CFA Level 1 - Equity & Fixed Income Investments Flashcards

Question 1

Differentiate between primary and secondary equity markets.

Accepted Answer

**Primary Market:** Where new securities are issued for the first time (e.g., IPOs, SEOs). Funds go directly to the issuer. **Secondary Market:** Where previously issued securities are traded among investors. Funds go to the selling investor, not the issuer.

Question 2

Explain Market, Limit, and Stop orders in equity trading.

Accepted Answer

**Market Order:** Executes immediately at the best available price. **Limit Order:** Specifies a maximum purchase price or minimum selling price; only executes if that price or better is met. **Stop Order:** Becomes a market order once a specified 'stop price' is reached, used to limit losses or protect gains.

Question 3

List and briefly describe Porter's Five Forces of Industry Analysis.

Accepted Answer

1. **Threat of New Entrants:** How easily new competitors can enter. 2. **Bargaining Power of Buyers:** Influence buyers have on prices. 3. **Bargaining Power of Suppliers:** Influence suppliers have on input costs. 4. **Threat of Substitute Products/Services:** Availability of alternative solutions. 5. **Intensity of Rivalry:** Competition among existing firms.

Question 4

How do different stages of the business cycle generally impact equity performance?

Accepted Answer

**Expansion:** Strong earnings growth, rising stock prices. **Peak:** Growth slows, inflation concerns, market volatility. **Contraction/Recession:** Declining earnings, falling stock prices. **Trough:** Economic activity bottoms out, potential for recovery, often a good entry point for investors.

Question 5

State the Gordon Growth Model (GGM) formula and its key assumptions.

Accepted Answer

The GGM values a stock based on a constant growth rate of dividends.
Formula: $V_0 = \frac{D_1}{r - g}$
Where: $V_0$ = current intrinsic value, $D_1$ = next year's expected dividend, $r$ = required rate of return, $g$ = constant dividend growth rate.
Assumptions: Dividends grow at a constant rate ($g$) indefinitely, and $r > g$.

Question 6

When is a Two-Stage Dividend Discount Model (DDM) appropriate, and what are its components?

Accepted Answer

Appropriate when a company is expected to experience a period of high growth, followed by a period of stable, lower growth.
Components:
1.  **High-Growth Stage:** Dividends are projected individually for a finite period.
2.  **Constant-Growth Stage:** A terminal value is calculated at the end of the high-growth period using the Gordon Growth Model, representing the present value of all future dividends in the stable growth phase.

Question 7

Define Free Cash Flow to Equity (FCFE) and provide its calculation from Net Income.

Accepted Answer

FCFE is the cash flow available to common equity holders after all operating expenses and debt obligations are paid, and necessary investments in working capital and fixed capital have been made.
Calculation: $FCFE = Net \ Income + Depreciation \ \& \ Amortization - Capital \ Expenditures - \Delta Working \ Capital + Net \ Borrowing$

Question 8

Define Free Cash Flow to Firm (FCFF) and provide its calculation from EBIT.

Accepted Answer

FCFF is the total pretax cash flow generated by the company's operations that is available to all providers of capital (both debt and equity holders) after all operating expenses and necessary investments in working capital and fixed capital.
Calculation: $FCFF = EBIT(1 - Tax \ Rate) + Depreciation \ \& \ Amortization - Capital \ Expenditures - \Delta Working \ Capital$

Question 9

Explain the Price-to-Earnings (P/E) ratio and differentiate between trailing and forward P/E.

Accepted Answer

The P/E ratio measures how much investors are willing to pay per dollar of earnings.
Formula: $P/E = \frac{Market \ Price \ per \ Share}{Earnings \ per \ Share}$
**Trailing P/E:** Uses past 12 months' earnings.
**Forward P/E:** Uses expected future 12 months' earnings, often preferred as it's forward-looking.

Question 10

Explain the Price-to-Book (P/B) ratio and its common use.

Accepted Answer

The P/B ratio compares a company's market value to its book value of equity.
Formula: $P/B = \frac{Market \ Price \ per \ Share}{Book \ Value \ per \ Share}$
It's often used for valuing financial institutions or companies with significant tangible assets, and as an indicator of potential undervaluation or overvaluation relative to accounting value.

Question 11

Explain the Enterprise Value to EBITDA (EV/EBITDA) ratio and its advantages.

Accepted Answer

EV/EBITDA compares the total value of a company (Enterprise Value) to its operating profitability before non-cash expenses.
Formula: $EV/EBITDA = \frac{Market \ Value \ of \ Equity + Market \ Value \ of \ Debt - Cash \ \& \ Equivalents}{EBITDA}$
Advantages: Useful for comparing companies with different capital structures, tax rates, or depreciation policies, as it's pre-interest, pre-tax, and pre-depreciation/amortization.

Question 12

How is the "justified" P/E ratio derived from the Gordon Growth Model?

Accepted Answer

The justified P/E ratio is the P/E ratio that is consistent with a company's fundamentals.
Derived from GGM: $P_0 = \frac{D_1}{r - g}$. Since $D_1 = E_1 	imes (1 - b)$ (where $b$ is retention rate and $1-b$ is payout ratio), and $g = b 	imes ROE$, we can substitute:
$\frac{P_0}{E_1} = \frac{1 - b}{r - g}$ or $\frac{P_0}{E_1} = \frac{Payout \ Ratio}{r - g}$.
This shows that justified P/E is positively related to payout ratio and growth rate, and negatively related to the required rate of return.

Question 13

Differentiate between callable and putable bonds from the investor's perspective.

Accepted Answer

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

Question 14

What is a convertible bond, and what are its key features?

Accepted Answer

A convertible bond is a hybrid security that gives the bondholder the right to convert the bond into a specified number of common shares of the issuing company.
Key Features:
*   **Equity Upside:** Allows participation in stock price appreciation.
*   **Downside Protection:** Provides fixed income payments and principal repayment if the stock doesn't perform well.
*   **Lower Yield:** Typically offers a lower coupon rate than non-convertible bonds due to the conversion option.

Question 15

Explain the purpose of bond covenants and distinguish between affirmative and negative covenants.

Accepted Answer

Bond covenants are legally binding clauses in a bond indenture designed to protect bondholders by restricting the issuer's actions.
**Affirmative Covenants:** Require the issuer to perform certain actions (e.g., maintain insurance, pay taxes, provide financial reports).
**Negative Covenants:** Restrict the issuer from certain actions (e.g., limit additional debt, restrict dividend payments, prohibit asset sales).

Question 16

Define Current Yield for a bond and provide its formula.

Accepted Answer

Current Yield measures the annual income an investor receives from a bond relative to its current market price. It does not consider capital gains/losses or the time value of money.
Formula: $Current \ Yield = \frac{Annual \ Coupon \ Payment}{Current \ Market \ Price}$

Question 17

What is Yield to Maturity (YTM) and what does it assume?

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. It is the discount rate that equates the present value of a bond's future cash flows (coupon payments and principal) to its current market price.
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 18

When is Yield to Call (YTC) relevant, and how does it differ from YTM?

Accepted Answer

YTC is relevant for callable bonds. It calculates the yield assuming the bond is called on its first call date, rather than held to maturity. It's the discount rate that equates the present value of the bond's cash flows (coupon payments up to the call date and the call price) to its current market price.
Difference from YTM: YTC uses the call price and call date instead of the par value and maturity date. Investors typically consider the lower of YTM or YTC as the most likely return.

Question 19

Define Macaulay Duration and explain its significance.

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 relative to the bond's full price.
Significance: It's a measure of a bond's interest rate sensitivity. A higher Macaulay duration indicates greater price sensitivity to changes in interest rates. It's expressed in years.

Question 20

State the formula for Modified Duration and explain its interpretation.

Accepted Answer

Modified Duration is a more practical measure of interest rate sensitivity than Macaulay Duration, as it directly estimates the percentage change in a bond's price for a 1% change in yield.
Formula: $Modified \ Duration = \frac{Macaulay \ Duration}{(1 + YTM/k)}$ (where k is number of compounding periods per year) or more simply, $Modified \ Duration \approx \frac{Macaulay \ Duration}{(1 + YTM)}$ for annual compounding.
Interpretation: If a bond has a modified duration of 5, its price is expected to change by approximately 5% for every 1% change in its yield.

Question 21

When is Effective Duration used, and why is it preferred over Modified Duration for certain bonds?

Accepted Answer

Effective Duration is used for bonds with embedded options (e.g., callable, putable bonds) where the cash flows are not fixed but depend on interest rate changes. It measures the approximate percentage change in a bond's price for a 1% change in interest rates, considering how the embedded option's value changes.
Formula (approximate): $Effective \ Duration = \frac{P_- - P_+}{2 	imes P_0 	imes \Delta y}$
Where $P_-$ and $P_+$ are bond prices if yield decreases/increases by $\Delta y$, and $P_0$ is original price.
Preference: Modified Duration assumes fixed cash flows, which is not true for bonds with embedded options. Effective Duration accounts for the option's impact on cash flows, providing a more accurate measure of interest rate risk.

Question 22

Explain bond convexity and differentiate between positive and negative convexity.

Accepted Answer

Convexity measures the curvature of a bond's price-yield relationship. Duration is a linear approximation, but convexity accounts for the non-linear relationship, improving the accuracy of price change estimates for larger yield changes.
**Positive Convexity:** Most option-free bonds exhibit positive convexity. Their price increases at an increasing rate when yields fall and decreases at a decreasing rate when yields rise. This is favorable for bondholders.
**Negative Convexity:** Bonds with embedded call options (callable bonds) can exhibit negative convexity at certain yield levels. Their price appreciation is capped when yields fall (due to call risk), and their price decline accelerates when yields rise. This is unfavorable for bondholders.

Question 23

Define credit risk in fixed income and identify its two main components.

Accepted Answer

Credit risk is the risk that a bond issuer will fail to make timely principal and/or interest payments as promised.
Two main components:
1.  **Default Risk (or Default Probability):** The likelihood that the issuer will fail to meet its obligations.
2.  **Loss Severity (or Loss Given Default):** The portion of a bond's value (principal and interest) that an investor will lose if a default occurs. It is often expressed as a percentage of the bond's value.

Question 24

What is the role of credit rating agencies in assessing credit risk?

Accepted Answer

Credit rating agencies (e.g., S&P, Moody's, Fitch) assess the creditworthiness of bond issuers and their specific debt issues. They assign ratings (e.g., AAA, AA, BBB, BB) that reflect their opinion on the issuer's ability and willingness to meet its financial obligations.
Role:
*   Provide independent assessments of credit risk to investors.
*   Influence bond yields (lower-rated bonds typically require higher yields).
*   Serve as benchmarks for investment-grade vs. speculative-grade debt.

CFA Level 1 - Equity & Fixed Income Investments

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