**Level II Concepts** | Breakdown per Exam Weight (%)

Ethical & Professional Standards**10 - 15%**

Quantitative

Methods**5 - 10%**

Economics

Theory**5 - 10%**

Financial Reporting and Analysis**15 - 20%**

Corporate

Finance**5 - 15%**

Equity

Valuation**15 - 25%**

Fixed

Income**10 - 20%**

Derivative

Instruments**5 - 15%**

Alternative

Investments**5 - 10%**

Portfolio & Wealth Management**5 - 10%**

**Level II Concepts** | Overview of Content Covered

**Click Each Button to Expand/Collapse Information on Given Section**

**All Relevant Concepts and Respective Descriptions Sourced from CFA® Institute's 2017 Study Guide Materials**

**Part 1: Valuation Concepts**

**Applications and Processes of Equity Valuation**

- Define both valuation and intrinsic value; explain origins of "perceived" mispricings (over/under valuations)
- Explain the going concern assumption and contrast values under going concern vs. liquidation scenarios
- Describe and justify definitions of value in conducting public company valuation (relevance & validity of valuation)
- Describe applications of equity valuation
- Describe relevant questions when conducting industry and competitive analysis (strategic considerations)
- Contrast absolute versus relative valuation models; describe examples of each type of methodology
- Describe sum-of-the-parts (SOTP) valuation and conglomerate discounts
- Explain broad criteria when determining an appropriate approach for valuing a particular company

**Return Concepts**

- Distinguish among the following: realized holding period return, expected holding period return, required return, return from convergence of price to instrinsic value, discount rate, and internal rate of return
- Calculate and interpret an equity risk premium using historical and forward-looking estimation methodology
- Estimate required return on an equity investment using the following: capital asset pricing model (CAPM), the Fama - French model, the Pastor - Stambaugh model, macro-economic multifactor models, and the build-up method
- Explain beta estimation for public companies, thinly-traded public companies, and nonpublic companies
- Describe pros and cons of methodology used to estimate the required rate of return on an equity investment
- Explain international considerations in required return estimation
- Explain and calculate the weighted average cost of capital (WACC) for a company
- Evaluate the relevance of using a particular rate of return as a discount rate, given a description of the cash flows and other relevant facts

**Part 2: Industry and Company Analysis and Discounted Dividend Valuation**

**Industry Analysis**

- Compare "growth relative to GDP growth" and "market growth and market share" methodologies for forecasting revenue
- Evaluate whether economies of scale are present in an industry through margin analysis and turnover levels
- Describe relationship between return on invested capital (ROIC) and competitive advantage
- Explain how competitive factors affect prices and costs
- Evaluate the effects of technological developments on demand, selling prices, costs, and margins
- Explain an analyst’s choices in developing projections beyond the short-term forecast horizon

**Company Analysis**

- Compare top-down, bottom-up, and hybrid methodologies for developing equity valuation model inputs
- Forecast following: cost of goods sold (COGS), selling, general and administrative costs (SGA), financing costs, and income taxes
- Describe approaches to balance sheet modeling
- Judge the competitive position of a company based on a Porter's five forces analysis
- Explain forecast process for industry and company sales and costs when they are subject to price inflation or deflation
- Explain considerations in the choice of an explicit forecast horizon
- Demonstrate the development of a sales-based pro forma company model

**Discounted Dividend Valuation**

- Compare dividends, free cash flow, and residual income as inputs to DCF methodology and identify investment situations for which each measure is suitable
- Calculate and interpret the value of common stock using the dividend discount model (DDM) for single and multiple holding periods
- Calculate the value of a common stock using the Gordon growth model and explain the model’s underlying assumptions
- Calculate and interpret the implied growth rate of dividends using the Gordon growth model and current stock price (P-naught)
- Calculate and interpret the present value of growth opportunities (PVGO) and the component of the leading price-to-earnings ratio (P/E) related to PVGO
- Calculate and interpret the justified leading and trailing P/Es using the Gordon growth model
- Calculate the value of noncallable fixed-rate perpetual preferred stock
- Describe strengths and limitations of the Gordon growth model and justify its selection to value a company’s common shares
- Explain the assumptions and justify the selection of the two-stage DDM, the H-model, the three-stage DDM, or spreadsheet modeling to value a company’s common shares
- Explain the growth phase, transitional phase, and maturity phase of a business
- Describe terminal value and explain alternative approaches to determining the terminal value in a DDM
- Calculate and interpret the value of common shares using the two-stage DDM, the H-model, and the three-stage DDM
- Estimate a required return based on any DDM, including the Gordon growth model and the H-model
- Explain the use of spreadsheet modeling to forecast dividends and to value common shares
- Calculate and interpret the sustainable growth rate of a company and demonstrate the use of DuPont analysis to estimate a company’s sustainable growth rate
- Evaluate whether a stock is overvalued, fairly valued, or undervalued by the market based on a DDM estimate of value

**Part 3: Free Cash Flow and Other Valuation Models**

**Free Cash Flow Valuation**

- Compare the free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) approaches to valuation
- Explain the ownership perspective implicit in the FCFE approach
- Explain the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE
- Calculate FCFF and FCFE
- Describe approaches for forecasting FCFF and FCFE
- Compare the FCFE model and dividend discount models
- Explain how dividends, share repurchases, share issues, and changes in leverage may affect future FCFF and FCFE
- Evaluate the use of net income and EBITDA as proxies for cash flow in valuation
- Explain the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE models and select and justify the appropriate model given a company’s characteristics
- Estimate a company’s value using the appropriate free cash flow model(s)
- Explain the use of sensitivity analysis in FCFF and FCFE valuations
- Describe approaches for calculating the terminal value in a multistage valuation model
- Evaluate whether a stock is overvalued, fairly valued, or undervalued based on a free cash flow valuation model

**Market-Based Valuation: Price and Enterprise Value Multiples**

- Distinguish between the method of comparables and the method based on forecasted fundamentals as approaches to using price multiples in valuation, and explain economic rationales for each approach
- Calculate and interpret a justified price multiple
- Describe rationales for and possible drawbacks to using alternative price multiples and dividend yield in valuation
- Calculate and interpret alternative price multiples and dividend yield
- Calculate and interpret underlying earnings, explain methods of normalizing earnings per share (EPS), and calculate normalized EPS
- Explain and justify the use of earnings yield (E/P)
- Describe fundamental factors that influence alternative price multiples and dividend yield
- Calculate and interpret the justified price-to-earnings ratio (P/E), price-to-book ratio (P/B), and price-to-sales ratio (P/S) for a stock, based on forecasted fundamentals
- Calculate and interpret a predicted P/E, given a cross-sectional regression on fundamentals, and explain limitations to the cross-sectional regression methodology
- Evaluate a stock by the method of comparables and explain the importance of fundamentals in using the method of comparables
- Calculate and interpret the P/E-to-growth ratio (PEG) and explain its use in relative valuation
- Calculate and explain the use of price multiples in determining terminal value in a multistage discounted cash flow (DCF) model
- Explain alternative definitions of cash flow used in price and enterprise value (EV) multiples and describe limitations of each definition
- Calculate and interpret EV multiples and evaluate the use of EV/EBITDA
- Explain sources of differences in cross-border valuation comparisons
- Describe momentum indicators and their use in valuation
- Explain the use of the arithmetic mean, the harmonic mean, the weighted harmonic mean, and the median to describe the central tendency of a group of multiples
- Evaluate whether a stock is overvalued, fairly valued, or undervalued based on comparisons of multiples

**Residual Income Valuation**

- Calculate and interpret residual income, economic value added, and market value added
- Describe the uses of residual income models
- Calculate the intrinsic value of a common stock using the residual income model and compare value recognition in residual income and other present value models
- Explain fundamental determinants of residual income
- Explain the relation between residual income valuation and the justified price-to-book ratio based on forecasted fundamentals
- Calculate and interpret the intrinsic value of a common stock using single-stage (constant-growth) and multistage residual income models
- Calculate the implied growth rate in residual income, given the market price-to-book ratio and an estimate of the required rate of return on equity
- Explain continuing residual income and justify an estimate of continuing residual income at the forecast horizon, given company and industry prospects
- Compare residual income models to dividend discount and free cash flow models
- Explain strengths and weaknesses of residual income models and justify the selection of a residual income model to value a company’s common stock
- Describe accounting issues in applying residual income models
- Evaluate whether a stock is overvalued, fairly valued, or undervalued based on a residual income model

**Private Company Valuation**

- Compare public and private company valuation
- Describe uses of private business valuation and explain applications of greatest concern to financial analysts
- Explain various definitions of value and demonstrate how different definitions can lead to different estimates of value
- Explain the income, market, and asset-based approaches to private company valuation and factors relevant to the selection of each approach
- Explain cash flow estimation issues related to private companies and adjustments required to estimate normalized earnings
- Calculate the value of a private company using free cash flow, capitalized cash flow, and/or excess earnings methods
- Explain factors that require adjustment when estimating the discount rate for private companies
- Compare models used to estimate the required rate of return to private company equity (for example, the CAPM, the expanded CAPM, and the build-up approach)
- Calculate the value of a private company based on market approach methods and describe advantages and disadvantages of each method
- Describe the asset-based approach to private company valuation
- Explain and evaluate the effects on private company valuations of discounts and premiums based on control and marketability
- Describe the role of valuation standards in valuing private companies

**Part 1: Intercorporate Investments, Post-Employment and Share-Based Compensation, and Multinational Operations**

**Intercorporate Investments**

- Describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for 1) investments in financial assets, 2) investments in associates, 3) joint ventures, 4) business combinations, and 5) special purpose and variable interest entities
- Distinguish between IFRS and US GAAP in the classification, measurement, and disclosure of investments in financial assets, investments in associates, joint ventures, business combinations, and special purpose and variable interest entities
- Analyze how different methods used to account for intercorporate investments affect financial statements and ratios

**Employee Compensation: Post-Employment and Share-Based**

- Describe the types of post-employment benefit plans and implications for financial reports
- Explain and calculate measures of a defined benefit pension obligation (i.e., present value of the defined benefit obligation and projected benefit obligation) and net pension liability (or asset)
- Describe the components of a company’s defined benefit pension costs
- Explain and calculate the effect of a defined benefit plan’s assumptions on the defined benefit obligation and periodic pension cost
- Explain and calculate how adjusting for items of pension and other post-employment benefits that are reported in the notes to the financial statements affects financial statements and ratios
- Interpret pension plan note disclosures including cash flow related information
- Explain issues associated with accounting for share-based compensation
- Explain how accounting for stock grants and stock options affects financial statements, and the importance of companies’ assumptions in valuing these grants and options

**Multinational Operations**

- Distinguish among presentation (reporting) currency, functional currency, and local currency
- Describe foreign currency transaction exposure, including accounting for and disclosures about foreign currency transaction gains and losses
- Analyze how changes in exchange rates affect the translated sales of the subsidiary and parent company
- Compare the current rate method and the temporal method, evaluate how each affects the parent company’s balance sheet and income statement, and determine which method is appropriate in various scenarios
- Calculate the translation effects and evaluate the translation of a subsidiary’s balance sheet and income statement into the parent company’s presentation currency
- Analyze how the current rate method and the temporal method affect financial statements and ratios
- Analyze how alternative translation methods for subsidiaries operating in hyperinflationary economies affect financial statements and ratios
- Describe how multinational operations affect a company’s effective tax rate
- Explain how changes in the components of sales affect the sustainability of sales growth
- Analyze how currency fluctuations potentially affect financial results, given a company’s countries of operation

**Part 2: Quality of Financial Reports and Financial Statement Analysis**

**Evaluating Quality of Financial Reports**

- Demonstrate the use of a conceptual framework for assessing the quality of a company’s financial reports
- Explain potential problems that affect the quality of financial reports
- Describe how to evaluate the quality of a company’s financial reports
- Evaluate the quality of a company’s financial reports
- Describe the concept of sustainable (persistent) earnings
- Describe indicators of earnings quality
- Explain mean reversion in earnings and how the accruals component of earnings affects the speed of mean reversion
- Evaluate the earnings quality of a company
- Describe indicators of cash flow quality
- Evaluate the cash flow quality of a company
- Describe indicators of balance sheet quality
- Evaluate the balance sheet quality of a company
- Describe sources of information about risk

**Integration of Financial Statement Analysis Techniques**

- Demonstrate the use of a framework for the analysis of financial statements, given a particular problem, question, or purpose (e.g., valuing equity based on comparables, critiquing a credit rating, obtaining a comprehensive picture of financial leverage, evaluating the perspectives given in management’s discussion of financial results)
- Identify financial reporting choices and biases that affect the quality and comparability of companies’ financial statements and explain how such biases may affect financial decisions
- Evaluate the quality of a company’s financial data and recommend appropriate adjustments to improve quality and comparability with similar companies, including adjustments for differences in accounting standards, methods, and assumptions
- Evaluate how a given change in accounting standards, methods, or assumptions affects financial statements and ratios
- Analyze and interpret how balance sheet modifications, earnings normalization, and cash flow statement related modifications affect a company’s financial statements, financial ratios, and overall financial condition

**Part 1: Valuation Concepts**

**The Term Structure and Interest Rate Dynamics**

- Describe relationships among spot rates, forward rates, yield to maturity, expected and realized returns on bonds, and the shape of the yield curve
- Describe the forward pricing and forward rate models and calculate forward and spot prices and rates using those models
- Describe how zero-coupon rates (spot rates) may be obtained from the par curve by bootstrapping
- Describe the assumptions concerning the evolution of spot rates in relation to forward rates implicit in active bond portfolio management
- Describe the strategy of riding the yield curve
- Explain the swap rate curve and why and how market participants use it in valuation
- Calculate and interpret the swap spread for a given maturity
- Describe the Z-spread
- Describe the TED and Libor–OIS spreads
- Explain traditional theories of the term structure of interest rates and describe the implications of each theory for forward rates and the shape of the yield curve
- Describe modern term structure models and how they are used
- Explain how a bond’s exposure to each of the factors driving the yield curve can be measured and how these exposures can be used to manage yield curve risks
- Explain the maturity structure of yield volatilities and their effect on price volatility

**The Arbitrage-Free Valuation Framework**

- Explain what is meant by arbitrage-free valuation of a fixed-income instrument
- Calculate the arbitrage-free value of an option-free, fixed-rate coupon bond
- Describe a binomial interest rate tree framework
- Describe the backward induction valuation methodology and calculate the value of a fixed-income instrument given its cash flow at each node
- Describe the process of calibrating a binomial interest rate tree to match a specific term structure
- Compare pricing using the zero-coupon yield curve with pricing using an arbitrage-free binomial lattice
- Describe pathwise valuation in a binomial interest rate framework and calculate the value of a fixed-income instrument given its cash flows along each path
- Describe a Monte Carlo forward-rate simulation and its application

**Part 2: Topics in Fixed Income Analysis**

**Valuation and Analysis: Bonds With Embedded Options**

- Describe fixed-income securities with embedded options
- Explain the relationships between the values of a callable or putable bond, the underlying option-free (straight) bond, and the embedded option
- Describe how the arbitrage-free framework can be used to value a bond with embedded options
- Explain how interest rate volatility affects the value of a callable or putable bond
- Explain how changes in the level and shape of the yield curve affect the value of a callable or putable bond
- Calculate the value of a callable or putable bond from an interest rate tree
- Explain the calculation and use of option-adjusted spreads
- Explain how interest rate volatility affects option-adjusted spreads
- Calculate and interpret effective duration of a callable or putable bond
- Compare effective durations of callable, putable, and straight bonds
- Describe the use of one-sided durations and key rate durations to evaluate the interest rate sensitivity of bonds with embedded options
- Compare effective convexities of callable, putable, and straight bonds
- Describe defining features of a convertible bond
- Calculate and interpret the components of a convertible bond’s value
- Describe how a convertible bond is valued in an arbitrage-free framework
- Compare the risk–return characteristics of a convertible bond with the risk–return characteristics of a straight bond and of the underlying common stock

**Credit Analysis Models**

- Explain probability of default, loss given default, expected loss, and present value of the expected loss and describe the relative importance of each across the credit spectrum
- Explain credit scoring and credit ratings, including why they are called ordinal rankings
- Explain strengths and weaknesses of credit ratings
- Explain structural models of corporate credit risk, including why equity can be viewed as a call option on the company’s assets
- Explain reduced form models of corporate credit risk, including why debt can be valued as the sum of expected discounted cash flows after adjusting for risk
- Explain assumptions, strengths, and weaknesses of both structural and reduced form models of corporate credit risk
- Explain the determinants of the term structure of credit spreads
- Calculate and interpret the present value of the expected loss on a bond over a given time horizon
- Compare the credit analysis required for asset-backed securities to analysis of corporate debt

**Credit Default Swaps**

- Describe credit default swaps (CDS), single-name and index CDS, and the parameters that define a given CDS product
- Describe credit events and settlement protocols with respect to CDS
- Explain the principles underlying, and factors that influence, the market’s pricing of CDS
- Describe the use of CDS to manage credit exposures and to express views regarding changes in shape and/or level of the credit curve
- Describe the use of CDS to take advantage of valuation disparities among separate markets, such as bonds, loans, equities, and equity-linked instruments

**Part 1: Ethical and Professional Standards**

**Code of Ethics and Standards of Professional Conduct**

- Describe the six components of the Code of Ethics and the seven Standards of Professional Conduct
- Explain the ethical responsibilities required of CFA Institute members and candidates in the CFA Program by the Code and Standards

**Guidance for Standards I - VII**

- Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to specific situations
- Recommend practices and procedures designed to prevent violations of the Code of Ethics and Standards of Professional Conduct

**CFA® Institute Research Objectivity Standards **

- Explain the objectives of the Research Objectivity Standards
- Evaluate company policies and practices related to research objectivity, and distinguish between changes required and changes recommended for compliance with the Research Objectivity Standards

**Part 2: Application of Ethical and Professional Standards**

**The Glenarm Company**

- Evaluate the practices and policies presented
- Explain the appropriate action to take in response to conduct that violates the CFA Institute Code of Ethics and Standards of Professional Conduct

**Preston Partners**

- Evaluate the practices and policies presented
- Explain the appropriate action to take in response to conduct that violates the CFA Institute Code of Ethics and Standards of Professional Conduct

**Super Selection**

- Evaluate the practices and policies presented
- Explain the appropriate action to take in response to conduct that violates the CFA Institute Code of Ethics and Standards of Professional Conduct

**Trade Allocation: Fair Dealing and Disclosure**

- Evaluate trade allocation practices and determine whether they comply with the CFA Institute Standards of Professional Conduct addressing fair dealing and client loyalty
- Describe appropriate actions to take in response to trade allocation practices that do not adequately respect client interests

**Changing Investment Objectives**

- Evaluate the disclosure of investment objectives and basic policies and determine whether they comply with the CFA Institute Standards of Professional Conduct
- Describe appropriate actions needed to ensure adequate disclosure of the investment process

**Part 1: Corporate Finance**

**Capital Budgeting**

- Calculate the yearly cash flows of expansion and replacement capital projects and evaluate how the choice of depreciation method affects those cash flows
- Explain how inflation affects capital budgeting analysis
- Evaluate capital projects and determine the optimal capital project in situations of 1) mutually exclusive projects with unequal lives, using either the least common multiple of lives approach or the equivalent annual annuity approach, and 2) capital rationing
- Explain how sensitivity analysis, scenario analysis, and Monte Carlo simulation can be used to assess the stand-alone risk of a capital project
- Explain and calculate the discount rate, based on market risk methods, to use in valuing a capital project
- Describe types of real options and evaluate a capital project using real options
- Describe common capital budgeting pitfalls
- Calculate and interpret accounting income and economic income in the context of capital budgeting
- Distinguish among the economic profit, residual income, and claims valuation models for capital budgeting and evaluate a capital project using each

**Capital Structure**

- Explain the Modigliani–Miller propositions regarding capital structure, including the effects of leverage, taxes, financial distress, agency costs, and asymmetric information on a company’s cost of equity, cost of capital, and optimal capital structure
- Describe target capital structure and explain why a company’s actual capital structure may fluctuate around its target
- Describe the role of debt ratings in capital structure policy
- Explain factors an analyst should consider in evaluating the effect of capital structure policy on valuation
- Describe international differences in the use of financial leverage, factors that explain these differences, and implications of these differences for investment analysis

**Dividends and Share Repurchases: Analysis**

- Compare theories of dividend policy and explain implications of each for share value given a description of a corporate dividend action
- Describe types of information (signals) that dividend initiations, increases, decreases, and omissions may convey
- Explain how clientele effects and agency issues may affect a company’s payout policy
- Explain factors that affect dividend policy
- Calculate and interpret the effective tax rate on a given currency unit of corporate earnings under double taxation, dividend imputation, and split-rate tax systems
- Compare stable dividend, constant dividend payout ratio, and residual dividend payout policies, and calculate the dividend under each policy
- Explain the choice between paying cash dividends and repurchasing shares
- Describe broad trends in corporate dividend policies
- Calculate and interpret dividend coverage ratios based on 1) net income and 2) free cash flow
- Identify characteristics of companies that may not be able to sustain their cash dividend

**Part 2: Financing and Control Issues**

**Corporate Performance, Governance, and Business Ethics**

- Compare interests of key stakeholder groups and explain the purpose of a stakeholder impact analysis
- Discuss problems that can arise in principal–agent relationships and mechanisms that may mitigate such problems
- Discuss roots of unethical behavior and how managers might ensure that ethical issues are considered in business decision making
- Compare the Friedman doctrine, Utilitarianism, Kantian Ethics, and Rights and Justice Theories as approaches to ethical decision making

**Corporate Governance**

- Describe objectives and core attributes of an effective corporate governance system and evaluate whether a company’s corporate governance has those attributes
- Compare major business forms and describe the conflicts of interest associated with each
- Explain conflicts that arise in agency relationships, including manager–shareholder conflicts and director–shareholder conflicts
- Describe responsibilities of the board of directors and explain qualifications and core competencies that an investment analyst should look for in the board of directors
- Explain effective corporate governance practice as it relates to the board of directors and evaluate strengths and weaknesses of a company’s corporate governance practice
- Describe elements of a company’s statement of corporate governance policies that investment analysts should assess
- Describe environmental, social, and governance risk exposures
- Explain the valuation implications of corporate governance

**Mergers and Acquisitions**

- Classify merger and acquisition (M&A) activities based on forms of integration and relatedness of business activities
- Explain common motivations behind M&A activity
- Explain bootstrapping of earnings per share (EPS) and calculate a company’s post-merger EPS
- Explain, based on industry life cycles, the relation between merger motivations and types of mergers
- Contrast merger transaction characteristics by form of acquisition, method of payment, and attitude of target management
- Distinguish among pre-offer and post-offer takeover defense mechanisms
- Calculate and interpret the Herfindahl–Hirschman Index and evaluate the likelihood of an antitrust challenge for a given business combination
- Compare the discounted cash flow, comparable company, and comparable transaction analyses for valuing a target company, including the advantages and disadvantages of each
- Calculate free cash flows for a target company and estimate the company’s intrinsic value based on discounted cash flow analysis
- Estimate the value of a target company using comparable company and comparable transaction analyses
- Evaluate a takeover bid and calculate the estimated post-acquisition value of an acquirer and the gains accrued to the target shareholders versus the acquirer shareholders
- Explain how price and payment method affect the distribution of risks and benefits in M&A transactions
- Describe characteristics of M&A transactions that create value
- Distinguish among equity carve-outs, spin-offs, split-offs, and liquidation
- Explain common reasons for restructuring

**Part 1: Valuation and Strategies**

**Pricing and Valuation of Forward Commitments**

- Describe and compare how equity, interest rate, fixed-income, and currency forward and futures contracts are priced and valued
- Calculate and interpret the no-arbitrage value of equity, interest rate, fixed-income, and currency forward and futures contracts
- Describe and compare how interest rate, currency, and equity swaps are priced and valued
- Calculate and interpret the no-arbitrage value of interest rate, currency, and equity swaps

**Valuation of Contingent Claims**

- Describe and interpret the binomial option valuation model and its component terms
- Calculate the no-arbitrage values of European and American options using a two-period binomial model
- Identify an arbitrage opportunity involving options and describe the related arbitrage
- Describe how interest rate options are valued using a two-period binomial model
- Calculate and interpret the value of an interest rate option using a two-period binomial model
- Describe how the value of a European option can be analyzed as the present value of the option’s expected payoff at expiration
- Identify assumptions of the Black–Scholes–Merton option valuation model
- Interpret the components of the Black–Scholes–Merton model as applied to call options in terms of a leveraged position in the underlying
- Describe how the Black–Scholes–Merton model is used to value European options on equities and currencies
- Describe how the Black model is used to value European options on futures
- Describe how the Black model is used to value European interest rate options and European swaptions
- Interpret each of the option Greeks
- Describe how a delta hedge is executed
- Describe the role of gamma risk in options trading
- Define implied volatility and explain how it is used in options trading

**Derivatives Strategies**

- Describe how interest rate, currency, and equity swaps, futures, and forwards can be used to modify risk and return
- Describe how to replicate an asset by using options and by using cash plus forwards or futures
- Describe the investment objectives, structure, payoff, and risk(s) of a covered call position
- Describe the investment objectives, structure, payoff, and risks(s) of a protective put position
- Calculate and interpret the value at expiration, profit, maximum profit, maximum loss, and breakeven underlying price at expiration for covered calls and protective puts
- Contrast protective put and covered call positions to being long an asset and short a forward on the asset
- Describe the investment objective(s), structure, payoffs, and risks of the following option strategies: bull spread, bear spread, collar, and straddle
- Calculate and interpret the value at expiration, profit, maximum profit, maximum loss, and breakeven underlying price at expiration of the following option strategies: bull spread, bear spread, collar, and straddle
- Describe uses of calendar spreads
- Identify and evaluate appropriate derivatives strategies consistent with given investment objectives

**Part 1: Quantitative Methods for Valuation**

**Correlation and Regression**

- Calculate and interpret a sample covariance and a sample correlation coefficient and interpret a scatter plot
- Describe limitations to correlation analysis
- Formulate a test of the hypothesis that the population correlation coefficient equals zero and determine whether the hypothesis is rejected at a given level of significance
- Distinguish between the dependent and independent variables in a linear regression
- Describe the assumptions underlying linear regression and interpret regression coefficients
- Calculate and interpret the standard error of estimate, the coefficient of determination, and a confidence interval for a regression coefficient
- Formulate a null and alternative hypothesis about a population value of a regression coefficient and determine the appropriate test statistic and whether the null hypothesis is rejected at a given level of significance
- Calculate the predicted value for the dependent variable, given an estimated regression model and a value for the independent variable
- Calculate and interpret a confidence interval for the predicted value of the dependent variable
- Describe the use of analysis of variance (ANOVA) in regression analysis, interpret ANOVA results, and calculate and interpret the F-statistic
- Describe limitations of regression analysis

**Multiple Regression and Issues in Regression Analysis**

- Formulate a multiple regression equation to describe the relation between a dependent variable and several independent variables and determine the statistical significance of each independent variable
- Interpret estimated regression coefficients and their p-values
- Formulate a null and an alternative hypothesis about the population value of a regression coefficient, calculate the value of the test statistic, and determine whether to reject the null hypothesis at a given level of significance
- Interpret the results of hypothesis tests of regression coefficients
- Calculate and interpret 1) a confidence interval for the population value of a regression coefficient and 2) a predicted value for the dependent variable, given an estimated regression model and assumed values for the independent variables
- Explain the assumptions of a multiple regression model
- Calculate and interpret the F-statistic, and describe how it is used in regression analysis
- Distinguish between and interpret the R² and adjusted R² in multiple regression
- Evaluate how well a regression model explains the dependent variable by analyzing the output of the regression equation and an ANOVA table
- Formulate a multiple regression equation by using dummy variables to represent qualitative factors and interpret the coefficients and regression results
- Explain the types of heteroskedasticity and how heteroskedasticity and serial correlation affect statistical inference
- Describe multicollinearity and explain its causes and effects in regression analysis
- Describe how model misspecification affects the results of a regression analysis and describe how to avoid common forms of misspecification
- Describe models with qualitative dependent variables
- Evaluate and interpret a multiple regression model and its results

**Time-Series Analysis**

- Calculate and evaluate the predicted trend value for a time series, modeled as either a linear trend or a log-linear trend, given the estimated trend coefficients
- Describe factors that determine whether a linear or a log-linear trend should be used with a particular time series and evaluate limitations of trend models
- Explain the requirement for a time series to be covariance stationary and describe the significance of a series that is not stationary
- Describe the structure of an autoregressive (AR) model of order p and calculate one- and two-period-ahead forecasts given the estimated coefficients
- Explain how autocorrelations of the residuals can be used to test whether the autoregressive model fits the time series
- Explain mean reversion and calculate a mean-reverting level
- Contrast in-sample and out-of-sample forecasts and compare the forecasting accuracy of different time-series models based on the root mean squared error criterion
- Explain the instability of coefficients of time-series models
- Describe characteristics of random walk processes and contrast them to covariance stationary processes
- Describe implications of unit roots for time-series analysis, explain when unit roots are likely to occur and how to test for them, and demonstrate how a time series with a unit root can be transformed so it can be analyzed with an AR model
- Describe the steps of the unit root test for nonstationarity and explain the relation of the test to autoregressive time-series models
- Explain how to test and correct for seasonality in a time-series model and calculate and interpret a forecasted value using an AR model with a seasonal lag
- Explain autoregressive conditional heteroskedasticity (ARCH) and describe how ARCH models can be applied to predict the variance of a time series
- Explain how time-series variables should be analyzed for nonstationarity and/or cointegration before use in a linear regression
- Determine an appropriate time-series model to analyze a given investment problem and justify that choice

**Excerpt from "Probabilistic Approaches: Scenario Analysis, Decision Trees, and Simulations"**

- Describe steps in running a simulation
- Explain three ways to define the probability distributions for a simulation’s variables
- Describe how to treat correlation across variables in a simulation
- Describe advantages of using simulations in decision making
- Describe some common constraints introduced into simulations
- Describe issues in using simulations in risk assessment
- Compare scenario analysis, decision trees, and simulations

**Part 1: Economics for Valuation**

**Currency Exchange Rates: Determination and Forecasting**

- Calculate and interpret the bid–ask spread on a spot or forward foreign currency quotation and describe the factors that affect the bid–offer spread
- Identify a triangular arbitrage opportunity and calculate its profit, given the bid–offer quotations for three currencies
- Distinguish between spot and forward rates and calculate the forward premium/discount for a given currency
- Calculate the mark-to-market value of a forward contract
- Explain international parity relations (covered and uncovered interest rate parity, purchasing power parity, and the international Fisher effect)
- Describe relations among the international parity conditions
- Evaluate the use of the current spot rate, the forward rate, purchasing power parity, and uncovered interest parity to forecast future spot exchange rates
- Explain approaches to assessing the long-run fair value of an exchange rate
- Describe the carry trade and its relation to uncovered interest rate parity and calculate the profit from a carry trade
- Explain how flows in the balance of payment accounts affect currency exchange rates
- Describe the Mundell–Fleming model, the monetary approach, and the asset market (portfolio balance) approach to exchange rate determination
- Forecast the direction of the expected change in an exchange rate based on balance of payment, Mundell–Fleming, monetary, and asset market approaches to exchange rate determination
- Explain the potential effects of monetary and fiscal policy on exchange rates
- Describe objectives of central bank intervention and capital controls and describe the effectiveness of intervention and capital controls
- Describe warning signs of a currency crisis
- Describe uses of technical analysis in forecasting exchange rates

**Economic Growth and the Investment Decision**

- Compare factors favoring and limiting economic growth in developed and developing economies
- Describe the relation between the long-run rate of stock market appreciation and the sustainable growth rate of the economy
- Explain why potential GDP and its growth rate matter for equity and fixed income investors
- Distinguish between capital deepening investment and technological progress and explain how each affects economic growth and labor productivity
- Forecast potential GDP based on growth accounting relations
- Explain how natural resources affect economic growth and evaluate the argument that limited availability of natural resources constrains economic growth
- Explain how demographics, immigration, and labor force participation affect the rate and sustainability of economic growth
- Explain how investment in physical capital, human capital, and technological development affects economic growth
- Compare classical growth theory, neoclassical growth theory, and endogenous growth theory
- Explain and evaluate convergence hypotheses
- Describe the economic rationale for governments to provide incentives to private investment in technology and knowledge
- Describe the expected impact of removing trade barriers on capital investment and profits, employment and wages, and growth in the economies involved

**Economics of Regulation**

- Describe classifications of regulations and regulators
- Describe uses of self-regulation in financial markets
- Describe the economic rationale for regulatory intervention
- Describe regulatory interdependencies and their effects
- Describe tools of regulatory intervention in markets
- Explain purposes in regulating commerce and financial markets
- Describe anticompetitive behaviors targeted by antitrust laws globally and evaluate the antitrust risk associated with a given business strategy
- Describe benefits and costs of regulation
- Evaluate how a specific regulation affects an industry, company, or security

**Part 1: Process, Asset Allocation, and Risk Management**

**The Portfolio Management Process and The Investment Policy Statement**

- Explain the importance of the portfolio perspective
- Describe the steps of the portfolio management process and the components of those steps
- Explain the role of the investment policy statement in the portfolio management process and describe the elements of an investment policy statement
- Explain how capital market expectations and the investment policy statement help influence the strategic asset allocation decision and how an investor’s investment time horizon may influence the investor’s strategic asset allocation
- Define investment objectives and constraints and explain and distinguish among the types of investment objectives and constraints
- Contrast the types of investment time horizons, determine the time horizon for a particular investor, and evaluate the effects of this time horizon on portfolio choice
- Justify ethical conduct as a requirement for managing investment portfolios

**An Introduction to Multifactor Models**

- Describe arbitrage pricing theory (APT), including its underlying assumptions and its relation to multifactor models
- Define arbitrage opportunity and determine whether an arbitrage opportunity exists
- Calculate the expected return on an asset given an asset’s factor sensitivities and the factor risk premiums
- Describe and compare macroeconomic factor models, fundamental factor models, and statistical factor models
- Explain sources of active risk and interpret tracking risk and the information ratio
- Describe uses of multifactor models and interpret the output of analyses based on multifactor models
- Describe the potential benefits for investors in considering multiple risk dimensions when modeling asset returns

**Measuring and Managing Market Risk**

- Explain the use of value at risk (VaR) in measuring portfolio risk
- Compare the parametric (variance–covariance), historical simulation, and Monte Carlo simulation methods for estimating VaR
- Estimate and interpret VaR under the parametric, historical simulation, and Monte Carlo simulation methods
- Describe advantages and limitations of VaR
- Describe extensions of VaR
- Describe sensitivity risk measures and scenario risk measures and compare these measures to VaR
- Demonstrate how equity, fixed-income, and options exposure measures may be used in measuring and managing market risk and volatility risk
- Describe the use of sensitivity risk measures and scenario risk measures
- Describe advantages and limitations of sensitivity risk measures and scenario risk measures
- Describe risk measures used by banks, asset managers, pension funds, and insurers
- Explain constraints used in managing market risks, including risk budgeting, position limits, scenario limits, and stop-loss limits
- Explain how risk measures may be used in capital allocation decisions

**Part 2: Economic Analysis, Active Management, and Trading**

**Economics and Investment Markets**

- Explain the notion that to affect market values, economic factors must affect one or more of the following: (1) default-free interest rates across maturities, (2) the timing and/or magnitude of expected cash flows, and (3) risk premiums
- Explain the role of expectations and changes in expectations in market valuation
- Explain the relationship between the long-term growth rate of the economy, the volatility of the growth rate, and the average level of real short-term interest rates
- Explain how the phase of the business cycle affects policy and short-term interest rates, the slope of the term structure of interest rates, and the relative performance of bonds of differing maturities
- Describe the factors that affect yield spreads between non-inflation-adjusted and inflation-indexed bonds
- Explain how the phase of the business cycle affects credit spreads and the performance of credit-sensitive fixed-income instruments
- Explain how the characteristics of the markets for a company’s products affect the company’s credit quality
- Explain how the phase of the business cycle affects short-term and long-term earnings growth expectations
- Explain the relationship between the consumption-hedging properties of equity and the equity risk premium
- Describe cyclical effects on valuation multiples
- Describe the implications of the business cycle for a given style strategy (value, growth, small capitalization, large capitalization)
- Describe how economic analysis is used in sector rotation strategies
- Describe the economic factors affecting investment in commercial real estate

**Analysis of Active Portfolio Management**

- Describe how value added by active management is measured
- Calculate and interpret the information ratio (ex post and ex ante) and contrast it to the Sharpe ratio
- State and interpret the fundamental law of active portfolio management including its component terms—transfer coefficient, information coefficient, breadth, and active risk (aggressiveness)
- Explain how the information ratio may be useful in investment manager selection and choosing the level of active portfolio risk
- Compare active management strategies (including market timing and security selection) and evaluate strategy changes in terms of the fundamental law of active management
- Describe the practical strengths and limitations of the fundamental law of active management

**Algorithmic and High-Frequency Trading**

- Define algorithmic trading
- Distinguish between execution algorithms and high-frequency trading algorithms
- Describe types of execution algorithms and high-frequency trading algorithms
- Describe market fragmentation and its effects on how trades are placed
- Describe the use of technology in risk management and regulatory oversight
- Describe issues and concerns related to the impact of algorithmic and high-frequency trading on securities markets

**Part 1: Alternative Investments**

**Private Real Estate Investments**

- Classify and describe basic forms of real estate investments
- Describe the characteristics, the classification, and basic segments of real estate
- Explain the role in a portfolio, economic value determinants, investment characteristics, and principal risks of private real estate
- Describe commercial property types, including their distinctive investment characteristics
- Compare the income, cost, and sales comparison approaches to valuing real estate properties
- Estimate and interpret the inputs (for example, net operating income, capitalization rate, and discount rate) to the direct capitalization and discounted cash flow valuation methods
- Calculate the value of a property using the direct capitalization and discounted cash flow valuation methods
- Compare the direct capitalization and discounted cash flow valuation methods
- Calculate the value of a property using the cost and sales comparison approaches
- Describe due diligence in private equity real estate investment
- Discuss private equity real estate investment indices, including their construction and potential biases
- Explain the role in a portfolio, the major economic value determinants, investment characteristics, principal risks, and due diligence of private real estate debt investment
- Calculate and interpret financial ratios used to analyze and evaluate private real estate investments

**Publicly Traded Real Estate Securities**

- Describe types of publicly traded real estate securities
- Explain advantages and disadvantages of investing in real estate through publicly traded securities
- Explain economic value determinants, investment characteristics, principal risks, and due diligence considerations for real estate investment trust (REIT) shares
- Describe types of REITs
- Justify the use of net asset value per share (NAVPS) in REIT valuation and estimate NAVPS based on forecasted cash net operating income
- Describe the use of funds from operations (FFO) and adjusted funds from operations (AFFO) in REIT valuation
- Compare the net asset value, relative value (price-to-FFO and price-to-AFFO), and discounted cash flow approaches to REIT valuation
- Calculate the value of a REIT share using net asset value, price-to-FFO and price-to-AFFO, and discounted cash flow approaches

**Private Equity Valuation & Venture Capital**

- Explain sources of value creation in private equity
- Explain how private equity firms align their interests with those of the managers of portfolio companies
- Distinguish between the characteristics of buyout and venture capital investments
- Describe valuation issues in buyout and venture capital transactions
- Explain alternative exit routes in private equity and their impact on value
- Explain private equity fund structures, terms, valuation, and due diligence in the context of an analysis of private equity fund returns
- Explain risks and costs of investing in private equity
- Interpret and compare financial performance of private equity funds from the perspective of an investor
- Calculate management fees, carried interest, net asset value, distributed to paid in (DPI), residual value to paid in (RVPI), and total value to paid in (TVPI) of a private equity fund
- Calculate pre-money valuation, post-money valuation, ownership fraction, and price per share applying the venture capital method 1) with single and multiple financing rounds and 2) in terms of IRR
- Demonstrate alternative methods to account for risk in venture capital

**Commodities and Commodity Derivatives: An Introduction**

- Compare characteristics of commodity sectors
- Compare the life cycle of commodity sectors from production through trading or consumption
- Contrast the valuation of commodities with the valuation of equities and bonds
- Describe types of participants in commodity futures markets
- Analyze the relationship between spot prices and expected future prices in markets in contango and markets in backwardation
- Compare theories of commodity futures returns
- Describe, calculate, and interpret the components of total return for a fully collateralized commodity futures contract
- Contrast roll return in markets in contango and markets in backwardation
- Describe how commodity swaps are used to obtain or modify exposure to commodities
- Describe how the construction of commodity indexes affects index returns

**The Holistic Approach** | How **THR** Helps You Pass Level II