CFALevel II

ASSOCIATION FOR INVESTMENT MANAGEMENT AND RESEARCH®

Study Guide

®

CFA®

Receipt of this Study Guide is not con-firmation of your enrollment in theCFA Program. If you do not receive anenrollment acceptance letter or letter ofincomplete application within twomonths from the date you mailed yourapplication, please contact AIMR.

®

2003C H A RT E R E D F I NA N C I A L A NA LY S T™ P ROG RA M

AIMR Board of Governors, 2002–2003 The AIMR Governors are elected representatives of the membership. The Governors are responsible for overseeing all aspects of AIMR activities, including education of CFA candidates and members, member and society services, advocacy, and professional conduct. Dwight D. Churchill, CFA, Chair

Fidelity Management & Research Co. Merrimack, New Hampshire

Theodore R. Aronson, CFA, Vice Chair Aronson + Partners Philadelphia, Pennsylvania

Philippe A. Sarasin, CFA, Immediate Past Chair Lombard, Odier & Cie Geneva, Switzerland

Thomas A. Bowman, CFA, President and CEO AIMR Charlottesville, Virginia

Robert E. Angelica, CFA AT&T Investment Management Corp. Basking Ridge, New Jersey Jeffrey J. Diermeier, CFA UBS Global Asset Management (Americas) Inc. Chicago, Illinois Frank C. Dohn, CFA

Bankers Trust Company Los Angeles, California

Vincent Duhamel, CFA State Street Global Advisors Hong Kong

Denise M. Farkas, CFA Spero-Smith Investment Advisers, Inc. Beachwood, Ohio

Khalid Ghayur, CFA MSCI Princeton, New Jersey

Emilio Gonzalez, CFA Perpetual Investments Sydney, Australia

Monique E.M. Gravel, CFA

CIBC World Markets Inc. Montreal, Canada

Amaury Jordan, CFA Infidar Investment Advisory Ltd. Zurich, Switzerland

Cheryl-Ann E. Lister, CFA

Bermuda Monetary Authority Hamilton, Bermuda

Janet T. Miller, CFA Rowland & Company Atlanta, Georgia

George W. Noyes, CFA Standish Mellon Asset Management Boston, Massachusetts

Yoshiharu Okazaki, CFA

Pictet Asset Management (Japan) Ltd. Tokyo, Japan

John C. Stannard, CFA Frank Russell Company London, United Kingdom

Malcolm M. Trevillian, CFA

Franklin Street Partners Chapel Hill, North Carolina

Donald W. Trotter, CFA Atlantic Asset Management Overland Park, Kansas

Association for Investment Management and Research Setting a Higher Standard for Investment Professionals Worldwide™

2003 CFA® Level II Study Guide

©2002 Association for Investment Management and Research

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying,

recording, or otherwise, without the prior written permission of the copyright holder. Chartered Financial Analyst®, CFA®, and AIMR® are marks of the

Association for Investment Management and Research.

IBSN 0-935015-82-5

Printed in the United States of America

ASSOCIATION FOR INVESTMENT MANAGEMENT AND RESEARCH®

P.O. Box 3668 Charlottesville, Virginia 22903 U.S.A.

Telephone: 434-951-5499 or 800-247-8132 Fax: 434-951-5262

Email: info@aimr.org www.aimr.org

Acknowledgments AIMR wishes to thank the volunteers and consultants who are members of the Candidate Curriculum Committee (CCC) and the Council of Examiners (COE). These volunteers and consultants have earned their CFA charters; they represent AIMR’s global and professional diversity and bring a wide variety of experience to the curriculum and examination process. Without their hard work and dedication, the CFA Study and Examination Program could not maintain its rigorous standards or continue its educational services to the investment community. 2001-2002 Candidate Curriculum Committee The CCC is responsible for editorial review of the CFA curriculum and general oversight of the CFA curriculum process Peter B. Mackey, CFA, Chair Washington, DC James W. Bronson, CFA Newport Beach, California Barbara G. Cornyn, CFA Washington, DC John H. Crockett, CFA Fairfax, Virginia

Jean-Francois Delisle, CFA Levis Quebec, Canada Bradley J. Herndon, CFA Indianapolis, Indiana Barbara A. MacLeod, CFA Delaware, Ohio Douglas J. Manz, CFA Corrales, New Mexico

Alan M. Meder, CFA Chicago, Illinois Matthew H. Scanlan, CFA San Francisco, California George H. Troughton, CFA Chico, California

2002-2003 Council of Examiners The COE is responsible for writing the Item Set and Essay portions of the CFA examinations. Thomas B. Welch, CFA, Chair Saint Louis, Missouri Andrew J. Abouchar, CFA Waterloo, Ontario, Canada Richard O. Applebach, Jr., CFA Louisville, Kentucky William A. Barker, CFA Ottawa, Ontario, Canada Susan A. Borrelli, CFA Atlanta, Georgia Michael A. Broihahn, CFA Miami, Florida Richard A. DeFusco, CFA Lincoln, Nebraska Carolyn Cosgriff East, CFA Dallas, Texas Marilyn J. Ettinger, CFA Jersey City, New Jersey Timothy D. Fyffe, CFA Lexington, Kentucky Jacques R. Gagne, CFA Quebec City, Canada

Susan Rowe Ingram, CFA Raleigh, North Carolina James G. Jones, CFA Bolivar, Missouri Dorothy C. Kelly, CFA Charlottesville, Virginia Robert E. Lamy, CFA Winston-Salem, North Carolina Jeffrey D. Lorenzen, CFA Des Moines, Iowa John L. Maginn, CFA Omaha, Nebraska Michael G. McMillan, CFA Annandale, Virginia Gregory M. Noronha, CFA Glendale, Arizona Michael D. O’Brien, CFA Los Angeles, California Kathy L. Pilgrim, CFA Dallas, Texas

Thomas R. Robinson, CFA Coral Gables, Florida William H. Sackley, CFA Wilmington, North Carolina Sandeep Singh, CFA Brockport, New York David M. Smith, CFA Albany, New York Gary C. Sanger, CFA Baton Rouge, Louisiana George Spentzos, CFA London, United Kingdom David B. Stevens, CFA Minneapolis, Minnesota John D. Stowe, CFA Columbia, Missouri Mohan Subbiah, CFA London, United Kingdom

Curriculum and Examinations The Curriculum and Examinations Department of AIMR is composed of staff professionals who assist the AIMR Governors, the Candidate Curriculum Committee, and the Council of Examiners to develop and administer the CFA Program. Thomas A. Bowman, CFA, President and CEO Annette V. Abbott, Associate Robert R. Johnson, CFA, Senior Vice-President Nancy A. Dudley, Vice President Mary K. Erickson, CFA, Vice President Dennis W. McLeavey, CFA, Vice President Jan R. Squires, CFA, Vice President Donald L. Tuttle, CFA, Vice President Philip J. Young, CFA, Vice President Jerald E. Pinto, CFA, Visiting Scholar Marcia L. Akers, Associate Colleen I. Anderson, Associate Tabatha C. Callander, Associate Maureen L. Coppa, Associate

Aimee E. Dick, Associate Matthew B. Ehrich, Associate Barbara P. Evans, Associate Carey M. Hare, Associate Julie A. Hilton, Associate Dorothy L. Kirby, Associate Wanda A. Lauziere, Associate John H. Mastrandea, Associate Lisa M. McDonald, Associate Terry M. Murphy, Associate Z. Mahala Page, Associate Sara C. Schwind, Associate Katherine L. Stephens, Associate Jenis D. Tapscott, Associate Jan M. Walton, Associate Helen K. Weaver, Associate

Contents Introduction....................................................................................................................................................... 1 CFA Program Background ............................................................................................................................... 1 CFA Program Outline ....................................................................................................................................... 2 Preparing for the Level II Examination ............................................................................................................ 7 Taking the Level II Examination ...................................................................................................................... 8 Completing the CFA Program ........................................................................................................................ 17 CFA Program Calendar .................................................................................................................................. 20 2003 CFA Study and Examination Program Textbooks: Primary Readings .................................................. 21 Ethical and Professional Standards Study Session 1 ............................................................................................................................................... 23 Study Session 2 ............................................................................................................................................... 25 Investment Tools Study Session 3. Quantitative Methods for Valuation .................................................................................... 27 Study Session 4. Economics for Valuation..................................................................................................... 31 Study Session 5. Financial Statement Analysis: Intercorporate Investments and Business Combinations .... 36 Study Session 6. Financial Statement Analysis: Global Issues....................................................................... 39 Study Session 7. Financial Statement Analysis: Earnings Quality Issues ...................................................... 41 Asset Valuation Study Session 8. Basic Valuation Concepts.................................................................................................... 44 Study Session 9. Equity Investments: Industry and Company Analysis......................................................... 46 Study Session 10. Equity Investments: Valuation Models ............................................................................. 49 Study Session 11. Equity Investments: Valuation Models and Applications ................................................. 52 Study Session 12. Equity Investments: Special Valuation Cases ................................................................... 55 Study Session 13. Debt Investments: Credit Analysis .................................................................................... 57 Study Session 14. Debt Investments: Valuation Issues .................................................................................. 59 Study Session 15. Debt Investments: Structured Securities............................................................................ 63 Study Session 16. Derivative Investments: Futures and Swaps...................................................................... 67 Study Session 17. Derivative Investments: Options ....................................................................................... 72 Portfolio Management Study Session 18. Capital Market Theory and Asset Pricing ......................................................................... 75

Introduction

Congratulations on becoming a Level II candidate in the Chartered Financial Analyst (CFA) Study and Examination Program. The charter you seek is respected around the world as a mark of accomplishment and dedication, and each of the three levels of the program represents a distinct achievement in professional career development. Passing Level I was a significant milestone and studying for Level II will expand your knowledge and enhance your skills in investment analysis and portfolio management.

Level II Study Guide The purpose of the CFA Program is to help candidates learn. This Level II study guide is intended to help you plan a comprehensive self-study program to master the concepts contained in the AIMR Candidate Body of Knowledge and prepare for the 2003 CFA examination. The study guide includes the following contents:

1. Background information about the Association for Investment Management and Research (AIMR) and the CFA Program.

2. An outline of the CFA Program. 3. Guidelines for preparing for the CFA Level II

examination. 4. Suggestions for taking the CFA Level II

examination. 5. Information about completing the CFA

Program. 6. A calendar of important CFA Program dates. 7. A suggested study program encompassing 18

study sessions that cover the four functional areas in the Candidate Body of Knowledge (ethical & professional standards, investment tools, asset valuation, and portfolio management).

8. Instructions for ordering textbooks and an order form from PBD Worldwide Fulfillment Services, distributor of textbooks and other materials in the CFA curriculum.

CFA Program Background Background AIMR is a global nonprofit organization with 116 Member Societies and Member Chapters and more than 160,000 members and candidates—investment analysts, portfolio managers, and other investment decision makers employed by investment firms, banks, broker/dealers, investment company

complexes, insurance companies, agencies, and universities. The association’s mission is to serve investors through its membership by providing global leadership in investment education, sustaining high standards of professional conduct, and administering the CFA Program. AIMR also is widely known for its Global Investment Performance Standards (GIPS®), which provide professionals with a global standard for reporting investment results.

AIMR was formed in January 1990 through the merger of the Institute of Chartered Financial Analysts (ICFA) and the Financial Analysts Federation (FAF). The ICFA was the original grantor of the CFA designation, and the FAF was the umbrella organization for financial analyst societies.

Program History During the 39-year history of the CFA Program, over 407,000 examinations have been administered to candidates and more than 50,000 charters have been awarded. The dramatic growth in candidates and charterholders is indicative of the CFA Program’s focus on a relevant curriculum, rigorous examinations, and the highest professional conduct, and also reflects a strong desire among financial professionals to achieve and maintain high standards.

AIMR Member Societies and Member Chapters Many candidates find membership in an AIMR Member Society or Chapter to be a valuable part of their preparation for the examinations. Societies and chapters are made up of leading investment professionals who can offer experienced perspectives on topics covered in the Candidate Body of Knowledge. Most societies and chapters also offer educational programs, designed to enhance practicing professionals’ knowledge of the business, which also may be of interest to candidates. Finally, many societies and chapters sponsor candidate study groups and preparatory courses. To locate the local society nearest you, contact AIMR at (phone) 434-951-5499 or 800-247-8132, (fax) 434-951-5262, (e-mail) info@aimr.org, or visit the AIMR Web site www.aimr.org.

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CFA Program Outline

AIMR Candidate Body of Knowledge The CFA curriculum is grounded in the practice of the investment profession. AIMR periodically conducts a job analysis involving CFA charterholders around the world to determine those elements of the body of investment knowledge and skills that are important to charterholders in their practice. The most recent job analysis was completed in 2001. The survey results define the Candidate Body of Knowledge (CBOK) and to determine how much emphasis each of the major topic areas receives on the CFA examinations.

The CBOK is organized into four major topic areas: ethical and professional standards, tools and inputs for investment valuation and management, asset valuation, and portfolio management and performance presentation. The topic areas covered in the CFA Program are shown in the CBOK outline that begins on page 3.

Two features of the CBOK are especially relevant

to the CFA examinations. First, the curriculum for each level of the CFA Program is organized primarily around a functional area: • The Level I study program emphasizes tools and

inputs and includes an introduction to asset valuation and portfolio management techniques.

• The Level II study program emphasizes asset valuation and includes applications of the tools and inputs (including economics, financial statement analysis, and quantitative methods) in asset valuation.

• The Level III study program emphasizes portfolio management and includes strategies for applying the tools, inputs, and asset valuation models in managing equity, fixed-income, and derivative investments for individuals and institutions.

Second, because they are an integral part of the other three functional areas of investment management, ethical and professional standards are covered at all three levels of the curriculum.

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CFA Candidate Body of Knowledge (CBOK) Outline Following is an outline of the major topics in the CBOK. A detailed presentation of the CBOK can be found on the AIMR Web site at www.aimr.org/cfaprogram/cbok.html.

Ethical and Professional Standards 1. Professional Standards of Practice 2. Topical Issues Quantitative Methods 1. Time Value of Money 2. Basic Statistical Concepts 3. Probability Concepts and Random Variables 4. Common Probability Distributions 5. Sampling and Estimation 6. Statistical Inference and Hypothesis Testing 7. Correlation Analysis and Linear Regression 8. Multivariate Regression 9. Time Series Analysis 10. Portfolio Concepts Economics 1. Market Forces of Supply and Demand 2. Elasticity 3. The Firm and Industry Organization 4. Supply and Demand for Productive Resources 5. Measuring National Income 6. Economic Fluctuations and Unemployment 7. The Monetary System 8. Inflation: Causes and Consequences 9. International Trade 10. International Finance 11. The Macroeconomics of an Open Economy 12. Aggregate Demand and Aggregate Supply 13. Sources of Economic Growth 14. Government Regulation 15. Natural Resource Markets 16. Relationship of Economic Activity to the Investment Process Financial Statement Analysis 1. Financial Reporting System 2. Principal Financial Statements 3. Earnings Quality and Nonrecurring Items 4. Analysis of Inventories 5. Analysis of Long-Lived Assets 6. Analysis of Income Taxes 7. Analysis of Financing Liabilities 8. Analysis of Leases 9. Analysis of Off-Balance-Sheet Activities 10. Analysis of Pensions, Stock Compensation, and Other Employee Benefits 11. Analysis of Inter-Corporate Investments 12. Analysis of Business Combinations 13. Analysis of Multinational Operations 14. Ratio and Financial Analysis Corporate Finance 1. Fundamental Issues 2. Capital Investment Decisions 3. Business and Financial Risk 4. Long-term Financial Policy 5. Mergers and Acquisitions 6. Valuation Implications of Corporate Finance

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Analysis of Equity Investments 1. Organization and Functioning of Securities Markets 2. Security Market Indexes and Benchmarks 3. Equity Risk Definition and Measurement 4. Fundamental Analysis 5. Special Applications of Fundamental Analysis 6. Technical analysis Analysis of Debt Investments 1. Debt Securities 2. Risks Associated with Investing in Bonds 3. Global Bond Sectors and Instruments 4. Yield Spreads 5. Introduction to the Valuation of Debt Securities 6. Yield Measures, Spot Rates, and Forward Rates 7. Measurement of Interest Rate Risk 8. The Term Structure and Volatility of Interest Rates 9. Valuing Bonds with Embedded Options 10. Mortgage-Backed Securities (MBS) 11. Asset-Backed Securities 12. Valuing Mortgage-Backed and Asset-Backed Securities 13. Assessing Trading Strategies 14. Principles of Credit Analysis Analysis of Derivatives 1. Derivative Markets and Instruments 2. Forward Markets and Instruments 3. Futures Markets 4. Options Markets 5. Swaps Markets Analysis of Alternative Investments 1. Real Estate 2. Investment Companies 3. Venture Capital 4. Hedge Funds 5. Closely-held Companies 6. Distressed Securities/Bankruptcies 7. Commodity Markets and Commodity Derivatives Portfolio Management 1. Capital Market Theory 2. Management of Individual Investor Portfolios 3. Management of Institutional Investor Portfolios 4. Pension Plan and Employee Benefit Funds 5. Endowment Funds and Foundations 6. Insurance Companies 7. Other Corporate Investors 8. Capital Market Expectations 9. Asset Allocation 10. Portfolio Construction and Revision 11. Equity Portfolio Management Strategies 12. Debt Portfolio Management Strategies 13. Real Estate and Alternative Investments in Portfolio Management 14. Risk Management 15. Performance Measurement 16. Presentation of Performance Results

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Curriculum Structure Mastery of the CBOK is the major purpose of the CFA Program. The Level II curriculum is organized into 18 study sessions, each devoted to a particular topic area that is part of the CBOK. The examinations, though an important step toward achieving the CFA charter, are designed primarily to help you demonstrate competency in the CBOK as set forth in the CFA curriculum. As you design your personal study program, you should emphasize mastery of the CBOK and the practical application of that knowledge.

Readings in the curriculum are designated either Preliminary or Assigned: • Preliminary Readings may be included to help

candidates who need to review fundamental concepts and techniques or who have a weak background in a particular area.

• Reading Assignments are the core of the study sessions and form the primary basis for the examination questions, although examination questions also may draw upon Preliminary Readings.

Many of the readings have end-of-chapter questions, problems, or appendixes that demonstrate useful applications of concepts provided in the text material. Unless these exercises or appendixes are specifically assigned, however, you should focus your study on the text material and the examples provided therein.

Learning Objectives and Learning Outcome Statements The Candidate Curriculum Committee (CCC) and AIMR staff choose curriculum materials to reflect the CBOK. Learning objectives, which are common in various forms at all levels of education, are integral to the CFA curriculum and examination process. The CFA candidate curriculum uses two types of learning objectives: (1) topic-level learning objectives and (2) reading-specific learning outcome statements (LOS). A collection of topic-level learning objectives and reading-specific LOS makes up each study session; the primary purpose of topic-level learning objectives and LOS in the CFA curriculum is to enhance candidate learning.

Topic-Level Learning Objectives Topic-level learning objectives give a broad overview of the material to be learned and indicate the depth of knowledge expected. These learning objectives are shown in boxes preceding the first

study session in a particular topic area. For instance, the topic-level learning objective for Ethical and Professional Standards is located at the start of Study Session 1.

Level I is the foundation for the CFA Program and provides the basic tools of asset valuation and inputs for portfolio management. The Level I topic-level learning objectives require you to • have a thorough understanding (i.e., full and

complete comprehension) of the AIMR Code of Ethics and Standards of Professional Conduct;

• demonstrate a thorough understanding of important investment tools—quantitative methods, economics, and financial statement analysis;

• have a working knowledge (i.e., useful understanding) of the fundamentals of risk and return, asset valuation, and portfolio management—including the basic measurements of risk and return, the common approaches to valuing assets, and the key elements of the portfolio management process.

Based on the knowledge and skills you developed at Level I, the topic-level learning objectives for Level II require you to • analyze and value debt, equity, and derivative

assets and recommend those assets with the most (or least) attractive expected return–risk characteristics for purchase (or sale);

• apply a top-down valuation approach based on global trends, national economies, industry- and company-specific factors, and individual asset characteristics;

• apply an alternative (bottom-up) approach involving the identification of those companies and industries/sectors that are under- or overvalued regardless of the macroeconomic forecast;

• use a variety of valuation techniques, as well as the DuPont approach to financial analysis;

• incorporate international factors in asset valuations;

• apply knowledge of the AIMR Code of Ethics and Standards of Professional Conduct to recognize and avoid unprofessional practices and violations of standards in a variety of conduct areas.

Based on the knowledge and skills you developed at Level I and Level II, the Level III topic-level learning objectives require you to • develop suitable investment policies that meet

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the specific requirements and circumstances of individual and institutional investors;

• incorporate domestic and international economic forecasts and capital market conditions into portfolio investment strategies;

• determine asset allocations that are consistent with investment policies and strategies;

• implement portfolio strategies that consider the costs and benefits of timely execution;

• monitor and evaluate portfolio performance and respond to changes in requirements and circum-stances;

• anticipate potential professional conduct problems and create compliance procedures based on the AIMR Code of Ethics and Standards of Professional Conduct to resolve or adequately address those problems;

• create a performance presentation that complies with the GIPS standards; and evaluate and recommend changes to a sample performance presentation that would bring the presentation into compliance with the GIPS standards;

• support your recommendations relating to portfolio management topics, constructively critique the recommendations of others, and suggest changes to improve results.

Learning Outcome Statements Reading-specific LOS are listed for each reading in each study session. In general, LOS help you understand how each reading addresses the learning objective for the topic, and for a particular reading the LOS indicate what you should be able to accomplish after studying that reading. Because the relevant material is often concentrated in a specific part of the assigned reading, another objective of the LOS is to focus your study toward specific sections and away from other material (such as an author’s opinion or extraneous details) that is less relevant to the topic-level learning objectives. Thus you should use the LOS to guide and focus your study.

The LOS link the Candidate Body of Knowledge to the curriculum and the CFA examinations. LOS guide the examinations as well as the candidates; the LOS indicate to the Council of Examiners what examination questions the curriculum will support. Each examination question is based explicitly on one or more LOS; however, the examination question may go beyond the one or two command words typically used in the LOS. For instance, given a LOS that contains the command word “calculate,” candidates should be prepared not only to perform

the indicated calculation but also to discuss, de-scribe, explain, and otherwise address the calculation, the formula(s) on which the calculation is based, and the results of the calculation. Also, candidates should be aware that examination questions, especially at Level III, may combine or synthesize LOS from several study sessions and/or topics. The LOS should not, therefore, be viewed as a proxy for examination questions. Nevertheless, if you can accomplish the goals set forth in the LOS, you should be able to perform successfully on the examinations.

Both LOS and the essay examinations use command words to guide you (see page 12 for a complete list and description of command words). In the LOS, command words indicate the degree of understanding required. On the essay examinations, the command words indicate what you must do to answer the question successfully. Although many Level II item set examination questions do not use specific command words, part of your preparation and study should include becoming familiar with these command words as they are used in LOS. Even though you obviously cannot “draw a profit or loss diagram” in an item set context, for instance, you can evaluate, analyze, or interpret a drawn diagram that is provided. Developing the ability to draw the diagram certainly improves your ability to evaluate, analyze, or interpret the diagram.

Exam Questions and Exam Levels Examination questions at a given level of the CFA Program will not be based explicitly on LOS from another level. Candidates, however, should recognize the essential “building block” nature of the program, and their preparation should reflect the fact that certain curricular materials at Levels II and III necessarily extend from material at prior levels.

Study Materials The 2003 curriculum includes professional journal articles, textbooks, and other readings designed to help you master the topics in the Candidate Body of Knowledge, and the study sessions contained in this study guide address all those readings. A complete list of the textbooks required for all three levels of the CFA examination appears on page 21.

Past essay examination questions and guideline answers provided to candidates are also a major part of the curriculum. You are expected to be familiar with the content of the past three years’ Level II essay examinations. A careful review of this material will help you identify topics that have been

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tested in the past. Note, however, that the curriculum changes from year to year and each examination is based on the curriculum assigned that year. You should study past examinations with the understanding that the 2003 curriculum outlined in this study guide will be the basis for the 2003 examinations. In addition, you should note that every examination is a sampling from the curriculum and that the sampling differs from year to year.

You should review the guideline answers carefully. Guideline answers are published after the examinations are graded and reflect the full scope of answers that merited credit. As a result, guideline answers are often more detailed than would be required for full credit on an actual examination and the published guideline answers may not reflect all answers that were given partial or full credit during the grading process. Nonetheless, the guideline answers are a useful addition to the CFA curriculum and your study program.

Preparing for the Level II Examination By successfully completing the Level I examination, you have demonstrated your ability to use the basic tools and techniques of investment analysis. As a Level II candidate, you can now turn your attention to applying those tools to the valuation of investment opportunities.

This study guide is the key to preparing for the Level II CFA examination. After reading this preliminary section, you should review the study sessions to gain an important overview of what needs to be accomplished during the coming months. (A one-page outline of these study sessions is provided on page 22.) Then order the appropriate textbooks and readings so you can begin your study. Candidate textbook ordering instructions and order forms are located in the back of this study guide. Textbooks will be available for purchase after October 1, 2002. Although many textbooks are used on more than one level, AIMR advises candidates to purchase the editions noted in this study guide. Using an outdated edition may result in in-complete preparation for certain parts of the examination.

Organizing Your Study Program An orderly, systematic approach to examination preparation and exam-taking strategy is critical to successful completion of the Level II examination. You should dedicate a consistent block of time every week to reading and studying. Complete all

reading assignments in each study session. Use the learning outcome statements to identify the relevant material and depth of knowledge required. Under-line, take notes, and highlight important points. AIMR estimates that you will need to devote 10–15 hours per week for 18 weeks to prepare adequately for the Level II examination. Allow a minimum of one week of study for each session, with completion scheduled for late April. This schedule will allow you to spend the final month before the examination reviewing the assigned readings, prior years’ examinations, and guideline answers. You will undoubtedly adjust your study time to conform to your own strengths and weaknesses, and you will probably spend more time on some study sessions than on others. You should allow ample time for both in-depth study of all topic areas and additional concentration in those topic areas for which you feel least prepared.

AIMR strives to develop examinations that are challenging, comprehensive, fair, and, relevant to the practice of investment management. Although each topic area will be represented on the examination, to address every reading or concept in a six-hour examination would be impossible, and constructing the examinations reflects a process of sampling from the curriculum. Candidates have found, however, that trying to anticipate the content or composition of a given year’s examination is not a successful preparation strategy. You should approach the curriculum primarily as a means of improving your knowledge and skills as an investment professional and secondarily as a way of preparing for the examination. A thorough understanding of all topics to the degree indicated in the LOS is the best preparation for answering questions on the examination.

Warning In the months following your enrollment in the CFA Program, you may receive numerous solicitations for preparatory courses and review materials. Although the CFA Program is designed as a distance learning, self-study program, AIMR under-stands that candidates have different learning styles. For some candidates, prep courses and/or review notes may facilitate the learning process. However, we strongly believe that such products should be complements to, not substitutes for, the prescribed curriculum. In designing the examinations, the Council of Examiners references only the

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curriculum prescribed by AIMR in the study guide and the LOS developed for that curriculum.

Furthermore, AIMR does not endorse, promote, review, or warrant the accuracy of the products or services offered by preparatory organizations. AIMR does not verify or endorse the pass rates or other claims made by these organizations.

As a service to candidates, AIMR makes candidate lists accessible to vendors of preparatory courses and review materials. Should you wish to have your name removed from any mailing lists made available to these organizations, please either check the appropriate box located in Section 11 of the enrollment form or contact AIMR at (phone) 800-247-8132 or 434-951-5499, (fax) 434-951-5262, (email) info@aimr.org, or visit the AIMR Web site at www.aimr.org

Candidate Bulletin To be fair to all candidates, AIMR does not respond directly to individual candidate inquiries about the content of the curriculum or examinations. As a forum to respond to candidates’ content-oriented questions, AIMR publishes and mails to enrolled candidates a Candidate Bulletin in approximately January and April. The Candidate Bulletins are also available on the AIMR Web site. If you have a question about curriculum or examination content, you should contact AIMR to have your question considered for inclusion in a Candidate Bulletin. Candidates should carefully read these Bulletins, which contain information about policy changes, where to direct curriculum questions, curriculum errata, answers to frequently asked questions, and notices of candidate disciplinary actions. Candidates who enroll after the first Bulletin is mailed will receive a copy of that issue with their Study Guide.

Questions about the administration of the examination are always welcomed at info@aimr.org, and will be answered individually.

AIMR Web site AIMR’s Web site (www.aimr.org) offers a private section devoted to CFA Candidate Services. This restricted-access section of the site, which is avail-able only to CFA candidates and AIMR members, contains valuable information for enrolled candidates about policies, deadlines, address

changes, and other issues. Candidates can download numerous documents from this section, including study guides, practice examination questions, guideline answers, and discounted subscription in-formation. Candidates can also download the forms required for duplicate examination results, special requests, and membership information. In addition, candidates may receive their examination tickets and results on-line from this private Candidate Services section.

To obtain your user name and password for the CFA Candidate Services section, go to www.aimr.org/canservices and follow the instructions. Visit the AIMR Web site often for up-to-date information about the CFA Program.

Taking the Level II Examination The 2003 CFA Level II examination will be given in two parts—a morning session of three hours and an afternoon session of three hours—for a combined total of 360 minutes and 360 points; therefore, the weight of each question is the same as the number of minutes allotted.

2003 Examination Guideline Topic Area Weights The periodic job analysis survey of practicing CFA charterholders not only identifies those elements of the body of investment knowledge that are important to the professional practice of investment management, but also helps the Council of Examiners determine approximately how much emphasis (weight) each of the major topic areas should receive on the CFA examinations. Those weights are shown in the following table and should be used to help allocate your study efforts. Because the curriculum is designed to help you gain knowledge about each topic area, the study sessions and the number of pages assigned in the curriculum does not necessarily match the examination topic weights and are not an indicator of the number of examination questions in each topic area. By design, the CFA examinations only sample the curriculum, and examination questions also may draw on a breadth of knowledge and a variety of skills.

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2003 Examination Guideline Topic Area Weights

Topic Survey Results Level I Level II Level III

Ethical and Professional Standards 10% 15% 10% 10% Investment Tools: • Economics* • Quantitative Analysis • Financial Statement Analysis**

10 10 20

10 12 28

0–10 0–10 25–35

0

0–10 0

Asset Valuation*** 35 30 35–45 30–40

Portfolio Management*** 15 5 5–15 40–60

TOTAL 100% 100% 100% 100%

*Economics is part of Portfolio Management at Level III. **Corporate Finance is part of Financial Statement Analysis at Level I. ***Derivatives are a part of both Asset Valuation (Level I and Level II) and Portfolio Management (Level III).

2003 Examination Format Weights The 2003 Level II examination will consist of 50 percent essay/short answer questions or problems (morning session) and 50 percent item sets (afternoon session). The following table shows the topic areas that will be tested in each examination format.

2003 Level II Examination Format Weights Topic Format Weight Minutes Ethical and Professional Standards Item Set 10% 36

Economics Item Set 10% 36

Quantitative Analysis Item Set 10% 36

Financial Statement Analysis Item Set 20% 72

Asset Valuation Essay 40% 144

Portfolio Management Essay 10% 36

TOTAL 100% 360

The above table shows the general weights assigned to topic areas in each examination format. However, candidates should recognize that, effective with the 2003 examination, any of the assigned topics may be tested in either format; topics may also be tested in combination in a particular format. Your preparation, therefore, should be focused on mastering the assigned LOS independent of any format considerations; in particular you are advised not to alter your preparation in any attempt to match topics and formats. Also, attempting to predict which topic will be tested in which format is

generally not a useful exercise.

Item Set Format and Examples The item set format consists of a vignette or short case situation followed by six multiple choice questions based on the vignette. To acquaint candidates with the scope and appearance of the item set format, two sample item sets are provided below. Note that these examples have fewer than the six multiple choice questions per item set on the examination. You should also note that, although these samples provide justification for each correct answer, you will not be required, or have the

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opportunity, to justify your answers in the actual examination item sets. Finally, these examples are intended only to illustrate the item set format; they should not be taken as an indication of the type of content or level of difficulty of item sets that will appear on the actual examination.

Item Set #1 (Ethics): Superior Asset Management has offices and provides investment advisory services to clients living in various countries. Each country has different securities laws and regulations and no prohibition exists against using material nonpublic information: • Home Country (HC) has no securities laws or

regulations. • Less Strict Country (LSC) has securities laws

and regulations that are less strict than the requirements of the AIMR Code and Standards and also states that the law of the locality where business is conducted governs.

• More Strict Country (MSC) has securities laws and regulations that are more strict than the requirements of the AIMR Code and Standards and states that the law of the locality where clients reside governs.

Superior wants to ensure that its portfolio managers comply with the applicable laws, rules, and regulations of the various countries where Superior does business. Specifically, Superior is concerned about the activities of the following four portfolio managers:

• Diane Grant, an AIMR member, resides in LSC but does business in HC and LSC.

• Brenda Klein, a candidate in the CFA Program, resides in LSC and manages accounts for clients who reside in either LSC or MSC. LSC law applies

• Chris Thompson, CFA, resides in MSC and does business in LSC with clients who are citizens of LSC. MSC law applies.

• John Wilson, an AIMR member, resides in HC and does business in HC, LSC, and MSC. LSC and MSC laws apply.

1. Which of the following best describes Grant’s

responsibility under the AIMR Standards of Professional Conduct? Grant may: A. not use material nonpublic information for

her HC clients, her LSC clients, or herself.

B. use material nonpublic information for her HC clients, LSC clients, and for herself.

C. use material nonpublic information for her HC clients but not for her LSC clients or herself.

D. use material nonpublic information for her HC clients and LSC clients but not for herself.

2. According to AIMR Standards, Klein must adhere to: A. AIMR Code and Standards for her LSC and

MSC clients. B. MSC laws and regulations for both LSC

and MSC clients. C. AIMR Code and Standards for her LSC

clients and MSC laws and regulations for her MSC clients.

D. LSC laws and regulations for her LSC clients and MSC laws and regulations for her MSC clients.

3. Thompson also manages accounts for clients who reside in MSC. According to AIMR Standards, Thompson must adhere to: A. MSC laws and regulations for her LSC and

MSC clients. B. AIMR Code and Standards for her LSC

and MSC clients. C. AIMR Code and Standards for her LSC

clients and MSC laws and regulations for her MSC clients.

D. LSC laws and regulations for her LSC clients and MSC laws and regulations for her MSC clients.

4. According to AIMR Standards, Wilson must adhere to: A. AIMR Code and Standards for his HC,

LSC, and MSC clients. B. The laws and regulations of MSC for his

HC, LSC, and MSC clients. C. AIMR Code and Standards for his HC and

LSC clients and the laws and regulations of MSC for his MSC clients.

D. The laws and regulations of HC for his HC clients, the laws and regulations of LSC for his LSC clients, and the laws and regulations for MSC for his MSC clients.

Item Set #1 Guideline Answers: 1. A is correct. Because applicable law is less

strict than the AIMR Code and Standards, the member must adhere to the Code and Standards,

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which say that material nonpublic information may not be used under any circumstances.

Exhibit 2 Variable Estimates for 2002 POP 34.7 INC 27.4 ADV 8.2

2. C is correct. When AIMR Code and Standards impose a higher degree of responsibility than applicable laws, the AIMR Code and Standards must be applied. This is the case for Klein’s clients in LSC. If applicable law is more strict than the requirements of the Code and Standards, however, members, CFA charterholders, and candidates in the CFA program must adhere to applicable law. This is the case for Klein’s clients in MSC.

Exhibit 3 Critical Values for Students t Distribution

Area in Upper Tail Degrees of Freedom 10% 5% 2.5% 16 1.3368 1.7459 2.1199 17 1.3334 1.7459 2.1098 18 1.3304 1.7341 2.1009 19 1.3277 1.7291 2.0930 20 1.3253 1.7247 2.0860

3. A is correct. An analyst or portfolio manager working in an international environment is required to have knowledge of the laws of the country where he or she is working. When involved with securities of a country with laws and regulations that are more strict than the AIMR Code and Standards, the stricter laws and regulations of the analyst’s home country (in this case MSC) prevail.

1. Using the regression model developed, the sales

forecast in millions of U.S. dollars for 2002 is closest to: A. 215. 4. C is correct. If applicable law is more strict than

the requirements of the AIMR Code and Standards, members, CFA charterholders, and candidates in the CFA program must adhere to applicable law. Thus, the Code and Standards apply to Wilson’s HC and LSC clients and the laws and regulations of MSC apply to his MSC clients.

B. 280. C. 417. D. 426.

2. The unadjusted R2 indicates that the intercept

and the independent variables together explain: A. 80.4% of total BoneMax annual sales. B. 80.4% of the variability of BoneMax annual

sales.

Item Set #2 (Quantitative Analysis) C. 89.7% of the variability of BoneMax annual

sales. Peggy Parsons, CFA, wants to forecast sales of BoneMax, a prescription drug for treating osteoporosis. Parsons has developed the sales regression model shown in Exhibit 1 and supporting data found in Exhibits 2 and 3 to assist in her sales forecast of BoneMax.

D. less than 20% of the variability of BoneMax annual sales.

3. At the 5 percent level of significance, is the

regression coefficient of the average income of U.S. women over the age of 60 (INC) significantly different from zero?

Exhibit 1 BoneMax Sales Regression Model SALES = 8.530 + 6.078 (POP) + 5.330 (INC) + 7.380 (ADV) t-values: (2.48) (2.23) (2.10) (2.75) Unadjusted R2=0.804 Number of observations = 20 annual observations

Notes: SALES = sales of BoneMax (US$ millions) POP = population (millions) of U.S. women over age 60 INC = average income (US$ thousands) of U.S. women over age 60 ADV = advertising dollars spent on BoneMax (US$ millions)

A. No, because 2.10 < 2.1199 B. Yes, because 2.10 > 1.7247 C. Yes, because 2.10 > 1.7459 D. Yes, because 2.10 > 2.0860

4. In testing the statistical significance of the regression coefficient of advertising dollars spent on BoneMax, Parsons must know which of the following inputs?

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5. The standard error of the estimated coefficient

for advertising dollars spent on BoneMax (ADV) is closest to: A. 0.373. B. 2.211. C. 2.684. D. 5.934.

Item Set #2, Guideline Answers 1. D is correct. 8.530 + (6.078 × 34.7) + (5.330 × $27.4) + (7.380 × $8.2) = $426.0 million. 2. B is correct. 3. A is correct because with df = 20 – (3+1) = 16

and a 2-tailed test = 2.5% area, the critical t-value = 2.1199. 4. D is correct because both inputs are necessary

to determine the statistical significance of an individual regression coefficient.

5. C is correct. The standard error is equal to 7.380/2.75.

Essay Format and Command Words The essay format consists of a question, which may contain several parts, that requires candidates to provide an open-ended or template-based response. You can become familiar with typical essay question formats by reviewing prior years’ examinations.

Each essay question will contain one or more “command” words. These words are printed in bold type in the examination question and are intended to direct your answer to the question. When more than one command word is used in a question (e.g., recommend and justify), you must respond to each command word and you should be certain your response to the second command (justification) is consistent with your response to the first command (recommendation). Some questions contain instructions about numbers in your answer; the numbers are given in italic font. Command words and italic numbers are both important. For example, “List and describe three methods of inventory accounting” is a six-part question that requires you

to list the names of three methods and provide a description of each method you listed.

Degrees of freedom

One-tailed or two-tailed test

A. No No B. No Yes C. Yes No D. Yes Yes

The following command words may be used on the 2003 Level II examination. Analyze: To study or determine the nature and

relationship of the parts of by analysis. Appraise: To judge and analyze the worth,

significance, or status of. Arrange: To put into a proper order or into a

correct or suitable sequence, relationship, or adjustment.

Calculate: To ascertain or determine by mathematical processes.

Characterize: To describe the essential character or quality of.

Cite: To quote by way of evidence, authority, or proof.

Classify: To arrange in classes; to assign to a category.

Combine: To bring into such close relationship as to obscure individual characteristics.

Comment: To observe, remark, or express an opinion or attitude concerning what has been seen or heard about the subject at hand.

Compare: To examine the character or qualities of, for the primary purpose of discovering resemblances.

Compose: To form by putting together; to form the substance of.

Compute: To determine, especially by mathematical means.

Conclude: To make a decision about; to reach a logically necessary end by reasoning.

Construct: To create by organizing ideas or concepts logically and coherently.

Contrast: To compare in respect to differences. Convert: To change from one form or function to

another. Create: To produce or bring about by a course of

action or imaginative skill. Criticize: To consider the merits and demerits of

and judge accordingly; to find fault with. Critique: To offer a critical review or

commentary. Define: To set forth the meaning of; specifically,

to formulate a definition of. Demonstrate: To prove or make clear by reasoning or

evidence; to illustrate and explain, especially with examples.

Describe: To transmit a mental image, an impression, or an understanding of the nature and characteristics of.

Design: To conceive or plan out in the mind.

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Determine: To come to a decision as the result of

investigation or reasoning; to settle or decide by choice among alternatives or possibilities.

Diagram: To represent by or put into the form of a diagram.

Differentiate: To mark or show a difference in; to develop different characteristics in.

Discriminate: To mark or perceive the distinguishing or peculiar features of; to distinguish by discerning or exposing differences.

Discuss: To discourse about through reasoning or argument; to present in detail.

Distinguish: To perceive a difference in; to separate into kinds, classes, or categories.

Draft: To draw up, compose, prepare, frame. Draw: To express graphically in words; to

delineate. Estimate: To judge the value, worth, or

significance of. Evaluate: To determine or fix the value of; to

determine the significance or worth of, usually by careful appraisal and study.

Explain: To give the meaning or significance of; to provide an understanding of; to give the reason for or cause of.

Formulate: To put into a systematized statement or expression; to prepare according to a formula.

Give: To yield or furnish as a product, consequence, or effect; to offer for the consideration, acceptance, or use of another.

Identify: To establish the identity of; to show or prove the sameness of.

Illustrate: To make clear, especially by giving examples or instances. Indicate: To point out or point to with more or less

exactness; to show or make known with a fair degree of certainty.

Infer: To derive as a conclusion from factors or premises.

Interpret: To explain or tell the meaning of; to present in understandable terms. Judge: To form an opinion about through careful weighing of evidence and testing of premises. Justify: To prove or show to be valid, sound, or

conforming to fact or reason; to furnish grounds or evidence for.

List: To enumerate. Match: To pair up or put in a set as possessing

equal or harmonizing attributes. Modify: To make minor changes to give a new

orientation to or to serve a new end.

Name: To mention or identify by name. Order: To put in order; to arrange. Outline: To indicate the principal features or different parts of. Predict: To declare in advance; to foretell on the

basis of observation, experience, or reason.

Prepare: To put into written form; to draw up. Present: To offer or convey by way of message;

to furnish or provide. Rearrange: To put back into proper order or into a

correct or suitable sequence, relationship, or adjustment.

Recommend: To bring forward as being fit or worthy; to indicate as being one’s choice for something or as otherwise having one’s approval or support.

Record: To set down in writing; to make an answer. Relate: To show or establish logical or causal connection between. Respond: To say or write something in return; to

make an answer. Restate: To state again in a new form. Review: To make a formal or official

examination of the state of; to go over or examine critically or deliberately.

Revise: To make a new, amended, improved, or up-to-date version of.

Select: To choose from a number or group—usually, by fitness, excellence, or other distinguishing feature.

Separate: To set or keep apart; to make a distinction between; to sort.

Show: To set forth in a statement, account, or description; to make evident or clear.

Solve: To find a solution for a problem. State: To express in words. Subdivide: To divide the parts into more parts. Summarize: To tell in or reduce to a summary. Support: To provide with verification,

corroboration, or substantiation. Write: To put on paper; to record, state, or

explain.

Strategies for Taking the Examination General suggestions for all types of examination questions include the following: • Answer the questions with curriculum

assignments in mind. When preparing the CFA examination, the Council of Examiners is guided by the assigned reading materials and the LOS.

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• Pay attention to the time. The minutes allocated

to a question equal the maximum points allowed, so a 15-minute question cannot receive more than 15 points of credit. This means that, in general, you should not spend 30 minutes on a 15-minute question. Although you may finish some questions in less than the allotted time which will allow you to spend more time on other questions, you should plan to devote only as much time to each question as indicated by its time allocation.

• Candidates should learn and practice all the major features of their chosen approved calculator well in advance of the exam. For instance, candidates should be prepared to set their calculator display formats to any specified number of decimal places and to change that format quickly during the exam, as different exam questions may require different levels of precision.

Specific suggestions for essay questions include the following: • Write essay answers in blue or black ink, and

write legibly and concisely. Please do not use red or green ink, because graders typically use these colors.

Specific suggestions for item set questions include the following:

• Unless specifically directed otherwise, you may answer the questions in any order you want. Make sure that you answer the question on the pages provided for that question. AIMR will only grade answers that are written on the correct answer pages. You may make marks or notes on the question pages, but your notes will not be graded.

• Your score is the number of correct answers. No deduction is taken for incorrect responses and you will not be penalized for guessing. You should attempt to answer all questions

• Select the best answer for each question and darken the oval on the machine-gradable answer sheet that corresponds to that answer. Justification of your answers is not required for item set questions. • Some essay questions provide templates for

ease in answering the question. For those questions, candidates should answer on the templates provided and follow the instructions given in the template. Candidates who re-draw the template on a following answer page waste valuable time.

• Only answers recorded on the answer sheet will be graded, and any answers recorded in the item set examination book itself will not be graded. Any stray marks on the answer sheet may cause your examination to be incorrectly graded.

• Show all your calculations for essay questions even if the question does not specifically instruct you to do so. You will be able to check your work this way. Also, if your answer is wrong, the grader can give partial credit, where warranted, if you show your calculations. If the question specifically says, “Show your work,” you must present your calculations as part of a complete answer to that question.

• Candidates are advised to record their answers on the answer sheet as they take the test rather than wait until the end of the examination session.

• Candidates should note that the only appropriate mark on the answer sheet is a neat and complete darkening of the ovals; other marks (X, , incomplete darkening, circling, etc.) are not appropriate and may cause your answer to be graded incorrectly. • Pay close attention to the command words and

number instructions in essay questions. The command words are in bold type, and the number instructions are italicized (see preceding section, “Essay Format and Command Words,” on page 12.)

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• Use an outline, bullet points, and/or sentence

fragments in essay answers to convey your ideas logically and consistently, but quickly. Complete sentences are not required, and no deductions are taken for misspellings, improper grammar, or incorrect punctuation.

• For the item set portion of the examination, answers recorded with other than a No. 2 or HB pencil (i.e., ink or other types of pencil) cannot be scored electronically, causing your answers to be graded incorrectly. Essay questions should be answered in blue or black ink; essay answers written in pencil are difficult for the graders to read.

• Providing more than the required number of essay responses will not earn extra points. The required number of responses will be graded in the order you present them. Additional responses will be ignored. For example, if the question asks you to “discuss three reasons” and you discuss five, only the first three reasons will be graded.

• The following items may be carried into the test center in your pockets or in a clear plastic bag measuring approximately 8” x 8” (20 cm x 20 cm): Examination Admission Ticket; current (not expired) government-issued photo identification; approved calculators including calculator cases; pencils, erasers, calculator batteries, eyeglasses, earplugs, medicine, tissues, other necessary personal items; wallets, money purses; and food and drinks (to be consumed outside of the testing room.) You may use two clear plastic bags if you cannot fit all of your items into one bag.

• If your answers are partly inconsistent or illogical, you will not receive credit. For example, if the question asks you to recommend and justify, the second part (justification) must be consistent with the first part (recommendation) to earn points.

• To receive full credit, your answers must directly and specifically address the questions asked. Answers containing a general discussion of the topic area, but that do not address the question asked, will not receive full credit even if accurate.

• The following items are prohibited at the test center: Bags of any kind including backpacks, handbags, tote bags, briefcases, luggage, and lunch containers; study materials including notes, papers, text books, study guides, scrap paper, present/future value tables, and calculator manuals; cellular telephones, pagers, headsets, computers, electronic organizers, personal data assistants, or any other remote communication or photographic equipment; and watches with engaged alarms or timers.

Examination Rules Candidates must comply with AIMR's conditions, requirements, policies, and procedures that are set forth in AIMR's Articles of Incorporation, Bylaws, Code of Ethics, Standards of Professional Conduct, and Rules of Procedure for Proceedings Related to Professional Conduct. Candidates are also required to abide by the examination rules and regulations, candidate pledge, and proctor's verbal instructions during the exam administration. Candidates who violate these conditions, requirements, policies, and procedures during the exam may have their examination results voided and be subject to disciplinary sanction by AIMR's Professional Conduct Program, which may include a suspension or revocation of participation in the CFA Study and Examination Program.

• AIMR’s preferred form of ID is a valid passport. Whatever form of identification you present must meet all of the criteria listed below. It must

be current and valid—it cannot be expired; contain your photo; be issued by a government agency; and be a single document (not a combination of two or more pieces of identification).

Photocopies of identification documents will not be accepted. Your ID will be inspected prior to the start of the examination. If your ID is determined to be invalid, you will not be admitted to the examination. Once you are seated, your ID must remain on your desk in full view and proctors will again inspect IDs during the examination. Proctors are instructed to submit to AIMR photocopies of questionable IDs that may be discovered during the

Among the most important examination rules are the following:

• You must bring several pens (blue or black ink) as well as a supply of sharpened No. 2 or HB pencils. Extra pens, pencils, or pencil sharpeners will not be available at the test center. Loose erasers and small pencil sharpeners are permitted.

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Examination Comments Center administration of the examinations, and validity

determinations will be made by AIMR following the examinations. Failure by the proctors to detect an invalid ID prior to the start of the examination, admittance to the testing room, or even completion of the examination does not imply that the ID is valid or that your scores will ultimately be reported. Use of an invalid ID is considered a violation of AIMR rules and will result in voiding of examination results.

After taking the examination, you may go to www.aimr.org/canservices to submit comments about exam questions that may have contained errors or to submit comments about your test center.

Grading the CFA Examination After the examination, all examination materials are returned to AIMR for grading. Anonymity during the grading process is assured because only the candidate number appears on the examination book. The item set answer sheet, which has your name and signature, is graded by machine using the same quality control procedures that are used for the Level I multiple choice examination.

• Only the following two calculator models are approved for use on the CFA examinations:

Hewlett Packard 12C Texas Instruments BAII Plus

The essay questions are graded by a carefully selected group of practitioner and academic CFA charterholders. Certain essay examinations are further reviewed by experienced graders or Senior Graders, each of whom is a CFA charterholder.

These are the only models of calculators permitted for use on the CFA examinations; no other calculators are allowed in the testing room. On exam day, your calculator(s) will be inspected prior to the start of the examination. Your calculator(s) must then remain on your desk in full view and proctors will continue to inspect calculators during the examination. Failure by proctors to detect an unauthorized calculator prior to the start of the examination, or your use of an unauthorized calculator at any time during the examination, does not imply that the calculator is an approved model or that your scores will ultimately be reported. Use of an unauthorized calculator is considered a violation of AIMR rules and will result in voiding of examination results. You are encouraged to select one of these models immediately and to practice with it throughout your period of study. Both models are available for purchase internationally. For more information, visit http://www.aimr.org/ cfaprogram/calculatorpolicy.html

The AIMR Board of Governors, the body responsible for establishing the CFA examination and grading standards, sets the minimum passing score for each examination level. Pass rates are a result of, not a determinant of, the minimum passing score. You should note that AIMR does not release the minimum passing score for any examination level.

Pass Rates As the table of CFA examination results on page 19 demonstrates, examination pass rates vary widely over time and among examination levels. For example, over the 10-year period from 1992 to 2001, the pass rate for Level I candidates ranged from 48 percent to 64 percent; for Level II candidates, from 46 percent to 65 percent; and for Level III candidates, from 59 percent to 82 percent. Over the entire history of the examination, the average pass rate is 56 percent for Level I, 58 percent for Level II, and 70 percent for Level III. Candidates should recognize that pass rates will continue to vary over time.

Secure Examinations All testing materials, used and unused, must be re-turned to AIMR following administration of the examinations. If you remove any testing materials from the test center, your results will be voided and you will be subject to disciplinary sanction by AIMR's Professional Conduct Program, which may include a suspension or revocation of your participation in the CFA Study and Examination Program.

Examination Results Completed examinations become the property of AIMR and will not be returned in either original or copied form. Examination results are reported as either “pass” or “fail”; exact numeric scores are not released to candidates. Level II results are distributed by mail and are available on-line usually within ten weeks of the examination date. Examination results are not released via

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Accruing Qualified Work Experience telephone or e-mail. If you do not receive your

results by September 1, 2003, please contact AIMR.

No investment experience is necessary to take any of the CFA examinations. Before a CFA charter can be awarded, however, a candidate must meet certain requirements as outlined in the enrollment package and on AIMR’s Web site. In addition to passing the Level III CFA examination and applying for membership, you must have accrued 36 months of qualified work experience prior to earning the charter. This experience may be accrued from previous positions, while you complete the program, or after you pass the Level III examination.

Candidates should understand that the score matrix provided with examination results is an indicator of overall performance and cannot be used to determine approximate scores or pass/fail status. The “<=50%” range is considered poor; “51%–70%” is considered poor to average; “>70%” is considered average to above average.

If you would like your failed examination to be reviewed, AIMR staff can perform an Examination Score Retabulation. The retabulation is a manual check to verify that all parts of all questions were graded and that the scores were added correctly. The retabulation is not a regrading and will not change the grades awarded to your individual answers. Unless an error is found in totaling or recording your scores, the original pass/fail decision on your examination will not be affected. This service is available at a cost of US $100.00. To request an Examination Score Retabulation, complete the request form available on the AIMR Web site, or request a copy of the form from Information Central at (phone) 434-951-5499 or 800-247-8132, (fax) 434-951-5262 or (email) info@aimr.org. Your payment must accompany the form. The deadline for requests is December 1, 2003.

Candidates are provided the work experience guidelines for the eventual award of the CFA charter beginning with the CFA Program Level I materials. The work experience is self-reported only when you enroll for the Level III examination. As long as you have met the entrance requirements for the CFA Program, you are eligible to sit for the examination. If you do not have the required work experience following completion of the Level III examination, the charter will not be awarded until you have satisfied the 36-month experience requirement.

Ongoing Obligations A candidate who becomes a CFA charterholder must comply with AIMR’s conditions, requirements, policies, and procedures that apply to a CFA charterholder and AIMR member. These are set forth in the AIMR Articles of Incorporation, Bylaws, Code of Ethics, Standards of Professional Conduct, Rules of Procedure for Proceedings Related to Professional Conduct, and encompass other conditions, requirements, policies, and procedures that may be established and amended from time to time. Two key requirements are the submission of an annual Professional Conduct Statement and the payment of membership dues. Failure to comply with AIMR’s conditions, requirements, policies, and procedures can result in disciplinary sanctions, including suspension or revocation of member-ship and the right to use the CFA designation.

Completing the CFA Program Passing the CFA examinations is only part of the requirements for earning the CFA charter and becoming an active member of AIMR.

AIMR Membership CFA candidates are not automatically members of AIMR. Candidates must apply for membership in both AIMR and a local society before they can receive the CFA charter. The local society membership requirement is waived for candidates or charterholders who work more than 50 miles from the nearest society. You are encouraged to apply for AIMR membership so that you can begin enjoying the numerous benefits designed for investment professionals. For information on membership requirements and benefits, contact AIMR at (phone) 434-951-5499 or 800-247-8132, (fax) 434-951-5262, (email) info@aimr.org or visit the AIMR Web site at www.aimr.org.

CFA Continuing Education Candidates who complete the CFA Program should realize that their professional education is not completed but rather has just begun. As part of their lifetime commitment to the continual enhancement of their knowledge, skills, and

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abilities, CFA charterholders are strongly encouraged to participate in AIMR’s Continuing Education (CE) Program. Continuing education opportunities are frequently identified in articles in the AIMR Exchange. A wide variety of activities qualify for CE credits, including conferences, seminars, and readings.

Proper and Ethical Use of the CFA Designation The CFA designation is not simply an acronym or generic term for financial analysts. Rather, the CFA mark is an exclusive, unique trademark owned by AIMR that is registered with the U.S. Patent and Trademark Office and in several other countries. The CFA mark must be used appropriately if AIMR is to maintain exclusive control of its use. Therefore, the CFA mark must always be used as an adjective, never as a noun. The mark should not be used in the plural or in the possessive. For example, references to a “CFA” or a “Chartered Financial Analyst” are improper. A proper use of the designation would be to state that one is a “CFA charterholder” or that one “earned the right to use the CFA designation.” Charterholders are not given the CFA but are awarded the right to use the CFA designation.

Standard II (A) of the Standards of Professional Conduct limits the use of the CFA designation to those who have received their charters and requires that the designation be used

only in a dignified and judicious manner. The Standards of Practice Handbook states that it is “… the responsibility of AIMR members, CFA charterholders, and candidates in the CFA Program to use the CFA designation or refer to their candidacies in the CFA Program properly and in a manner that does not mislead the investing public or others” (emphasis added).

As a candidate, you may reference your participation in the CFA Program, but the reference must clearly state that you are a candidate for the right to use the CFA designation and cannot imply that you have achieved any type of partial designation. A candidate who has passed the Level III examination but has not yet received notice of having earned the CFA charter may say, “I have passed all three levels of the CFA Program and will be eligible for the CFA charter upon completion of the required work experience” (or a similar accurate statement as to why the charter has not yet been awarded). A currently enrolled candidate may say, “I am a Level I (II or III) candidate in the CFA Program.” A self-declared candidate for a given level must be enrolled to take the examination within the year. Candidates should not cite the expected date of examination completion. Final award of the charter is subject to completion of CFA Program requirements and AIMR Board approval.

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1963 – 2001 CANDIDATE EXAMINATION RESULTS ALL CFA CANDIDATES LEVEL I LEVEL II LEVEL III

Year Total % Pass Total Pass Fail % Pass Total Pass Fail % Pass Total Pass Fail % Pass1963 1964 1965 1966 1967

284 1,732 1,993 2,010 1,693

94% 84% 83% 75% 83%

— 1,241 767 621 594

— 986 649 481 423

— 255 118 140 171

—% 79% 85% 77% 71%

— 302 865 708 556

— 283 678 469 496

— 19 187 239 60

—% 94% 78% 66% 89%

284 189 361 681 543

268 179 329 563 491

16 10 32 118 52

94% 95% 91% 83% 90%

1968 1969 1970 1971 1972

1,579 1,316 1,409 1,458 1,486

73% 74% 67% 69% 70%

592 556 644 755 731

412 409 424 464 466

180 147 220 291 265

70% 74% 66% 61% 64%

447 413 372 341 461

334 322 285 253 354

113 91 87 88 107

75% 78% 77% 74% 77%

540 347 393 362 294

414 237 238 288 214

126 110 155 74 80

77% 68% 61% 80% 73%

1973 1974 1975 1976 1977

1,630 1,797 1,841 1,706 1,993

60% 74% 75% 76% 74%

721 862 808 634 667

432 604 568 457 421

289 258 240 177 246

60% 70% 70% 72% 63%

565 511 563 641 632

324 377 421 477 510

241 134 142 164 122

57% 74% 75% 74% 81%

344 424 470 431 694

222 355 393 363 540

122 69 77 68 154

65% 84% 84% 84% 78%

1978 1979 1980 1981 1982

2,008 1,876 1,985 2,253 2,886

73% 76% 73% 71% 64%

925 824 949 1,107 1,532

596 522 602 677 903

329 302 347 430 629

64% 63% 63% 61% 59%

444 550 528 684 714

379 460 407 580 489

65 90 121 104 225

85% 84% 77% 85% 68%

639 502 508 462 640

481 441 437 340 469

158 61 71 122 171

75% 88% 86% 74% 73%

1983 1984 1985 1986 1987

3,243 4,030 4,285 4,837 5,702

65% 63% 67% 65% 62%

1,655 2,075 2,186 2,366 3,095

1,082 1,199 1,317 1,405 1,782

573 876 869 961 1,313

65% 58% 60% 59% 58%

978 1,147 1,309 1,379 1,555

637 701 965 884 995

341 446 344 495 560

65% 61% 74% 64% 64%

610 808 790 1,092 1,052

392 658 579 845 755

218 150 211 247 297

64% 81% 73% 77% 72%

1988 1989 1990 1991 1992

7,091 8,064 8,760 9,868 10,518

60% 62% 64% 62% 65%

3,927 4,149 4,415 4,950 5,002

2,174 2,237 2,658 3,087 2,928

1,753 1,912 1,757 1,863 2,074

55% 54% 60% 62% 59%

1,946 2,484 2,522 3,002 3,503

1,163 1,590 1,594 1,618 2,258

783 894 928 1,384 1,245

60% 64% 63% 54% 64%

1,218 1,431 1,823 1,916 2,013

864 1,133 1,360 1,436 1,658

354 298 463 480 355

71% 79% 75% 75% 82%

1993 1994 1995 1996 1997

12,809 15,413 19,516 24,600 30,642

59% 52% 52% 58% 55%

6,588 8,445 11,340 14,381 16,833

3,616 4,087 5,692 7,669 8,847

2,972 4,358 5,648 6,712 7,986

55% 48% 50% 53% 53%

3,679 4,418 5,518 7,098 8,493

2,061 2,109 2,535 4,596 5,010

1,618 2,309 2,983 2,502 3,483

56% 48% 46% 65% 59%

2,542 2,550 2,658 3,121 5,316

1,936 1,859 1,860 2,001 3,119

606 691 698 1,120 2,197

76% 73% 70% 64% 59%

1998 1999 2000 2001

38,689 45,143 53,345 65,707

60% 60% 55% 54%

21,743 23,199 27,625 36,317

12,855 14,757 14,314 17,726

8,889 8,442 13,311 18,591

59% 64% 52% 49%

10,295 13,496 16,036 17,897

6,433 7,329 8,636 8,321

3,862 6,167 7,400 9,573

62% 54% 54% 46%

6,650 8,448 9,684 11,493

3,895 5,015 6,274 9,410

2,755 3,433 3,410 2,083

59% 59% 65% 82%

1963–2001 407,198 59% 215,823 119,944 95,879 56% 117,052 67,334 49,715 58% 74,323 52,309 22,014 70%

19 ©

2002, AIM

R®

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CFA Program Calendar 2002-2003 16 September 2002 Initial deadline for new registrations/enrollments to be received by AIMR September Study Guides available and mailed to applicants October Textbooks available for purchase from book distributor November Past years’ essay examination questions/guideline answers for Level II and Level

III available from book distributor 16 December Second deadline for new registrations/enrollments to be received by AIMR 17 March 2003 Final deadline for new registrations/enrollments to be received by AIMR (AIMR

cannot guarantee that registrations or enrollments received after 17 March will be accepted)

17 March Final deadline for special test center requests, disability accommodation requests,

and requests for religious alternative dates to be received by AIMR 31 March All test center changes must be received by AIMR April Examination Admission tickets distributed 31 May 2003 Examination Day 1 June 2003 Examination Day in Eastern Asia and Oceania June-July Examination papers graded Late July Examination results distributed to Level I candidates Mid-August Examination results distributed to Level II and III candidates September CFA charterholders announced for year 2003

2003 CFA Study and Examination Program

Textbooks: Primary Readings Level I • 2003 CFA Level I Candidate Readings (AIMR, 2002) • Standards of Practice Handbook, 8th edition (AIMR, 1999) • Quantitative Methods for Investment Analysis, Richard A. DeFusco, Dennis W. McLeavey, Jerald E.

Pinto, and David E. Runkle (AIMR, 2001) • Economics: Private and Public Choice, 9th edition, James D. Gwartney, Richard L. Stroup, and Russell S.

Sobel (Dryden, 2000) • The Analysis and Use of Financial Statements, 2nd edition, Gerald I. White, Ashwinpaul C. Sondhi, and

Dov Fried (Wiley, 1998) • Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C. Brown (Dryden,

2000) • Fundamentals of Financial Management, 8th edition, Eugene F. Brigham and Joel F. Houston (Dryden,

1998) • Fixed Income Analysis for the Chartered Financial Analyst Program, Frank J. Fabozzi (Frank J. Fabozzi

Associates, 2000) • Futures, Options & Swaps, 3rd edition, Robert W. Kolb (Blackwell, 1999) Level II • 2003 CFA Level II Candidate Readings (AIMR, 2002) • Standards of Practice Handbook, 8th edition (AIMR, 1999) • Standards of Practice Casebook (AIMR, 1996) • Quantitative Methods for Investment Analysis, Richard A. DeFusco, Dennis W. McLeavey, Jerald E.

Pinto, and David E. Runkle (AIMR, 2001) • The Analysis and Use of Financial Statements, 2nd edition, Gerald I. White, Ashwinpaul C. Sondhi, and

Dov Fried (Wiley, 1998) • Analysis of Equity Investments: Valuation, John D. Stowe, Thomas R. Robinson, Jerald E. Pinto, and

Dennis W. McLeavey (AIMR, 2002) • Company Performance and Measures of Value Added, Pamela P. Peterson and David R. Peterson

(Research Foundation of the ICFA, 1997) • Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C. Brown,

(Dryden, 2000) • Fixed Income Analysis for the Chartered Financial Analyst Program, Frank J. Fabozzi (Frank J. Fabozzi

Associates, 2000) • Futures, Options & Swaps, 3rd edition, Robert W. Kolb (Blackwell, 2000) Level III • 2003 CFA Level III Candidate Readings (AIMR, 2002) • Standards of Practice Handbook, 8th edition (AIMR, 1999) • Standards of Practice Casebook (AIMR, 1996) • Quantitative Methods for Investment Analysis, Richard A. DeFusco, Dennis W. McLeavey, Jerald E.

Pinto, and David E. Runkle (AIMR, 2001) • Emerging Stock Markets: Risk, Return and Performance, Christopher B. Barry, John W. Peavy III, and

Mauricio Rodriguez (Research Foundation of the ICFA, 1997) • Fixed Income Readings for the Chartered Financial Analyst Program, Frank J. Fabozzi (Frank J. Fabozzi

Associates, 2000) • Futures, Options & Swaps, 3rd edition, Robert W. Kolb (Blackwell, 1999) • Beyond Value at Risk, Kevin Dowd (Wiley, 1998)

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2003 CFA Level II Study Guide Outline Study

Session

Topic

Readings 1–2 Ethical and

Professional Standards

Standards of Practice Handbook, 8th ed. Standards of Practice Casebook (Introduction plus three cases) 2003 CFA Level II Candidate Readings: Train & Melfe; Four articles from Standards Reporter

3 Quantitative Methods

Quantitative Methods for Investment Analysis (DeFusco, McLeavey, Pinto & Runkle), Ch. 7−9

4 Economics 2003 CFA Level II Candidate Readings: Dornbusch, Fisher, and Startz (2 chapters); Shapiro (2 chapters); Solnik &

McLeavey; Benninga & Sarig 5–7 Financial

Statement Analysis

The Analysis and Use of Financial Statements, 2nd ed. (White, Sondhi, & Fried), Ch. 13, 15, 17

2003 CFA Level II Candidate Readings: White, Sondhi, & Fried; Brigham & Houston; Shapiro; Hawkins (2);

Robinson & Munter 8 Basic

Valuation Concepts

Analysis of Equity Investments: Valuation (Stowe, Robinson, Pinto, & McLeavey), Forward, Ch. 1

Company Performance and Measures of Value Added (Peterson & Peterson) 2003 CFA Level II Candidate Readings: Bernstein & Pigler; Bernstein, Bayer, & Pigler

9–12 Equity Investments

Investment Analysis and Portfolio Management, 6th ed. (Reilly & Brown), Ch. 12, 20

Analysis of Equity Investments: Valuation (Stowe, Robinson, Pinto, and McLeavey), Ch. 2–5

2003 CFA Level II Candidate Readings: Porter; Hooke; Lee; Pratt, Reilly, & Schweihs (2 chapters); Gardella

13–15 Debt Investments

Fixed Income Analysis for the Chartered Financial Analyst Program (Fabozzi), Level I, Ch. 7; Level II, Ch. 1–5, 8, 9

Investment Analysis and Portfolio Management, 6th ed. (Reilly & Brown), Ch. 25

16–17 Derivative Investments

Futures, Options & Swaps, 3rd ed. (Kolb), Ch. 3, 4, 5, 7, 9, 11, 13, 14, 16, 20, 21

Fixed Income Analysis for the Chartered Financial Analyst Program (Fabozzi), Level II, Ch. 7

2003 CFA Level II Candidate Readings: Figlewski

18 Portfolio Management

Investment Analysis and Portfolio Management, 6th ed. (Reilly & Brown), Ch. 8–10

2003 CFA Level II Candidate Readings: Bodie, Kane, & Marcus

Study Review

Essay Questions and Guideline Answers (2000, 2001, and 2002)

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Ethical and Professional Standards The candidate should be able to apply knowledge of the AIMR Code of Ethics and Standards of Professional Conduct to recognize and avoid unprofessional practices and violations of the Code and Standards involving plagiarism, duty to employer, disclosure of conflicts of interest and additional compensation arrangements, responsibilities of supervisors, reasonable basis and representations, research reports, independence and objectivity, fair dealing, inside information, the Prudent Investor Rule, and soft dollars, among others.

Study Session 1 Ethical and Professional Standards Reading Assignments 1. “Code of Ethics,” p. 1, Standards of Practice Handbook, 8th edition (AIMR, 1999) 2. “Standards of Professional Conduct,” pp. 2–7, Standards of Practice Handbook, 8th edition

(AIMR, 1999) 3. Standards of Practice Handbook, 8th edition, “Preface” and pp. 9–283 (AIMR, 1999) 4.* “Prudence in Perspective,” Ch. 2 including Appendixes 3 and 4, Investing and Managing

Trusts under the New Prudent Investor Rule, John Train and Thomas A. Melfe, (Harvard Business School Press, 1999)

Learning Outcomes 1. “Code of Ethics”

The Code of Ethics establishes the framework for ethical decision making in the investment profession. The candidate should be able to state the four components of the Code of Ethics.

2. “Standards of Professional Conduct”

The AIMR Standards are organized into five categories: I. Fundamental Responsibilities II. Relationships with and Responsibilities to the Profession III. Relationships with and Responsibilities to the Employer IV. Relationships with and Responsibilities to Clients and Prospects V. Relationships with and Responsibilities to the Investing Public Each category contains multiple concepts for which the candidate is responsible. The candidate should be able to identify the ethical responsibilities required by the Code and Standards in these areas.

3. Standards of Practice Handbook

The Handbook addresses the application of the Code and Standards. For each standard, the Handbook discusses the purpose and scope of the standard, the application of the standard to factual situations, and procedures for complying with the standard. Topical studies address the application of the Code and Standards in five specific areas: (1) fiduciary duty,

* Readings marked with an asterisk are contained in the 2003 CFA Level II Candidate Readings.

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(2) insider trading, (3) personal investing, (4) corporate governance, and (5) AIMR’s Soft Dollar Standards. The candidate should focus on (1) “the purpose and scope of the standard” for each standard, (2) the “application of the standard” for each standard, and (3) the five topical studies.

The candidate should be able to a) interpret the Code and Standards in the context of specific situations; b) explain the application of the Code and Standards in situations that present multiple

issues of questionable professional conduct; c) identify violations of the Code and Standards; d) interpret the topical studies as they relate to the Code and Standards; e) identify disciplinary procedures and sanctions set forth in the Code and Standards.

4. “Prudence in Perspective”

The candidate should be able to a) state the five basic principles of the New Prudent Investor Rule; b) explain the general fiduciary standards to which a trustee must adhere; c) differentiate between the old Prudent Man Rule and the new Prudent Investor Rule

from the perspectives of individual investments, total portfolio, and delegation of duty;

d) discuss the general fiduciary standards carried over from the old Prudent Man Rule to the new Prudent Investor Rule.

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Study Session 2 Ethical and Professional Standards Reading Assignments 1. Standards of Practice Casebook (AIMR, 1996)

A. “Introduction” B. “The Glenarm Company,” Glen A. Holden, Jr. C. “Preston Partners,” Jules A. Huot D. “Super Selection,” Paul F. Van Schyndel

2.* “Trade Allocation: Fair Dealing and Disclosure,” Standards Reporter (AIMR, November/December 1996)

3.* “Case Study: Changing Investment Objectives,” Standards Reporter (AIMR, January/February 1998)

4.* “Compensation for Trading Errors,” Standards Reporter (AIMR, September/October 1998) 5.* “Case Study: Soft Dollars,” Standards Reporter (AIMR, May/June 1997)

Learning Outcomes Note: For each of the assigned readings in this study session, the candidate should be able to

a) evaluate the conduct described in each reading with respect to the Code and Standards;

b) distinguish between conduct that complies with the Code and Standards and conduct that violates the Code and Standards;

c) demonstrate the appropriate actions to take in response to conduct that violates the Code and Standards;

d) draft compliance procedures to implement the principles and requirements of the Code and Standards.

In addition, candidates are responsible for the specific learning outcomes for each reading. 1. Standards of Practice Casebook

Note: The Standards of Practice Casebook is based on an earlier edition of the Standards of Practice Handbook. Although the Casebook has not changed, certain references, including the statement of the Standards of Professional Conduct on pages 5–9, have been superseded by the 8th edition of the Standards of Practice Handbook.

The candidate should be able to identify violations of the AIMR Code of Ethics and Standards of Professional Conduct and demonstrate the appropriate response to ethically challenging situations. The cases are designed to present issues in a way that closely approximates how individuals practicing in the investment industry encounter ethical issues in their day-to-day activities. The “Introduction” is a guide to effective use of the Standards of Practice Casebook and includes a brief description of AIMR’s Disciplinary Process. The cases discuss several important aspects of the Code and Standards. Subheadings of each case discussion provide guidance on the important concepts contained in that case.

* Readings marked with an asterisk are contained in the 2003 CFA Level II Candidate Readings.

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2. “Trade Allocation: Fair Dealing and Disclosure”

The candidate should be able to a) demonstrate the violations of the Code and Standards that occur by entering into

trading allocations on an ad hoc basis; b) describe the steps necessary to ensure that adequate trade allocation practices are

followed. 3. “Case Study: Changing Investment Objectives”

The candidate should be able to a) demonstrate the violations of the Code and Standards that occur through improper

disclosure of investment product or style; b) describe the steps necessary to ensure adequate disclosure of the investment process.

4. “Compensation for Trading Errors”

The candidate should be able to demonstrate how improperly attempting to compensate for trading errors may lead to potential violations of the Standards of Professional Conduct.

5. “Case Study: Soft Dollars”

The candidate should be able to a) state the two fundamental principles involved in evaluating any soft dollar

arrangements; b) identify four requirements for meeting fiduciary obligations with regard to soft dollar

arrangements; c) identify violations of the Standards of Professional Conduct through improper use of

soft dollar arrangements.

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Quantitative Methods The candidate should be able to demonstrate a thorough knowledge of and the ability to apply decision making under uncertainty, correlation analysis, and linear and multiple regression analysis.

Study Session 3 Investment Tools Quantitative Methods for Valuation Reading Assignments 1. Quantitative Methods for Investment Analysis, Richard A. DeFusco, Dennis W. McLeavey,

Jerald E. Pinto, and David E. Runkle (AIMR, 2001) A. “Hypothesis Testing,” Ch. 7 B. “Correlation and Regression,” Ch. 8 C. “Multiple Regression and Issues in Regression Analysis,” Ch. 9

Note: Candidates are responsible for the problems at the end of each chapter. Solutions to the problems are found at the end of each chapter.

Learning Outcomes 1. A. “Hypothesis Testing”

The candidate should be able to a) distinguish between one-tailed and two-tailed hypothesis tests; b) define and interpret a Type I and a Type II error; c) discuss how the choice of significance level affects the probabilities of Type I

and Type II errors; d) distinguish between a statistical decision and an economic decision; e) discuss the p-value approach to hypothesis testing; f) select the test statistic for a hypothesis test regarding the population mean of a

normal distribution with (1) known or (2) unknown variance; g) formulate a null and an alternative hypothesis about a population mean and

determine whether the null hypothesis is rejected at a given level of significance;

h) formulate a null and an alternative hypothesis about the equality of two population means (normally distributed populations, independent samples), select the appropriate test statistic, and determine whether the null hypothesis is rejected at a given level of significance;

i) formulate a null and an alternative hypothesis about the mean difference of two normal populations (paired comparisons test), select the appropriate test statistic, and determine whether the null hypothesis is rejected at a given level of significance;

j) discuss the choice between tests of differences between means and tests of mean differences in relation to the independence of samples;

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k) formulate a null and an alternative hypothesis about the variance of a normally

distributed population, select the appropriate test statistic, and determine whether the null hypothesis is rejected at a given level of significance;

l) formulate a null and an alternative hypothesis about the equality of the variances of two populations (normally distributed, independent samples), select the appropriate test statistic, and determine whether the null hypothesis is rejected at a given level of significance;

m) distinguish between parametric and nonparametric tests, and describe the situations where the use of nonparametric tests may be appropriate.

Corrections/Clarifications • On page 324, delete “equals or” in the last line of text immediately before Figure 7-2. In the

Figure itself, the Rejection Region should be z > 1.645. • On page 335, in Example 7-4 Solution to 4, change 119 to 120 in the two places 119 appears

as the denominator. This changes the resulting equation to –0.89/0.602704 = –1.477. The corrected t value of –1.477 is still not significant at the 0.10, 0.05, or 0.01 levels.

• On page 343, in the last sentence of the boxed Example 7-7, insert the word “cannot”

between “We” and “conclude.” (“We cannot conclude ...”) • On page 345, replace the last two sentences of Example 7-8 with the following: “Because

1.434 is less than the critical value 1.61, we cannot reject the null hypothesis that the population variance of returns is the same in the pre- and post-crash periods.”

• On page 359, the third line should read: “Thus, t = (77.74 minus 42.56) ...” instead of 77.74

+ 42.56.

B. “Correlation and Regression” The candidate should be able to a) calculate the covariance between two random variables; b) calculate and interpret a correlation coefficient; c) formulate a test of the hypothesis that the population correlation coefficient

equals zero and determine whether the hypothesis is rejected at a given level of significance;

d) explain how outliers can affect correlations; e) explain the nature of spurious correlation; f) calculate the standard error of the estimate and the coefficient of determination; g) calculate a confidence interval for a regression coefficient; h) formulate a null and an alternative hypothesis regarding a population value of a

regression coefficient, select the appropriate test statistic, and determine whether the null hypothesis is rejected at a given level of significance;

i) interpret a regression coefficient;

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j) calculate a predicted value for the dependent variable given an estimated

regression model and a value for the independent variable; k) calculate and interpret a confidence interval for the predicted value of a

dependent variable; l) describe the use of analysis of variance (ANOVA) in regression analysis; m) define and interpret an F-statistic; n) discuss the limitations of regression analysis.

Corrections/Clarifications • On page 408 the first line of Problem 10(d) should state “Define Regression SS ...” instead

of “... MSS.” • On page 418 at the end of solution to Problem 4, the calculation of the correlation

coefficient should have a denominator of 12.91 × 0.8165. • On page 421 in the solution to 12(a) the estimated variance of the prediction error should

equal 0.66694. The remainder of the answer is unchanged.

C. “Multiple Regression and Issues in Regression Analysis”

The candidate should be able to a) formulate a multiple regression equation to describe the relationship between a

dependent variable and several independent variables, determine the statistical significance of each independent variable, and interpret the coefficients;

b) formulate a null and an alternative hypothesis about the population value of a regression coefficient, calculate the value of the test statistic, and determine whether the null hypothesis is rejected at a given level of significance, using a one-tailed or two-tailed test;

c) calculate a confidence interval for the population value of a regression coefficient in a multiple regression;

d) explain the assumptions of a multiple regression model; e) discuss the residual and its relationship to the standard error of estimate; f) calculate the standard error of estimate, given the sum of squared residuals from

the regression, the number of observations, and the number of independent variables;

g) calculate a predicted value for the dependent variable, given an estimated regression model and assumed values for the independent variables;

h) define, calculate, and interpret the F-statistic and discuss how it is used in regression analysis;

i) define, distinguish between, and interpret the R2 and adjusted R2 in multiple regression;

j) infer how well a regression model explains the dependent variable by analyzing the output of the regression equation and an ANOVA table;

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k) formulate a multiple regression equation using dummy variables to represent

qualitative factors and interpret the coefficients; l) define and discuss conditional and unconditional heteroskedasticity; m) describe serial correlation and discuss its effect on statistical inference; n) explain how to test and correct for heteroskedasticity and serial correlation; o) calculate and interpret a Durbin-Watson statistic; p) describe multicollinearity and discuss its causes and effects in regression

analysis; q) discuss models for qualitative dependent variables; r) interpret the economic meaning of the results of multiple regression analysis.

Corrections/Clarifications • In Example 9-11 (pages 457 through 459), numbers in the example text were transferred

incorrectly from Tables 9-11 and 9-12. The standard error, t-statistic, coefficient, and R2 numbers shown in the text should be the same as those shown in the tables.

• In Example 9-11, replace the last sentence on page 457 with “This result implies that

returns on the FSTF are more volatile than returns on the growth index.” • On the top of page 459, in the last paragraph of Example 9-11, delete the sentence

beginning with “In fact ...” and ending “greater than 1.”

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Economics The candidate should be able to interpret and apply forecasts of domestic and international economic and industrial activity in the valuation of markets and investment alternatives, analyze the relationships among domestic and foreign economies and markets, relate the economic cycle to various industries and companies, and use economic information to analyze company and industry trends and to make investment valuations.

Study Session 4 Investment Tools Economics for Valuation Reading Assignments 1.* Macroeconomics, 8th edition, Rudiger Dornbusch, Stanley Fischer, and Richard Startz

(McGraw-Hill/Irwin, 2001) A. “Growth and Accumulation,” Ch. 3 B. “Growth and Policy,” Ch. 4

2.* Foundations of Multinational Financial Management, 3rd edition, Alan C. Shapiro (Prentice Hall, 1998) A. “The Foreign Exchange Market,” Ch. 5 B. “Parity Conditions in International Finance and Currency Forecasting,” Ch. 7

3.* “International Asset Pricing,” Ch. 5, International Investments, 5th edition, Bruno Solnik and Dennis McLeavey (Addison Wesley Longman, forthcoming)

4.* “Analyzing the Firm’s Environment,” Ch. 5, Corporate Finance: A Valuation Approach, Simon Benninga and Oded Sarig (McGraw–Hill, 1997)

Learning Outcomes 1. A. “Growth and Accumulation”

Note: Suggested problems from the end of this chapter are included below. Solutions are reprinted in the 2003 Level II Candidate Readings.

The candidate should be able to a) explain the production function approach to analyzing the sources of economic

growth; b) distinguish between input growth and growth in total factor productivity as

components of economic growth; c) describe the importance of factor shares of income in determining economic

growth; d) calculate growth in economic output by applying the growth accounting

equation; e) contrast growth in total output with growth in per capita output; f) define convergence and analyze an example of convergence using the growth

accounting framework;

* Readings marked with an asterisk are contained in the 2003 CFA Level II Candidate Readings.

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g) discuss the influence of natural resources and human capital on economic

growth; h) demonstrate how neoclassical growth theory can be used to explain trends in

economic growth. Problems: Technical 1, 3, 8

B. “Growth and Policy”

The candidate should be able to a) describe endogenous growth theory and contrast the implications of endogenous

growth theory and neoclassical growth theory; b) explain the implications for growth of the difference between private returns

and social returns to capital; c) distinguish between absolute convergence and conditional convergence and

discuss the implications of the distinction for understanding international differences in growth rates;

d) discuss the relationships between population growth and economic growth in the context of a growth model;

e) describe how a growth model can be used to analyze the growth experience of countries such as the “Asian Tigers;”

f) describe the key features of a plan for reforming economies that have operated under a highly centralized system;

g) evaluate the argument that the limited availability of natural resources places limits on economic growth;

h) discuss the factors that are likely to promote economic growth. 2. A. "The Foreign Exchange Market”

The candidate should be able to a) calculate the spread on a foreign currency quotation; b) explain how spreads on foreign currency quotations can differ as a result of

market conditions, bank/dealer positions, trading volume, and (for forward contracts) maturity/length of contract;

c) calculate currency cross rates, given two spot or forward foreign exchange quotations involving three currencies;

d) calculate the profit on a triangular arbitrage opportunity, given three currency quotations;

e) compute the effect of transaction costs (spreads) on a foreign exchange arbitrage opportunity;

f) calculate a forward discount or premium and express either as an annualized rate;

g) explain the theory of interest rate parity; h) compute covered interest arbitrage and determine whether an arbitrageur can

profit from given interest rate and currency differentials; i) calculate a forward rate under an assumption of interest rate parity; j) calculate a covered interest differential, taking into account transaction costs.

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Corrections/Clarifications • On page 111, in the first illustration, in the 8th line of the solution, replace $1.7036 with

$1.4436. • On page 117, the 90-day British pound was selling at a 0.59% discount rather than the

amount stated. In the formula immediately following, the result should be 0.0059 instead of 0.0153.

• On page 119, the example indicates that the investor should convert the $1 million to

DM at the spot rate of DM 1.5311/$, which is presented as generating DM 1,533,110. This result should be corrected to DM 1,531,100 throughout the discussion. The rest of the illustration is consistent with this correction. The final sum of $1,019,996.39 is rounded to $1,020,000.

• On page 120, Figure 5.7 has the same typographical error as is on page 119. • On page 123, Illustration Step 3 should conclude: $327,328.44($317,313.25 ×

1.0315625).

B. “Parity Conditions in International Finance and Currency Forecasting”

The candidate should be able to a) calculate for a specified currency, the exchange rate implied by purchasing

power parity (PPP); b) calculate a real (inflation-adjusted) exchange rate for a currency and compare

that rate with the PPP-determined rate; c) determine the relative levels of inflation among countries, using observed spot

and forward exchange rate relationships; d) discuss the implications of purchasing power parity for the movement of

exchange rates; e) differentiate between capital market integration and capital market segmentation

and infer the effects of each on a country’s equilibrium interest rates and exchange rates;

f) calculate the expected nominal and real interest rates produced by the Fisher effect;

g) estimate a future exchange rate based on the international Fisher effect; h) calculate an expected future spot exchange rate based on the unbiased forward

rate relationship. Corrections/Clarifications In Exhibit 7.5 on page 165 of the original text, Point D of the graph should be located at coordinates (−3,−2) rather than the current location. The describing text is correct; the location on the graph is incorrect.

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3. “International Asset Pricing”

Note: Candidates are responsible for the practice problems at the end of the chapter. Answers to the chapter problems are found at the end of the chapter. The candidate should be able to a) explain international market integration and international market segmentation; b) discuss the impediments to international capital mobility; c) discuss the factors that favor international market integration; d) explain the extension of the domestic capital asset pricing model (CAPM) to an

international context (the extended CAPM); e) determine whether the real exchange rate changes in a period, given the beginning-of-

period (nominal) exchange rate, the inflation rates in the period, and the end-of-period (nominal) exchange rate;

f) calculate the expected exchange rate and the expected domestic-currency holding period return on a foreign bond (security), given expected and predictable inflation rates for the period, the beginning-of-period nominal exchange rate, and the real exchange rate (assumed to be constant);

g) calculate the end-of-period real exchange rate and the domestic-currency ex-post return on a foreign bond (security), given the end-of-period exchange rate, the beginning-of-period real exchange rate, and the inflation rates during the period;

h) explain a foreign currency risk premium in terms of interest rate differentials and in terms of the forward rate;

i) calculate a foreign currency risk premium; j) calculate the expected returns on a stock using the international capital asset pricing

model (ICAPM), given its world market beta and currency exposure as well as the appropriate risk-free rates and risk premiums;

k) define currency exposure and explain exposures in terms of correlations; l) explain the effect of market segmentation on the ICAPM; m) discuss the likely exchange rate exposure of a company based on a description of its

activities and explain the impact of both real and nominal exchange rate changes on the valuation of the company;

n) discuss the currency exposures of national economies, equity markets, and bond markets;

o) explain the models that relate real exchange rate changes to domestic economic activity.

4. “Analyzing the Firm’s Environment”

The candidate should be able to a) estimate the future relationship between gross domestic product (GDP) growth and

industry sales, using historical data for each variable; b) forecast and interpret industry sales by applying the estimated relationship between

GDP growth and industry sales to a forecasted GDP growth rate; c) interpret the results of a regression analysis of industry sales on an economic variable,

such as annual changes in real GDP;

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d) determine whether data measuring sales and other economic variables should include

or exclude, depending on the purpose of the analysis, the effect of inflation or deflation, and calculate adjustments as appropriate;

e) infer industry and company performance under conditions specified in an economic forecast, using industry/company performance at various points in past business cycles;

f) identify and explain changes in the market shares of firms in an industry as macroeconomic conditions change;

g) determine the current stage of a product’s life cycle and infer implications for product sales, profits, and competition, using historical data and information about the product;

h) differentiate between a product life cycle and broader industry trends in product development;

i) explain the significance of “regression toward the mean” as a tendency in industry profits;

j) identify and discuss factors that may contribute to changes in a company’s market share of an industry’s sales;

k) estimate how a company’s market share is affected by changes in the company’s marketing efforts and by changes in competition;

l) calculate a company’s growth rate, given the industry growth rate and the company’s projected change in market share.

Corrections/Clarifications • On page 144 of the original text, in the ninth line, “$86.6 billion” should be “$85.9 billion.” • On page 152 of the original text, the first line below the first equation should read: “where N

is … and ΣMj denotes…”

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Financial Statement Analysis The candidate should be able to analyze and use financial statements and disclosures in the investment valuation process; analyze a company’s liquidity, profitability, financial stability, solvency, and asset utilization; and analyze the effect of alternative accounting methods and assumptions on financial statements. The candidate should be familiar with the forms, terminology, and financial significance of mergers and acquisitions. The candidate should also be able to analyze differences among U.S., country-specific, and international accounting standards, and incorporate the findings into financial and valuation analyses. Some of the accounting concepts in the Financial Statement Analysis study sessions (Session 5 through Session 7) may be superseded by updated rulings and/or announcements issued after a reading was published. Although candidates are not expected to learn material that is outdated, they should be familiar with the overall analytical framework contained in these sessions. Candidates will not be penalized for applying updated rules. The reading assignments include specific problems that are helpful in understanding the important concepts in each reading. Answers to the questions, exercises, problems, and cases are in the Solutions Manual for The Analysis and Use of Financial Statements by Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried (2nd edition, Wiley, 1998). The Solutions Manual is listed in the Supplemental Material on the textbook order form in this Study Guide. Except where noted, the “Boxes” in this book are not part of the Level II reading assignment. Reading 2 in study session 5 is the revised Ch. 14 from the forthcoming The Analysis and Use of Financial Statements, 3rd edition. The solutions for the problems assigned in Ch.14 are printed in the candidate readings book.

Study Session 5 Investment Tools Financial Statement Analysis: Intercorporate Investments and Business Combinations Reading Assignments 1. “Analysis of Intercorporate Investments,” Ch. 13, pp. 671–717, The Analysis and Use of

Financial Statements, 2nd edition, Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried (Wiley, 1998)

2.* “Analysis of Business Combinations,” Ch. 14 including Box 14-1, but omitting “Income Tax Effects of Business Combinations” (pp. 23−27) and “Push-Down Accounting” (pp. 37−40), The Analysis and Use of Financial Statements, 3rd edition, Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried (Wiley, forthcoming)

3.* “Mergers, LBOs, Divestitures, and Holding Companies,” Ch. 21, Fundamentals of Financial Management, 8th edition, Eugene F. Brigham and Joel F. Houston (Dryden, 1998)

* Readings marked with an asterisk are contained in the 2003 CFA Level II Candidate Readings.

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Learning Outcomes 1. “Analysis of Intercorporate Investments”

The candidate should be able to a) determine whether a debt security or equity security should be classified as held to

maturity, available for sale, or as a trading security; b) compute the effect of debt-security and equity-security classification on the financial

statements and financial ratios; c) compute the mark-to-market investment return on an investment portfolio; d) calculate the balance sheet carrying value of an investment, using the cost method,

equity method, and consolidation method; e) determine, given various ownership and/or control levels and relevant accounting

standards, whether the cost method, equity method, proportionate consolidation method, or consolidation method should be used;

f) differentiate among the cost method, equity method, consolidation method, and proportionate consolidation method, and compare the effects of using each method on a company’s financial statements and financial ratios;

g) define a reportable segment, and discuss the uses and limitations of the data; h) analyze, prepare, and illustrate the disclosure requirements for a reportable segment. Problems: 13-1, 13-5, 13-6, 13-13, 13-15

2. “Analysis of Business Combinations”

The candidate should be able to a) describe the purchase methods of accounting for business combinations under

International Accounting Standards Board (IASB) and U.S. Generally Accepted Accounting Principles (GAAP) and describe the pooling of interests method under IASB GAAP;

b) compare and contrast the pooling method under IASB GAAP to the purchase methods under U.S. and IASB GAAP;

c) identify the conditions under which the pooling-of-interests method can be used according to IASB GAAP;

d) construct consolidated balance sheets and income statements, according to both U.S and IASB GAAP, using the purchase method;

e) construct a consolidated balance sheet and income statement, according to IASB GAAP, using the pooling method;

f) compare and contrast the effects of the pooling method to the two variants of the purchase method on the balance sheet, the income statement, and the statement of cash flows, and various financial ratios;

g) compare the effects of the three acquisition accounting methods on the various financial ratios;

h) describe goodwill and discuss its treatment for purposes of financial analysis according to U.S. and IASB GAAP;

i) analyze the effects of a spin-off on a firm’s financial statements. Problems: 1−6

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3. “Mergers, LBOs, Divestitures, and Holding Companies”

Note: Suggested Questions (Q) and Problems (P) from the end of this chapter are included below. Solutions are reprinted in the 2003 Level II Candidate Readings. The candidate should be able to a) analyze rationales for a potential merger; b) analyze and differentiate among sources of synergistic effects from mergers; c) differentiate among horizontal, vertical, congeneric, and conglomerate mergers; d) differentiate between hostile and friendly mergers; e) differentiate between financial and operating mergers; f) determine the value to the acquiring company of a potential acquisition target

company; g) evaluate a potential merger using discounted cash flow analysis and market multiple

analysis; h) discuss the role of investment bankers in mergers; i) discuss the defensive tactics that a target company can use against the threat of a

hostile takeover; j) differentiate among mergers, corporate alliances, and leveraged buyouts; k) discuss the different forms a divestiture may take and the reasons for divestitures; l) define a holding company and list advantages and disadvantages of this

organizational form. Questions/Problems: Q 21-1, 21-3, 21-5; P 21-1, 21-2, 21-3, 21-4, 21-6

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Study Session 6 Investment Tools Financial Statement Analysis: Global Issues Reading Assignments 1.* “Measuring Accounting Exposure,” Ch. 8, Foundations of Multinational Financial

Management, 3rd edition, Alan C. Shapiro (Prentice Hall, 1998) 2. “Analysis of Multinational Operations,” Ch. 15, pp. 819–854, The Analysis and Use of

Financial Statements, 2nd edition, Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried (Wiley, 1998)

3.* “Accounting Bulletin #99, International Accounting Standards: Updated Review, Handling Diversity and U.S. GAAP Contrasted,” David F. Hawkins (Merrill Lynch, 2001)

Learning Outcomes 1. “Measuring Accounting Exposure”

The candidate should be able to a) distinguish between a company’s accounting (translation) exposure and economic

(operating and transaction) exposure to exchange rate changes; b) compare and contrast the four principal currency translation methods; c) compute a company’s translation exposure and any resulting translation gain or loss; d) distinguish between the functional currency and the reporting currency.

2. “Analysis of Multinational Operations”

Note: Candidates are not required to read the cases. The candidate should be able to a) determine the impact of changes in local currency sales and changes in exchange

rates on the translated sales of the subsidiary and parent company; b) distinguish between the all-current method and the temporal method, explain the

effects of each on the parent’s balance sheet and income statement, and determine which method is appropriate in various scenarios;

c) calculate the translation effects and evaluate the translation of a subsidiary’s balance sheet and income statement into the parent’s currency using the all-current method and the temporal method;

d) determine how the translation of a subsidiary’s financial statements will affect the subsidiary’s financial ratios;

e) determine how using the temporal method versus the all-current method will affect the parent company’s financial ratios;

f) discuss alternative accounting methods for hyperinflationary subsidiaries. Problems: 15-1, 15-3, 15-4

* Readings marked with an asterisk are contained in the 2003 CFA Level II Candidate Readings.

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3. “Accounting Bulletin #99, International Accounting Standards: Updated Review,

Handling Diversity and U.S. GAAP Contrasted” The candidate should be able to describe the differences between the IASB and US GAAP treatment of • • •

upward revaluation of tangible and intangible assets acquired-in-process R&D

• cash flow statements

• • •

intangible assets amortization development costs segment disclosures asset impairment.

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Study Session 7 Investment Tools Financial Statement Analysis: Earnings Quality Issues Reading Assignments 1.* “Understanding Retirement Benefit Accounting and Disclosures for Financial Analysis,”

Thomas R. Robinson and Paul Munter (AIMR, 2002) 2.* “Accounting Bulletin #69, Detecting Lower Earnings Quality,” David F. Hawkins (Merrill

Lynch, 1998) 3. “Analysis of Financial Statements: A Synthesis,” Ch. 17, The Analysis and Use of

Financial Statements, 2nd edition, Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried (Wiley, 1998)

Learning Outcomes 1. “Understanding Retirement Benefit Accounting and Disclosures for Financial

Analysis” The candidate should be able to a) explain the differences in accounting for defined contribution and defined benefit

pension plans; b) distinguish between pay-related and non-pay related pension plans; c) explain the following measures of defined benefit pension plan liabilities:

• projected benefit obligation • accumulated benefit obligation • vested benefit obligation;

d) explain the following terms related to defined benefit pension plans and other retirement benefits and discuss the impact of each on expenses, assets, and liabilities: • service cost • interest cost • actual return on plan assets • expected return on plan assets • prior service cost and related amortization • net gains and losses and related amortization • transition liability and related amortization • contributions • benefits paid • accumulated postretirement benefit obligation;

e) explain the effect of changes in the following pension and other retirement plan assumptions on measures of liability and expense, and on the financial statements and ratios: • discount rate • rate of compensation increase

* Readings marked with an asterisk are contained in the 2003 CFA Level II Candidate Readings.

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• rate of return on plan assets • healthcare inflation rate;

f) explain and calculate the minimum liability adjustment; g) explain the differences between U.S. Generally Accepted Accounting Principles

(GAAP) and International Accounting Standards (IASB) for pension and other post-retirement benefit plans;

h) compute the liability (or asset) to be reported on a company’s balance sheet based upon pension and other post-retirement benefit disclosures under U.S. GAAP;

i) calculate the underlying economic liability (or asset) of a company based upon pension and other post-retirement benefit disclosures;

j) calculate the pension or other post-retirement benefit expense (income) to be reported on a company’s income statement based upon footnote and other disclosures under U.S. GAAP;

k) calculate the underlying economic pension and other post-retirement expense (income) based upon disclosures on both an operating and net basis;

l) determine which measure of underlying pension expense is better suited for evaluating past performance versus forecasting;

m) compute and analyze the impact of retirement benefit accounting on reported financial statement results and ratios, including: • adjusting pension and other retirement benefit assets and liabilities for off-

balance sheet items, and • adjusting pension and other retirement benefit expense for the impact of

amortized items and non-operating items. 2. “Accounting Bulletin #69, Detecting Lower Earnings Quality”

The candidate should be able to identify and discuss accounting practices that contribute to a deterioration of earnings quality, including • research and development in progress write-offs arising from business acquisitions • restructuring charges • unrecorded stock-option compensation costs • front-end income loading • deferral of costs • recognition of deferred-tax assets • classification of expenditures • use of reserves • adoption of less conservative accounting estimates, practices, and principles.

3. “Analysis of Financial Statements: A Synthesis”

The candidate should be able to a) modify the balance sheet for assets and liabilities that are not recorded; b) modify the balance sheet for the current value of assets and liabilities; c) compute a company’s normal operating earnings and comprehensive income;

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d) determine and interpret the effect on reported financial results and ratios of a

company’s choices of accounting methods and assumptions (e.g., inventory methods, depreciation methods, lease or purchase of long term assets);

e) determine and interpret the effect on reported financial results and ratios of changes in accounting methods and assumptions (e.g., depreciation methods or assumptions, employee benefit plan assumptions);

f) determine and interpret the effects of balance sheet modifications and earnings normalization on a company's financial statements, financial ratios and overall financial condition;

g) identify indicators of high and low earnings quality; h) illustrate how accounting choices affect whether cash flows are classified as

operating, financing, or investing. Case: 17-1 (1, 2, 3)

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Asset Valuation The candidate should be able to analyze and apply concepts, such as discounted cash flow and sustainable growth, that are basic to the valuation of all asset classes. Asset valuation at Level I emphasizes the characteristics of different asset classes, often focusing on key differences among these characteristics. At Level II the emphasis shifts to the analysis and valuation of various assets.

Study Session 8 Asset Valuation Basic Valuation Concepts Reading Assignments 1. Analysis of Equity Investments: Valuation, John D. Stowe, Thomas R. Robinson, Jerald E.

Pinto, and Dennis W. McLeavey (AIMR, 2002) A. “Forward,” by George H. Troughton B. “Equity Valuation Process,” Ch. 1

2. Company Performance and Measures of Value Added, pp. 1–47, Pamela P. Peterson and David R. Peterson (Research Foundation of the ICFA, 1997)

3.* “An Analysis of EVA,” Richard Bernstein and Carmen Pigler, Quantitative Viewpoint (Merrill Lynch, 19 December 1997)

4.* “An Analysis of EVA − Part II,” Richard Bernstein, Kari Bayer, and Carmen Pigler, Quantitative Viewpoint (Merrill Lynch, 3 February 1998)

Note: Candidates are responsible for the practice problems at the end of reading 1B. Solutions to the problems are found at the end of the chapter.

Learning Outcomes 1. A. “Forward”

The candidate should be able to a) explain how the classic works of Graham and Dodd and John Burr Williams are

reflected in modern security analysis; b) identify where Modern Portfolio Theory (MPT) has been incorporated into

modern equity valuation models; c) list the basic rudiments of dividend discount models, free cash flow models,

market multiple models, and residual income models.

B. “Equity Valuation Process” The candidate should be able to a) define valuation and discuss the uses of valuation models; b) discuss the importance of expectations in the use of valuation models; c) define and calculate alpha; d) contrast top-down and bottom-up approaches to equity analysis; e) contrast quantitative and qualitative factors in valuation;

* Readings marked with an asterisk are contained in the 2003 CFA Level II Candidate Readings.

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f) discuss the importance of quality of inputs in valuation; g) discuss the importance of the interpretation of footnotes to accounting

statements and other disclosures; h) contrast the going-concern and non-going-concern assumptions in valuation; i) contrast absolute and relative valuation models; j) discuss the role of ownership perspective in valuation.

2. Company Performance and Measures of Value Added

The candidate should be able to a) calculate the traditional measures of performance; b) analyze the advantages and disadvantages of using return on investment ratios and

Tobin’s Q as measures of company performance; c) distinguish between economic profit and accounting profit and relate economic profit

to net present value; d) calculate economic value added (EVA) and market value added (MVA); e) describe the process for determining cash flow return on investment (CFROI); f) demonstrate the link between EVA and MVA; g) explain the differences among EVA, MVA, and CFROI; h) compare the empirical relationship between stock returns and value-added measures

with the empirical relationship between stock returns and more traditional valuation measures;

i) discuss the reasons why market-value-added measures may not be superior to stock returns in measuring corporate performance.

3. “An Analysis of EVA”

The candidate should be able to a) briefly explain EVA and MVA and the connection between the two concepts; b) demonstrate how EVA can be used as a criterion for selecting stocks; c) discuss the risk–return results of selection strategies based on EVA and MVA as well

as several other traditional measures of valuation (see also Reading 2, LOS h). 4. “An Analysis of EVA − Part II”

The candidate should be able to a) explain why investment strategies based on the growth in EVA and/or the growth in

MVA might be more closely related to future stock performance than strategies based on the absolute levels of EVA and/or MVA;

b) relate EVA and MVA to value and/or momentum strategies.

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Analysis of Equity Investments The candidate should be able to apply fundamental analysis to investment valuation, analyze special situations (e.g., closely held companies, venture capital, and companies with very high growth rates), and use various equity valuation models to estimate equity risk and return.

Study Session 9 Asset Valuation Equity Investments: Industry and Company Analysis Reading Assignments 1.* “Competitive Strategy: The Core Concepts,” Michael E. Porter, Competitive Advantage:

Creating and Sustaining Superior Performance (The Free Press, 1985) 2.* “Industry Analysis,” Ch. 6, Security Analysis On Wall Street: A Comprehensive Guide To

Today’s Valuation Methods, Jeffrey C. Hooke (Wiley, 1998) 3. Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C.

Brown (Dryden, 2000) A. “Analysis of Financial Statements,” Ch. 12 B. “Company Analysis and Stock Selection,” Ch. 20, pp. 792−852

Learning Outcomes 1. “Competitive Strategy: The Core Concepts”

The candidate should be able to a) analyze the competitive advantage and competitive strategy of a company and the

competitive forces that affect the profitability of a company; b) discuss the two fundamental questions determining the choice of competitive

strategy; c) analyze basic types of competitive advantage that a company can possess and the

generic strategies for achieving a competitive advantage; d) analyze the risks associated with each of the generic strategies; e) discuss the difficulties and risks of simultaneously using more than one of the generic

strategies; f) explain the role of a generic strategy in the strategic planning process.

2. “Industry Analysis”

The candidate should be able to a) discuss the factors that should be included in an industry analysis model; b) illustrate the life cycle of a typical industry; c) analyze the effects of business cycles on industries (growth, defensive, cyclical); d) analyze the impact of external factors (such as technology, government, foreign

influences, demography, and social changes) on industries; e) illustrate the inputs and methods used in preparing an industry demand-and-supply

analysis; f) explain factors that affect industry pricing practices;

* Readings marked with an asterisk are contained in the 2003 CFA Level II Candidate Readings.

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g) analyze the effects of international competition on industries.

3. A. “Analysis of Financial Statements”

Note: Candidates should supplement their study of this reading with a review of Study Sessions 5, 6, and 7.

The candidate should be able to a) describe some of the important accounting choices (typically explained in the

footnotes of financial statements) that companies must make when constructing financial statements using generally accepted accounting principles (GAAP);

b) describe how a company’s accounting choices make comparability among companies difficult;

c) distinguish among “cash flows from operating activities” (from the statement of cash flows), “traditional cash flow,” and “free cash flow;”

d) calculate financial ratios in the following categories: common size, internal liquidity, operating efficiency, operating profitability, business risk, financial risk, growth, and external liquidity;

e) compute return on equity (ROE) using the DuPont system and the extended DuPont system;

f) discuss business risk and financial risk; g) prepare, using financial ratios, a comparative analysis of a company over time

and relative to its industry or to the market; h) discuss the challenges of international ratio analysis; i) contrast the ratios that are most likely to be useful for valuing common stock,

establishing bond ratings, and forecasting bankruptcy; j) explain limitations of ratio analysis.

Corrections/Clarifications •

•

•

•

•

On page 392, in the calculation of the Quick Ratio for 1997, the numerator should be 449.

On page 409, in the calculations of Fixed Financial Cost Coverage for 1998, 1997, and 1996, the numerators should be 835, 708, and 604, respectively.

On page 411, in the calculation of the Cash Flow/Long-Term Debt Ratio for 1998, the equation should read: 1998: [511 + 189 + (–24)] / 473 = 143%.

On page 411, in the calculation of the Cash Flow/Total Debt Ratio for 1998, the equation should read: 1998: 676 / 2,053 = 32.9%.

In the table on page 412, the entries for Traditional Cash Flow for 1998 and 1997 should be 676 and 568, respectively.

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B. “Company Analysis and Stock Selection”

The candidate should be able to a) demonstrate techniques for estimating future earnings per share for a company,

the earnings multiplier for a company, and the future value of a company’s shares;

b) compute and analyze the relative valuation ratios that analysts use to evaluate equity investments;

c) infer, using valuation methods, whether a particular stock is an attractive investment;

d) distinguish between economic value added (EVA), market value added (MVA), and the franchise factor concept;

e) illustrate why the standard dividend discount model (DDM) may be inappropriate for valuing a growth company;

f) compare the alternative growth models and their underlying assumptions; g) calculate the value of a company using the DDM; h) analyze the factors that should be considered when evaluating a company on a

global basis.

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Study Session 10 Asset Valuation Equity Investments: Valuation Models Reading Assignments 1. Analysis of Equity Investments: Valuation, John D. Stowe, Thomas R. Robinson, Jerald

E. Pinto, and Dennis W. McLeavey (AIMR, 2002) A. “Discounted Dividend Valuation,” Ch. 2 B. “Free Cash Flow Valuation,” Ch. 3

Note: Candidates are responsible for the practice problems at the end of each chapter. Solutions to the problems are found at the end of each chapter.

Learning Outcomes 1. A. “Discounted Dividend Valuation”

The candidate should be able to a) discuss the advantages and disadvantages of dividends, free cash flow, and

residual income as measures of cash flow in discounted cash flow valuation, and identify the investment situation for which each is suitable;

b) determine the circumstances when a dividend discount model (DDM) is appropriate for valuing a stock;

c) explain the capital asset pricing model (CAPM), arbitrage pricing theory (APT), and bond yield plus risk premium approaches for estimating the required rate of return for an equity investment, and calculate the required rate of return using each approach;

d) estimate the Gordon growth model equity risk premium; e) discuss the limitations to using the CAPM and APT to estimate the required

return on equity; f) estimate the required return on equity using the build-up approach; g) calculate the expected holding-period return on a stock given its current price,

expected next-period price, and expected next-period dividend; h) contrast the expected holding-period return with the required rate of return; i) discuss the effect on expected return of the convergence of price to value, given

that price does not equal value; j) calculate the value of a common stock using the DDM for one-, two-, and

multiple-period holding periods; k) calculate the value of a common stock using the Gordon growth model and

explain the underlying assumptions; l) calculate the expected rate of return or implied dividend growth rate in the

Gordon growth model, given the market price, the expected dividend, and either the expected rate of return or the dividend growth rate;

m) explain and calculate justified leading and trailing price-to-earnings (P/E) ratios based on fundamentals, using the Gordon growth model;

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n) calculate the value of fixed-rate perpetual preferred stock given the stock’s

annual dividend and the discount rate; o) explain and calculate the present value of growth opportunities (PVGO) given

current earnings per share, the required rate of return, and the value of the stock; p) explain the strengths and limitations of the Gordon growth model, and justify

the selection of the Gordon growth model to value a company, given the characteristics of the company being valued;

q) explain the assumptions and justify the selection of the two-stage DDM, the H-model, the three-stage DDM, or spreadsheet modeling;

r) explain the growth phase, transitional phase, and maturity phase of a business; s) explain terminal value and discuss alternative approaches to determining the

terminal value in a discounted dividend model; t) calculate the value of a common stock using the two-stage DDM, the H-model,

and the three-stage DDM; u) explain how to estimate the implied expected rate of return for any DDM,

including the two-stage DDM, the H-model, the three-stage DDM, and the spreadsheet model;

v) calculate the implied expected rate of return for the H-model and a general two-stage model;

w) explain the strengths and limitations of the two-stage DDM, the H-model, the three-stage DDM, and the spreadsheet model;

x) define sustainable growth rate and explain the underlying assumptions; y) calculate the sustainable growth rate for a company; z) estimate, using the DuPont model, the return on equity used to estimate a

company’s sustainable growth rate; aa) discuss the use of dividend discount models as discipline for portfolio selection,

and explain two risk control methodologies.

B. “Free Cash Flow Valuation” The candidate should be able to a) define and interpret free cash flow to the firm (FCFF) and free cash flow to

equity (FCFE); b) describe the FCFF and FCFE approaches to valuation and contrast the

appropriate discount rates for each model; c) explain the strengths and limitations of the FCFE model; d) contrast the ownership perspective implicit in the FCFE approach to the

ownership perspective implicit in the dividend discount approach; e) discuss the appropriate adjustments to net income, earnings before interest and

taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), or cash flow from operations (CFO) to arrive at FCFF and FCFE;

f) calculate FCFF and FCFE given a company’s financial statements prepared according to U.S. Generally Accepted Accounting Principles or International Accounting Standards;

g) discuss approaches for forecasting FCFF and FCFE; h) contrast the recognition of value in the FCFE model to the recognition of value

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in dividend discount models;

i) explain how dividends, share repurchases, share issues, and changes in leverage may affect FCFF and FCFE;

j) critique the use of net income and EBITDA as proxies for cash flow in valuation;

k) describe the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE models and discuss the assumptions underlying each model;

l) justify the selection of a single-stage, two-stage, or three-stage FCFF or FCFE model given characteristics of the company being valued;

m) calculate the value of a company using the single-stage, two-stage, and three-stage FCFF and FCFE models;

n) explain how sensitivity analysis can be used in FCFF and FCFE valuations; o) discuss the approaches for calculating the terminal value in a multistage

valuation model; p) describe the characteristics of companies for which the FCFF model is preferred

to the FCFE model.

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Study Session 11 Asset Valuation Equity Investments: Valuation Models and Applications Reading Assignments 1. Analysis of Equity Investments: Valuation, John D. Stowe, Thomas R. Robinson, Jerald E.

Pinto, and Dennis W. McLeavey (AIMR, 2002) A. “Market-Based Valuation: Price Multiples,” Ch. 4 B. “Residual Income Valuation,” Ch. 5

2.* “Star Cruises: Fair winds for a young star,” Andrew Lee, HSBC Research (Malaysia) Sdn Bhd Company Report (HSBC Research (Malaysia) Sdn Bhd, 1 September 1999)

Note: Candidates are responsible for the practice problems at the end of readings 1A and 1B. Solutions to the problems are found at the end of each chapter.

Learning Outcomes 1. A. “Market-Based Valuation: Price Multiples”

The candidate should be able to a) distinguish between the method of comparables and the method based on

fundamental forecasts as approaches to using price multiples in valuation and discuss the economic rationales for each;

b) define a justified price multiple; c) discuss arguments for and against the use of price-to-earnings (P/E) ratios for

valuation; d) define and calculate a stock’s trailing P/E and leading P/E; e) define underlying earnings, and calculate underlying earnings given earnings

per share and nonrecurring items in the income statement; f) define normalized earnings per share, discuss the methods of normalizing

earnings per share, and calculate normalized earnings per share by each method; g) explain and justify the use of earnings yield for ranking common stocks; h) discuss the fundamental factors that influence P/E; i) calculate a justified P/E based on forecasted fundamentals; j) calculate a predicted P/E ratio given a cross-sectional regression on

fundamentals; k) evaluate a common stock based on P/E ratios using the method of comparables; l) define and calculate the P/E-to-growth (PEG) ratio, and explain its use in

relative valuation; m) explain the use of price multiples to determine terminal value in a multistage

discounted cash flow model and compute a terminal value based on comparables;

n) define and calculate the price to book (P/B) and price to sales (P/S) ratios; o) discuss arguments for and against the use of P/B and P/S ratios;

* Readings marked with an asterisk are contained in the 2003 CFA Level II Candidate Readings.

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p) calculate justified P/B and P/S ratios based on fundamentals; q) discuss the fundamentals that influence P/B and P/S ratios; r) evaluate a stock based on P/B and P/S ratios using the method of comparables; s) discuss alternative definitions of cash flow including earnings-plus-non-cash

charges (CF) and cash flow from operations (CFO), and explain the limitations of each;

t) define and calculate P/CF, P/CFO, price to free cash flow to equity (P/FCFE) and price to EBITDA (P/EBITDA);

u) discuss arguments for and against the use of price to cash flow ratios; v) discuss the fundamental factors that influence price to cash flow ratios; w) evaluate a stock based on price to cash flow ratios using the method of

comparables and a specified definition of cash flow; x) define and calculate the enterprise value (EV) to EBITDA ratio; y) discuss arguments for and against the use of EV/EBITDA ratios; z) discuss the fundamental factors that influence the EV/EBITDA ratio; aa) evaluate a company based on EV/EBITDA ratios using the method of comparables; ab) define and calculate dividend yield (D/P); ac) discuss arguments for and against the use of dividend yield; ad) discuss the fundamental factors that influence dividend yields; ae) evaluate a stock using dividend yields based on the method of comparables; af) discuss the sources of differences in cross-border valuation comparisons; ag) describe the main types of momentum indicators and their use in valuation.

B. “Residual Income Valuation” The candidate should be able to a) define and calculate residual income; b) describe alternative measures of residual earnings such as economic value

added; c) discuss the uses of residual income models; d) calculate future values of residual income given current book value, consensus

earnings growth estimates, and an assumed dividend payout ratio; e) calculate the intrinsic value of a share of common stock using the residual

income model; f) contrast the recognition of value in the residual income model to value

recognition in other present value models; g) discuss the strengths and weaknesses of the residual income model; h) justify the choice of the residual income model for equity valuation given

characteristics of the company being valued; i) discuss the fundamental determinants or drivers of residual income; j) explain the relationship between residual income valuation and the justified

price-to-book ratio based on forecasted fundamentals; k) explain the relationship of the residual income model to the dividend discount

model and free cash flow to equity model; l) discuss the major accounting issues in applying residual income models;

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m) calculate an implied growth rate in residual income given the market price-to-

book ratio and an estimate of the required rate of return on equity; n) define continuing residual income and list the common assumptions regarding

continuing residual income; o) justify an estimate of continuing residual income at the earnings forecast

horizon given company and industry prospects; p) calculate the intrinsic value of a share of common stock using a multistage

residual income model, given the required rate of return, forecasted earnings per share over a finite horizon, and forecasted continuing residual earnings.

2. “Star Cruises: Fair winds for a young star”

The candidate should be able to discuss the generic features of security analysis and the application of analytical techniques in the valuation of a company.

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Study Session 12 Asset Valuation Equity Investments: Special Valuation Cases Reading Assignments 1.* Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 3rd edition,

Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs (Irwin, 1995) A. “Minority Interest Discounts, Control Premiums, and Other Discounts and

Premiums,” Ch. 14 B. “Discounts for Lack of Marketability,” Ch. 15, pp. 331–334, 342–359

2.* “Selecting and Structuring Investments: The Venture Capitalist’s Perspective,” Lee A. Gardella, Readings in Venture Capital (AIMR, 1997)

Learning Outcomes: 1. A. “Minority Interest Discounts, Control Premiums, and Other Discounts and

Premiums” The candidate should be able to a) describe the concept and importance of control; b) explain the factors affecting the magnitude of a given control premium; c) describe the position of a minority shareholder; d) discuss how the valuation approaches used may impact the control

premium/minority discount issue; e) discuss the selection of a standard of value and how the selection affects

minority discounts or control premiums; f) discuss the impact of state statute provisions on minority versus control value; g) discuss the top down, horizontal, and bottom up approaches for valuing

minority interests; h) discuss the market evidence with respect to control premiums and minority

discounts.

B. “Discounts for Lack of Marketability” The candidate should be able to a) discuss the importance of marketability and differentiate between marketability

and liquidity; b) discuss the general results of the studies of private stock transactions; c) discuss the transactional considerations encountered when attempting to

liquidate a controlling interest in a closely held company; d) describe the factors that affect the discount for lack of marketability.

2. “Selecting and Structuring Investments: The Venture Capitalist’s Perspective”

The candidate should be able to a) describe how venture capital deals are generated;

* Readings marked with an asterisk are contained in the 2003 CFA Level II Candidate Readings.

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b) analyze the due diligence process and evaluate its effect on the effectiveness of an

investment strategy; c) explain the issues that affect the valuation of a venture capital investment; d) differentiate the concerns of the entrepreneur from the concerns of the venture

capitalist when structuring an investment.

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Analysis of Debt Investments The candidate should be able to estimate risk and returns for debt instruments, analyze debt instruments with unique features, and value debt instruments with embedded options.

Study Session 13 Asset Valuation Debt Investments: Credit Analysis Reading Assignments 1. “General Principles of Credit Analysis,” Level II, Ch. 9 including Appendix, Fixed Income

Analysis for the Chartered Financial Analyst Program, Frank J. Fabozzi, (Frank J. Fabozzi Associates, 2000)

Note: Candidates are responsible for the questions at the end of the chapter. Solutions to the questions are found at the end of the chapter.

Learning Outcomes 1. “General Principles of Credit Analysis” including Appendix

The candidate should be able to a) distinguish among default risk, credit spread risk, and downgrade risk; b) explain how credit analysis encompasses examination of the borrower’s character, the

borrower’s capacity to repay, the issues underlying collateral, and the issue’s covenants;

c) identify the factors considered by rating agencies in assessing the quality of management and explain the importance of these factors;

d) discuss sources of liquidity for a company and the importance of these sources in the credit analysis process;

e) explain the key ratios used by credit analysts to assess the ability of a company to satisfy its debt obligations (i.e., short-term solvency ratios, capitalization ratios, and coverage ratios) and discuss the importance of these ratios;

f) compute the ratios explained in (e) above and use their level and trend to evaluate an issuer’s potential credit rating;

g) explain the limitations of traditional ratios; h) discuss why and how cash flow from operations is used to assess the ability of an

issuer to service its debt obligations and to assess the financial flexibility of a company;

i) describe the various covenants and discuss their importance in assessing credit risk for both investment grade and non-investment grade companies;

j) explain the typical elements of the debt structure of a high-yield issuer, the interrelationships among these elements, and the impact of these elements on the risk position of the lender;

k) explain the importance of the corporate structure of a high-yield issuer that has a holding company;

l) explain why some investors advocate using an equity perspective when analyzing the credit worthiness of high-yield issues;

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m) discuss the factors considered by rating agencies in rating asset-backed securities (i.e.,

collateral credit quality, seller/servicer quality, cash flow stress and payment structure, and legal structure);

n) explain how the creditworthiness of municipal bonds is assessed, and compare the analysis of tax-backed debt with the analysis of revenue obligations;

o) discuss the key economic and political risks considered by Standard & Poor’s in assigning sovereign ratings;

p) explain why two ratings are assigned to each national government and discuss the key factors emphasized by Standard & Poor’s for each rating;

q) contrast the credit analysis required for corporate bonds, asset-backed securities, municipal securities, and sovereign debt;

r) explain the use of traditional ratios to identify corporate issuers that may be downgraded.

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Study Session 14 Asset Valuation Debt Investments: Valuation Issues Reading Assignments: 1. Fixed Income Analysis for the Chartered Financial Analyst Program, Frank J. Fabozzi

(Frank J. Fabozzi Associates, 2000) A. “Introduction to the Measurement of Interest Rate Risk,” Level I, Ch. 7 B. “The Term Structure and the Volatility of Interest Rates,” Level II, Ch. 1 C. “Valuing Bonds with Embedded Options,” Level II, Ch. 2 D. “Valuation of Interest Rate Derivative Instruments,” Level II, Ch. 8

Note: Candidates are responsible for the questions at the end of each chapter. Solutions to the questions are found at the end of each chapter.

Learning Outcomes 1. A. “Introduction to the Measurement of Interest Rate Risk”

The candidate should be able to a)

b) c)

d)

e)

f)

g)

h)

i)

j)

k)

distinguish between the full valuation approach and the duration/convexity approach for measuring interest rate risk, and explain the advantage of using the full valuation approach;

describe stress testing in relation to interest rate risk; compute the duration of a bond, given information about how the bond’s price

will increase and decrease for a given change in interest rates; compute the approximate percentage price change for a bond, given the bond’s

duration and a specified change in yield; explain, both verbally and graphically, why duration is more effective in

estimating the price impact for small changes rather than large changes in interest rates;

draw and interpret a graph of the relationship between price and yield for a callable and prepayable security and use the graph to explain what is meant by negative convexity;

draw and interpret a graph of the relationship between price and yield for a putable bond;

explain how rate shocks for interest rates used to compute duration may affect the duration calculation;

distinguish among modified duration, effective (or option-adjusted) duration, and Macaulay duration;

explain why effective duration, rather than modified duration or Macaulay duration, should be used to measure the interest rate risk for bonds with embedded options;

compute the duration of a portfolio, given the duration of the bonds comprising the portfolio, and discuss the limitations of portfolio duration;

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l)

m)

n)

o)

p) q) r) s)

•

compute the convexity measure of a bond, given information about how the price will increase and decrease for a given change in interest rates;

compute the convexity adjustment to the duration estimate of a bond’s percentage price change, given the convexity measure and a specified change in interest rates;

estimate a bond’s percentage price change, given the bond’s duration and convexity and a specified change in interest rates;

explain why convexity measures will differ among dealers and venders of analytical services because of differences in scaling;

explain the difference between modified convexity and effective convexity; compute the price value of a basis point (“dollar value of an 01”) of a bond; state the relationship between duration and the price value of a basis point; explain the importance of yield volatility in measuring the exposure of a bond

position to interest rate risk. Corrections/Clarifications

On page 279, the title of the last table should read: “Percentage price change based on an initial yield of 5%.

B. “The Term Structure and the Volatility of Interest Rates” The candidate should be able to a) describe and interpret the different shapes that have been observed for the

Treasury yield curve; b) explain the concept of the slope of the yield curve; c) illustrate and explain a parallel and a nonparallel shift in the yield curve; d) illustrate and explain a yield curve twist and a change in the curvature of the

yield curve (i.e., butterfly shift); e) describe and explain the factors that have been observed to drive Treasury

security returns and the importance of each factor; f) explain the various universes of Treasury securities that are used to construct

the theoretical spot rate curve and discuss their advantages and disadvantages; g) explain the various theories of the term structure of interest rates (i.e., pure

expectations, liquidity, preferred habitat, and market segmentation) and the implications of each theory for the shape of the yield curve;

h) interpret forward rates in the context of the theories of the term structure; i) explain two interpretations of forward rates based on arbitrage arguments; j) describe how to measure and compute the effects of the yield curve risk of a

security or a portfolio, using key rate duration; k) compute and interpret yield volatility, given historical yields; l) explain the issues associated with calculating yield volatility (i.e., the number of

observations to use and the annualizing of daily yield volatility); m) distinguish between historical yield volatility and implied yield volatility; n) explain how yield volatility is forecasted.

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Corrections/Clarifications • On page 304, in the second paragraph, the two occurrences of “6-month” should be changed

to “5-year.” • On page 311, in the third paragraph, the five occurrences of “scenario 1” should be changed

to “scenario 2.”

C. “Valuing Bonds with Embedded Options”

The candidate should be able to a) explain the concept of an interest rate model; b) explain the concept of an interest rate tree; c) explain the backward induction valuation methodology within the binomial

interest rate tree framework; d) compute the value of an option-free bond, using an interest rate tree; e) compute the value of a callable bond from an interest rate tree, given the call

schedule and the rule for calling a bond; f) explain how the value of the embedded call option is determined; g) explain the relationship among the values of a callable (putable) bond, the

corresponding option-free bond, and the embedded option; h) explain the effect of volatility on the arbitrage-free value of an option; i) explain how option-adjusted spread is calculated using the binomial model; j) interpret an option-adjusted spread with respect to a nominal spread and to

benchmark interest rates; k) explain how effective duration and effective convexity are calculated using the

binomial model; l) compute the value of a putable bond, using an interest rate tree; m) explain how the binomial model can accommodate multiple embedded options; n) explain how the binomial model can be used to value a step-up callable note and

a capped floater; o) formulate the appropriate “nodal decision” within the backward induction

methodology of the interest rate tree framework for each of the following bonds: putable bond, callable bond, putable/callable bond, multiple step-up callable bond, and a floater with a cap;

p) describe the basic features of a convertible bond; q) compute the value and explain the meaning of the following for a convertible

bond: conversion value, straight value, market conversion price, market conversion premium per share, market conversion premium ratio, premium payback period, and premium over straight value;

r) discuss the components of a convertible bond’s value that must be included in an option-based valuation approach;

s) compare the risk–return characteristics of a convertible bond with the risk–return characteristics of ownership of the underlying common stock.

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Corrections/Clarifications • On page 380, in the answer to Question 9f, replace $126.076 with $102.076.

D. “Valuation of Interest Rate Derivative Instruments” The candidate should be able to a) explain how the theoretical price of a futures contract is determined; b) compute the theoretical price of a Treasury futures contract; c) explain how the theoretical price of a Treasury bond futures contract is affected

by the delivery options; d) explain the complications in extending the standard arbitrage pricing model to

the valuation of Treasury bond and note futures contracts; e) compute the floating-rate payments for a swap; f) explain how the swap rate and swap spread are determined; g) describe how the value of a swap is determined; h) calculate the swap rate, swap spread, and value of a swap; i) explain the two components of the option price and the factors that affect the

value of an option; j) identify the limitations of using the Black–Scholes option pricing model to

value interest rate options; k) compute the price of an option on a bond using the arbitrage-free binomial

model; l) discuss the Black model for valuing options on futures; m) explain how to measure the sensitivity of an option’s value to the changes in the

factors that affect the option’s value; n) compute the value of an interest rate cap or floor using the arbitrage-free

binomial model. Corrections/Clarifications • On page 611, the three occurrences of “June 30” when referring to the 3-month Eurodollar

CD futures contract settlement date should be replaced with “9.” The fifth sentence beginning with “That futures contract…” should be replaced with “That futures contract reflects the market’s expectation of 3-month LIBOR on April 1 of year 1.”

• On page 627, in the first sentence of the second paragraph, replace “American” with

“European.” • On page 641, in the equation in Question 8a, delete the term “SR.” • On page 649, in the solution to Question 8a, replace the “20” over the summation sign with

“10.”

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Study Session 15 Asset Valuation Debt Investments: Structured Securities Reading Assignments: 1. Fixed Income Analysis for the Chartered Financial Analyst Program, Frank J. Fabozzi

(Frank J. Fabozzi Associates, 2000) A. “Mortgage-Backed Securities,” Level II, Ch. 3 B. “Asset-Backed Securities,” Level II, Ch. 4 C. “Valuing Mortgage-Backed and Asset-Backed Securities,” Level II, Ch. 5

2. “Swap Contracts, Convertible Securities, and Other Embedded Derivatives,” Ch. 25, pp. 1071-1082, Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C. Brown (Dryden, 2000)

Note: Candidates are responsible for the questions at the end of readings 1A through 1C. Solutions to the questions are found at the end of each chapter.

Learning Outcomes: 1. A. “Mortgage-Backed Securities”

The candidate should be able to a) b)

c) d) e)

f)

g) h)

i)

j) k) l)

m)

describe a mortgage loan; describe the cash flow characteristics of a fixed-rate, level payment, fully

amortized mortgage loan; describe prepayments and how they result in prepayment risk; explain the investment characteristics of mortgage passthrough securities; explain the importance of prepayments to the estimation of the cash flow of a

mortgage-backed security; compute the weighted average coupon and weighted average maturity of a

mortgage pool; explain a conditional prepayment rate and a single monthly mortality rate; describe the Public Securities Association (PSA) prepayment benchmark and its

relationship to the conditional prepayment rate; calculate the prepayment amount for a month, given the single monthly

mortality rate; identify the factors that affect prepayments; explain contraction and extension prepayment risks and why they occur; explain why the average life of a mortgage-backed security is a more relevant

measure than the security’s maturity; explain why and how a collateralized mortgage obligation (CMO) is created and

distinguish among the different types of CMO structures (including sequential-pay tranches, accrual tranches, floater tranches, inverse floater tranches, planned amortization class tranches, support tranches, and support tranches with schedules);

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n)

o)

p)

q)

r)

s)

t)

describe how a CMO distributes prepayment risk among tranches so as to create products that provide a better matching of assets and liabilities for institutional investors;

identify the risk characteristics of each type of CMO tranche and determine the relative performance given changes in the interest rate environment;

explain, for planned amortization class (PAC) tranches, the initial PAC collar and the effective collar;

explain why the support tranches have the greatest prepayment risk in a CMO structure;

explain stripped mortgage-backed securities, principal mortgage strips (principal-only securities), and interest mortgage strips (interest-only securities);

explain the investment characteristics of principal-only and interest-only mortgage strips;

compare and contrast agency and nonagency mortgage-backed securities. Corrections/Clarifications • On page 438, Question 31 should begin: “Assume that in FJF-01 in the chapter…”

B. “Asset-Backed Securities” The candidate should be able to a)

b) c)

d)

e)

f) g) h)

i) j)

k)

l)

m)

explain the difference between amortizing assets and non-amortizing assets and why the former may have prepayments;

explain the difference between an external and internal credit enhancement; explain the different types of external credit enhancements (corporate

guarantees, letter of credit, and bond insurance) and the problems associated with enhancing by means of third-party guarantors;

explain the different types of internal credit enhancements (reserve accounts and senior-subordinated structures);

describe, and explain the purpose of, a shifting interest mechanism in a senior-subordinated structure;

distinguish between a pass-through structure and a pay-through structure; explain optional clean-up call provisions; describe the cash flow for securities backed by closed-end home equity loans,

open-end home equity loans, manufactured housing loans, student loans, and Small Business Administration loans;

explain a prospectus prepayment curve for home equity loan-backed securities; explain why an available funds cap exists when securities are backed by

adjustable-rate home equity loans; describe a non-accelerating senior tranche and a planned amortization class

tranche in a home equity loan-backed structure; explain why prepayments that result from refinancing may not be significant for

manufactured housing-backed securities and automobile loan-backed securities; explain an absolute prepayment rate and a conditional prepayment rate;

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n)

o)

p)

q) r)

describe the structure of a credit card receivable-backed security, including the lock-out period and the principal-amortization period;

explain the early amortization trigger for a credit card receivable-backed security;

describe the basic structure of a collateralized bond obligation (CBO), including the types of bonds used as collateral and the types of tranches created;

explain why the manager of a CBO must use interest rate derivatives; explain the different periods in the life of a CBO: start-up phase, reinvestment

phase, and pay down phase.

Corrections/Clarifications • On page 478, Question 11 should read: “What is a ‘latter of percent or call date’ clean-up

call provision?” • On page 479, in Question 21, replace “mortgage” with “mortality.” • On page 483, in the solution to Question 11, delete the first sentence.

C. “Valuing Mortgage-Backed and Asset-Backed Securities” The candidate should be able to a)

b) c) d)

e)

f)

g) h)

i)

j)

k)

l)

explain how to compute the cash flow yield of a mortgage-backed or asset-backed security;

compute the bond-equivalent yield of a cash flow yield; discuss the limitations of the cash flow yield measure; explain the limitations of the nominal spread and the zero-volatility spread for a

mortgage-backed security; describe the Monte Carlo simulation model for valuing a mortgage-backed

security; explain why the binomial model or any other model that uses the backward

induction method cannot be used to value a mortgage-backed security; explain the critical assumptions of the Monte Carlo simulation model; explain why the Monte Carlo simulation model without adjustments to the

interest rate paths does not provide an arbitrage-free value; explain how the option-adjusted spread is computed using the Monte Carlo

simulation model and how this spread measure is interpreted; apply option-adjusted spread analysis to value mortgage-backed securities and

identify rich and cheap securities; explain how effective duration is computed using the Monte Carlo simulation

model; discuss some major assumptions that result in differences in effective durations

reported by dealers and vendors;

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m)

n)

o)

p)

explain other measures of duration used by practitioners in the mortgage-backed market (including cash flow duration, coupon curve duration, and empirical duration) and discuss the limitations of these duration measures;

explain how to compute the cash flow duration for a mortgage-backed security and compare this measure with the (1) modified duration and (2) effective duration measures that result from using the Monte Carlo simulation model;

determine when an asset-backed security should be valued using the zero-volatility spread approach or the option-adjusted spread approach (using Monte Carlo simulation);

determine whether the nominal spread, zero-volatility spread, or the option-adjusted spread should be used to evaluate a specific fixed income security.

Corrections/Clarifications • On page 499, in the last complete paragraph that begins “The procedure for determining…”

the next-to-last sentence should begin “On the right-hand side…” and the last sentence should read: “The average present value over all the paths on the left-hand side…”

2. “Swap Contracts, Convertible Securities, and Other Embedded Derivatives”

The candidate should be able to a) compare and contrast structured notes to regular fixed-income securities; b) describe the cash flow characteristics of dual-currency bonds, equity-index-linked

notes, commodity-linked bull and bear bonds, and swap-linked notes.

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Analysis of Derivative Investments The candidate should be able to value and describe the use of derivative securities including futures, forwards, options, and swaps.

Study Session 16 Asset Valuation Derivative Investments: Futures and Swaps Reading Assignments Futures Pricing 1. Futures, Options & Swaps, 3rd edition, Robert W. Kolb (Blackwell, 1999)

A. “Futures Prices,” Ch. 3, pp. 43–76 B. “Interest Rate Futures: Introduction,” Ch. 5, pp. 112–117 and 125–130 C. “Stock Index Futures: Introduction,” Ch. 7, pp. 202–212 D. “Foreign Exchange Futures,” Ch. 9, pp. 261–266

Risk Management with Futures 2. Futures, Options & Swaps, 3rd edition, Robert W. Kolb (Blackwell, 1999)

A. “Using Futures Markets,” Ch. 4, pp. 98–105 B. “Interest Rate Futures: Introduction,” Ch. 5, pp. 138–145 C. “Stock Index Futures: Introduction,” Ch. 7, pp. 214–217 D. “Foreign Exchange Futures,” Ch. 9, pp. 273–277

Swaps 3. Futures, Options & Swaps, 3rd edition, Robert W. Kolb (Blackwell, 1999)

A. “The Swaps Market: Introduction,” Ch. 20, pp. 608–623, 628−629 and 632–639 B. “Swaps: Economic Analysis and Pricing,” Ch. 21, pp. 648–671

Learning Outcomes Note: Candidates should understand the assumptions made to derive the cost-of-carry model and should be aware of what happens to the no-arbitrage fair value as these assumptions are relaxed (in particular, that the no-arbitrage fair value moves from a single price to a range of possible prices). Candidates should also understand the trading strategies used to exploit any violation of the no-arbitrage fair value. 1. A. “Futures Prices”

The candidate should be able to a) differentiate between spot (cash) and futures prices and explain why the basis

must converge to zero at expiration; b) identify the existence of an arbitrage opportunity, identify and arrange the

appropriate strategy (a cash-and-carry arbitrage or a reverse cash-and-carry arbitrage), list the appropriate trades to take advantage of the arbitrage opportunity, and compute the corresponding arbitrage profits;

c) compute the implied repo rate, given the cash price and futures price; d) illustrate how market imperfections (transaction costs, unequal borrowing and

lending rates, and restrictions on short selling) create upper and lower no-arbitrage futures pricing bounds;

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e) illustrate and explain what determines the differing futures price patterns under

normal backwardation, contango, and the net hedging hypothesis.

B. “Interest Rate Futures: Introduction” The candidate should be able to a) compute, given the appropriate interest rate, the price quote of a U.S. Treasury

bill (T-Bill) futures contract and a Eurodollar futures contract; b) identify the existence of an arbitrage opportunity, identify and arrange the

appropriate strategy (a cash-and-carry arbitrage or a reverse cash-and-carry arbitrage), and compute the corresponding arbitrage profits;

c) calculate the implied repo rate, given the spot Treasury bill price and the Treasury bill futures price for the period from “today” until the expiration of the futures, and annualize that implied repo rate.

C. “Stock Index Futures: Introduction”

The candidate should be able to a) describe index arbitrage and program trading; b) describe the effects of dividends on the cost-of-carry model; c) define and calculate the fair value of a stock index futures contract.

D. “Foreign Exchange Futures”

The candidate should be able to a) compute, using the cost-of-carry model, the theoretical futures price and

determine whether an arbitrage profit exists; b) identify and construct the appropriate strategy (a cash-and-carry arbitrage or a

reverse cash-and-carry arbitrage) to exploit an arbitrage opportunity and compute the profits from such a strategy.

2. A. “Using Futures Markets”

The candidate should be able to a) determine, given a risk exposure, whether a short or long hedge is appropriate; b) explain a cross-hedge and describe a situation that would necessitate a cross-

hedge; c) calculate the appropriate number of futures contracts needed to create a risk-

minimizing hedge, given the beta coefficient estimated from regressing changes in the cash price (dependent variable) on changes in the futures price (independent variable).

Corrections/Clarifications

• Equation 4.4 on page 103 should read:F

SF

F

FSSF COVHR

22 σσσσρ

−=−=

• Delete the two sentences following the definition of terms for equation 4.5 on page 103,

beginning: “The estimated β from this regression ...” and replace with the following:

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“The negative of the estimated β from this regression gives the risk-minimizing hedge ratio, because the estimated β itself equals the sample covariance between the independent (Ft) and dependent (St) variables divided by the sample variance of the independent variable. The negative of the estimated β exactly matches the definition of the risk-minimizing hedge ratio in Equation 4.4.”

• Footnote #13 on page 111 should read:

13. To find the risk-minimizing hedge ratio, we take the derivative of the portfolio’s risk in Equation 4.3 with respect to HR, set the derivative equal to zero, and solve for HR:

022 22

=+= FSSFFP HR

HRdd

σσρσσ

F

SF

F

SSF

COVHR 2σσ

σρ −=−=

B. “Interest Rate Futures: Introduction” The candidate should be able to a) identify whether a long hedge or a short hedge is appropriate, using interest rate

futures, for a given scenario; b) calculate the total cash flows of a hedged position and compare them with the

cash flows of an unhedged position; c) compute the impact of cross-hedging on the total cash flows of a hedging

strategy.

C. “Stock Index Futures: Introduction” The candidate should be able to a) calculate the hedge ratio, identify whether a long hedge or a short hedge is

appropriate, and determine the appropriate number of futures contracts to implement the required long or short hedge;

b) calculate the total cash flows of a hedged position and compare these cash flows with the cash flows of an unhedged position.

Corrections/Clarifications • The centered equation at the top of page 215 should read:

F

P

VV

− = – )250)($1060(

000,000,40$ = –150.94 ≈ –151 contracts

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• Equation 7.6 on page 215 should read:

PF

P

VV

β

− = Number of Contracts

• The computed number of contracts on page 215 should read:

–

)250)($1060(

000,000,40$ 1.22 = – 184.15 ≈ – 185 contracts

D. “Foreign Exchange Futures” The candidate should be able to a) identify whether a long hedge or a short hedge is appropriate and determine the

appropriate number of foreign exchange futures contracts to implement the required long or short hedge;

b) calculate the total cash flows of a hedged position and compare these cash flows with the cash flows of an unhedged position.

3. A. “The Swaps Market: Introduction”

Note: The term “box and arrow diagram” refers to diagrams similar to those in Figures 20.4 through 20.8.

The candidate should be able to a) discuss the characteristics of and motivations for swap contracts and

differentiate swap contracts from futures contracts, especially with respect to payment date versus expiration date;

b) diagram (with a box and arrow diagram) and calculate the cash flows between the parties to a plain vanilla swap contract, including situations in which an intermediary participates;

c) distinguish between swap situations in which all cash flows are netted and swap situations that involve an exchange of principal;

d) illustrate the appropriate cash flow diagram for a swap and calculate the net borrowing/lending costs for the two swap counterparties;

e) differentiate among a plain vanilla interest rate swap, an amortizing swap, an accreting swap, a seasonal swap, an off-market swap, a forward swap, a basis swap, a yield curve swap, a constant-maturity swap, and a diff swap;

f) illustrate and explain how a plain vanilla interest rate swap and a plain vanilla currency swap can be combined to form a combined interest rate and currency swap (CIRCUS);

g) diagram (with a box and arrow diagram) and calculate the net periodic swap cash flows for an equity swap, given the equity return, notional principal, fixed percentage return, and the tenor of the swap.

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B. “Swaps: Economic Analysis and Pricing”

The candidate should be able to a) demonstrate how swap agreements can be viewed as a combination of capital

market instruments and as a portfolio of forward rate agreements; b) demonstrate how an interest rate swap agreement can be viewed as a strip of

Eurodollar futures contracts and as a zero-cost interest rate collar; c) show how a forward rate agreement is the same as a pair of interest rate options; d) demonstrate how a swap agreement can be viewed as a portfolio of caps and

floors.

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Study Session 17 Asset Valuation Derivative Investments: Options Reading Assignments 1. Futures, Options & Swaps, 3rd edition, Robert W. Kolb (Blackwell, 2000)

A. “Option Payoffs and Option Strategies,” Ch. 11, pp. 316–346 B. “European Option Pricing,” Ch. 13, pp. 381–386 and pp. 396–405 C. “Option Sensitivities and Option Hedging,” Ch. 14, pp. 422–437

(Do not study Tables 14.2 through 14.5) D. “Options on Stock Indexes, Foreign Currency, and Futures,” Ch. 16, pp. 486–493

2. “Interest Rate Derivative Instruments,” Level II, Ch. 7, Fixed Income Analysis for the Chartered Financial Analyst Program, Frank J. Fabozzi (Frank J. Fabozzi Associates, 2000)

3.* “What Does an Option Pricing Model Tell Us about Option Prices?” Stephen Figlewski, cial Analysts Journal (AIMR, September/October 1989) Finan

Learning Outcomes Note: Candidates should understand the option-pricing models, the assumptions made to derive such models, and the uses of such models. Options are assets whose future (expiration) payoff profiles are known. These readings introduce the models that are used to find the present value of those payoff profiles. Candidates should also understand the variables that are used in these models and how changing the values of those variables affect the price of the option. 1. A. “Option Payoffs and Option Strategies”

The candidate should be able to a) calculate the cost of the following option-trading strategies: straddle, strangle,

bull and bear spreads, and butterfly spread; b) determine, using a profit/loss diagram, the profit or loss of an option-trading

strategy for any asset value; c) compare the impact of covered calls with the impact of portfolio hedging on the

distribution of portfolio value; d) illustrate and explain the differences in expiration profits/losses of a hedged and

unhedged portfolio, using the expiration profit/loss diagram of a portfolio hedging strategy and the portfolio (index) profit/loss profile;

e) demonstrate how to create a stock synthetically, using a European put option, a European call option, and a risk-free discount bond;

f) calculate, using put–call parity, the value of a European call (put), given the corresponding European put (call) value;

g) show and explain why put–call parity must always hold for European-style options.

* Readings marked with an asterisk are contained in the 2003 CFA Level II Candidate Readings.

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B. “European Option Pricing”

The candidate should be able to a) describe how to replicate a European equity call option synthetically, using

stocks and bonds; b) discuss alternative methods for estimating volatility inputs for the Black–

Scholes model; c) calculate, given the Black–Scholes model or the binomial model (single- and

two-period only), the value of a European call (put) option, using the appropriate inputs;

d) draw the single- and two-period binomial tree for both the underlying asset and the corresponding option;

e) annualize a stock’s standard deviation of returns, given either a daily, weekly, or monthly standard deviation;

f) explain how the Black–Scholes model is adjusted when dividends are paid at a continuous rate.

Corrections/Clarifications • Equation 13.15 on page 399 (“European Option Pricing”) omits a negative sign in the last

item in the equation. The last term should read −St N(−d1).

C. “Option Sensitivities and Option Hedging”

The candidate should be able to a) draw the payoff diagram of a European put option or European call option

before and at expiration; b) calculate delta or the change in option price, given the change in asset price and

the change in option price or delta; c) analyze the properties of a delta-neutral portfolio and relate those properties to

hedging; d) diagram and explain the delta of a European put or call as a function of asset

price; e) diagram and explain option price as a function of increasing volatility; f) diagram and explain an option’s sensitivity to volatility as a function of asset

price; g) relate rho to changes in an option’s time to expiration and underlying stock

price; h) relate gamma to changes in an option’s delta and underlying stock price.

D. “Options on Stock Indexes, Foreign Currency, and Futures”

The candidate should be able to a) calculate the value of a European call (put) option, given the formulas for either

the Black–Scholes model or the binomial model (single- and two-period only) when no continuous dividend is paid by the underlying security;

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b) calculate the value of a European call (put) option, given the formulas for the

Merton model when a continuous dividend is paid by the underlying security; c) draw the single- and two-period binomial tree for both the underlying asset and

the corresponding option for an asset that pays a continuous dividend; d) explain the condition necessary for the Merton model to be the same as the

Black–Scholes model. 2. “Interest Rate Derivative Instruments”

Note: Candidates are also responsible for the questions at the end of the chapter. Solutions to the questions are found at the end of the chapter.

The candidate should be able to a) describe counterparty risk; b) describe the basic features of an interest rate option contract; c) describe futures options and their trading mechanics; d) explain an interest rate swap and the relationship between interest rate swaps and

forward contracts; e) explain an interest rate cap and floor and the relationship between caps and floors and

options; f) compute the payoff for a cap and a floor; g) contrast options on interest rates and options on fixed income securities; h) interpret cap and floor positions in isolation and when combined with an existing

position. 3. “What Does an Option Pricing Model Tell Us about Option Prices”

The candidate should be able to a) explain why using the dynamic riskless arbitrage strategy (the force behind the

Black–Scholes option pricing model) is difficult in real markets (see also pp. 428–430 in Kolb);

b) identify the factors that are not part of the Black–Scholes option pricing model but that may still affect option prices;

c) discuss the reasons the Black–Scholes model may be wrong; d) discuss the reasons the Black–Scholes model may provide the correct value of an

option even though that value is different from the market price of the option.

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Portfolio Management The candidate should be able to estimate the return and determine the risk of various securities, and apply the basic principles of the portfolio management process to specific scenarios.

Study Session 18 Portfolio Management Capital Market Theory and Asset Pricing Reading Assignments 1. Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C.

Brown (Dryden, 2000) A. “An Introduction to Portfolio Management,” Ch. 8 B. “An Introduction to Asset Pricing Models,” Ch. 9 C. “Extensions and Testing of Asset Pricing Theories,” Ch. 10

2.* “The Process of Portfolio Management,” Ch. 26, Investments, 5th edition, Zvi Bodie, Alex Kane, and Alan J. Marcus (McGraw-Hill, 2002)

Learning Outcomes 1. A. “An Introduction to Portfolio Management”

The candidate should be able to a) describe the concept of risk aversion and discuss the implications for the

investment process; b) identify several measures of risk and explain the circumstances in which their

use might be appropriate in both stand-alone and portfolio contexts; c) compute the standard deviation of rates of return for a risky asset; d) describe and illustrate the change in the risk–return tradeoff of a two-asset

portfolio as the correlation between the two assets changes in specified ways; e) describe and calculate the expected return and the variance or standard deviation

of a two-asset portfolio; f) describe and calculate the covariance and correlation coefficient between two

asset returns; g) list the statistical inputs necessary to apply Markowitz portfolio theory in a large

portfolio context; h) describe and illustrate the concept of the efficient frontier and show, using

utility analysis, how a risk averse investor selects the optimal portfolio.

B. “An Introduction to Asset Pricing Models” The candidate should be able to

a) explain how the presence of a risk-free asset changes the characteristics of the Markowitz efficient frontier;

b) describe the market portfolio and the role it plays in the formation of the capital market line (CML);

c) distinguish between systematic and unsystematic risk;

* Readings marked with an asterisk are contained in the 2003 CFA Level II Candidate Readings.

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76

d) explain and illustrate the standard deviation of return as a function of the number of stocks in the portfolio;

e) discuss the security market line (SML) and how it differs from the CML; f) define and calculate the beta of a risky asset; g) calculate, based on the SML, the expected return for an asset; determine

whether the asset is undervalued, overvalued, or properly valued; and outline the appropriate trading strategy;

h) compare and contrast the assumptions of the arbitrage pricing theory (APT) to the CAPM.

C. “Extensions and Testing of Asset Pricing Theories”

The candidate should be able to a) evaluate the effect on the security market line (SML) of relaxing each of the

following assumptions: taxes, transactions costs, heterogeneous expectations, and multiple planning periods;

b) discuss the stability of individual asset and portfolio betas over time; c) discuss beta estimation problems and why published beta estimates may differ; d) describe the concept of benchmark error and its implications for testing the

CAPM; e) discuss why Roll’s critique of the CAPM and Shanken’s challenge to the APT

cause many observers to consider the models to be untestable. 2. “The Process of Portfolio Management”

Note: Suggested problems from the end of this chapter are included below. Solutions are reprinted in the 2003 Level II Candidate Readings.

The candidate should be able to a) identify the steps in the investment process; b) discuss portfolio objectives and the common types of portfolio constraints for

individual and institutional investors; c) explain the steps in the process of asset allocation; d) explain how taxes and the concept of tax deferral may affect asset allocation; e) discuss how investors’ life cycle stages can affect their goal setting; f) compare and contrast defined contribution pension plans to defined benefit pension

plans, and discuss why defined benefit plans would be more likely to use equities in their investment portfolio;

g) explain why the shareholders of a company which has a defined benefit plan might prefer a portfolio consisting of 100 percent bonds.

Problems: 1, 12

Ordering Instructions for Curriculum Textbooks through PBD Worldwide Fulfillment Services

Payment As a service to CFA candidates, AIMR has negotiated discounted prices and arranged for PBD Worldwide Fulfillment Services, in Alpharetta, Georgia, to serve as a central facility to fill candidates’ orders for all textbooks assigned in the 2003 CFA curriculum. Details of ordering and payment procedures are spelled out in this section.

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2003 LEVEL II ORDER FORM*U.S. CANDIDATES (includes all U.S. territories)PBD Worldwide Fulfillment Services /AIMR Orders, P.O. Box 931788, Atlanta, Georgia 31193-1788800-789-AIMR or 770-442-8633, ext. 298; fax 770-442-9742; e-mail aimrpubs@pbd.comTo order online, go to www.pbdbookstore.com

Please review Ordering Instructions before placing your order.

Book Title and Author(s) Type PriceBook Code Quantity

2003 CFA Level II Candidate Readings (includes exams/guideline answers**) (AIMR) Softbound $45.00 033102 _________The Analysis and Use of Financial Statements, 2nd ed. (White, Sondhi, and Fried) Hardbound $78.00 009005 _________Analysis of Equity Investments: Valuation (AIMR) Hardbound $50.00 023301 _________Company Performance and Measures of Value Added (RFICFA) Softbound $20.00 989010 _________Fixed Income Analysis for the Chartered Financial Analyst Program (Fabozzi) Hardbound $85.00 019006 _________Futures, Options, and Swaps, 3rd ed. (Kolb) Hardbound $70.00 009001 _________Investment Analysis and Portfolio Management, 6th ed. (Reilly and Brown) Hardbound $75.00 019001 _________Quantitative Methods for Investment Analysis (AIMR) Hardbound $60.00 013301 _________Standards of Practice Casebook (AIMR) Softbound $20.00 953301 _________Standards of Practice Handbook, 8th ed. (AIMR) Softbound $25.00 991101 _________

Solutions ManualsSolutions Manual for The Analysis and Use of Financial Statements, 2nd ed.

(White, Sondhi, and Fried)Softbound $35.00 009006 _________

Solutions Manual for Futures, Options, & Swaps, 3rd ed. (Kolb) Softbound $22.00 009002 _________Solutions Manual for Investment Analysis and Portfolio Management, 6th ed.

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2003 LEVEL II ORDER FORM*CANADIAN CANDIDATESPBD Worldwide Fulfillment Services /AIMR Orders, P.O. Box 931788, Atlanta, Georgia 31193-1788800-789-AIMR or 770-442-8633, ext. 298; fax 770-442-9742; e-mail aimrpubs@pbd.comTo order online, go to www.pbdbookstore.comPlease review Ordering Instructions before placing your order.

Book Title and Author(s) Type PriceBook Code Quantity

2003 CFA Level II Candidate Readings (includes exams/guideline answers**) (AIMR) Softbound US$45.00 033102 ________The Analysis and Use of Financial Statements, 2nd ed. (White, Sondhi, and Fried) Hardbound US$78.00 009005 ________Analysis of Equity Investments: Valuation (AIMR) Hardbound US$50.00 023301 ________Company Performance and Measures of Value Added (RFICFA) Softbound US$20.00 989010 ________Fixed Income Analysis for the Chartered Financial Analyst Program (Fabozzi) Hardbound US$85.00 019006 ________Futures, Options, and Swaps, 3rd ed. (Kolb) Hardbound US$70.00 009001 ________Investment Analysis and Portfolio Management, 6th ed. (Reilly and Brown) Hardbound US$75.00 019001 ________Quantitative Methods for Investment Analysis (AIMR) Hardbound US$60.00 013301 ________Standards of Practice Casebook (AIMR) Softbound US$20.00 953301 ________Standards of Practice Handbook, 8th ed. (AIMR) Softbound US$25.00 991101 ________

Solutions ManualsSolutions Manual for The Analysis and Use of Financial Statements, 2nd ed. (White,

Sondhi, and Fried)Softbound US$35.00 009006 ________

Solutions Manual for Futures, Options, & Swaps, 3rd ed. (Kolb) Softbound US$22.00 009002 ________Solutions Manual for Investment Analysis and Portfolio Management, 6th ed. (Reilly

and Brown)Softbound US$20.00 019002 ________

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2003 LEVEL II ORDER FORM*INTERNATIONAL CANDIDATESPBD Worldwide Fulfillment Services /AIMR Orders, P.O. Box 931788, Atlanta, Georgia 31193-1788770-442-8633, ext. 298; fax 770-442-9742; e-mail aimrpubs@pbd.comTo order online, go to www.pbdbookstore.comPlease review Ordering Instructions before placing your order.

Book Title and Author(s) Type PriceBook Code Quantity

2003 CFA Level II Candidate Readings (includes exams/guideline answers**) (AIMR) Softbound US$45.00 033102 ________The Analysis and Use of Financial Statements, 2nd ed. (White, Sondhi, and Fried) Hardbound US$78.00 009005 ________Analysis of Equity Investments: Valuation (AIMR) Hardbound US$50.00 023301 ________Company Performance and Measures of Value Added (RFICFA) Softbound US$20.00 989010 ________Fixed Income Analysis for the Chartered Financial Analyst Program (Fabozzi) Hardbound US$85.00 019006 ________Futures, Options, and Swaps, 3rd ed. (Kolb) Hardbound US$70.00 009001 ________Investment Analysis and Portfolio Management, 6th ed. (Reilly and Brown) Hardbound US$75.00 019001 ________Quantitative Methods for Investment Analysis (AIMR) Hardbound US$60.00 013301 ________Standards of Practice Casebook (AIMR) Softbound US$20.00 953301 ________Standards of Practice Handbook, 8th ed. (AIMR) Softbound US$25.00 991101 ________

Solutions ManualsSolutions Manual for The Analysis and Use of Financial Statements, 2nd ed. (White,

Sondhi, and Fried)Softbound US$35.00 009006 ________

Solutions Manual for Futures, Options, & Swaps, 3rd ed. (Kolb) Softbound US$22.00 009002 ________Solutions Manual for Investment Analysis and Portfolio Management, 6th ed. (Reilly

and Brown)Softbound US$20.00 019002 ________

Ship to: [PLEASE PRINT OR TYPE]

Name ___________________________________________________________________________ Candidate Number [required] _________________________

Company _____________________________________________________________________________________________________________________________(Company address strongly preferred; please leave blank if shipping to residential address)

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