# All you need to know to pass the CFA level 2 exam

By | May 31, 2012

The CFA exams are just around the corner, and level 2 is definitely the one with more material to cover. However, you don’t actually have to know EVERYTHING to pass this exam (65% is usually enough to get through). Going through past exam papers for the last 10 years, here is a list of what you certainly positively need to know. If you already dominate these areas, you are virtually through to level 3.

Ethics
1) Make sure you know all Standards of Professional Standards, but focus on Fiduciary Duties, Investment Recommendations and Actions (disclosure of conflicts, due diligence and reasonable basis, priority of transactions. Make sure you are also comfortable with Duties to Clients (fair dealing, suitability, etc.)
2) Know compliance procedures (at least two) to deter violations of each standard.

Quantitative Methods
1) Know how to explain heteroskedasticity, autocorrelation and multicollinearity. Know how to detect and correct each of these violations.
2) Focus on multiple linear regression — know SST=SSR+SSE, MSR = SSR/k; MSE = SSE /n-k-1; also know SEE = the square root of MSE and of course that R squared = SSR/SST or 1 – SSE/SST
3) Know how to calculate the t-score (t calc = point estimate – hypoth value / standard error)
4) Know how to calculate y, given x’s in a regression equation
5) Know the difference between F and t-tests, when to use each
6) Know how to calculate the correlation coefficient (r) = cov a,b / std dev a x std dev b
7) Know what is a dummy variable (no…it is not the others in the room taking the exam) and when to use it
8] Know Type I and Type II errors
9) Know for times series how to calculate the men reverting level for an AR model
10) Know what the RMSE is and when to use it (don’t worry about calculating it, in my opinion)
11) Know the properties of covariance stationary (no unit root, mean reverting level, constant and finite mean, variance and covariance)
12) Know how to distinguish the equations for an AR(1) model, AR(2) model, AR (1) model with seasonality, linear trend, log linear trend, random walk, random walk w/ a drift models.
13) Know how to evaluate a regression output to see if it is well specified to the data (i.e., does it have a unit room problem, are any of the residuals correlated, etc.).
14) Know what is ARCH and how to detect it.

Corporate Finance
1) Know the formula for the WACC
2) Know the formula for NPV and IRR
3) Know how to calculate DOL, DFL and DTL (degree of operating leverage…)
4) Know what is the Dividend Signaling Hypothesis
5) Know 6 good reasons for a merger
6) Know 3 Bad reasons for a merger
7) Know 8 takeover defense measures
8) Know how to calculate the gain, cost and NPV of a merger for cash and stock.
9) Review Corporate Governance Best Practices (hit this material hard).
10) Know the factors affecting dividend policy (double taxation, split-tax rate, tax imputation, current income vs capital gains, etc.)
11) Know the advantages and disadvantages of share repurchases vs cash dividends
12) Know the Herfindahl-Hirschman Index (HHI) for determining if a market is highly concentrated or highly competitive….do not get confused with the Herfindahl index discussed in the Equity Section
13) Know what is a residual dividend model and what are the disadvantages of applying it.
14) Make sure you know M&M theory as well as Proposition I and II with no taxes (capital structure is irrelevant and WACC is constant) vs Proposition I and II with taxes (100% debt and WACC declines at first, then levels out and then increases)
15) Know how to calculate the Break Even Quantity given fixed costs, price per unit and variable costs.
16) Know how to select among projects (NPV and IRR) when the projects have unequal lives – i.e., Least Common Multiple of Lives and EAA (Equivalent Annual Annuity) – they have asked this before….

Equity Investments
1) Know how to calculate and explain ex ante alpha and ex post alpha
2) Know the six ways to reduce trading execution costs
3) Know the costs of trading (commission, market impact and opportunity costs)
4) Know the effects of inflation on valuation – for example the difference between passing through 75% vs 100% of inflation as higher prices onto customers…you may also want to know the relevant formula in case they as k it again as a calculation on the exam.
5) Know how to calculate franchise value, what it is and its components; and that If ROE > r franchise factor is > 0 and if FF > 0 higher retention rate means higher growth factor and higher franchise P/E
6) Know Porter’s 5 forces COLD
7) Know the three generic strategies COLD
8) Know advantages and disadvantages of DDM, FCF models and RI models
9) Know with regard to valuation in emerging markets to adjust cash flows rather than discount rates because…
10) Know 3 ways to determine cost of equity (CAPM, APT and LT bond yield + premium)
11) Know Gordon Growth model COLD
12) Know 2 stage DDM COLD
13) Know when to use Gordon and 2 stage DDMs
14) Know how to calculate PVGO
15)Know H-model calculation
16) Know the strengths and weaknesses of multistage growth models (at least two)
17) Know how to calculate FCFF, FCFE COLD!!! Know how to use both in a single stage and two-stage calculations.
18) Know how to calculate P/E and how to get P/E ratio from constant growth DDM formula
19) Know how to calculate both leading and trailing P/E
20) Know advantages and disadvantages of P/E, P/CF, P/BV and P/Sales and the components of each multiple’s calculations
21)Know the method of comparables in that if the firm multiple , the benchmark multiple the security is undervalued…
22) Know EVA and MVA formula and differences between the two measures
23) Know that RI = EPSt – (r x Bt-1) and that RI is economic profits and that if ROE>r then RI is positive and the firm’s MV of equity should be greater than BV of equity.
24) Know the industry life cycle stages COLD
25) Know the advantages and disadvantages of using dividends, FCFE, FCFF, and residual income as the relevant DCF method
26) Remember that EPS= ROE x BVS (somehow it can show up on the exam)…to normalize EPS
27) Know performance measurement problems for hedge funds
28) Know the different measures of risk for hedge funds – VAR and maximum drawdown – they ask this all the time on the Level 3 exam…
29) Make sure you know the two methods of valuing income properties (direct income capitalization and gross income multiplier) – and how to calculate each.
30) Know how to calculate a cap rate for real estate valuation
31) Understand the concepts and know how to calculate after tax equity reversion and recapture of depreciation and after tax cash flow for real estate.
32) Know the 6 different forms of real estate investments and who generally invests in them and the justifications for each type.

Debt Investments

1) For credit analysis know the areas that a credit rating agency will analyze to determine a credit rating: 1) asset backed debt (e.g., quality of collateral, servicer quality…), municipal bonds, sovereign debt, high-yield debt.

2) Know all the concepts we went over in class regarding price-yield curve, duration, convexity, callable bond and non-callable bond.
3) Know how to calculate effective duration and convexity
4) Know the preferred habitat, pure expectations and liquidity preference theories and how they explain different shapes of the yield curve.
5) Know when key rate durations are used and how to calculate them and the change in portfolio value.
6) Know how to do backward induction for non-callable bonds, callable bonds and putable bonds.
7) Know how to explain YTM, spot rates, static spread (zero volatility spread) and OAS.
8) Know that option value = zvs – OAS
9) Know convertible bonds and calculations COLD!!! – yes, all of them!!!
10) Know 4 factors that affect MBS prepayments
11) Know the two forms of prepayment risk – extension and contraction risk
12) Know CMO prepayment risk for PAC I, PAC II, Supoort tranches, IOs and POs.
13) Know external and internal credit enhancements for ABS.
14) Know what is a lockout period
15) Make sure you can understand and can explain the difference between a cash arbitrage CDO and synthetic CDO and the different tranches (senior, mezzanine, equity).
16) Know the advantages of synthetic CDO vs cash CDO.
17) Know the different levels of call protection for commercial mortgage-backed securities

Derivatives

1) Know the No Arbitrage Pricing Formula for forwards (FP = So (1 +Rf)T
2) Equity Forward formula — FP equity = (So -PVD) (1+Rf) T
3) Forward on Fixed Income securities — FP = (So -PVC) X (1+Rf)T
4) For FRA know that the long position in FRA is the party that would borrow. If LIBOR ends up above forward rate in FRA, long side has right to borrow at below market rates and receives a payment.
5) Know FRA “price” is forward rate implied by current spot rate
FR (j,k) = (1+L (j+k) X (j+k)/360) / 1+L (j) x (j/360) -1 x 360/k — hopefully you will never see this on the real exam.
6) Know currency forward (interest rate parity) formula: FP currency = So X (1+Rd) /(1+R foreign)… remember to do it the way the currency is quoted.
7) Know how to do cash and carry and reverse cash and carry formula, and steps at initiation and expiration.
8) Treasury Bond Futures — FP = [bond price X (1+rf) T – FVC] / Conversion Factor
9) Equity Futures Stock — FP = So (1+Rf) T – FVD
10) Equity Futures Index — FP (index) = So X e raised to the (R-o)T
11) Know caps and floors and when to use them and how. Also know what a collar is and when to use it – what you are achieving.
12) Know how to do the binomial option pricing model as we did in class
13) Know the assumptions and limitations of the Black Scholes Merton Model.
14) Know the effect of each variable on a call option (asset price, volatility, time, etc.)
15) Know how to explain delta and gamma
16) Know what is delta neutral hedging and how to calculate the number of calls for delta hedge = number of shares of stock / delta of call option
17) Know interest rate, currency and equity swaps as we did in class.
18) Know swaptions COLD!!!
19) Know that for swap pricing and valuation that the value to the fixed-pay side = PV of floating – PV of fixed AND that value to floating pay side = PV of fixed – PV of floating.
20) Know what is a credit default swap, who would buy it, who would sell it and why.
21) Know put call parity and how to use it to determine arbitrage opportunity.

Financial Statement Analysis

1. Know the difference between LIFO and FIFO effects on B/S and I/S and that COGS=BI + P -EI
2. Know the effects of changing from straight line to accel. dep or vice versa on ROA, ROE, D/E ratio, net income, future depreciation, current depreciation, etc.
3. Be able to adjust financial ratios for off-balance sheet financing such as sales of accounts receivable with recourse, take-or-pay contracts, cap. leases, etc. from Level I
4. Know Marketable Securities Classifications: HTM, AFS and Trading and how realized/unrealized gains/losses are treated.
5. Know the difference in how fair value hedges, cash flow hedges, and net investment hedges are treated — new this year!!!
6. Know the accounting for intercorporate investments: equity, cost/market and consolidation and to a limited extent proportionate consolidation.
7. Know the main points of purchase method under US GAAP and International Standards. Be familiar with pooling method.
8. Know the steps to construct balance sheet and income statement under purchase method (US and Int’l)
9. Know the effects of changing discount rate, compensation growth rate and expected return on plan assets and inflation rate on PBO, Funded Status, etc.
10. Know the components and how to calculate pension expense, FMV of pension plan assets, PBO (ending), and Funded Status of Plan.
11. Know how to reconcile funded status of plan with reported asset (liability) on B/S pre-2006
12. Know the 3 and 5-components of duPont, be ready to calculate and analyze
13. Know how to calculate growth rate (g = RR X ROE)
14. Know how to calculate i/s and b/s under temporal and all-current rate method
15. Know how a net liability and net asset position may arise under which method and the effect on each from a depreciating or appreciating foreign currency
16. Know the differences between temporal and current rate methods.
17) Know how to calculate flow effect and holding effect under all current rate method and temporal method.
18)Go over ratios — current, quick, A/R turnover, average collection period, a/p turnover, inventory turnover, payables payment period, TAT, Fixed asset turnover, gross profit margin, net and operating profit margins, ROA, ROE and D/E, LTD/Total capital, D/A and interest coverage ratios.
19) Know how US GAAP and IFRS are similar and differ in application to pension accounting.

Economics

1. Know the factors that promote economic growth
2. Know the classical growth theory, the neoclassical growth theory and the new growth theory in terms of what each says about population growth, savings rate, technology, etc.
3) Know the endogenous growth theory (assumes constant MPC, straight savings curve, etc.)
4) Know the 1/3 rule
5) Know PPP — law of one price, relative PPP and formulae
6) Know International Fisher relation and formula (interest rate differentials = expected inflation differentials)
7) Know uncovered interest rate parity which says that countries with high nominal interest rates should see their currencies depreciate
8) Know interest rate parity which says that countries with high nominal interest rates will have their currencies sell at a forward or discount to prevent arbitrage
9) Know what is a foreign currency risk premium and how to calculate it.
10) Know the asset market approach and how the exchange rate will initially change and ultimately change when there is a market disruption like the Fed announcing unexpectedly an increase in the money supply.

Portfolio Management

1) Know how to calculate E(R), std dev and variance for two asset portfolio COLD!!!
2) Know the minimum variance frontier, the efficient frontier, the global minimum variance prottfolio and how to select the optimal portfolio on the efficient frontier
3) Know how to explain systematic and unsytematic risk, beta, the CML, CAL and SML
4) Know two differences between SML and CML
5) Know how to calculate any of the components of CAPM and know how to calculate beta
6) Know the assumptions behind APT and CAPM
7) Know similarities and differences between CAPM and APT
****8) BE READY FOR AN IPS (Investment Policy Statement) item set again for an individual investor—review the 2 objectives and 5 constraints well…
9) Know how to calculate the information ratio, what it represents, what is active return and acyive risk as well as active risk squared formula
10) Know the difference between a factor portfolio and a tracking portfolio.
11) Know how to calculate the expected return on a global portfolio using ICAPM
12) Know how to calculate the forward premium or discount on a currency vis-à-vis another currency (focus on the currency in the denominator).
13) Know how to determine if a nominal currency exchange rate changes over a period of time how much of the currency change is due to real changes and how much is due to inflation (i.e., any portion that is not due to inflation is real rate changes) and whether the currency has changed or not changed in real terms.
14) Know how to calculate arbitrage using triangular arbitrage for three currencies – not very much emphasized this year but they sometimes love to ask it…
15) Know what is a foreign currency risk premium, what it represents (i.e., real exchange rate risk), and how to calculate it.
16) Know the steps to the Black Treynor model…the components to the risky portfolio (partly passively managed and partly actively managed) and how to formulate the optimal portfolio.

Category: CFA