TERMS

Functional Area	Topic	Study Sessions	Readings
Ethical and Professional Standards	Ethical and Professional Standards	Study Session 1 (PDF)	1-4
Tools and Inputs	Quantitative Analysis	Study Session 2 (PDF)	5-8
	Quantitative Analysis	Study Session 3 (PDF)	9-12
	Economics	Study Session 4 (PDF)	13-17
		Study Session 5 (PDF)	18-23
		Study Session 6 (PDF)	24-28
	Financial Reporting and Analysis	Study Session 7 (PDF)	29-31
		Study Session 8 (PDF)	32-34
		Study Session 9 (PDF)	35-38
		Study Session 10 (PDF)	39-43
	Corporate Finance	Study Session 11 (PDF)	44-48
Portfolio Management	Portfolio Management	Study Session 12 (PDF)	49-51
Asset Valuation	Equity Investments	Study Session 13 (PDF)	52-55
	Equity Investments	Study Session 14 (PDF)	56-59
	Fixed Income	Study Session 15 (PDF)	60-63
	Fixed Income	Study Session 16 (PDF)	64-66
	Derivatives	Study Session 17 (PDF)	67-72
	Alternative Investments	Study Session 18 (PDF)	73-74

Reading 1: Code of Ethics and Standards of Professional Conduct

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

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

c. explain the ethical responsibilities required by the Code and Standards, including the 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 of Professional Conduct by applying the Code and Standards to situations involving issues of professional integrity;

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

c. recommend practices and procedures designed to prevent violations of the Code of 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 standards apply to and who is served by the standards;

Reading 4: Global Investment Performance Standards (GIPS®)

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

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

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

LEARNING OUTCOMES

Reading 5: The Time Value of Money

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

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

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

d. calculate and interpret the future value (FV) and present value (PV) of a single sum of money, an ordinary annuity, an annuity due, a perpetuity (PV only), and a series 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 identify problems associated with the IRR rule;

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

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

Reading 7: Statistical Concepts and Market Returns

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

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

d. define, calculate, and interpret measures of central tendency, including the population 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;

g. calculate and interpret the proportion of observations falling within a specified number 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 negatively skewed return distribution, and describe the relative locations of the mean, median, and mode for a nonsymmetrical distribution;

Reading 8: Probability Concepts

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

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

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

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

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

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

LEARNING OUTCOMES

Reading 9: Common Probability Distributions

a. explain a probability distribution and distinguish between discrete and continuous 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 cumulative distribution function, and calculate and interpret probabilities for a random variable, 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 binomial distribution functions, and construct a binomial tree to describe stock price movement;

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

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

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

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

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

j. explain the relationship between normal and lognormal distributions and why the 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 a specific holding period return;

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

Reading 10: Sampling and Estimation

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

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

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

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

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

Reading 11: Hypothesis Testing

a. define a hypothesis, describe the steps of hypothesis testing, interpret and discuss the choice of the null hypothesis and alternative hypothesis, and distinguish 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 significance level, 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 the relation 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 test concerning 1) the population mean of a normally distributed population with

a) known or b) unknown variance, 2) the equality of the population means of two normally distributed populations, based on independent random samples with a) equal or b) unequal assumed variances, and 3) the mean difference of two normally distributed populations (paired comparisons test);

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

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

Reading 12: Technical Analysis

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

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 that influence each measure;

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

Reading 14: Efficiency and Equity

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

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

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

d. discuss the relationship between consumer surplus, producer surplus, and equilibrium;

e. explain 1) how efficient markets ensure optimal resource utilization and 2) the obstacles 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 and the 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-term impacts of outside shocks, and describe the effects of rent ceilings on the existence 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 a minimum wage above the equilibrium wage;

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

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

Reading 16: Organizing Production

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

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

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

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

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

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 coordinating economic activity.

Reading 17: Output and Costs

b. describe and explain the relations among total product of labor, marginal product of labor, and average product of labor, and describe increasing and decreasing 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 various cost curves;

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

LEARNING OUTCOMES

Reading 18: Perfect Competition

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

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

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

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

Reading 19: Monopoly

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

b. explain the relation between price, marginal revenue, and elasticity for a monopoly, 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 natural monopoly.

Reading 20: Monopolistic Competition and Oligopoly

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

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

d. explain the kinked demand curve model and the dominant firm model, and describe 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 factors that determine the elasticity of the demand for labor;

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

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

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

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

Reading 22: Monitoring Jobs and the Price Level

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

c. explain the types of unemployment, full employment, the natural rate of unemployment, 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 the main 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 aggregate supply, explain movement along the long-run and short-run aggregate supply curves (LAS and SAS), and discuss the reasons for changes in potential GDP and aggregate 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 explain the factors that can change aggregate demand;

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

d. compare and contrast the classical, Keynesian, and monetarist schools of macroeconomics.

Reading 24: Money, the Price Level, and Inflation

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

c. describe the economic functions of and differentiate among the various depository 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 policy and how the Fed uses its policy tools to control the quantity of money, and describe the assets and liabilities on the Fed’s balance sheet;

e. discuss the creation of money, including the role played by excess reserves, and calculate 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 the demand for money curve, including the effects of changes in real GDP and financial innovation;

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

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

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

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

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

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

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

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

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 curve and its relation to supply-side economics;

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

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

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

e. explain the limitations of discretionary fiscal policy, and differentiate between discretionary 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) means for achieving the goals, including how the Fed operationalizes those goals;

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

c. discuss monetary policy’s transmission mechanism (chain of events) between changing the federal funds rate and achieving the ultimate monetary policy goal when fighting either inflation or recession, and explain loose links and time lags in the adjustment process;

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

Reading 28: An Overview of Central Banks

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

Reading 29: Financial Statement Analysis: An Introduction

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

c. discuss the importance of financial statement notes and supplementary information (including disclosures of accounting methods, estimates and assumptions) 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 statements and supplementary information that analysts use in financial statement analysis;

Reading 30: Financial Reporting Mechanics

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

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

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

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

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

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 reporting standards in security analysis and valuation;

b. explain the role of standard-setting bodies, such as the International Accounting Standards Board and the U.S. Financial Accounting Standards Board, and regulatory authorities such as the International Organization of Securities Commissions, the U.K. Financial Services Authority, and the U.S. Securities and Exchange Commission in establishing and enforcing financial reporting standards;

c. discuss the ongoing barriers to developing one universally accepted set of financial 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 preparing financial statements;

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

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

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

Reading 32: Understanding the Income Statement

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

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

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

d. determine which method of depreciation, accounting for inventory, or amortizing intangibles 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 of intangibles;

f. distinguish between the operating and nonoperating components of the income statement;

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

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

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

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

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

Reading 33: Understanding the Balance Sheet

a. illustrate and interpret the components of the assets, liabilities, and equity sections of the balance sheet, and discuss the uses of the balance sheet in financial analysis;

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

g. demonstrate the appropriate classifications and related accounting treatments for marketable and non-marketable financial instruments held as assets or owed

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

Reading 34: Understanding the Cash Flow Statement

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

c. compare and contrast the key differences in cash flow statements prepared under international financial reporting standards and U.S. generally accepted accounting principles;

d. demonstrate the difference between the direct and indirect methods of presenting cash from operating activities and explain the arguments in favor of each;

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

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

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

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

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

Reading 35: Inventories

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

b. discuss how inventories are reported in the financial statements and how the lower 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 and explain the relationship among and the usefulness of inventory and cost of goods sold data provided by the FIFO, weighted average cost, and LIFO methods when prices are 1) stable, 2) decreasing, or 3) increasing;

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

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

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

Reading 36: Long-Lived Assets

a. explain the accounting standards related to the capitalization of expenditures as part 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 including the effect on the interest coverage ratio of capitalizing interest costs;

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

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

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

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

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

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

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

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

Reading 37: Income Taxes

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

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

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

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

f. distinguish between temporary and permanent items in pretax financial income and 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 might affect an analyst’s view of a company);

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

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

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

Reading 38: Long-Term Liabilities and Leases

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

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

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 and on financial statements and ratios;

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

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

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

h. distinguish between a sales-type lease and a direct financing lease, and determine 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 the sale of receivables affect financial statements and selected financial ratios.

Reading 39: Financial Analysis Techniques

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

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

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

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

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

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

Reading 40: Financial Reporting Quality: Red Flags and Accounting

Warning Signs

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

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

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

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

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

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

Reading 41: Accounting Shenanigans on the Cash Flow Statement

The candidate should be able to analyze and discuss the following ways to manipulate the cash flow statement:

Reading 42: Financial Statement Analysis: Applications

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

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

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

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

Reading 43: International Standards Convergence

a. identify and explain the major international accounting standards for each asset and 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 major revenue and expense categories on the income statement, and the key differences from U.S. GAAP;

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

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

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 the proper cash flows and determining the proper discount rate;

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

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

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

f. describe and account for the relative popularity of the various capital budgeting methods, and explain the relation between NPV and company value and stock price.

Reading 45: Cost of Capital

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

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

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

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

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

f. calculate and interpret the cost of fixed rate debt capital using the yield-tomaturity 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 pricing model approach, the dividend discount model approach, and the bond yield plus risk premium approach;

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

k. describe the marginal cost of capital schedule, explain why it may be upwardsloping with respect to additional capital, and calculate and interpret its breakpoints;

Reading 46: Working Capital Management

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

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

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

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

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

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

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

Reading 47: Financial Statement Analysis

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

Reading 48: The Corporate Governance of Listed Companies:

A Manual for Investors

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

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

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

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

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

g. evaluate, from a shareowner’s perspective, company policies related to voting rules, shareowner sponsored proposals, common stock classes, and takeover defenses.

Reading 49: The Asset Allocation Decision

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

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

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

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

e. describe the importance of asset allocation, in terms of the percentage of a portfolio’s return that can be explained by the target asset allocation, and explain how political and economic factors result in differing asset allocations by investors in various countries.

Reading 50: An Introduction to Portfolio Management

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

c. compute and interpret the expected return, variance, and standard deviation for an individual investment and the expected return and standard deviation for a portfolio;

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

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

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

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

Reading 51: An Introduction to Asset Pricing Models

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

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

c. define systematic and unsystematic risk, and explain why an investor should not expect 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 evaluate whether the security is overvalued, undervalued, or properly valued.

Reading 52: Organization and Functioning of Securities Markets

b. distinguish between primary and secondary capital markets, and explain how secondary markets support primary 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, including exchange membership, types of orders, and market makers;

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

g. describe the process of buying a stock on margin, compute the rate of return on a margin transaction, define maintenance margin, and determine the stock price at 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 direction of bias exhibited by, each of the three predominant weighting schemes used in constructing stock market indexes, and compute a price-weighted, a valueweighted, and an unweighted index series for three stocks;

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

Reading 54: Efficient Capital Markets

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

b. describe the tests used to examine each of the three forms of the EMH, identify various market anomalies and explain their implications for the EMH, and explain the 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 the portfolio 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

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

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

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

Reading 56: An Introduction to Security Valuation

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

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

d. show how to use the DDM to develop an earnings multiplier model, and explain the 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 riskfree rate, the expected rate of inflation, and a risk premium) and discuss the risk factors to be assessed in determining a country risk premium for use in estimating the required return for foreign securities;

f. estimate the dividend growth rate, given the components of the required return on 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 defensive company and a defensive stock, 3) a cyclical company and a cyclical stock, 4) a speculative company and a speculative stock, and 5) a value stock and a growth stock;

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

Reading 59: Introduction to Price Multiples

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

Reading 60: Features of Debt Securities

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

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

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

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

Reading 61: Risks Associated with Investing in Bonds

b. identify the relations among a bond’s coupon rate, the yield required by the market, and the bond’s price relative to par value (i.e., discount, premium, or equal 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 an option-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’s price may differ from par value;

g. describe yield curve risk and explain why duration does not account for yield curve 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 why prepayable amortizing securities expose investors to greater reinvestment risk than nonamortizing securities;

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

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

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

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

Reading 62: Overview of Bond Sectors and Instruments

a. describe the features, credit risk characteristics, and distribution methods for government 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 differentiate between on-the-run and off-the-run Treasury securities;

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

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

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

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

h. describe the characteristics and motivation for the various types of debt issued by corporations (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 in an asset-backed security’s transaction, state the motivation for a corporation to issue an asset-backed security, and describe the types of external credit enhancements for asset-backed securities;

k. describe the mechanisms available for placing bonds in the primary market and differentiate 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.

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

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

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

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

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

Reading 64: Introduction to the Valuation of Debt Securities

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

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

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

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

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

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

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

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

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

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

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

h. explain a forward rate, and compute spot rates from forward rates, forward rates from 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 explain the 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 price and yield;

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

e. distinguish among the alternative definitions of duration, and explain why effective duration is the most appropriate measure of interest rate risk for bonds with embedded options;

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

g. describe the convexity measure of a bond and estimate a bond’s percentage price change, given the bond’s duration and convexity and a specified change in interest rates;

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

Reading 67: Derivative Markets and Instruments

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

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

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

Reading 68: Forward Markets and Contracts

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

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

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

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

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

Reading 69: Futures Markets and Contracts

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

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

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

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

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

Reading 70: Option Markets and Contracts

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

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

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

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

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

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

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

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

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

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

Reading 71: Swap Markets and Contracts

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

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 the strategies of buying and selling calls and puts, and indicate the market outlook of 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 a covered call strategy and a protective put strategy, and explain the risk management application of each strategy.

Reading 73: Alternative Investments

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

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

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

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

g. explain the stages in venture capital investing, venture capital investment characteristics, and challenges to venture capital valuation and performance measurement;

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

i. discuss the descriptive accuracy of the term “hedge fund,” define hedge fund in terms of objectives, legal structure, and fee structure, and describe the various classifications of hedge funds;

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

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

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

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

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

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 terms of contango and backwardation;

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

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

The Structure of Hedge Funds

Like private equity funds, hedge funds are typically organized as either limited partnerships or limited liability corporations to protect investors from losses exceeding their initial investment and to avoid double taxation of corporate earnings.

The high fees earned by hedge fund managers has been widely criticized, particularly when the returns generated include some exposure to beta. Beta can be obtained very cheaply through passive investments such as index funds. However, to the extent that the hedge fund returns offer diversification the fees may simply represent a sort of insurance premium that investors are willing to payÂ in exchange for risk reduction.

The investments made by hedge funds are often illiquid, and as such many funds require a lock-up period before investments can be withdrawn. In addition, most funds allow cash inflows and outflows only at specific times (usually quarterly.)

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Financial literacy is the ability to understand finance. Raising interest in personal finance is now a focus of state-run programs in countries including Australia, Japan, the United States and the UK.^[1]

The Department of the Treasury is a leader in promoting financial education. Treasury established the Office of Financial Education in May of 2002. The Office works to promote access to the financial education tools that can help all Americans make wiser choices in all areas of personal financial management, with a special emphasis on saving, credit management, home ownership and retirement planning. The Office also coordinates the efforts of the Financial Literacy and Education Commission, a group chaired by the Secretary of Treasury and composed of representatives from 20 federal departments, agencies and commissions, which works to improve financial literacy and education for people throughout the United States.

MyMoney.gov is the U.S. government’s website dedicated to teaching all Americans the basics about financial education. Whether you are planning to buy a home, balancing your checkbook, or investing in your 401k, the resources on MyMoney.gov can help you do it better. Throughout the site, you will find important information from 20 federal agencies government wide.

The business cycle refers to the swings in gross domestic product from recovery to recession. There are several factors influencing the business cycle.

Consumers tend to be the most important, reflecting 60-70% of GDP in developed countries. Trends in consumer spending can be monitored through retail sales and personal income data.

Business spending on inventories and investment is a smaller but more volatile component of GDP. It can be tracked using surveys such as PMI or ISM.

Monetary policy is used by governments to dampen the overall business cycle. The ability to use monetary policy as a business cycle lever is dampened by inflation, the pace of growth, unemployment levels and capacity utilization.

Inflation has different effects on different types of assets. As a result, it is important both to diversify assets in terms of their response to inflation and to form expectations of inflation in order to overweight the assets that will respond best to future conditions.

Cash – inflation causes rising interest rates, and therefore cash tends to earn a higher return when inflation is higher.

Bonds – inflation erodes the fixed payments and terminal values of bonds. Therefore, bonds perform worse when inflation is higher.

Stocks – inflation can increase asset values but erode real cash flows. Rising interest rates can reduce the present value of future cash flows. Stocks tend to do best when inflation is low and predictable, and to fall in either high inflation or deflation.

Real estate – higher cash flows and asset values tend to result in a positive relationship between real estate and inflation.

The N-firm concentration ratio is an intuitive measure of industry concentration. Industries with high (or low) levels of concentration have few (or many) competitors.

The N-firm concentration ratio is found simply by adding the market shares of the N largest firms in the industry. For example, in an industry with six competitors with respective market shares of 30%, 20%, 20%, 10%, 10% and 10% the three firm concentration ratio would be 30% + 20% + 20% = 70% and the 5-firm concentration ratio would be 90%.

The N-firm concentration ratio is an intuitive measure, but the Herfindahl index provides a greater degree of discrimination. As a result, when the two indicators offer differing signals the Herfindahl index is likely more reliable.

Derivative agreements are contracts between two parties, under which at least one of the parties faces a financial obligation to the other. Each counterparty to a contract can be subjected to credit risk, or the possibility that the other party fails to meet its obigation.

In a forward contract, commitments are made at the contract outset but settlement is due at expiration. Consider an agreement under which party A agrees to buy the S&P 500 index from party B for 1,500 in one year. IfÂ the S&P 500 is at 1,400, party A owes party B 100, and party B faces potential credit risk (prior to settlement) and actual credit risk (at the time of settlement.) When the S&P 500 is higher than 1,500 it is party A that is subject to credit risk.

Swap contracts are similar to a series of forward contracts, with interim payments occurring along the way. Each payment exposes one party to credit risk. As each payment is made, the total potential credit risk is reduced.

Option contracts have unilateral credit risk – only the seller is obligated to make a payment, so only the buyer is exposed to credit risk once the initial premium has been paid.

Market risks related to the economy, interest rates, and the state of the market are relatively unimportant when considering investments in distressed securities. There are, however, several types of risks that particularly apply to investments in distressed securities.

Event risk relates to unexpected company-specific or situation-specific events that affect valuation.

Market liquidity risk arises because distressed securities are less liquid, and demand runs in cycles.

J-factor risk relates to the judge presiding over bankruptcy proceedings. The track record in adjudication and restructuring can play a significant role in both the overall outcome and determining the optimum securities in which to invest.

When considering an investment in private equity, investors need to consider a number of factors.

· Does the investor have liquidity needs that would prohibit tying up funds for 7-10 years

· Will the investor be able to fund promised commitments to the private equity fund when called for

What mix of sector, stage and geography is required to provide the best diversification In addition, selecting managers requires special due diligence considerations:

o Identity of current investors – do they have particular expertise that lends confidence to outsiders

The Herfindahl index is a measure of how concentrated an industry is. An industry with few competitors will have a high level of concentration, while many competitors results in low concentration.

The Herfindahl index measures concentration as the sum of the squared market share of each firm in the industry. For example, consider an industry with six competitors, with respective market share of 30%, 20%, 20%, 10%, 10% and 10% the Herfindahl index will be (0.3*0.3) + (0.2*0.2) + (0.2*0.2) + (0.1*0.1) + (0.1*0.1) + (0.1*0.1) = 0.09 + 0.04 + 0.04 + 0.01+0.01 + 0.01 = 0.2.

As a general rule, a Herfindahl index below 0.1 signals low concentration, while a Herfindahl index above 0.18 signals high concentration. Between 0.1 and 0.18 the industry is moderately concentrated.

If all firms in an industry have equal market share, the reciprocal of the Herfindahl index (1/H) will equal the number of firms in the industry. For industry in which firms have unequal share, the reciprocal of the Herfindahl indicates the “equivalent” number of firms. In this example, the six firms in the industry have the same level of concentration as an industry with 1/0.2 = 5 competitors with equal market share.

Compared to the N-firm concentration ratio, the Herfindahl index offers greater discrimination as it includes all firms in the industry and weights the firms according to market share. However, it is not a particularly intuitive measure.

The Income Statement: Operating versus Non-Operating Components

On the income statement, accounting standards encourage separate treatment of operating and non-operating items. Operating items are those relating to the day-to-day management of the enterprise: sales, cost of sales, selling, general and administrative expense, research and development costs, etc. Often the net of these items is presented as a subtotal, operating income.

Non-operating items include investing and financing activities, which are reported separately from operating income (unless pertaining to a financial services firm, for which such items are operational.) Non operating items include the interest, dividends and profits on investments made in the securities of other companies; interest expense; etc.

Some investments in other companies are made for strategic reasons, such as access to raw materials. In these cases, investors and analysts may wish to classify the investments as operating.

While taxes are a normal operating expense, they are also affected by non-operating items. Often, analysts will adjust operating profit by the tax rate to arrive at NOPAT (net operating profit after tax.)

Cash Flow Return on Investment (CFROI)

Cash Flow Return on Investment (CFROI) is an internal rate of return (IRR) type metric measuring the return expected to be generated by a firm’s existing assets throughout their useful lives. CFROI can be calculated in five steps:

· compute the average life of assets by dividing gross assets by depreciation expense

· compute gross cash flow by adjusting net income for non-cash charges, financing expenses, operating lease payments and equity reserve accounts

· compute the gross investment as gross plant and equipment adjusted for reserves, capitalized expenses, restructuring charges, amortization and the present value of operating leases

· compute the value of any assets that will not depreciate (which will represent the future value)

Accounting for Foreign Currency Transactions

When companies using different currencies transact business, at least one of the companies will have to translate a foreign currency into its home currency. For sales made in cash, this can be done at the time of sale.

When the sale is made on credit, the company will have to record an account receivable or account payable until the account is settled. During the interim, the relative values of the currencies could change. The accounting treatment for such changes is governed by International Accounting Standard (IAS) 21 and U.S. Financial Accounting Standard (FAS) 52. The treatment is the same under either method.

· At the time of sale, the sale is recorded at the current exchange rate and an equivalent value asset or liability is created.

· If balance sheets are prepared prior to collection, the asset or liability must be restated to the then-current exchange rate value. The change is recognized as an unrealized exchange rate gain/loss on the income statement.

· When the account is collected, the asset or liability is removed and any previously unrecognized gain/loss is recognized on the income statement.

Since the asset and liability are always presented at fair value and changes flow through the income statement, there is seldom need to adjust the financial statements to examine the effect.

Psychological Traps in Investment Analysis

Investment analysts can fall into several psychological traps (and should strive to avoid doing so.)

Anchoring refers to giving disproportionate weight to the first information received about a topic.

Confirming evidence is the tendency to give more weight to information that supports existing or preferred points of view than to information that contradicts the preferred view.

Recallability is when forecasts are overly influenced by events that left a strong impression on the forecaster’s memory.

Sentiment Indicators

Sentiment indicators monitor the activity of market participants such as floor traders, insiders, mutual fund managers, etc. The premise behind such indicators is that certain types of investors will have similar reactions to future market events as they have had to past events. These reactions may prove useful for identifying market turning points.

Insiders and New York Stock Exchange members have historically been “right.” They tend to be net buyers at market tops and net sellers at market bottoms.

Advisory services, on the other hand, tend to buy at the top and sell at the bottom. Tracking the sentiment of newsletter writers, for example, may prove to be a useful contrary indicator.

Escalation Bias

In behavioral finance, escalation bias causes investors to invest more in money-losing investments for which they feel responsible than they invest in an ongoing successful investment. The popular concept of “averaging down” to reduce the average price paid for the investment may be representative of this bias.

The rational, traditional finance model would expect investors to re-evaluate holdings for potential bad news that they had failed to incorporate into their initial valuation. If the re-evaluation supports the investment, then more could be added. Otherwise, it would be wiser to exit the position and take the loss.

Using Derivatives to Hedge Different Types of Credit Risk

· Credit spread risk is the chance the spread between the risky bond and risk-free securities will vary after purchase

· Downgrade risk is the chance a rating agency will lower its rating on the issuer

A binary credit option pays off only if a specified negative event occurs. These can be used to hedge default risk or downgrade risk.

Credit spread options pay off based on the spread over a benchmark rate. They can be used to hedge credit spread risk.

Managing Credit Risk Associated With Derivative Contracts

Derivative contracts are agreements between two parties to pay a cash flow or series of cash flows based on the value of some underlying instrument. Whenever one of the counterparties is owed a cash flow that party faces credit risk: the chance that the other party will fail to honor its obligation. There are a number of ways firms dealing with a large number of derivative contracts can manage this risk.

Position limits are simply pre-set guidelines on how much exposure can be allocated to a given party. The limits could be in dollar terms, a percentage of the notional value of total contracts, or based on other factors (such as allocating a higher limit to more trusted parties.)

Certain futures contracts are periodically “marked to market,” a process by which the interim differences in value are settled before the contracts expire. The associated mark to market payments are smaller and more frequent, reducing the credit risk compared to a single large payment at the end of the contract. The most one party could lose is the change in value during the time since the last mark to market.

Collateral such as margin are required for many contracts. The margin is a small percentage of the notional value kept in escrow. Usually if the margin falls to a specific percentage of how much is actually owed, either more margin must be put up or the margin is paid out and the contract terminated.

Netting procedures are set up for most contracts so that if both parties owe something only the difference (the net payment) is made by the party owing the larger amount. This reduces the credit risk and causes it to apply only to the party owed the larger amount.

Traditional credit analysis techniques can be used to vet counterparties according to credit standards at the outset of a contract. However, if the contract is long-term in nature the credit quality can change during the contract life.

Finally, there are a number of credit derivatives that can be used to transfer specific aspects of credit risk to other parties willing to accept the risk.

Alternative Routes to Hedge Fund Return Replication

With the growth in the hedge fund industry has come a decline in the value added by hedge fund managers. Given the high fees typically charged by hedge funds, some have questioned whether passive approaches can be constructed that would provide returns similar to those of hedge funds while offering greater transparency and liquidity.

In the Winter 2007 Journal of Wealth Management Harry Kat discusses three general approaches to hedge fund replication:

In a factor model, linear regressions determine the market exposures experienced by a hedge fund or hedge fund index. Factors may include stock, bond, commodity and currency returns, or changes in credit spreads and market volatility. These exposures can then be taken via index products or derivative instruments.

In the case of funds that add value by timing short-term changes in market exposure, the investor’s trading behavior can be compared to mechanical trading rules.

The FundCreator product is a risk management tool that allows the investor to target the risk and correlation properties desired in order to maximize diversification potential.

Six Stages of Business Cycle Investing

In Technical Analysis Explained, Martin Pring notes that since there are three major financial markets (stocks, bonds and commodities) and each has two turning points in a given cycle, there are six turning points in each cycle. He calls these turning points the six stages and uses them as a reference point for identifying the current phase of the business cycle and by extension the next likely turning point.

Stage 1: Slowing growth rates or early recession. Interest rates start to fall and bonds rally.

Commodity Benchmarks

As with any asset class, investments in commodities should be compared with an appropriate benchmark for risk and return. A number of commodity indices are in wide use, which all attempt to replicate the returns available to holding long positions in commodities. The indices can vary widely in terms of composition (which commodities are included), weighting scheme, and purpose. It is important to choose an index that matches the investment practices being used.

Since a futures contract is a zero-sum game (every long position is offset by a corresponding short position) it is not possible to market-weight a futures index. Instead, weighting strategies range from judgment-based methods, to equal-weight, to weightings based on world production levels. The benchmarks typically offer representations of both spot return and total return.

Credit Exposures for Derivative Contracts

Option contracts have unilateral credit risk – only the seller is obligated to make a payment, so only the buyer is exposed to credit risk once the initial premium has been paid.

Market Structure Indicators

Market structure indicators are the primary tool of technical analysis. They monitor the trends of various price indexes, market breadth, volume, etc. Technical analysts use them to monitor the health of the prevailing trend.

Market structure indicators include moving averages, patterns, trendlines and peak/trough analysis. Most of the time, the trends for various indicators move together. When the different indicators diverge, or offer different signals, it is often a sign that a trend reversal will take place.

Flow of Funds Indicators

Flow of funds measures analyze the financial positions of various types of investors to determine their potential capacity to buy or sell stocks. Since every buy order must be matched with a sell order of equal magnitude, flow of funds indicators are not interested so much in the ex-post balance between supply and demand, but with the implications of ex-ante supply and demand imbalances on price.

Although flow of funds measures can indicate an ability to buy or sell, they do not give any sign of the willingness to do so. Furthermore, some of the data is reported with a lag and may no longer be relevant by the time it is available.

Sentiment Indicators

Insiders and New York Stock Exchange members have historically been “right.” They tend to be net buyers at market tops and net sellers at market bottoms.

Advisory services, on the other hand, tend to buy at the top and sell at the bottom. Tracking the sentiment of newsletter writers, for example, may prove to be a useful contrary indicator.

Peak and Trough Progression

Peak and trough progressions are a simple tool used in technical analysis to determine the primary trend and identify reversals in the trend. It is based on the theory that markets progress in waves.

In an uptrend, each successive peak and trough will be at a higher point than the preceding one (higher highs and higher lows). In a downtrend, each peak and trough will be lower (lower highs and lower lows) than the preceding.

When a series of rising or falling peaks and troughs is interrupted, it is a signal that a trend reversal may be taking place. For a true reversal signal in a bull market, both a lower trough and a subsequent lower peak must be identified.

Further, the length of time between peaks and troughs can signal whether a trend is a primary, intermediate, or short-term trend.

Efficient Market Hypothesis: Strong Form

The strong-form efficient market hypothesis assumes that stock prices reflect all information, whether public or private. As such, it encompasses both the weak-form EMH and the semistrong-form EMH. If a market is strong form efficient, it is also weak- and semistrong-form efficient.

In a strong-form efficient market no group of investors should be able to generate excess risk-adjusted returns. Technical analysis, fundamental analysis, and even inside information will provide little value once the information is known.

In essence, the strong form efficient market assumes a perfect market in which all information is cost-free and universally available to all market participants simultaneously.

Efficient Market Hypothesis: Semi-Strong Form

The semistrong form of the efficient market hypothesis assumes that security prices adjust rapidly to all publicly available information. Such information includes market based information and thus the semistrong EMH encompasses the weak form EMH (if markets are semistrong efficient, they are also weak form efficient.)

In addition to market information, other public information includes earnings and dividend announcements, financial ratios, accounting practices, stock splits, and economic and political news. If markets are semistrong efficient, investors should not be able to earn excess risk-adjusted returns if their decisions are based on information that has already been made public. Neither technical analysis nor fundamental analysis would provide a predictable edge.

Standardized Unexpected Earnings (SUE)

Standardized unexpected earnings is a means of comparing earnings surprise to the company’s track record of earnings surprise. For example, Cisco was once said to consistently beat earnings estimates by a penny. Thus, if the company did beat by a penny it was hardly unexpected. A method frequently used in academic research to adjust for this factor is the standardized unexpected earnings, or SUE.

SUE = the earnings surprise at a given time divided by the standard deviation of earnings surprises measured over some historic period such as the previous 20 quarters.

Consider a stock that had a $0.03 earnings surprise, and that the standard deviation of past earnings surprises is $0.05. The surprise is smaller than normal, and the standardized earnings surprise would be $0.03/$0.05 = 0.6.

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