Level Exam Prep Schweser’s Secret Sauce eBook SCHOOL OF PROFESSIONAL AND CONTINUING EDUCATION SCHWESER L e v e l II Sc h w e s e r ’s Se c r e t Sa u c e ® Foreword iii Ethical and Professional Standards: SS & Quantitative Methods: SS 11 Economics: SS 27 Financial Reporting and Analysis: SS & 44 Corporate Finance: SS & 63 Equity: SS 9, 10, & 1 85 Fixed Income: SS 12 & 108 Derivatives: SS 14 126 Alternative Investments: SS 15 144 Portfolio Management: SS 16 & 162 Essential Exam Strategies 178 Index 186 © 2017 Kaplan, Inc SCH W ESER’S SEC RET SAUCE®: 2017 LEVEL II CFAđ â Kaplan, Inc All rights reserved Published in 2017 by Kaplan Schweser Printed in the United States o f America ISBN : 978-1-4754-4368-4 I f this book does not have the hologram with the Kaplan Schweser logo on the back cover, it was distributed without permission o f Kaplan Schweser, a Division o f Kaplan, Inc., and is in direct violation o f global copyright laws Your assistance in pursuing potential violators o f this law is greatly appreciated Required CFA Institute disclaimer: “CFA Institute does not endorse, promote, or warrant the accuracy or quality o f the products or services offered by Kaplan Schweser CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.” Certain materials contained within this text are the copyrighted property of CFA Institute The following is the copyright disclosure for these materials: “Copyright, 2016, CFA Institute Reproduced and republished from 2017 Learning Outcome Statements, Level I, II, and III questions from CFA® Program Materials, CFA Institute Standards o f Professional Conduct, and CFA Institutes Global Investment Performance Standards with permission from CFA Institute All Rights Reserved.” These materials may not be copied without written permission from the author The unauthorized duplication o f these notes is a violation of global copyright laws and the CFA Institute Code of Ethics Your assistance in pursuing potential violators o f this law is greatly appreciated Disclaimer: Schweser study tools should be used in conjunction with the original readings as set forth by CFA Institute in their 2017 Level II CFA Study Guide The information contained in these materials covers topics contained in the readings referenced by CFA Institute and is believed to be accurate However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam success The authors of the referenced readings have not endorsed or sponsored Schweser study tools Page ii © 2017 Kaplan, Inc Fo r ew o r d Secret Sauce® offers concise and readable explanations o f the major ideas in the Level II CFA curriculum This book does not cover every Learning Outcome Statement (LOS) and, as you are aware, any LOS is “fair game” for the exam We focus here on those LOS that are core concepts in finance and accounting, have application to other LOS, are complex and difficult for candidates, or require memorization o f characteristics or relationships Secret Sauce is easy to carry with you and will allow you to study these key concepts, definitions, and techniques over and over, an important part o f mastering the material When you get to topics where the coverage here appears too brief or raises questions in your mind, this is your cue to go back to your SchweserNotes to fill in the gaps in your understanding There is no shortcut to learning the vast breadth o f subject matter covered by the Level II curriculum, but this volume will be a valuable tool for reviewing the material as you progress in your studies over the months leading up to exam day Pass rates remain around 45% , and returning Level II candidates make comments such as, “I was surprised at how difficult the exam was.” You should not despair because o f this, but more importantly not underestimate the challenge Our study materials, practice exams, question bank, videos, seminars, and Secret Sauce are all designed to help you study as efficiently as possible, grasp and retain the material, and apply it with confidence on exam day Best regards, *Ke*tt 7(Je4ttoutcC Dr Bijesh Tolia, CFA, CA Vice President o f CFA Education and Level II Manager Kaplan Schweser © 2017 Kaplan, Inc Kent Westlund, CFA, CPA Content Specialist Page iii E t h ic a l a n d P r o f e s s io n a l St a n d a r d s Study Sessions & Topic Weight on Exam -1 % SchweserNotes™ Reference Book 1, Pages 1—101 For many candidates, ethics is difficult material to master Even though you are an ethical person, you will not be prepared to perform well on this portion o f the Level II exam without a comprehensive knowledge o f the Standards o f Professional Conduct Up to 15% o f Level II exam points come from the ethics material, so you should view this topic as an area where you can set yourself apart from the person sitting next to you in the exam room Futhermore, CFA Institute has indicated that performance on the ethics material serves as a “tie-breaker” for exam scores very close to the minimum passing score (This is referred to as the “ethics adjustment.”) To summarize, the ethics m aterial is worth taking seriously W ith 10—15% o f the points and the possibility o f pushing a marginal exam into the pass column (not to mention the fact that as a candidate you are obligated to abide by CFA Institute Standards), it is foolhardy not to devote substantial time to Level II ethics A St u d y P l a n f o r E t h ic s The big question is, “W hat I need to know?” The answer is that you really need to be able to apply the ethics material You simply must spend time learning the Standards and developing some intuition about how CFA Institute expects you to respond on the exam Here are several quick guidelines to help in your preparation:• • Focus on the Standards The Standards o f Professional Conduct are the key to the ethics material The Code o f Ethics is a poetic statement o f objectives, but the heart o f the testing comes from the Standards © 2017 Kaplan, Inc Page Study Sessions & Ethical and Professional Standards • • • • Broad interpretation A broad definition o f most standards is needed for testing purposes even i f it seems too broad to apply in your ‘real w orld”situation For instance, a key component of the professional standards is the concept o f disclosure (e.g., disclosure o f conflicts o f interest, compensation plans, and soft dollar arrangements) On the exam, you need to interpret what needs to be disclosed very broadly A good guideline is that if there is any question in your mind about whether a particular bit of information needs to be disclosed, then it most certainly needs disclosing Err on the side o f massive disclosure! Always side with the employer Many view the Code and Standards to be an employer-oriented document That is, for many readers the employer’s interests seem to be more amply protected I f there is a potential conflict between the employee and employer, always side with the employer D efend the charter CFA Institute views itself as the guardian o f the industry’s reputation and, specifically, the guardian o f the CFA® designation On the exam, be very suspicious o f activity that makes industry professionals and CFA charterholders look bad Assume a ll investors are inexperienced Many different scenarios can show up on the exam (e.g., a money manager contemplating a trade for a large trust fund) However, when you study this material, view the Standards from the perspective o f a money manager with fiduciary responsibility for a small account belonging to inexperienced investors Assuming that the investors are inexperienced makes some issues more clear Now, how should you approach this material? There are two keys here • • First, you need to read the m aterial very carefully We suggest that you underline key words and concepts and commit them to memory It’s probably a good idea to start your study effort with a careful read o f ethics and then go over the material again in May Second., you should answer every practice ethics question you can get your hands on to develop some intuition The truth is that on the exam, you are going to encounter a number o f ethics questions that you don’t immediately know the answer to Answering a lot o f practice questions will help you develop some intuition about how CFA Institute expects you to interpret the ethical situations on the exam Also, study every example in the Standards o f Practice H andbook and be prepared for questions on the exam that test similar concepts Th e C o d e o f E t h ic s Cross-Reference to CFA Institute Assigned Topic Review #1 Members o f the CFA Institute and candidates for the CFA designation must: • Act with integrity, competence, diligence, and respect, and in an ethical manner with the public, clients, prospective clients, employers, employees, colleagues in the investment profession, and other participants in the global capital markets Page © 2017 Kaplan, Inc Study Sessions & Ethical and Professional Standards • • • • • Place the integrity o f the investment profession and the interests o f clients above their own personal interests Use reasonable care and exercise independent professional judgment when conducting investment analysis, making investment recommendations, taking investment actions, and engaging in other professional activities Practice and encourage others to practice in a professional and ethical manner that will reflect credit on themselves and the profession Promote the integrity and viability o f the global capital markets for the ultimate benefit o f society Maintain and improve their professional competence and strive to maintain and improve the competence o f other investment professionals St a n d a r d s o f P r o f e s s io n a l C o n d u c t Cross-Reference to CFA Institute Assigned Topic Review #2 The following is a summary o f the Standards o f Professional Conduct Focus on the purpose o f the standard, applications o f the standard, and proper procedures o f compliance for each standard Standard I: Professionalism 1(A) Knowledge of the Law Understand and comply with laws, rules, regulations, and Code and Standards o f any authority governing your activities In the event o f a conflict, follow the more strict law, rule, or regulation Do not knowingly participate or assist in violations, and dissociate from any known violation Professor's N ote: The requirem ent to disassociate fro m any violations com m itted by others is explicit in the Standard This m ight m ean resigning fro m the fir m in extrem e cases The gu idan ce statem ent also m akes clear th at you aren't requ ired to report p o ten tia l violations o f the Code a n d Standards com m itted by other m em bers or candidates to CFA Institute, although it is encouraged C om pliance w ith any ap p licable fid u cia ry duties to clients w ou ld now be covered under this standard 1(B) Independence and Objectivity Use reasonable care to exercise independence and objectivity in professional activities Don’t offer, solicit, or accept any gift, benefit, compensation, or consideration that would compromise either your own or someone else’s independence and objectivity © 2017 Kaplan, Inc Page Study Sessions & Ethical and Professional Standards Professor's N ote: The p roh ib itio n against accepting gifts, benefits, com pensation, or other consideration th at m ight com prom ise you r independence a n d objectivity includes a ll situations beyond ju s t those involving clients a n d prospects, including investm ent ban kin g relationships, p u b lic com panies the analyst is follow in g, pressure on sell-side analysts by buy-side clients, a n d issuer-paid research 1(C) Misrepresentation Do not knowingly misrepresent facts regarding investment analysis, recommendations, actions, or other professional activities Professor's N ote: P lagiarism is addressed under the broader category o f m is rep resen ta tion 1(D) Misconduct Do not engage in any professional conduct that involves dishonesty, fraud, or deceit Do not anything that reflects poorly on your integrity, good reputation, trustworthiness, or professional competence Professor's N ote: The scope o f this stan dard addresses only profession al m isconduct a n d n ot p erson al misconduct There is no attem pt to overreach or regulate one's p erson al behavior Standard II: Integrity of Capital Markets 11(A) Material Nonpublic Information I f you are in possession o f nonpublic information that could affect an investment’s value, not act or induce someone else to act on the information Professor's N ote: This S tan dard addressing insider trading states th at m em bers a n d candidates must not a ct or cause others to act on m aterial nonpublic in form ation u n til th at sam e in form ation is m ade p u blic This is a strict stan dard— it does n ot m atter w hether the in form ation is o b ta in ed in breach o f a duty, is m isappropriated, or relates to a tender offer The “m osaic theory" still applies, a n d an analyst can take action based on her analysis o f p u b lic a n d n on m aterial nonpublic inform ation 11(B) Market Manipulation Do not engage in any practices intended to mislead market participants through distorted prices or artificially inflated trading volume Standard III: Duties to Clients 111(A) Page Loyalty, Prudence, and Care Always act for the benefit of clients and place clients’ interests before your employer’s or your own interests You must be loyal to clients, use reasonable care, and exercise prudent judgment © 2017 Kaplan, Inc E s s e n t ia l E x a m St r a t e g ie s Ga m e P l a n This chapter provides important guidance about how to pass the Level II CFA exam These insights and techniques will help you successfully demonstrate your hard-earned knowledge on exam day On the Level II exam, you are expected to demonstrate a greater depth o f understanding than on the Level I exam Furthermore, the caliber o f the average Level II student is significantly higher than that o f the average Level I candidate Consequently, success at Level I is no guarantee o f success at Level II There are some important differences between preparing for the Level II exam and the Level I exam First, the question format will be different The entire Level II exam will be in item set format Item sets are short cases, usually about one or two pages in length, followed by a series o f six multiple choice questions on the material in the case The morning and the afternoon sessions will include ten item sets each We begin by showing you some proven approaches to mastering the Level II CFA curriculum Next, we will communicate a plan for the last week before the exam We will offer important suggestions to make sure you are prepared on exam day— that you’re not so flustered by the time you begin the exam that your performance is negatively affected We will also spend some time discussing strategies for taking the exam and for approaching individual questions Th e P r a c t ic e F ie l d As you prepare for the CFA exam, try to focus on the exam itself Don’t add to your stress level by worrying about whether or not you’ll pass or what might happen if you don’t Many o f the tips we provide are proven exam-day stress reducers Your grasp o f the content, combined with our test-taking tips, should leave you very well prepared for the exam You will be ready for the questions, and you will be ready for the exam experience All o f the faculty at Kaplan Schweser have earned the CFA charter and have extensive experience teaching the topics covered in the CFA curriculum We know what you are experiencing, and we have witnessed thousands o f candidates go Page 178 © 2017 Kaplan, Inc Essential Exam Strategies through the process o f earning the right to use the CFA designation Now, we want to share with you the time-honored strategies that we have personally seen lead to success on the Level II exam There are two fundamentals for success on the Level II exam: focus on the big picture and know the main concepts The Big Picture Focusing on the big picture means you should know something about as many concepts as possible For example, many candidates are not comfortable with pension accounting, because it seems to them like a lot o f adjustments that not make a big difference in analyzing a stock Our advice is to learn some o f the basics for the exam For example, learn the differences between IFRS and U.S GAAP in recognizing pension expense in income statement versus O C I By remembering some basic information on exam day, you will be able to narrow your answer choices on an item set You probably won’t get every question correct with only a basic grasp o f the concept, but you can improve your odds on a multiple-choice question from 33% to 30% by eliminating one incorrect answer choice Also, you will be better able to discriminate between relevant and irrelevant information in a question Another component o f the big picture focus is studying as many topics as possible It is a poor exam strategy to ignore significant pieces o f the curriculum Some candidates believe that as long as they know a few topics very well, they can bluff their way through the rest o f the exam These may be smart people, but their exam strategy isn’t smart Know the Main Concepts By knowing the main concepts, we mean identifying the “must know” Level II subject matter W ith the help o f many experienced folks here at Kaplan Schweser, we have done some o f that in the previous chapters o f this book These are the concepts that we think you have to know to be successful on the Level II exam In any given year, some o f these concepts might be omitted, but if you can answer every question on these concepts, you will dramatically increase your odds o f passing the exam Generally, the idea is to be correct on most o f the questions on important concepts, and then rely on your “big picture” knowledge to get points on the remaining material © 2017 Kaplan, Inc Page 179 Essential Exam Strategies Topic Weighting In preparing for the exam, pay attention to the weights assigned to each topic in the curriculum The topic weights are as follows: Topic Exam Weight Ethical and Professional Standards 10-15% Quantitative Methods 5-10% Economics 5-10% Financial Reporting and Analysis 15-20% Corporate Finance 5-15% Equity Valuation 15-25% Fixed Income 10-20% Derivatives 5-15% Alternative Investments 5-10% Portfolio Management 5-10% Total 100% Formulas At Level II, the emphasis shifts away from blindly memorizing formulas and then plugging numbers into them Instead, you also need to know in which situations the formula can be applied appropriately and the assumptions that support it Being able to work with formulas will be important to your exam day success, but don’t focus on simply memorizing them Ru l e B o o k At some point in your studies, we recommend that you take time to review the information in the “Candidate Resources” section o f CFA Institute Web site {www.cfainstitute.org) (You will probably find this to be a nice break from accounting or derivatives!) For example, be sure that you are able arrive on exam day with a v alid (not expired) international travel passport Select an approved calculator (TI BA II Plus or HP 12C) and learn how to use it Read the Candidate Bulletins that are issued by CFA Institute in the months before the exam, and be aware o f items you can and cannot take to the exam CFA Institute strictly prohibits taking any o f the following into the testing room: • • • Food or drinks Backpacks, briefcases, or luggage o f any kind Study materials Page 180 © 2017 Kaplan, Inc Essential Exam Strategies • • • Scratch paper or calculator manuals Highlighters, rulers, or correction fluid (white-out) Cell phones or any personal electronics These policies w ill apply to you Every year, many candidates have problems on exam day because they assume their case is a legitimate exception There is no such thing I f you read the rules and follow them, you will reduce the potential for unexpected stress on exam day F in a l Wa r m -U ps You should have a strategy for the last week before the exam I f possible, take at least some o f the week off from work (better yet, the entire week) Save at least one practice exam (six hours) for this last week To simulate the actual exam, avoid looking through or studying this exam until you are ready to sit down and take it for the first time Take the exam early in the week, and time yourself Then, use the results to determine where to focus your study efforts over the last few days You should devote much o f your time to areas where you performed poorly, but spend enough time on your stronger topics to keep them fresh in your mind and keep your confidence level up Visit the actual exam center sometime during the week before the exam Determine how long it will take to get there on exam day and where you can park Even if you are returning to the same site where you took the Level I exam, be sure nothing has changed Locate a nearby lunch destination in the area The fewer surprises on exam day, the better Expect problems on exam day Be prepared for things like cold or hot rooms, noise, or long lines There are some elements o f the testing environment that you cannot control, but if you are prepared for them, your exam performance is less likely to be affected Avoid “binge” studying the evening before the exam Relax and make a concerted effort to get a good night’s sleep; tired candidates make silly mistakes You will miss easy points if you are not rested This seems like a trite point, but it is difficult to overemphasize the importance o f going into the exam refreshed © 2017 Kaplan, Inc Page 181 Essential Exam Strategies CFA In s t it u t e Q u e s t io n C o n s t r u c t io n Gu id e l in e s CFA Institute has released very specific guidelines it uses to develop multiple choice questions We will review the most important issues, but refer to the Candidate Resources section o f the CFA Institute Web site (www.cfainstitute.org) for more detailed information Construction of Multiple Choice Questions Item set questions on the Level II CFA exam consist o f a one- to two-page vignette, a stem (which can be a question, a statement, or a table), and three possible answers labeled A, B, and C One o f the three choices is the correct answer and the other two are incorrect The incorrect choices are carefully selected to be common errors made by candidates, so don’t be lulled into a false sense o f security just because your answer happens to show up among the choices Word Choice in Stems CFAI Institute question stems often include qualifying words such as: • • • • • • • M ost likely Least likely Best described M ost appropriate M ost accurate Least appropriate Least accurate Questions that require a calculation, such that the choices are numerical choices (as in our example), will generally use “closest to.” I f you’ve taken the right approach on the question, your answer will be very close to one o f the choices, and not nearly as close to any o f the others Notice that this is consistent with the idea that you should choose the “best” response among the three choices It is possible, for example, that you could argue that two choices are “appropriate,” but only one o f them is “most appropriate.” Don’t spend your time creating unlikely scenarios where another choice might just be possible in some unusual circumstance CFA Institute does not use any o f the following as answer choices: • • All o f the above None o f the above Page 182 â 2017 Kaplan, Inc Essential Exam Strategies ã • • Cannot determine Cannot calculate Not enough information to determine How is an Item Set (Selected Response) Different From Level I Multiple Choice? An item set is a short story, called a vignette, followed by a series o f six questions The Level II exam will consist o f ten such item sets in the morning, and ten item sets in the afternoon According to CFA Institute, the vignette is usually about one and one-half pages in length, although some are more than two pages, and a few are less than one page You will have 18 minutes for each item set (three minutes for each o f the six questions), but remember that you must allow time to read and digest the information given It is generally a good idea to read the questions before reading the vignette; that way you know what specific information you are looking for in the vignette According to CFA Institute, -4 % o f the Level II questions will be quantitative, meaning that calculations will be required to determine the answer The remaining questions will be qualitative, requiring knowledge o f how to apply and interpret the concepts in the curriculum Note that this can include the interpretation o f numerical data that is provided for you Don’t expect the qualitative questions to be easier than the quantitative ones Answering a Multiple Choice Question in a Level II Item Set Here are some tips to keep in mind as you work through item set questions: • • Do not judge the facts presented in the case If part o f the scenario seems unrealistic, not twist the facts to fit your “real world” understanding o f the topic Accept the facts as given and answer the questions using the CFA curriculum Read each question carefully! Watch for double negatives, like “All o f the following are disadvantages except:” It is very important not to miss words by reading too quickly; for example, “most likely” instead o f “least likely.” Professor's N ote: One suggestion to keep “least likely" a n d ‘‘m ost lik ely ” straight on the exam is to circle the words “lea st” a n d “m ost” w henever you spot them in a question • • Read a ll answer choices Don’t just stop when you get to one that sounds right; there may be a better choice After you read each question, formulate your own answer before reading the answer choices Anticipate what you expect the answer to be © 2017 Kaplan, Inc Page 183 Essential Exam Strategies • • • • On calculation problems, after you select an answer choice, pause for a moment and think about whether the answer makes sense Is the sign (positive or negative) of your answer correct, or does the direction o f change make sense? Do not look for patterns in a series of answers Just because the last three questions all had “C ” for an answer, not expect that the next question must be “A.” There is no reason to expect that CFA Institute has any preference as to how many questions have one letter answer or another Be very sure that you mark your answer in the right place on the answer sheet If you skip questions or the topics out o f order, double check where you are putting your answers Mismarking can be devastating if you not catch it soon enough! Finally, not lose your confidence Nobody gets a perfect score on the CFA exam; it just does not happen Remember, the passing score is less than 70% — that means you can answer more than 30% o f questions (108 points) incorrectly and still pass Even if you begin to struggle on a few questions (or even five or six in a row), not lose your confidence W hat to Do W ith a Difficult Question in an Item Set You will run into questions that give you trouble You might not understand the question, you may think none o f the answers make sense, or you may not know that concept Here are some tips to follow if you find yourself facing a difficult question: • • If the question does not make sense, or if none o f the answers look correct, reread the question to see if you missed something If you are still unsure, mark an answer choice and move on N ever leave an answer blank A blank answer has a maximum point value o f zero A randomly marked answer has an expected value o f 0.33 x = 1.0 point You are not penalized for wrong answers, so it pays to guess Time Management: General Comments Candidates who fail the CFA exam frequently cite time management as their biggest downfall Here are some tips to help you manage your time wisely: • • • • Take at least one practice exam and time yourself This will give you some indication o f whether you will have problems on exam day One way to alleviate time pressure is to bank a few minutes by doing an easy topic first Select a topic with which you feel comfortable and go there Pace yourself Don’t rush excessively, but even more importantly, be sure not to get bogged down If you run into an especially long or tough question, don’t dwell on it Take an educated guess and come back to it later if time permits Page 184 © 2017 Kaplan, Inc Essential Exam Strategies Exam Day Tips Keep the following in mind going into your test: • • • • • • • • • • • • • • • Check your passport to make sure it doesn’t expire before exam day Print your exam ticket from the CFA Institute website Make sure your name appears on the ticket the same way as in your passport Don’t write anything on your exam ticket Read the Testing Policies page on the CFA Institute website Visit your test site before exam day to plan for travel time, parking, and lunch Have a lunch destination planned beforehand Get plenty of sleep the night before; don’t stay up cramming Review the Code and Standards the day before the exam The exam room might be either too hot or too cold Layer your clothing Get to the testing site early, so you are not rushed Expect a crowd at the larger sites Don’t unseal your exam packet until the proctor tells you to Don’t assume anything that is not given in the question Don’t jump to conclusions; read all three answer choices Fill in an answer for every question There is no penalty for guessing; all that counts is the number o f correct answers Do not let your eyes wander around the room Never look at or even give the appearance o f looking at another candidate’s paper Put your pencil down immediately when the proctor calls time Don’t be that guy! © 2017 Kaplan, Inc Page 185 In d e x c A abandonment options 66 ability to tolerate risk 162 absolute convergence 41 accounting income 67 accumulated postretirement benefit obligation (APBO) 53 acquisition forms 79 acquisition method 47 acquisitions 77 active investment strategies 165 active risk 166 adjusted beta 88 after-tax operating cash flow 63 agency relationship 76 amortization and deferral of gains or losses 51 amortization of unrecognized prior service cost 51 analysis of variance (ANOVA) 14, 15 antitrust action 81 arbitrage opportunity 165 arbitrage pricing theory (APT) 165 asset purchase 78 asset purchase option 48 asymmetric information 70 at-risk equity investment 48 attitude of target management 79 autoregressive (AR) model 18 Autoregressive Conditional Heteroskedasticity (ARCH) 23 B bear hug 79 beta estimation 88 binomial option pricing model (OPM) 134 Black-Scholes-Merton (BSM) model 135 bootstrapping 77 bottom-up analysis 89 breadth 174 Page 186 calculating the translation gain or loss 56 call option 135 capital budgeting 63 capital rationing 66 capital structure 68, 70, 71 carried interest 158 cash divestitures 84 cash flow estimation 63, 64 cash offer 84 CFA Institute Research Objectivity Standards chain rule of forecasting 19 choice of accounting method 47 claims valuation 68 classical growth theory 40 clawback 158 club convergence 41 Code of Ethics coefficient instability 22 coefficient of determination 15 cointegration 22 commercial real estate 172 comparable company analysis 82 comparable transaction analysis 82 compensation arrangements conditional convergence 41 conditional VaR 169 confidence interval 16 confidentiality conflicts of interest conglomerate mergers 77 consolidation requirements 49 consolidations 77 constant variance 12 consumption-hedging properties of equity 172 continuing residual income 103 control mechanisms 155 corporate governance 76 corporate governance terms 158 © 2017 Kaplan, Inc Index correlation 11,25 correlation coefficient 11 costs of financial distress 70 country-specific factors 72 covariance stationary 19 Cox-Ingersoll-Ross (CIR) model 111 credit default swap (CDS) 124 credit ratings 122 credit scores 122 credit spreads 172 cumulative translation adjustment (CTA) 56 currency forwards 130 currency swap 131, 132 current rate method 55, 56 D debt guarantee 48 debt securities held-to-maturity 44 decision making 25 decision trees 26, 67 defined-benefit plan 50 delta 138 delta-neutral hedging 138 delta-neutral portfolio 138 diligence direct capitalization method 145 discounted cash flow (DCF) 81, 91 discounted cash flow method 145 discount rate 52, 66 distributed to paid-in capital 158 distribution waterfall 158 dividend discount models (DDMs) 91 dividend policy 72 Dornbusch overshooting model 36 due diligence 156 dynamic hedge 138 E earnings sustainability 58 earn-outs 155 economic growth 27 economic income 67 economic profit 68,91 economies of scale 89 effective duration 111 effective tax rate 57 effect of price 84 endogenous growth theory 41 enhanced active strategies 165 equity carve-outs 84 equity method 46 equity swap 131, 133 equity valuation process 85 equivalent annual annuity (EAA) approach 65 ethics evaluating the profitability of real options 67 ex-ante tracking error 169 execution algorithms 175 exit routes 157 expansion project 63 expected loss 121 expected return on plan assets 51, 52 externalities 64 F factor risk premiums 166 factors 71 factor sensitivities 166 fair dealing Fama-French model 88 Financial Accounting Standards Board (FASB) 48 financial leverage ratios 57 financial ratios 57 firm value 71 first differencing 20 fixed income securities 128 flexibility options 67 forward contract 126, 127 forward rate agreements (FRAs) 128 forwards on fixed income securities 128 free cash flow (FCF) 81 free cash flow (FCF) models 91 free cash flow to equity (FCFE) 95 free cash flow to the firm (FCFF) 95 functional currency 54 fundamental factor models 166 fundamental law of active portfolio management, the 174 fundamental options 67 fundamental pension assumptions 52 © 2017 Kaplan, Inc Page 187 Index G K GAAP 44 gamma 139 Gordon growth model 92 growth relative to GDP growth approach 89 key man clauses 158 key rate duration 111 knowledge of the law H lease residual guarantee 48 legal and regulatory constraints 163 linear relationship 12 linear trend model 17 liquidations 84 liquidity constraints 163 liquidity preference theory 110 liquidity ratios 57 local expectations theory 110 log-linear trend model 18 loss given default 121 loyalty Herfindahl-Hirschman Index (HHI) 80 heteroskedasticity 17 HHI concentration level 81 high-frequency algorithms 173 historical average EPS 98 H-model 92 holding period return 87 Ho-Lee model 111 horizontal mergers 77 hurdle rate 66, 158 hybrid analysis 89 I IFRS 44 incremental VaR 169 independence independently distributed 12 independent variable 12 index CDS 124 individual and institutional investors 164 industry life cycles 78 information coefficient 174 information ratio 166, 173 initial investment outlay 63 Integrity of Capital Markets intercorporate investments 44 interest cost 31 interest rate swap 131 investment analysis investment constraints 163 investment objectives 162 Investment Policy Statement (IPS) 164 investments in trading securities 44 J justified price multiple 97 Page 188 L M macroeconomic factor models 166 marginal VaR 169 market growth and market share approach 89 market manipulation market timer 174 mean reversion 20 merger bid 83 merger motivations 78 mergers 77 merger target 81 method of comparables 97, 101 method of forecasted fundamentals 97 method of payment 79 minority interest 47 misconduct misrepresentation MM Propositions 68, 70 Monte Carlo simulation 66 motivations 77 multicollinearity 17 multifactor model 88 multinational operations 54 multiple regression 12, 14 multistage residual income model 103 mutually exclusive projects with unequal lives 64 © 2017 Kaplan, Inc Index N neoclassical growth theory 40 net agency costs 70 noncompete clauses 155 non-pension postretirement benefits 53 nonpublic information normally distributed 12 N-period swap 131 o objectivity one-period binomial tree 134 operating efficiency ratios 57 opportunity cost 101 option pricing models 67 primary beneficiary 49 private equity 154 private equity risk factors 158 probability distributions 25 probability of default 121 professionalism profitability ratios 57 projected benefit obligation (PBO) 50 project risk analysis 65 proxy battle 79, 80 pure monetary model 36 put-call parity 133 Q quantitative methods 11 R P paid-in capital 158 participation rights 48 passive investment strategies 165 Pastor-Stambaugh model 88 payer swaption 137 payment method 84 pecking order theory 70 PEG ratio 99 pension assumptions 52 phase of the business cycle 172 portfolio concepts 162 portfolio management process 162 post-offer defense mechanisms 80 PRAT model 95 predicted Y-value 12 preferred habitat theory 110 pre-offer defense mechanisms 80 presentation present value of expected loss 121 present value of growth opportunities (PVGO) 93 price-to-adjusted CFO (P/CFO) 101 price-to-book (P/B) ratio 99 price-to-cash-flow ratios 100 price-to-EBITDA 101 price-to-FCFE 101 pricing a currency swap 132 pricing an FRA 129 pricing contracts 126 pricing swaps 130 random walk 20 ratchet 158 rate of compensation increase 52 real options 66 reasonable basis receiver swaption 137 record retention reduced form models of corporate credit risk 123 referral fees regression analysis 12 regulatory arbitrage 43 regulatory capture 43 relative purchasing power parity 32 relative VaR 169 remeasurement 54 replacement chain approach 65 replacement project 64 Research Objectivity Standards residual income model 68, 91, 102 residual term 12 residual value to paid-in capital 158 restructuring 84 return objectives 163 rho 138 risk assessment 26 risk-controlled active strategies 165 risk objectives 162 risk tolerance 162 root mean squared error (RMSE) 21 © 2017 Kaplan, Inc Page 189 Index s scenario analysis 26, 65 seasonality 21 segmented markets theory 110 semi-active strategies 165 sensitivity analysis 65 serial correlation 17 service cost 51 share-based compensation 53 Sharpe ratio 173 simulation 25, 26 special purpose entity (SPE) 48 spin-offs 84 split-offs 84 standard error of estimate (SEE) 15 Standards of Professional Conduct 1, static trade-off theory 70, 71 statistical factor models 166 statutory merger 77 statutory tax rate 57 stock offer 84 stock purchase 78 strategic asset allocation 165 structural change 22 structural models of corporate credit risk 122 subordinated debt 48 subsidiary merger 77 suitability sunk costs 64 sustainable growth rate (SGR) 94 swaptions 137 synthetic instruments 133 T tag-along, drag-along 155 takeover defense mechanisms 80 target fund size 158 tax constraints 163 temporal method 54, 55, 57 tender offer 80 terminal year after-tax non-operating cash flow (TNOCF) 64 Page 190 term structure of credit spreads 123 test statistics 13 theta 138 time horizon constraints 163 time-series analysis 17, 24 timing options 66 top-down analysis 89 total periodic pension cost 51 total return perspective 163 total value to paid-in capital 158 tracking risk 166 trading securities 44 trailing basis 98 transaction characteristics 78 transfer coefficient 174 translation 54, 56, 57 u unbiased expectations theory 110 unique circumstances 163 unit root 20 U.S GAAP 45 V valuation models 68 valuation of forward contracts 126 value added by active management 173 valuing a currency swap 132 valuing an FRA 129 valuing futures contracts 128 valuing swaps 130 variable interest entity (VIE) 48 Vasicek model 111 vega 138 venture capital 156 vertical mergers 77 vintage 158 voluntary divestitures 84 voting control 49 Y yield 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