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# 2018 CFA Level 2 Quicksheet

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Coefficient of determination (R2 = RSS / SST).

vC,

V ^ / / T-x \

/A X \ B ,

offer

.B C

X bid

'A ' B , n >

vC, bid

'A '

'A '

B C \ ^ / offer

bid-ask spread = ask quote - bid quote Cross rates with bid-ask spreads:

ECONOMICS

Scenario analysis Discrete No Yes Decision trees Discrete Yes No

Accommodates Correlated Variables' Simulations Continuous Does not matter Yes

Sequential ?

Appropriate m ethod Distribution o f risk

CTt+l = a0 + al£t Risk Types:

= ao + ai^t-i + Bt Variance of ARCH series: A 2 A A A 2

(1 — b j) RM SE: square root of average squared error. Random W alk T im e Series: xt = xt-i + £t Seasonality: indicated by statistically significant lagged err. term. Correct by adding lagged term. ARCH: detected by estimating:

X offer bid

Currency arbitrage: “Up the bid and down the ask.” Forward premium = (forward price) - (spot price) Value of fwd currency contract prior to expiration:

Autocorrelation. Correlation among error terms. Detect with Durbin-Watson test; positive autocorrelation if D W < d(. Correct by adjusting standard errors using Hansen method. Multicollinearity. High correlation among Xs.

R = R . + E(inflation) nominal real International Fisher Relation:

Neoclassical Growth T heory

= long-term growth rate of labor force

= long-term growth rate of technology

Mundell-Fleming model: Impact of monetary and fiscal policies on interest rates & exchange rates. Under high capital mobility, expansionary monetary policy/restrictive fiscal policy —> low interest rates —> currency depreciation. Under low capital mobility, expansionary monetary policy/ expansionary fiscal policy —> current account deficits —» currency depreciation. Dornbusch overshooting model: Restrictive monetary policy —» short-term appreciation of currency, then slow depreciation to PPP value. Labor Productivity: output per worker Y/L = T(K/L)‘' Growth Accounting: growth rate in potential GDP

= change in spot price (A/B) Profit on FX Carry Trade = interest differential - change in the spot rate of investment currency.

where: % AS(A/B)

%AS(A/B) = inflation Xj - inflation,B)

R . — R . = E(inflation.) nominal A nominal B v A' E(inflationB) Relative Purchasing Power Parity: High inflation rates leads to currency depreciation.

, = R , - K Fisher relation:

(FPt — FP)(contract size) Vt = 1 + R

a s w

(%

e

Uncovered interest rate parity:

F = ^ -------- days 360 /

a

Covered interest rate parity: 1 + R

360 \

A

Unit root: coefficient on lagged dep. vbl. = 1. Series with unit root is not covariance stationary. First differencing will often eliminate the unit root. Autoregressive (AR) model: specified correctly if autocorrelation of residuals not significant. Mean reverting level for A R(1): bo

Detect if F-test significant, t-tests insignificant. Correct by dropping X variables. M odel M isspecification • Omitting a variable.

change over time. To determine if a time series is covariance stationary, (1) plot data, (2) run an AR model and test correlations, and/or (3) perform Dickey Fuller test.

HI (A) HI (B)

VI VI (A)

v (A) V (B) V (C)

V

IV (C)

IV (B)

IV IV (A)

HI (D) HI (E)

HI (C)

III

VI (C)

II (B)

II II (A)

I (B) I (C ) I (D)

I I (A)

E x a m ETHICAL AND PROFESSIONAL STANDARDS

2018 C F A ®

LEV EL II SCHW ESER' C r it ic a l C o n c e pt s f o r t h e

0 1 + R B days 360Variable should be transformed. Incorrectly pooling data. Using lagged dependent vbl. as independent vbl. Forecasting the past. Measuring independent variables with error. Effects o f M isspecification Regression coefficients are biased and inconsistent, lack of confidence in hypothesis tests of the coefficients or in the model predictions. Linear trend model: yt = b0 + b,t + £t Log-linear trend model: ln(yt ) = b0 + b,t + £t Covariance stationary: mean and variance don’t

VI (B)

VII

Detect with Breusch-Pagan test. Correct with White-corrected standard errors.

M ultiple Regression

Regression Analysis— Problem s • Heteroskedasticity. Non-constant error variance.

% of variability of Y explained by Xs; higher R2 means better fit.

Smaller SEE means better fit.

F = M SR / M SE with k and n — k — 1 df (1-tail) Standard error of estimate (SEE = VM SE ).

sg SST = RSS + SSE. M SR = RSS / k. M SE = SSE / ( n - k - 1). Test statistical significance of regression:

X

Confidence Interval: bj ± |tc

Yi = b0 + ( b 1x X l i ) + (b2 x X 2l)

Y ± tc x SE of forecast

VII (A)

Estimated intercept: b0 = Y — bjX Confidence interval for predicted Y-value: A

<J\

Estimated slope coefficient: cov xy

( sx )( s y ) t-test for r (n - 2 d f): t = rVn — 2

rXY =

Simple Linear Regression Correlation: covXY

QUANTITATIVE METHODS

Professionalism Knowledge of the Law Independence and Objectivity Misrepresentation Misconduct Integrity of Capital Markets Material Nonpublic Information Market Manipulation Duties to Clients Loyalty, Prudence, and Care Fair Dealing Performance Presentation Preservation of Confidentiality Duties to Employers Loyalty Additional Compensation Arrangements Responsibilities of Supervisors Investment Analysis, Recommendations, and Action Diligence and Reasonable Basis Communication with Clients and Prospective Clients Record Retention Conflicts of Interest Disclosure o f Conflicts Priority of Transactions Referral Fees Responsibilities as a CFA Institute Member or CFA Candidate Conduct in the CFA Program Reference to CFA Institute, CFA Designation, and CFA Program

VII (B)

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a (long-term growth rate of capital) (1 - a) (long-term growth rate of labor) growth rate in potential GDP(b3 X X 3i) + £;

Test statistical significance of b; H (): b = 0, A / t = y , n — k — 1 df Reject if |t| > critical t or p-value < a .long-term growth rate in labor productivity Classical Growth T heory • Real GDP/person reverts to subsistence level.

Sustainable growth rate is a function of population growth, labor’s share of income, and the rate of technological advancement. Growth rate in labor productivity driven only by improvement in technology.

Used to detect earnings manipulation based on eight variables.

Hyperinfl. = cumul. infl. > 100% over 3 yrs. GAAP: use temporal method. IFRS: 1st, restate foreign curr. st. for infl. 2nd, translate with current rates. Net purch. power gain/loss reported in income.

A L

Beneish model:

Hyperinflation: GAAP vs. IFRS

| in savings rate —> permanent T in growth rate. R & D expenditures ] technological progress.Assets, liabilities, equity, revenues, and expenses are higher under acquisition compared to the equity method.A dm inistrative regulations: Issued by government. Ju d icial law : Findings o f the court.Unrealized FX gains and losses on available-for-sale debt securities recognized on income statement under IFRS and as O CI under U.S. GAAP. IFRS permits either the “partial goodwill” orIndependent regulator can be SRO or non-SRO.Independent SROs are more prevalent in common-law countries than in civil-law countries.Inform ational friction s arise in the presence of information asymmetry. Externalities deal with provision of public goods.

Impairment losses on passive investments: IFRS — Reversal allowed if due to specific event. U.S. GAAP — No reversal o f impairment losses. Fair value accounting, investment in associates: — Only for venture capital, mutual funds, etc. U.S. GAAP — Fair value accounting allowed for all. Goodwill impairment processes:

PBO components: current service cost, interest cost, actuarial gains/losses, benefits paid.Funded status = plan assets — PBO = balance sheet asset (liability) under GAAP and IFRS.

NI E B T E B IT RO E = -------x ---------x ------------x

IFRS — Either operating or financing cash flows. U.S. GAAP — Must classify as operating cash flow. R O E decomposed (extended D uPont equation) Tax Interest EBIT Burden Burden Margin

Dividend/interest income and interest expense:

U.S. GAAP — OCI, amortized with corridor approach.

Actuarial gains/losses: IFRS — Remeasurements in O CI and not amortized.

U.S. GAAP - Reported in OCI; amortized to P&L.

Prior service cost: IFRS — Recognized as an expense in P&L.

U.S. GAAP — Recognized; recorded at fair value.

IFRS — Contingent assets are not recognized.

Acquisition method contingent asset recognition:

IFRS - 1 step (recoverable amount vs. carrying value) U.S. GAAP — 2 steps (identify; measure amount)

E B T E B IT revenue

U.S. GAAP — No such restriction.

IFRS — Restricts reclassification into/out o f FVPL.

IFRS A N D U .S. GAAP D IFFER E N C ES Reclassification of passive investments:

2. Adequate: Cover company’s cost o f capital.

High-quality earnings are: 1. Sustainable: Expected to recur in future.

Total periodic pension cost (under both IFRS and GAAP) = contributions — A funded status. IFRS and GAAP differ on where the total periodic pension cost (TPPC) is reflected (Income statement vs. OCI). Under GAAP, periodic pension cost in P&LPrice mechanisms, restricting or requiring certain activities, and provision o f public goods or financing o f private projects.Company law, tax law, contract law, competition law, banking law, bankruptcy law, and dispute resolution system.Under IFRS, reported pension expense = service cost + past service cost + net interest expense. Under IFRS, discount rate = expected rate of return on plan assets. Net interest expense = discount rate x beginning funded status. If funded status was positive, a net interest income would be recognized.Mergers leading to excessive market share blocked.

revenue

T otal Asset T urnover

) / 2

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Evaluating Projects with Unequal Lives • Least common multiple o f lives method.

Capital Budgeting Replacement

Capital Budgeting Expansion

) / 2

g

e n d

(NI - CFO - CFI) accruals ratio ^ = (NOA

Accruals Ratio (cash flow statem ent approach)

g

X Financial

e n d

) accruals ratio ^ = (NOA

g

— NOABE

n d

(NOAE

Accruals Ratio (balance sheet approach)

average assets average assets average equity

Leverage

Original F/S vs. All-Current • Pure BS and IS ratios unchanged.

M ultinational Operations: Choice o f M ethod

For self-contained sub, functional ^ presentation currency; use current rate method:

Regulatory arbitrage:

Prudential supervision:

Include disclosure requirements, regulations to mitigate agency conflicts, and regulations to protect small investors.

Securities m arket regulations:

Seek to protect investors and to ensure stability o f financial system.

F in an cial m arket regulations:

Regulations Covering Com m erce

Tools o f Regulatory Intervention

Exploiting regulatory differences between jurisdictions, or difference between substance and interpretation o f a regulation.

Regulatory body is influenced or controlled by industry being regulated.

Anticompetitive Behaviors and Antitrust Laws • Discriminatory pricing, bundling, exclusive dealing.

Regulatory Interdependencies and T heir Effects Regulatory capture theory:

Econom ic Rationale for Regulatory Intervention

Self-Regulation in Financial Markets

Classifications o f Regulators • Can be government agencies or independent.

Classifications o f Regulations • Statutes: Laws made by legislative bodies.

Endogenous Growth Theory • Investment in capital can have constant returns.

( 1 - a )

( 1 - a ) G* =

Assumes diminishing returns to capital. g* =

If TPPC < firm contribution, difference = A in PBO (reclassify difference from CFF to CFO after- tax). If TPPC > firm contribution, diff = borrowing (reclassify difference from CFO to CFF after-tax).

Monitoring institutions to reduce system-wide risks and protect investors.

N et regulatory burden:

Differences between IFRS and U .S. GAAP

treatm ent o f intercorporate investments include:

Cash Flow Adjustment

TPPC = ending PBO — beginning PBO + benefits paid - actual return on plan assets TPPC = contributions — (ending funded status - beginning funded status)

Total Periodic Pension C ost

= service cost + interest cost ± amortization of actuarial (gains) and losses + amortization o f past service cost — expected return on plan assets.

Income Statement

Balance Sheet

Pension Accounting

Costs to the regulated entities minus the private benefits of regulation.

“full goodwill” methods to value goodwill and noncontrolling interest. U.S. GAAP requires the full goodwill method.

Equity, acquisition, & proportionate consolidation: • All three methods report same net income.

Joint Venture: 50% shared control. Equity method. Financial Effect o f Choice o f M ethod

Acquisition method required under U.S. GAAP and IFRS. Goodwill not amortized, subject to annual impairment test. All assets, liabilities, revenue, and expenses o f subsidiary are combined with parent, excluding intercomp, trans. If <100%, minority interest acct. for share not owned.

Business Combinations: >50% owned, control.

20—50% owned, significant influence. With equity method, pro- rata share of the investee’s earnings incr. B/S inv. acct., also in I/S. Div. received decrease investment account (div. not in I/S).

Investments in Associates:

<20% owned, no significant influence.

Accounting for Intercorporate Investments Investment in Financial Assets:

Require a cost-benefit analysis to be revisited before the regulation is renewed.

Sunset clauses:FINANCIAL STATEMENT ANALYSIS

NOABE

Assets/liabilities at current rate. Common stock at historical rate. Income statement at average rate. Exposure = shareholders’ equity. Dividends at rate when paid. For integrated sub., functional = presentation currency, use temporal method: • Monetary assets/liabilities at current rate. Nonmonetary assets/liabilities at historical rate. Sales, SGA at average rate. CO G S, depreciation at historical rate. Exposure = monetary assets - monetary liabilities. Net asset position & depr. foreign currency = loss. Net liab. position & depr. foreign currency = gain.NOABE

Held-to-maturity at cost on balance sheet; interest and realized gain/loss on income statement. Available-for-sale at FM V with unrealized gains/ losses in equity on B/S; dividends, interest, realized gains/losses on I/S. Held-for-trading at FMV; dividends, interest, realized and unrealized gains/losses on I/S. Designated as fair value — like held for trading.CORPORATE FINANCE

Initial ouday = FCInv + WCInv CF = (S - C -D ) ( l - T ) + D = (S - C )(l - T ) + D T • T N O C F = SaLr + NWCInv - T(Salr - B.r)Same as expansion, except current after-tax salvage of old assets reduces initial outlay. Incremental depreciation is A in depreciation.

Equivalent annual annuity (EAA) method: annuity w/ PV equal to PV o f project cash flows.If LC depreciating (appreciating), translated mixed ratios will be larger (smaller). Discount nominal (real) cash flows at nominal (real)

If positive NPV projects > available capital, choose the combination with the highest NPV.Timing, abandonment, expansion, flexibility, fundamental options.Share repurchase is equivalent to cash dividend, assuming equal tax treatment. Unexpected share repurchase is good news. Rationale for: (1) potential tax advantages, (2) share price support/signaling, (3) added flexibility, (4) and (5) increasing financial leverage.Econ dep. based on A in investment’s MV. Econ income is calculated before interest expense (cost o f capital is reflected in discount rate). Accounting income = revenues - expenses. Acc. dep’n based on original investment cost. Interest (financing costs) deducted before calculating accounting income.Residual dividend: dividends based on earnings less funds retained to finance capital budget. Longer-term residual dividend: forecast capital budget, smooth dividend payout. Dividend stability: dividend growth aligned with sustainable growth rate. Target payout ratio: long-term payout ratio target.Economic profit = NO PAT - $WACC Market Value Added = t= i (1 + W A C C )r Residual income: = NI — equity charge; discounted at required return on equity. Claims valuation separates CFs based on equity claims (discounted at cost o f equity) and debt holders (discounted at cost o f debt).

GainT = TP = PT — VT

c f i

0 +

p

= r = P l ~

EQUITY Holding period return:

equity carve-outs, spin-offs, split-offs, and liquidations.

Forms of divestitures:

some of risks & rewards shift to target. If higher confidence in synergies; acquirer prefers cash & target prefers stock.

M erger Risk & Reward Cash offer: acquirer assumes risk & receives reward. Stock offer:

GainA = S — TP = S — (PT — VT )

Synergies (to acquirer):

a t = V a + V t + S — C Takeover prem ium (to target):

p

Y

M erger Valuations C om binedfirm :

: target value from takeover transaction; takeover premium included.

Com parable transaction analysis

target value from relative valuation metrics on similar firms + takeover premium.

Com parable company analysis-,

adjusted WACC.

Methods to Determ ine Target Value D C F m ethod: target proforma FCF discounted at

H H I = ^ ( M S i X l 0 0 ) 2

n

market power = sum o f squared market shares for all industry firms. In a moderately-concentrated industry (HHI 1,000 to 1,800), a merger is likely to be challenged if H H I increases 100 points (or increases 50 points for H H I >1,800).

=

1 +

consensus long-term earnings growth rate

long-term government bond yield

Mitigate conflicts o