Conduct.

Reading 3: Introduction to the Global Investment Performance

Standards (GIPS®)

The candidate should be able to:

a. explain why the GIPS standards were created, what parties the GIPS standards

apply to, and who is served by the standards;

b. explain the construction and purpose of composites in performance reporting;

c. explain the requirements for verification of compliance with GIPS standards.

Reading 4: Global Investment Performance Standards (GIPS®)

The candidate should be able to:

a. describe the key characteristics of the GIPS standards and the fundamentals of

compliance;

b. describe the scope of the GIPS standards with respect to an investment firm’s

definition and historical performance record;

c. explain how the GIPS standards are implemented in countries with existing

standards for performance reporting and describe the appropriate response

when the GIPS standards and local regulations conflict;

d. characterize the eight major sections of the GIPS standards.

www.cfainstitute.org/toolkit—Your online preparation resource

This introductory study session presents the fundamentals of some of those

quantitative techniques that are essential in almost any type of financial

analysis, and which will be used throughout the remainder of the CFA curriculum.

This session introduces two main building blocks of the quantitative analytical tool

kit: the time value of money and statistics and probability theory.

The time value of money concept is one of the main principles of financial

valuation. The calculations based on this principle (e.g., present value, future

value, and internal rate of return) are the basic tools used to support corporate

finance decisions and estimate the fair value of fixed income, equity, or any other

type of security or investment.

Similarly, the basic concepts of statistics and probability theory constitute the

essential tools used in describing the main statistical properties of a population

and understanding and applying various probability concepts in practice.

READING ASSIGNMENTS

Reading 5 The Time Value of Money

Quantitative Methods for Investment Analysis, Second Edition,

by Richard A. DeFusco, CFA, Dennis W. McLeavey, CFA, Jerald E.

Pinto, CFA, and David E. Runkle, CFA

Reading 6 Discounted Cash Flow Applications

Quantitative Methods for Investment Analysis, Second Edition,

by Richard A. DeFusco, CFA, Dennis W. McLeavey, CFA, Jerald E.

Pinto, CFA, and David E. Runkle, CFA

Reading 7 Statistical Concepts and Market Returns

Quantitative Methods for Investment Analysis, Second Edition,

by Richard A. DeFusco, CFA, Dennis W. McLeavey, CFA, Jerald E.

Pinto, CFA, and David E. Runkle, CFA

Reading 8 Probability Concepts

Quantitative Methods for Investment Analysis, Second Edition,

by Richard A. DeFusco, CFA, Dennis W. McLeavey, CFA, Jerald E.

Pinto, CFA, and David E. Runkle, CFA

STUDY SESSION 2

QUANTITATIVE METHODS:

Basic Concepts

Study Session 2

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LEARNING OUTCOMES

Reading 5: The Time Value of Money

The candidate should be able to:

a. interpret interest rates as required rate of return, discount rate, or opportunity

cost;

b. explain an interest rate as the sum of a real risk-free rate, expected inflation, and

premiums that compensate investors for distinct types of risk;

c. calculate and interpret the effective annual rate, given the stated annual interest

rate and the frequency of compounding;

d. solve time value of money problems when compounding periods are other than

annual;

e. calculate and interpret the future value (FV) and present value (PV) of a single

sum of money, an ordinary annuity, an annuity due, a perpetuity (PV only), and a

series of unequal cash flows;

f. draw a time line and solve time value of money applications (for example,

mortgages and savings for college tuition or retirement).

Reading 6: Discounted Cash Flow Applications

The candidate should be able to:

a. calculate and interpret the net present value (NPV) and the internal rate of return

(IRR) of an investment, contrast the NPV rule to the IRR rule, and identify

problems associated with the IRR rule;

b. define, calculate, and interpret a holding period return (total return);

c. calculate, interpret, and distinguish between the money-weighted and timeweighted

rates of return of a portfolio and appraise the performance of

portfolios based on these measures;

d. calculate and interpret the bank discount yield, holding period yield, effective

annual yield, and money market yield for a U.S. Treasury bill;

e. convert among holding period yields, money market yields, effective annual

yields, and bond equivalent yields.

Reading 7: Statistical Concepts and Market Returns

The candidate should be able to:

a. differentiate between descriptive statistics and inferential statistics, between a

population and a sample, and among the types of measurement scales;

b. explain a parameter, a sample statistic, and a frequency distribution;

c. calculate and interpret relative frequencies and cumulative relative frequencies,

given a frequency distribution;

d. describe the properties of a data set presented as a histogram or a frequency

polygon;

e. define, calculate, and interpret measures of central tendency, including the

population mean, sample mean, arithmetic mean, weighted average or mean

(including a portfolio return viewed as a weighted mean), geometric mean,

harmonic mean, median, and mode;

Study Session 2

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f. describe, calculate, and interpret quartiles, quintiles, deciles, and percentiles;

g. define, calculate, and interpret 1) a range and a mean absolute deviation and

2) the variance and standard deviation of a population and of a sample;

h. calculate and interpret the proportion of observations falling within a specified

number of standard deviations of the mean using Chebyshev’s inequality;

i. define, calculate, and interpret the coefficient of variation and the Sharpe ratio;

j. define and interpret skewness, explain the meaning of a positively or negatively

skewed return distribution, and describe the relative locations of the mean,

median, and mode for a nonsymmetrical distribution;

k. define and interpret measures of sample skewness and kurtosis;

l. discuss the use of arithmetic mean or geometric mean when determining

investment returns.

Reading 8: Probability Concepts

The candidate should be able to:

a. define a random variable, an outcome, an event, mutually exclusive events, and

exhaustive events;

b. explain the two defining properties of probability and distinguish among

empirical, subjective, and a priori probabilities;

c. state the probability of an event in terms of odds for or against the event;

d. distinguish between unconditional and conditional probabilities;

e. define and explain the multiplication, addition, and total probability rules;

f. calculate and interpret 1) the joint probability of two events, 2) the probability

that at least one of two events will occur, given the probability of each and the

joint probability of the two events, and 3) a joint probability of any number of

independent events;

g. distinguish between dependent and independent events;

h. calculate and interpret, using the total probability rule, an unconditional

probability;

i. explain the use of conditional expectation in investment applications;

j. diagram an investment problem using a tree diagram;

k. calculate and interpret covariance and correlation;

l. calculate and interpret the expected value, variance, and standard deviation of a

random variable and of returns on a portfolio;

m. calculate and interpret covariance given a joint probability function;

n. calculate and interpret an updated probability using Bayes’ formula;

o. identify the most appropriate method to solve a particular counting problem and

solve counting problems using the factorial, combination, and permutation

notations.

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This study session introduces some of the discrete and continuous probability

distributions most commonly used to describe the behavior of random

variables. Probability theory and calculations are widely applied in finance, for

example, in the field of investment and project valuation and in financial risk

management.

Furthermore, this session teaches how to estimate different parameters (e.g.,

mean and standard deviation) of a population if only a sample, rather than the

whole population, can be observed. Hypothesis testing is a closely related topic.

This session presents the techniques that can be applied to accept or reject an

assumed hypothesis (null hypothesis) about various parameters of a population.

Finally, you will also learn about the fundamentals of technical analysis. It is

important that analysts properly understand the assumptions and limitations when

applying these tools as mis-specified models or improperly used tools can result in

misleading conclusions.

READING ASSIGNMENTS

Reading 9 Common Probability Distributions

Quantitative Methods for Investment Analysis, Second Edition, by

Richard A. DeFusco, CFA, Dennis W. McLeavey, CFA, Jerald E.

Pinto, CFA, and David E. Runkle, CFA

Reading 10 Sampling and Estimation

Quantitative Methods for Investment Analysis, Second Edition, by

Richard A. DeFusco, CFA, Dennis W. McLeavey, CFA, Jerald E.

Pinto, CFA, and David E. Runkle, CFA

Reading 11 Hypothesis Testing

Quantitative Methods for Investment Analysis, Second Edition, by

Richard A. DeFusco, CFA, Dennis W. McLeavey, CFA, Jerald E.

Pinto, CFA, and David E. Runkle, CFA

Reading 12 Technical Analysis

Investment Analysis and Portfolio Management, Eighth Edition,

by Frank K. Reilly, CFA and Keith C. Brown, CFA

STUDY SESSION 3

QUANTITATIVE METHODS:

Application

Study Session 3

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LEARNING OUTCOMES

Reading 9: Common Probability Distributions

The candidate should be able to:

a. explain a probability distribution and distinguish between discrete and

continuous random variables;

b. describe the set of possible outcomes of a specified discrete random variable;

c. interpret a probability function, a probability density function, and a cumulative

distribution function;

d. calculate and interpret probabilities for a random variable, given its cumulative

distribution function;

e. define a discrete uniform random variable and a binomial random variable;

f. calculate and interpret probabilities given the discrete uniform and the binomial

distribution functions;

g. construct a binomial tree to describe stock price movement;

h. describe the continuous uniform distribution and calculate and interpret

probabilities, given a continuous uniform probability distribution;

i. explain the key properties of the normal distribution, distinguish between a

univariate and a multivariate distribution, and explain the role of correlation in

the multivariate normal distribution;

j. determine the probability that a normally distributed random variable lies inside a

given confidence interval;

k. define the standard normal distribution, explain how to standardize a random

variable, and calculate and interpret probabilities using the standard normal

distribution;

l. define shortfall risk, calculate the safety-first ratio, and select an optimal portfolio

using Roy’s safety-first criterion;

m. explain the relationship between normal and lognormal distributions and why

the lognormal distribution is used to model asset prices;

n. distinguish between discretely and continuously compounded rates of return and

calculate and interpret a continuously compounded rate of return, given a

specific holding period return;

o. explain Monte Carlo simulation and historical simulation and describe their major

applications and limitations.

Reading 10: Sampling and Estimation

The candidate should be able to:

a. define simple random sampling, sampling error, and a sampling distribution, and

interpret sampling error;

b. distinguish between simple random and stratified random sampling;

c. distinguish between time-series and cross-sectional data;

d. interpret the central limit theorem and describe its importance;

e. calculate and interpret the standard error of the sample mean;

f. distinguish between a point estimate and a confidence interval estimate of a

population parameter;

Study Session 3

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g. identify and describe the desirable properties of an estimator;

h. explain the construction of confidence intervals;

i. describe the properties of Student’s t-distribution and calculate and interpret its

degrees of freedom;

j. calculate and interpret a confidence interval for a population mean, given a

normal distribution with 1) a known population variance, 2) an unknown

population variance, or 3) an unknown variance and a large sample size;

k. discuss the issues regarding selection of the appropriate sample size, data-mining

bias, sample selection bias, survivorship bias, look-ahead bias, and time-period

bias.

Reading 11: Hypothesis Testing

The candidate should be able to:

a. define a hypothesis, describe the steps of hypothesis testing, interpret and

discuss the choice of the null hypothesis and alternative hypothesis, and

distinguish between one-tailed and two-tailed tests of hypotheses;

b. define and interpret a test statistic, a Type I and a Type II error, and a significance

level, and explain how significance levels are used in hypothesis testing;

c. define and interpret a decision rule and the power of a test, and explain the

relation between confidence intervals and hypothesis tests;

d. distinguish between a statistical result and an economically meaningful result;

e. explain and interpret the p-value as it relates to hypothesis testing;

f. identify the appropriate test statistic and interpret the results for a hypothesis test

concerning the population mean of both large and small samples when the

population is normally or approximately distributed and the variance is 1) known

or 2) unknown;

g. identify the appropriate test statistic and interpret the results for a hypothesis test

concerning the equality of the population means of two at least approximately

normally distributed populations, based on independent random samples with

1) equal or 2) unequal assumed variances;

h. identify the appropriate test statistic and interpret the results for a hypothesis test

concerning the mean difference of two normally distributed populations (paired

comparisons test);

i. identify the appropriate test statistic and interpret the results for a hypothesis test

concerning 1) the variance of a normally distributed population, and 2) the

equality of the variances of two normally distributed populations, based on two

independent random samples;

j. distinguish between parametric and nonparametric tests and describe the

situations in which the use of nonparametric tests may be appropriate.

Reading 12: Technical Analysis

The candidate should be able to:

a. explain the underlying assumptions of technical analysis;

b. discuss the advantages of and challenges to technical analysis;

c. list and describe examples of each major category of technical trading rules and

indicators.

www.cfainstitute.org/toolkit—Your online preparation resource

This study session focuses on microeconomic concepts and how firms are

affected by these concepts. One of the main concepts related to the

equilibrium between demand and supply is elasticity, which measures the rate of

changes on the equilibrium price level. A second key concept is efficiency, which is

a measure of the firm’s “optimal” output given its cost and revenue functions.

Understanding these concepts enables analysts to differentiate among various

companies on an individual level and to determine their attractiveness for

an investor.

READING ASSIGNMENTS

Reading 13 Elasticity

Economics, Eighth Edition, by Michael Parkin

Reading 14 Efficiency and Equity

Economics, Eighth Edition, by Michael Parkin

Reading 15 Markets in Action

Economics, Eighth Edition, by Michael Parkin

Reading 16 Organizing Production

Economics, Eighth Edition, by Michael Parkin

Reading 17 Output and Costs

Economics, Eighth Edition, by Michael Parkin

STUDY SESSION 4

ECONOMICS:

Microeconomic Analysis

LEARNING OUTCOMES

Reading 13: Elasticity

The candidate should be able to:

a. calculate and interpret the elasticities of demand (price elasticity, cross elasticity,

and income elasticity) and the elasticity of supply and discuss the factors that

influence each measure;

b. calculate elasticities on a straight-line demand curve, differentiate among elastic,

inelastic, and unit elastic demand, and describe the relation between price

elasticity of demand and total revenue.

Study Session 4

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Reading 14: Efficiency and Equity

The candidate should be able to:

a. explain the various means of markets to allocate resources, describe marginal

benefit and marginal cost, and demonstrate why the efficient quantity occurs

when marginal benefit equals marginal cost;

b. distinguish between the price and the value of a product and explain the

demand curve and consumer surplus;

c. distinguish between the cost and the price of a product and explain the supply

curve and producer surplus;

d. discuss the relationship between consumer surplus, producer surplus, and

equilibrium;

e. explain 1) how efficient markets ensure optimal resource utilization and 2) the

obstacles to efficiency and the resulting underproduction or overproduction,

including the concept of deadweight loss;

f. explain the two groups of ideas about the fairness principle (utilitarianism and

the symmetry principle) and discuss the relation between fairness and efficiency.

Reading 15: Markets in Action

The candidate should be able to:

a. explain market equilibrium, distinguish between long-term and short-term

effects of outside shocks, and describe the effects of rent ceilings on the

existence of black markets in the housing sector and on the market’s efficiency;

b. describe labor market equilibrium and explain the effects and inefficiencies of a

minimum wage above the equilibrium wage;

c. explain the impact of taxes on supply, demand, and market equilibrium, and

describe tax incidence and its relation to demand and supply elasticity;

d. discuss the impact of subsidies, quotas, and markets for illegal goods on

demand, supply, and market equilibrium.

Reading 16: Organizing Production

The candidate should be able to:

a. explain the types of opportunity cost and their relation to economic profit, and

calculate economic profit;

b. discuss a company’s constraints and their impact on achievability of maximum

profit;

c. differentiate between technological efficiency and economic efficiency and

calculate economic efficiency of various companies under different scenarios;

d. explain command systems and incentive systems to organize production, the

principal-agent problem, and measures a firm uses to reduce the principal-agent

problem;

e. describe the different types of business organization and the advantages and

disadvantages of each;

f. calculate and interpret the four-firm concentration ratio and the Herfindahl-

Hirschman Index and discuss the limitations of concentration measures;

g. explain why companies are often more efficient than markets in coordinating

economic activity.

www.cfainstitute.org/toolkit—Your online preparation resource

Study Session 4

Reading 17: Output and Costs

The candidate should be able to:

a. differentiate between short-run and long-run decision time frames;

b. describe and explain the relations among total product of labor, marginal

product of labor, and average product of labor, and describe increasing and

decreasing marginal returns;

c. distinguish among total cost (including both fixed cost and variable cost),

marginal cost, and average cost, and explain the relations among the various

cost curves;

d. explain the company’s production function, its properties of diminishing returns

and diminishing marginal product of capital, the relation between short-run and

long-run costs, and how economies and diseconomies of scale affect long-run

costs.

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This study session first compares and contrasts the different market structures

in which companies operate. The market environment influences the price a

company can demand for its goods or services. The most important of these

market forms are monopoly and perfect competition, although monopolistic

competition and oligopoly are also covered.

The study session then introduces the macroeconomic concepts that have

an effect on all companies in the same environment, be it a country, a group

of related countries, or a particular industry. The study session concludes

by describing how an economy’s aggregate supply and aggregate demand

are determined.

READING ASSIGNMENTS

Reading 18 Perfect Competition

Economics, Eighth Edition, by Michael Parkin

Reading 19 Monopoly

Economics, Eighth Edition, by Michael Parkin

Reading 20 Monopolistic Competition and Oligopoly

Economics, Eighth Edition, by Michael Parkin

Reading 21 Markets for Factors of Production

Economics, Eighth Edition, by Michael Parkin

Reading 22 Monitoring Jobs and the Price Level

Economics, Eighth Edition, by Michael Parkin

Reading 23 Aggregate Supply and Aggregate Demand

Economics, Eighth Edition, by Michael Parkin

STUDY SESSION 5

ECONOMICS:

Market Structure and Macroeconomic Analysis

Study Session 5

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LEARNING OUTCOMES

Reading 18: Perfect Competition

The candidate should be able to:

a. describe the characteristics of perfect competition, explain why companies in a

perfectly competitive market are price takers, and differentiate between market

and company demand curves;

b. determine the profit maximizing (loss minimizing) output for a perfectly

competitive company and explain marginal cost, marginal revenue, and

economic profit and loss;

c. describe a perfectly competitive company’s short-run supply curve and explain

the impact of changes in demand, entry and exit of companies, and changes in

plant size on the long-run equilibrium;

d. discuss how a permanent change in demand or changes in technology affect

price, output, and economic profit.

Reading 19: Monopoly

The candidate should be able to:

a. describe the characteristics of a monopoly, including factors that allow a

monopoly to arise and monopoly price-setting strategies;

b. explain the relation between price, marginal revenue, and elasticity for a

monopoly and determine a monopoly’s profit-maximizing price and quantity;

c. explain price discrimination and why perfect price discrimination is efficient;

d. explain how consumer and producer surplus are redistributed in a monopoly,

including the occurrence of deadweight loss and rent seeking;

e. explain the potential gains from monopoly and the regulation of a natural

monopoly.

Reading 20: Monopolistic Competition and Oligopoly

The candidate should be able to:

a. describe the characteristics of monopolistic competition and an oligopoly;

b. determine the profit-maximizing (loss-minimizing) output under monopolistic

competition, explain why long-run economic profit under monopolistic

competition is zero, and determine if monopolistic competition is efficient;

c. explain the importance of innovation, product development, advertising, and

branding under monopolistic competition;

d. explain the kinked demand curve model and the dominant firm model and

determine the profit-maximizing (loss-minimizing) output under each model;

e. describe oligopoly games including the Prisoners’ Dilemma.

Reading 21: Markets for Factors of Production

The candidate should be able to:

a. explain why demand for the factors of production is called derived demand,

differentiate between marginal revenue and marginal revenue product (MRP),

and describe how the MRP determines the demand for labor and the wage rate;

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Study Session 5

b. describe the factors that cause changes in the demand for labor and the factors

that determine the elasticity of the demand for labor;

c. describe the factors determining the supply of labor, including the substitution

and income effects, and discuss the factors related to changes in the supply of

labor, including capital accumulation;

d. describe the effects on wages of labor unions and of a monopsony and explain

the possible consequences for a market that offers an efficient wage;

e. differentiate between physical capital and financial capital and explain the

relation between the demand for physical capital and the demand for financial

capital;

f. explain the factors that influence the demand and supply of capital;

g. differentiate between renewable and nonrenewable natural resources and

describe the supply curve for each;

h. differentiate between economic rent and opportunity costs.

Reading 22: Monitoring Jobs and the Price Level

The candidate should be able to:

a. define an unemployed person and interpret the main labor market indicators;

b. define aggregate hours and real wage rates and explain their relation to gross

domestic product (GDP);

c. explain the types of unemployment, full employment, the natural rate of

unemployment, and the relation between unemployment and real GDP;

d. explain and calculate the consumer price index (CPI) and the inflation rate,

describe the relation between the CPI and the inflation rate, and explain the

main sources of CPI bias.

Reading 23: Aggregate Supply and Aggregate Demand

The candidate should be able to:

a. explain the factors that influence real GDP and long-run and short-run aggregate

supply, explain movement along the long-run and short-run aggregate supply

curves (LAS and SAS), and discuss the reasons for changes in potential GDP and

aggregate supply;

b. explain the components of and the factors that affect real GDP demand, describe

the aggregate demand curve and why it slopes downward, and explain the

factors that can change aggregate demand;

c. differentiate between short-run and long-run macroeconomic equilibrium and

explain how economic growth, inflation, and changes in aggregate demand and

supply influence the macroeconomic equilibrium;

d. compare and contrast the classical, Keynesian, and monetarist schools of

macroeconomics.

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This study session focuses on the monetary sector of an economy. It examines

the functions of money and how it is created, highlighting the special role of

the central bank within an economy. Supply and demand for resources, such as

labor and capital, and goods are strongly interrelated. This study session describes

circumstances when this relationship may lead to inflation or unemployment and

how these concepts relate to the business cycle. Finally, the goals and implications

of fiscal and monetary policy are explored by examining some of the main models

of macroeconomic theory (classical, Keynesian, and monetarist).

READING ASSIGNMENTS

Reading 24 Money, the Price Level, and Inflation

Economics, Eighth Edition, by Michael Parkin

Reading 25 U.S. Inflation, Unemployment, and Business Cycles

Economics, Eighth Edition, by Michael Parkin

Reading 26 Fiscal Policy

Economics, Eighth Edition, by Michael Parkin

Reading 27 Monetary Policy

Economics, Eighth Edition, by Michael Parkin

Reading 28 An Overview of Central Banks

International Economic Indicators and Central Banks,

by Anne Dolganos Picker

STUDY SESSION 6

ECONOMICS:

Monetary and Fiscal Economics

LEARNING OUTCOMES

Reading 24: Money, the Price Level, and Inflation

The candidate should be able to:

a. explain the functions of money;

b. describe the components of the M1 and M2 measures of money and discuss why

checks and credit cards are not counted as money;

Study Session 6

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c. describe the economic functions of and differentiate among the various

depository institutions and explain the impact of financial regulation,

deregulation, and innovation;

d. explain the goals of the U.S. Federal Reserve (Fed) in conducting monetary policy

and how the Fed uses its policy tools to control the quantity of money, and

describe the assets and liabilities on the Fed’s balance sheet;

e. discuss the creation of money, including the role played by excess reserves, and

calculate the amount of loans a bank can generate, given new deposits;

f. describe the monetary base and explain the relation among the monetary base,

the money multiplier, and the quantity of money;

g. explain the factors that influence the demand for money and describe the

demand for money curve, including the effects of changes in real GDP and

financial innovation;

h. explain interest rate determination and the short-run and long-run effects of

money on real GDP;

i. discuss the quantity theory of money and its relation to aggregate supply and

aggregate demand.

Reading 25: U.S. Inflation, Unemployment, and Business Cycles

The candidate should be able to:

a. differentiate between inflation and the price level;

b. describe and distinguish among the factors resulting in demand-pull and costpush

inflation and describe the evolution of demand-pull and cost-push

inflationary processes;

c. explain the costs of anticipated inflation;

d. explain the relation among inflation, nominal interest rates, and the demand and

supply of money;

e. explain the impact of inflation on unemployment and describe the short-run and

long-run Phillips curve, including the effect of changes in the natural rate of

unemployment;

f. explain how economic growth, inflation, and unemployment affect the business

cycle;

g. describe mainstream business cycle theory and real business cycle (RBC) theory

and distinguish between them, including the role of productivity changes.

Reading 26: Fiscal Policy

The candidate should be able to:

a. explain supply side effects on employment, potential GDP, and aggregate supply,

including the income tax and taxes on expenditure, and describe the Laffer curve

and its relation to supply side economics;

b. discuss the sources of investment finance and the influence of fiscal policy on

capital markets, including the crowding-out effect;

c. discuss the generational effects of fiscal policy, including generational accounting

and generational imbalance;

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Study Session 6

d. discuss the use of fiscal policy to stabilize the economy, including the effects of

the government expenditure multiplier, the tax multiplier, and the balanced

budget multiplier;

e. explain the limitations of discretionary fiscal policy and differentiate between

discretionary fiscal policy and automatic stabilizers.

Reading 27: Monetary Policy

The candidate should be able to:

a. discuss the goals of U.S. monetary policy and the Fed’s means for achieving the

goals, including how the Fed operationalizes those goals;

b. describe how the Fed conducts monetary policy and explain the Fed’s decisionmaking

strategy, including an instrument rule, a targeting rule, open-market

operations, and the market for reserves;

c. discuss monetary policy’s transmission mechanism (chain of events) between

changing the federal funds rate and achieving the ultimate monetary policy goal

when fighting either inflation or recession, and explain loose links and time lags

in the adjustment process;

d. describe alternative monetary policy strategies and explain why they have been

rejected by the Fed.

Reading 28: An Overview of Central Banks

The candidate should be able to:

a. identify the functions of a central bank;

b. discuss monetary policy and the tools utilized by central banks to carry out

monetary policy.

www.cfainstitute.org/toolkit—Your online preparation resource

The readings in this study session discuss the general principles of the financial

reporting system, underscoring the critical role of the analysis of financial

reports in investment decision making.

The first reading introduces the range of information that an analyst may

use in analyzing the financial performance of a company, including the principal

financial statements (the income statement, balance sheet, statement of cash

flows, and statement of changes in owners’ equity), notes to those statements,

and management’s discussion and analysis of results. A general framework for

addressing most financial statement analysis tasks is also presented.

A company’s financial statements are the end-products of a process for

recording the business transactions of the company. The second reading illustrates

this process, introducing such basic concepts as the accounting equation and

accounting accruals.

The presentation of financial information to the public by a company must

conform to applicable financial reporting standards based on factors such as the

jurisdiction in which the information is released. The final reading in this study

explores the role of financial reporting standard-setting bodies worldwide and the

International Financial Reporting Standards framework promulgated by one key

body, the International Accounting Standards Board. The movement towards

worldwide convergence of financial reporting standards is also introduced.

STUDY SESSION 7

FINANCIAL REPORTING AND ANALYSIS:

An Introduction

Note:

New rulings and/or

pronouncements issued

after the publication of the

readings in Study Sessions 7

through 10 in financial

statement analysis may

cause some of the

information in these

readings to become dated.

Candidates are expected to

be familiar with the overall

analytical framework

contained in the study

session readings, as well as

the implications of

alternative accounting

methods for financial

analysis and valuation, as

provided in the assigned

readings.

For the purpose of

Level I questions on

financial statement

analysis, when a ratio is

defined and calculated

differently in various texts,

candidates should use the

definitions given in the CFA

Institute copyrighted

readings by Robinson, et al.

Variations in ratio

definitions are part of the

nature of practical financial

analysis.

READING ASSIGNMENTS

Reading 29 Financial Statement Analysis: An Introduction

International Financial Statement Analysis, by Thomas R.

Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,

CFA, and Michael A. Broihahn, CFA

Reading 30 Financial Reporting Mechanics

International Financial Statement Analysis, by Thomas R.

Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,

CFA, and Michael A. Broihahn, CFA

Reading 31 Financial Reporting Standards

International Financial Statement Analysis, by Thomas R.

Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,

CFA, and Michael A. Broihahn, CFA

Study Session 7

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LEARNING OUTCOMES

Reading 29: Financial Statement Analysis: An Introduction

The candidate should be able to:

a. discuss the roles of financial reporting and financial statement analysis;

b. discuss the role of key financial statements (income statement, balance sheet,

statement of cash flows, and statement of changes in owners’ equity) in

evaluating a company’s performance and financial position;

c. discuss the importance of financial statement notes and supplementary

information, including disclosures of accounting methods, estimates, and

assumptions, and management’s discussion and analysis;

d. discuss the objective of audits of financial statements, the types of audit reports,

and the importance of effective internal controls;

e. identify and explain information sources other than annual financial statements

and supplementary information that analysts use in financial statement analysis;

f. describe the steps in the financial statement analysis framework.

Reading 30: Financial Reporting Mechanics

The candidate should be able to:

a. explain the relationship of financial statement elements and accounts, and

classify accounts into the financial statement elements;

b. explain the accounting equation in its basic and expanded forms;

c. explain the process of recording business transactions using an accounting

system based on the accounting equations;

d. explain the need for accruals and other adjustments in preparing financial

statements;

e. explain the relationships among the income statement, balance sheet, statement

of cash flows, and statement of owners’ equity;

f. describe the flow of information in an accounting system;

g. explain the use of the results of the accounting process in security analysis.

Study Session 7

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Reading 31: Financial Reporting Standards

The candidate should be able to:

a. explain the objective of financial statements and the importance of reporting

standards in security analysis and valuation;

b. explain the role of standard-setting bodies, such as the International Accounting

Standards Board and the U.S. Financial Accounting Standards Board, and

regulatory authorities such as the International Organization of Securities

Commissions, the U.K. Financial Services Authority, and the U.S. Securities and

Exchange Commission in establishing and enforcing financial reporting

standards;

c. discuss the ongoing barriers to developing one universally accepted set of

financial reporting standards;

d. describe the International Financial Reporting Standards (IFRS) framework,

including the qualitative characteristics of financial statements, the required

reporting elements, and the constraints and assumptions in preparing financial

statements;

e. explain the general requirements for financial statements;

f. compare and contrast key concepts of financial reporting standards under IFRS

and alternative reporting systems, and discuss the implications for financial

analysis of differing financial reporting systems;

g. identify the characteristics of a coherent financial reporting framework and

barriers to creating a coherent financial reporting network;

h. discuss the importance of monitoring developments in financial reporting

standards and of evaluating company disclosures of significant accounting

policies.

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Each reading in this study session focuses on one of the three major financial

statements: the balance sheet, the income statement, and the statement of

cash flows. For each financial statement, the chapter details its purpose,

construction, pertinent ratios, and common-size analysis. Understanding these

concepts allows a financial analyst to evaluate trends in performance for several

measurement periods and to compare the performance of different companies

during the same period(s). Additional analyst tools, such as the earnings per share

calculation, are also described.

READING ASSIGNMENTS

Reading 32 Understanding the Income Statement

International Financial Statement Analysis, by Thomas R.

Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,

CFA, and Michael A. Broihahn, CFA

Reading 33 Understanding the Balance Sheet

International Financial Statement Analysis, by Thomas R.

Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,

CFA, and Michael A. Broihahn, CFA

Reading 34 Understanding the Cash Flow Statement

International Financial Statement Analysis, by Thomas R.

Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,

CFA, and Michael A. Broihahn, CFA

Reading 35 Financial Analysis Techniques

International Financial Statement Analysis, by Thomas R.

Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,

CFA, and Michael A. Broihahn, CFA

STUDY SESSION 8

FINANCIAL REPORTING AND ANALYSIS:

The Income Statement, Balance Sheet,

and Cash Flow Statement

Study Session 8

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LEARNING OUTCOMES

Reading 32: Understanding the Income Statement

The candidate should be able to:

a. describe the components of the income statement, and construct an income

statement using the alternative presentation formats of that statement;

b. explain the general principles of revenue recognition and accrual accounting,

demonstrate specific revenue recognition applications (including accounting for

long-term contracts, installment sales, barter transactions, and gross and net

reporting of revenue), and discuss the implications of revenue recognition

principles for financial analysis;

c. discuss the general principles of expense recognition, such as the matching

principle, specific expense recognition applications (including depreciation of

long-term assets and inventory methods), and the implications of expense

recognition principles for financial analysis;

d. demonstrate the appropriate method of depreciating long-term assets,

accounting for inventory, or amortizing intangibles, based on facts that might

influence the decision;

e. distinguish between the operating and nonoperating components of the income

statement;

f. discuss the financial reporting treatment and analysis of nonrecurring items

(including discontinued operations, extraordinary items, and unusual or

infrequent items) and changes in accounting standards;

g. describe the components of earnings per share and calculate a company’s

earnings per share (both basic and diluted earnings per share) for both a simple

and complex capital structure;

h. differentiate between dilutive and antidilutive securities, and discuss the

implications of each for the earnings per share calculation;

i. describe and calculate comprehensive income;

j. state the accounting classification for items that are excluded from the income

statement but affect owners’ equity, and list the major types of items receiving

that treatment.

Reading 33: Understanding the Balance Sheet

The candidate should be able to:

a. illustrate and interpret the components of the balance sheet and discuss the uses

of the balance sheet in financial analysis;

b. describe the various formats of balance sheet presentation;

c. explain how assets and liabilities arise from the accrual process;

d. compare and contrast current and noncurrent assets and liabilities;

e. explain the measurement bases (e.g., historical cost and fair value) of assets and

liabilities, including current assets, current liabilities, tangible assets, and

intangible assets;

f. demonstrate the appropriate classifications and related accounting treatments

for marketable and nonmarketable financial instruments held as assets or owed

by the company as liabilities;

Study Session 8

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g. list and explain the components of owners’ equity;

h. interpret balance sheets and statements of changes in equity.

Reading 34: Understanding the Cash Flow Statement

The candidate should be able to:

a. compare and contrast cash flows from operating, investing, and financing

activities and classify cash flow items as relating to one of these three categories,

given a description of the items;

b. describe how noncash investing and financing activities are reported;

c. compare and contrast the key differences in cash flow statements prepared

under international financial reporting standards and U.S. generally accepted

accounting principles;

d. demonstrate the difference between the direct and indirect methods of

presenting cash from operating activities and explain the arguments in favor of

each;

e. demonstrate the steps in the preparation of direct and indirect cash flow

statements, including how cash flows can be computed using income statement

and balance sheet data;

f. describe the process of converting a cash flow statement from the indirect to the

direct method of presentation;

g. analyze and interpret a cash flow statement using both total currency amounts

and common-size cash flow statements;

h. explain and calculate free cash flow to the firm, free cash flow to equity, and

other cash flow ratios.

Reading 35: Financial Analysis Techniques

The candidate should be able to:

a. evaluate and compare companies using ratio analysis, common-size financial

statements, and charts in financial analysis;

b. describe the limitations of ratio analysis;

c. describe the various techniques of common-size analysis and interpret the results

of such analysis;

d. calculate, classify, and interpret activity, liquidity, solvency, profitability, and

valuation ratios;

e. demonstrate how ratios are related and how to evaluate a company using a

combination of different ratios;

f. demonstrate the application of and interpret changes in the component parts of

the DuPont analysis (the decomposition of return on equity);

g. calculate and interpret the ratios used in equity analysis, credit analysis, and

segment analysis;

h. describe how ratio analysis and other techniques can be used to model and

forecast earnings.

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The readings in this study session examine specific categories of assets and

liabilities that are particularly susceptible to the impact of alternative

accounting policies and estimates. Analysts must understand the effects of

alternative policies on financial statements and ratios and be able to execute

appropriate adjustments to enhance comparability between companies. In

addition, analysts must be alert to differences between a company’s reported

financial statements and economic reality.

The description and measurement of inventories require careful attention

because the investment in inventories is frequently the largest current asset for

merchandizing and manufacturing companies. For these companies, the

measurement of inventory cost (i.e., cost of goods sold) is a critical factor in

determining gross profit and other measures of company profitability. Long-term

operating assets are often the largest category of assets on a company’s balance

sheet. The analyst needs to scrutinize management’s choices with respect to

recognizing expenses associated with the operating assets because of the

potentially large impact such choices can have on reported earnings and the

opportunities for financial statement manipulation during longer time periods.

A company’s accounting policies (such as depreciation choices) can cause

differences in taxes reported in financial statements and taxes reported on tax

returns. The reading “Income Taxes” discusses several issues that arise relating to

deferred taxes.

Both on- and off-balance sheet debt affect a company’s liquidity and solvency

and have consequences for its long-term growth and viability. The notes of the

financial statements must be carefully reviewed to ensure that all potential

liabilities (e.g., leasing arrangements and other contractual commitments) are

STUDY SESSION 9

FINANCIAL REPORTING AND ANALYSIS:

Inventories, Long-Term Assets, Deferred Taxes,

and On- and Off-Balance Sheet Debt

Study Session 9

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appropriately evaluated for their conformity to economic reality. Adjustments to

the financial statements may be required to achieve comparability when

evaluating several companies and may also be required to improve credit and

investment decision-making.

READING ASSIGNMENTS

Reading 36 Inventories

International Financial Statement Analysis, by Thomas R.

Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,

CFA, and Michael A. Broihahn, CFA

Reading 37 Long-Lived Assets

International Financial Statement Analysis, by Thomas R.

Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,

CFA, and Michael A. Broihahn, CFA

Reading 38 Income Taxes

International Financial Statement Analysis, by Thomas R.

Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,

CFA, and Michael A. Broihahn, CFA

Reading 39 Long-Term Liabilities and Leases

International Financial Statement Analysis, by Thomas R.

Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,

CFA, and Michael A. Broihahn, CFA

LEARNING OUTCOMES

Reading 36: Inventories

The candidate should be able to:

a. explain IFRS and U.S. GAAP rules for determining inventory cost, including which

costs are capitalized and methods of allocating costs between cost of goods sold

and inventory;

b. discuss how inventories are reported on the financial statements and how the

lower of cost or net realizable value is used and applied;

c. compute ending inventory balances and cost of goods sold using the FIFO,

weighted average cost, and LIFO methods to account for product inventory and

explain the relationship among and the usefulness of inventory and cost of

goods sold data provided by the FIFO, weighted average cost, and LIFO methods

when prices are 1) stable, 2) decreasing, or 3) increasing;

d. discuss and calculate ratios useful for evaluating inventory management;

e. analyze the financial statements of companies using different inventory

accounting methods by comparing and describing the effect of the different

methods on cost of goods sold, inventory balances, and other financial

statement items;

f. compute and describe the effects of the choice of inventory method on

profitability, liquidity, activity, and solvency ratios;

g. calculate adjustments to reported financial statements related to inventory

assumptions to aid in comparing and evaluating companies;

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Study Session 9

h. discuss the reasons that a LIFO reserve might rise or decline during a given period

and discuss the implications for financial analysis.

Reading 37: Long-Lived Assets

The candidate should be able to:

a. explain the accounting standards related to the capitalization of expenditures as

part of long-lived assets, including interest costs;

b. compute and describe the effects of capitalizing versus expensing on net income,

shareholders’ equity, cash flow from operations, and financial ratios, including

the effect on the interest coverage ratio of capitalizing interest costs;

c. explain the circumstances in which software development costs and research and

development costs are capitalized;

d. identify the different depreciation methods for long-lived tangible assets, and

discuss how the choice of method, useful lives, and salvage values affect a

company’s financial statements, ratios, and taxes;

e. discuss the use of fixed asset disclosures to compare companies’ average age of

depreciable assets and calculate, using such disclosures, the average age and

average depreciable life of fixed assets;

f. describe amortization of intangible assets with finite useful lives and the

estimates that affect the amortization calculations;

g. discuss the liability for closure, removal, and environmental effects of long-lived

operating assets, and discuss the financial statement impact and ratio effects of

that liability;

h. discuss the impact of sales or exchanges of long-lived assets on financial

statements;

i. define impairment of long-lived tangible and intangible assets and explain what

effect such impairment has on a company’s financial statements and ratios;

j. calculate and describe both the initial and long-lived effects of asset revaluations

on financial ratios.

Reading 38: Income Taxes

The candidate should be able to:

a. explain the differences between accounting profit and taxable income, and

define key terms, including deferred tax assets, deferred tax liabilities, valuation

allowance, taxes payable, and income tax expense;

b. explain how deferred tax liabilities and assets are created and the factors that

determine how a company’s deferred tax liabilities and assets should be treated

for the purposes of financial analysis;

c. determine the tax base of a company’s assets and liabilities;

d. calculate income tax expense, income taxes payable, deferred tax assets, and

deferred tax liabilities, and calculate and interpret the adjustment to the financial

statements related to a change in the income tax rate;

e. evaluate the impact of tax rate changes on a company’s financial statements and

ratios;

f. distinguish between temporary and permanent items in pre-tax financial income

and taxable income;

Study Session 9

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g. discuss the valuation allowance for deferred tax assets—when it is required and

what impact it has on financial statements;

h. compare and contrast a company’s deferred tax items;

i. analyze disclosures relating to deferred tax items and the effective tax rate

reconciliation, and discuss how information included in these disclosures affects

a company’s financial statements and financial ratios;

j. identify the key provisions of and differences between income tax accounting

under IFRS and U.S. GAAP.

Reading 39: Long-Term Liabilities and Leases

The candidate should be able to:

a. compute the effects of debt issuance and amortization of bond discounts and

premiums on financial statements and ratios;

b. explain the role of debt covenants in protecting creditors by restricting a

company’s ability to invest, pay dividends, or make other operating and strategic

decisions;

c. describe the presentation of, and disclosures relating to, financing liabilities;

d. determine the effects of changing interest rates on the market value of debt and

on financial statements and ratios;

e. describe two types of debt with equity features (convertible debt and debt with

warrants) and calculate the effect of issuance of such instruments on a

company’s debt ratios;

f. discuss the motivations for leasing assets instead of purchasing them and the

incentives for reporting the leases as operating leases rather than finance leases;

g. determine the effects of finance and operating leases on the financial statements

and ratios of the lessees and lessors;

h. distinguish between a sales-type lease and a direct financing lease, and

determine the effects on the financial statements and ratios of the lessors;

i. describe the types and economic consequences of off-balance sheet financing

and determine how take-or-pay contracts, throughput arrangements, and the

sale of receivables affect financial statements and selected financial ratios.

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The readings in this study session discuss financial statement analysis

applications and the international convergence of accounting standards.

The most frequently used tools and techniques to evaluate companies include

common size analysis, cross-sectional analysis, trend analysis, and ratio analysis.

Beyond mere knowledge of these tools, however, the analyst must recognize the

implications of accounting choices on the quality of a company’s reported financial

results. Then the analyst can apply these financial analysis techniques to major

analyst tasks including the evaluation of past and future financial performance,

credit risk, and the screening of potential equity investments. The readings also

discuss analyst adjustments to reported financials. Such adjustments are often

needed to put companies’ reported results on a comparable basis.

This study session concludes with a reading on convergence of international

and U.S. accounting standards. Although there has been much progress in

harmonizing accounting standards globally, as this reading discusses, significant

variations still exist among generally accepted accounting principles from one

country to another.

STUDY SESSION 10

FINANCIAL REPORTING AND ANALYSIS:

Applications and International Standards

Convergence

Study Session 10

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READING ASSIGNMENTS

Reading 40 Financial Reporting Quality: Red Flags and Accounting Warning

Signs

Commercial Lending Review, by Thomas R. Robinson, CFA

and Paul Munter

Reading 41 Accounting Shenanigans on the Cash Flow Statement

The CPA Journal, by Mark A. Siegel

Reading 42 Financial Statement Analysis: Applications

International Financial Statement Analysis, by Thomas R.

Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,

CFA, and Michael A. Broihahn, CFA

Reading 43 International Standards Convergence

International Financial Statement Analysis, by Thomas R.

Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,

CFA, and Michael A. Broihahn, CFA

LEARNING OUTCOMES

Reading 40: Financial Reporting Quality: Red Flags and Accounting

Warning Signs

The candidate should be able to:

a. describe incentives that might induce a company’s management to overreport or

underreport earnings;

b. describe activities that will result in a low quality of earnings;

c. describe the “fraud triangle”;

d. describe the risk factors that may lead to fraudulent accounting related to

1) incentives and pressures, 2) opportunities, and 3) attitudes and

rationalizations;

e. describe common accounting warning signs and methods for detecting each;

f. describe the accounting warning signs related to the Enron accounting scandal;

g. describe the accounting warning signs related to the Sunbeam accounting

scandal.

Reading 41: Accounting Shenanigans on the Cash Flow Statement

The candidate should be able to analyze and discuss the following ways to

manipulate the cash flow statement:

_ stretching out payables,

_ financing of payables,

_ securitization of receivables, and

_ using stock buybacks to offset dilution of earnings.

Reading 42: Financial Statement Analysis: Applications

The candidate should be able to:

a. evaluate a company’s past financial performance and explain how a company’s

strategy is reflected in past financial performance;

Study Session 10

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b. prepare a basic projection of a company’s future net income and cash flow;

c. describe the role of financial statement analysis in assessing the credit quality of

a potential debt investment;

d. discuss the use of financial statement analysis in screening for potential equity

investments;

e. determine and justify appropriate analyst adjustments to a company’s financial

statements to facilitate comparison with another company.

Reading 43: International Standards Convergence

The candidate should be able to:

a. identify and explain the major international accounting standards for each asset

and liability category on the balance sheet and the key differences from U.S.

generally accepted accounting principles (GAAP);

b. identify and explain the major international accounting standards for major

revenue and expense categories on the income statement and the key

differences from U.S. GAAP;

c. identify and explain the major differences between international and U.S. GAAP

accounting standards concerning the treatment of interest and dividends on the

statement of cash flows;

d. interpret the effect of differences between international and U.S. GAAP

accounting standards on the balance sheet, income statement, and the

statement of changes in equity for some commonly used financial ratios.

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This study session covers the principles that corporations use to make their

investing and financing decisions. Capital budgeting is the process of making

decisions about which long-term projects the corporation should accept for

investment and which it should reject. Both the expected return of a project and

the financing cost should be taken into account. The cost of capital, or the rate

of return required for a project, must be developed using economically sound

methods. Corporate managers are also concerned with shorter-term liquidity and

solvency and use financial statements to evaluate performance as well as to

develop and communicate future plans.

The final reading in this study session is on corporate governance practices,

which can expose the firm to a heightened risk of ethical lapses. Although these

practices may not be inherently unethical, they create the potential for conflicts of

interest to develop between shareholders and managers, and the extent of that

conflict affects the company’s valuation.

READING ASSIGNMENTS

Reading 44 Capital Budgeting

by John D. Stowe, CFA and Jacques R. Gagne, CFA

Reading 45 Cost of Capital

by Yves Courtois, CFA, Gene C. Lai, and Pamela P. Peterson, CFA

Reading 46 Working Capital Management

by Edgar A. Norton, Jr., CFA, Kenneth L. Parkinson,

and Pamela P. Peterson, CFA

Reading 47 Financial Statement Analysis

by Pamela P. Peterson, CFA

Reading 48 The Corporate Governance of Listed Companies: A Manual

for Investors

STUDY SESSION 11

CORPORATE FINANCE

Study Session 11

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LEARNING OUTCOMES

Reading 44: Capital Budgeting

The candidate should be able to:

a. explain the capital budgeting process, including the typical steps of the process,

and distinguish among the various categories of capital projects;

b. discuss the basic principles of capital budgeting, including the choice of the

proper cash flows;

c. explain how the following project interactions affect the evaluation of a capital

project: 1) independent versus mutually exclusive projects, 2) project sequencing,

and 3) unlimited funds versus capital rationing;

d. calculate and interpret the results using each of the following methods to

evaluate a single capital project: net present value (NPV), internal rate of return

(IRR), payback period, discounted payback period, and profitability index (PI);

e. explain the NPV profile, compare and contrast the NPV and IRR methods when

evaluating independent and mutually exclusive projects, and describe the

problems associated with each of the evaluation methods;

f. describe and account for the relative popularity of the various capital budgeting

methods and explain the relation between NPV and company value and stock

price.

Reading 45: Cost of Capital

The candidate should be able to:

a. calculate and interpret the weighted average cost of capital (WACC) of a

company;

b. describe how taxes affect the cost of capital from different capital sources;

c. describe alternative methods of calculating the weights used in the WACC,

including the use of the company’s target capital structure;

d. explain how the marginal cost of capital and the investment opportunity

schedule are used to determine the optimal capital budget;

e. explain the marginal cost of capital’s role in determining the net present value of

a project;

f. calculate and interpret the cost of fixed rate debt capital using the yield-tomaturity

approach and the debt-rating approach;

g. calculate and interpret the cost of noncallable, nonconvertible preferred stock;

h. calculate and interpret the cost of equity capital using the capital asset pricing

model approach, the dividend discount model approach, and the bond-yield-plus

risk-premium approach;

i. calculate and interpret the beta and cost of capital for a project;

j. explain the country equity risk premium in the estimation of the cost of equity

for a company located in a developing market;

k. describe the marginal cost of capital schedule, explain why it may be upwardsloping

with respect to additional capital, and calculate and interpret its breakpoints;

l. explain and demonstrate the correct treatment of flotation costs.

Study Session 11

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Reading 46: Working Capital Management

The candidate should be able to:

a. describe primary and secondary sources of liquidity and factors that influence a

company’s liquidity position;

b. compare a company’s liquidity measures with those of peer companies;

c. evaluate overall working capital effectiveness of a company, using the operating

and cash conversion cycles, and compare its effectiveness with other peer

companies;

d. identify and evaluate the necessary tools to use in managing a company’s net

daily cash position;

e. compute and interpret comparable yields on various securities, compare portfolio

returns against a standard benchmark, and evaluate a company’s short-term

investment policy guidelines;

f. assess the performance of a company’s accounts receivable, inventory

management, and accounts payable functions against historical figures and

comparable peer company values;

g. evaluate the choices of short-term funding available to a company and

recommend a financing method.

Reading 47: Financial Statement Analysis

The candidate should be able to demonstrate the use of pro forma income

and balance sheet statements.

Reading 48: The Corporate Governance of Listed Companies: A Manual

for Investors

The candidate should be able to:

a. define and describe corporate governance;

b. discuss and critique characteristics and practices related to board and committee

independence, experience, compensation, external consultants, and frequency of

elections, and determine whether they are supportive of shareowner protection;

c. describe board independence and explain the importance of independent board

members in corporate governance;

d. identify factors that indicate a board and its members possess the experience

required to govern the company for the benefit of its shareowners;

e. explain the provisions that should be included in a strong corporate code of

ethics and the implications of a weak code of ethics with regard to related-party

transactions and personal use of company assets;

f. state the key areas of responsibility for which board committees are typically

created and explain the criteria for assessing whether each committee is able to

adequately represent shareowner interests;

g. evaluate, from a shareowner’s perspective, company policies related to voting

rules, shareowner sponsored proposals, common stock classes, and takeover

defenses.

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As the first discussion in the CFA curriculum on portfolio management, this

study session provides the critical framework and context for subsequent

Level I study sessions covering equities, fixed income, derivatives, and alternative

investments. Furthermore, this study session provides the underlying theories and

tools for portfolio management at Levels II and III.

The first reading discusses the asset allocation decision and the portfolio

management process—they are an integrated set of steps undertaken in a

consistent manner to create and maintain an appropriate portfolio (combination

of assets) to meet clients’ stated goals. The last two readings focus on the design

of a portfolio and introduce the capital asset pricing model (CAPM), a centerpiece

of modern financial economics that relates the risk of an asset to its expected

return.

READING ASSIGNMENTS

Reading 49 The Asset Allocation Decision

Investment Analysis and Portfolio Management, Eighth Edition,

by Frank K. Reilly, CFA and Keith C. Brown, CFA

Reading 50 An Introduction to Portfolio Management

Investment Analysis and Portfolio Management, Eighth Edition,

by Frank K. Reilly, CFA and Keith C. Brown, CFA

Reading 51 An Introduction to Asset Pricing Models

Investment Analysis and Portfolio Management, Eighth Edition,

by Frank K. Reilly, CFA and Keith C. Brown, CFA

STUDY SESSION 12

PORTFOLIO MANAGEMENT

Study Session 12

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LEARNING OUTCOMES

Reading 49: The Asset Allocation Decision

The candidate should be able to:

a. describe the steps in the portfolio management process and explain the reasons

for a policy statement;

b. explain why investment objectives should be expressed in terms of risk and return

and list the factors that may affect an investor’s risk tolerance;

c. describe the return objectives of capital preservation, capital appreciation, current

income, and total return;

d. describe the investment constraints of liquidity, time horizon, tax concerns, legal

and regulatory factors, and unique needs and preferences;

e. describe the importance of asset allocation, in terms of the percentage of a

portfolio’s return that can be explained by the target asset allocation, and explain

how political and economic factors result in differing asset allocations by

investors in various countries.

Reading 50: An Introduction to Portfolio Management

The candidate should be able to:

a. define risk aversion and discuss evidence that suggests that individuals are

generally risk averse;

b. list the assumptions about investor behavior underlying the Markowitz model;

c. compute and interpret the expected return, variance, and standard deviation for an

individual investment and the expected return and standard deviation for a portfolio;

d. compute and interpret the covariance of rates of return and show how it is

related to the correlation coefficient;

e. list the components of the portfolio standard deviation formula;

f. describe the efficient frontier and explain the implications for incremental returns

as an investor assumes more risk;

g. explain the concept of an optimal portfolio and show how each investor may

have a different optimal portfolio.

Reading 51: An Introduction to Asset Pricing Models

The candidate should be able to:

a. explain the capital market theory, including its underlying assumptions, and

explain the effect on expected returns, the standard deviation of returns, and

possible risk–return combinations when a risk-free asset is combined with a

portfolio of risky assets;

b. identify the market portfolio and describe the role of the market portfolio in the

formation of the capital market line (CML);

c. define systematic and unsystematic risk and explain why an investor should not

expect to receive additional return for assuming unsystematic risk;

d. explain the capital asset pricing model, including the security market line (SML)

and beta and describe the effects of relaxing its underlying assumptions;

e. calculate, using the SML, the expected return on a security and evaluate whether

the security is overvalued, undervalued, or properly valued.

www.cfainstitute.org/toolkit—Your online preparation resource

This study session addresses how securities are bought and sold and what

constitutes a well-functioning securities market. The reading on market indices

gives an understanding of how indices are constructed and calculated and the

biases inherent in each of the weighting schemes used.

Some of the most interesting and important work in the investment field

during the past several decades revolves around the efficient market hypothesis

(EMH) and its implications for active versus passive equity portfolio management.

The readings on this subject provide an understanding of the EMH and the

seemingly persistent anomalies to the theory, an understanding that is necessary

to judge the value of fundamental or technical security analysis.

READING ASSIGNMENTS

Reading 52 Organization and Functioning of Securities Markets

Investment Analysis and Portfolio Management, Eighth Edition,

by Frank K. Reilly, CFA and Keith C. Brown, CFA

Reading 53 Security-Market Indexes

Investment Analysis and Portfolio Management, Eighth Edition,

by Frank K. Reilly, CFA and Keith C. Brown, CFA

Reading 54 Efficient Capital Markets

Investment Analysis and Portfolio Management, Eighth Edition,

by Frank K. Reilly, CFA and Keith C. Brown, CFA

Reading 55 Market Efficiency and Anomalies

Beyond The Random Walk: A Guide to Stock Market Anomalies

and Low Risk Investing, by Vijay Singal, CFA

STUDY SESSION 13

EQUITY:

Securities Markets

Study Session 13

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LEARNING OUTCOMES

Reading 52: Organization and Functioning of Securities Markets

The candidate should be able to:

a. describe the characteristics of a well-functioning securities market;

b. distinguish between primary and secondary capital markets and explain how

secondary markets support primary markets;

c. distinguish between call and continuous markets;

d. compare and contrast the structural differences among national stock exchanges,

regional stock exchanges, and the over-the-counter (OTC) markets;

e. compare and contrast major characteristics of various exchange markets,

including exchange membership, types of orders, and market makers;

f. describe the process of selling a stock short and discuss an investor’s likely

motivation for selling short;

g. describe the process of buying a stock on margin, compute the rate of return on

a margin transaction, define maintenance margin, and determine the stock price

at which the investor would receive a margin call.

Reading 53: Security-Market Indexes

The candidate should be able to:

a. compare and contrast the characteristics of, and discuss the source and direction

of bias exhibited by, each of the three predominant weighting schemes used in

constructing stock market indices and compute a price-weighted, a valueweighted,

and an unweighted index series for three stocks;

b. compare and contrast major structural features of domestic and global stock

indices, bond indices, and composite stock-bond indices;

c. state how low correlations between global markets support global investment.

Reading 54: Efficient Capital Markets

The candidate should be able to:

a. define an efficient capital market and describe and contrast the three forms of

the efficient market hypothesis (EMH);

b. describe the tests used to examine each of the three forms of the EMH, identify

various market anomalies and explain their implications for the EMH, and explain

the overall conclusions about each form of the EMH;

c. explain the implications of stock market efficiency for technical analysis,

fundamental analysis, the portfolio management process, the role of the

portfolio manager, and the rationale for investing in index funds;

d. define behavioral finance and describe prospect theory, over-confidence bias,

confirmation bias, and escalation bias.

Reading 55: Market Efficiency and Anomalies

The candidate should be able to:

a. explain the three limitations to achieving fully efficient markets;

Study Session 13

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b. describe four problems that may prevent arbitrageurs from correcting anomalies;

c. explain why an apparent anomaly may be justified and describe the common

biases that distort testing for mispricings;

d. explain why a mispricing may persist and why valid anomalies may not be

profitable.

www.cfainstitute.org/toolkit—Your online preparation resource

STUDY SESSION 14

EQUITY:

Industry and Company Analysis

This study session focuses on industry and company analysis and describes the

tools used in forming an opinion about investing in a particular stock or group

of stocks.

This study session begins with the essential tools of equity valuation: the

discounted cash flow technique and the relative valuation approach. These

techniques provide the means to estimate a reasonable price for a stock. The

readings about industry analysis are an important element in the valuation

process, providing the top-down context crucial to estimating a company’s

potential. Also addressed is estimating a company’s earnings per share by

forecasting sales and profit margins.

The last reading in this study session focuses on price multiples, one of the

most familiar and widely used tools in estimating the value of a company, and

introduces the application of four commonly used price multiples to valuation.

READING ASSIGNMENTS

Reading 56 An Introduction to Security Valuation

Investment Analysis and Portfolio Management, Eighth Edition,

by Frank K. Reilly, CFA and Keith C. Brown, CFA

Reading 57 Industry Analysis

Investment Analysis and Portfolio Management, Eighth Edition,

by Frank K. Reilly, CFA and Keith C. Brown, CFA

Reading 58 Company Analysis and Stock Valuation

Investment Analysis and Portfolio Management, Eighth Edition,

by Frank K. Reilly, CFA and Keith C. Brown, CFA

Reading 59 Introduction to Price Multiples

by John D. Stowe, CFA, Thomas R. Robinson, CFA, Jerald E.

Pinto, CFA, and Dennis W. McLeavey, CFA

Study Session 14

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LEARNING OUTCOMES

Reading 56: An Introduction to Security Valuation

The candidate should be able to:

a. explain the top-down approach, and its underlying logic, to the security valuation

process;

b. state the various forms of investment returns;

c. calculate and interpret the value of both a preferred stock and a common stock

using the dividend discount model (DDM);

d. show how to use the DDM to develop an earnings multiplier model and explain

the factors in the DDM that affect a stock’s price-to-earnings (P/E) ratio;

e. explain the components of an investor’s required rate of return (i.e., the real riskfree

rate, the expected rate of inflation, and a risk premium) and discuss the risk

factors to be assessed in determining an equity risk premium for use in

estimating the required return for the investment in each country;

f. estimate the dividend growth rate, given the components of the required rate of

return incorporating the earnings retention rate and current stock price;

g. describe a process for developing estimated inputs to be used in the DDM,

including the required rate of return and expected growth rate of dividends.

Reading 57: Industry Analysis

The candidate should be able to describe how structural economic changes

(e.g., demographics, technology, politics, and regulation) may affect industries.

Reading 58: Company Analysis and Stock Valuation

The candidate should be able to:

a. differentiate between 1) a growth company and a growth stock, 2) a defensive

company and a defensive stock, 3) a cyclical company and a cyclical stock, 4) a

speculative company and a speculative stock, and 5) a value stock and a

growth stock;

b. describe and estimate the expected earnings per share (EPS) and earnings

multiplier for a company and use the multiple to make an investment decision

regarding the company.

Reading 59: Introduction to Price Multiples

The candidate should be able to:

a. discuss the rationales for, and the possible drawbacks to, the use of price-toearnings

ratio (P/E), price-to-book value (P/BV), price-to-sales ratio (P/S), and

price-to-cash flow (P/CF) in equity valuation;

b. calculate and interpret P/E, P/BV, P/S, and P/CF.

www.cfainstitute.org/toolkit—Your online preparation resource

This study session presents the foundation for fixed-income investments, one of

the largest and fastest growing segments of global financial markets. It begins

with an introduction to the basic features and characteristics of fixed-income

securities and the associated risks. The session then builds by describing the

primary issuers, sectors, and types of bonds. Finally, the study session concludes

with an introduction to yields and spreads and the effect of monetary policy on

financial markets. These readings combined are the primary building blocks for

mastering the analysis, valuation, and management of fixed-income securities.

READING ASSIGNMENTS

Reading 60 Features of Debt Securities

Fixed Income Analysis for the Chartered Financial Analyst®

Program, Second Edition, by Frank J. Fabozzi, CFA, editor

Reading 61 Risks Associated with Investing in Bonds

Fixed Income Analysis for the Chartered Financial Analyst®

Program, Second Edition, by Frank J. Fabozzi, CFA, editor

Reading 62 Overview of Bond Sectors and Instruments

Fixed Income Analysis for the Chartered Financial Analyst®

Program, Second Edition, by Frank J. Fabozzi, CFA, editor

Reading 63 Understanding Yield Spreads

Fixed Income Analysis for the Chartered Financial Analyst®

Program, Second Edition, by Frank J. Fabozzi, CFA, editor

STUDY SESSION 15

FIXED INCOME:

Basic Concepts

LEARNING OUTCOMES

Reading 60: Features of Debt Securities

The candidate should be able to:

a. explain the purposes of a bond’s indenture and describe affirmative and negative

covenants;

b. describe the basic features of a bond, the various coupon rate structures, and the

structure of floating-rate securities;

Study Session 15

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c. define accrued interest, full price, and clean price;

d. explain the provisions for redemption and retirement of bonds;

e. identify the common options embedded in a bond issue, explain the importance

of embedded options, and state whether such options benefit the issuer or the

bondholder;

f. describe methods used by institutional investors in the bond market to finance

the purchase of a security (i.e., margin buying and repurchase agreements).

Reading 61: Risks Associated with Investing in Bonds

The candidate should be able to:

a. explain the risks associated with investing in bonds;

b. identify the relations among a bond’s coupon rate, the yield required by the

market, and the bond’s price relative to par value (i.e., discount, premium, or

equal to par);

c. explain how features of a bond (e.g., maturity, coupon, and embedded options)

and the level of a bond’s yield affect the bond’s interest rate risk;

d. identify the relationship among the price of a callable bond, the price of an

option-free bond, and the price of the embedded call option;

e. explain the interest rate risk of a floating-rate security and why such a security’s

price may differ from par value;

f. compute and interpret the duration and dollar duration of a bond;

g. describe yield-curve risk and explain why duration does not account for yieldcurve

risk for a portfolio of bonds;

h. explain the disadvantages of a callable or prepayable security to an investor;

i. identify the factors that affect the reinvestment risk of a security and explain why

prepayable amortizing securities expose investors to greater reinvestment risk

than nonamortizing securities;

j. describe the various forms of credit risk and describe the meaning and role of

credit ratings;

k. explain liquidity risk and why it might be important to investors even if they

expect to hold a security to the maturity date;

l. describe the exchange rate risk an investor faces when a bond makes payments

in a foreign currency;

m. explain inflation risk;

n. explain how yield volatility affects the price of a bond with an embedded option

and how changes in volatility affect the value of a callable bond and a putable

bond;

o. describe the various forms of event risk.

Reading 62: Overview of Bond Sectors and Instruments

The candidate should be able to:

a. describe the features, credit risk characteristics, and distribution methods for

government securities;

b. describe the types of securities issued by the U.S. Department of the Treasury

(e.g. bills, notes, bonds, and inflation protection securities), and differentiate

between on-the-run and off-the-run Treasury securities;

Study Session 15

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c. describe how stripped Treasury securities are created and distinguish between

coupon strips and principal strips;

d. describe the types and characteristics of securities issued by U.S. federal

agencies;

e. describe the types and characteristics of mortgage-backed securities and explain

the cash flow, prepayments, and prepayment risk for each type;

f. state the motivation for creating a collateralized mortgage obligation;

g. describe the types of securities issued by municipalities in the United States and

distinguish between tax-backed debt and revenue bonds;

h. describe the characteristics and motivation for the various types of debt issued by

corporations (including corporate bonds, medium-term notes, structured notes,

commercial paper, negotiable CDs, and bankers acceptances);

i. define an asset-backed security, describe the role of a special purpose vehicle in

an asset-backed security’s transaction, state the motivation for a corporation to

issue an asset-backed security, and describe the types of external credit

enhancements for asset-backed securities;

j. describe collateralized debt obligations;

k. describe the mechanisms available for placing bonds in the primary market and

differentiate the primary and secondary markets in bonds.

Reading 63: Understanding Yield Spreads

The candidate should be able to:

a. identify the interest rate policy tools available to a central bank (e.g., the U.S.

Federal Reserve);

b. describe a yield curve and the various shapes of the yield curve;

c. explain the basic theories of the term structure of interest rates and describe the

implications of each theory for the shape of the yield curve;

d. define a spot rate;

e. compute, compare, and contrast the various yield spread measures;

f. describe a credit spread and discuss the suggested relation between credit

spreads and the well-being of the economy;

g. identify how embedded options affect yield spreads;

h. explain how the liquidity or issue-size of a bond affects its yield spread relative to

risk-free securities and relative to other securities;

i. compute the after-tax yield of a taxable security and the tax-equivalent yield of a

tax-exempt security;

j. define LIBOR and explain its importance to funded investors who borrow short

term.

www.cfainstitute.org/toolkit—Your online preparation resource

This study session illustrates the primary tools for valuation and analysis of fixed

income securities and markets. It begins with a study of basic valuation theory

and techniques for bonds and concludes with a more in-depth explanation of the

primary tools for fixed-income investment valuation, specifically, interest rate and

yield valuation and interest rate risk measurement and analysis.

READING ASSIGNMENTS

Reading 64 Introduction to the Valuation of Debt Securities

Fixed Income Analysis for the Chartered Financial Analyst®

Program, Second Edition, by Frank J. Fabozzi, CFA, editor

Reading 65 Yield Measures, Spot Rates, and Forward Rates

Fixed Income Analysis for the Chartered Financial Analyst®

Program, Second Edition, by Frank J. Fabozzi, CFA, editor

Reading 66 Introduction to the Measurement of Interest Rate Risk

Fixed Income Analysis for the Chartered Financial Analyst®

Program, Second Edition, by Frank J. Fabozzi, CFA, editor

STUDY SESSION 16

FIXED INCOME:

Analysis and Valuation

LEARNING OUTCOMES

Reading 64: Introduction to the Valuation of Debt Securities

The candidate should be able to:

a. explain the steps in the bond valuation process;

b. identify the types of bonds for which estimating the expected cash flows is

difficult and explain the problems encountered when estimating the cash flows

for these bonds;

c. compute the value of a bond and the change in value that is attributable to a

change in the discount rate;

d. explain how the price of a bond changes as the bond approaches its maturity

date and compute the change in value that is attributable to the passage of time;

e. compute the value of a zero-coupon bond;

Study Session 16

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f. explain the arbitrage-free valuation approach and the market process that forces

the price of a bond toward its arbitrage-free value and explain how a dealer can

generate an arbitrage profit if a bond is mispriced.

Reading 65: Yield Measures, Spot Rates, and Forward Rates

The candidate should be able to:

a. explain the sources of return from investing in a bond;

b. compute and interpret the traditional yield measures for fixed-rate bonds and

explain their limitations and assumptions;

c. explain the importance of reinvestment income in generating the yield computed

at the time of purchase, calculate the amount of income required to generate

that yield, and discuss the factors that affect reinvestment risk;

d. compute and interpret the bond equivalent yield of an annual-pay bond and the

annual-pay yield of a semiannual-pay bond;

e. describe the methodology for computing the theoretical Treasury spot rate curve

and compute the value of a bond using spot rates;

f. differentiate between the nominal spread, the zero-volatility spread, and the

option-adjusted spread;

g. describe how the option-adjusted spread accounts for the option cost in a bond

with an embedded option;

h. explain a forward rate and compute spot rates from forward rates, forward rates

from spot rates, and the value of a bond using forward rates.

Reading 66: Introduction to the Measurement of Interest Rate Risk

The candidate should be able to:

a. distinguish between the full valuation approach (the scenario analysis approach)

and the duration/convexity approach for measuring interest rate risk and explain

the advantage of using the full valuation approach;

b. demonstrate the price volatility characteristics for option-free, callable,

prepayable, and putable bonds when interest rates change;

c. describe positive convexity, negative convexity, and their relation to bond price

and yield;

d. compute and interpret the effective duration of a bond, given information about

how the bond’s price will increase and decrease for given changes in interest

rates, and compute the approximate percentage price change for a bond, given

the bond’s effective duration and a specified change in yield;

e. distinguish among the alternative definitions of duration and explain why

effective duration is the most appropriate measure of interest rate risk for bonds

with embedded options;

f. compute the duration of a portfolio, given the duration of the bonds comprising

the portfolio, and explain the limitations of portfolio duration;

g. describe the convexity measure of a bond and estimate a bond’s percentage

price change, given the bond’s duration and convexity and a specified change in

interest rates;

h. differentiate between modified convexity and effective convexity;

i. compute the price value of a basis point (PVBP), and explain its relationship to

duration.

www.cfainstitute.org/toolkit—Your online preparation resource

STUDY SESSION 17

DERIVATIVE INVESTMENTS

Derivatives—financial instruments that offer a return based on the return

of some underlying asset—have become increasingly important and

fundamental in effectively managing financial risk and creating synthetic

exposures to asset classes. As in other security markets, arbitrage and market

efficiency play a critical role in establishing prices and maintaining parity.

This study session builds the conceptual framework for understanding

derivative investments (forwards, futures, options, and swaps), derivative markets,

and the use of options in risk management.

READING ASSIGNMENTS

Reading 67 Derivative Markets and Instruments

Analysis of Derivatives for the Chartered Financial Analyst®

Program, by Don M. Chance, CFA

Reading 68 Forward Markets and Contracts

Analysis of Derivatives for the Chartered Financial Analyst®

Program, by Don M. Chance, CFA

Reading 69 Futures Markets and Contracts

Analysis of Derivatives for the Chartered Financial Analyst®

Program, by Don M. Chance, CFA

Reading 70 Option Markets and Contracts

Analysis of Derivatives for the Chartered Financial Analyst®

Program, by Don M. Chance, CFA

Reading 71 Swap Markets and Contracts

Analysis of Derivatives for the Chartered Financial Analyst®

Program, by Don M. Chance, CFA

Reading 72 Risk Management Applications of Option Strategies

Analysis of Derivatives for the Chartered Financial Analyst®

Program, by Don M. Chance, CFA

Study Session 17

www.cfainstitute.org/toolkit—Your online preparation resource

LEARNING OUTCOMES

Reading 67: Derivative Markets and Instruments

The candidate should be able to:

a. define a derivative and differentiate between exchange-traded and over-thecounter

derivatives;

b. define a forward commitment and a contingent claim;

c. differentiate the basic characteristics of forward contracts, futures contracts,

options (calls and puts), and swaps;

d. discuss the purposes and criticisms of derivative markets;

e. explain arbitrage and the role it plays in determining prices and promoting

market efficiency.

Reading 68: Forward Markets and Contracts

The candidate should be able to:

a. explain delivery/settlement and default risk for both long and short positions in a

forward contract;

b. describe the procedures for settling a forward contract at expiration and discuss

how termination alternatives prior to expiration can affect credit risk;

c. differentiate between a dealer and an end user of a forward contract;

d. describe the characteristics of equity forward contracts and forward contracts on

zero-coupon and coupon bonds;

e. describe the characteristics of the Eurodollar time deposit market and define

LIBOR and Euribor;

f. describe the characteristics and calculate the gain/loss of forward rate

agreements (FRAs);

g. calculate and interpret the payoff of an FRA, and explain each of the component

terms;

h. describe the characteristics of currency forward contracts.

Reading 69: Futures Markets and Contracts

The candidate should be able to:

a. describe the characteristics of futures contracts;

b. distinguish between futures contracts and forward contracts;

c. differentiate between margin in the securities markets and margin in the futures

markets, and explain the role of initial margin, maintenance margin, variation

margin, and settlement in futures trading;

d. describe price limits and the process of marking to market and compute and

interpret the margin balance, given the previous day’s balance and the change in

the futures price;

e. describe how a futures contract can be terminated at or prior to expiration;

f. describe the characteristics of the following types of futures contracts: Eurodollar,

Treasury bond, stock index, and currency.

Study Session 17

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Reading 70: Option Markets and Contracts

The candidate should be able to:

a. define European option, American option, and the concept of moneyness of an

option;

b. differentiate between exchange-traded options and over-the-counter options;

c. identify the types of options in terms of the underlying instruments;

d. compare and contrast interest rate options with forward rate agreements (FRAs);

e. define interest rate caps, floors, and collars;

f. compute and interpret option payoffs, and explain how interest rate option

payoffs differ from the payoffs of other types of options;

g. define intrinsic value and time value and explain their relationship;

h. determine the minimum and maximum values of European options and

American options;

i. calculate and interpret the lowest prices of European and American calls and

puts based on the rules for minimum values and lower bounds;

j. explain how option prices are affected by the exercise price and the time to

expiration;

k. explain put–call parity for European options, and relate put–call parity to

arbitrage and the construction of synthetic options;

l. contrast American options with European options in terms of the lower bounds

on option prices and the possibility of early exercise;

m. explain how cash flows on the underlying asset affect put–call parity and the

lower bounds of option prices;

n. indicate the directional effect of an interest rate change or volatility change on

an option’s price.

Reading 71: Swap Markets and Contracts

The candidate should be able to:

a. describe the characteristics of swap contracts and explain how swaps are

terminated;

b. define, calculate, and interpret the payment of currency swaps, plain vanilla

interest rate swaps, and equity swaps.

Reading 72: Risk Management Applications of Option Strategies

The candidate should be able to:

a. determine the value at expiration, profit, maximum profit, maximum loss,

breakeven underlying price at expiration, and general shape of the graph of the

strategies of buying and selling calls and puts, and indicate the market outlook

of investors using these strategies;

b. determine the value at expiration, profit, maximum profit, maximum loss,

breakeven underlying price at expiration, and general shape of the graph of a

covered call strategy and a protective put strategy, and explain the risk

management application of each strategy.

www.cfainstitute.org/toolkit—Your online preparation resource

Because of diversification benefits and higher expectations of investment

returns, investors are increasingly turning to alternative investments. This

study session describes the common types of alternative investments, methods

for their valuation, unique risks and opportunities associated with them, and the

relation between alternative investments and traditional investments.

Although finding a single definition of an “alternative” investment is difficult,

certain features (e.g., limited liquidity, infrequent valuations, and unique legal

structures) are typically associated with alternative investments. This study session

discusses these features and how to evaluate their impact on expected returns

and investment decisions in more detail. The reading provides an overview of the

major categories of alternative investments, including real estate, private equity,

venture capital, hedge funds, closely held companies, distressed securities, and

commodities.

Each of these categories has several unique characteristics, and the readings

discuss valuation methods for illiquid assets (such as direct real estate or closely

held companies), performance measures for private equity and venture capital

investments, differences between various hedge fund strategies, and

implementation vehicles for investments in alternative assets.

READING ASSIGNMENTS

Reading 73 Alternative Investments

Global Investments, Sixth Edition, by Bruno Solnik

and Dennis McLeavey, CFA

Reading 74 Investing in Commodities

Global Perspectives on Investment Management: Learning from

the Leaders, edited by Rodney N. Sullivan, CFA

STUDY SESSION 18

ALTERNATIVE INVESTMENTS

Study Session 18

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LEARNING OUTCOMES

Reading 73: Alternative Investments

The candidate should be able to:

a. differentiate between an open-end and a closed-end fund, and explain how net

asset value of a fund is calculated and the nature of fees charged by investment

companies;

b. distinguish among style, sector, index, global, and stable value strategies in

equity investment and among exchange traded funds (ETFs), traditional mutual

funds, and closed-end funds;

c. explain the advantages and risks of ETFs;

d. describe the forms of real estate investment and explain their characteristics as

an investable asset class;

e. describe the various approaches to the valuation of real estate;

f. calculate the net operating income (NOI) from a real estate investment, the value

of a property using the sales comparison and income approaches, and the aftertax

cash flows, net present value, and yield of a real estate investment;

g. explain the stages in venture capital investing, venture capital investment

characteristics and challenges to venture capital valuation and performance

measurement;

h. calculate the net present value (NPV) of a venture capital project, given the

project’s possible payoff and conditional failure probabilities;

i. define hedge fund in terms of objectives, legal structure, and fee structure, and

describe the various classifications of hedge funds;

j. explain the benefits and drawbacks to fund of funds investing;

k. discuss the leverage and unique risks of hedge funds;

l. discuss the performance of hedge funds, the biases present in hedge fund

performance measurement, and explain the effect of survivorship bias on the

reported return and risk measures for a hedge fund database;

m. explain how the legal environment affects the valuation of closely held

companies;

n. describe alternative valuation methods for closely held companies and distinguish

among the bases for the discounts and premiums for these companies;

o. discuss distressed securities investing and compare venture capital investing with

distressed securities investing;

p. discuss the role of commodities as a vehicle for investing in production and

consumption;

q. explain the motivation for investing in commodities, commodities derivatives,

and commodity-linked securities;

r. discuss the sources of return on a collateralized commodity futures position.

Reading 74 Investing in Commodities

The candidate should be able to:

a. explain the relationship between spot prices and expected future prices in terms

of contango and backwardation;

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Study Session 18

b. describe the sources of return and risk for a commodity investment and the

effect on a portfolio of adding an allocation to commodities;

c. explain why a commodity index strategy is generally considered an active

investment.