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

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

Standards of Professional Conduct as well as the Global Investment Performance

Standards (GIPS®).

The principles and guidance presented in the CFA Institute Standards of

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

program to maintain the highest professional standards among investment

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

Code of Ethics and Standards of Professional Conduct. The guidance reviews the

purpose and scope of each standard, presents recommended procedures for

compliance, and provides examples of the standard in practice.

The Global Investment Performance Standards (GIPS) facilitate efficient

comparison of investment performance across investment managers and country

borders by prescribing methodology and standards that are consistent with a clear

and honest presentation of returns. Having a global standard for reporting

investment performance minimizes the potential for ambiguous or misleading

presentations.

READING ASSIGNMENTS

Reading 1 Code of Ethics and Standards of Professional Conduct Standards of Practice Handbook, Ninth Edition

Reading 2 “Guidance” for Standards I–VIIStandards of Practice Handbook, Ninth Edition

Reading 3 Introduction to the Global Investment Performance Standards(GIPS®)

Reading 4 Global Investment Performance Standards (GIPS®)

STUDY SESSION 1ETHICAL AND PROFESSIONAL STANDARDS

Study Session 1


LEARNING OUTCOMES

Reading 1: Code of Ethics and Standards of Professional Conduct

The candidate should be able to:

a. describe the structure of the CFA Institute Professional Conduct Program and theprocess for the enforcement of the Code and Standards;

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

c. explain the ethical responsibilities required by the Code and Standards, includingthe multiple sub-sections of each Standard.

Reading 2: “Guidance” for Standards I–VII


a. demonstrate a thorough knowledge of the Code of Ethics and Standards ofProfessional Conduct by applying the Code and Standards to situations involvingissues of professional integrity;

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

c. recommend practices and procedures designed to prevent violations of the Codeof Ethics and Standards of Professional Conduct.

Reading 3: Introduction to the Global Investment Performance Standards (GIPS®)


a. explain why the GIPS standards were created, what parties the GIPS standardsapply to and who is served by the standards;

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

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

Reading 4: Global Investment Performance Standards (GIPS®)


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

b. describe the scope of the GIPS standards with respect to an investment firm’sdefinition and historical performance record;

c. explain how the GIPS standards are implemented in countries with existingstandards for performance reporting and describe the appropriate responsewhen the GIPS standards and local regulations conflict;

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


This introductory study session presents the fundamentals of those quantitative

techniques that are essential in almost any type of financial analysis, and

which will be used throughout the remainder of the CFA Program curriculum. This

session introduces two main building blocks of the quantitative analytical tool kit:

(1) the time value of money and (2) statistics and probability theory.

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

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

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

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

type of security or investment.

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

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

and understanding and applying various probability concepts in practice.

READING ASSIGNMENTS

Reading 5 The Time Value of MoneyQuantitative Methods for Investment Analysis, Second Edition, by Richard A. DeFusco, CFA, Dennis W. McLeavey, CFA, Jerald E.Pinto, CFA, and David E. Runkle, CFA

Reading 6 Discounted Cash Flow ApplicationsQuantitative Methods for Investment Analysis, Second Edition, by Richard A. DeFusco, CFA, Dennis W. McLeavey, CFA, Jerald E.Pinto, CFA, and David E. Runkle, CFA

Reading 7 Statistical Concepts and Market Returns Quantitative Methods for Investment Analysis, Second Edition, by Richard A. DeFusco, CFA, Dennis W. McLeavey, CFA, Jerald E.Pinto, CFA, and David E. Runkle, CFA

Reading 8 Probability Concepts Quantitative Methods for Investment Analysis, Second Edition, by Richard A. DeFusco, CFA, Dennis W. McLeavey, CFA, Jerald E.Pinto, CFA, and David E. Runkle, CFA

STUDY SESSION 2QUANTITATIVE METHODS: Basic Concepts

Study Session 2


LEARNING OUTCOMES

Reading 5: The Time Value of Money


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

b. explain an interest rate as the sum of a real risk-free rate, expected inflation, andpremiums that compensate investors for distinct types of risk;

c. calculate and interpret the effective annual rate, given the stated annual interestrate and the frequency of compounding, and solve time value of moneyproblems when compounding periods are other than annual;

d. calculate and interpret the future value (FV) and present value (PV) of a singlesum of money, an ordinary annuity, an annuity due, a perpetuity (PV only), and aseries of unequal cash flows;

e. draw a time line, and solve time value of money applications (for example,mortgages and savings for college tuition or retirement).

Reading 6: Discounted Cash Flow Applications


a. calculate and interpret the net present value (NPV) and the internal rate of return(IRR) of an investment, contrast the NPV rule to the IRR rule, and identifyproblems associated with the IRR rule;

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

c. calculate, interpret, and distinguish between the money-weighted and time-weighted rates of return of a portfolio and appraise the performance ofportfolios based on these measures;

d. calculate and interpret the bank discount yield, holding period yield, effectiveannual yield, and money market yield for a U.S. Treasury bill; and convert amongholding period yields, money market yields, effective annual yields, and bondequivalent yields.

Reading 7: Statistical Concepts and Market Returns


a. differentiate between descriptive statistics and inferential statistics, between apopulation and a sample, and among the types of measurement scales;

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

c. calculate and interpret relative frequencies and cumulative relative frequencies,given a frequency distribution, and describe the properties of a dataset presentedas a histogram or a frequency polygon;

d. define, calculate, and interpret measures of central tendency, including thepopulation mean, sample mean, arithmetic mean, weighted average or mean(including a portfolio return viewed as a weighted mean), geometric mean,harmonic mean, median, and mode;

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

f. define, calculate, and interpret 1) a range and a mean absolute deviation, and 2 )the variance and standard deviation of a population and of a sample;

Study Session 2


g. calculate and interpret the proportion of observations falling within a specifiednumber of standard deviations of the mean, using Chebyshev’s inequality;

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

i. define and interpret skewness, explain the meaning of a positively or negativelyskewed return distribution, and describe the relative locations of the mean,median, and mode for a nonsymmetrical distribution;

j. define and interpret measures of sample skewness and kurtosis.

Reading 8: Probability Concepts


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

b. explain the two defining properties of probability, and distinguish amongempirical, subjective, and a priori probabilities;

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

d. distinguish between unconditional and conditional probabilities;

e. calculate and interpret 1) the joint probability of two events, 2) the probabilitythat at least one of two events will occur, given the probability of each and thejoint probability of the two events, and 3) a joint probability of any number ofindependent events;

f. distinguish between dependent and independent events;

g. calculate and interpret, using the total probability rule, an unconditionalprobability;

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

i. diagram an investment problem, using a tree diagram;

j. calculate and interpret covariance and correlation;

k. calculate and interpret the expected value, variance, and standard deviation of arandom variable and of returns on a portfolio;

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

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

n. identify the most appropriate method to solve a particular counting problem,and solve counting problems using the factorial, combination, and permutationnotations.


This study session introduces the discrete and continuous probability

distributions that are most commonly used to describe the behavior of

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

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

management.

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

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

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

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

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

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

important that analysts properly understand the assumptions and limitations when

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

misleading conclusions.

READING ASSIGNMENTS

Reading 9 Common Probability DistributionsQuantitative Methods for Investment Analysis, Second Edition, byRichard A. DeFusco, CFA, Dennis W. McLeavey, CFA, Jerald E.Pinto, CFA, and David E. Runkle, CFA

Reading 10 Sampling and EstimationQuantitative Methods for Investment Analysis, Second Edition, byRichard A. DeFusco, CFA, Dennis W. McLeavey, CFA, Jerald E.Pinto, CFA, and David E. Runkle, CFA

Reading 11 Hypothesis TestingQuantitative Methods for Investment Analysis, Second Edition, byRichard A. DeFusco, CFA, Dennis W. McLeavey, CFA, Jerald E.Pinto, CFA, and David E. Runkle, CFA

Reading 12 Technical AnalysisInvestment Analysis and Portfolio Management, Eighth Edition,by Frank K. Reilly, CFA and Keith C. Brown, CFA

STUDY SESSION 3QUANTITATIVE METHODS: Application

Study Session 3


LEARNING OUTCOMES

Reading 9: Common Probability Distributions


a. explain a probability distribution and distinguish between discrete andcontinuous random variables;

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

c. interpret a probability function, a probability density function, and a cumulativedistribution function, and calculate and interpret probabilities for a randomvariable, given its cumulative distribution function;

d. define a discrete uniform random variable and a binomial random variable,calculate and interpret probabilities given the discrete uniform and the binomialdistribution functions, and construct a binomial tree to describe stock pricemovement;

e. describe the continuous uniform distribution, and calculate and interpretprobabilities, given a continuous uniform probability distribution;

f. explain the key properties of the normal distribution, distinguish between aunivariate and a multivariate distribution, and explain the role of correlation inthe multivariate normal distribution;

g. construct and interpret a confidence interval for a normally distributed randomvariable, and determine the probability that a normally distributed randomvariable lies inside a given confidence interval;

h. define the standard normal distribution, explain how to standardize a randomvariable, and calculate and interpret probabilities using the standard normaldistribution;

i. define shortfall risk, calculate the safety-first ratio, and select an optimal portfoliousing Roy’s safety-first criterion;

j. explain the relationship between normal and lognormal distributions and whythe lognormal distribution is used to model asset prices;

k. distinguish between discretely and continuously compounded rates of return,and calculate and interpret a continuously compounded rate of return, given aspecific holding period return;

l. explain Monte Carlo simulation and historical simulation, and describe theirmajor applications and limitations.

Reading 10: Sampling and Estimation


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

b. distinguish between simple random and stratified random sampling;

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

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

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

f. distinguish between a point estimate and a confidence interval estimate of apopulation parameter;

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

Study Session 3


h. explain the construction of confidence intervals;

i. describe the properties of Student’s t-distribution, and calculate and interpret itsdegrees of freedom;

j. calculate and interpret a confidence interval for a population mean, given anormal distribution with 1) a known population variance, 2) an unknownpopulation variance, or 3) with an unknown variance and the sample size islarge;

k. discuss the issues regarding selection of the appropriate sample size, data-miningbias, sample selection bias, survivorship bias, look-ahead bias, and time-periodbias.

Reading 11: Hypothesis Testing


a. define a hypothesis, describe the steps of hypothesis testing, interpret anddiscuss the choice of the null hypothesis and alternative hypothesis, anddistinguish between one-tailed and two-tailed tests of hypotheses;

b. define and interpret a test statistic, a Type I and a Type II error, and a significancelevel, and explain how significance levels are used in hypothesis testing;

c. define and interpret a decision rule and the power of a test, and explain therelation between confidence intervals and hypothesis tests;

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

e. identify the appropriate test statistic and interpret the results for a hypothesis testconcerning 1) the population mean of a normally distributed population with a) known or b) unknown variance, 2) the equality of the population means oftwo normally distributed populations, based on independent random sampleswith a) equal or b) unequal assumed variances, and 3) the mean difference oftwo normally distributed populations (paired comparisons test);

f. identify the appropriate test statistic and interpret the results for a hypothesis testconcerning 1) the variance of a normally distributed population, and 2) theequality of the variances of two normally distributed populations, based on twoindependent random samples;

g. distinguish between parametric and nonparametric tests and describe thesituations in which the use of nonparametric tests may be appropriate.

Reading 12: Technical Analysis


a. explain the underlying assumptions of technical analysis;

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

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


This study session focuses on microeconomic concepts and how firms are

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

equilibrium between demand and supply is elasticity, which measures the

dependency between demand and supply and the impact of changes in either

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

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

Understanding these concepts enables analysts to differentiate among various

companies on an individual level, and to determine their attractiveness for

an investor.

READING ASSIGNMENTS

Reading 13 ElasticityEconomics, Eighth Edition, by Michael Parkin

Reading 14 Efficiency and EquityEconomics, Eighth Edition, by Michael Parkin

Reading 15 Markets in ActionEconomics, Eighth Edition, by Michael Parkin

Reading 16 Organizing ProductionEconomics, Eighth Edition, by Michael Parkin

Reading 17 Output and CostsEconomics, Eighth Edition, by Michael Parkin

STUDY SESSION 4ECONOMICS:Microeconomic Analysis

Study Session 4


LEARNING OUTCOMES

Reading 13: Elasticity


a. calculate and interpret the elasticities of demand (price elasticity, cross elasticity,income elasticity) and the elasticity of supply, and discuss the factors thatinfluence each measure;

b. calculate elasticities on a straight-line demand curve, differentiate among elastic,inelastic, and unit elastic demand, and describe the relation between priceelasticity of demand and total revenue.

Reading 14: Efficiency and Equity


a. explain the various means of markets to allocate resources efficiently, marginalbenefit and marginal cost, and demonstrate why the efficient quantity occurswhere marginal benefit equals marginal cost;

b. distinguish between the price and the value of a product and explain thedemand curve and consumer surplus;

c. distinguish between the cost and the price of a product and explain the supplycurve and producer surplus;

d. discuss the relationship between consumer surplus, producer surplus, andequilibrium;

e. explain 1) how efficient markets ensure optimal resource utilization and 2) theobstacles to efficiency and the resulting underproduction or overproduction,including the concept of deadweight loss;

f. explain the two groups of ideas about the fairness principle (utilitarianism andthe symmetry principle) and discuss the relation between fairness and efficiency.

Reading 15: Markets in Action


a. explain market equilibrium, distinguish between long-term and short-termimpacts of outside shocks, and describe the effects of rent ceilings on theexistence of black markets in the housing sector and on the market’s efficiency;

b. describe labor market equilibrium and explain the effects and inefficiencies of aminimum wage above the equilibrium wage;

c. explain the impact of taxes on supply, demand, and market equilibrium, anddescribe tax incidence and its relation to demand and supply elasticity;

d. discuss the impact of subsidies, quotas, and markets for illegal goods ondemand, supply, and market equilibrium.

Reading 16: Organizing Production


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

b. discuss a firm’s constraints and their impact on achievability of maximum profit;

c. differentiate between technological efficiency and economic efficiency, andcalculate economic efficiency of various firms under different scenarios;


Study Session 4

d. explain command systems and incentive systems to organize production, theprincipal-agent problem, and measures a firm uses to reduce the principal-agentproblem;

e. describe the different types of business organization and the advantages anddisadvantages of each;

f. characterize the four market types;

g. calculate and interpret the four-firm concentration ratio and the Herfindahl-Hirschman Index, and discuss the limitations of concentration measures;

h. explain why firms are often more efficient than markets in coordinatingeconomic activity.

Reading 17: Output and Costs


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

b. describe and explain the relations among total product of labor, marginalproduct of labor, and average product of labor, and describe increasing anddecreasing marginal returns;

c. distinguish among total cost (including both fixed cost and variable cost),marginal cost, and average cost, and explain the relations among the variouscost curves;

d. explain the firm’s production function, its properties of diminishing returns anddiminishing marginal product of capital, the relation between short-run andlong-run costs, and how economies and diseconomies of scale affect long-runcosts.


This study session first compares and contrasts the different market structures

in which firms operate. The market environment influences the price a firm

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

are monopoly and perfect competition, although monopolistic competition and

oligopoly are also covered.

The study session then introduces the macroeconomic concepts that have an

impact on all firms in the same environment, be it a country, a group of related

countries, or a particular industry. The readings explain the business cycle, and

how to forecast changes in the business cycle and the impact on, among other

things, price levels and profitability. The study session concludes by describing

how an economy’s aggregate supply and aggregate demand are determined.

READING ASSIGNMENTS

Reading 18 Perfect CompetitionEconomics, Eighth Edition, by Michael Parkin

Reading 19 MonopolyEconomics, Eighth Edition, by Michael Parkin

Reading 20 Monopolistic Competition and OligopolyEconomics, Eighth Edition, by Michael Parkin

Reading 21 Markets for Factors of ProductionEconomics, Eighth Edition, by Michael Parkin

Reading 22 Monitoring Jobs and the Price LevelEconomics, Eighth Edition, by Michael Parkin

Reading 23 Aggregate Supply and Aggregate DemandEconomics, Eighth Edition, by Michael Parkin

STUDY SESSION 5ECONOMICS:Market Structure and Macroeconomic Analysis

Study Session 5


LEARNING OUTCOMES

Reading 18: Perfect Competition


a. describe the characteristics of perfect competition, explain why firms in aperfectly competitive market are price takers, and differentiate between marketand firm demand curves;

b. determine the profit maximizing (loss minimizing) output for a perfectlycompetitive firm, and explain marginal cost, marginal revenue, and economicprofit and loss;

c. describe a perfectly competitive firm’s short-run supply curve and explain theimpact of changes in demand, entry and exit of firms, and changes in plant sizeon the long-run equilibrium;

d. discuss how a permanent change in demand or changes in technology affectprice, output, and economic profit.

Reading 19: Monopoly


a. describe the characteristics of a monopoly, including factors that allow amonopoly to arise, and monopoly price-setting strategies;

b. explain the relation between price, marginal revenue, and elasticity for amonopoly, and determine a monopoly’s profit-maximizing price and quantity;

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

d. explain how consumer and producer surplus are redistributed in a monopoly,including the occurrence of deadweight loss and rent seeking;

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

Reading 20: Monopolistic Competition and Oligopoly


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

b. determine the profit-maximizing (loss-minimizing) output under monopolisticcompetition and an oligopoly, explain why long-run economic profit undermonopolistic competition is zero, and determine if monopolistic competition isefficient;

c. explain the importance of innovation, product development, advertising, andbranding under monopolistic competition;

d. explain the kinked demand curve model and the dominant firm model, anddescribe oligopoly games including the Prisoners’ Dilemma.

Reading 21: Markets for Factors of Production


a. explain why demand for the factors of production is called derived demand,differentiate between marginal revenue and marginal revenue product (MRP),and describe how the MRP determines the demand for labor and the wage rate;

b. describe the factors that cause changes in the demand for labor and the factorsthat determine the elasticity of the demand for labor;


Study Session 5

c. describe the factors determining the supply of labor, including the substitutionand income effects, and discuss the factors related to changes in the supply oflabor, including capital accumulation;

d. describe the effects on wages of labor unions and of a monopsony, and explainthe possible consequences for a market that offers an efficient wage;

e. differentiate between physical capital and financial capital, and explain therelation between the demand for physical capital and the demand for financialcapital;

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

g. differentiate between renewable and non-renewable natural resources anddescribe the supply curve for each;

h. differentiate between economic rent and opportunity costs.

Reading 22: Monitoring Jobs and the Price Level


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

b. define aggregate hours and real wage rates, and explain their relation to grossdomestic product (GDP);

c. explain the types of unemployment, full employment, the natural rate ofunemployment, and the relation between unemployment and real GDP;

d. explain and calculate the consumer price index (CPI) and the inflation rate,describe the relation between the CPI and the inflation rate, and explain themain sources of CPI bias.

Reading 23: Aggregate Supply and Aggregate Demand


a. explain the factors that influence real GDP and long-run and short-run aggregatesupply, explain movement along the long-run and short-run aggregate supplycurves (LAS and SAS), and discuss the reasons for changes in potential GDP andaggregate supply;

b. explain the components of and the factors that affect real GDP demanded,describe the aggregate demand curve and why it slopes downward, and explainthe factors that can change aggregate demand;

c. differentiate between short-run and long-run macroeconomic equilibrium, andexplain how economic growth, inflation, and changes in aggregate demand andsupply influence the macroeconomic equilibrium;

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


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

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

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

labor and capital, and goods are strongly interrelated and this study session

describes circumstances when this may lead to inflation and the transmission

mechanisms between the monetary sector and the real part of the economy.

Finally, the goals and implications of fiscal and monetary policy are explored by

examining some of the main models of macroeconomic theory (Classical,

Keynesian, and Monetarist).

READING ASSIGNMENTS

Reading 24 Money, the Price Level, and InflationEconomics, Eighth Edition, by Michael Parkin

Reading 25 U.S. Inflation, Unemployment, and Business CyclesEconomics, Eighth Edition, by Michael Parkin

Reading 26 Fiscal Policy Economics, Eighth Edition, by Michael Parkin

Reading 27 Monetary PolicyEconomics, Eighth Edition, by Michael Parkin

Reading 28 An Overview of Central BanksInternational Economic Indicators and Central Banks, by Anne Dolganos Picker

STUDY SESSION 6ECONOMICS:Monetary and Fiscal Economics

LEARNING OUTCOMES

Reading 24: Money, the Price Level, and Inflation


a. explain the functions of money;

b. describe the components of the M1 and M2 measures of money, and discusswhy checks and credit cards are not counted as money;

Study Session 6


c. describe the economic functions of and differentiate among the variousdepository institutions, and explain the impact of financial regulation,deregulation, and innovation;

d. explain the goals of the U.S. Federal Reserve (Fed) in conducting monetary policyand how the Fed uses its policy tools to control the quantity of money, anddescribe the assets and liabilities on the Fed’s balance sheet;

e. discuss the creation of money, including the role played by excess reserves, andcalculate the amount of loans a bank can generate, given new deposits;

f. describe the monetary base, and explain the relation among the monetary base,the money multiplier, and the quantity of money;

g. explain the factors that influence the demand for money, and describe thedemand for money curve, including the effects of changes in real GDP andfinancial innovation;

h. explain interest rate determination, and the short-run and long-run effects ofmoney on real GDP;

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

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


a. differentiate between inflation and the price-level;

b. describe and distinguish among the factors resulting in demand-pull and cost-push inflation, and describe the evolution of demand-pull and cost-pushinflationary processes;

c. distinguish between anticipated and unanticipated inflation, and explain thecosts of anticipated inflation;

d. explain the impact of inflation on unemployment, and describe the short-run andlong-run Phillips curve, including the effect of changes in the natural rate ofunemployment;

e. explain the relation among inflation, nominal interest rates, and the demand andsupply of money;

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

g. describe mainstream business cycle theory and real business cycle (RBC) theory,and distinguish between them, including the role of productivity changes.

Reading 26: Fiscal Policy


a. explain supply-side effects on employment, potential GDP, and aggregate supply,including the income tax and taxes on expenditure, and describe the Laffer curveand its relation to supply-side economics;

b. discuss the sources of investment finance, and the influence of fiscal policy oncapital markets, including the crowding-out effect;

c. discuss the generational effects of fiscal policy, including generational accountingand generational imbalance;


Study Session 6

d. discuss the use of fiscal policy to stabilize the economy, including the effects ofthe government expenditure multiplier, the tax multiplier, and the balancedbudget multiplier;

e. explain the limitations of discretionary fiscal policy, and differentiate betweendiscretionary fiscal policy and automatic stabilizers.

Reading 27: Monetary Policy


a. discuss the goals of U.S. monetary policy and the Federal Reserve’s (Fed’s) meansfor achieving the goals, including how the Fed operationalizes those goals;

b. describe how the Fed conducts monetary policy, and explain the Fed’s decision-making strategy including an instrument rule, a targeting rule, open-marketoperations, and the market for reserves;

c. discuss monetary policy’s transmission mechanism (chain of events) betweenchanging the federal funds rate and achieving the ultimate monetary policy goalwhen fighting either inflation or recession, and explain loose links and time lagsin the adjustment process;

d. describe alternative monetary policy strategies, and explain why they have beenrejected by the Fed.

Reading 28: An Overview of Central Banks


a. identify the functions of a central bank;

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


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

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

reports in investment decision making.

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

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

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

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

management discussion and analysis of results. A general framework for

addressing most financial statement analysis tasks is also presented.

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

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

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

accounting accruals.

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

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

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

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

International Financial Reporting Standards framework promulgated by one key

body, the International Accounting Standards Board. The movement towards

worldwide convergence of financial reporting standards is also introduced.

STUDY SESSION 7FINANCIAL REPORTING AND ANALYSIS:An Introduction

Note:New rulings and/or pronouncements issuedafter the publication of thereadings in Study Sessions 7through 10 on financialreporting and analysis maycause some of the information in these readings to become dated.Candidates are expected tobe familiar with the overallanalytical framework contained in the study session readings, as well asthe implications of alternative accountingmethods for financialanalysis and valuation, asprovided in the assignedreadings.

For the purpose ofLevel I questions on financial statement analysis, when a ratio isdefined and calculated differently in various texts,candidates should use thedefinitions given in the CFAInstitute copyrighted readings by Robinson, et al.Variations in ratio definitions are part of thenature of practical financialanalysis.

READING ASSIGNMENTS

Reading 29 Financial Statement Analysis: An IntroductionInternational Financial Statement Analysis, by Thomas R.Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,CFA, and Michael A. Broihahn, CFA

Reading 30 Financial Reporting MechanicsInternational Financial Statement Analysis, by Thomas R.Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,CFA, and Michael A. Broihahn, CFA

Reading 31 Financial Reporting StandardsInternational Financial Statement Analysis, by Thomas R.Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,CFA, and Michael A. Broihahn, CFA

Study Session 7


LEARNING OUTCOMES

Reading 29: Financial Statement Analysis: An Introduction


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

b. discuss the role of key financial statements (income statement, balance sheet,cash flow statement and statement of changes in owners’ equity) in evaluating acompany’s performance and financial position;

c. discuss the importance of financial statement notes and supplementaryinformation (including disclosures of accounting methods, estimates andassumptions) and management’s discussion and analysis;

d. discuss the objective of audits of financial statements, the types of audit reports,and the importance of effective internal controls;

e. identify and explain information sources other than annual financial statementsand supplementary information that analysts use in financial statement analysis;

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

Reading 30: Financial Reporting Mechanics


a. identify the groups (operating, investing, and financing activities) into whichbusiness activities are categorized for financial reporting purposes and classifyany business activity into the appropriate group;

b. explain the relationship of financial statement elements and accounts, andclassify accounts into the financial statement elements;

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

d. explain the process of recording business transactions using an accountingsystem based on the accounting equations;

e. explain the need for accruals and other adjustments in preparing financialstatements;

Study Session 7


f. prepare financial statements, given account balances or other elements in therelevant accounting equation, and explain the relationships among the incomestatement, balance sheet, statement of cash flows, and statement of owners’equity;

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

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

Reading 31: Financial Reporting Standards


a. explain the objective of financial statements and the importance of reportingstandards in security analysis and valuation;

b. explain the role of standard-setting bodies, such as the International AccountingStandards Board and the U.S. Financial Accounting Standards Board, andregulatory authorities such as the International Organization of SecuritiesCommissions, the U.K. Financial Services Authority, and the U.S. Securities andExchange Commission in establishing and enforcing financial reportingstandards;

c. discuss the ongoing barriers to developing one universally accepted set offinancial reporting standards;

d. describe the International Financial Reporting Standards (IFRS) framework,including the objective of financial statements, their qualitative characteristics,required reporting elements, and the constraints and assumptions in preparingfinancial statements;

e. explain the general requirements for financial statements;

f. compare and contrast key concepts of financial reporting standards under IFRSand alternative reporting systems, and discuss the implications for financialanalysis of differing financial reporting systems;

g. identify the characteristics of a coherent financial reporting framework andbarriers to creating a coherent financial reporting network;

h. discuss the importance of monitoring developments in financial reportingstandards and evaluate company disclosures of significant accounting policies.


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

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

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

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

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

measurement periods and to compare the performance of different companies

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

calculation are also described.

READING ASSIGNMENTS

Reading 32 Understanding the Income StatementInternational Financial Statement Analysis, by Thomas R.Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,CFA, and Michael A. Broihahn, CFA

Reading 33 Understanding the Balance Sheet International Financial Statement Analysis, by Thomas R.Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,CFA, and Michael A. Broihahn, CFA

Reading 34 Understanding the Cash Flow StatementInternational Financial Statement Analysis, by Thomas R.Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,CFA, and Michael A. Broihahn, CFA

STUDY SESSION 8FINANCIAL REPORTING AND ANALYSIS:The Income Statement, Balance Sheet, and Cash Flow Statement

LEARNING OUTCOMES

Reading 32: Understanding the Income Statement


a. describe the components of the income statement and construct an incomestatement using the alternative presentation formats of that statement;

Study Session 8


b. explain the general principles of revenue recognition and accrual accounting,demonstrate specific revenue recognition applications (including accounting forlong-term contracts, installment sales, barter transactions, and gross and netreporting of revenue), and discuss the implications of revenue recognitionprinciples for financial analysis;

c. discuss the general principles of expense recognition, such as the matchingprinciple, specific expense recognition applications (including depreciation oflong-term assets and inventory methods), and the implications of expenserecognition principles for financial analysis;

d. determine which method of depreciation, accounting for inventory, or amortizingintangibles is appropriate, based on facts that might influence the decision;

e. demonstrate the depreciation of long-term assets using each approved method,accounting for inventory using each approved method, and amortization ofintangibles;

f. distinguish between the operating and nonoperating components of the incomestatement;

g. discuss the financial reporting treatment and analysis of nonrecurring items(including discontinued operations, extraordinary items, and unusual orinfrequent items), and changes in accounting standards;

h. describe the components of earnings per share and calculate a company’searnings per share (both basic and diluted earnings per share) for both a simpleand complex capital structure;

i. differentiate between dilutive and antidilutive securities, and discuss theimplications of each for the earnings per share calculation;

j. evaluate a company’s financial performance using common-size incomestatements and financial ratios based on the income statement;

k. state the accounting classification for items that are excluded from the incomestatement but affect owners’ equity, and list the major types of items receivingthat treatment;

l. describe and calculate comprehensive income.

Reading 33: Understanding the Balance Sheet


a. illustrate and interpret the components of the assets, liabilities, and equitysections of the balance sheet, and discuss the uses of the balance sheet infinancial analysis;

b. describe the various formats of balance sheet presentation;

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

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

e. explain the measurement bases (e.g., historical cost and fair value) of assets andliabilities, including current assets, current liabilities, tangible assets, andintangible assets;

f. discuss off-balance sheet disclosures;

g. demonstrate the appropriate classifications and related accounting treatmentsfor marketable and non-marketable financial instruments held as assets or owedby the company as liabilities;

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

Study Session 8


i. interpret balance sheets, common-size balance sheets, the statement of changesin equity, and commonly used balance sheet ratios.

Reading 34: Understanding the Cash Flow Statement


a. compare and contrast cash flows from operating, investing, and financingactivities, and classify cash flow items as relating to one of these threecategories, given a description of the items;

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

c. compare and contrast the key differences in cash flow statements preparedunder international financial reporting standards and U.S. generally acceptedaccounting principles;

d. demonstrate the difference between the direct and indirect methods ofpresenting cash from operating activities and explain the arguments in favor ofeach;

e. demonstrate how the cash flow statement is linked to the income statement andbalance sheet;

f. demonstrate the steps in the preparation of direct and indirect cash flowstatements, including how cash flows can be computed using income statementand balance sheet data;

g. describe the process of converting a statement of cash flows from the indirect tothe direct method of presentation;

h. analyze and interpret a cash flow statement using both total currency amountsand common-size cash flow statements;

i. explain and calculate free cash flow to the firm, free cash flow to equity, andother cash flow ratios.


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

liabilities that are particularly susceptible to the impact of alternative

accounting policies and estimates. Analysts must understand the effects of

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

appropriate adjustments to enhance comparability between companies. In

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

financial statements and economic reality.

The description and measurement of inventories require careful attention

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

merchandizing and manufacturing companies. For these companies, the

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

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

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

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

recognizing expenses associated with the operating assets because of the

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

opportunities for financial statement manipulation over longer time periods.

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

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

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

deferred taxes.

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

solvency, and have consequences for its long-term growth and viability. The notes

of the financial statements must be carefully reviewed to ensure that all potential

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

appropriately evaluated for their conformity to economic reality. Adjustments to

the financial statements may be required to achieve comparability when

STUDY SESSION 9FINANCIAL REPORTING AND ANALYSIS: Inventories, Long-Term Assets, Deferred Taxes,and On- and Off-Balance Sheet Debt

Study Session 9


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

investment decision-making.

READING ASSIGNMENTS

Reading 35 InventoriesInternational Financial Statement Analysis, by Thomas R.Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,CFA, and Michael A. Broihahn, CFA

Reading 36 Long-Lived AssetsInternational Financial Statement Analysis, by Thomas R.Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,CFA, and Michael A. Broihahn, CFA

Reading 37 Income TaxesInternational Financial Statement Analysis, by Thomas R.Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,CFA, and Michael A. Broihahn, CFA

Reading 38 Long-Term Liabilities and LeasesInternational Financial Statement Analysis, by Thomas R.Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,CFA, and Michael A. Broihahn, CFA

LEARNING OUTCOMES

Reading 35: Inventories


a. explain IFRS and U.S. GAAP rules for determining inventory cost including whichcosts are capitalized and methods of allocating costs between cost of goods soldand inventory;

b. discuss how inventories are reported in the financial statements and how thelower of cost or net realizable value is used and applied;

c. compute ending inventory balances and cost of goods sold using the FIFO,weighted average cost, and LIFO methods to account for product inventory andexplain the relationship among and the usefulness of inventory and cost ofgoods sold data provided by the FIFO, weighted average cost, and LIFO methodswhen prices are 1) stable, 2) decreasing, or 3) increasing;

d. discuss ratios useful for evaluating inventory management;

e. analyze the financial statements of companies using different inventoryaccounting methods to compare and describe the effect of the differentmethods on cost of goods sold, inventory balances, and other financialstatement items; and compute and describe the effects of the choice ofinventory method on profitability, liquidity, activity, and solvency ratios;

f. calculate adjustments to reported financial statements related to inventoryassumptions in order to aid in comparing and evaluating companies;

g. discuss the reasons that a LIFO reserve might rise or decline during a given periodand discuss the implications for financial analysis.


Study Session 9

Reading 36: Long-Lived Assets


a. explain the accounting standards related to the capitalization of expenditures aspart of long-lived assets, including interest costs;

b. compute and describe the effects of capitalizing versus expensing on net income,shareholders’ equity, cash flow from operations, and financial ratios includingthe effect on the interest coverage ratio of capitalizing interest costs;

c. explain the circumstances in which software development costs and research anddevelopment costs are capitalized;

d. identify the different depreciation methods for long-lived tangible assets anddiscuss how the choice of method, useful lives, and salvage values affect acompany’s financial statements, ratios, and taxes;

e. discuss the use of fixed asset disclosures to compare companies’ average age ofdepreciable assets, and calculate, using such disclosures, the average age andaverage depreciable life of fixed assets;

f. describe amortization of intangible assets with finite useful lives, and theestimates that affect the amortization calculations;

g. discuss the liability for closure, removal, and environmental effects of long-livedoperating assets, and discuss the financial statement impact and ratio effects ofthat liability;

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

i. define impairment of long-lived tangible and intangible assets and explain whateffect such impairment has on a company’s financial statements and ratios;

j. calculate and describe both the initial and long-lived effects of asset revaluationson financial ratios.

Reading 37: Income Taxes


a. explain the differences between accounting profit and taxable income, anddefine key terms including deferred tax assets, deferred tax liabilities, valuationallowance, taxes payable, and income tax expense;

b. explain how deferred tax liabilities and assets are created and the factors thatdetermine how a company’s deferred tax liabilities and assets should be treatedfor the purposes of financial analysis;

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

d. calculate income tax expense, income taxes payable, deferred tax assets anddeferred tax liabilities, and calculate and interpret the adjustment to the financialstatements related to a change in the income tax rate;

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

f. distinguish between temporary and permanent items in pretax financial incomeand taxable income;

g. discuss the implications of a valuation allowance for deferred tax assets (i.e.,when it is required, what impact it has on financial statements, and how it mightaffect an analyst’s view of a company);

Study Session 9


h. compare and contrast a company’s deferred tax items and effective tax ratereconciliation between reporting periods;

i. analyze disclosures relating to deferred tax items and the effective tax ratereconciliation, and discuss how information included in these disclosures affectsa company’s financial statements and financial ratios;

j. identify the key provisions of and differences between income tax accountingunder IFRS and U.S. GAAP.

Reading 38: Long-Term Liabilities and Leases


a. compute the effects of debt issuance and amortization of bond discounts andpremiums on financial statements and ratios;

b. explain the role of debt covenants in protecting creditors by restricting acompany’s ability to invest, pay dividends, or make other operating and strategicdecisions;

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

d. determine the effects of changing interest rates on the market value of debt andon financial statements and ratios;

e. describe two types of debt with equity features (convertible debt and debt withwarrants) and calculate the effect of issuance of such instruments on acompany’s debt ratios;

f. discuss the motivations for leasing assets instead of purchasing them and theincentives for reporting the leases as operating leases rather than finance leases;

g. determine the effects of finance and operating leases on the financial statementsand ratios of the lessees and lessors;

h. distinguish between a sales-type lease and a direct financing lease, anddetermine the effects on the financial statements and ratios of the lessors;

i. describe the types and economic consequences of off-balance-sheet financing,and determine how take-or-pay contracts, throughput arrangements, and thesale of receivables affect financial statements and selected financial ratios.


The readings in this study session discuss financial analysis techniques, financial

statement analysis applications, and the international convergence of

accounting standards.

The most frequently used tools and techniques to evaluate companies include

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

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

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

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

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

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

discusses analyst adjustments to reported financials. Such adjustments are often

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

This study session concludes with a reading on convergence of international

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

harmonizing accounting standards globally, as this reading discusses, there are still

significant variations between generally accepted accounting principles from one

country to another.

READING ASSIGNMENTS

Reading 39 Financial Analysis TechniquesInternational Financial Statement Analysis, by Thomas R.Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,CFA, and Michael A. Broihahn, CFA

Reading 40 Financial Reporting Quality: Red Flags and Accounting WarningSignsCommercial Lending Review, by Thomas R. Robinson, CFA and Paul Munter

Reading 41 Accounting Shenanigans on the Cash Flow StatementThe CPA Journal, by Marc A. Siegel

STUDY SESSION 10FINANCIAL REPORTING AND ANALYSIS:Techniques, Applications, and InternationalStandards Convergence

Study Session 10


Reading 42 Financial Statement Analysis: ApplicationsInternational Financial Statement Analysis, by Thomas R.Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,CFA, and Michael A. Broihahn, CFA

Reading 43 International Standards ConvergenceInternational Financial Statement Analysis, by Thomas R.Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry,CFA, and Michael A. Broihahn, CFA

LEARNING OUTCOMES

Reading 39: Financial Analysis Techniques

a. evaluate and compare companies using ratio analysis, common-size financialstatements, and charts in financial analysis;

b. describe the limitations of ratio analysis;

c. calculate, classify, and interpret activity, liquidity, solvency, profitability, andvaluation ratios;

d. demonstrate how ratios are related and how to evaluate a company using acombination of different ratios;

e. demonstrate the application of and interpret changes in the component parts ofthe DuPont analysis (the decomposition of return on equity);

f. calculate and interpret the ratios used in equity analysis, credit analysis, andsegment analysis;

g. describe how the results of common-size and ratio analysis can be used to modeland forecast earnings.

Reading 40: Financial Reporting Quality: Red Flags and AccountingWarning Signs


a. describe incentives that might induce a company management to overreport orunderreport earnings;

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

c. describe the “fraud triangle”;

d. describe the risk factors related to incentives and pressures that may lead tofraudulent accounting;

e. describe the risk factors related to opportunities that may lead to fraudulentaccounting;

f. describe the risk factors related to attitudes and rationalizations that may lead tofraudulent accounting;

g. describe common accounting warning signs and methods of detecting each;

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

i. describe the accounting warning signs related to the Sunbeam accountingscandal.

Study Session 10


Reading 41: Accounting Shenanigans on the Cash Flow Statement

The candidate should be able to analyze and discuss the following ways tomanipulate the cash flow statement:� stretching out payables

� financing of payables

� securitization of receivables

� using stock buybacks to offset dilution of earnings

Reading 42: Financial Statement Analysis: Applications


a. evaluate a company’s past financial performance and explain how a company’sstrategy is reflected in past financial performance;

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

c. describe the role of financial statement analysis in assessing the credit quality ofa potential debt investment;

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

e. determine and justify appropriate analyst adjustments to a company’s financialstatements to facilitate comparison with another company.

Reading 43: International Standards Convergence


a. identify and explain the major international accounting standards for each assetand liability category on the balance sheet and the key differences from U.S.generally accepted accounting principles (GAAP);

b. identify and explain the major international accounting standards for majorrevenue and expense categories on the income statement, and the keydifferences from U.S. GAAP;

c. identify and explain the major differences between international and U.S. GAAPaccounting standards concerning the treatment of interest and dividends on thecash flow statement;

d. interpret the effect of differences between international and U.S. GAAPaccounting standards on the balance sheet, income statement, and thestatement of changes in equity for some commonly used financial ratios.


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

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

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

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

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

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

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

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

develop and communicate future plans.

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

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

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

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

conflict affects the firm’s valuation.

READING ASSIGNMENTS

Reading 44 Capital Budgetingby John D. Stowe, CFA and Jacques R. Gagne, CFA

Reading 45 Cost of Capitalby Yves Courtois, CFA, Gene C. Lai, and Pamela P. Peterson, CFA

Reading 46 Working Capital Managementby Edgar A. Norton, Jr., CFA, Kenneth L. Parkinson, and Pamela P. Peterson, CFA

Reading 47 Financial Statement Analysisby Pamela P. Peterson, CFA

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

STUDY SESSION 11CORPORATE FINANCE

Study Session 11


LEARNING OUTCOMES

Reading 44: Capital Budgeting


a. explain the capital budgeting process, including the typical steps of the process,and distinguish among the various categories of capital projects;

b. discuss the basic principles of capital budgeting, including the choice of theproper cash flows and determining the proper discount rate;

c. explain how the following project interactions affect the evaluation of a capitalproject: (1) independent versus mutually exclusive projects, (2) projectsequencing, and (3) unlimited funds versus capital rationing;

d. calculate and interpret the results using each of the following methods toevaluate a single capital project: net present value (NPV), internal rate of return(IRR), payback period, discounted payback period, average accounting rate ofreturn (AAR), and profitability index (PI);

e. explain the NPV profile, compare and contrast the NPV and IRR methods whenevaluating independent and mutually exclusive projects, and describe theproblems that can arise when using an IRR;

f. describe and account for the relative popularity of the various capital budgetingmethods, and explain the relation between NPV and company value and stockprice.

Reading 45: Cost of Capital


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

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

c. describe alternative methods of calculating the weights used in the weightedaverage cost of capital, including the use of the company’s target capitalstructure;

d. explain how the marginal cost of capital and the investment opportunityschedule are used to determine the optimal capital budget;

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

f. calculate and interpret the cost of fixed rate debt capital using the yield-to-maturity approach and the debt-rating approach;

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

h. calculate and interpret the cost of equity capital using the capital asset pricingmodel approach, the dividend discount model approach, and the bond yield plusrisk premium approach;

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

j. explain the country equity risk premium in the estimation of the cost of equityfor a company located in a developing market;

k. describe the marginal cost of capital schedule, explain why it may be upward-sloping with respect to additional capital, and calculate and interpret its break-points;

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

Study Session 11


Reading 46: Working Capital Management


a. calculate and interpret liquidity measures using selected financial ratios for acompany and compare it with peer companies;

b. evaluate overall working capital effectiveness of a company, using the operatingand cash conversion cycles, and compare its effectiveness with other peercompanies;

c. classify the components of a cash forecast and prepare a cash forecast, givenestimates of revenues, expenses, and other items;

d. identify and evaluate the necessary tools to use in managing a company’s netdaily cash position;

e. compute and interpret comparable yields on various securities, compare portfolioreturns against a standard benchmark, and evaluate a company’s short-terminvestment policy guidelines;

f. assess the performance of a company’s accounts receivable, inventorymanagement, and accounts payable functions against historical figures andcomparable peer company values;

g. evaluate the choices of short-term funding available to a company andrecommend a financing method.

Reading 47: Financial Statement Analysis


a. calculate, interpret, and discuss the DuPont expression and extended DuPontexpression for a company’s return on equity and demonstrate its use in corporateanalysis;

b. demonstrate the use of pro forma income and balance sheet statements.

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


a. define and describe corporate governance;

b. discuss and critique characteristics and practices related to board and committeeindependence, experience, compensation, external consultants, and frequency ofelections and determine whether they are supportive of shareowner protection;

c. describe board independence and explain the importance of independent boardmembers in corporate governance;

d. identify factors that indicate a board and its members possess the experiencerequired to govern the company for the benefit of its shareowners;

e. explain the provisions that should be included in a strong corporate code ofethics and the implications of a weak code of ethics with regard to related-partytransactions and personal use of company assets;

f. state the key areas of responsibility for which board committees are typicallycreated, and explain the criteria for assessing whether each committee is able toadequately represent shareowner interests;

g. evaluate, from a shareowner’s perspective, company policies related to votingrules, shareowner sponsored proposals, common stock classes, and takeoverdefenses.


As the first discussion within the CFA curriculum on portfolio management,

this study session provides the critical framework and context for subsequent

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

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

tools for portfolio management at Levels II and III.

The first reading discusses the asset allocation decision and the portfolio

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

consistent manner to create and maintain an appropriate portfolio (combination

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

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

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

return.

READING ASSIGNMENTS

Reading 49 The Asset Allocation DecisionInvestment Analysis and Portfolio Management, Eighth Edition,by Frank K. Reilly, CFA and Keith C. Brown, CFA

Reading 50 An Introduction to Portfolio ManagementInvestment Analysis and Portfolio Management, Eighth Edition,by Frank K. Reilly, CFA and Keith C. Brown, CFA

Reading 51 An Introduction to Asset Pricing ModelsInvestment Analysis and Portfolio Management, Eighth Edition,by Frank K. Reilly, CFA and Keith C. Brown, CFA

STUDY SESSION 12PORTFOLIO MANAGEMENT

LEARNING OUTCOMES

Reading 49: The Asset Allocation Decision


a. describe the steps in the portfolio management process, and explain the reasonsfor a policy statement;

Study Session 12


b. explain why investment objectives should be expressed in terms of risk andreturn, and list the factors that may affect an investor’s risk tolerance;

c. describe the return objectives of capital preservation, capital appreciation, currentincome, and total return;

d. describe the investment constraints of liquidity, time horizon, tax concerns, legaland regulatory factors, and unique needs and preferences;

e. describe the importance of asset allocation, in terms of the percentage of aportfolio’s return that can be explained by the target asset allocation, and explainhow political and economic factors result in differing asset allocations byinvestors in various countries.

Reading 50: An Introduction to Portfolio Management


a. define risk aversion and discuss evidence that suggests that individuals aregenerally risk averse;

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

c. compute and interpret the expected return, variance, and standard deviation foran individual investment and the expected return and standard deviation for aportfolio;

d. compute and interpret the covariance of rates of return, and show how it isrelated to the correlation coefficient;

e. list the components of the portfolio standard deviation formula, and explain therelevant importance of these components when adding an investment to aportfolio;

f. describe the efficient frontier, and explain the implications for incrementalreturns as an investor assumes more risk;

g. explain the concept of an optimal portfolio, and show how each investor mayhave a different optimal portfolio.

Reading 51: An Introduction to Asset Pricing Models


a. explain the capital market theory, including its underlying assumptions, andexplain the effect on expected returns, the standard deviation of returns, andpossible risk/return combinations when a risk-free asset is combined with aportfolio of risky assets;

b. identify the market portfolio, and describe the role of the market portfolio in theformation of the capital market line (CML);

c. define systematic and unsystematic risk, and explain why an investor should notexpect to receive additional return for assuming unsystematic risk;

d. explain the capital asset pricing model, including the security market line (SML)and beta, and describe the effects of relaxing its underlying assumptions;

e. calculate, using the SML, the expected return on a security, and evaluatewhether the security is overvalued, undervalued, or properly valued.


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

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

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

biases inherent in each of the weighting schemes used.

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

during the past several decades revolves around the efficient market hypothesis

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

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

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

to judge the value of fundamental or technical security analysis.

READING ASSIGNMENTS

Reading 52 Organization and Functioning of Securities MarketsInvestment Analysis and Portfolio Management, Eighth Edition,by Frank K. Reilly, CFA and Keith C. Brown, CFA

Reading 53 Security-Market IndexesInvestment Analysis and Portfolio Management, Eighth Edition,by Frank K. Reilly, CFA and Keith C. Brown, CFA

Reading 54 Efficient Capital MarketsInvestment Analysis and Portfolio Management, Eighth Edition,by Frank K. Reilly, CFA and Keith C. Brown, CFA

Reading 55 Market Efficiency and AnomaliesBeyond The Random Walk: A Guide to Stock Market Anomaliesand Low Risk Investing, by Vijay Singal, CFA

STUDY SESSION 13EQUITY INVESTMENTS: Securities Markets

Study Session 13


LEARNING OUTCOMES

Reading 52: Organization and Functioning of Securities Markets


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

b. distinguish between primary and secondary capital markets, and explain howsecondary markets support primary markets;

c. distinguish between call and continuous markets;

d. compare and contrast the structural differences among national stock exchanges,regional stock exchanges, and the over-the-counter (OTC) markets;

e. compare and contrast major characteristics of exchange markets, includingexchange membership, types of orders, and market makers;

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

g. describe the process of buying a stock on margin, compute the rate of return ona margin transaction, define maintenance margin, and determine the stock priceat which the investor would receive a margin call.

Reading 53: Security-Market Indexes


a. compare and contrast the characteristics of, and discuss the source and directionof bias exhibited by, each of the three predominant weighting schemes used inconstructing stock market indexes, and compute a price-weighted, a value-weighted, and an unweighted index series for three stocks;

b. compare and contrast major structural features of domestic and global stockindexes, bond indexes, and composite stock-bond indexes;

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

Reading 54: Efficient Capital Markets


a. define an efficient capital market and describe and contrast the three forms ofthe efficient market hypothesis (EMH);

b. describe the tests used to examine each of the three forms of the EMH, identifyvarious market anomalies and explain their implications for the EMH, and explainthe overall conclusions about each form of the EMH;

c. explain the implications of stock market efficiency for technical analysis,fundamental analysis, the portfolio management process, the role of theportfolio manager, and the rationale for investing in index funds;

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

Reading 55: Market Efficiency and Anomalies


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

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

Study Session 13


c. explain why an apparent anomaly may be justified and describe the commonbiases that distort testing for mispricings;

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


STUDY SESSION 14EQUITY INVESTMENTS:Industry and Company Analysis

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

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

of stocks.

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

discounted cash flow technique and the relative valuation approach. These

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

readings on industry analysis are an important element in the valuation process,

providing the top down context crucial to estimating a company’s potential.

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

sales and profit margins.

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

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

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

READING ASSIGNMENTS

Reading 56 An Introduction to Security ValuationInvestment Analysis and Portfolio Management, Eighth Edition,by Frank K. Reilly, CFA and Keith C. Brown, CFA

Reading 57 Industry AnalysisInvestment Analysis and Portfolio Management, Eighth Edition,by Frank K. Reilly, CFA and Keith C. Brown, CFA

Reading 58 Company Analysis and Stock ValuationInvestment Analysis and Portfolio Management, Eighth Edition,by Frank K. Reilly, CFA and Keith C. Brown, CFA

Reading 59 Introduction to Price Multiplesby John D. Stowe, CFA, Thomas R. Robinson, CFA, Jerald E.Pinto, CFA, and Dennis W. McLeavey, CFA

Study Session 14


LEARNING OUTCOMES

Reading 56: An Introduction to Security Valuation


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

b. state the various forms of investment returns;

c. calculate and interpret the value both of a preferred stock and a common stockusing the dividend discount model (DDM);

d. show how to use the DDM to develop an earnings multiplier model, and explainthe factors in the DDM that affect a stock’s price-to-earnings (P/E) ratio;

e. explain the components of an investor’s required rate of return (i.e., the real risk-free rate, the expected rate of inflation, and a risk premium) and discuss the riskfactors to be assessed in determining a country risk premium for use inestimating the required return for foreign securities;

f. estimate the dividend growth rate, given the components of the required returnon equity and incorporating the earnings retention rate and current stock price;

g. describe a process for developing estimated inputs to be used in the DDM,including the required rate of return and expected growth rate of dividends.

Reading 57: Industry Analysis

The candidate should be able to describe how structural economic changes(e.g., demographics, technology, politics, and regulation) may affect industries.

Reading 58: Company Analysis and Stock Valuation


a. differentiate between 1) a growth company and a growth stock, 2) a defensivecompany and a defensive stock, 3) a cyclical company and a cyclical stock, 4) aspeculative company and a speculative stock, and 5) a value stock and agrowth stock;

b. describe and estimate the expected earnings per share (EPS) and earningsmultiplier for a company and use the multiple to make an investment decisionregarding the company.

Reading 59: Introduction to Price Multiples


a. discuss the rationales for, and the possible drawbacks to, the use of price toearnings (P/E), price to book value (P/BV), price to sales (P/S), and price to cashflow (P/CF) in equity valuation;

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


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

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

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

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

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

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

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

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

READING ASSIGNMENTS

Reading 60 Features of Debt SecuritiesFixed Income Analysis for the Chartered Financial Analyst®

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

Reading 61 Risks Associated with Investing in BondsFixed Income Analysis for the Chartered Financial Analyst®


Reading 62 Overview of Bond Sectors and InstrumentsFixed Income Analysis for the Chartered Financial Analyst®


Reading 63 Understanding Yield SpreadsFixed Income Analysis for the Chartered Financial Analyst®


STUDY SESSION 15FIXED INCOME:Basic Concepts

LEARNING OUTCOMES

Reading 60: Features of Debt Securities


a. explain the purposes of a bond’s indenture, and describe affirmative andnegative covenants;

b. describe the basic features of a bond, the various coupon rate structures, and thestructure of floating-rate securities;

Study Session 15


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

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

e. identify the common options embedded in a bond issue, explain the importanceof embedded options, and state whether such options benefit the issuer or thebondholder;

f. describe methods used by institutional investors in the bond market to financethe purchase of a security (i.e., margin buying and repurchase agreements).

Reading 61: Risks Associated with Investing in Bonds


a. explain the risks associated with investing in bonds;

b. identify the relations among a bond’s coupon rate, the yield required by themarket, and the bond’s price relative to par value (i.e., discount, premium, orequal to par);

c. explain how features of a bond (e.g., maturity, coupon, and embedded options)and the level of a bond’s yield affect the bond’s interest rate risk;

d. identify the relationship among the price of a callable bond, the price of anoption-free bond, and the price of the embedded call option;

e. explain the interest rate risk of a floating-rate security and why such a security’sprice may differ from par value;

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

g. describe yield curve risk and explain why duration does not account for yieldcurve risk for a portfolio of bonds;

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

i. identify the factors that affect the reinvestment risk of a security and explain whyprepayable amortizing securities expose investors to greater reinvestment riskthan nonamortizing securities;

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

k. explain liquidity risk and why it might be important to investors even if theyexpect to hold a security to the maturity date;

l. describe the exchange rate risk an investor faces when a bond makes paymentsin a foreign currency;

m. explain inflation risk;

n. explain how yield volatility affects the price of a bond with an embedded optionand how changes in volatility affect the value of a callable bond and a putablebond;

o. describe the various forms of event risk.

Reading 62: Overview of Bond Sectors and Instruments


a. describe the features, credit risk characteristics, and distribution methods forgovernment securities;

b. describe the types of securities issued by the U.S. Department of the Treasury(e.g. bills, notes, bonds, and inflation protection securities), and differentiatebetween on-the-run and off-the-run Treasury securities;

Study Session 15


c. describe how stripped Treasury securities are created and distinguish betweencoupon strips and principal strips;

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

e. describe the types and characteristics of mortgage-backed securities and explainthe cash flow, prepayments, and prepayment risk for each type;

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

g. describe the types of securities issued by municipalities in the United States, anddistinguish between tax-backed debt and revenue bonds;

h. describe the characteristics and motivation for the various types of debt issued bycorporations (including corporate bonds, medium-term notes, structured notes,commercial paper, negotiable CDs, and bankers acceptances);

i. define an asset-backed security, describe the role of a special purpose vehicle inan asset-backed security’s transaction, state the motivation for a corporation toissue an asset-backed security, and describe the types of external creditenhancements for asset-backed securities;

j. describe collateralized debt obligations;

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

Reading 63: Understanding Yield Spreads


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

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

c. explain the basic theories of the term structure of interest rates and describe theimplications of each theory for the shape of the yield curve;

d. define a spot rate;

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

f. describe a credit spread and discuss the suggested relation between creditspreads and the well-being of the economy;

g. identify how embedded options affect yield spreads;

h. explain how the liquidity or issue-size of a bond affects its yield spread relative torisk-free securities and relative to other securities;

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

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


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

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

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

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

yield valuation and interest rate risk measurement and analysis.

READING ASSIGNMENTS

Reading 64 Introduction to the Valuation of Debt SecuritiesFixed Income Analysis for the Chartered Financial Analyst®


Reading 65 Yield Measures, Spot Rates, and Forward RatesFixed Income Analysis for the Chartered Financial Analyst®


Reading 66 Introduction to the Measurement of Interest Rate RiskFixed Income Analysis for the Chartered Financial Analyst®


STUDY SESSION 16FIXED INCOME:Analysis and Valuation

LEARNING OUTCOMES

Reading 64: Introduction to the Valuation of Debt Securities


a. explain the steps in the bond valuation process;

b. identify the types of bonds for which estimating the expected cash flows isdifficult, and explain the problems encountered when estimating the cash flowsfor these bonds;

c. compute the value of a bond and the change in value that is attributable to achange in the discount rate;

d. explain how the price of a bond changes as the bond approaches its maturitydate, and compute the change in value that is attributable to the passage oftime;

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

Study Session 16


f. explain the arbitrage-free valuation approach and the market process that forcesthe price of a bond toward its arbitrage-free value, and explain how a dealer cangenerate an arbitrage profit if a bond is mispriced.

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


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

b. compute and interpret the traditional yield measures for fixed-rate bonds andexplain their limitations and assumptions;

c. explain the importance of reinvestment income in generating the yield computedat the time of purchase, calculate the amount of income required to generatethat yield, and discuss the factors that affect reinvestment risk;

d. compute and interpret the bond equivalent yield of an annual-pay bond, and theannual-pay yield of a semiannual-pay bond;

e. describe the methodology for computing the theoretical Treasury spot rate curveand compute the value of a bond using spot rates;

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

g. describe how the option-adjusted spread accounts for the option cost in a bondwith an embedded option;

h. explain a forward rate, and compute spot rates from forward rates, forward ratesfrom spot rates, and the value of a bond using forward rates.

Reading 66: Introduction to the Measurement of Interest Rate Risk


a. distinguish between the full valuation approach (the scenario analysis approach)and the duration/convexity approach for measuring interest rate risk, and explainthe advantage of using the full valuation approach;

b. demonstrate the price volatility characteristics for option-free, callable,prepayable, and putable bonds when interest rates change;

c. describe positive convexity, negative convexity, and their relation to bond priceand yield;

d. compute and interpret the effective duration of a bond, given information abouthow the bond’s price will increase and decrease for given changes in interestrates, and compute the approximate percentage price change for a bond, giventhe bond’s effective duration and a specified change in yield;

e. distinguish among the alternative definitions of duration, and explain whyeffective duration is the most appropriate measure of interest rate risk for bondswith embedded options;

f. compute the duration of a portfolio, given the duration of the bonds comprisingthe portfolio, and explain the limitations of portfolio duration;

g. describe the convexity measure of a bond and estimate a bond’s percentageprice change, given the bond’s duration and convexity and a specified change ininterest rates;

h. differentiate between modified convexity and effective convexity;

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


STUDY SESSION 17DERIVATIVES

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

of some underlying asset—have become increasingly important and

fundamental in effectively managing financial risk and creating synthetic

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

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

This study session builds the conceptual framework for understanding

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

and the use of options in risk management.

READING ASSIGNMENTS

Reading 67 Derivative Markets and InstrumentsAnalysis of Derivatives for the Chartered Financial Analyst®

Program, by Don M. Chance, CFA

Reading 68 Forward Markets and ContractsAnalysis of Derivatives for the Chartered Financial Analyst®


Reading 69 Futures Markets and ContractsAnalysis of Derivatives for the Chartered Financial Analyst®


Reading 70 Option Markets and ContractsAnalysis of Derivatives for the Chartered Financial Analyst®


Reading 71 Swap Markets and ContractsAnalysis of Derivatives for the Chartered Financial Analyst®


Reading 72 Risk Management Applications of Option StrategiesAnalysis of Derivatives for the Chartered Financial Analyst®


Study Session 17


LEARNING OUTCOMES

Reading 67: Derivative Markets and Instruments


a. define a derivative and differentiate between exchange-traded and over-the-counter derivatives;

b. define a forward commitment and a contingent claim, and describe the basiccharacteristics of forward contracts, futures contracts, options (calls and puts),and swaps;

c. discuss the purposes and criticisms of derivative markets;

d. explain arbitrage and the role it plays in determining prices and promotingmarket efficiency.

Reading 68: Forward Markets and Contracts


a. differentiate between the positions held by the long and short parties to aforward contract in terms of delivery/settlement and default risk;

b. describe the procedures for settling a forward contract at expiration, and discusshow termination alternatives prior to expiration can affect credit risk;

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

d. describe the characteristics of equity forward contracts and forward contracts onzero-coupon and coupon bonds;

e. describe the characteristics of the Eurodollar time deposit market, and defineLIBOR and Euribor;

f. describe the characteristics of forward rate agreements (FRAs);

g. calculate and interpret the payoff of an FRA and explain each of the componentterms;

h. describe the characteristics of currency forward contracts.

Reading 69: Futures Markets and Contracts


a. describe the characteristics of futures contracts, and distinguish between futurescontracts and forward contracts;

b. differentiate between margin in the securities markets and margin in the futuresmarkets, and define initial margin, maintenance margin, variation margin, andsettlement price;

c. describe price limits and the process of marking to market, and compute andinterpret the margin balance, given the previous day’s balance and the change inthe futures price;

d. describe how a futures contract can be terminated at or prior to expiration by aclose-out (i.e., offset), a delivery, an equivalent cash settlement, or an exchange-for-physicals;

e. describe the characteristics of the following types of futures contracts: Eurodollar,Treasury bond, stock index, and currency.

Study Session 17


Reading 70: Option Markets and Contracts


a. define European option, American option, and moneyness, and differentiatebetween exchange-traded options and over-the-counter options;

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

c. compare and contrast interest rate options to forward rate agreements (FRAs);

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

e. compute and interpret option payoffs, and explain how interest rate optionpayoffs differ from the payoffs of other types of options;

f. define intrinsic value and time value, and explain their relationship;

g. determine the minimum and maximum values of European options andAmerican options;

h. calculate and interpret the lowest prices of European and American calls andputs based on the rules for minimum values and lower bounds;

i. explain how option prices are affected by the exercise price and the time toexpiration;

j. explain put–call parity for European options, and relate put–call parity toarbitrage and the construction of synthetic options;

k. contrast American options with European options in terms of the lower boundson option prices and the possibility of early exercise;

l. explain how cash flows on the underlying asset affect put–call parity and thelower bounds of option prices;

m. indicate the directional effect of an interest rate change or volatility change onan option’s price.

Reading 71: Swap Markets and Contracts


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

b. define and give examples of currency swaps, plain vanilla interest rate swaps,and equity swaps, and calculate and interpret the payments on each.

Reading 72: Risk Management Applications of Option Strategies


a. determine the value at expiration, profit, maximum profit, maximum loss,breakeven underlying price at expiration, and general shape of the graph of thestrategies of buying and selling calls and puts, and indicate the market outlookof investors using these strategies;

b. determine the value at expiration, profit, maximum profit, maximum loss,breakeven underlying price at expiration, and general shape of the graph of acovered call strategy and a protective put strategy, and explain the riskmanagement application of each strategy.


Due to diversification benefits and higher expectations of investment returns,

investors are increasingly turning to alternative investments. This study

session describes the common types of alternative investments, methods for their

valuation, unique risks and opportunities associated with them, and the relation

between alternative investments and traditional investments.

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

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

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

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

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

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

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

commodities.

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

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

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

capital investments, differences between various hedge fund strategies, and

implementation vehicles for investments in alternative assets.

READING ASSIGNMENTS

Reading 73 Alternative InvestmentsGlobal Investments, Sixth Edition, by Bruno Solnik and Dennis McLeavey, CFA

Reading 74 Investing in CommoditiesGlobal Perspectives on Investment Management: Learning fromthe Leaders, edited by Rodney N. Sullivan, CFA

STUDY SESSION 18ALTERNATIVE INVESTMENTS

Study Session 18


LEARNING OUTCOMES

Reading 73: Alternative Investments


a. differentiate between an open-end and a closed-end fund, and explain how netasset value of a fund is calculated and the nature of fees charged by investmentcompanies;

b. distinguish among style, sector, index, global, and stable value strategies inequity investment and among exchange traded funds (ETFs), traditional mutualfunds, and closed end funds;

c. explain the advantages and risks of ETFs;

d. describe the forms of real estate investment and explain their characteristics asan investable asset class;

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

f. calculate the net operating income (NOI) from a real estate investment, the valueof a property using the sales comparison and income approaches, and the after-tax cash flows, net present value, and yield of a real estate investment;

g. explain the stages in venture capital investing, venture capital investmentcharacteristics, and challenges to venture capital valuation and performancemeasurement;

h. calculate the net present value (NPV) of a venture capital project, given theproject’s possible payoff and conditional failure probabilities;

i. discuss the descriptive accuracy of the term “hedge fund,” define hedge fund interms of objectives, legal structure, and fee structure, and describe the variousclassifications of hedge funds;

j. explain the benefits and drawbacks to fund of funds investing;

k. discuss the leverage and unique risks of hedge funds;

l. discuss the performance of hedge funds, the biases present in hedge fundperformance measurement, and explain the effect of survivorship bias on thereported return and risk measures for a hedge fund database;

m. explain how the legal environment affects the valuation of closely heldcompanies;

n. describe alternative valuation methods for closely held companies and distinguishamong the bases for the discounts and premiums for these companies;

o. discuss distressed securities investing and compare venture capital investing withdistressed securities investing;

p. discuss the role of commodities as a vehicle for investing in production andconsumption;

q. explain the motivation for investing in commodities, commodities derivatives,and commodity-linked securities;

r. discuss the sources of return on a collateralized commodity futures position.

Reading 74: Investing in Commodities


a. explain the relationship between spot prices and expected future prices in termsof contango and backwardation;


Study Session 18

b. describe the sources of return and risk for a commodity investment and theeffect on a portfolio of adding a long-term commodity class;

c. explain why even a commodity index strategy should be considered an activeinvestment.

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