## CFA Exam – Level 2 2011… (after) thoughts

I went into the exam pretty confident and well prepared after learning my lessons from my first unsuccessful attempt last year… but I certainly wasn’t prepared enough… I give myself only a 60% chance of passing vs 50/50 last year.

I think the exam was pretty difficult and I was surprised at the topic area coverage…

- I believe the Schweser instructors mention that anything is fair game on the exam and it couldn’t be far from the truth for Level 2 2011.
- I had not seen about 30% of the questions in any of the 3 mock exams I did (CFA 2010 & Schweser)…
- The focus is on testing the theoretical understanding and you definitely need to understand the concepts… memorizing will not go very far.
- I would say all of the new material introduced for 2011 was thoroughly tested…

All in all… a difficult exam.

I enjoyed writing the summaries and I referred to them during review. I will continue doing to do so after the exam results… hopefully I will only write for Level 3 material.

Best luck!

**Update:** I removed some exam information on request from CFA Institute.

## CFA Reading on Derivatives – FRA and Futures Markets & Contracts

CFA Level 2 – Derivatives; Study Session 16, Reading 61 in 2011 curriculum/Reading 59 in 2010 – Futures Markets & Contracts

I will go over FRAs and Futures in this post. (FRA is part of previous reading)

**Forward Rate Agreements (FRA)**

FRA is yet another derivative product. The underlying in an FRA is an interest rate on a deposit or on a loan i.e. the price of an FRA is an interest rate. The deposit/loan can be for any period in the future and the beginning of this period can also be any period in the future. It is the beginning and ending of these periods that form the notation of an FRA.

For example, 2 x 5 FRA means that the derivative contract expires in 2 months and the underlying deposit or loan is initiated at the end of 2 months (from now) and ends at the end of 5 months (from now) i.e. the deposit/loan period is for 5 – 2 = 3 months and (it is worth repeating) those 3 months start 2 months from now. (confusing I know but it is imperative you get your head around this)

An FRA is a forward contract in which the long, agrees to pay a fixed interest payment at a future date and receive an interest payment at a rate to be determined at expiration of the contract (not the expiration of the deposit/loan).

*Value of an FRA from CFA Institute:*

The value of an FRA based on a Eurodollar deposit is the present value of $1 to be received at expiration minus the present value of $1 plus the FRA rate to be received at the maturity date of the Eurodollar deposit on which the FRA is based, with appropriate (days/360) adjustments.

The payment made at the expiration of the FRA is the difference between the Value of the FRA and the agreed upon price of the FRA, adjusted by the notional principal and the number of days.

The payoff is also discounted, however, to reflect the fact that the underlying rate on which the instrument is based assumes that payment will occur at a later date… remember that the period of deposit/loan starts at the expiration of the FRA contract and the interest payment on this deposit/loan is made at the end of the period.

Let’s move on to Futures Markets and begin by establishing the difference between Futures & Forwards

Figure 2 http://psc.ky.gov/agencies/psc/training/Risk/sld012.htm

Pricing Futures is similar to Forwards, **future price for an asset with no storage costs** is given by:

The market price of a Forward contract is the amount a party to the transaction is willing to pay to terminate the contract. However, because futures are traded on an exchange and are settled and marked-to-market daily , the Futures contract have zero value at the end of the day and have non-zero value during the day.

Value of a futures contract = Current Futures price – Futures price at last mark-to-market

Because of the daily settlement feature of futures, cash is exchanged daily between the long and the short and this cash can be invested to earn a return. And because of this futures prices are sometimes higher than forwards for an identical contract.

The following table illustrates the difference:

**Costs & Benefits of holding the underlying asset**

If holding an underlying asset results in monetary costs and benefits (net cost), futures price is:.

If holding an underlying asset results in non-monetary benefits (convenience yield), futures price is:

All other formulas (dividend paying asset, coupon paying asset, etc) for pricing futures are similar to forwards.

In the next topic, I will discuss contango and backwardation.

Source of all formulas: Schweser Notes

## What is the theoretical relation among various rates in Economics?

I have been reviewing study session 4 in CFA Level 2 Economics and I can’t seem to get my head around all the parity relations… hence a post to clarify my thoughts and develop a clear understanding.

All parity relations are a function of exchange rates, nominal interest rates, real interest rates and inflation rates between the a pair of countries/currencies.

**Interest Rate Parity – Exchange Rate > Nominal Interest Rate**

Covered Interest Rate Parity:

*forward exchange rate* as a function of the spot exchange rate and nominal interest rates.

Uncovered Interest Rate Parity:

*expected spot exchange rate* as a function of the current spot exchange rate and nominal interest rates

**International Fischer Relation – Inflation Rate > Nominal Interest Rate**

difference in nominal interest rates should be equal to difference in expected inflation rates because real rates as equal

**Purchasing Power Parity (PPP) – Exchange Rate > Inflation Rate**

Absolute PPP

price of a basket of similar goods between two countries should be equal (rarely is in practice)

Relative PPP

*expected spot exchange rate* as a function of the current spot exchange rate and inflation rates (note similarity to uncovered interest rate parity)

Approximate Relative PPP

difference in inflation rates is equal to the *expected appreciation/depreciation *of the currency

The above stuff is easy on its own but gets tricky when combined with International Asset Pricing reading from study session 18 on Portfolio Management.

**Real Exchange Rate**

explains the changes in nominal exchange rate not explained by the *difference in* *price levels* i.e.

(Note here that the price levels are already adjusted for inflation, hence if real exchange rates are constant then any change in nominal exchange rate is explained by the difference in inflation)

Also,

% Change in Real Exchange Rate = % Change in Nominal Exchange rate – (Inflation in DC – Inflation in FC)

**Foreign Currency Risk Premium – Exchange Rate > Real Interest rates**

is the difference between the % change in exchange rates and the difference in real interest rates

I think that should clarify the interplay of different rates.

## CFA Reading on Derivatives – Forward Markets & Contracts

CFA Level 2 – Derivatives; Study Session 16, Reading 60 in 2011 curriculum/Reading 58 in 2010 – Forward Markets & Contracts

According to the Schweser, most people find the Derivatives topic to be the most difficult in Level 2 … I find it fun and relatively easy (perhaps because I want to work in the dazzling world of derivatives)… Because you need to understand forwards to understands futures and swaps, this will be a long post.

The key to derivatives is to understand how the price of the underlying asset and interest rates influence the value of the derivative…read on and it will be clear.

**What is a Forward contract? **

The following is verbatim from the CFA curriculum and I think it is succinct and to the point.

The holder of a long forward contract (the “long”) is obligated to take delivery of the underlying asset and pay the forward price at expiration. The holder of a short forward contract (the “short”) is obligated to deliver the underlying asset and accept payment of the forward price at expiration.

At expiration, a forward contract can be terminated by having the short make delivery of asset to the long or having the long and short exchange the equivalent cash value. If the asset is worth more (less) than the forward price, the short (long) pays the long (short) the cash difference between the market price or rate and the price or rate agreed on in the contract.

A party can terminate a forward contract prior to expiration by entering into an opposite transaction with the same or a different counterparty. It is possible to leave both the original and new transactions in place, thereby leaving both transactions subject to credit risk [counterparty risk], or to have the two transactions cancel each other. In the latter case, the party owing the greater amount pays the market value to the other party, resulting in the elimination of the remaining credit risk. This elimination can be achieved, however, only if the counterparty to the second transaction is the same counterparty as in the first.

**What is the price and value of a forward contract?**

The forward price is the price that a long will pay the short at expiration and expect the short to deliver the asset. There is no cash exchange at the beginning of the contract and hence the value of the contract at initiation is zero.

The *value* of a forward contract after initiation and during the term of the contract as the price of the underlying asset (S) changes. The value (profit/loss) of a forward contract between initiation and expiration is the current price of the asset less the present value of the forward price (at expiration).

Here is a payoff chart of a long position in a forward contract

The value or payoff of a short position is the opposite of the long i.e. if long is valued at +10, short is valued at -10… this is true for all derivatives because derivatives are a zero-sum game i.e. one’s gain is another’s loss.

Why we need to value forward contracts:

Valuation of a forward contract is important because 1) it makes good business sense to know the values of future commitments, 2) accounting rules require that forward contracts be accounted for in income statements and balance sheets, 3) the value gives a good measure of the credit exposure, and 4) the value can be used to determine the amount of money one party would have to pay another party to terminate a position.

**Formulas to calculate Forward Price and to value forward contract**

- General formula (for security without cash flows i.e. dividends, interest, etc):

Calculating the forward price of a security with cash flow includes one additional which is either the present or future value of the cash flow discounted at the risk free rate.

- FP of an equity security (can be stocks, stock portfolios or stock indices) with discrete dividends:

Vt (value of a long position at time t)

- FP of a fixed income security (Instead of dividends, we adjust coupons, in reality there are adjustments for special features i.e. call, put, convertible, etc):

Vt (value of a long position at time t)

(note that forward contracts on bonds must expire before the bond’s maturity, no point buying a bond on maturity)

- FP of an equity index or a continuous compounding security (instead of a discrete cash flow, we assume continuous cash flow)

Vt (value of a long position at time t)

- FP of a currency forward contract = forward exchange rate quoted as domestic currency/foreign currency (remember that currency units are always quoted in terms of another currency i.e. CADUSD = USD/CAD where USD = Domestic Currency & CAD = Foreign Currency)

(Hint: numerator interest rate corresponds to currency of numerator, for example if spot price was quoted as USD/CAD, the RDC = USD interest rate & RFC = CAD interest rate). In words of CFA Institute:

The [forward]price, which is actually an exchange rate, of a forward contract on a currency is the spot rate discounted at the foreign interest rate over the life of the contract and then compounded at the domestic interest rate to the expiration date of the contract.

Vt (value of a long position at time t)* *

… next post will cover FRAs and Futures Markets & Contract

## CFA Reading: Equity Concepts & Techniques

CFA Level 2 – Equity Investments; Study Session 11, Reading 38 in 2011 curriculum/Reading 36 in 2010.

This reading introduces some of the basic concepts of analyzing equity investments. I’m excluding the theoretical parts and will focus mostly on bits of interesting corollaries…

A global industry analysis should examine:

- return potential evidenced by demand analysis
- value creation
- industry life cycle
- competition structure
- competitive advantage
- competitive strategies
- co-opetition and the value net (yes…co-opetition is a word)
- sector rotation
- risk elements evidenced by market competition
- value chain competition
- government participation
- cash flow covariance

**Dupont Analysis**

Global financial analysis involves comparing company ratios with global industry averages. In this context, DuPont analysis uses various combinations of the tax retention, debt burden, operating margin, asset turnover, and leverage ratios.

Extended Dupont formula for Return on Equity (ROE):

**Franchise Value or PVGO**

Intrinsic P/E can be broken down into tangible P/E and Franchise P/E. Tangible P/E assumes constant earnings and Franchise P/E is the present value of growth opportunities divided by next year’s earnings i.e. PVGO/E. Think of tangible P/E as the average industry growth rate and franchise value as the additional growth that is unique to the company/industry.

r = required rate of return

b = Retention Ratio = (1 – Dividend Payout Ratio)

**Analyze Effects of Inflation on Valuation**

Inflation affects historical inventory and borrowing costs on reported earnings, as well as the inflation tax reflected in capital gains taxes (i.e. you purchase an asset today which increases in value equal to inflation rate, you decide to sell the asset and incur capital gains tax… you actual are losing capital because the rise in asset value is due to inflation).

To analyze the effect of inflation on a firm’s valuation, you must estimate the degree of inflation flow-through denoted by λ in textbook.

A company/industry with high inflation flow-through rate will be valued more because it can pass the higher input costs to the consumer and maintain profit margins.

**Herfindahl Index** (we have seen this before in Corporate Finance)

This index is used to measure competition in an industry. The US Department of Justice uses this index to measure industry concentration. The formula is straightforward…

I doubt that Canada’s Competition Bureau uses this index considering the prevalence oligopolistic industries in Canada (banking & communication are two big ones)

## Interest rates on bonds & mortgages

Government of Canada (GOC) Bond Yields…slowly & surely creeping up…Notice the ‘U-shaped’ turnaround for terms longer than 1 year… noticeable in the 5yr term.

If you prefer the yield curve… which is a subset of the above data but presented differently

Fixed Mortgage Rates are based off of the respective GOC bond yields…(figure 1). The solid lines (right axis) in the figure below is the difference between the GOC bond yield and the corresponding term mortgage rate. This chart illustrates that mortgage rates don’t change as frequently as bond yields do. Look at the difference between the 3yr bond yield and the 3yr mortgage rate, it is sloping down or in other words hasn’t risen as much as the 3yr bond yields.

## CFA learnings applied – The Dollar’s Impact on Stocks So Far in 2011

Bespoke has a nice post on the impact of US Dollar’s depreciation on earnings of US companies… this is a very simple yet very applied example of the CFA Level 2 reading on Multinational Operations.

The US dollar index (trade weighted measure against other currencies) is down about 3% in 2011. How does this affect earnings of US companies? US companies can be broadly classified in to two categories: those that do 100% of business is in US and in USD and those that do a significant share of their business globally… it is the second category of companies that are most affected by currency fluctuation…

How does USD depreciation affect stocks?

When the dollar is rising, US companies that do most or all of their business within our borders stand to benefit, while US companies with large amounts of revenues outside of the country lose out. The opposite occurs when the dollar is declining — companies with large amounts of international revenues benefit at the expense of the domestics.

If the above is not intuitive, visit my earlier post here.

As shown in the second chart below, the average YTD performance of stocks in the decile with the largest percentage of international revenues is 7.68%, which is by far the best performing decile. The average YTD performance for stocks with no international revenues is 3.09%. This performance is inline with what one would expect given the dollar’s decline.

Loosely speaking, about 3-4% of the 7.68% rise in the top performing decile can be attributed to currency depreciation and the rest to the general market rise…

Going forward, if you expect the dollar to continue its decline, the stocks with large amounts of international revenues should continue to outperform. If you expect the dollar to reverse course and head higher, the stocks with little or no international revenues should start to pick up.

…