CFA Terminology and Definitions

Quantitative Methods:

 Coefficient Variation (CV): desperation relative to mean

 Z score: number of SD is from the population mean
 Binomial Disruption: Up or down (heads vs tails)
 Sampling Distribution: Equal size random samples
 Central Limit Theorem: As sample size gets larger the sample distribution approaches the
normal distribution
 Standard error: Standard deviation of distribution of means
 Confidence Interval: Range of values the mean will be, with a given probability
 Null Hypothesis: Wants to reject
 One tailed test: Value is great than or less than a number
 Two tailed test: value is equal to a given number
 Type I error: reject a null hypothesis that is true.
 Type II error: Fail to reject a null hypothesis that is false.
 T test (population mean), Chi Squared test (since population variance), F statistic (two
population variances)

Economics

 Operate in the short run: Total Revenue > Variable Cost

 Perfect Competition: Many firms with no pricing power, lower barriers to entry and
homogenous products
 Monopolistic competition: Many firms, some pricing power, low barriers to entry, differentiated
products and large advertising expense.
 Oligopoly: Few firms that have significant pricing power, high barriers to entry and products may
be differentiated or homogenous
 Monopoly: Single firm with significant pricing power, high barriers to entry and advertising is
used to compete with substitute products.
 In all market structures: marginal revenue = marginal cost
 Leading Indicator (before market move), coincident Indicator (same time as market move),
lagging Indicator (after market move)
 Factors affecting aggregate demand: Consumers wealth, business expectations, consumer’s
income expectations, capacity utilization, monetary/fiscal policy, exchange rates and global
economic growth.
 Factors affecting short run aggregate supply: Input prices, labor productivity, expectations for
output prices, taxes and subsides, exchange rates.
 Factors affecting long run aggregate supply: Size of labor force, human capital, supply of natural
resources, stock of physical capital and level of technology.
 Frictional Unemployment: time lag in matching qualified workers with job openings
  Structural Unemployment: Unemployed worker do not have the skills to match newly created
jobs
 Cyclical Unemployment: Economy producing at less than capacity during contraction phase of
business cycle
 Monetary policy: Expansionary when policy rate > neutral rate (economic growth + inflation
target)
 Fiscal policy: Expansionary when budget deficit is increasing
 Current Account: (X-M) and net income/transfers from abroad
 Capital Account: Capital transfers and sales/purchases of nonfinancial assets
 Financial Account: Government owned assets abroad and foreign owned assets abroad
 Trade Agreements: Free trade (No barriers to trade/services), Customer union (Common trade
policies with non-members), Common market (No barriers for labor/capital movements),
Economic Union (Same economic policy) and Monetary union (Same currency)
 Pegs: Fixed Peg (+/- 1% peg against foreign currency), Target Zone(allows wider spread than a
fixed peg) and Crawling peg (pegged periodically)

Financial Reporting

 Five step revenue recognition model: 1. Identify contracts 2.Indetify performance obligations
3.Determine transaction price 4. Allocate price to obligations 5.Recognize when obligations are
satisfied
 Discontinued Operations: reported net of taxes after net income
 Direct Method: Starts with cash collections, cash input, cash operating expenses, cash interest
expense and cash taxes
 Indirect Method: Starts with net income, adding back gains/losses resulting from
financing/investing cash flows, adding back all non-cash charges and adding assets/liability
accounts that result from operations (Ex: Inventory)
 Vertical Common size: Balance sheet (% of assets), Income statement (% of sales), Cash flow
statement (% of cash flow from operations, financing or investing)
 Horizontal Common size: Each line item relative to its value in a common base period
 Liquidity ratios: Ability to pay its short-term liabilities
 Operating performance ratios: How well management operates the business
 Held for trading: Fair value on balance sheet and dividends, interest, realized/unrealized
gains/losses are all recognized in the income statement
 Available for sale: Fair value on balance sheet and dividends, interest, realized gains/losses are
all recognized in the income statement and unrealized realized gains/losses are all recognized
other comprehensive income
 Held to maturity: Amortized cost on balance sheet and interest, realized gains/losses are
recognized in the income statement
 Capitalizing: Increases short term profits, income variability and assets/equity
  IFRS revaluation: Revaluation gain is recognized in net income only to the extent reverses
recognized impairment loss and further gains are recognized in equity as revaluation surplus
(but gains/losses investment properties are recognized as income)
 U.S GAAP revaluation: revaluation is not permitted
 Deferred Taxes: Created when taxable income and pretax income differs
 Deferred Tax Liability: Is when taxable income is less than pretax income due to temporary
differences. If DTL is not expected to reverse treat it as equity.
 Deferred Tax Asset: is created when taxable income is great than pretax income due to
temporary differences. If the DTA will not be realized a valuation allowance must be recognized
 Capital Leases: Lead to higher asset, liabilities, CFO, D/E, and lower NI in erly years, CFF, current
ratio, WC, asset turnover, ROA and ROE but lead to the same total cash flow as operating leases
 Defined contribution: employer contribution expensed in period incurred
 Defined benefit: A pension payment where overfunded plans are recognized as an asset and
underfunded plan recognized as a liability.
 Interest expense: is the book value of the bond at the beginning of the year multiplied by the
market value of interest at the time the bond were issued.

Corporate Finance

 Total Leverage: percent change in net income from a given percent change in sales.
 Operating leverage: percent change in EBIT from a given percent change in sales.
 Financial Leverage: Percent change in net income for a given change in EBIT.
 Cash dividend and share repurchase have the same effect on shareholder wealth.
 Share repurchased with borrowed funds will:
o Increase EPS if cost of debt < earning yield (Earning/Price)
o Decrease EPS if cost of debt > earning yield (Earning/Price)
 Share repurchased will:
o Increase book value per share if stock price < BVPS
o Decrease book value per share if stock price > BVPS
 Primary sources of liquidity: Cash balances, short term funding and cash flow management of
collections payments.
 Secondary sources of liquidity: Liquidating assets, negotiating debt agreements and bankruptcy
protection.
 On tier board: Includes internal and external directors.
 Two tier board: There is both a supervisory board of external directors and management board
of internal directors
 Board comities:
o Audit Board: Financial reporting
o Governance: Legal/ethical compliance
o Nominations: Finds board candidates
o Remuneration: Compensation for senior management
o Investment: Review large capital projects, asset purchases/sales
Portfolio Management

 Constraints: Liquidity needs, time horizon, tax concerns, legal/regulatory factors and unique
needs/preferences
 Markowitz efficient frontier: The set of portfolios that have highest return for a given level of
risk
 Combing preferences with the optimal set of portfolios: Where the indifference curve and
capital allocation line (CAPM) or efficient frontier intersect and is measured with the standard
deviation.
 Capital Market Line (CML): Is the level of risk/return for a risk free rates of returns combined
with specific asset risks so investors should be compensated for systematic and unsystematic
risk (standard deviation). You should invest at the point where the capital market line and
efficient frontier interest.
 Security Market Line (SML): Investors should only be compensated for risk relative to the
market. Unsystematic is diversified away and investors are compensated for systematic risk
(beta). To get the SML use the equation for CAPM. You can use the SML line to identify
mispriced stocks, a plot above the line shows less risk for a certain return (undervalued stock)
and a plot under the line shows more risk for a certain return (overvalued stock).
 The Sharpe ratio and M-squared measures excess return per unit of total risk.
 Treynor measure and Jensen’s aloha measure excess return per unit of systematic risk.

Securities Market & Equity Investments

 Operationally efficient: low transaction cost

 Informational efficient: prices rapidly adjust to new information
 Execution instructions: how to trade (Ex: Market Order)
 Validity Instructions: When to execute (Ex: Stop Order)
 Clearing instructions: Who settles the trade (Ex: Broker/Clearing House)
 Quote Driven market: investors get quotes from dealers
 Order driven markets: buyers and sellers get matched with one another
 Brokered market: Broker finds connects a buyer with a seller
 Weak Form: Can’t beat market with technical analysis, past prices don’t relate to future
performance
 Semi-Strong Form: Can’t beat market with fundamental, prices reflect public information
 Strong Form: Cant beta market, prices reflect public/not public info
 Industry Life Cycle:
o Embryonic: Slow Growth, high prices, large investment needed, high risk of failure
o Growth: Rapid Growth, Falling prices, limited competition, increasing profitability
o Shakeout: Slower growth, intense competition, declining profitability, cost cutting,
weaker firms fail/merge
o Decline: negative growth/prices and consolidation
  Porters Five Forces: Rivalry among existing competitors, threat of new entrants, power of
suppliers, power of buyer and threat of substitute product

Fixed Income

 Issuer: Person who owes holder

 Indenture: Convents
 Coupon < Yield is discount bond and Coupon > Yield is premium bond
 Constant yield price trajectory: Price approaches par as bond nears maturity.
 Bullet: Principal paid at maturity
 Sinking fund: Early redemption
 Flat/Clean price: Doesn’t include accrued interest
 Full/Dirty price: Includes accrued interest
 Government uses actual/360 while corporate uses 30/360
 Matrix pricing: For illiquid bonds and use yields with bonds with similar credit ratings
 Foreign bond: foreign issuer
 Eurobond: outside of any one country and is denominated in currencies other than those of
countries in which the bonds are sold.
 Underwritten offering: Investment banks buy entire issue, then sell it to the public
 Best efforts offering: Investment banks act as the broker
 Shelf registration: Sell a specific amount over a period of time (in intervals)
 Embedded Options: Callable (Issuer can repay), Puttable (bondholder can sell bond back),
Convertible (Bondholder can exchange the bond for issuer of common stock) and Warrants
(Bondholder may buy issuers common stock at exercise price).
 Yield Measure: G spread (spread above government yield), I spread (spread above swap rate), (Z
spread account for shape of yield curve) and if Z spread is great than OAS it’s a callable bond
 Market price risk: Interest rate risk
 Macaulay Duration: Reinvestment risk = price risk
 Effective Duration: Required for bonds with embedded options
 Convexity: Is a measured rate of change of duration and if its positive interest falls and duration
goes up.
 Agency RMBS: Conforming loans (good loans)
 CMOs: pass through MBS is collateral and it may have sequential pay or PAC/support structures.
 Commercial MBS: Non-recourse mortgages on commercial properties are collateral
 Secured bonds: Are backed by specific collateral and senior to unsecured bonds (which only
have claim to asset)
 Internal credit rating: Excess spread, overcollateralization or waterfall structure
 Investment grade: Baa3/BBB- or above
 Corporate family rating (CFR): issuer rating
 Corporate Credit rating (CPR): security rating
 Four C’s: Capacity, collateral, covenants and character
Derivatives

 Law of on price: same expected cash flow = same price

 Forwards have counterparty (credit) risk while futures do not because gains/losses are realized
as they occur
 Forward Rate Agreement (FRA): Forward contract for borrower to lend money at a certain rate
in the future date
 Interest Rate Swap: Swap floating for fixed rate and is a series off of market FRA’s with PV=0
 American>European option: Call options on dividend paying stocks or a put is in the money
 Holding costs increase value for a call but decrease value for a put
 Holding benefit decrease value for a call but increase value for a put

Alternative Investments

 Event Driven Strategies: investment based on event (Ex: Merger)

 Relative Value Strategies: Investment based on definite value (Ex: Arbitrage or Asset Backed
Securities)
 Equity Strategies: Investment based on opinion (Ex: Fundamental/Quantitative Analysis)
 Macro Strategies: Investment based on global economy
 Hard Hurdle: Get fees on returns higher than hurdle
 Soft Hurdle: Get fees on all returns if hurdle is hit
 High Water Mark: No fees until previous high is hit
 Venture Capital Stage: Formative (early), Later (Product Development) then Mezzanine (Prepare
for IPO)
 Portfolio Company Valuation: DCF, market comparables, asset based (P/BV)
 Exit Strategies: Writing off or getting money (Ex: IPO/Secondary Sale/Write Off)
 Includes: REITS, farmland/timberland, whole loans and construction loans
 Property Valuation Method: Sales comparables, income approach and cost approach
 Contango: future price > spot price
 Backwardation: future price < spot price
 Collateral Yield: return on T-bill posted as margin
 Price return: Due to change in spot price
 Roll Yield: positive for backwardation and negative for contango
 Includes: Long lived asset for public use
 Brownfield: Existing infrastructure
 Greenfield Infrastructure to be built