CFA

Level
®

II
Study Guide

CFA 2003
C H A R T E R E D F I N A N C I A L A N A LY S T P R O G R A M
™

Receipt of this Study Guide is not con-

firmation of your enrollment in the
CFA Program. If you do not receive an ®

enrollment acceptance letter or letter of

incomplete application within two
A SSOCIATION FOR
months from the date you mailed your I NVESTMENT M ANAGEM ENT
application, please contact AIMR. AND R ESEARCH ®
AIMR Board of Governors, 2002–2003

The AIMR Governors are elected representatives of the membership. The Governors are responsible for
overseeing all aspects of AIMR activities, including education of CFA candidates and members, member and
society services, advocacy, and professional conduct.

Dwight D. Churchill, CFA, Chair Emilio Gonzalez, CFA

Fidelity Management & Research Co. Perpetual Investments
Merrimack, New Hampshire Sydney, Australia

Theodore R. Aronson, CFA, Vice Chair Monique E.M. Gravel, CFA

Aronson + Partners CIBC World Markets Inc.
Philadelphia, Pennsylvania Montreal, Canada

Philippe A. Sarasin, CFA, Immediate Past Chair Amaury Jordan, CFA

Lombard, Odier & Cie Infidar Investment Advisory Ltd.
Geneva, Switzerland Zurich, Switzerland

Thomas A. Bowman, CFA, President and CEO Cheryl-Ann E. Lister, CFA

AIMR Bermuda Monetary Authority
Charlottesville, Virginia Hamilton, Bermuda

Robert E. Angelica, CFA Janet T. Miller, CFA

AT&T Investment Management Corp. Rowland & Company
Basking Ridge, New Jersey Atlanta, Georgia

Jeffrey J. Diermeier, CFA George W. Noyes, CFA

UBS Global Asset Management (Americas) Inc. Standish Mellon Asset Management
Chicago, Illinois Boston, Massachusetts

Frank C. Dohn, CFA Yoshiharu Okazaki, CFA

Bankers Trust Company Pictet Asset Management (Japan) Ltd.
Los Angeles, California Tokyo, Japan

Vincent Duhamel, CFA John C. Stannard, CFA

State Street Global Advisors Frank Russell Company
Hong Kong London, United Kingdom

Denise M. Farkas, CFA Malcolm M. Trevillian, CFA

Spero-Smith Investment Advisers, Inc. Franklin Street Partners
Beachwood, Ohio Chapel Hill, North Carolina

Khalid Ghayur, CFA Donald W. Trotter, CFA

MSCI Atlantic Asset Management
Princeton, New Jersey Overland Park, Kansas

Association for Investment Management and Research

Setting a Higher Standard for Investment Professionals Worldwide™
2003 CFA® Level II Study Guide

©2002 Association for Investment Management and Research

All rights reserved. No part of this publication may be reproduced, stored in a retrieval
system, or transmitted, in any form or by any means, electronic, mechanical, photocopying,
recording, or otherwise, without the prior written permission of the copyright holder.
Chartered Financial Analyst®, CFA®, and AIMR® are marks of the
Association for Investment Management and Research.

IBSN 0-935015-82-5

Printed in the United States of America

ASSOCIATION FOR
INVESTMENT MANAGEMENT
AND RESEARCH®

P.O. Box 3668

Charlottesville, Virginia 22903 U.S.A.
Telephone: 434-951-5499 or 800-247-8132
Fax: 434-951-5262
Email: [email protected]
www.aimr.org
Acknowledgments
AIMR wishes to thank the volunteers and consultants who are members of the Candidate Curriculum Committee
(CCC) and the Council of Examiners (COE). These volunteers and consultants have earned their CFA charters;
they represent AIMR’s global and professional diversity and bring a wide variety of experience to the curriculum
and examination process. Without their hard work and dedication, the CFA Study and Examination Program
could not maintain its rigorous standards or continue its educational services to the investment community.

2001-2002 Candidate Curriculum Committee

The CCC is responsible for editorial review of the CFA curriculum and general oversight of the CFA curriculum
process

Peter B. Mackey, CFA, Chair Jean-Francois Delisle, CFA Alan M. Meder, CFA
Washington, DC Levis Quebec, Canada Chicago, Illinois
James W. Bronson, CFA Bradley J. Herndon, CFA Matthew H. Scanlan, CFA
Newport Beach, California Indianapolis, Indiana San Francisco, California
Barbara G. Cornyn, CFA Barbara A. MacLeod, CFA George H. Troughton, CFA
Washington, DC Delaware, Ohio Chico, California
John H. Crockett, CFA Douglas J. Manz, CFA
Fairfax, Virginia Corrales, New Mexico

2002-2003 Council of Examiners

The COE is responsible for writing the Item Set and Essay portions of the CFA examinations.

Thomas B. Welch, CFA, Chair Susan Rowe Ingram, CFA Thomas R. Robinson, CFA
Saint Louis, Missouri Raleigh, North Carolina Coral Gables, Florida
Andrew J. Abouchar, CFA James G. Jones, CFA William H. Sackley, CFA
Waterloo, Ontario, Canada Bolivar, Missouri Wilmington, North Carolina
Richard O. Applebach, Jr., CFA Dorothy C. Kelly, CFA Sandeep Singh, CFA
Louisville, Kentucky Charlottesville, Virginia Brockport, New York
William A. Barker, CFA Robert E. Lamy, CFA David M. Smith, CFA
Ottawa, Ontario, Canada Winston-Salem, Albany, New York
Susan A. Borrelli, CFA North Carolina Gary C. Sanger, CFA
Atlanta, Georgia Jeffrey D. Lorenzen, CFA Baton Rouge, Louisiana
Michael A. Broihahn, CFA Des Moines, Iowa George Spentzos, CFA
Miami, Florida John L. Maginn, CFA London, United Kingdom
Richard A. DeFusco, CFA Omaha, Nebraska David B. Stevens, CFA
Lincoln, Nebraska Michael G. McMillan, CFA Minneapolis, Minnesota
Carolyn Cosgriff East, CFA Annandale, Virginia John D. Stowe, CFA
Dallas, Texas Gregory M. Noronha, CFA Columbia, Missouri
Marilyn J. Ettinger, CFA Glendale, Arizona Mohan Subbiah, CFA
Jersey City, New Jersey Michael D. O’Brien, CFA London, United Kingdom
Timothy D. Fyffe, CFA Los Angeles, California
Lexington, Kentucky Kathy L. Pilgrim, CFA
Jacques R. Gagne, CFA Dallas, Texas
Quebec City, Canada
Curriculum and Examinations

The Curriculum and Examinations Department of AIMR is composed of staff professionals who assist the AIMR
Governors, the Candidate Curriculum Committee, and the Council of Examiners to develop and administer the
CFA Program.

Thomas A. Bowman, CFA, President and CEO Aimee E. Dick, Associate

Annette V. Abbott, Associate Matthew B. Ehrich, Associate
Barbara P. Evans, Associate
Robert R. Johnson, CFA, Senior Vice-President Carey M. Hare, Associate
Nancy A. Dudley, Vice President Julie A. Hilton, Associate
Mary K. Erickson, CFA, Vice President Dorothy L. Kirby, Associate
Dennis W. McLeavey, CFA, Vice President Wanda A. Lauziere, Associate
Jan R. Squires, CFA, Vice President John H. Mastrandea, Associate
Donald L. Tuttle, CFA, Vice President Lisa M. McDonald, Associate
Philip J. Young, CFA, Vice President Terry M. Murphy, Associate
Jerald E. Pinto, CFA, Visiting Scholar Z. Mahala Page, Associate
Marcia L. Akers, Associate Sara C. Schwind, Associate
Colleen I. Anderson, Associate Katherine L. Stephens, Associate
Tabatha C. Callander, Associate Jenis D. Tapscott, Associate
Maureen L. Coppa, Associate Jan M. Walton, Associate
Helen K. Weaver, Associate
Contents
Introduction....................................................................................................................................................... 1
CFA Program Background ............................................................................................................................... 1
CFA Program Outline ....................................................................................................................................... 2
Preparing for the Level II Examination ............................................................................................................ 7
Taking the Level II Examination ...................................................................................................................... 8
Completing the CFA Program ........................................................................................................................ 17
CFA Program Calendar .................................................................................................................................. 20
2003 CFA Study and Examination Program Textbooks: Primary Readings .................................................. 21

Ethical and Professional Standards

Study Session 1 ............................................................................................................................................... 23
Study Session 2 ............................................................................................................................................... 25

Investment Tools
Study Session 3. Quantitative Methods for Valuation .................................................................................... 27
Study Session 4. Economics for Valuation..................................................................................................... 31
Study Session 5. Financial Statement Analysis: Intercorporate Investments and Business Combinations .... 36
Study Session 6. Financial Statement Analysis: Global Issues....................................................................... 39
Study Session 7. Financial Statement Analysis: Earnings Quality Issues ...................................................... 41

Asset Valuation
Study Session 8. Basic Valuation Concepts.................................................................................................... 44
Study Session 9. Equity Investments: Industry and Company Analysis......................................................... 46
Study Session 10. Equity Investments: Valuation Models ............................................................................. 49
Study Session 11. Equity Investments: Valuation Models and Applications ................................................. 52
Study Session 12. Equity Investments: Special Valuation Cases ................................................................... 55
Study Session 13. Debt Investments: Credit Analysis .................................................................................... 57
Study Session 14. Debt Investments: Valuation Issues .................................................................................. 59
Study Session 15. Debt Investments: Structured Securities............................................................................ 63
Study Session 16. Derivative Investments: Futures and Swaps...................................................................... 67
Study Session 17. Derivative Investments: Options ....................................................................................... 72

Portfolio Management
Study Session 18. Capital Market Theory and Asset Pricing ......................................................................... 75
 Introduction complexes, insurance companies, agencies, and
Congratulations on becoming a Level II candidate in universities. The association’s mission is to serve
the Chartered Financial Analyst (CFA) Study and investors through its membership by providing
Examination Program. The charter you seek is global leadership in investment education,
respected around the world as a mark of sustaining high standards of professional conduct,
accomplishment and dedication, and each of the and administering the CFA Program. AIMR also is
three levels of the program represents a distinct widely known for its Global Investment
achievement in professional career development. Performance Standards (GIPS®), which provide
Passing Level I was a significant milestone and professionals with a global standard for reporting
studying for Level II will expand your knowledge investment results.
and enhance your skills in investment analysis and AIMR was formed in January 1990 through the
portfolio management. merger of the Institute of Chartered Financial
Analysts (ICFA) and the Financial Analysts
Level II Study Guide Federation (FAF). The ICFA was the original
The purpose of the CFA Program is to help grantor of the CFA designation, and the FAF was
candidates learn. This Level II study guide is the umbrella organization for financial analyst
intended to help you plan a comprehensive self- societies.
study program to master the concepts contained in
the AIMR Candidate Body of Knowledge and Program History
prepare for the 2003 CFA examination. The study During the 39-year history of the CFA Program,
guide includes the following contents: over 407,000 examinations have been administered
to candidates and more than 50,000 charters have
1. Background information about the Association been awarded. The dramatic growth in candidates
for Investment Management and Research and charterholders is indicative of the CFA
(AIMR) and the CFA Program. Program’s focus on a relevant curriculum, rigorous
2. An outline of the CFA Program. examinations, and the highest professional conduct,
3. Guidelines for preparing for the CFA Level II and also reflects a strong desire among financial
examination. professionals to achieve and maintain high
4. Suggestions for taking the CFA Level II standards.
examination.
5. Information about completing the CFA AIMR Member Societies and Member
Program. Chapters
6. A calendar of important CFA Program dates. Many candidates find membership in an AIMR
7. A suggested study program encompassing 18 Member Society or Chapter to be a valuable part of
study sessions that cover the four functional their preparation for the examinations. Societies and
areas in the Candidate Body of Knowledge chapters are made up of leading investment
(ethical & professional standards, investment professionals who can offer experienced
tools, asset valuation, and portfolio perspectives on topics covered in the Candidate
management). Body of Knowledge. Most societies and chapters
8. Instructions for ordering textbooks and an order also offer educational programs, designed to
form from PBD Worldwide Fulfillment enhance practicing professionals’ knowledge of the
Services, distributor of textbooks and other business, which also may be of interest to
materials in the CFA curriculum. candidates. Finally, many societies and chapters
CFA Program Background sponsor candidate study groups and preparatory
courses. To locate the local society nearest you,
Background contact AIMR at (phone) 434-951-5499 or 800-247-
AIMR is a global nonprofit organization with 116 8132, (fax) 434-951-5262, (e-mail) [email protected],
Member Societies and Member Chapters and more or visit the AIMR Web site www.aimr.org.
than 160,000 members and candidates—investment
analysts, portfolio managers, and other investment
decision makers employed by investment firms,
banks, broker/dealers, investment company

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 CFA Program Outline to the CFA examinations. First, the curriculum for
each level of the CFA Program is organized
AIMR Candidate Body of Knowledge primarily around a functional area:
The CFA curriculum is grounded in the practice of • The Level I study program emphasizes tools and
the investment profession. AIMR periodically inputs and includes an introduction to asset
conducts a job analysis involving CFA valuation and portfolio management techniques.
charterholders around the world to determine those • The Level II study program emphasizes asset
elements of the body of investment knowledge and valuation and includes applications of the tools
skills that are important to charterholders in their and inputs (including economics, financial
practice. The most recent job analysis was statement analysis, and quantitative methods) in
completed in 2001. The survey results define the asset valuation.
Candidate Body of Knowledge (CBOK) and to
• The Level III study program emphasizes
determine how much emphasis each of the major
portfolio management and includes strategies
topic areas receives on the CFA examinations.
for applying the tools, inputs, and asset
The CBOK is organized into four major topic
valuation models in managing equity,
areas: ethical and professional standards, tools and
fixed-income, and derivative investments for
inputs for investment valuation and management,
individuals and institutions.
asset valuation, and portfolio management and
Second, because they are an integral part of the
performance presentation. The topic areas covered
other three functional areas of investment
in the CFA Program are shown in the CBOK outline
management, ethical and professional standards are
that begins on page 3.
covered at all three levels of the curriculum.
Two features of the CBOK are especially relevant

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CFA Candidate Body of Knowledge (CBOK) Outline
Following is an outline of the major topics in the CBOK. A detailed presentation of the CBOK can be found on
the AIMR Web site at www.aimr.org/cfaprogram/cbok.html.

Ethical and Professional Standards

1. Professional Standards of Practice
2. Topical Issues
Quantitative Methods
1. Time Value of Money
2. Basic Statistical Concepts
3. Probability Concepts and Random Variables
4. Common Probability Distributions
5. Sampling and Estimation
6. Statistical Inference and Hypothesis Testing
7. Correlation Analysis and Linear Regression
8. Multivariate Regression
9. Time Series Analysis
10. Portfolio Concepts
Economics
1. Market Forces of Supply and Demand
2. Elasticity
3. The Firm and Industry Organization
4. Supply and Demand for Productive Resources
5. Measuring National Income
6. Economic Fluctuations and Unemployment
7. The Monetary System
8. Inflation: Causes and Consequences
9. International Trade
10. International Finance
11. The Macroeconomics of an Open Economy
12. Aggregate Demand and Aggregate Supply
13. Sources of Economic Growth
14. Government Regulation
15. Natural Resource Markets
16. Relationship of Economic Activity to the Investment Process
Financial Statement Analysis
1. Financial Reporting System
2. Principal Financial Statements
3. Earnings Quality and Nonrecurring Items
4. Analysis of Inventories
5. Analysis of Long-Lived Assets
6. Analysis of Income Taxes
7. Analysis of Financing Liabilities
8. Analysis of Leases
9. Analysis of Off-Balance-Sheet Activities
10. Analysis of Pensions, Stock Compensation, and Other Employee Benefits
11. Analysis of Inter-Corporate Investments
12. Analysis of Business Combinations
13. Analysis of Multinational Operations
14. Ratio and Financial Analysis
Corporate Finance
1. Fundamental Issues
2. Capital Investment Decisions
3. Business and Financial Risk
4. Long-term Financial Policy
5. Mergers and Acquisitions
6. Valuation Implications of Corporate Finance
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Analysis of Equity Investments
1. Organization and Functioning of Securities Markets
2. Security Market Indexes and Benchmarks
3. Equity Risk Definition and Measurement
4. Fundamental Analysis
5. Special Applications of Fundamental Analysis
6. Technical analysis
Analysis of Debt Investments
1. Debt Securities
2. Risks Associated with Investing in Bonds
3. Global Bond Sectors and Instruments
4. Yield Spreads
5. Introduction to the Valuation of Debt Securities
6. Yield Measures, Spot Rates, and Forward Rates
7. Measurement of Interest Rate Risk
8. The Term Structure and Volatility of Interest Rates
9. Valuing Bonds with Embedded Options
10. Mortgage-Backed Securities (MBS)
11. Asset-Backed Securities
12. Valuing Mortgage-Backed and Asset-Backed Securities
13. Assessing Trading Strategies
14. Principles of Credit Analysis
Analysis of Derivatives
1. Derivative Markets and Instruments
2. Forward Markets and Instruments
3. Futures Markets
4. Options Markets
5. Swaps Markets
Analysis of Alternative Investments
1. Real Estate
2. Investment Companies
3. Venture Capital
4. Hedge Funds
5. Closely-held Companies
6. Distressed Securities/Bankruptcies
7. Commodity Markets and Commodity Derivatives
Portfolio Management
1. Capital Market Theory
2. Management of Individual Investor Portfolios
3. Management of Institutional Investor Portfolios
4. Pension Plan and Employee Benefit Funds
5. Endowment Funds and Foundations
6. Insurance Companies
7. Other Corporate Investors
8. Capital Market Expectations
9. Asset Allocation
10. Portfolio Construction and Revision
11. Equity Portfolio Management Strategies
12. Debt Portfolio Management Strategies
13. Real Estate and Alternative Investments in Portfolio Management
14. Risk Management
15. Performance Measurement
16. Presentation of Performance Results

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©2002, AIMR®
Curriculum Structure study session in a particular topic area. For instance,
Mastery of the CBOK is the major purpose of the the topic-level learning objective for Ethical and
CFA Program. The Level II curriculum is organized Professional Standards is located at the start of
into 18 study sessions, each devoted to a particular Study Session 1.
topic area that is part of the CBOK. The Level I is the foundation for the CFA Program and
examinations, though an important step toward provides the basic tools of asset valuation and inputs
achieving the CFA charter, are designed primarily to for portfolio management. The Level I topic-level
help you demonstrate competency in the CBOK as learning objectives require you to
set forth in the CFA curriculum. As you design your • have a thorough understanding (i.e., full and
personal study program, you should emphasize complete comprehension) of the AIMR Code of
mastery of the CBOK and the practical application Ethics and Standards of Professional Conduct;
of that knowledge. • demonstrate a thorough understanding of
Readings in the curriculum are designated either important investment tools—quantitative
Preliminary or Assigned: methods, economics, and financial statement
• Preliminary Readings may be included to help analysis;
candidates who need to review fundamental • have a working knowledge (i.e., useful
concepts and techniques or who have a weak understanding) of the fundamentals of risk and
background in a particular area. return, asset valuation, and portfolio
• Reading Assignments are the core of the study management—including the basic
sessions and form the primary basis for the measurements of risk and return, the common
examination questions, although examination approaches to valuing assets, and the key
questions also may draw upon Preliminary elements of the portfolio management process.
Readings. Based on the knowledge and skills you developed at
Many of the readings have end-of-chapter Level I, the topic-level learning objectives for Level
questions, problems, or appendixes that demonstrate II require you to
useful applications of concepts provided in the text • analyze and value debt, equity, and derivative
material. Unless these exercises or appendixes are assets and recommend those assets with the
specifically assigned, however, you should focus most (or least) attractive expected return–risk
your study on the text material and the examples characteristics for purchase (or sale);
provided therein. • apply a top-down valuation approach based on
global trends, national economies, industry- and
Learning Objectives and Learning company-specific factors, and individual asset
Outcome Statements characteristics;
The Candidate Curriculum Committee (CCC) and • apply an alternative (bottom-up) approach
AIMR staff choose curriculum materials to reflect involving the identification of those companies
the CBOK. Learning objectives, which are common and industries/sectors that are under- or
in various forms at all levels of education, are overvalued regardless of the macroeconomic
integral to the CFA curriculum and examination forecast;
process. The CFA candidate curriculum uses two • use a variety of valuation techniques, as well as
types of learning objectives: (1) topic-level learning the DuPont approach to financial analysis;
objectives and (2) reading-specific learning outcome
• incorporate international factors in asset
statements (LOS). A collection of topic-level
valuations;
learning objectives and reading-specific LOS makes
• apply knowledge of the AIMR Code of Ethics
up each study session; the primary purpose of topic-
and Standards of Professional Conduct to
level learning objectives and LOS in the CFA
recognize and avoid unprofessional practices
curriculum is to enhance candidate learning.
and violations of standards in a variety of
Topic-Level Learning Objectives conduct areas.
Topic-level learning objectives give a broad Based on the knowledge and skills you developed at
overview of the material to be learned and indicate Level I and Level II, the Level III topic-level
the depth of knowledge expected. These learning learning objectives require you to
objectives are shown in boxes preceding the first • develop suitable investment policies that meet

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©2002, AIMR®
 the specific requirements and circumstances of the indicated calculation but also to discuss, de-
individual and institutional investors; scribe, explain, and otherwise address the
• incorporate domestic and international calculation, the formula(s) on which the calculation
economic forecasts and capital market is based, and the results of the calculation. Also,
conditions into portfolio investment strategies; candidates should be aware that examination
• determine asset allocations that are consistent questions, especially at Level III, may combine or
with investment policies and strategies; synthesize LOS from several study sessions and/or
• implement portfolio strategies that consider the topics. The LOS should not, therefore, be viewed as
costs and benefits of timely execution; a proxy for examination questions. Nevertheless, if
• monitor and evaluate portfolio performance and you can accomplish the goals set forth in the LOS,
respond to changes in requirements and circum- you should be able to perform successfully on the
stances; examinations.
• anticipate potential professional conduct Both LOS and the essay examinations use
problems and create compliance procedures command words to guide you (see page 12 for a
based on the AIMR Code of Ethics and complete list and description of command words).
Standards of Professional Conduct to resolve or In the LOS, command words indicate the degree of
adequately address those problems; understanding required. On the essay examinations,
• create a performance presentation that complies the command words indicate what you must do to
with the GIPS standards; and evaluate and answer the question successfully. Although many
recommend changes to a sample performance Level II item set examination questions do not use
presentation that would bring the presentation specific command words, part of your preparation
into compliance with the GIPS standards; and study should include becoming familiar with
these command words as they are used in LOS.
• support your recommendations relating to
portfolio management topics, constructively Even though you obviously cannot “draw a profit or
loss diagram” in an item set context, for instance,
critique the recommendations of others, and
you can evaluate, analyze, or interpret a drawn
suggest changes to improve results.
diagram that is provided. Developing the ability to
Learning Outcome Statements draw the diagram certainly improves your ability to
Reading-specific LOS are listed for each reading in evaluate, analyze, or interpret the diagram.
each study session. In general, LOS help you
understand how each reading addresses the learning
Exam Questions and Exam Levels
Examination questions at a given level of the CFA
objective for the topic, and for a particular reading
Program will not be based explicitly on LOS from
the LOS indicate what you should be able to
another level. Candidates, however, should
accomplish after studying that reading. Because the
recognize the essential “building block” nature of
relevant material is often concentrated in a specific
the program, and their preparation should reflect the
part of the assigned reading, another objective of the
fact that certain curricular materials at Levels II and
LOS is to focus your study toward specific sections
III necessarily extend from material at prior levels.
and away from other material (such as an author’s
opinion or extraneous details) that is less relevant to Study Materials
the topic-level learning objectives. Thus you should The 2003 curriculum includes professional journal
use the LOS to guide and focus your study. articles, textbooks, and other readings designed to
The LOS link the Candidate Body of Knowledge help you master the topics in the Candidate Body of
to the curriculum and the CFA examinations. LOS Knowledge, and the study sessions contained in this
guide the examinations as well as the candidates; the study guide address all those readings. A complete
LOS indicate to the Council of Examiners what list of the textbooks required for all three levels of
examination questions the curriculum will support. the CFA examination appears on page 21.
Each examination question is based explicitly on Past essay examination questions and guideline
one or more LOS; however, the examination answers provided to candidates are also a major part
question may go beyond the one or two command of the curriculum. You are expected to be familiar
words typically used in the LOS. For instance, given with the content of the past three years’ Level II
a LOS that contains the command word “calculate,” essay examinations. A careful review of this
candidates should be prepared not only to perform material will help you identify topics that have been
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©2002, AIMR®
tested in the past. Note, however, that the reading assignments in each study session. Use the
curriculum changes from year to year and each learning outcome statements to identify the relevant
examination is based on the curriculum assigned material and depth of knowledge required. Under-
that year. You should study past examinations with line, take notes, and highlight important points.
the understanding that the 2003 curriculum outlined AIMR estimates that you will need to devote 10–15
in this study guide will be the basis for the 2003 hours per week for 18 weeks to prepare adequately
examinations. In addition, you should note that for the Level II examination. Allow a minimum of
every examination is a sampling from the one week of study for each session, with completion
curriculum and that the sampling differs from year scheduled for late April. This schedule will allow
to year. you to spend the final month before the examination
You should review the guideline answers reviewing the assigned readings, prior years’
carefully. Guideline answers are published after the examinations, and guideline answers. You will
examinations are graded and reflect the full scope of undoubtedly adjust your study time to conform to
answers that merited credit. As a result, guideline your own strengths and weaknesses, and you will
answers are often more detailed than would be probably spend more time on some study sessions
required for full credit on an actual examination and than on others. You should allow ample time for
the published guideline answers may not reflect all both in-depth study of all topic areas and additional
answers that were given partial or full credit during concentration in those topic areas for which you feel
the grading process. Nonetheless, the guideline least prepared.
answers are a useful addition to the CFA curriculum AIMR strives to develop examinations that are
and your study program. challenging, comprehensive, fair, and, relevant to
the practice of investment management. Although
Preparing for the Level II Examination each topic area will be represented on the
examination, to address every reading or concept in
By successfully completing the Level I examination,
a six-hour examination would be impossible, and
you have demonstrated your ability to use the basic
constructing the examinations reflects a process of
tools and techniques of investment analysis. As a
sampling from the curriculum. Candidates have
Level II candidate, you can now turn your attention
found, however, that trying to anticipate the content
to applying those tools to the valuation of
or composition of a given year’s examination is not
investment opportunities.
a successful preparation strategy. You should
This study guide is the key to preparing for the
approach the curriculum primarily as a means of
Level II CFA examination. After reading this
improving your knowledge and skills as an
preliminary section, you should review the study
investment professional and secondarily as a way of
sessions to gain an important overview of what
preparing for the examination. A thorough
needs to be accomplished during the coming
understanding of all topics to the degree indicated in
months. (A one-page outline of these study sessions
the LOS is the best preparation for answering
is provided on page 22.) Then order the appropriate
questions on the examination.
textbooks and readings so you can begin your study.
Candidate textbook ordering instructions and order Warning
forms are located in the back of this study guide. In the months following your enrollment in the CFA
Textbooks will be available for purchase after Program, you may receive numerous solicitations
October 1, 2002. Although many textbooks are used for preparatory courses and review materials.
on more than one level, AIMR advises candidates to Although the CFA Program is designed as a
purchase the editions noted in this study guide. distance learning, self-study program, AIMR under-
Using an outdated edition may result in in-complete stands that candidates have different learning styles.
preparation for certain parts of the examination. For some candidates, prep courses and/or review
Organizing Your Study Program notes may facilitate the learning process. However,
we strongly believe that such products should be
An orderly, systematic approach to examination
complements to, not substitutes for, the prescribed
preparation and exam-taking strategy is critical to
curriculum. In designing the examinations, the
successful completion of the Level II examination.
Council of Examiners references only the
You should dedicate a consistent block of time
every week to reading and studying. Complete all
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©2002, AIMR®
curriculum prescribed by AIMR in the study guide changes, and other issues. Candidates can download
and the LOS developed for that curriculum. numerous documents from this section, including
Furthermore, AIMR does not endorse, study guides, practice examination questions,
promote, review, or warrant the accuracy of the guideline answers, and discounted subscription in-
products or services offered by preparatory formation. Candidates can also download the forms
organizations. AIMR does not verify or endorse required for duplicate examination results, special
the pass rates or other claims made by these requests, and membership information. In addition,
organizations. candidates may receive their examination tickets
As a service to candidates, AIMR makes and results on-line from this private Candidate
candidate lists accessible to vendors of preparatory Services section.
courses and review materials. Should you wish to To obtain your user name and password for the
have your name removed from any mailing lists CFA Candidate Services section, go to
made available to these organizations, please either www.aimr.org/canservices and follow the
check the appropriate box located in Section 11 of instructions. Visit the AIMR Web site often for up-
the enrollment form or contact AIMR at (phone) to-date information about the CFA Program.
800-247-8132 or 434-951-5499, (fax) 434-951-
Taking the Level II Examination
5262, (email) [email protected], or visit the AIMR
Web site at www.aimr.org The 2003 CFA Level II examination will be given
in two parts—a morning session of three hours and
Candidate Bulletin an afternoon session of three hours—for a combined
To be fair to all candidates, AIMR does not respond total of 360 minutes and 360 points; therefore, the
directly to individual candidate inquiries about the weight of each question is the same as the number
content of the curriculum or examinations. As a of minutes allotted.
forum to respond to candidates’ content-oriented
questions, AIMR publishes and mails to enrolled 2003 Examination Guideline Topic Area
candidates a Candidate Bulletin in approximately Weights
January and April. The Candidate Bulletins are also The periodic job analysis survey of practicing CFA
available on the AIMR Web site. If you have a charterholders not only identifies those elements of
question about curriculum or examination content, the body of investment knowledge that are
you should contact AIMR to have your question important to the professional practice of investment
considered for inclusion in a Candidate Bulletin. management, but also helps the Council of
Candidates should carefully read these Bulletins, Examiners determine approximately how much
which contain information about policy changes, emphasis (weight) each of the major topic areas
where to direct curriculum questions, curriculum should receive on the CFA examinations. Those
errata, answers to frequently asked questions, and weights are shown in the following table and should
notices of candidate disciplinary actions. Candidates be used to help allocate your study efforts. Because
who enroll after the first Bulletin is mailed will the curriculum is designed to help you gain
receive a copy of that issue with their Study Guide. knowledge about each topic area, the study sessions
Questions about the administration of the and the number of pages assigned in the curriculum
examination are always welcomed at does not necessarily match the examination topic
[email protected], and will be answered individually. weights and are not an indicator of the number of
examination questions in each topic area. By design,
AIMR Web site the CFA examinations only sample the curriculum,
AIMR’s Web site (www.aimr.org) offers a private and examination questions also may draw on a
section devoted to CFA Candidate Services. This breadth of knowledge and a variety of skills.
restricted-access section of the site, which is avail-
able only to CFA candidates and AIMR members,
contains valuable information for enrolled
candidates about policies, deadlines, address

8
©2002, AIMR®
 2003 Examination Guideline Topic Area Weights
Survey
Topic Results Level I Level II Level III
Ethical and Professional Standards 10% 15% 10% 10%
Investment Tools:
• Economics* 10 10 0–10 0
• Quantitative Analysis 10 12 0–10 0–10
• Financial Statement Analysis** 20 28 25–35 0
Asset Valuation*** 35 30 35–45 30–40
Portfolio Management*** 15 5 5–15 40–60
TOTAL 100% 100% 100% 100%
*Economics is part of Portfolio Management at Level III.
**Corporate Finance is part of Financial Statement Analysis at Level I.
***Derivatives are a part of both Asset Valuation (Level I and Level II) and Portfolio Management (Level III).

2003 Examination Format Weights

The 2003 Level II examination will consist of 50 percent essay/short answer questions or problems (morning
session) and 50 percent item sets (afternoon session). The following table shows the topic areas that will be tested
in each examination format.

2003 Level II Examination Format Weights

Topic Format Weight Minutes
Ethical and Professional Standards Item Set 10% 36
Economics Item Set 10% 36
Quantitative Analysis Item Set 10% 36
Financial Statement Analysis Item Set 20% 72
Asset Valuation Essay 40% 144
Portfolio Management Essay 10% 36
TOTAL 100% 360

The above table shows the general weights assigned generally not a useful exercise.
to topic areas in each examination format. However,
candidates should recognize that, effective with the Item Set Format and Examples
2003 examination, any of the assigned topics may The item set format consists of a vignette or short
be tested in either format; topics may also be tested case situation followed by six multiple choice
in combination in a particular format. Your questions based on the vignette. To acquaint
preparation, therefore, should be focused on candidates with the scope and appearance of the
mastering the assigned LOS independent of any item set format, two sample item sets are provided
format considerations; in particular you are advised below. Note that these examples have fewer than the
not to alter your preparation in any attempt to match six multiple choice questions per item set on the
topics and formats. Also, attempting to predict examination. You should also note that, although
which topic will be tested in which format is these samples provide justification for each correct
answer, you will not be required, or have the

9
©2002, AIMR®
opportunity, to justify your answers in the actual B. use material nonpublic information for her
examination item sets. Finally, these examples are HC clients, LSC clients, and for herself.
intended only to illustrate the item set format; they C. use material nonpublic information for her
should not be taken as an indication of the type of HC clients but not for her LSC clients or
content or level of difficulty of item sets that will herself.
appear on the actual examination. D. use material nonpublic information for her
HC clients and LSC clients but not for
Item Set #1 (Ethics): herself.
Superior Asset Management has offices and
provides investment advisory services to clients 2. According to AIMR Standards, Klein must
living in various countries. Each country has adhere to:
different securities laws and regulations and no A. AIMR Code and Standards for her LSC and
prohibition exists against using material nonpublic MSC clients.
information: B. MSC laws and regulations for both LSC
• Home Country (HC) has no securities laws or and MSC clients.
regulations. C. AIMR Code and Standards for her LSC
• Less Strict Country (LSC) has securities laws clients and MSC laws and regulations for
and regulations that are less strict than the her MSC clients.
requirements of the AIMR Code and Standards D. LSC laws and regulations for her LSC
and also states that the law of the locality clients and MSC laws and regulations for
where business is conducted governs. her MSC clients.
• More Strict Country (MSC) has securities laws 3. Thompson also manages accounts for clients
and regulations that are more strict than the who reside in MSC. According to AIMR
requirements of the AIMR Code and Standards Standards, Thompson must adhere to:
and states that the law of the locality where A. MSC laws and regulations for her LSC and
clients reside governs. MSC clients.
Superior wants to ensure that its portfolio managers B. AIMR Code and Standards for her LSC
comply with the applicable laws, rules, and and MSC clients.
regulations of the various countries where Superior C. AIMR Code and Standards for her LSC
does business. Specifically, Superior is concerned clients and MSC laws and regulations for
about the activities of the following four portfolio her MSC clients.
managers: D. LSC laws and regulations for her LSC
• Diane Grant, an AIMR member, resides in clients and MSC laws and regulations for
LSC but does business in HC and LSC. her MSC clients.
• Brenda Klein, a candidate in the CFA Program, 4. According to AIMR Standards, Wilson must
resides in LSC and manages accounts for adhere to:
clients who reside in either LSC or MSC. LSC A. AIMR Code and Standards for his HC,
law applies LSC, and MSC clients.
• Chris Thompson, CFA, resides in MSC and B. The laws and regulations of MSC for his
does business in LSC with clients who are HC, LSC, and MSC clients.
citizens of LSC. MSC law applies. C. AIMR Code and Standards for his HC and
• John Wilson, an AIMR member, resides in HC LSC clients and the laws and regulations of
and does business in HC, LSC, and MSC. LSC MSC for his MSC clients.
and MSC laws apply. D. The laws and regulations of HC for his HC
clients, the laws and regulations of LSC for
1. Which of the following best describes Grant’s his LSC clients, and the laws and
responsibility under the AIMR Standards of regulations for MSC for his MSC clients.
Professional Conduct? Grant may:
Item Set #1 Guideline Answers:
A. not use material nonpublic information for
1. A is correct. Because applicable law is less
her HC clients, her LSC clients, or herself.
strict than the AIMR Code and Standards, the
member must adhere to the Code and Standards,
10
©2002, AIMR®
 which say that material nonpublic information Exhibit 2
may not be used under any circumstances. Variable Estimates for 2002
2. C is correct. When AIMR Code and Standards POP 34.7
impose a higher degree of responsibility than INC 27.4
applicable laws, the AIMR Code and Standards
ADV 8.2
must be applied. This is the case for Klein’s
clients in LSC. If applicable law is more strict
Exhibit 3
than the requirements of the Code and
Critical Values for Students t Distribution
Standards, however, members, CFA
Degrees of Area in Upper Tail
charterholders, and candidates in the CFA Freedom 10% 5% 2.5%
program must adhere to applicable law. This is 16 1.3368 1.7459 2.1199
the case for Klein’s clients in MSC.
17 1.3334 1.7459 2.1098
3. A is correct. An analyst or portfolio manager
working in an international environment is 18 1.3304 1.7341 2.1009
required to have knowledge of the laws of the 19 1.3277 1.7291 2.0930
country where he or she is working. When 20 1.3253 1.7247 2.0860
involved with securities of a country with laws
and regulations that are more strict than the 1. Using the regression model developed, the sales
AIMR Code and Standards, the stricter laws and forecast in millions of U.S. dollars for 2002 is
regulations of the analyst’s home country (in closest to:
this case MSC) prevail.
4. C is correct. If applicable law is more strict than A. 215.
the requirements of the AIMR Code and B. 280.
Standards, members, CFA charterholders, and C. 417.
candidates in the CFA program must adhere to D. 426.
applicable law. Thus, the Code and Standards
apply to Wilson’s HC and LSC clients and the 2. The unadjusted R2 indicates that the intercept
laws and regulations of MSC apply to his MSC and the independent variables together explain:
clients. A. 80.4% of total BoneMax annual sales.
B. 80.4% of the variability of BoneMax annual
Item Set #2 (Quantitative Analysis) sales.
Peggy Parsons, CFA, wants to forecast sales of C. 89.7% of the variability of BoneMax annual
BoneMax, a prescription drug for treating sales.
osteoporosis. Parsons has developed the sales D. less than 20% of the variability of
regression model shown in Exhibit 1 and supporting BoneMax annual sales.
data found in Exhibits 2 and 3 to assist in her sales
forecast of BoneMax. 3. At the 5 percent level of significance, is the
regression coefficient of the average income of
Exhibit 1 U.S. women over the age of 60 (INC)
BoneMax Sales Regression Model significantly different from zero?
SALES = 8.530 + 6.078 (POP) + 5.330 (INC) + 7.380 (ADV) A. No, because 2.10 < 2.1199
t-values: (2.48) (2.23) (2.10) (2.75) B. Yes, because 2.10 > 1.7247
C. Yes, because 2.10 > 1.7459
Unadjusted R2=0.804 D. Yes, because 2.10 > 2.0860
Number of observations = 20 annual observations
4. In testing the statistical significance of the
Notes:
SALES = sales of BoneMax (US$ millions) regression coefficient of advertising dollars
POP = population (millions) of U.S. women over age 60 spent on BoneMax, Parsons must know which
INC = average income (US$ thousands) of U.S. women of the following inputs?
over age 60
ADV = advertising dollars spent on BoneMax (US$ millions)

11
©2002, AIMR®
 Degrees of One-tailed or to list the names of three methods and provide a
freedom two-tailed test description of each method you listed.
A. No No The following command words may be used on
B. No Yes the 2003 Level II examination.
C. Yes No Analyze: To study or determine the nature and
D. Yes Yes relationship of the parts of by analysis.
Appraise: To judge and analyze the worth,
significance, or status of.
5. The standard error of the estimated coefficient
for advertising dollars spent on BoneMax Arrange: To put into a proper order or into a
correct or suitable sequence,
(ADV) is closest to: relationship, or adjustment.
A. 0.373. Calculate: To ascertain or determine by
B. 2.211. mathematical processes.
C. 2.684. Characterize: To describe the essential character or
D. 5.934. quality of.
Cite: To quote by way of evidence, authority,
Item Set #2, Guideline Answers or proof.
1. D is correct. 8.530 + (6.078 × 34.7) + (5.330 × Classify: To arrange in classes; to assign to a
$27.4) + (7.380 × $8.2) = $426.0 million. category.
2. B is correct. Combine: To bring into such close relationship as
3. A is correct because with df = 20 – (3+1) = 16 to obscure individual characteristics.
and a 2-tailed test = 2.5% area, the critical Comment: To observe, remark, or express an
opinion or attitude concerning what has
t-value = 2.1199. been seen or heard about the subject at
4. D is correct because both inputs are necessary hand.
to determine the statistical significance of an Compare: To examine the character or qualities of,
individual regression coefficient. for the primary purpose of discovering
5. C is correct. The standard error is equal to resemblances.
7.380/2.75. Compose: To form by putting together; to form the
substance of.
Essay Format and Command Words Compute: To determine, especially by
The essay format consists of a question, which may mathematical means.
contain several parts, that requires candidates to Conclude: To make a decision about; to reach a
provide an open-ended or template-based response. logically necessary end by reasoning.
You can become familiar with typical essay Construct: To create by organizing ideas or
question formats by reviewing prior years’ concepts logically and coherently.
examinations. Contrast: To compare in respect to differences.
Each essay question will contain one or more Convert: To change from one form or function to
“command” words. These words are printed in bold another.
type in the examination question and are intended to Create: To produce or bring about by a course of
direct your answer to the question. When more than action or imaginative skill.
one command word is used in a question (e.g., Criticize: To consider the merits and demerits of
recommend and justify), you must respond to each and judge accordingly; to find fault with.
command word and you should be certain your Critique: To offer a critical review or
commentary.
response to the second command (justification) is
Define: To set forth the meaning of; specifically,
consistent with your response to the first command
to formulate a definition of.
(recommendation). Some questions contain
Demonstrate: To prove or make clear by reasoning or
instructions about numbers in your answer; the evidence; to illustrate and explain,
numbers are given in italic font. Command words especially with examples.
and italic numbers are both important. For example, Describe: To transmit a mental image, an
“List and describe three methods of inventory impression, or an understanding of the
accounting” is a six-part question that requires you nature and characteristics of.
Design: To conceive or plan out in the mind.

12
©2002, AIMR®
Determine: To come to a decision as the result of Name: To mention or identify by name.
investigation or reasoning; to settle or Order: To put in order; to arrange.
decide by choice among alternatives or Outline: To indicate the principal features
possibilities. or different parts of.
Diagram: To represent by or put into the form of a Predict: To declare in advance; to foretell on the
diagram. basis of observation, experience, or
Differentiate: To mark or show a difference in; to reason.
develop different characteristics in. Prepare: To put into written form; to draw
Discriminate: To mark or perceive the distinguishing up.
or peculiar features of; to distinguish by Present: To offer or convey by way of message;
discerning or exposing differences. to furnish or provide.
Discuss: To discourse about through reasoning or Rearrange: To put back into proper order or into a
argument; to present in detail. correct or suitable sequence,
Distinguish: To perceive a difference in; to separate relationship, or adjustment.
into kinds, classes, or categories. Recommend: To bring forward as being fit or worthy;
Draft: To draw up, compose, prepare, frame. to indicate as being one’s choice for
Draw: To express graphically in words; to something or as otherwise having one’s
delineate. approval or support.
Estimate: To judge the value, worth, or Record: To set down in writing; to make an
significance of. answer.
Evaluate: To determine or fix the value of; to Relate: To show or establish logical or
determine the significance or worth of, causal connection between.
usually by careful appraisal and study. Respond: To say or write something in return; to
Explain: To give the meaning or significance of; make an answer.
to provide an understanding of; to give Restate: To state again in a new form.
the reason for or cause of. Review: To make a formal or official
Formulate: To put into a systematized statement or examination of the state of; to go over or
expression; to prepare according to a examine critically or deliberately.
formula. Revise: To make a new, amended, improved, or
Give: To yield or furnish as a product, up-to-date version of.
consequence, or effect; to offer for the Select: To choose from a number or group—
consideration, acceptance, or use of usually, by fitness, excellence, or other
another. distinguishing feature.
Identify: To establish the identity of; to show or Separate: To set or keep apart; to make a
prove the sameness of. distinction between; to sort.
Illustrate: To make clear, especially by giving Show: To set forth in a statement, account, or
examples or instances. description; to make evident or clear.
Indicate: To point out or point to with more or less Solve: To find a solution for a problem.
exactness; to show or make known with a State: To express in words.
fair degree of certainty.
Subdivide: To divide the parts into more parts.
Infer: To derive as a conclusion from factors or
Summarize: To tell in or reduce to a summary.
premises.
Interpret: To explain or tell the meaning of;
Support: To provide with verification,
corroboration, or substantiation.
to present in understandable terms.
Judge: To form an opinion about through
Write: To put on paper; to record, state, or
explain.
careful weighing of evidence and
testing of premises.
Justify: To prove or show to be valid, sound, or Strategies for Taking the Examination
conforming to fact or reason; to furnish General suggestions for all types of examination
grounds or evidence for. questions include the following:
List: To enumerate. • Answer the questions with curriculum
Match: To pair up or put in a set as possessing assignments in mind. When preparing the CFA
equal or harmonizing attributes. examination, the Council of Examiners is
Modify: To make minor changes to give a new guided by the assigned reading materials and
orientation to or to serve a new end. the LOS.
13
©2002, AIMR®
• Pay attention to the time. The minutes allocated
to a question equal the maximum points
allowed, so a 15-minute question cannot receive
more than 15 points of credit. This means that,
in general, you should not spend 30 minutes on
a 15-minute question. Although you may finish
some questions in less than the allotted time
which will allow you to spend more time on
other questions, you should plan to devote only
as much time to each question as indicated by
its time allocation.
• Candidates should learn and practice all the
major features of their chosen approved
calculator well in advance of the exam. For
instance, candidates should be prepared to set
their calculator display formats to any specified
number of decimal places and to change that Specific suggestions for essay questions include the
format quickly during the exam, as different following:
exam questions may require different levels of • Write essay answers in blue or black ink, and
precision. write legibly and concisely. Please do not use
Specific suggestions for item set questions include red or green ink, because graders typically use
the following: these colors.
• Your score is the number of correct answers. • Unless specifically directed otherwise, you may
No deduction is taken for incorrect responses answer the questions in any order you want.
and you will not be penalized for guessing. You Make sure that you answer the question on the
should attempt to answer all questions pages provided for that question. AIMR will
• Select the best answer for each question and only grade answers that are written on the
darken the oval on the machine-gradable answer correct answer pages. You may make marks or
sheet that corresponds to that answer. notes on the question pages, but your notes will
Justification of your answers is not required for not be graded.
item set questions. • Some essay questions provide templates for
• Only answers recorded on the answer sheet will ease in answering the question. For those
be graded, and any answers recorded in the questions, candidates should answer on the
item set examination book itself will not be templates provided and follow the instructions
graded. Any stray marks on the answer sheet given in the template. Candidates who re-draw
may cause your examination to be incorrectly the template on a following answer page waste
graded. valuable time.
• Candidates are advised to record their answers • Show all your calculations for essay questions
on the answer sheet as they take the test rather even if the question does not specifically
than wait until the end of the examination instruct you to do so. You will be able to check
session. your work this way. Also, if your answer is
• Candidates should note that the only wrong, the grader can give partial credit, where
appropriate mark on the answer sheet is a neat warranted, if you show your calculations. If the
and complete darkening of the ovals; other question specifically says, “Show your work,”
marks (X, 9, incomplete darkening, circling, you must present your calculations as part of a
etc.) are not appropriate and may cause your complete answer to that question.
answer to be graded incorrectly. • Pay close attention to the command words and
number instructions in essay questions. The
command words are in bold type, and the
number instructions are italicized (see
preceding section, “Essay Format and
Command Words,” on page 12.)
14
©2002, AIMR®
• Use an outline, bullet points, and/or sentence • For the item set portion of the examination,
fragments in essay answers to convey your answers recorded with other than a No. 2 or HB
ideas logically and consistently, but quickly. pencil (i.e., ink or other types of pencil) cannot
Complete sentences are not required, and no be scored electronically, causing your answers
deductions are taken for misspellings, improper to be graded incorrectly. Essay questions should
grammar, or incorrect punctuation. be answered in blue or black ink; essay answers
• Providing more than the required number of written in pencil are difficult for the graders to
essay responses will not earn extra points. The read.
required number of responses will be graded in • The following items may be carried into the test
the order you present them. Additional center in your pockets or in a clear plastic bag
responses will be ignored. For example, if the measuring approximately 8” x 8” (20 cm x 20
question asks you to “discuss three reasons” cm): Examination Admission Ticket; current
and you discuss five, only the first three reasons (not expired) government-issued photo
will be graded. identification; approved calculators including
• If your answers are partly inconsistent or calculator cases; pencils, erasers, calculator
illogical, you will not receive credit. For batteries, eyeglasses, earplugs, medicine,
example, if the question asks you to tissues, other necessary personal items; wallets,
recommend and justify, the second part money purses; and food and drinks (to be
(justification) must be consistent with the first consumed outside of the testing room.) You
part (recommendation) to earn points. may use two clear plastic bags if you cannot fit
• To receive full credit, your answers must all of your items into one bag.
directly and specifically address the questions • The following items are prohibited at the test
asked. Answers containing a general discussion center: Bags of any kind including backpacks,
of the topic area, but that do not address the handbags, tote bags, briefcases, luggage, and
question asked, will not receive full credit even lunch containers; study materials including
if accurate. notes, papers, text books, study guides, scrap
paper, present/future value tables, and
Examination Rules calculator manuals; cellular telephones, pagers,
Candidates must comply with AIMR's conditions, headsets, computers, electronic organizers,
requirements, policies, and procedures that are set personal data assistants, or any other remote
forth in AIMR's Articles of Incorporation, Bylaws, communication or photographic equipment; and
Code of Ethics, Standards of Professional Conduct, watches with engaged alarms or timers.
and Rules of Procedure for Proceedings Related to • AIMR’s preferred form of ID is a valid
Professional Conduct. Candidates are also required passport. Whatever form of identification you
to abide by the examination rules and regulations, present must meet all of the criteria listed
candidate pledge, and proctor's verbal instructions below. It must
during the exam administration. Candidates who 9 be current and valid—it cannot be
violate these conditions, requirements, policies, and expired;
procedures during the exam may have their 9 contain your photo;
examination results voided and be subject to 9 be issued by a government agency; and
disciplinary sanction by AIMR's Professional 9 be a single document (not a combination
Conduct Program, which may include a suspension of two or more pieces of identification).
or revocation of participation in the CFA Study and Photocopies of identification documents will
Examination Program. not be accepted. Your ID will be inspected prior
Among the most important examination rules are to the start of the examination. If your ID is
the following: determined to be invalid, you will not be
• You must bring several pens (blue or black ink) admitted to the examination. Once you are
as well as a supply of sharpened No. 2 or HB seated, your ID must remain on your desk in
pencils. Extra pens, pencils, or pencil full view and proctors will again inspect IDs
sharpeners will not be available at the test during the examination. Proctors are instructed
center. Loose erasers and small pencil to submit to AIMR photocopies of questionable
sharpeners are permitted. IDs that may be discovered during the
15
©2002, AIMR®
 administration of the examinations, and validity Examination Comments Center
determinations will be made by AIMR After taking the examination, you may go to
following the examinations. Failure by the www.aimr.org/canservices to submit comments
proctors to detect an invalid ID prior to the start about exam questions that may have contained
of the examination, admittance to the testing errors or to submit comments about your test center.
room, or even completion of the examination
does not imply that the ID is valid or that your Grading the CFA Examination
scores will ultimately be reported. Use of an After the examination, all examination materials are
invalid ID is considered a violation of AIMR returned to AIMR for grading. Anonymity during
rules and will result in voiding of examination the grading process is assured because only the
results. candidate number appears on the examination book.
• Only the following two calculator models are The item set answer sheet, which has your name and
approved for use on the CFA examinations: signature, is graded by machine using the same
9 Hewlett Packard 12C quality control procedures that are used for the
9 Texas Instruments BAII Plus Level I multiple choice examination.
These are the only models of calculators The essay questions are graded by a carefully
permitted for use on the CFA examinations; no selected group of practitioner and academic CFA
other calculators are allowed in the testing charterholders. Certain essay examinations are
room. On exam day, your calculator(s) will be further reviewed by experienced graders or Senior
inspected prior to the start of the examination. Graders, each of whom is a CFA charterholder.
Your calculator(s) must then remain on your The AIMR Board of Governors, the body
desk in full view and proctors will continue to responsible for establishing the CFA examination
inspect calculators during the examination. and grading standards, sets the minimum passing
Failure by proctors to detect an unauthorized score for each examination level. Pass rates are a
calculator prior to the start of the examination, result of, not a determinant of, the minimum passing
or your use of an unauthorized calculator at any score. You should note that AIMR does not release
time during the examination, does not imply the minimum passing score for any examination
that the calculator is an approved model or that level.
your scores will ultimately be reported. Use of Pass Rates
an unauthorized calculator is considered a As the table of CFA examination results on page 19
violation of AIMR rules and will result in demonstrates, examination pass rates vary widely
voiding of examination results. You are over time and among examination levels. For
encouraged to select one of these models example, over the 10-year period from 1992 to
immediately and to practice with it throughout 2001, the pass rate for Level I candidates ranged
your period of study. Both models are available from 48 percent to 64 percent; for Level II
for purchase internationally. For more candidates, from 46 percent to 65 percent; and for
information, visit http://www.aimr.org/ Level III candidates, from 59 percent to 82 percent.
cfaprogram/calculatorpolicy.html Over the entire history of the examination, the
Secure Examinations average pass rate is 56 percent for Level I, 58
All testing materials, used and unused, must be re- percent for Level II, and 70 percent for Level III.
turned to AIMR following administration of the Candidates should recognize that pass rates will
examinations. If you remove any testing materials continue to vary over time.
from the test center, your results will be voided and Examination Results
you will be subject to disciplinary sanction by Completed examinations become the property of
AIMR's Professional Conduct Program, which may AIMR and will not be returned in either original
include a suspension or revocation of your or copied form. Examination results are reported
participation in the CFA Study and Examination as either “pass” or “fail”; exact numeric scores
Program. are not released to candidates. Level II results are
distributed by mail and are available on-line
usually within ten weeks of the examination date.
Examination results are not released via

16
©2002, AIMR®
telephone or e-mail. If you do not receive your Accruing Qualified Work Experience
results by September 1, 2003, please contact No investment experience is necessary to take
AIMR. any of the CFA examinations. Before a CFA
Candidates should understand that the score charter can be awarded, however, a candidate
matrix provided with examination results is an must meet certain requirements as outlined in the
indicator of overall performance and cannot be enrollment package and on AIMR’s Web site. In
used to determine approximate scores or pass/fail addition to passing the Level III CFA
status. The “<=50%” range is considered poor; examination and applying for membership, you
“51%–70%” is considered poor to average; must have accrued 36 months of qualified work
“>70%” is considered average to above average. experience prior to earning the charter. This
If you would like your failed examination to be experience may be accrued from previous
reviewed, AIMR staff can perform an positions, while you complete the program, or
Examination Score Retabulation. The after you pass the Level III examination.
retabulation is a manual check to verify that all Candidates are provided the work experience
parts of all questions were graded and that the guidelines for the eventual award of the CFA
scores were added correctly. The retabulation is charter beginning with the CFA Program Level I
not a regrading and will not change the grades materials. The work experience is self-reported
awarded to your individual answers. Unless an only when you enroll for the Level III
error is found in totaling or recording your examination. As long as you have met the
scores, the original pass/fail decision on your entrance requirements for the CFA Program, you
examination will not be affected. This service is are eligible to sit for the examination. If you do
available at a cost of US $100.00. To request an not have the required work experience following
Examination Score Retabulation, complete the completion of the Level III examination, the
request form available on the AIMR Web site, or charter will not be awarded until you have
request a copy of the form from Information satisfied the 36-month experience requirement.
Central at (phone) 434-951-5499 or 800-247-
8132, (fax) 434-951-5262 or (email) Ongoing Obligations
[email protected]. Your payment must accompany A candidate who becomes a CFA charterholder
the form. The deadline for requests is December must comply with AIMR’s conditions,
1, 2003. requirements, policies, and procedures that apply
to a CFA charterholder and AIMR member.
Completing the CFA Program These are set forth in the AIMR Articles of
Passing the CFA examinations is only part of Incorporation, Bylaws, Code of Ethics, Standards
the requirements for earning the CFA charter of Professional Conduct, Rules of Procedure for
and becoming an active member of AIMR. Proceedings Related to Professional Conduct,
and encompass other conditions, requirements,
AIMR Membership policies, and procedures that may be established
CFA candidates are not automatically members of and amended from time to time. Two key
AIMR. Candidates must apply for membership in requirements are the submission of an annual
both AIMR and a local society before they can Professional Conduct Statement and the payment
receive the CFA charter. The local society of membership dues. Failure to comply with
membership requirement is waived for candidates or AIMR’s conditions, requirements, policies, and
charterholders who work more than 50 miles from procedures can result in disciplinary sanctions,
the nearest society. You are encouraged to apply for including suspension or revocation of member-
AIMR membership so that you can begin enjoying ship and the right to use the CFA designation.
the numerous benefits designed for investment
professionals. For information on membership CFA Continuing Education
requirements and benefits, contact AIMR at (phone) Candidates who complete the CFA Program
434-951-5499 or 800-247-8132, (fax) 434-951- should realize that their professional education is
5262, (email) [email protected] or visit the AIMR Web not completed but rather has just begun. As part
site at www.aimr.org. of their lifetime commitment to the continual
enhancement of their knowledge, skills, and

17
©2002, AIMR®
abilities, CFA charterholders are strongly only in a dignified and judicious manner. The
encouraged to participate in AIMR’s Continuing Standards of Practice Handbook states that it is
Education (CE) Program. Continuing education “… the responsibility of AIMR members, CFA
opportunities are frequently identified in articles charterholders, and candidates in the CFA
in the AIMR Exchange. A wide variety of Program to use the CFA designation or refer to
activities qualify for CE credits, including their candidacies in the CFA Program properly
conferences, seminars, and readings. and in a manner that does not mislead the
investing public or others” (emphasis added).
Proper and Ethical Use of the CFA As a candidate, you may reference your
Designation participation in the CFA Program, but the
The CFA designation is not simply an acronym reference must clearly state that you are a
or generic term for financial analysts. Rather, the candidate for the right to use the CFA
CFA mark is an exclusive, unique trademark designation and cannot imply that you have
owned by AIMR that is registered with the U.S. achieved any type of partial designation. A
Patent and Trademark Office and in several other candidate who has passed the Level III
countries. The CFA mark must be used examination but has not yet received notice of
appropriately if AIMR is to maintain exclusive having earned the CFA charter may say, “I have
control of its use. Therefore, the CFA mark passed all three levels of the CFA Program and
must always be used as an adjective, never as will be eligible for the CFA charter upon
a noun. The mark should not be used in the completion of the required work experience” (or
plural or in the possessive. For example, a similar accurate statement as to why the charter
references to a “CFA” or a “Chartered Financial has not yet been awarded). A currently enrolled
Analyst” are improper. A proper use of the candidate may say, “I am a Level I (II or III)
designation would be to state that one is a “CFA candidate in the CFA Program.” A self-declared
charterholder” or that one “earned the right to candidate for a given level must be enrolled to
use the CFA designation.” Charterholders are not take the examination within the year. Candidates
given the CFA but are awarded the right to use should not cite the expected date of examination
the CFA designation. completion. Final award of the charter is subject
Standard II (A) of the Standards of to completion of CFA Program requirements and
Professional Conduct limits the use of the CFA AIMR Board approval.
designation to those who have received their
charters and requires that the designation be used

18
©2002, AIMR®
 1963 – 2001 CANDIDATE EXAMINATION RESULTS
ALL CFA CANDIDATES LEVEL I LEVEL II LEVEL III
Year Total % Pass Total Pass Fail % Pass Total Pass Fail % Pass Total Pass Fail % Pass
1963 284 94% — — — —% — — — —% 284 268 16 94%
1964 1,732 84% 1,241 986 255 79% 302 283 19 94% 189 179 10 95%
1965 1,993 83% 767 649 118 85% 865 678 187 78% 361 329 32 91%
1966 2,010 75% 621 481 140 77% 708 469 239 66% 681 563 118 83%
1967 1,693 83% 594 423 171 71% 556 496 60 89% 543 491 52 90%
1968 1,579 73% 592 412 180 70% 447 334 113 75% 540 414 126 77%
1969 1,316 74% 556 409 147 74% 413 322 91 78% 347 237 110 68%
1970 1,409 67% 644 424 220 66% 372 285 87 77% 393 238 155 61%
1971 1,458 69% 755 464 291 61% 341 253 88 74% 362 288 74 80%
1972 1,486 70% 731 466 265 64% 461 354 107 77% 294 214 80 73%
1973 1,630 60% 721 432 289 60% 565 324 241 57% 344 222 122 65%
1974 1,797 74% 862 604 258 70% 511 377 134 74% 424 355 69 84%
1975 1,841 75% 808 568 240 70% 563 421 142 75% 470 393 77 84%
1976 1,706 76% 634 457 177 72% 641 477 164 74% 431 363 68 84%
1977 1,993 74% 667 421 246 63% 632 510 122 81% 694 540 154 78%
1978 2,008 73% 925 596 329 64% 444 379 65 85% 639 481 158 75%
1979 1,876 76% 824 522 302 63% 550 460 90 84% 502 441 61 88%
©2002, AIMR®

1980 1,985 73% 949 602 347 63% 528 407 121 77% 508 437 71 86%
1981 2,253 71% 1,107 677 430 61% 684 580 104 85% 462 340 122 74%
1982 2,886 64% 1,532 903 629 59% 714 489 225 68% 640 469 171 73%
19

1983 3,243 65% 1,655 1,082 573 65% 978 637 341 65% 610 392 218 64%
1984 4,030 63% 2,075 1,199 876 58% 1,147 701 446 61% 808 658 150 81%
1985 4,285 67% 2,186 1,317 869 60% 1,309 965 344 74% 790 579 211 73%
1986 4,837 65% 2,366 1,405 961 59% 1,379 884 495 64% 1,092 845 247 77%
1987 5,702 62% 3,095 1,782 1,313 58% 1,555 995 560 64% 1,052 755 297 72%
1988 7,091 60% 3,927 2,174 1,753 55% 1,946 1,163 783 60% 1,218 864 354 71%
1989 8,064 62% 4,149 2,237 1,912 54% 2,484 1,590 894 64% 1,431 1,133 298 79%
1990 8,760 64% 4,415 2,658 1,757 60% 2,522 1,594 928 63% 1,823 1,360 463 75%
1991 9,868 62% 4,950 3,087 1,863 62% 3,002 1,618 1,384 54% 1,916 1,436 480 75%
1992 10,518 65% 5,002 2,928 2,074 59% 3,503 2,258 1,245 64% 2,013 1,658 355 82%
1993 12,809 59% 6,588 3,616 2,972 55% 3,679 2,061 1,618 56% 2,542 1,936 606 76%
1994 15,413 52% 8,445 4,087 4,358 48% 4,418 2,109 2,309 48% 2,550 1,859 691 73%
1995 19,516 52% 11,340 5,692 5,648 50% 5,518 2,535 2,983 46% 2,658 1,860 698 70%
1996 24,600 58% 14,381 7,669 6,712 53% 7,098 4,596 2,502 65% 3,121 2,001 1,120 64%
1997 30,642 55% 16,833 8,847 7,986 53% 8,493 5,010 3,483 59% 5,316 3,119 2,197 59%
1998 38,689 60% 21,743 12,855 8,889 59% 10,295 6,433 3,862 62% 6,650 3,895 2,755 59%
1999 45,143 60% 23,199 14,757 8,442 64% 13,496 7,329 6,167 54% 8,448 5,015 3,433 59%
2000 53,345 55% 27,625 14,314 13,311 52% 16,036 8,636 7,400 54% 9,684 6,274 3,410 65%
2001 65,707 54% 36,317 17,726 18,591 49% 17,897 8,321 9,573 46% 11,493 9,410 2,083 82%
1963–2001 407,198 59% 215,823 119,944 95,879 56% 117,052 67,334 49,715 58% 74,323 52,309 22,014 70%
 CFA Program Calendar 2002-2003

16 September 2002 Initial deadline for new registrations/enrollments to be received by AIMR

September Study Guides available and mailed to applicants

October Textbooks available for purchase from book distributor

November Past years’ essay examination questions/guideline answers for Level II and Level
III available from book distributor

16 December Second deadline for new registrations/enrollments to be received by AIMR

17 March 2003 Final deadline for new registrations/enrollments to be received by AIMR (AIMR
cannot guarantee that registrations or enrollments received after 17 March will be
accepted)

17 March Final deadline for special test center requests, disability accommodation requests,
and requests for religious alternative dates to be received by AIMR

31 March All test center changes must be received by AIMR

April Examination Admission tickets distributed

31 May 2003 Examination Day

1 June 2003 Examination Day in Eastern Asia and Oceania

June-July Examination papers graded

Late July Examination results distributed to Level I candidates

Mid-August Examination results distributed to Level II and III candidates

September CFA charterholders announced for year 2003

20
©2002, AIMR®
 2003 CFA Study and Examination Program
Textbooks: Primary Readings
Level I
• 2003 CFA Level I Candidate Readings (AIMR, 2002)
• Standards of Practice Handbook, 8th edition (AIMR, 1999)
• Quantitative Methods for Investment Analysis, Richard A. DeFusco, Dennis W. McLeavey, Jerald E.
Pinto, and David E. Runkle (AIMR, 2001)
• Economics: Private and Public Choice, 9th edition, James D. Gwartney, Richard L. Stroup, and Russell S.
Sobel (Dryden, 2000)
• The Analysis and Use of Financial Statements, 2nd edition, Gerald I. White, Ashwinpaul C. Sondhi, and
Dov Fried (Wiley, 1998)
• Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C. Brown (Dryden,
2000)
• Fundamentals of Financial Management, 8th edition, Eugene F. Brigham and Joel F. Houston (Dryden,
1998)
• Fixed Income Analysis for the Chartered Financial Analyst Program, Frank J. Fabozzi (Frank J. Fabozzi
Associates, 2000)
• Futures, Options & Swaps, 3rd edition, Robert W. Kolb (Blackwell, 1999)
Level II
• 2003 CFA Level II Candidate Readings (AIMR, 2002)
• Standards of Practice Handbook, 8th edition (AIMR, 1999)
• Standards of Practice Casebook (AIMR, 1996)
• Quantitative Methods for Investment Analysis, Richard A. DeFusco, Dennis W. McLeavey, Jerald E.
Pinto, and David E. Runkle (AIMR, 2001)
• The Analysis and Use of Financial Statements, 2nd edition, Gerald I. White, Ashwinpaul C. Sondhi, and
Dov Fried (Wiley, 1998)
• Analysis of Equity Investments: Valuation, John D. Stowe, Thomas R. Robinson, Jerald E. Pinto, and
Dennis W. McLeavey (AIMR, 2002)
• Company Performance and Measures of Value Added, Pamela P. Peterson and David R. Peterson
(Research Foundation of the ICFA, 1997)
• Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C. Brown,
(Dryden, 2000)
• Fixed Income Analysis for the Chartered Financial Analyst Program, Frank J. Fabozzi (Frank J. Fabozzi
Associates, 2000)
• Futures, Options & Swaps, 3rd edition, Robert W. Kolb (Blackwell, 2000)
Level III
• 2003 CFA Level III Candidate Readings (AIMR, 2002)
• Standards of Practice Handbook, 8th edition (AIMR, 1999)
• Standards of Practice Casebook (AIMR, 1996)
• Quantitative Methods for Investment Analysis, Richard A. DeFusco, Dennis W. McLeavey, Jerald E.
Pinto, and David E. Runkle (AIMR, 2001)
• Emerging Stock Markets: Risk, Return and Performance, Christopher B. Barry, John W. Peavy III, and
Mauricio Rodriguez (Research Foundation of the ICFA, 1997)
• Fixed Income Readings for the Chartered Financial Analyst Program, Frank J. Fabozzi (Frank J. Fabozzi
Associates, 2000)
• Futures, Options & Swaps, 3rd edition, Robert W. Kolb (Blackwell, 1999)
• Beyond Value at Risk, Kevin Dowd (Wiley, 1998)

21
©2002, AIMR®
 2003 CFA Level II Study Guide Outline
Study
Session Topic Readings
1–2 Ethical and Standards of Practice Handbook, 8th ed.
Professional Standards of Practice Casebook (Introduction plus three cases)
Standards 2003 CFA Level II Candidate Readings:
Train & Melfe; Four articles from Standards Reporter
3 Quantitative Quantitative Methods for Investment Analysis (DeFusco, McLeavey, Pinto &
Methods Runkle), Ch. 7−9
4 Economics 2003 CFA Level II Candidate Readings:
Dornbusch, Fisher, and Startz (2 chapters); Shapiro (2 chapters); Solnik &
McLeavey; Benninga & Sarig
5–7 Financial The Analysis and Use of Financial Statements, 2nd ed. (White, Sondhi, &
Statement Fried), Ch. 13, 15, 17
Analysis 2003 CFA Level II Candidate Readings:
White, Sondhi, & Fried; Brigham & Houston; Shapiro; Hawkins (2);
Robinson & Munter
8 Basic Analysis of Equity Investments: Valuation (Stowe, Robinson, Pinto, & McLeavey),
Valuation Forward, Ch. 1
Concepts Company Performance and Measures of Value Added (Peterson & Peterson)
2003 CFA Level II Candidate Readings:
Bernstein & Pigler; Bernstein, Bayer, & Pigler
9–12 Equity Investment Analysis and Portfolio Management, 6th ed. (Reilly & Brown), Ch.
Investments 12, 20
Analysis of Equity Investments: Valuation (Stowe, Robinson, Pinto, and
McLeavey), Ch. 2–5
2003 CFA Level II Candidate Readings:
Porter; Hooke; Lee; Pratt, Reilly, & Schweihs (2 chapters); Gardella
13–15 Debt Fixed Income Analysis for the Chartered Financial Analyst Program
Investments (Fabozzi), Level I, Ch. 7; Level II, Ch. 1–5, 8, 9
Investment Analysis and Portfolio Management, 6th ed. (Reilly & Brown), Ch.
25
16–17 Derivative Futures, Options & Swaps, 3rd ed. (Kolb), Ch. 3, 4, 5, 7, 9, 11, 13, 14, 16, 20,
Investments 21
Fixed Income Analysis for the Chartered Financial Analyst Program
(Fabozzi), Level II, Ch. 7
2003 CFA Level II Candidate Readings:
Figlewski
18 Portfolio Investment Analysis and Portfolio Management, 6th ed. (Reilly & Brown), Ch.
Management 8–10
2003 CFA Level II Candidate Readings:
Bodie, Kane, & Marcus
Study Essay Questions and Guideline Answers (2000, 2001, and 2002)
Review

22
©2002, AIMR®
 Ethical and Professional Standards
The candidate should be able to apply knowledge of the AIMR Code of Ethics and Standards of
Professional Conduct to recognize and avoid unprofessional practices and violations of the Code
and Standards involving plagiarism, duty to employer, disclosure of conflicts of interest and
additional compensation arrangements, responsibilities of supervisors, reasonable basis and
representations, research reports, independence and objectivity, fair dealing, inside information,
the Prudent Investor Rule, and soft dollars, among others.
Study Session 1
Ethical and Professional Standards

Reading Assignments
1. “Code of Ethics,” p. 1, Standards of Practice Handbook, 8th edition (AIMR, 1999)
2. “Standards of Professional Conduct,” pp. 2–7, Standards of Practice Handbook, 8th edition
(AIMR, 1999)
3. Standards of Practice Handbook, 8th edition, “Preface” and pp. 9–283 (AIMR, 1999)
*
4. “Prudence in Perspective,” Ch. 2 including Appendixes 3 and 4, Investing and Managing
Trusts under the New Prudent Investor Rule, John Train and Thomas A. Melfe, (Harvard
Business School Press, 1999)

Learning Outcomes
1. “Code of Ethics”
The Code of Ethics establishes the framework for ethical decision making in the investment
profession. The candidate should be able to state the four components of the Code of
Ethics.

2. “Standards of Professional Conduct”

The AIMR Standards are organized into five categories:
I. Fundamental Responsibilities
II. Relationships with and Responsibilities to the Profession
III. Relationships with and Responsibilities to the Employer
IV. Relationships with and Responsibilities to Clients and Prospects
V. Relationships with and Responsibilities to the Investing Public
Each category contains multiple concepts for which the candidate is responsible. The
candidate should be able to identify the ethical responsibilities required by the Code and
Standards in these areas.

3. Standards of Practice Handbook

The Handbook addresses the application of the Code and Standards. For each standard, the
Handbook discusses the purpose and scope of the standard, the application of the standard
to factual situations, and procedures for complying with the standard. Topical studies
address the application of the Code and Standards in five specific areas: (1) fiduciary duty,

*
Readings marked with an asterisk are contained in the 2003 CFA Level II Candidate Readings.
23
©2002, AIMR®
 (2) insider trading, (3) personal investing, (4) corporate governance, and (5) AIMR’s Soft
Dollar Standards.

The candidate should focus on (1) “the purpose and scope of the standard” for each
standard, (2) the “application of the standard” for each standard, and (3) the five topical
studies.

The candidate should be able to

a) interpret the Code and Standards in the context of specific situations;
b) explain the application of the Code and Standards in situations that present multiple
issues of questionable professional conduct;
c) identify violations of the Code and Standards;
d) interpret the topical studies as they relate to the Code and Standards;
e) identify disciplinary procedures and sanctions set forth in the Code and Standards.

4. “Prudence in Perspective”
The candidate should be able to
a) state the five basic principles of the New Prudent Investor Rule;
b) explain the general fiduciary standards to which a trustee must adhere;
c) differentiate between the old Prudent Man Rule and the new Prudent Investor Rule
from the perspectives of individual investments, total portfolio, and delegation of
duty;
d) discuss the general fiduciary standards carried over from the old Prudent Man Rule to
the new Prudent Investor Rule.

24
©2002, AIMR®
Study Session 2
Ethical and Professional Standards

Reading Assignments
1. Standards of Practice Casebook (AIMR, 1996)
A. “Introduction”
B. “The Glenarm Company,” Glen A. Holden, Jr.
C. “Preston Partners,” Jules A. Huot
D. “Super Selection,” Paul F. Van Schyndel
2.* “Trade Allocation: Fair Dealing and Disclosure,” Standards Reporter (AIMR,
November/December 1996)
3.* “Case Study: Changing Investment Objectives,” Standards Reporter (AIMR,
January/February 1998)
4.* “Compensation for Trading Errors,” Standards Reporter (AIMR, September/October 1998)
5.* “Case Study: Soft Dollars,” Standards Reporter (AIMR, May/June 1997)

Learning Outcomes
Note: For each of the assigned readings in this study session, the candidate should be able to
a) evaluate the conduct described in each reading with respect to the Code and
Standards;
b) distinguish between conduct that complies with the Code and Standards and conduct
that violates the Code and Standards;
c) demonstrate the appropriate actions to take in response to conduct that violates the
Code and Standards;
d) draft compliance procedures to implement the principles and requirements of the
Code and Standards.
In addition, candidates are responsible for the specific learning outcomes for each reading.

1. Standards of Practice Casebook

Note: The Standards of Practice Casebook is based on an earlier edition of the Standards
of Practice Handbook. Although the Casebook has not changed, certain references,
including the statement of the Standards of Professional Conduct on pages 5–9, have been
superseded by the 8th edition of the Standards of Practice Handbook.

The candidate should be able to identify violations of the AIMR Code of Ethics and
Standards of Professional Conduct and demonstrate the appropriate response to ethically
challenging situations. The cases are designed to present issues in a way that closely
approximates how individuals practicing in the investment industry encounter ethical issues
in their day-to-day activities. The “Introduction” is a guide to effective use of the Standards
of Practice Casebook and includes a brief description of AIMR’s Disciplinary Process.
The cases discuss several important aspects of the Code and Standards. Subheadings of
each case discussion provide guidance on the important concepts contained in that case.

*
Readings marked with an asterisk are contained in the 2003 CFA Level II Candidate Readings.
25
©2002, AIMR®
2. “Trade Allocation: Fair Dealing and Disclosure”
The candidate should be able to
a) demonstrate the violations of the Code and Standards that occur by entering into
trading allocations on an ad hoc basis;
b) describe the steps necessary to ensure that adequate trade allocation practices are
followed.

3. “Case Study: Changing Investment Objectives”

The candidate should be able to
a) demonstrate the violations of the Code and Standards that occur through improper
disclosure of investment product or style;
b) describe the steps necessary to ensure adequate disclosure of the investment process.

4. “Compensation for Trading Errors”

The candidate should be able to demonstrate how improperly attempting to compensate for
trading errors may lead to potential violations of the Standards of Professional Conduct.

5. “Case Study: Soft Dollars”

The candidate should be able to
a) state the two fundamental principles involved in evaluating any soft dollar
arrangements;
b) identify four requirements for meeting fiduciary obligations with regard to soft dollar
arrangements;
c) identify violations of the Standards of Professional Conduct through improper use of
soft dollar arrangements.

26
©2002, AIMR®
 Quantitative Methods
The candidate should be able to demonstrate a thorough knowledge of and the ability to apply
decision making under uncertainty, correlation analysis, and linear and multiple regression
analysis.
Study Session 3
Investment Tools
Quantitative Methods for Valuation

Reading Assignments
1. Quantitative Methods for Investment Analysis, Richard A. DeFusco, Dennis W. McLeavey,
Jerald E. Pinto, and David E. Runkle (AIMR, 2001)
A. “Hypothesis Testing,” Ch. 7
B. “Correlation and Regression,” Ch. 8
C. “Multiple Regression and Issues in Regression Analysis,” Ch. 9

Note: Candidates are responsible for the problems at the end of each chapter. Solutions to the
problems are found at the end of each chapter.

Learning Outcomes
1. A. “Hypothesis Testing”
The candidate should be able to
a) distinguish between one-tailed and two-tailed hypothesis tests;
b) define and interpret a Type I and a Type II error;
c) discuss how the choice of significance level affects the probabilities of Type I
and Type II errors;
d) distinguish between a statistical decision and an economic decision;
e) discuss the p-value approach to hypothesis testing;
f) select the test statistic for a hypothesis test regarding the population mean of a
normal distribution with (1) known or (2) unknown variance;
g) formulate a null and an alternative hypothesis about a population mean and
determine whether the null hypothesis is rejected at a given level of
significance;
h) formulate a null and an alternative hypothesis about the equality of two
population means (normally distributed populations, independent samples),
select the appropriate test statistic, and determine whether the null hypothesis is
rejected at a given level of significance;
i) formulate a null and an alternative hypothesis about the mean difference of two
normal populations (paired comparisons test), select the appropriate test
statistic, and determine whether the null hypothesis is rejected at a given level
of significance;
j) discuss the choice between tests of differences between means and tests of mean
differences in relation to the independence of samples;

27
©2002, AIMR®
 k) formulate a null and an alternative hypothesis about the variance of a normally
distributed population, select the appropriate test statistic, and determine
whether the null hypothesis is rejected at a given level of significance;
l) formulate a null and an alternative hypothesis about the equality of the
variances of two populations (normally distributed, independent samples), select
the appropriate test statistic, and determine whether the null hypothesis is
rejected at a given level of significance;
m) distinguish between parametric and nonparametric tests, and describe the
situations where the use of nonparametric tests may be appropriate.

Corrections/Clarifications

• On page 324, delete “equals or” in the last line of text immediately before Figure 7-2. In the
Figure itself, the Rejection Region should be z > 1.645.

• On page 335, in Example 7-4 Solution to 4, change 119 to 120 in the two places 119 appears
as the denominator. This changes the resulting equation to –0.89/0.602704 = –1.477. The
corrected t value of –1.477 is still not significant at the 0.10, 0.05, or 0.01 levels.

• On page 343, in the last sentence of the boxed Example 7-7, insert the word “cannot”
between “We” and “conclude.” (“We cannot conclude ...”)

• On page 345, replace the last two sentences of Example 7-8 with the following: “Because
1.434 is less than the critical value 1.61, we cannot reject the null hypothesis that the
population variance of returns is the same in the pre- and post-crash periods.”

• On page 359, the third line should read: “Thus, t = (77.74 minus 42.56) ...” instead of 77.74
+ 42.56.

B. “Correlation and Regression”

The candidate should be able to
a) calculate the covariance between two random variables;
b) calculate and interpret a correlation coefficient;
c) 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;
d) explain how outliers can affect correlations;
e) explain the nature of spurious correlation;
f) calculate the standard error of the estimate and the coefficient of determination;
g) calculate a confidence interval for a regression coefficient;
h) formulate a null and an alternative hypothesis regarding a population value of a
regression coefficient, select the appropriate test statistic, and determine
whether the null hypothesis is rejected at a given level of significance;
i) interpret a regression coefficient;

28
©2002, AIMR®
 j) calculate a predicted value for the dependent variable given an estimated
regression model and a value for the independent variable;
k) calculate and interpret a confidence interval for the predicted value of a
dependent variable;
l) describe the use of analysis of variance (ANOVA) in regression analysis;
m) define and interpret an F-statistic;
n) discuss the limitations of regression analysis.

Corrections/Clarifications

• On page 408 the first line of Problem 10(d) should state “Define Regression SS ...” instead
of “... MSS.”

• On page 418 at the end of solution to Problem 4, the calculation of the correlation
coefficient should have a denominator of 12.91 × 0.8165.

• On page 421 in the solution to 12(a) the estimated variance of the prediction error should
equal 0.66694. The remainder of the answer is unchanged.

C. “Multiple Regression and Issues in Regression Analysis”

The candidate should be able to
a) formulate a multiple regression equation to describe the relationship between a
dependent variable and several independent variables, determine the statistical
significance of each independent variable, and interpret the coefficients;
b) 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 the null hypothesis is rejected at a given level of significance, using a
one-tailed or two-tailed test;
c) calculate a confidence interval for the population value of a regression
coefficient in a multiple regression;
d) explain the assumptions of a multiple regression model;
e) discuss the residual and its relationship to the standard error of estimate;
f) calculate the standard error of estimate, given the sum of squared residuals from
the regression, the number of observations, and the number of independent
variables;
g) calculate a predicted value for the dependent variable, given an estimated
regression model and assumed values for the independent variables;
h) define, calculate, and interpret the F-statistic and discuss how it is used in
regression analysis;
i) define, distinguish between, and interpret the R2 and adjusted R2 in multiple
regression;
j) infer how well a regression model explains the dependent variable by analyzing
the output of the regression equation and an ANOVA table;

29
©2002, AIMR®
 k) formulate a multiple regression equation using dummy variables to represent
qualitative factors and interpret the coefficients;
l) define and discuss conditional and unconditional heteroskedasticity;
m) describe serial correlation and discuss its effect on statistical inference;
n) explain how to test and correct for heteroskedasticity and serial correlation;
o) calculate and interpret a Durbin-Watson statistic;
p) describe multicollinearity and discuss its causes and effects in regression
analysis;
q) discuss models for qualitative dependent variables;
r) interpret the economic meaning of the results of multiple regression analysis.

Corrections/Clarifications

• In Example 9-11 (pages 457 through 459), numbers in the example text were transferred
incorrectly from Tables 9-11 and 9-12. The standard error, t-statistic, coefficient, and R2
numbers shown in the text should be the same as those shown in the tables.

• In Example 9-11, replace the last sentence on page 457 with “This result implies that
returns on the FSTF are more volatile than returns on the growth index.”

• On the top of page 459, in the last paragraph of Example 9-11, delete the sentence
beginning with “In fact ...” and ending “greater than 1.”

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 Economics
The candidate should be able to interpret and apply forecasts of domestic and international
economic and industrial activity in the valuation of markets and investment alternatives, analyze
the relationships among domestic and foreign economies and markets, relate the economic cycle
to various industries and companies, and use economic information to analyze company and
industry trends and to make investment valuations.
Study Session 4
Investment Tools
Economics for Valuation

Reading Assignments
1.* Macroeconomics, 8th edition, Rudiger Dornbusch, Stanley Fischer, and Richard Startz
(McGraw-Hill/Irwin, 2001)
A. “Growth and Accumulation,” Ch. 3
B. “Growth and Policy,” Ch. 4
2. Foundations of Multinational Financial Management, 3rd edition, Alan C. Shapiro
*

(Prentice Hall, 1998)

A. “The Foreign Exchange Market,” Ch. 5
B. “Parity Conditions in International Finance and Currency Forecasting,” Ch. 7
3.* “International Asset Pricing,” Ch. 5, International Investments, 5th edition, Bruno Solnik
and Dennis McLeavey (Addison Wesley Longman, forthcoming)
4.* “Analyzing the Firm’s Environment,” Ch. 5, Corporate Finance: A Valuation Approach,
Simon Benninga and Oded Sarig (McGraw–Hill, 1997)

Learning Outcomes
1. A. “Growth and Accumulation”
Note: Suggested problems from the end of this chapter are included below. Solutions
are reprinted in the 2003 Level II Candidate Readings.

The candidate should be able to

a) explain the production function approach to analyzing the sources of economic
growth;
b) distinguish between input growth and growth in total factor productivity as
components of economic growth;
c) describe the importance of factor shares of income in determining economic
growth;
d) calculate growth in economic output by applying the growth accounting
equation;
e) contrast growth in total output with growth in per capita output;
f) define convergence and analyze an example of convergence using the growth
accounting framework;

*
Readings marked with an asterisk are contained in the 2003 CFA Level II Candidate Readings.
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 g) discuss the influence of natural resources and human capital on economic
growth;
h) demonstrate how neoclassical growth theory can be used to explain trends in
economic growth.
Problems: Technical 1, 3, 8

B. “Growth and Policy”

The candidate should be able to
a) describe endogenous growth theory and contrast the implications of endogenous
growth theory and neoclassical growth theory;
b) explain the implications for growth of the difference between private returns
and social returns to capital;
c) distinguish between absolute convergence and conditional convergence and
discuss the implications of the distinction for understanding international
differences in growth rates;
d) discuss the relationships between population growth and economic growth in
the context of a growth model;
e) describe how a growth model can be used to analyze the growth experience of
countries such as the “Asian Tigers;”
f) describe the key features of a plan for reforming economies that have operated
under a highly centralized system;
g) evaluate the argument that the limited availability of natural resources places
limits on economic growth;
h) discuss the factors that are likely to promote economic growth.

2. A. "The Foreign Exchange Market”

The candidate should be able to
a) calculate the spread on a foreign currency quotation;
b) explain how spreads on foreign currency quotations can differ as a result of
market conditions, bank/dealer positions, trading volume, and (for forward
contracts) maturity/length of contract;
c) calculate currency cross rates, given two spot or forward foreign exchange
quotations involving three currencies;
d) calculate the profit on a triangular arbitrage opportunity, given three currency
quotations;
e) compute the effect of transaction costs (spreads) on a foreign exchange arbitrage
opportunity;
f) calculate a forward discount or premium and express either as an annualized
rate;
g) explain the theory of interest rate parity;
h) compute covered interest arbitrage and determine whether an arbitrageur can
profit from given interest rate and currency differentials;
i) calculate a forward rate under an assumption of interest rate parity;
j) calculate a covered interest differential, taking into account transaction costs.

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 Corrections/Clarifications

• On page 111, in the first illustration, in the 8th line of the solution, replace $1.7036 with
$1.4436.

• On page 117, the 90-day British pound was selling at a 0.59% discount rather than the
amount stated. In the formula immediately following, the result should be 0.0059 instead
of 0.0153.

• On page 119, the example indicates that the investor should convert the $1 million to
DM at the spot rate of DM 1.5311/$, which is presented as generating DM 1,533,110.
This result should be corrected to DM 1,531,100 throughout the discussion. The rest of
the illustration is consistent with this correction. The final sum of $1,019,996.39 is
rounded to $1,020,000.

• On page 120, Figure 5.7 has the same typographical error as is on page 119.

• On page 123, Illustration Step 3 should conclude: $327,328.44($317,313.25 ×

1.0315625).

B. “Parity Conditions in International Finance and Currency Forecasting”

The candidate should be able to
a) calculate for a specified currency, the exchange rate implied by purchasing
power parity (PPP);
b) calculate a real (inflation-adjusted) exchange rate for a currency and compare
that rate with the PPP-determined rate;
c) determine the relative levels of inflation among countries, using observed spot
and forward exchange rate relationships;
d) discuss the implications of purchasing power parity for the movement of
exchange rates;
e) differentiate between capital market integration and capital market segmentation
and infer the effects of each on a country’s equilibrium interest rates and
exchange rates;
f) calculate the expected nominal and real interest rates produced by the Fisher
effect;
g) estimate a future exchange rate based on the international Fisher effect;
h) calculate an expected future spot exchange rate based on the unbiased forward
rate relationship.

Corrections/Clarifications

In Exhibit 7.5 on page 165 of the original text, Point D of the graph should be located at
coordinates (−3,−2) rather than the current location. The describing text is correct; the location
on the graph is incorrect.
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3. “International Asset Pricing”
Note: Candidates are responsible for the practice problems at the end of the chapter.
Answers to the chapter problems are found at the end of the chapter.

The candidate should be able to

a) explain international market integration and international market segmentation;
b) discuss the impediments to international capital mobility;
c) discuss the factors that favor international market integration;
d) explain the extension of the domestic capital asset pricing model (CAPM) to an
international context (the extended CAPM);
e) determine whether the real exchange rate changes in a period, given the beginning-of-
period (nominal) exchange rate, the inflation rates in the period, and the end-of-period
(nominal) exchange rate;
f) calculate the expected exchange rate and the expected domestic-currency holding
period return on a foreign bond (security), given expected and predictable inflation
rates for the period, the beginning-of-period nominal exchange rate, and the real
exchange rate (assumed to be constant);
g) calculate the end-of-period real exchange rate and the domestic-currency ex-post
return on a foreign bond (security), given the end-of-period exchange rate, the
beginning-of-period real exchange rate, and the inflation rates during the period;
h) explain a foreign currency risk premium in terms of interest rate differentials and in
terms of the forward rate;
i) calculate a foreign currency risk premium;
j) calculate the expected returns on a stock using the international capital asset pricing
model (ICAPM), given its world market beta and currency exposure as well as the
appropriate risk-free rates and risk premiums;
k) define currency exposure and explain exposures in terms of correlations;
l) explain the effect of market segmentation on the ICAPM;
m) discuss the likely exchange rate exposure of a company based on a description of its
activities and explain the impact of both real and nominal exchange rate changes on
the valuation of the company;
n) discuss the currency exposures of national economies, equity markets, and bond
markets;
o) explain the models that relate real exchange rate changes to domestic economic
activity.

4. “Analyzing the Firm’s Environment”

The candidate should be able to
a) estimate the future relationship between gross domestic product (GDP) growth and
industry sales, using historical data for each variable;
b) forecast and interpret industry sales by applying the estimated relationship between
GDP growth and industry sales to a forecasted GDP growth rate;
c) interpret the results of a regression analysis of industry sales on an economic variable,
such as annual changes in real GDP;

34
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 d) determine whether data measuring sales and other economic variables should include
or exclude, depending on the purpose of the analysis, the effect of inflation or
deflation, and calculate adjustments as appropriate;
e) infer industry and company performance under conditions specified in an economic
forecast, using industry/company performance at various points in past business
cycles;
f) identify and explain changes in the market shares of firms in an industry as
macroeconomic conditions change;
g) determine the current stage of a product’s life cycle and infer implications for product
sales, profits, and competition, using historical data and information about the
product;
h) differentiate between a product life cycle and broader industry trends in product
development;
i) explain the significance of “regression toward the mean” as a tendency in industry
profits;
j) identify and discuss factors that may contribute to changes in a company’s market
share of an industry’s sales;
k) estimate how a company’s market share is affected by changes in the company’s
marketing efforts and by changes in competition;
l) calculate a company’s growth rate, given the industry growth rate and the company’s
projected change in market share.

Corrections/Clarifications

• On page 144 of the original text, in the ninth line, “$86.6 billion” should be “$85.9 billion.”

• On page 152 of the original text, the first line below the first equation should read: “where N
is … and ΣMj denotes…”

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 Financial Statement Analysis
The candidate should be able to analyze and use financial statements and disclosures in the
investment valuation process; analyze a company’s liquidity, profitability, financial stability,
solvency, and asset utilization; and analyze the effect of alternative accounting methods and
assumptions on financial statements. The candidate should be familiar with the forms,
terminology, and financial significance of mergers and acquisitions. The candidate should also
be able to analyze differences among U.S., country-specific, and international accounting
standards, and incorporate the findings into financial and valuation analyses.

Some of the accounting concepts in the Financial Statement Analysis study sessions (Session 5
through Session 7) may be superseded by updated rulings and/or announcements issued after a
reading was published. Although candidates are not expected to learn material that is outdated,
they should be familiar with the overall analytical framework contained in these sessions.
Candidates will not be penalized for applying updated rules.

The reading assignments include specific problems that are helpful in understanding the
important concepts in each reading. Answers to the questions, exercises, problems, and cases are
in the Solutions Manual for The Analysis and Use of Financial Statements by Gerald I. White,
Ashwinpaul C. Sondhi, and Dov Fried (2nd edition, Wiley, 1998). The Solutions Manual is listed
in the Supplemental Material on the textbook order form in this Study Guide. Except where
noted, the “Boxes” in this book are not part of the Level II reading assignment. Reading 2 in
study session 5 is the revised Ch. 14 from the forthcoming The Analysis and Use of Financial
Statements, 3rd edition. The solutions for the problems assigned in Ch.14 are printed in the
candidate readings book.

Study Session 5
Investment Tools
Financial Statement Analysis: Intercorporate Investments and Business Combinations

Reading Assignments
1. “Analysis of Intercorporate Investments,” Ch. 13, pp. 671–717, The Analysis and Use of
Financial Statements, 2nd edition, Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried
(Wiley, 1998)
2.* “Analysis of Business Combinations,” Ch. 14 including Box 14-1, but omitting “Income
Tax Effects of Business Combinations” (pp. 23−27) and “Push-Down Accounting” (pp.
37−40), The Analysis and Use of Financial Statements, 3rd edition, Gerald I. White,
Ashwinpaul C. Sondhi, and Dov Fried (Wiley, forthcoming)
*
3. “Mergers, LBOs, Divestitures, and Holding Companies,” Ch. 21, Fundamentals of
Financial Management, 8th edition, Eugene F. Brigham and Joel F. Houston (Dryden,
1998)

*
Readings marked with an asterisk are contained in the 2003 CFA Level II Candidate Readings.
36
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Learning Outcomes
1. “Analysis of Intercorporate Investments”
The candidate should be able to
a) determine whether a debt security or equity security should be classified as held to
maturity, available for sale, or as a trading security;
b) compute the effect of debt-security and equity-security classification on the financial
statements and financial ratios;
c) compute the mark-to-market investment return on an investment portfolio;
d) calculate the balance sheet carrying value of an investment, using the cost method,
equity method, and consolidation method;
e) determine, given various ownership and/or control levels and relevant accounting
standards, whether the cost method, equity method, proportionate consolidation
method, or consolidation method should be used;
f) differentiate among the cost method, equity method, consolidation method, and
proportionate consolidation method, and compare the effects of using each method on
a company’s financial statements and financial ratios;
g) define a reportable segment, and discuss the uses and limitations of the data;
h) analyze, prepare, and illustrate the disclosure requirements for a reportable segment.
Problems: 13-1, 13-5, 13-6, 13-13, 13-15

2. “Analysis of Business Combinations”

The candidate should be able to
a) describe the purchase methods of accounting for business combinations under
International Accounting Standards Board (IASB) and U.S. Generally Accepted
Accounting Principles (GAAP) and describe the pooling of interests method under
IASB GAAP;
b) compare and contrast the pooling method under IASB GAAP to the purchase
methods under U.S. and IASB GAAP;
c) identify the conditions under which the pooling-of-interests method can be used
according to IASB GAAP;
d) construct consolidated balance sheets and income statements, according to both U.S
and IASB GAAP, using the purchase method;
e) construct a consolidated balance sheet and income statement, according to IASB
GAAP, using the pooling method;
f) compare and contrast the effects of the pooling method to the two variants of the
purchase method on the balance sheet, the income statement, and the statement of
cash flows, and various financial ratios;
g) compare the effects of the three acquisition accounting methods on the various
financial ratios;
h) describe goodwill and discuss its treatment for purposes of financial analysis
according to U.S. and IASB GAAP;
i) analyze the effects of a spin-off on a firm’s financial statements.
Problems: 1−6

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3. “Mergers, LBOs, Divestitures, and Holding Companies”
Note: Suggested Questions (Q) and Problems (P) from the end of this chapter are included
below. Solutions are reprinted in the 2003 Level II Candidate Readings.

The candidate should be able to

a) analyze rationales for a potential merger;
b) analyze and differentiate among sources of synergistic effects from mergers;
c) differentiate among horizontal, vertical, congeneric, and conglomerate mergers;
d) differentiate between hostile and friendly mergers;
e) differentiate between financial and operating mergers;
f) determine the value to the acquiring company of a potential acquisition target
company;
g) evaluate a potential merger using discounted cash flow analysis and market multiple
analysis;
h) discuss the role of investment bankers in mergers;
i) discuss the defensive tactics that a target company can use against the threat of a
hostile takeover;
j) differentiate among mergers, corporate alliances, and leveraged buyouts;
k) discuss the different forms a divestiture may take and the reasons for divestitures;
l) define a holding company and list advantages and disadvantages of this
organizational form.
Questions/Problems: Q 21-1, 21-3, 21-5; P 21-1, 21-2, 21-3, 21-4, 21-6

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Study Session 6
Investment Tools
Financial Statement Analysis: Global Issues

Reading Assignments
1.* “Measuring Accounting Exposure,” Ch. 8, Foundations of Multinational Financial
Management, 3rd edition, Alan C. Shapiro (Prentice Hall, 1998)
2. “Analysis of Multinational Operations,” Ch. 15, pp. 819–854, The Analysis and Use of
Financial Statements, 2nd edition, Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried
(Wiley, 1998)
*
3. “Accounting Bulletin #99, International Accounting Standards: Updated Review, Handling
Diversity and U.S. GAAP Contrasted,” David F. Hawkins (Merrill Lynch, 2001)

Learning Outcomes
1. “Measuring Accounting Exposure”
The candidate should be able to
a) distinguish between a company’s accounting (translation) exposure and economic
(operating and transaction) exposure to exchange rate changes;
b) compare and contrast the four principal currency translation methods;
c) compute a company’s translation exposure and any resulting translation gain or loss;
d) distinguish between the functional currency and the reporting currency.

2. “Analysis of Multinational Operations”

Note: Candidates are not required to read the cases.
The candidate should be able to
a) determine the impact of changes in local currency sales and changes in exchange
rates on the translated sales of the subsidiary and parent company;
b) distinguish between the all-current method and the temporal method, explain the
effects of each on the parent’s balance sheet and income statement, and determine
which method is appropriate in various scenarios;
c) calculate the translation effects and evaluate the translation of a subsidiary’s balance
sheet and income statement into the parent’s currency using the all-current method
and the temporal method;
d) determine how the translation of a subsidiary’s financial statements will affect the
subsidiary’s financial ratios;
e) determine how using the temporal method versus the all-current method will affect
the parent company’s financial ratios;
f) discuss alternative accounting methods for hyperinflationary subsidiaries.
Problems: 15-1, 15-3, 15-4

*
Readings marked with an asterisk are contained in the 2003 CFA Level II Candidate Readings.
39
©2002, AIMR®
3. “Accounting Bulletin #99, International Accounting Standards: Updated Review,
Handling Diversity and U.S. GAAP Contrasted”
The candidate should be able to describe the differences between the IASB and US GAAP
treatment of
• upward revaluation of tangible and intangible assets
• acquired-in-process R&D
• cash flow statements
• intangible assets amortization
• development costs
• segment disclosures
• asset impairment.

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Study Session 7
Investment Tools
Financial Statement Analysis: Earnings Quality Issues

Reading Assignments
1.* “Understanding Retirement Benefit Accounting and Disclosures for Financial Analysis,”
Thomas R. Robinson and Paul Munter (AIMR, 2002)
*
2. “Accounting Bulletin #69, Detecting Lower Earnings Quality,” David F. Hawkins (Merrill
Lynch, 1998)
3. “Analysis of Financial Statements: A Synthesis,” Ch. 17, The Analysis and Use of
Financial Statements, 2nd edition, Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried
(Wiley, 1998)

Learning Outcomes
1. “Understanding Retirement Benefit Accounting and Disclosures for Financial
Analysis”
The candidate should be able to
a) explain the differences in accounting for defined contribution and defined benefit
pension plans;
b) distinguish between pay-related and non-pay related pension plans;
c) explain the following measures of defined benefit pension plan liabilities:
• projected benefit obligation
• accumulated benefit obligation
• vested benefit obligation;
d) explain the following terms related to defined benefit pension plans and other
retirement benefits and discuss the impact of each on expenses, assets, and liabilities:
• service cost
• interest cost
• actual return on plan assets
• expected return on plan assets
• prior service cost and related amortization
• net gains and losses and related amortization
• transition liability and related amortization
• contributions
• benefits paid
• accumulated postretirement benefit obligation;
e) explain the effect of changes in the following pension and other retirement plan
assumptions on measures of liability and expense, and on the financial statements and
ratios:
• discount rate
• rate of compensation increase

*
Readings marked with an asterisk are contained in the 2003 CFA Level II Candidate Readings.
41
©2002, AIMR®
 • rate of return on plan assets
• healthcare inflation rate;
f) explain and calculate the minimum liability adjustment;
g) explain the differences between U.S. Generally Accepted Accounting Principles
(GAAP) and International Accounting Standards (IASB) for pension and other post-
retirement benefit plans;
h) compute the liability (or asset) to be reported on a company’s balance sheet based
upon pension and other post-retirement benefit disclosures under U.S. GAAP;
i) calculate the underlying economic liability (or asset) of a company based upon
pension and other post-retirement benefit disclosures;
j) calculate the pension or other post-retirement benefit expense (income) to be reported
on a company’s income statement based upon footnote and other disclosures under
U.S. GAAP;
k) calculate the underlying economic pension and other post-retirement expense
(income) based upon disclosures on both an operating and net basis;
l) determine which measure of underlying pension expense is better suited for
evaluating past performance versus forecasting;
m) compute and analyze the impact of retirement benefit accounting on reported
financial statement results and ratios, including:
• adjusting pension and other retirement benefit assets and liabilities for off-
balance sheet items, and
• adjusting pension and other retirement benefit expense for the impact of
amortized items and non-operating items.

2. “Accounting Bulletin #69, Detecting Lower Earnings Quality”

The candidate should be able to identify and discuss accounting practices that contribute to
a deterioration of earnings quality, including
• research and development in progress write-offs arising from business acquisitions
• restructuring charges
• unrecorded stock-option compensation costs
• front-end income loading
• deferral of costs
• recognition of deferred-tax assets
• classification of expenditures
• use of reserves
• adoption of less conservative accounting estimates, practices, and principles.

3. “Analysis of Financial Statements: A Synthesis”

The candidate should be able to
a) modify the balance sheet for assets and liabilities that are not recorded;
b) modify the balance sheet for the current value of assets and liabilities;
c) compute a company’s normal operating earnings and comprehensive income;

42
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d) determine and interpret the effect on reported financial results and ratios of a
company’s choices of accounting methods and assumptions (e.g., inventory methods,
depreciation methods, lease or purchase of long term assets);
e) determine and interpret the effect on reported financial results and ratios of changes
in accounting methods and assumptions (e.g., depreciation methods or assumptions,
employee benefit plan assumptions);
f) determine and interpret the effects of balance sheet modifications and earnings
normalization on a company's financial statements, financial ratios and overall
financial condition;
g) identify indicators of high and low earnings quality;
h) illustrate how accounting choices affect whether cash flows are classified as
operating, financing, or investing.
Case: 17-1 (1, 2, 3)

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 Asset Valuation
The candidate should be able to analyze and apply concepts, such as discounted cash flow and
sustainable growth, that are basic to the valuation of all asset classes. Asset valuation at Level I
emphasizes the characteristics of different asset classes, often focusing on key differences among
these characteristics. At Level II the emphasis shifts to the analysis and valuation of various
assets.
Study Session 8
Asset Valuation
Basic Valuation Concepts

Reading Assignments
1. Analysis of Equity Investments: Valuation, John D. Stowe, Thomas R. Robinson, Jerald E.
Pinto, and Dennis W. McLeavey (AIMR, 2002)
A. “Forward,” by George H. Troughton
B. “Equity Valuation Process,” Ch. 1
2. Company Performance and Measures of Value Added, pp. 1–47, Pamela P. Peterson and
David R. Peterson (Research Foundation of the ICFA, 1997)
3. *
“An Analysis of EVA,” Richard Bernstein and Carmen Pigler, Quantitative Viewpoint
(Merrill Lynch, 19 December 1997)
4. *
“An Analysis of EVA − Part II,” Richard Bernstein, Kari Bayer, and Carmen Pigler,
Quantitative Viewpoint (Merrill Lynch, 3 February 1998)

Note: Candidates are responsible for the practice problems at the end of reading 1B. Solutions to
the problems are found at the end of the chapter.

Learning Outcomes
1. A. “Forward”
The candidate should be able to
a) explain how the classic works of Graham and Dodd and John Burr Williams are
reflected in modern security analysis;
b) identify where Modern Portfolio Theory (MPT) has been incorporated into
modern equity valuation models;
c) list the basic rudiments of dividend discount models, free cash flow models,
market multiple models, and residual income models.

B. “Equity Valuation Process”

The candidate should be able to
a) define valuation and discuss the uses of valuation models;
b) discuss the importance of expectations in the use of valuation models;
c) define and calculate alpha;
d) contrast top-down and bottom-up approaches to equity analysis;
e) contrast quantitative and qualitative factors in valuation;

*
Readings marked with an asterisk are contained in the 2003 CFA Level II Candidate Readings.
44
©2002, AIMR®
 f) discuss the importance of quality of inputs in valuation;
g) discuss the importance of the interpretation of footnotes to accounting
statements and other disclosures;
h) contrast the going-concern and non-going-concern assumptions in valuation;
i) contrast absolute and relative valuation models;
j) discuss the role of ownership perspective in valuation.

2. Company Performance and Measures of Value Added

The candidate should be able to
a) calculate the traditional measures of performance;
b) analyze the advantages and disadvantages of using return on investment ratios and
Tobin’s Q as measures of company performance;
c) distinguish between economic profit and accounting profit and relate economic profit
to net present value;
d) calculate economic value added (EVA) and market value added (MVA);
e) describe the process for determining cash flow return on investment (CFROI);
f) demonstrate the link between EVA and MVA;
g) explain the differences among EVA, MVA, and CFROI;
h) compare the empirical relationship between stock returns and value-added measures
with the empirical relationship between stock returns and more traditional valuation
measures;
i) discuss the reasons why market-value-added measures may not be superior to stock
returns in measuring corporate performance.

3. “An Analysis of EVA”

The candidate should be able to
a) briefly explain EVA and MVA and the connection between the two concepts;
b) demonstrate how EVA can be used as a criterion for selecting stocks;
c) discuss the risk–return results of selection strategies based on EVA and MVA as well
as several other traditional measures of valuation (see also Reading 2, LOS h).

4. “An Analysis of EVA − Part II”

The candidate should be able to
a) explain why investment strategies based on the growth in EVA and/or the growth in
MVA might be more closely related to future stock performance than strategies based
on the absolute levels of EVA and/or MVA;
b) relate EVA and MVA to value and/or momentum strategies.

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 Analysis of Equity Investments
The candidate should be able to apply fundamental analysis to investment valuation, analyze
special situations (e.g., closely held companies, venture capital, and companies with very high
growth rates), and use various equity valuation models to estimate equity risk and return.
Study Session 9
Asset Valuation
Equity Investments: Industry and Company Analysis

Reading Assignments
1.* “Competitive Strategy: The Core Concepts,” Michael E. Porter, Competitive Advantage:
Creating and Sustaining Superior Performance (The Free Press, 1985)
*
2. “Industry Analysis,” Ch. 6, Security Analysis On Wall Street: A Comprehensive Guide To
Today’s Valuation Methods, Jeffrey C. Hooke (Wiley, 1998)
3. Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C.
Brown (Dryden, 2000)
A. “Analysis of Financial Statements,” Ch. 12
B. “Company Analysis and Stock Selection,” Ch. 20, pp. 792−852

Learning Outcomes
1. “Competitive Strategy: The Core Concepts”
The candidate should be able to
a) analyze the competitive advantage and competitive strategy of a company and the
competitive forces that affect the profitability of a company;
b) discuss the two fundamental questions determining the choice of competitive
strategy;
c) analyze basic types of competitive advantage that a company can possess and the
generic strategies for achieving a competitive advantage;
d) analyze the risks associated with each of the generic strategies;
e) discuss the difficulties and risks of simultaneously using more than one of the generic
strategies;
f) explain the role of a generic strategy in the strategic planning process.

2. “Industry Analysis”
The candidate should be able to
a) discuss the factors that should be included in an industry analysis model;
b) illustrate the life cycle of a typical industry;
c) analyze the effects of business cycles on industries (growth, defensive, cyclical);
d) analyze the impact of external factors (such as technology, government, foreign
influences, demography, and social changes) on industries;
e) illustrate the inputs and methods used in preparing an industry demand-and-supply
analysis;
f) explain factors that affect industry pricing practices;

*
Readings marked with an asterisk are contained in the 2003 CFA Level II Candidate Readings.
46
©2002, AIMR®
 g) analyze the effects of international competition on industries.

3. A. “Analysis of Financial Statements”

Note: Candidates should supplement their study of this reading with a review of
Study Sessions 5, 6, and 7.

The candidate should be able to

a) describe some of the important accounting choices (typically explained in the
footnotes of financial statements) that companies must make when constructing
financial statements using generally accepted accounting principles (GAAP);
b) describe how a company’s accounting choices make comparability among
companies difficult;
c) distinguish among “cash flows from operating activities” (from the statement of
cash flows), “traditional cash flow,” and “free cash flow;”
d) calculate financial ratios in the following categories: common size, internal
liquidity, operating efficiency, operating profitability, business risk, financial
risk, growth, and external liquidity;
e) compute return on equity (ROE) using the DuPont system and the extended
DuPont system;
f) discuss business risk and financial risk;
g) prepare, using financial ratios, a comparative analysis of a company over time
and relative to its industry or to the market;
h) discuss the challenges of international ratio analysis;
i) contrast the ratios that are most likely to be useful for valuing common stock,
establishing bond ratings, and forecasting bankruptcy;
j) explain limitations of ratio analysis.

Corrections/Clarifications

• On page 392, in the calculation of the Quick Ratio for 1997, the numerator should be 449.

• On page 409, in the calculations of Fixed Financial Cost Coverage for 1998, 1997, and
1996, the numerators should be 835, 708, and 604, respectively.

• On page 411, in the calculation of the Cash Flow/Long-Term Debt Ratio for 1998, the
equation should read: 1998: [511 + 189 + (–24)] / 473 = 143%.

• On page 411, in the calculation of the Cash Flow/Total Debt Ratio for 1998, the equation
should read: 1998: 676 / 2,053 = 32.9%.

• In the table on page 412, the entries for Traditional Cash Flow for 1998 and 1997 should
be 676 and 568, respectively.

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B. “Company Analysis and Stock Selection”
The candidate should be able to
a) demonstrate techniques for estimating future earnings per share for a company,
the earnings multiplier for a company, and the future value of a company’s
shares;
b) compute and analyze the relative valuation ratios that analysts use to evaluate
equity investments;
c) infer, using valuation methods, whether a particular stock is an attractive
investment;
d) distinguish between economic value added (EVA), market value added
(MVA), and the franchise factor concept;
e) illustrate why the standard dividend discount model (DDM) may be
inappropriate for valuing a growth company;
f) compare the alternative growth models and their underlying assumptions;
g) calculate the value of a company using the DDM;
h) analyze the factors that should be considered when evaluating a company on a
global basis.

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Study Session 10
Asset Valuation
Equity Investments: Valuation Models

Reading Assignments
1. Analysis of Equity Investments: Valuation, John D. Stowe, Thomas R. Robinson, Jerald
E. Pinto, and Dennis W. McLeavey (AIMR, 2002)
A. “Discounted Dividend Valuation,” Ch. 2
B. “Free Cash Flow Valuation,” Ch. 3

Note: Candidates are responsible for the practice problems at the end of each chapter. Solutions
to the problems are found at the end of each chapter.

Learning Outcomes
1. A. “Discounted Dividend Valuation”
The candidate should be able to
a) discuss the advantages and disadvantages of dividends, free cash flow, and
residual income as measures of cash flow in discounted cash flow valuation, and
identify the investment situation for which each is suitable;
b) determine the circumstances when a dividend discount model (DDM) is
appropriate for valuing a stock;
c) explain the capital asset pricing model (CAPM), arbitrage pricing theory (APT),
and bond yield plus risk premium approaches for estimating the required rate of
return for an equity investment, and calculate the required rate of return using
each approach;
d) estimate the Gordon growth model equity risk premium;
e) discuss the limitations to using the CAPM and APT to estimate the required
return on equity;
f) estimate the required return on equity using the build-up approach;
g) calculate the expected holding-period return on a stock given its current price,
expected next-period price, and expected next-period dividend;
h) contrast the expected holding-period return with the required rate of return;
i) discuss the effect on expected return of the convergence of price to value, given
that price does not equal value;
j) calculate the value of a common stock using the DDM for one-, two-, and
multiple-period holding periods;
k) calculate the value of a common stock using the Gordon growth model and
explain the underlying assumptions;
l) calculate the expected rate of return or implied dividend growth rate in the
Gordon growth model, given the market price, the expected dividend, and either
the expected rate of return or the dividend growth rate;
m) explain and calculate justified leading and trailing price-to-earnings (P/E) ratios
based on fundamentals, using the Gordon growth model;

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 n) calculate the value of fixed-rate perpetual preferred stock given the stock’s
annual dividend and the discount rate;
o) explain and calculate the present value of growth opportunities (PVGO) given
current earnings per share, the required rate of return, and the value of the stock;
p) explain the strengths and limitations of the Gordon growth model, and justify
the selection of the Gordon growth model to value a company, given the
characteristics of the company being valued;
q) explain the assumptions and justify the selection of the two-stage DDM, the H-
model, the three-stage DDM, or spreadsheet modeling;
r) explain the growth phase, transitional phase, and maturity phase of a business;
s) explain terminal value and discuss alternative approaches to determining the
terminal value in a discounted dividend model;
t) calculate the value of a common stock using the two-stage DDM, the H-model,
and the three-stage DDM;
u) explain how to estimate the implied expected rate of return for any DDM,
including the two-stage DDM, the H-model, the three-stage DDM, and the
spreadsheet model;
v) calculate the implied expected rate of return for the H-model and a general two-
stage model;
w) explain the strengths and limitations of the two-stage DDM, the H-model, the
three-stage DDM, and the spreadsheet model;
x) define sustainable growth rate and explain the underlying assumptions;
y) calculate the sustainable growth rate for a company;
z) estimate, using the DuPont model, the return on equity used to estimate a
company’s sustainable growth rate;
aa) discuss the use of dividend discount models as discipline for portfolio selection,
and explain two risk control methodologies.

B. “Free Cash Flow Valuation”

The candidate should be able to
a) define and interpret free cash flow to the firm (FCFF) and free cash flow to
equity (FCFE);
b) describe the FCFF and FCFE approaches to valuation and contrast the
appropriate discount rates for each model;
c) explain the strengths and limitations of the FCFE model;
d) contrast the ownership perspective implicit in the FCFE approach to the
ownership perspective implicit in the dividend discount approach;
e) discuss the appropriate adjustments to net income, earnings before interest and
taxes (EBIT), earnings before interest, taxes, depreciation, and amortization
(EBITDA), or cash flow from operations (CFO) to arrive at FCFF and FCFE;
f) calculate FCFF and FCFE given a company’s financial statements prepared
according to U.S. Generally Accepted Accounting Principles or International
Accounting Standards;
g) discuss approaches for forecasting FCFF and FCFE;
h) contrast the recognition of value in the FCFE model to the recognition of value

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 in dividend discount models;
i) explain how dividends, share repurchases, share issues, and changes in leverage
may affect FCFF and FCFE;
j) critique the use of net income and EBITDA as proxies for cash flow in
valuation;
k) describe the single-stage (stable-growth), two-stage, and three-stage FCFF and
FCFE models and discuss the assumptions underlying each model;
l) justify the selection of a single-stage, two-stage, or three-stage FCFF or FCFE
model given characteristics of the company being valued;
m) calculate the value of a company using the single-stage, two-stage, and three-
stage FCFF and FCFE models;
n) explain how sensitivity analysis can be used in FCFF and FCFE valuations;
o) discuss the approaches for calculating the terminal value in a multistage
valuation model;
p) describe the characteristics of companies for which the FCFF model is preferred
to the FCFE model.

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Study Session 11
Asset Valuation
Equity Investments: Valuation Models and Applications

Reading Assignments
1. Analysis of Equity Investments: Valuation, John D. Stowe, Thomas R. Robinson, Jerald E.
Pinto, and Dennis W. McLeavey (AIMR, 2002)
A. “Market-Based Valuation: Price Multiples,” Ch. 4
B. “Residual Income Valuation,” Ch. 5
2.* “Star Cruises: Fair winds for a young star,” Andrew Lee, HSBC Research (Malaysia) Sdn
Bhd Company Report (HSBC Research (Malaysia) Sdn Bhd, 1 September 1999)

Note: Candidates are responsible for the practice problems at the end of readings 1A and 1B.
Solutions to the problems are found at the end of each chapter.

Learning Outcomes
1. A. “Market-Based Valuation: Price Multiples”
The candidate should be able to
a) distinguish between the method of comparables and the method based on
fundamental forecasts as approaches to using price multiples in valuation and
discuss the economic rationales for each;
b) define a justified price multiple;
c) discuss arguments for and against the use of price-to-earnings (P/E) ratios for
valuation;
d) define and calculate a stock’s trailing P/E and leading P/E;
e) define underlying earnings, and calculate underlying earnings given earnings
per share and nonrecurring items in the income statement;
f) define normalized earnings per share, discuss the methods of normalizing
earnings per share, and calculate normalized earnings per share by each method;
g) explain and justify the use of earnings yield for ranking common stocks;
h) discuss the fundamental factors that influence P/E;
i) calculate a justified P/E based on forecasted fundamentals;
j) calculate a predicted P/E ratio given a cross-sectional regression on
fundamentals;
k) evaluate a common stock based on P/E ratios using the method of comparables;
l) define and calculate the P/E-to-growth (PEG) ratio, and explain its use in
relative valuation;
m) explain the use of price multiples to determine terminal value in a multistage
discounted cash flow model and compute a terminal value based on
comparables;
n) define and calculate the price to book (P/B) and price to sales (P/S) ratios;
o) discuss arguments for and against the use of P/B and P/S ratios;

*
Readings marked with an asterisk are contained in the 2003 CFA Level II Candidate Readings.
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 p) calculate justified P/B and P/S ratios based on fundamentals;
q) discuss the fundamentals that influence P/B and P/S ratios;
r) evaluate a stock based on P/B and P/S ratios using the method of comparables;
s) discuss alternative definitions of cash flow including earnings-plus-non-cash
charges (CF) and cash flow from operations (CFO), and explain the limitations
of each;
t) define and calculate P/CF, P/CFO, price to free cash flow to equity (P/FCFE)
and price to EBITDA (P/EBITDA);
u) discuss arguments for and against the use of price to cash flow ratios;
v) discuss the fundamental factors that influence price to cash flow ratios;
w) evaluate a stock based on price to cash flow ratios using the method of
comparables and a specified definition of cash flow;
x) define and calculate the enterprise value (EV) to EBITDA ratio;
y) discuss arguments for and against the use of EV/EBITDA ratios;
z) discuss the fundamental factors that influence the EV/EBITDA ratio;
aa) evaluate a company based on EV/EBITDA ratios using the method of
comparables;
ab) define and calculate dividend yield (D/P);
ac) discuss arguments for and against the use of dividend yield;
ad) discuss the fundamental factors that influence dividend yields;
ae) evaluate a stock using dividend yields based on the method of comparables;
af) discuss the sources of differences in cross-border valuation comparisons;
ag) describe the main types of momentum indicators and their use in valuation.

B. “Residual Income Valuation”

The candidate should be able to
a) define and calculate residual income;
b) describe alternative measures of residual earnings such as economic value
added;
c) discuss the uses of residual income models;
d) calculate future values of residual income given current book value, consensus
earnings growth estimates, and an assumed dividend payout ratio;
e) calculate the intrinsic value of a share of common stock using the residual
income model;
f) contrast the recognition of value in the residual income model to value
recognition in other present value models;
g) discuss the strengths and weaknesses of the residual income model;
h) justify the choice of the residual income model for equity valuation given
characteristics of the company being valued;
i) discuss the fundamental determinants or drivers of residual income;
j) explain the relationship between residual income valuation and the justified
price-to-book ratio based on forecasted fundamentals;
k) explain the relationship of the residual income model to the dividend discount
model and free cash flow to equity model;
l) discuss the major accounting issues in applying residual income models;

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 m) calculate an implied growth rate in residual income given the market price-to-
book ratio and an estimate of the required rate of return on equity;
n) define continuing residual income and list the common assumptions regarding
continuing residual income;
o) justify an estimate of continuing residual income at the earnings forecast
horizon given company and industry prospects;
p) calculate the intrinsic value of a share of common stock using a multistage
residual income model, given the required rate of return, forecasted earnings per
share over a finite horizon, and forecasted continuing residual earnings.

2. “Star Cruises: Fair winds for a young star”

The candidate should be able to discuss the generic features of security analysis and the
application of analytical techniques in the valuation of a company.

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Study Session 12
Asset Valuation
Equity Investments: Special Valuation Cases

Reading Assignments
1.* Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 3rd edition,
Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs (Irwin, 1995)
A. “Minority Interest Discounts, Control Premiums, and Other Discounts and
Premiums,” Ch. 14
B. “Discounts for Lack of Marketability,” Ch. 15, pp. 331–334, 342–359
2.* “Selecting and Structuring Investments: The Venture Capitalist’s Perspective,” Lee A.
Gardella, Readings in Venture Capital (AIMR, 1997)

Learning Outcomes:
1. A. “Minority Interest Discounts, Control Premiums, and Other Discounts and
Premiums”
The candidate should be able to
a) describe the concept and importance of control;
b) explain the factors affecting the magnitude of a given control premium;
c) describe the position of a minority shareholder;
d) discuss how the valuation approaches used may impact the control
premium/minority discount issue;
e) discuss the selection of a standard of value and how the selection affects
minority discounts or control premiums;
f) discuss the impact of state statute provisions on minority versus control value;
g) discuss the top down, horizontal, and bottom up approaches for valuing
minority interests;
h) discuss the market evidence with respect to control premiums and minority
discounts.

B. “Discounts for Lack of Marketability”

The candidate should be able to
a) discuss the importance of marketability and differentiate between marketability
and liquidity;
b) discuss the general results of the studies of private stock transactions;
c) discuss the transactional considerations encountered when attempting to
liquidate a controlling interest in a closely held company;
d) describe the factors that affect the discount for lack of marketability.

2. “Selecting and Structuring Investments: The Venture Capitalist’s Perspective”

The candidate should be able to
a) describe how venture capital deals are generated;

*
Readings marked with an asterisk are contained in the 2003 CFA Level II Candidate Readings.
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©2002, AIMR®
b) analyze the due diligence process and evaluate its effect on the effectiveness of an
investment strategy;
c) explain the issues that affect the valuation of a venture capital investment;
d) differentiate the concerns of the entrepreneur from the concerns of the venture
capitalist when structuring an investment.

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 Analysis of Debt Investments
The candidate should be able to estimate risk and returns for debt instruments, analyze debt
instruments with unique features, and value debt instruments with embedded options.
Study Session 13
Asset Valuation
Debt Investments: Credit Analysis

Reading Assignments
1. “General Principles of Credit Analysis,” Level II, Ch. 9 including Appendix, Fixed Income
Analysis for the Chartered Financial Analyst Program, Frank J. Fabozzi, (Frank J. Fabozzi
Associates, 2000)

Note: Candidates are responsible for the questions at the end of the chapter. Solutions to the
questions are found at the end of the chapter.

Learning Outcomes
1. “General Principles of Credit Analysis” including Appendix
The candidate should be able to
a) distinguish among default risk, credit spread risk, and downgrade risk;
b) explain how credit analysis encompasses examination of the borrower’s character, the
borrower’s capacity to repay, the issues underlying collateral, and the issue’s
covenants;
c) identify the factors considered by rating agencies in assessing the quality of
management and explain the importance of these factors;
d) discuss sources of liquidity for a company and the importance of these sources in the
credit analysis process;
e) explain the key ratios used by credit analysts to assess the ability of a company to
satisfy its debt obligations (i.e., short-term solvency ratios, capitalization ratios, and
coverage ratios) and discuss the importance of these ratios;
f) compute the ratios explained in (e) above and use their level and trend to evaluate an
issuer’s potential credit rating;
g) explain the limitations of traditional ratios;
h) discuss why and how cash flow from operations is used to assess the ability of an
issuer to service its debt obligations and to assess the financial flexibility of a
company;
i) describe the various covenants and discuss their importance in assessing credit risk
for both investment grade and non-investment grade companies;
j) explain the typical elements of the debt structure of a high-yield issuer, the
interrelationships among these elements, and the impact of these elements on the risk
position of the lender;
k) explain the importance of the corporate structure of a high-yield issuer that has a
holding company;
l) explain why some investors advocate using an equity perspective when analyzing the
credit worthiness of high-yield issues;

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m) discuss the factors considered by rating agencies in rating asset-backed securities (i.e.,
collateral credit quality, seller/servicer quality, cash flow stress and payment
structure, and legal structure);
n) explain how the creditworthiness of municipal bonds is assessed, and compare the
analysis of tax-backed debt with the analysis of revenue obligations;
o) discuss the key economic and political risks considered by Standard & Poor’s in
assigning sovereign ratings;
p) explain why two ratings are assigned to each national government and discuss the key
factors emphasized by Standard & Poor’s for each rating;
q) contrast the credit analysis required for corporate bonds, asset-backed securities,
municipal securities, and sovereign debt;
r) explain the use of traditional ratios to identify corporate issuers that may be
downgraded.

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Study Session 14
Asset Valuation
Debt Investments: Valuation Issues

Reading Assignments:
1. Fixed Income Analysis for the Chartered Financial Analyst Program, Frank J. Fabozzi
(Frank J. Fabozzi Associates, 2000)
A. “Introduction to the Measurement of Interest Rate Risk,” Level I, Ch. 7
B. “The Term Structure and the Volatility of Interest Rates,” Level II, Ch. 1
C. “Valuing Bonds with Embedded Options,” Level II, Ch. 2
D. “Valuation of Interest Rate Derivative Instruments,” Level II, Ch. 8

Note: Candidates are responsible for the questions at the end of each chapter. Solutions to the
questions are found at the end of each chapter.

Learning Outcomes
1. A. “Introduction to the Measurement of Interest Rate Risk”
The candidate should be able to
a) distinguish between the full valuation approach and the duration/convexity
approach for measuring interest rate risk, and explain the advantage of using the
full valuation approach;
b) describe stress testing in relation to interest rate risk;
c) compute the duration of a bond, given information about how the bond’s price
will increase and decrease for a given change in interest rates;
d) compute the approximate percentage price change for a bond, given the bond’s
duration and a specified change in yield;
e) explain, both verbally and graphically, why duration is more effective in
estimating the price impact for small changes rather than large changes in
interest rates;
f) draw and interpret a graph of the relationship between price and yield for a
callable and prepayable security and use the graph to explain what is meant by
negative convexity;
g) draw and interpret a graph of the relationship between price and yield for a
putable bond;
h) explain how rate shocks for interest rates used to compute duration may affect
the duration calculation;
i) distinguish among modified duration, effective (or option-adjusted) duration,
and Macaulay duration;
j) explain why effective duration, rather than modified duration or Macaulay
duration, should be used to measure the interest rate risk for bonds with
embedded options;
k) compute the duration of a portfolio, given the duration of the bonds comprising
the portfolio, and discuss the limitations of portfolio duration;

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 l) compute the convexity measure of a bond, given information about how the
price will increase and decrease for a given change in interest rates;
m) compute the convexity adjustment to the duration estimate of a bond’s
percentage price change, given the convexity measure and a specified change in
interest rates;
n) estimate a bond’s percentage price change, given the bond’s duration and
convexity and a specified change in interest rates;
o) explain why convexity measures will differ among dealers and venders of
analytical services because of differences in scaling;
p) explain the difference between modified convexity and effective convexity;
q) compute the price value of a basis point (“dollar value of an 01”) of a bond;
r) state the relationship between duration and the price value of a basis point;
s) explain the importance of yield volatility in measuring the exposure of a bond
position to interest rate risk.

Corrections/Clarifications

• On page 279, the title of the last table should read: “Percentage price change based on an
initial yield of 5%.

B. “The Term Structure and the Volatility of Interest Rates”

The candidate should be able to
a) describe and interpret the different shapes that have been observed for the
Treasury yield curve;
b) explain the concept of the slope of the yield curve;
c) illustrate and explain a parallel and a nonparallel shift in the yield curve;
d) illustrate and explain a yield curve twist and a change in the curvature of the
yield curve (i.e., butterfly shift);
e) describe and explain the factors that have been observed to drive Treasury
security returns and the importance of each factor;
f) explain the various universes of Treasury securities that are used to construct
the theoretical spot rate curve and discuss their advantages and disadvantages;
g) explain the various theories of the term structure of interest rates (i.e., pure
expectations, liquidity, preferred habitat, and market segmentation) and the
implications of each theory for the shape of the yield curve;
h) interpret forward rates in the context of the theories of the term structure;
i) explain two interpretations of forward rates based on arbitrage arguments;
j) describe how to measure and compute the effects of the yield curve risk of a
security or a portfolio, using key rate duration;
k) compute and interpret yield volatility, given historical yields;
l) explain the issues associated with calculating yield volatility (i.e., the number of
observations to use and the annualizing of daily yield volatility);
m) distinguish between historical yield volatility and implied yield volatility;
n) explain how yield volatility is forecasted.

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Corrections/Clarifications

• On page 304, in the second paragraph, the two occurrences of “6-month” should be changed
to “5-year.”

• On page 311, in the third paragraph, the five occurrences of “scenario 1” should be changed
to “scenario 2.”

C. “Valuing Bonds with Embedded Options”

The candidate should be able to
a) explain the concept of an interest rate model;
b) explain the concept of an interest rate tree;
c) explain the backward induction valuation methodology within the binomial
interest rate tree framework;
d) compute the value of an option-free bond, using an interest rate tree;
e) compute the value of a callable bond from an interest rate tree, given the call
schedule and the rule for calling a bond;
f) explain how the value of the embedded call option is determined;
g) explain the relationship among the values of a callable (putable) bond, the
corresponding option-free bond, and the embedded option;
h) explain the effect of volatility on the arbitrage-free value of an option;
i) explain how option-adjusted spread is calculated using the binomial model;
j) interpret an option-adjusted spread with respect to a nominal spread and to
benchmark interest rates;
k) explain how effective duration and effective convexity are calculated using the
binomial model;
l) compute the value of a putable bond, using an interest rate tree;
m) explain how the binomial model can accommodate multiple embedded options;
n) explain how the binomial model can be used to value a step-up callable note and
a capped floater;
o) formulate the appropriate “nodal decision” within the backward induction
methodology of the interest rate tree framework for each of the following
bonds: putable bond, callable bond, putable/callable bond, multiple step-up
callable bond, and a floater with a cap;
p) describe the basic features of a convertible bond;
q) compute the value and explain the meaning of the following for a convertible
bond: conversion value, straight value, market conversion price, market
conversion premium per share, market conversion premium ratio, premium
payback period, and premium over straight value;
r) discuss the components of a convertible bond’s value that must be included in
an option-based valuation approach;
s) compare the risk–return characteristics of a convertible bond with the risk–
return characteristics of ownership of the underlying common stock.

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Corrections/Clarifications

• On page 380, in the answer to Question 9f, replace $126.076 with $102.076.

D. “Valuation of Interest Rate Derivative Instruments”

The candidate should be able to
a) explain how the theoretical price of a futures contract is determined;
b) compute the theoretical price of a Treasury futures contract;
c) explain how the theoretical price of a Treasury bond futures contract is affected
by the delivery options;
d) explain the complications in extending the standard arbitrage pricing model to
the valuation of Treasury bond and note futures contracts;
e) compute the floating-rate payments for a swap;
f) explain how the swap rate and swap spread are determined;
g) describe how the value of a swap is determined;
h) calculate the swap rate, swap spread, and value of a swap;
i) explain the two components of the option price and the factors that affect the
value of an option;
j) identify the limitations of using the Black–Scholes option pricing model to
value interest rate options;
k) compute the price of an option on a bond using the arbitrage-free binomial
model;
l) discuss the Black model for valuing options on futures;
m) explain how to measure the sensitivity of an option’s value to the changes in the
factors that affect the option’s value;
n) compute the value of an interest rate cap or floor using the arbitrage-free
binomial model.

Corrections/Clarifications

• On page 611, the three occurrences of “June 30” when referring to the 3-month Eurodollar
CD futures contract settlement date should be replaced with “9.” The fifth sentence
beginning with “That futures contract…” should be replaced with “That futures contract
reflects the market’s expectation of 3-month LIBOR on April 1 of year 1.”

• On page 627, in the first sentence of the second paragraph, replace “American” with
“European.”

• On page 641, in the equation in Question 8a, delete the term “SR.”

• On page 649, in the solution to Question 8a, replace the “20” over the summation sign with
“10.”

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Study Session 15
Asset Valuation
Debt Investments: Structured Securities

Reading Assignments:
1. Fixed Income Analysis for the Chartered Financial Analyst Program, Frank J. Fabozzi
(Frank J. Fabozzi Associates, 2000)
A. “Mortgage-Backed Securities,” Level II, Ch. 3
B. “Asset-Backed Securities,” Level II, Ch. 4
C. “Valuing Mortgage-Backed and Asset-Backed Securities,” Level II, Ch. 5
2. “Swap Contracts, Convertible Securities, and Other Embedded Derivatives,” Ch. 25, pp.
1071-1082, Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly
and Keith C. Brown (Dryden, 2000)

Note: Candidates are responsible for the questions at the end of readings 1A through 1C.
Solutions to the questions are found at the end of each chapter.

Learning Outcomes:
1. A. “Mortgage-Backed Securities”
The candidate should be able to
a) describe a mortgage loan;
b) describe the cash flow characteristics of a fixed-rate, level payment, fully
amortized mortgage loan;
c) describe prepayments and how they result in prepayment risk;
d) explain the investment characteristics of mortgage passthrough securities;
e) explain the importance of prepayments to the estimation of the cash flow of a
mortgage-backed security;
f) compute the weighted average coupon and weighted average maturity of a
mortgage pool;
g) explain a conditional prepayment rate and a single monthly mortality rate;
h) describe the Public Securities Association (PSA) prepayment benchmark and its
relationship to the conditional prepayment rate;
i) calculate the prepayment amount for a month, given the single monthly
mortality rate;
j) identify the factors that affect prepayments;
k) explain contraction and extension prepayment risks and why they occur;
l) explain why the average life of a mortgage-backed security is a more relevant
measure than the security’s maturity;
m) explain why and how a collateralized mortgage obligation (CMO) is created and
distinguish among the different types of CMO structures (including sequential-
pay tranches, accrual tranches, floater tranches, inverse floater tranches, planned
amortization class tranches, support tranches, and support tranches with
schedules);

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 n) describe how a CMO distributes prepayment risk among tranches so as to create
products that provide a better matching of assets and liabilities for institutional
investors;
o) identify the risk characteristics of each type of CMO tranche and determine the
relative performance given changes in the interest rate environment;
p) explain, for planned amortization class (PAC) tranches, the initial PAC collar
and the effective collar;
q) explain why the support tranches have the greatest prepayment risk in a CMO
structure;
r) explain stripped mortgage-backed securities, principal mortgage strips
(principal-only securities), and interest mortgage strips (interest-only securities);
s) explain the investment characteristics of principal-only and interest-only
mortgage strips;
t) compare and contrast agency and nonagency mortgage-backed securities.

Corrections/Clarifications

• On page 438, Question 31 should begin: “Assume that in FJF-01 in the chapter…”

B. “Asset-Backed Securities”
The candidate should be able to
a) explain the difference between amortizing assets and non-amortizing assets and
why the former may have prepayments;
b) explain the difference between an external and internal credit enhancement;
c) explain the different types of external credit enhancements (corporate
guarantees, letter of credit, and bond insurance) and the problems associated
with enhancing by means of third-party guarantors;
d) explain the different types of internal credit enhancements (reserve accounts and
senior-subordinated structures);
e) describe, and explain the purpose of, a shifting interest mechanism in a senior-
subordinated structure;
f) distinguish between a pass-through structure and a pay-through structure;
g) explain optional clean-up call provisions;
h) describe the cash flow for securities backed by closed-end home equity loans,
open-end home equity loans, manufactured housing loans, student loans, and
Small Business Administration loans;
i) explain a prospectus prepayment curve for home equity loan-backed securities;
j) explain why an available funds cap exists when securities are backed by
adjustable-rate home equity loans;
k) describe a non-accelerating senior tranche and a planned amortization class
tranche in a home equity loan-backed structure;
l) explain why prepayments that result from refinancing may not be significant for
manufactured housing-backed securities and automobile loan-backed securities;
m) explain an absolute prepayment rate and a conditional prepayment rate;

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©2002, AIMR®
 n) describe the structure of a credit card receivable-backed security, including the
lock-out period and the principal-amortization period;
o) explain the early amortization trigger for a credit card receivable-backed
security;
p) describe the basic structure of a collateralized bond obligation (CBO), including
the types of bonds used as collateral and the types of tranches created;
q) explain why the manager of a CBO must use interest rate derivatives;
r) explain the different periods in the life of a CBO: start-up phase, reinvestment
phase, and pay down phase.

Corrections/Clarifications

• On page 478, Question 11 should read: “What is a ‘latter of percent or call date’ clean-up
call provision?”

• On page 479, in Question 21, replace “mortgage” with “mortality.”

• On page 483, in the solution to Question 11, delete the first sentence.

C. “Valuing Mortgage-Backed and Asset-Backed Securities”

The candidate should be able to
a) explain how to compute the cash flow yield of a mortgage-backed or asset-
backed security;
b) compute the bond-equivalent yield of a cash flow yield;
c) discuss the limitations of the cash flow yield measure;
d) explain the limitations of the nominal spread and the zero-volatility spread for a
mortgage-backed security;
e) describe the Monte Carlo simulation model for valuing a mortgage-backed
security;
f) explain why the binomial model or any other model that uses the backward
induction method cannot be used to value a mortgage-backed security;
g) explain the critical assumptions of the Monte Carlo simulation model;
h) explain why the Monte Carlo simulation model without adjustments to the
interest rate paths does not provide an arbitrage-free value;
i) explain how the option-adjusted spread is computed using the Monte Carlo
simulation model and how this spread measure is interpreted;
j) apply option-adjusted spread analysis to value mortgage-backed securities and
identify rich and cheap securities;
k) explain how effective duration is computed using the Monte Carlo simulation
model;
l) discuss some major assumptions that result in differences in effective durations
reported by dealers and vendors;

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 m) explain other measures of duration used by practitioners in the mortgage-backed
market (including cash flow duration, coupon curve duration, and empirical
duration) and discuss the limitations of these duration measures;
n) explain how to compute the cash flow duration for a mortgage-backed security
and compare this measure with the (1) modified duration and (2) effective
duration measures that result from using the Monte Carlo simulation model;
o) determine when an asset-backed security should be valued using the zero-
volatility spread approach or the option-adjusted spread approach (using Monte
Carlo simulation);
p) determine whether the nominal spread, zero-volatility spread, or the option-
adjusted spread should be used to evaluate a specific fixed income security.

Corrections/Clarifications

• On page 499, in the last complete paragraph that begins “The procedure for determining…”
the next-to-last sentence should begin “On the right-hand side…” and the last sentence
should read: “The average present value over all the paths on the left-hand side…”

2. “Swap Contracts, Convertible Securities, and Other Embedded Derivatives”

The candidate should be able to
a) compare and contrast structured notes to regular fixed-income securities;
b) describe the cash flow characteristics of dual-currency bonds, equity-index-linked
notes, commodity-linked bull and bear bonds, and swap-linked notes.

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 Analysis of Derivative Investments
The candidate should be able to value and describe the use of derivative securities including
futures, forwards, options, and swaps.
Study Session 16
Asset Valuation
Derivative Investments: Futures and Swaps

Reading Assignments
Futures Pricing
1. Futures, Options & Swaps, 3rd edition, Robert W. Kolb (Blackwell, 1999)
A. “Futures Prices,” Ch. 3, pp. 43–76
B. “Interest Rate Futures: Introduction,” Ch. 5, pp. 112–117 and 125–130
C. “Stock Index Futures: Introduction,” Ch. 7, pp. 202–212
D. “Foreign Exchange Futures,” Ch. 9, pp. 261–266
Risk Management with Futures
2. Futures, Options & Swaps, 3rd edition, Robert W. Kolb (Blackwell, 1999)
A. “Using Futures Markets,” Ch. 4, pp. 98–105
B. “Interest Rate Futures: Introduction,” Ch. 5, pp. 138–145
C. “Stock Index Futures: Introduction,” Ch. 7, pp. 214–217
D. “Foreign Exchange Futures,” Ch. 9, pp. 273–277
Swaps
3. Futures, Options & Swaps, 3rd edition, Robert W. Kolb (Blackwell, 1999)
A. “The Swaps Market: Introduction,” Ch. 20, pp. 608–623, 628−629 and 632–639
B. “Swaps: Economic Analysis and Pricing,” Ch. 21, pp. 648–671

Learning Outcomes
Note: Candidates should understand the assumptions made to derive the cost-of-carry model and
should be aware of what happens to the no-arbitrage fair value as these assumptions are relaxed
(in particular, that the no-arbitrage fair value moves from a single price to a range of possible
prices). Candidates should also understand the trading strategies used to exploit any violation of
the no-arbitrage fair value.

1. A. “Futures Prices”
The candidate should be able to
a) differentiate between spot (cash) and futures prices and explain why the basis
must converge to zero at expiration;
b) identify the existence of an arbitrage opportunity, identify and arrange the
appropriate strategy (a cash-and-carry arbitrage or a reverse cash-and-carry
arbitrage), list the appropriate trades to take advantage of the arbitrage
opportunity, and compute the corresponding arbitrage profits;
c) compute the implied repo rate, given the cash price and futures price;
d) illustrate how market imperfections (transaction costs, unequal borrowing and
lending rates, and restrictions on short selling) create upper and lower no-
arbitrage futures pricing bounds;
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©2002, AIMR®
 e) illustrate and explain what determines the differing futures price patterns under
normal backwardation, contango, and the net hedging hypothesis.

B. “Interest Rate Futures: Introduction”

The candidate should be able to
a) compute, given the appropriate interest rate, the price quote of a U.S. Treasury
bill (T-Bill) futures contract and a Eurodollar futures contract;
b) identify the existence of an arbitrage opportunity, identify and arrange the
appropriate strategy (a cash-and-carry arbitrage or a reverse cash-and-carry
arbitrage), and compute the corresponding arbitrage profits;
c) calculate the implied repo rate, given the spot Treasury bill price and the
Treasury bill futures price for the period from “today” until the expiration of the
futures, and annualize that implied repo rate.

C. “Stock Index Futures: Introduction”

The candidate should be able to
a) describe index arbitrage and program trading;
b) describe the effects of dividends on the cost-of-carry model;
c) define and calculate the fair value of a stock index futures contract.

D. “Foreign Exchange Futures”

The candidate should be able to
a) compute, using the cost-of-carry model, the theoretical futures price and
determine whether an arbitrage profit exists;
b) identify and construct the appropriate strategy (a cash-and-carry arbitrage or a
reverse cash-and-carry arbitrage) to exploit an arbitrage opportunity and
compute the profits from such a strategy.

2. A. “Using Futures Markets”

The candidate should be able to
a) determine, given a risk exposure, whether a short or long hedge is appropriate;
b) explain a cross-hedge and describe a situation that would necessitate a cross-
hedge;
c) calculate the appropriate number of futures contracts needed to create a risk-
minimizing hedge, given the beta coefficient estimated from regressing changes
in the cash price (dependent variable) on changes in the futures price
(independent variable).

Corrections/Clarifications

ρ SF σ S σ F COVSF
• Equation 4.4 on page 103 should read: HR = − =−
σ F2
σ 2F

• Delete the two sentences following the definition of terms for equation 4.5 on page 103,
beginning: “The estimated β from this regression ...” and replace with the following:

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 “The negative of the estimated β from this regression gives the risk-minimizing hedge
ratio, because the estimated β itself equals the sample covariance between the
independent (Ft) and dependent (St) variables divided by the sample variance of the
independent variable. The negative of the estimated β exactly matches the definition of
the risk-minimizing hedge ratio in Equation 4.4.”

• Footnote #13 on page 111 should read:

13. To find the risk-minimizing hedge ratio, we take the derivative of the portfolio’s risk in
Equation 4.3 with respect to HR, set the derivative equal to zero, and solve for HR:

d σ 2P
= 2 HR σ 2 F + 2 ρ SF σ S σ F = 0
d HR

σS COV SF
HR = − ρ SF =−
σF σ 2F

B. “Interest Rate Futures: Introduction”

The candidate should be able to
a) identify whether a long hedge or a short hedge is appropriate, using interest rate
futures, for a given scenario;
b) calculate the total cash flows of a hedged position and compare them with the
cash flows of an unhedged position;
c) compute the impact of cross-hedging on the total cash flows of a hedging
strategy.

C. “Stock Index Futures: Introduction”

The candidate should be able to
a) calculate the hedge ratio, identify whether a long hedge or a short hedge is
appropriate, and determine the appropriate number of futures contracts to
implement the required long or short hedge;
b) calculate the total cash flows of a hedged position and compare these cash flows
with the cash flows of an unhedged position.

Corrections/Clarifications

• The centered equation at the top of page 215 should read:

VP $40,000,000
− =– = –150.94 ≈ –151 contracts
VF (1060)($250)

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©2002, AIMR®
 • Equation 7.6 on page 215 should read:

V 
−  P  β P = Number of Contracts
 VF 

• The computed number of contracts on page 215 should read:

 $40,000,000 
–   1.22 = – 184.15 ≈ – 185 contracts
 (1060 )($250 ) 

D. “Foreign Exchange Futures”

The candidate should be able to
a) identify whether a long hedge or a short hedge is appropriate and determine the
appropriate number of foreign exchange futures contracts to implement the
required long or short hedge;
b) calculate the total cash flows of a hedged position and compare these cash flows
with the cash flows of an unhedged position.

3. A. “The Swaps Market: Introduction”

Note: The term “box and arrow diagram” refers to diagrams similar to those in
Figures 20.4 through 20.8.

The candidate should be able to

a) discuss the characteristics of and motivations for swap contracts and
differentiate swap contracts from futures contracts, especially with respect to
payment date versus expiration date;
b) diagram (with a box and arrow diagram) and calculate the cash flows between
the parties to a plain vanilla swap contract, including situations in which an
intermediary participates;
c) distinguish between swap situations in which all cash flows are netted and swap
situations that involve an exchange of principal;
d) illustrate the appropriate cash flow diagram for a swap and calculate the net
borrowing/lending costs for the two swap counterparties;
e) differentiate among a plain vanilla interest rate swap, an amortizing swap, an
accreting swap, a seasonal swap, an off-market swap, a forward swap, a basis
swap, a yield curve swap, a constant-maturity swap, and a diff swap;
f) illustrate and explain how a plain vanilla interest rate swap and a plain vanilla
currency swap can be combined to form a combined interest rate and currency
swap (CIRCUS);
g) diagram (with a box and arrow diagram) and calculate the net periodic swap
cash flows for an equity swap, given the equity return, notional principal, fixed
percentage return, and the tenor of the swap.

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©2002, AIMR®
B. “Swaps: Economic Analysis and Pricing”
The candidate should be able to
a) demonstrate how swap agreements can be viewed as a combination of capital
market instruments and as a portfolio of forward rate agreements;
b) demonstrate how an interest rate swap agreement can be viewed as a strip of
Eurodollar futures contracts and as a zero-cost interest rate collar;
c) show how a forward rate agreement is the same as a pair of interest rate options;
d) demonstrate how a swap agreement can be viewed as a portfolio of caps and
floors.

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©2002, AIMR®
Study Session 17
Asset Valuation
Derivative Investments: Options

Reading Assignments
1. Futures, Options & Swaps, 3rd edition, Robert W. Kolb (Blackwell, 2000)
A. “Option Payoffs and Option Strategies,” Ch. 11, pp. 316–346
B. “European Option Pricing,” Ch. 13, pp. 381–386 and pp. 396–405
C. “Option Sensitivities and Option Hedging,” Ch. 14, pp. 422–437
(Do not study Tables 14.2 through 14.5)
D. “Options on Stock Indexes, Foreign Currency, and Futures,” Ch. 16, pp. 486–493
2. “Interest Rate Derivative Instruments,” Level II, Ch. 7, Fixed Income Analysis for the
Chartered Financial Analyst Program, Frank J. Fabozzi (Frank J. Fabozzi Associates,
2000)
*
3. “What Does an Option Pricing Model Tell Us about Option Prices?” Stephen Figlewski,
Financial Analysts Journal (AIMR, September/October 1989)

Learning Outcomes
Note: Candidates should understand the option-pricing models, the assumptions made to derive
such models, and the uses of such models. Options are assets whose future (expiration) payoff
profiles are known. These readings introduce the models that are used to find the present value of
those payoff profiles. Candidates should also understand the variables that are used in these
models and how changing the values of those variables affect the price of the option.

1. A. “Option Payoffs and Option Strategies”

The candidate should be able to
a) calculate the cost of the following option-trading strategies: straddle, strangle,
bull and bear spreads, and butterfly spread;
b) determine, using a profit/loss diagram, the profit or loss of an option-trading
strategy for any asset value;
c) compare the impact of covered calls with the impact of portfolio hedging on the
distribution of portfolio value;
d) illustrate and explain the differences in expiration profits/losses of a hedged and
unhedged portfolio, using the expiration profit/loss diagram of a portfolio
hedging strategy and the portfolio (index) profit/loss profile;
e) demonstrate how to create a stock synthetically, using a European put option, a
European call option, and a risk-free discount bond;
f) calculate, using put–call parity, the value of a European call (put), given the
corresponding European put (call) value;
g) show and explain why put–call parity must always hold for European-style
options.

*
Readings marked with an asterisk are contained in the 2003 CFA Level II Candidate Readings.
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©2002, AIMR®
 B. “European Option Pricing”
The candidate should be able to
a) describe how to replicate a European equity call option synthetically, using
stocks and bonds;
b) discuss alternative methods for estimating volatility inputs for the Black–
Scholes model;
c) calculate, given the Black–Scholes model or the binomial model (single- and
two-period only), the value of a European call (put) option, using the
appropriate inputs;
d) draw the single- and two-period binomial tree for both the underlying asset and
the corresponding option;
e) annualize a stock’s standard deviation of returns, given either a daily, weekly, or
monthly standard deviation;
f) explain how the Black–Scholes model is adjusted when dividends are paid at a
continuous rate.

Corrections/Clarifications

• Equation 13.15 on page 399 (“European Option Pricing”) omits a negative sign in the last
item in the equation. The last term should read −St N(−d1).

C. “Option Sensitivities and Option Hedging”

The candidate should be able to
a) draw the payoff diagram of a European put option or European call option
before and at expiration;
b) calculate delta or the change in option price, given the change in asset price and
the change in option price or delta;
c) analyze the properties of a delta-neutral portfolio and relate those properties to
hedging;
d) diagram and explain the delta of a European put or call as a function of asset
price;
e) diagram and explain option price as a function of increasing volatility;
f) diagram and explain an option’s sensitivity to volatility as a function of asset
price;
g) relate rho to changes in an option’s time to expiration and underlying stock
price;
h) relate gamma to changes in an option’s delta and underlying stock price.

D. “Options on Stock Indexes, Foreign Currency, and Futures”

The candidate should be able to
a) calculate the value of a European call (put) option, given the formulas for either
the Black–Scholes model or the binomial model (single- and two-period only)
when no continuous dividend is paid by the underlying security;

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©2002, AIMR®
 b) calculate the value of a European call (put) option, given the formulas for the
Merton model when a continuous dividend is paid by the underlying security;
c) draw the single- and two-period binomial tree for both the underlying asset and
the corresponding option for an asset that pays a continuous dividend;
d) explain the condition necessary for the Merton model to be the same as the
Black–Scholes model.

2. “Interest Rate Derivative Instruments”

Note: Candidates are also responsible for the questions at the end of the chapter. Solutions
to the questions are found at the end of the chapter.

The candidate should be able to

a) describe counterparty risk;
b) describe the basic features of an interest rate option contract;
c) describe futures options and their trading mechanics;
d) explain an interest rate swap and the relationship between interest rate swaps and
forward contracts;
e) explain an interest rate cap and floor and the relationship between caps and floors and
options;
f) compute the payoff for a cap and a floor;
g) contrast options on interest rates and options on fixed income securities;
h) interpret cap and floor positions in isolation and when combined with an existing
position.

3. “What Does an Option Pricing Model Tell Us about Option Prices”

The candidate should be able to
a) explain why using the dynamic riskless arbitrage strategy (the force behind the
Black–Scholes option pricing model) is difficult in real markets (see also pp. 428–430
in Kolb);
b) identify the factors that are not part of the Black–Scholes option pricing model but
that may still affect option prices;
c) discuss the reasons the Black–Scholes model may be wrong;
d) discuss the reasons the Black–Scholes model may provide the correct value of an
option even though that value is different from the market price of the option.

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 Portfolio Management
The candidate should be able to estimate the return and determine the risk of various securities,
and apply the basic principles of the portfolio management process to specific scenarios.
Study Session 18
Portfolio Management
Capital Market Theory and Asset Pricing

Reading Assignments
1. Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C.
Brown (Dryden, 2000)
A. “An Introduction to Portfolio Management,” Ch. 8
B. “An Introduction to Asset Pricing Models,” Ch. 9
C. “Extensions and Testing of Asset Pricing Theories,” Ch. 10
*
2. “The Process of Portfolio Management,” Ch. 26, Investments, 5th edition, Zvi Bodie, Alex
Kane, and Alan J. Marcus (McGraw-Hill, 2002)

Learning Outcomes
1. A. “An Introduction to Portfolio Management”
The candidate should be able to
a) describe the concept of risk aversion and discuss the implications for the
investment process;
b) identify several measures of risk and explain the circumstances in which their
use might be appropriate in both stand-alone and portfolio contexts;
c) compute the standard deviation of rates of return for a risky asset;
d) describe and illustrate the change in the risk–return tradeoff of a two-asset
portfolio as the correlation between the two assets changes in specified ways;
e) describe and calculate the expected return and the variance or standard deviation
of a two-asset portfolio;
f) describe and calculate the covariance and correlation coefficient between two
asset returns;
g) list the statistical inputs necessary to apply Markowitz portfolio theory in a large
portfolio context;
h) describe and illustrate the concept of the efficient frontier and show, using
utility analysis, how a risk averse investor selects the optimal portfolio.

B. “An Introduction to Asset Pricing Models”

The candidate should be able to
a) explain how the presence of a risk-free asset changes the characteristics of the
Markowitz efficient frontier;
b) describe the market portfolio and the role it plays in the formation of the capital
market line (CML);
c) distinguish between systematic and unsystematic risk;

*
Readings marked with an asterisk are contained in the 2003 CFA Level II Candidate Readings.
75
©2002, AIMR®
 d) explain and illustrate the standard deviation of return as a function of the
number of stocks in the portfolio;
e) discuss the security market line (SML) and how it differs from the CML;
f) define and calculate the beta of a risky asset;
g) calculate, based on the SML, the expected return for an asset; determine
whether the asset is undervalued, overvalued, or properly valued; and outline
the appropriate trading strategy;
h) compare and contrast the assumptions of the arbitrage pricing theory (APT) to
the CAPM.

C. “Extensions and Testing of Asset Pricing Theories”

The candidate should be able to
a) evaluate the effect on the security market line (SML) of relaxing each of the
following assumptions: taxes, transactions costs, heterogeneous expectations,
and multiple planning periods;
b) discuss the stability of individual asset and portfolio betas over time;
c) discuss beta estimation problems and why published beta estimates may differ;
d) describe the concept of benchmark error and its implications for testing the
CAPM;
e) discuss why Roll’s critique of the CAPM and Shanken’s challenge to the APT
cause many observers to consider the models to be untestable.

2. “The Process of Portfolio Management”

Note: Suggested problems from the end of this chapter are included below. Solutions are
reprinted in the 2003 Level II Candidate Readings.

The candidate should be able to

a) identify the steps in the investment process;
b) discuss portfolio objectives and the common types of portfolio constraints for
individual and institutional investors;
c) explain the steps in the process of asset allocation;
d) explain how taxes and the concept of tax deferral may affect asset allocation;
e) discuss how investors’ life cycle stages can affect their goal setting;
f) compare and contrast defined contribution pension plans to defined benefit pension
plans, and discuss why defined benefit plans would be more likely to use equities in
their investment portfolio;
g) explain why the shareholders of a company which has a defined benefit plan might
prefer a portfolio consisting of 100 percent bonds.
Problems: 1, 12

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©2002, AIMR®
Ordering Instructions for Curriculum Textbooks
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returned within 60 days of PBD’s ship date. Prior
Canada Brokerage Fees permission is required. Returns received within 30
days of PBD’s ship date are reimbursed at 100% of
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US$0.01 – US$40.00 US$6.25 days of PBD’s ship date are limited to 85% of
US$40.01 – US$100.00 US$17.25 purchase price. In both cases, reimbursement is limited
to cost of books only; shipping and handling are non-
US$100.01 – US$200.00 US$25.50
refundable. Included with each order is a “Returns
US$200.01 – US$350.00 US$32.95 Procedure for Candidates” form that must be
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US$1,000.01 – US$1,250.00 US$51.95 that the package can be traced. Books received without
US$1,250.01 – US$1,600.00 US$55.15 prior permission will be returned. Damaged shipments
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Back Orders
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fulfill all orders upon receipt. However, because of
Delivery of all in-stock items can be expected within
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Orders for all in-stock items will be shipped within 48
processed. All orders must be prepaid in U.S. funds.
hours; any books placed on back order will be charged
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up front at the time of order and will automatically be
additional duties and taxes incurred at customs. Contact
sent by the method requested on the order form as
your nearest customs broker for updates. Business days
soon as PBD receives additional stock from the
do not include Saturday and Sunday.
publisher. If you have questions about availability,
please contact PBD customer relations.
PBD Customer Relations
PBD will select the best method based on cost, location,
and time. If you do not receive your order within the
specified time frame, call the Customer Relations

AIMR has arranged for PBD to be its

authorized distributor of CFA
Candidate Program curriculum
materials.
2003 LEVEL II ORDER FORM*
U.S. CANDIDATES (includes all U.S. territories)
PBD Worldwide Fulfillment Services /AIMR Orders, P.O. Box 931788, Atlanta, Georgia 31193-1788
800-789-AIMR or 770-442-8633, ext. 298; fax 770-442-9742; e-mail [email protected]
To order online, go to www.pbdbookstore.com
Please review Ordering Instructions before placing your order.
Book
Book Title and Author(s) Type Price Code Quantity
2003 CFA Level II Candidate Readings (includes exams/guideline answers**) (AIMR) Softbound $45.00 033102 _________
The Analysis and Use of Financial Statements, 2nd ed. (White, Sondhi, and Fried) Hardbound $78.00 009005 _________
Analysis of Equity Investments: Valuation (AIMR) Hardbound $50.00 023301 _________
Company Performance and Measures of Value Added (RFICFA) Softbound $20.00 989010 _________
Fixed Income Analysis for the Chartered Financial Analyst Program (Fabozzi) Hardbound $85.00 019006 _________
Futures, Options, and Swaps, 3rd ed. (Kolb) Hardbound $70.00 009001 _________
Investment Analysis and Portfolio Management, 6th ed. (Reilly and Brown) Hardbound $75.00 019001 _________
Quantitative Methods for Investment Analysis (AIMR) Hardbound $60.00 013301 _________
Standards of Practice Casebook (AIMR) Softbound $20.00 953301 _________
Standards of Practice Handbook, 8th ed. (AIMR) Softbound $25.00 991101 _________
Solutions Manuals
Solutions Manual for The Analysis and Use of Financial Statements, 2nd ed. Softbound $35.00 009006 _________
(White, Sondhi, and Fried)
Solutions Manual for Futures, Options, & Swaps, 3rd ed. (Kolb) Softbound $22.00 009002 _________
Solutions Manual for Investment Analysis and Portfolio Management, 6th ed. Softbound $20.00 019002 _________
(Reilly and Brown)

Ship to: [PLEASE PRINT OR TYPE]

Name ___________________________________________________________________________ Candidate Number [required] _________________________

Company _____________________________________________________________________________________________________________________________
(Company address strongly preferred; please leave blank if shipping to residential address)

Street _________________________________________________________________________________________________________________________________
(Cannot ship to P.O. Box)

Street _________________________________________________________________________________________________________________________________

City _____________________________________ State ____________________________________ ZIP Code _____________________________________________

Daytime Telephone ___________________________________________ Fax _____________________________ E-mail ________________________________

(Required for shipping purposes only)

Payment Method: Figure Total Here:

Check or money order payable to PBD Total cost of books ordered $ _____________

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— — — — — — — — — — — — — — — —
Ground (5–7 business days)
$5.95 handling
Name on card __________________________________________
Priority (1–2 business days)
$10.95 handling plus $15 for first book
and $3.00 for each additional book $ _____________
Signature _______________________________________________

Billing information: [If different from Ship To address above] Total Cost of Order $ _____________

Address _________________________________________________________ * Order form information and prices valid

1 September 2002–1 June 2003.
City _____________________ State ____________ Zip__________________ ** Exams and guideline answers will be available in November.
See Ordering Instructions for new returns policy.

PBD Worldwide Fulfillment Services, authorized distributor for AIMR.

2003 LEVEL II ORDER FORM*
CANADIAN CANDIDATES
PBD Worldwide Fulfillment Services /AIMR Orders, P.O. Box 931788, Atlanta, Georgia 31193-1788
800-789-AIMR or 770-442-8633, ext. 298; fax 770-442-9742; e-mail [email protected]
To order online, go to www.pbdbookstore.com
Please review Ordering Instructions before placing your order.
Book
Book Title and Author(s) Type Price Code Quantity
2003 CFA Level II Candidate Readings (includes exams/guideline answers**) (AIMR) Softbound US$45.00 033102 ________
The Analysis and Use of Financial Statements, 2nd ed. (White, Sondhi, and Fried) Hardbound US$78.00 009005 ________
Analysis of Equity Investments: Valuation (AIMR) Hardbound US$50.00 023301 ________
Company Performance and Measures of Value Added (RFICFA) Softbound US$20.00 989010 ________
Fixed Income Analysis for the Chartered Financial Analyst Program (Fabozzi) Hardbound US$85.00 019006 ________
Futures, Options, and Swaps, 3rd ed. (Kolb) Hardbound US$70.00 009001 ________
Investment Analysis and Portfolio Management, 6th ed. (Reilly and Brown) Hardbound US$75.00 019001 ________
Quantitative Methods for Investment Analysis (AIMR) Hardbound US$60.00 013301 ________
Standards of Practice Casebook (AIMR) Softbound US$20.00 953301 ________
Standards of Practice Handbook, 8th ed. (AIMR) Softbound US$25.00 991101 ________
Solutions Manuals
Solutions Manual for The Analysis and Use of Financial Statements, 2nd ed. (White, Softbound US$35.00 009006 ________
Sondhi, and Fried)
Solutions Manual for Futures, Options, & Swaps, 3rd ed. (Kolb) Softbound US$22.00 009002 ________
Solutions Manual for Investment Analysis and Portfolio Management, 6th ed. (Reilly Softbound US$20.00 019002 ________
and Brown)

Ship to: [PLEASE PRINT OR TYPE]

Name ___________________________________________________________________________ Candidate Number [required] _________________________

Company _____________________________________________________________________________________________________________________________
(Company address strongly preferred; please leave blank if shipping to residential address)

Street _________________________________________________________________________________________________________________________________
(Cannot ship to P.O. Box)

Street _________________________________________________________________________________________________________________________________

City _____________________________________ Province _________________________________ Postal Code ___________________________________________

Daytime Telephone ___________________________________________ Fax _____________________________ E-mail ________________________________

(Required for shipping purposes only)

Payment Method: Figure Total Here:

Check or money order payable to PBD Total cost of books ordered US$ ___________

MasterCard (16 digits)
VISA (13 or 16 digits) If shipping to Canada, add

American Express (15 digits)
Discover (16 digits) 7% GST (#R123011538) US$ ___________
Brokerage fee (see table in Ordering Instructions) US$ ___________
Expiration Date: ________________________
(Required to process order) Delivery:
— — — — — — — — — — — — — — — —
Ground (5–7 business days)
US$5.95 handling plus US$1.50 per
Name on card __________________________________________ book

Priority (1–3 business days)
US$10.95 handling plus US$20.00 for first
Signature _______________________________________________ book plus US$3.00 for each additional book US$ __________
Billing information: [If different from Ship To address above] Total Cost of Order US$ __________

Address _________________________________________________________ * Order form information and prices valid

1 September 2002 – 1 June 2003.
City _____________________ Province ________ Postal Code __________ ** Exams and guideline answers will be available in November.

See Ordering Instructions for new returns policy.

PBD Worldwide Fulfillment Services, authorized distributor for AIMR.

2003 LEVEL II ORDER FORM*
INTERNATIONAL CANDIDATES
PBD Worldwide Fulfillment Services /AIMR Orders, P.O. Box 931788, Atlanta, Georgia 31193-1788
770-442-8633, ext. 298; fax 770-442-9742; e-mail [email protected]
To order online, go to www.pbdbookstore.com
Please review Ordering Instructions before placing your order.
Book
Book Title and Author(s) Type Price Code Quantity
2003 CFA Level II Candidate Readings (includes exams/guideline answers**) (AIMR) Softbound US$45.00 033102 ________
The Analysis and Use of Financial Statements, 2nd ed. (White, Sondhi, and Fried) Hardbound US$78.00 009005 ________
Analysis of Equity Investments: Valuation (AIMR) Hardbound US$50.00 023301 ________
Company Performance and Measures of Value Added (RFICFA) Softbound US$20.00 989010 ________
Fixed Income Analysis for the Chartered Financial Analyst Program (Fabozzi) Hardbound US$85.00 019006 ________
Futures, Options, and Swaps, 3rd ed. (Kolb) Hardbound US$70.00 009001 ________
Investment Analysis and Portfolio Management, 6th ed. (Reilly and Brown) Hardbound US$75.00 019001 ________
Quantitative Methods for Investment Analysis (AIMR) Hardbound US$60.00 013301 ________
Standards of Practice Casebook (AIMR) Softbound US$20.00 953301 ________
Standards of Practice Handbook, 8th ed. (AIMR) Softbound US$25.00 991101 ________
Solutions Manuals
Solutions Manual for The Analysis and Use of Financial Statements, 2nd ed. (White, Softbound US$35.00 009006 ________
Sondhi, and Fried)
Solutions Manual for Futures, Options, & Swaps, 3rd ed. (Kolb) Softbound US$22.00 009002 ________
Solutions Manual for Investment Analysis and Portfolio Management, 6th ed. (Reilly Softbound US$20.00 019002 ________
and Brown)

Ship to: [PLEASE PRINT OR TYPE]

Name ___________________________________________________________________________ Candidate Number [required] _________________________

Company _____________________________________________________________________________________________________________________________
(Company address strongly preferred; please leave blank if shipping to residential address)

Street _________________________________________________________________________________________________________________________________
(Cannot ship to P.O. Box)

Street _________________________________________________________________________________________________________________________________

City _____________________________________ Country _________________________________ Postal Code ___________________________________________

Daytime Telephone ___________________________________________ Fax _____________________________ E-mail ________________________________

(Required for shipping purposes only)

Payment Method: Figure Total Here:

Check or money order payable to PBD Total cost of books ordered US$ __________

MasterCard (16 digits)
VISA (13 or 16 digits)
Air Freight Delivery: (5–7 business days)

American Express (15 digits)
Discover (16 digits)
US$5.95 handling plus US$20.00 for
Expiration Date: ________________________ first book and US$3.00 for each
(Required to process order) additional book US$ __________
— — — — — — — — — — — — — — — —
Total Cost of Order US$ __________
Name on card __________________________________________
* Order form information and prices valid
Signature _______________________________________________ 1 September 2002 – 1 June 2003.
** Exams and guideline answers will be available in November.
Billing information: [If different from Ship To address above]
See Ordering Instructions for new returns policy.
Address _________________________________________________________

City _____________________ Country_________ Postal Code __________

PBD Worldwide Fulfillment Services, authorized distributor for AIMR.