CFA Level 1 - Equity Investments & Fixed Income Flashcards

Question 1

Explain the Gordon Growth Model (GGM) for equity valuation, including its formula and key assumptions.

Accepted Answer

The GGM values a stock based on the present value of an infinite series of dividends growing at a constant rate.
*   Formula: $P_0 = \frac{D_1}{r - g}$
*   Where: $P_0$ = current stock price, $D_1$ = expected dividend next period, $r$ = required rate of return, $g$ = constant dividend growth rate.
*   Assumptions: Dividends grow at a constant rate ($g$) indefinitely, $r > g$, and $r$ and $g$ are constant.

Question 2

When is a two-stage Dividend Discount Model (DDM) appropriate, and what is its basic approach?

Accepted Answer

A two-stage DDM is used when a company is expected to experience a period of high growth followed by a period of stable, lower growth. It calculates the present value of dividends during the high-growth phase and then the present value of the terminal value (using GGM) at the end of the high-growth phase.

Question 3

Differentiate between Free Cash Flow to Equity (FCFE) and Free Cash Flow to Firm (FCFF).

Accepted Answer

*   **FCFE**: Cash flow available to equity holders after all operating expenses and debt obligations are paid and necessary capital expenditures are made. Used to value equity directly.
*   **FCFF**: Total cash flow generated by the company's operations that is available to all providers of capital (both debt and equity holders) after operating expenses and capital expenditures. Used to value the entire firm.

Question 4

Outline the basic steps for valuing a company using the Free Cash Flow to Firm (FCFF) model.

Accepted Answer

1.  Forecast FCFF for a specific projection period (e.g., 5-10 years).
2.  Estimate a terminal value at the end of the projection period, often using a constant growth FCFF model.
3.  Discount all projected FCFFs and the terminal value back to the present using the Weighted Average Cost of Capital (WACC).
4.  The sum of these present values represents the total firm value. To get equity value, subtract the market value of debt.

Question 5

Define the Price-to-Earnings (P/E) ratio, its calculation, and common uses/limitations.

Accepted Answer

The P/E ratio is a valuation multiple that compares a company's current share price to its earnings per share (EPS).
*   Calculation: $P/E = \frac{	ext{Market Price per Share}}{	ext{Earnings per Share}}$
*   Uses: Widely used for comparing valuations of similar companies, indicating market sentiment.
*   Limitations: Can be distorted by non-recurring items, negative earnings, and differences in accounting policies.

Question 6

Briefly define and state the primary use of Price-to-Book (P/B), Price-to-Sales (P/S), and Enterprise Value to EBITDA (EV/EBITDA) ratios.

Accepted Answer

*   **P/B**: $\frac{	ext{Market Price per Share}}{	ext{Book Value per Share}}$. Useful for valuing financial institutions or companies with significant tangible assets.
*   **P/S**: $\frac{	ext{Market Price per Share}}{	ext{Sales per Share}}$. Useful for valuing growth companies or companies with negative earnings.
*   **EV/EBITDA**: $\frac{	ext{Enterprise Value}}{	ext{EBITDA}}$. A comprehensive measure that includes debt, useful for comparing companies with different capital structures.

Question 7

Distinguish between primary and secondary markets in the context of securities trading.

Accepted Answer

*   **Primary Market**: Where new securities are issued for the first time (e.g., IPOs, seasoned equity offerings). Funds go directly to the issuing company.
*   **Secondary Market**: Where previously issued securities are traded among investors (e.g., stock exchanges like NYSE, NASDAQ). Funds exchange hands between investors, not the issuing company.

Question 8

Describe the characteristics and execution of market, limit, and stop orders.

Accepted Answer

*   **Market Order**: An order to buy or sell immediately at the best available current price. Guarantees execution but not price.
*   **Limit Order**: An order to buy or sell at a specified price or better. Guarantees price but not execution.
*   **Stop Order (Stop-Loss)**: An order that becomes a market order once a specified "stop price" is reached. Used to limit losses or protect profits.

Question 9

Explain the three forms of the Efficient Market Hypothesis (EMH): weak-form, semi-strong form, and strong-form efficiency.

Accepted Answer

*   **Weak-form EMH**: Current prices reflect all past market data (prices, volume). Technical analysis cannot generate abnormal returns.
*   **Semi-strong form EMH**: Current prices reflect all public information (past market data + financial statements, news). Fundamental analysis cannot generate abnormal returns.
*   **Strong-form EMH**: Current prices reflect all public and private (insider) information. No one can consistently achieve abnormal returns.

Question 10

Compare and contrast price-weighted and value-weighted equity indices, providing an example of each.

Accepted Answer

*   **Price-weighted index**: Each stock's influence on the index is proportional to its price. Higher-priced stocks have a greater impact. Example: Dow Jones Industrial Average (DJIA).
*   **Value-weighted (or market-cap weighted) index**: Each stock's influence is proportional to its market capitalization (price x shares outstanding). Larger companies have a greater impact. Example: S&P 500, FTSE 100.

Question 11

Explain how diversification benefits a portfolio and what type of risk it primarily addresses.

Accepted Answer

Diversification reduces portfolio risk by combining assets that are not perfectly positively correlated. When one asset performs poorly, another might perform well, smoothing out overall portfolio returns. It primarily addresses **unsystematic (or specific) risk**, which is unique to individual assets.

Question 12

Differentiate between systematic and unsystematic risk in portfolio management.

Accepted Answer

*   **Systematic Risk (Market Risk)**: Risk inherent to the entire market or market segment. It cannot be diversified away (e.g., interest rate changes, recessions). Measured by Beta.
*   **Unsystematic Risk (Specific/Idiosyncratic Risk)**: Risk unique to a specific company or industry. It can be reduced or eliminated through diversification.

Question 13

Describe the relationship between a bond's price, its coupon rate, and its yield to maturity (YTM).

Accepted Answer

*   **Inverse Relationship**: Bond prices and YTM move in opposite directions. When YTM rises, bond prices fall, and vice versa.
*   **Coupon Rate vs. YTM**:
    *   If Coupon Rate > YTM, the bond trades at a **premium**.
    *   If Coupon Rate < YTM, the bond trades at a **discount**.
    *   If Coupon Rate = YTM, the bond trades at **par**.

Question 14

Define what constitutes a discount bond, a premium bond, and a par bond.

Accepted Answer

*   **Discount Bond**: A bond trading below its face (par) value. Occurs when its coupon rate is less than the prevailing market yield (YTM).
*   **Premium Bond**: A bond trading above its face (par) value. Occurs when its coupon rate is greater than the prevailing market yield (YTM).
*   **Par Bond**: A bond trading at its face (par) value. Occurs when its coupon rate equals the prevailing market yield (YTM).

Question 15

Define Yield to Maturity (YTM) and state its key assumptions.

Accepted Answer

YTM is the total return an investor can expect to receive if they hold a bond until maturity, assuming all coupon payments are reinvested at the YTM rate.
*   Assumptions:
    1.  The bond is held until maturity.
    2.  All coupon payments are reinvested at the YTM rate.
    3.  The issuer does not default.

Question 16

Explain the difference between current yield and yield to maturity (YTM) for a bond.

Accepted Answer

*   **Current Yield**: Measures the annual income an investor receives from a bond relative to its current market price. Calculation: $\frac{	ext{Annual Coupon Payment}}{	ext{Current Market Price}}$. It ignores capital gains/losses and reinvestment income.
*   **YTM**: The total return, including capital gains/losses and reinvestment income, if held to maturity. It is a more comprehensive measure of return.

Question 17

Differentiate between spot rates and forward rates in fixed income.

Accepted Answer

*   **Spot Rate**: The yield on a zero-coupon bond that matures at a specific future date. It's the current market interest rate for a single payment at a future time.
*   **Forward Rate**: An interest rate for a loan or investment that begins at some future date. It's an implied future spot rate derived from the current yield curve.

Question 18

Define Macaulay Duration and explain its interpretation.

Accepted Answer

Macaulay Duration is the weighted average time until a bond's cash flows are received. The weights are the present values of each cash flow as a percentage of the bond's full price. It represents the effective maturity of a bond. For a zero-coupon bond, Macaulay Duration equals its time to maturity.

Question 19

Define Modified Duration, provide its formula, and explain its use.

Accepted Answer

Modified Duration measures the percentage change in a bond's price for a 1% change in yield. It is a key measure of a bond's interest rate sensitivity.
*   Formula: $	ext{Modified Duration} = \frac{	ext{Macaulay Duration}}{(1 + 	ext{YTM}/	ext{Number of Compounding Periods})}$
*   Use: To estimate the percentage price change of a bond for a given change in interest rates: $\%\Delta P \approx -	ext{Modified Duration} 	imes \Delta YTM$.

Question 20

How does duration relate to a bond's interest rate risk?

Accepted Answer

Duration is a direct measure of a bond's interest rate risk. Bonds with higher durations are more sensitive to changes in interest rates, meaning their prices will fluctuate more significantly for a given change in yield compared to bonds with lower durations.

Question 21

Define bond convexity and explain why it is important in bond analysis.

Accepted Answer

Convexity measures the curvature of a bond's price-yield relationship. It accounts for the fact that duration is a linear approximation and that bond prices do not change linearly with yield changes.
*   Importance: Convexity improves the accuracy of bond price change estimates, especially for large yield changes. Bonds with positive convexity are more desirable as their price increases more when yields fall and decreases less when yields rise, compared to what duration alone would predict.

Question 22

What are the two main components of credit risk for a bond?

Accepted Answer

1.  **Default Risk (or Default Probability)**: The likelihood that a bond issuer will fail to make timely principal and/or interest payments.
2.  **Loss Severity (or Loss Given Default)**: The percentage of a bond's value (principal and interest) that an investor will lose if the issuer defaults. It's 1 minus the recovery rate.

Question 23

Explain the role of credit ratings in fixed income analysis and their limitations.

Accepted Answer

*   **Role**: Credit ratings (e.g., from S&P, Moody's, Fitch) assess the creditworthiness of bond issuers and their ability to meet debt obligations. They provide investors with an independent opinion on default risk, influencing bond yields and marketability.
*   **Limitations**: Ratings are opinions, not guarantees. They can be slow to react to changing financial conditions, may have conflicts of interest, and often lag market pricing.

Question 24

Differentiate between callable and putable bonds from the perspective of the issuer and the investor.

Accepted Answer

*   **Callable Bond**: Gives the issuer the right to repurchase the bond from the bondholder at a specified call price before maturity. This benefits the issuer (e.g., if interest rates fall) but creates reinvestment risk for the investor.
*   **Putable Bond**: Gives the bondholder the right to sell the bond back to the issuer at a specified put price before maturity. This benefits the investor (e.g., if interest rates rise or credit quality deteriorates) but is a disadvantage for the issuer.

Question 25

Identify two CFA Standards of Professional Conduct particularly relevant to investment analysis and portfolio management.

Accepted Answer

1.  **Standard III(A) - Loyalty, Prudence, and Care**: Members must act for the benefit of their clients and place client interests before their own.
2.  **Standard II(A) - Material Nonpublic Information**: Members who possess material nonpublic information that could affect the value of an investment must not act or cause others to act on the information.
3.  **Standard III(B) - Fair Dealing**: Members must deal fairly and objectively with all clients when providing investment analysis, making investment recommendations, or taking investment action.

CFA Level 1 - Equity Investments & Fixed Income

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