2004 CFA L2 – Study Tips

Schweser CFA Level 2 Study Tips 2004

Examination Weights and Structure

The morning session of the Level 2 exam (3 hours and 50 percent of the exam) is entirely essay format. The afternoon session (3 more hours and another 50 percent) is in multiple choice, item set format. For the 2004 exam, expect any topic (financial statement analysis, equity valuation, etc.) in either format. The 2004 examination guideline topic area weights, as developed by AIMR, are:

Topic / Guideline Topic
Area Weight
Ethical and Professional Standards / 10%
Economics / 0 to 10%
Quantitative Analysis / 0 to 10%
Financial Statement Analysis and Corporate Finance / 25 to 35%
Asset Valuation (Equity, Debt, and Derivatives) / 35 to 45%
Portfolio Management / 5 to 15%
Total / 100%

Ethics Study Tips – Study Session 1 & 2

Ethics is worth 10 percent of the exam, and is one of the keys to your success on exam day, so make it a top priority. Although you can fail ethics and still pass the exam, I wouldn’t recommend it. Study the details. As you know from Level 1, the ethics questions can be tricky, and nitpicky little details can be important on some ethics questions. Don’t assume that just because you’ve already seen the material at Level 1 you don’t need to study this time around. Level 2 ethics will be more difficult, more detailed, and more challenging than Level 1, so be prepared. In addition to starting early, study the ethics material more than once. It would be optimal if you could study ethics in January and once again in May.

Standards of Practice Handbook

I recommend that you buy and read the original Standards of Practice Handbook. Although we are very proud of our summaries of the ethics material, there are two reasons why we recommend that you buy the original Standards of Practice Handbook. (1) You are a CFA® candidate. As such, you have pledged to abide by the AIMR® Standards. (2) The ethics questions on the actual exam can be an exercise in minutia. You will be much better off if you read our summaries of the Standards and the original Handbook.

Old Ethics Exam Questions

Please note that the Level 2 ethics questions from 2000 through 2003 are not available to the public, so preparing for Level 2 ethics requires a complete and thorough reading of the Standards of Practice Handbook in addition to the study of old exam questions.

In Book 1 of our Level 2 Study Notes we have taken all the old ethics essay questions from 1995 to 1999 and revised them to conform to the item-set format by creating a “vignette” followed by a set of related multiple choice questions. As I noted already, AIMRÒ has changed its policy on exam topic formats for 2004, and now says “…any of the assigned topics may be tested in either format.” However, I think it’s likely that Level 2 ethics will continue to be tested in item-set format for 2004. Reviewing those old questions in item-set format will help you prepare for the ethics portion of the 2004 exam.

Quantitative Methods – Study Session 3

I’ve got good news, bad news, and extra good news for you. The good news is that two of the three topics in the Level 2 quant material are repeats of material you encountered at Level 1: hypothesis testing and simple linear regression (with only one independent variable). The bad news is that the new material on multiple linear regression (with more than one independent variable) is the most important of the three.

The extra good news is that if you have a firm grasp of hypothesis testing and simple linear regression, you can handle the multiple regression and anything you might see on the 2004 Level 2 exam. Hypothesis testing will most likely be tested as part of multiple regression; you will be asked to test the statistical significance of a regression parameter estimate. In addition, ALL of the important concepts in simple linear regression are repeated in the context of multiple regression (e.g., testing regression parameters and calculating predicted values of the dependent variable), and you’re most likely to see these tested as part of a multiple regression question.

The following are the must know quant topics:

§  Conducting a hypothesis test of a population mean using a z-test or t-test.

§  Testing the statistical significance of regression parameter estimates.

§  Interpreting regression parameter estimates.

§  Calculating confidence intervals for regression parameter estimates.

§  Calculating predicted values for the dependent variable in a multiple regression.

§  Interpreting the F-statistic, R-squared, and adjusted R-squared in multiple regression.

§  Interpreting the data in an ANOVA table.

In addition, make sure you are familiar with these concepts:

§  Conducting hypothesis tests of differences of means and mean differences.

§  Conducting hypothesis tests of variances and the equality of variances.

§  Identifying, testing for, and correcting for heteroskedasticity, serial correlation (the Durbin-Watson statistic), and multicollinearity.

Quant has been tested exclusively in item set format since 2001, which means the most recent quant questions that are publicly available come from the 2000 exam. AIMR® says quant will be 0 to 10 percent (0 to 36 points) on the 2004 exam. Expect two 6-question item sets that cover quant. However, don’t be surprised if instead you see a quant question in essay form in the morning section, either as a stand-alone question or as part of economics or equity valuation.

Economics: Study Session 4

If you’re following our suggested Level 2 weekly study schedule, you’ve probably started working on the economics material. According to AIMR®, economics will be zero to ten percent of the Level 2 exam (0 to 36 points). Historically, economics has been about ten percent of the exam, so I would expect to see 30 to 36 points this year. This material will be tested in either item set or essay format. In 2003 there were two economics essay questions worth a total of 18 points, plus an unknown number of item sets and points in the afternoon session.

Economics could be tested as part of a question that integrates economics with another topic area, such as quantitative methods and asset valuation. Be prepared to apply the investment tools you learn in this section to the analysis of equity, debt, and derivative securities.

Here are the concepts you must understand in order to be successful on this section of the exam:

§  Foreign exchange parity relations
There are three ways to forecast future expected spot rates: (1) using inflation rates and purchasing power parity, (2) interest rates and the uncovered interest parity, and (3) forward rates and the unbiased forward rate relationship. Know all three! Also make sure you can use interest rate parity to calculate the no-arbitrage forward exchange rate. This topic also shows up in Study Session 16 on pricing forward and futures contracts. Finally, you should be able to put these concepts together and use the asset market approach to determine the short-and long-run effects on exchange rates of an unexpected increase in the money supply. Parity conditions are the most popular Level 2 economics topic; they were tested in 2003.

§  International asset pricing
This is a lengthy topic with lots of learning outcome statements, and several concepts are very important. The first is the international capital asset pricing model (ICAPM). Understand the components of the model, including currency exposures and currency risk premiums, and be able to calculate the expected return on a stock given a specific formulation of the ICAPM. You should also be able to analyze the impact of currency risk on a company’s valuation (this topic was tested in 2003). Finally, don’t forget about calculating expected and realized domestic currency returns on foreign bonds, given changes in exchange rates.

§  Analyzing the firm’s environment
This is an old favorite with links to other places in the curriculum. Predicting industry sales using GDP as the independent variable is an application of regression analysis from quant in Study Session 3. Analyzing company performance throughout the stages of the business cycle and analyzing the product life cycle are also important topics in the equity valuation material in Study Sessions 10 and 11.

§  Economic growth theory
You should be able to contrast the implications of the two theories of economic growth (the neo-classical model and the endogenous growth theory), and discuss the factors that are likely to promote economic growth. This material provides a nice link to the credit analysis of sovereign debt in Study Session 14.

Economics Part 2

In last week’s tip I provided you with an overview of the most important topics in the Level 2 economics material. This week we’ll focus on one of those topics: foreign exchange parity relations, including relative purchasing power parity (PPP), uncovered interest rate parity, the international Fisher effect, foreign exchange expectations relation, and covered interest rate parity.

PPP says that the expected spot rate in one year (defined as FC per unit of DC) is:

expected spot rate = current spot rate × (1 + inflation in FC)/(1 + inflation in DC)

One of the most confusing things about using relative PPP is deciding which inflation rate to put in the numerator and which to put in the denominator. If you mix them up in a multiple choice question, your answer will be wrong, but it will almost certainly be included among the choices.

The key is to pay attention to how the exchange rates are quoted. In the formula above, the spot rate is quoted in FC per unit of DC, the FC inflation rate is in the numerator, and the DC inflation rate is in the denominator. So whichever rate is on the top in the spot quote is also on the top in the inflation ratio. For example, if the spot rate is quoted as USD/JPY, the U.S. inflation rate should be in the numerator and the Japanese inflation rate should be in the denominator.

Uncovered interest rate parity says the expected spot rate in one year (defined as FC per unit of DC) is:

expected spot rate = current spot rate × (1 + interest rate in FC)/(1 + interest rate in DC)

Covered interest rate parity says the no-arbitrage one-year forward rate (defined as FC per unit of DC) is:

forward rate = current spot rate ×(1 + interest rate in FC)/(1 + interest rate in DC)

Do the same thing for both uncovered and covered interest rate parity: if the spot rate is quoted as FC/DC, put the FC interest rate in the numerator and the DC interest rate in the denominator. For example, if the spot rate is quoted as CAD/AUD, put the Canadian interest rate in the numerator and the Australian interest rate in the denominator.

My advice is to forget about DC and FC, and simply take the spot rate quote as given (e.g., EUR/CHF), and use our simple rule to apply the appropriate formula (e.g., EUR on top and CHF on the bottom). If you’d like some practice with this, take a look at question 3 from the 2003 Level 2 exam.

Financial Statement Analysis: Study Session 5-7

This is the first of four emails regarding financial statement analysis and corporate finance. Level 2 is sometimes called “the accounting level” because 25 to 35 percent of the exam will come from financial statement analysis (and corporate finance, which is part of financial statement analysis at Level 2). Although the majority of the material will probably appear in the afternoon session in item set format, don’t be surprised if you see an essay accounting question in the morning session as well. In 2003 there was an 18 point accounting question in the morning portion of the exam. This material has always been challenging for Level 2 candidates, but you face even more uncertainty this year because the financial statement analysis curriculum has changed the most of any at Level 2 in 2004.

We’ll focus this week on the topics in Study Session 5. First let’s talk about what’s new in the study session. The biggest change is the addition of readings that you first encountered last year at Level 1: inventories, long-lived assets, income taxes, financing liabilities, and leases. However, the Level 2 learning outcome statements (LOS) are significantly different from those at Level 1. The Level 2 LOS use command words, like “compare and contrast,” “evaluate,” and “analyze,” that require a higher level of knowledge of the material. Don’t simply assume you know this material because it’s a repeat of Level 1—you need to spend some time studying it. Look for links with more traditional Level 2 topics. You’re likely to see this material tested as part of a question that requires you to make adjustments to the financial statements (see “Analysis of Financial Statements: A Synthesis” in Study Session 7.

Study Session 5 also includes a new reading on variable interest entities (VIE), which have been a hot topic in financial markets because of the role they played in recent, well-publicized accounting scandals.

Don’t forget about the traditional accounting topics, however: intercorporate investments, business combinations, and pension accounting. These three (along with currency translation, earnings quality, and financial statement adjustments) represent the heart and soul of the Level 2 accounting material, so expect to see all three of them on the 2004 exam. You can’t be successful at Level 2 without knowing those topics inside and out.