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ExamInsight
For CFA 2006 Level I Certification:
The Candidate’s Guide to
Chartered Financial Analyst
Learning Outcome Statements
www.financialexams.com

Practice exam provided by The Center For Financial Certification, Inc. Friendswood, Texas
Authors
Jane Vessey, CFA
M. Afdal Pamilih, CFA
David Stewart
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This book is dedicated to our fantastic children Adam and Julia who we love very much.
Jane Vessey & M. Afdal Pamilih




This Study Guide is dedicated to the widow(er)s and orphans of the “Silent Spring”. Those who
have sacrificed loved ones to the obscurity of quiet study and endured weekend sacrifice above
and beyond the call of continuing education. On the alter of a profession’s highest accreditation
these unsung heroes have sacrificed time with their spouse, shopping with Mom, and pitch and
catch with Dad. These patient supporters have endured tense attitudes, unfinished chores, extra
duties, and received the respect and appreciation of all who have studied throughout the “Silent
Spring”.
In particular, never ending thanks to:
Carol Lee, Mary Elizabeth, Sophia Victoria, David Todd II
David Stewart

ExamInsight®
For
The Candidate’s Guide to (CFA®)
Chartered Financial Analyst 2006 Level I
Learning Outcome Statements
www.financialexams.com
BY
Authors
Jane Vessey, CFA
M. Afdal Pamilih, CFA

Contributing Author
David Stewart
Jane Vessey
Jane Vessey manages a training company in the United Kingdom specializing in financial
analysis and investment. She is a visiting lecturer at Cass Business School teaching classes in
asset management and valuation. She also teaches a CFA
®
revision course at ISMA (the business
school at Reading University) and is an associate at a leading London financial training company
where she teaches courses covering investment management and related topics. She has
developed online training programs for students taking the CFA examinations and teaches CFA
courses for UKSIP (the UK Society of Investment Professionals).
Jane graduated in Mathematics from Oxford University, United Kingdom, and is a CFA charter
holder. She has some eighteen years experience working in the investment industry, starting out
as an equity analyst before becoming an investment manager. She was based in London and
Tokyo and took responsibility for managing equity portfolios invested in the Japanese and other
Asian markets. In 1990, Jane moved to Indonesia and established and ran an investment
management operation on behalf of Mees Pierson. She took responsibility for all areas of the
business, including investment, operations, marketing and administration. While in Asia, Jane
was involved in providing training to capital market participants and state officials and teaching
in courses provided by local universities.


M. Afdal Pamilih
Afdal has 18 years' experience working in the finance industry. He started his career with J.P.
Morgan, and then with County NatWest Government Securities, in New York specializing in the
development of quantitative products for foreign exchange and fixed income markets. After
returning to Indonesia in 1989 he was responsible for the development of investment services
and subsequently treasury management for leading banks in Jakarta.
Afdal has developed web-based training programs for the CFA examinations and has wide

teaching experience, including instructing at the School of Management, University of Surrey,
United Kingdom.
He obtained a MSc in Mathematics from the University of Texas at Arlington and holds the
Chartered Financial Analyst ("CFA") qualification.




David Stewart:
David Stewart has extensive experience in venture capital and business structural
reorganizations. As president of a private client broker dealer firm, he has business valuation and
project valuation experience on the venture capital side and portfolio management on the asset
management side. His analysis, commentary, books, and study guides have appeared in the
financial management, securities, and exam prep industries.
David has collaborated with experts in the field to produce the 2001 through 2006 editions of this
study guide. His extensive research into the CFA exam program and past exam histories, field
work, and consistent review of CFA Institute information allows him and his co-authors to
deliver high quality and up to date information.

About the Book:
ExamInsight to CFA Level I Certification is designed to help you master the Learning Outcome
Statements as quickly and as effectively as possible so you can pass the CFA Level I exam your
first time. This compact study guide and download test engine with 1250+ practice questions will
give you the information, practice exams, and test-taking tips that you need to reach a passing
level and feel confident that you are ready for the real exam
You can also feel confident that your are getting some of the best advice and coaching available,
since our authors are not only CFA charter holders and successful investment professionals, but
also teach CFA exam preparation courses in college, online, and in seminars. You get the benefit
of their combined international experience.
This book is divided into Study Sessions (1 – 18) that cover the Learning Outcome Statements and

the associated Assigned Readings. Appendix A (Exhibits 1 – 3), is a collection of exhibits and flow
charts for condensed reference and review, including examples of accounting statements, puts
and calls, PE breakdown, and financial ratios.
The 18 2006 CFA Level I Study Sessions breakout is as follows:
Ethical and Professional Standards
Study Session 1: Ethical and Professional Standards
Investment Tools
Study Session 2. Quantitative Methods: Basic Concepts
Study Session 3. Quantitative Methods: Application
Study Session 4. Economics: Macroeconomic Analysis
Study Session 5. Economics: Microeconomic Analysis
Study Session 6. Economics: Global Economic Analysis
Study Session 7. Financial Statement Analysis: Basic Concepts
Study Session 8. Financial Statement Analysis: Financial Ratios and Earnings Per Share
Study Session 9. Financial Statement Analysis: Assets
Study Session 10. Financial Statement Analysis: Liabilities
Study Session 11. Corporate Finance: Corporate Investing & Financing Decisions
Asset Valuation
Study Session 12. Equity Investments: Securities Markets
Study Session 13. Equity Investments: Industry and Company Analysis
Study Session 14. Fixed Income Investments: Basic Concepts
Study Session 15. Fixed Income Investments: Analysis and Valuation
Study Session 16. Derivative Investments
Study Session 17. Alternative Investments
Portfolio Management
Study Session 18. Portfolio Management
Download Supplemental Information: Obtain printable content from this links.

Preliminary Reading Assignments Supplement and Concept Check Questions Workbook



Online Information:
1. CFA Program:

2. The Code of Ethics (Full Text)

3. International Code Of Ethics And Standards Of Professional Conduct

4. Interpretations of CFA Institute's Code of Ethics and Standards of Professional Conduct

5. The Standards of Professional Conduct
Standard I: Fundamental Responsibilities
Standard II: Relationships with and Responsibilities to the Profession
Standard III: Relationships with and Responsibilities to the Employer
Standard IV: Relationships with and Responsibilities to Clients and Prospects
Standard V: Relationships with and Responsibilities to the Public




6. CFA Institute-PPSTM AIMR Performance Presentation Standards

7. Global Investment Performance Standards

8. Soft Dollar Learning Module




List of Chapters

STUDY SESSION 1 1
STUDY SESSION 2 47
STUDY SESSION 3 121
STUDY SESSION 4 185
STUDY SESSION 5 207
STUDY SESSION 6 247
STUDY SESSION 7 269
STUDY SESSION 8 307
STUDY SESSION 9 337
STUDY SESSION 10 365
STUDY SESSION 11 389
STUDY SESSION 12 443
STUDY SESSION 13 463
STUDY SESSION 14 499
STUDY SESSION 15 553
STUDY SESSION 16 589
STUDY SESSION 17 637
STUDY SESSION 18 665
Terminology 693
Appendix A: 695
Download Instructions 710




Table of Contents IX

Table of Contents
About the Book: VI
Online Information: VII

2006 CFA Level I Study and Examination Program Textbooks: XXVI
Dates Regarding the June 2006 CFA Examination XXVII
Preface XXVIII
Practice Questions and Answers XXVIII
CFA Program XXX
Requirements XXX
Study Program XXXI
Taking the Exam XXXII
On the Exam Day XXXIII
STUDY SESSION 1 1
Ethical and Professional Standards 1
Overview 1
Reading Assignments 1
1 Code of Ethics and Standards of Professional Conduct 2
Learning Outcome Statements (LOS) 2
Introduction 2
Standard I: Professionalism 4
Standard II: Integrity of Capital Markets 4
Standard III: Duties to Clients and Prospective Clients 4
Standard IV: Duties to Employers 6
Standard V: Investment Analysis, Recommendations, and Actions 6
Standard VI: Conflicts of Interest 7
Standard VII: Responsibilities as a CFA Institute Member or CFA Candidate 7
2 Guidance for Standards I - VII 8
Learning Outcome Statements (LOS) 8
Introduction 8
Standard I: Professionalism 9
Standard II: Integrity of Capital Markets 12
Standard III: Duties to Clients 14
Standard IV: Duties to Employers 19

Standard V: Investment Analysis, Recommendations, and Actions 22
Standard VI: Conflicts of Interest 23
Standard VII: Responsibilities as a CFA Institute Member or CFA Candidate 26
3 Introduction to the Global Investment Performance Standards (GIPS®) and 28
4 Global Investment Performance Standards 28
Learning Outcome Statements (LOS) 28
Introduction 29
Composites 30
Verification 31
GIPS objectives 31
Private equity 34
5
The Corporate Governance of Listed Companies: A Manual for Investors 35
X Table of Contents

Learning Outcome Statements (LOS) 35

Introduction 36
Independence 38
External consultants 40
Committees 41
STUDY SESSION 2 47
Quantitative Methods: Basic Concepts 47
Overview 47
Reading Assignments 47
6 The Time Value Of Money 48
Learning Outcome Statements (LOS) 48
Introduction 48
Interest rate and risk 49
Future value and present value of a single sum 50

Stated and effective annual interest rates 53
Value of money for periods other than annual 55
Series of cash flows (annuities) 58
Time lines 66
7 Discounted Cash Flow Applications 70
Learning Outcome Statements (LOS) 70
Introduction 70
Net Present Value (NPV) 70
Internal rate of return 72
Measuring portfolio returns 73
8 Statistical Concepts and Market Returns 81
Learning Outcome Statements (LOS) 81
Introduction 82
Statistics 82
1. Mean 89
2. Median 91
3. Mode 91
4. Harmonic mean 92
Measures of dispersion 93
Chebyshev’s inequality 98
Coefficient of variation 99
Symmetric and skewed distributions 101
Kurtosis 102
Semi-logarithmic scale 102
9 Probability Concepts 103
Learning Outcome Statements (LOS) 103
Introduction 104
Random variables 104
Calculating probabilities 105
General rule of multiplication 106

General rule of addition 107
Table of Contents XI

Covariance 112

Correlation 114
Bayes’ formula 116
Multiplication rule of counting 118
The general formula for labeling problems 118
Combination formula 119
Permutation formula 119
STUDY SESSION 3 121
Quantitative Methods: Applications 121
Overview 121
Reading Assignments 121
10 Common Probability Distributions 122
Learning Outcome Statements (LOS) 122
Introduction 123
Probability distributions 123
Binomial distributions 125
Binomial probability distribution 126
Mean and variance of binomial random variables 126
Binomial trees 127
Continuous uniform distribution 127
Normal distribution 129
Lognormal distributions 133
11 Sampling and Estimation 136
Learning Outcome Statements (LOS) 136
Introduction 136
Sampling 137

Central limit theorem 139
Estimating a population parameter 141
Confidence intervals 142
Student’s t – distribution 144
Confidence intervals for the population mean 146
Biases impacting on data selected 148
12 Hypothesis Testing 149
Learning Outcome Statements (LOS) 149
Introduction 150
Hypothesis testing 150
Choice of test 155
Tests for means of two different groups 159
Paired comparison tests 161
Testing for variance 164
Differences between variances 165
13 Correlation and Regression 167
Learning Outcome Statements (LOS) 167
Introduction 168
Scatter plots 168
XII Table of Contents

STUDY SESSION 4 185
Economics: Macroeconomic Analysis 185
Overview 185
Reading Assignments 185
14 Economic Fluctuations, Unemployment and Inflation 186
Learning Outcome Statements (LOS) 186
Introduction 186
The business cycle 186
The labor force 187

Types of unemployment 187
Inflation 188
15 Fiscal Policy 190
Learning Outcome Statements (LOS) 190
Introduction 190
Keynesian economics 190
16 Money and the Banking System 193
Learning Outcome Statements (LOS) 193
Introduction 193
Money supply 193
The banking system 193
17 Modern Macroeconomics: Monetary Policy 196
Learning Outcome Statements (LOS) 196
Introduction 196
Money demand and supply 196
Interest rates 199
18 Stabilization Policy, Output and Employment 201
Learning Outcome Statements (LOS) 201
Introduction 201
Index of leading indicators 201
Expectations 203
STUDY SESSION 5 207
Economics: Microeconomic Analysis 207
Overview 207
Reading Assignments 207
19 Demand and Consumer Choice, including Consumer Choice and Indifference Curves 208
Learning Outcome Statements (LOS) 208
Introduction 208
Other terms 209
LOS. 1. A. b) and LOS. 1. A. c) (as in preliminary reading) 210

Shifts in Demand 210
Price elasticity of demand 210
Income elasticity 212
Consumer indifference curves 212
20 Costs and the Supply of Goods 215
Learning Outcome Statements (LOS) 215
Table of Contents XIII

Introduction 215

Business costs 217
Costs 218
The law of diminishing returns 218
21 Price Takers and the Competitive Process 222
Learning Outcome Statements (LOS) 222
Introduction 222
Price-taker market 223
22 Price-Searcher Markets with Low Entry Barriers 227
Learning Outcome Statements (LOS) 227
Introduction 227
Competitive price-searcher markets 227
23 Price-Searcher Markets with High Entry Barriers 231
Learning Outcome Statements (LOS) 231
Introduction 231
Entry barrierss 232
Monopoly 232
Oligopoly 232
24 The Supply of and Demand for Productive Resources 235
Learning Outcome Statements (LOS) 235
Introduction 235

Shifts in the demand curve 237
Supply of resources 238
25 The Financial Environment: Markets, Institutions and Interest Rates 240
Learning Outcome Statements (LOS) 240
Introduction 240
Cost of capital 241
Nominal rate of interest 242
Inflation premium 243
Default risk premium 243
Liquidity premium 243
Maturity risk premium 243
STUDY SESSION 6 247
Economics: Global Economic Analysis 247
Overview 247
Reading Assignments 247
26. Gaining from International Trade 247
Learning Outcome Statements (LOS) 247
Introduction 248
Impact of free trade on supply and demand 249
Trade restrictions 250
27 Foreign Exchange 253
Learning Outcome Statements (LOS) 253
Introduction 253
Bid-ask spreads 254
XIV Table of Contents

Forward exchange rates 256

Forward premiums and discounts 257
Interest rate parity 258

28 Foreign Exchange Parity Relations 260
Learning Outcome Statements (LOS) 260
Introduction 260
Balance of payments 261
Current account 262
Financial account 262
Factors affecting exchange rates 263
Monetary policy 263
Fiscal policy 264
Purchasing Power Parity (PPP) 265
Absolute Purchasing Power Parity (Absolute PPP) 265
Relative Purchasing Power Parity (Relative PPP) 265
STUDY SESSION 7 269
Financial Statement Analysis: Basic Concepts 269
Overview 269
Readings Assignments 270
29 Framework for Financial Statement Analysis 270
Learning Outcome Statements (LOS) 270
Introduction 271
Role of FASB 272
Role of the auditor 273
30 Long-Term Assets 274
Learning Outcome Statements (LOS) 274
Introduction 274
Long-term assets 274
31 Accounting Income and Assets: The Accrual Concept 277
Learning Outcome Statements (LOS) 277
Introduction 277
Income statement 278
Revenue and expense recognition 279

Revenue recognition 281
Expense recognition 281
Software revenue recognition 281
Installment method 282
Cost recovery method 282
Percentage-of-completion method 282
Completed contract method 283
Nonrecurring items 286
Balance sheet 289
Stockholders’ equity 291
32 The Statement of Cash Flows 292
Learning Outcome Statements (LOS) 292
Table of Contents XV

Introduction 292

Cash flows from operating activities 293
Cash flows from investing activities 293
Cash flows from financing activities 293
33 Analysis of Cash Flows 294
Learning Outcome Statements (LOS) 294
Introduction 294
Statement of cash flows 294
Classification of individual items 295
Direct method 298
Indirect method 299
Acquisitions and divestures 300
Foreign subsidiaries 300
Analysis of cash flows 300
34 Future FASB Changes and the Analytical Challenges of GAAP 303

Learning Outcome Statements (LOS) 303
Introduction 303
Projects related to international convergence 303
Revenue recognition 304
STUDY SESSION 8 307
Financial Statement Analysis: Financial Ratios and Earnings per Share 307
Overview 307
Reading Assignments 307
35 Analysis of Financial Statements 308
Learning Outcome Statements (LOS) 308
Introduction 308
Financial information used in Examples 35-1 to 35-7 309
1. Common-size statements 311
2. Internal liquidity (solvency) 312
3. Operating performance 315
4. Risk analysis 317
5. Growth analysis 320
36 Dilutive Securities and Earnings per Share 323
Learning Outcome Statements (LOS) 323
Introduction 323
Simple capital structure 324
Weighted average number of shares 324
Complex capital structure 325
Convertible securities 326
Options and warrants 326
Simple capital structure 327
Complex capital structure 327
37 Seek and Ye Shall Find 38 Searching for Shenanigans 328
Learning Outcome Statements (LOS) 328
Introduction 328

XVI Table of Contents

Why do people resort to shenanigans? 330

STUDY SESSION 9 337
Financial Statement Analysis: Assets 337
Overview 337
Reading Assignments 337
39 Analysis of Inventories 338
Learning Outcome Statements (LOS) 338
Introduction 338
Balance sheet 342
Income statement 342
LIFO versus FIFO – impact on income statement and balance sheet 342
Adjustment of income to current cost income 344
Financial ratios under LIFO and FIFO 345
40 Analysis of Long-Lived Assets, Part 1 – The Capitalization Decision 347
Learning Outcome Statements (LOS) 347
Introduction 347
Impact of capitalizing versus expensing costs 349
Capitalization of interest 349
Capitalization of intangible assets 350
Asset revaluation 351
41 Analysis of Long-Lived Assets, Part 2 – Analysis of Depreciation and Impairment 352
Learning Outcome Statements (LOS) 352
Introduction 352
Different methods of calculating depreciation 353
Accelerated depreciation methods 354
Units-of-production and service hours method 357
Depletion 357

Amortization 357
Impact of choice of depreciation method on the financial statements 357
Changes in depreciation method 358
Impairment of long-lived assets 360
STUDY SESSION 10 365
Financial Statement Analysis: Liabilities 365
Overview 365
Reading Assignments 365
42 Analysis of Income Taxes 366
Learning Outcome Statements (LOS) 366
Introduction 366
Deferred tax liabilities and assets 369
Deferred tax liability or an increase in stockholders’ equity? 371
Changes in tax rates 373
43 Analysis of Financing Liabilities 374
Learning Outcome Statements (LOS) 374
Introduction 374
Convertible bonds, warrants, and convertible preferred stock 378
Table of Contents XVII

44
Leases and Off-Balance-Sheet Debt 380
Learning Outcome Statements (LOS) 380
Introduction 380
Classification of leases 381
Off-balance-sheet financing 385
Financial reporting by lessors 386
Financial statement reporting for a sales-type lease 386
Financial statement reporting for a direct-financing lease 387
STUDY SESSION 11 389

Corporate Finance 389
Overview 389
Reading Assignments 389
45 An Overview of Financial Management 390
Learning Outcome Statements (LOS) 390
Introduction 390
Stockholders versus managers 390
Stockholders (through managers) versus creditors 391
Mechanisms used to motivate managers to act in stockholders’ best interests 392
46 The Cost of Capital 393
Learning Outcome Statements (LOS) 393
Introduction 393
Component costs of capital 394
Cost of new equity 398
Weighted-average cost of capital (WACC) 399
Factors than affect the cost of capital 400
46 Questions 401
47 The Basics of Capital Budgeting 403
Learning Outcome Statements (LOS) 403
Introduction 403
Methods for evaluating investment proposals 404
Modified internal rate of return (MIRR) 409
48 Cash Flow Estimation and Other Topics in Capital Budgeting 412
Learning Outcome Statements (LOS) 412
Introduction 412
Defining cash flow 412
Projects with unequal lives 417
Inflation 418
49 Risk Analysis and the Optimal Capital Budget 419
Learning Outcome Statements (LOS) 419

Introduction 419
Measuring beta 423
50 Capital Structure and Leverage 424
Learning Outcome Statements (LOS) 424
Introduction 425
Target capital structure 425
XVIII Table of Contents

Business and financial risk 426

Operating leverage 426
Determining the optimal capital structure 431
Capital structure theory 432
51 Dividend Policy 434
Learning Outcome Statements (LOS) 434
Introduction 434
Dividend payment procedures 438
Non-cash dividends 439
Stock repurchases 439
STUDY SESSION 12 443
Equity Investments: Securities Markets 443
Overview 443
Reading Assignments 443
52 Organization and Functioning of Securities Markets 444
Learning Outcome Statements (LOS) 444
Introduction 444
Characteristics of a well-functioning market 444
Primary markets 445
Primary markets 446
Secondary markets 446

Secondary equity markets 446
Exchange membership 448
Types of orders 448
Short sales 449
Margin transactions 449
Institutionalization of securities markets 451
53 Security Market Indicator Series 452
Learning Outcome Statements (LOS) 452
Introduction 452
Security market indexes 452
54 Efficient Capital Markets 457
Learning Outcome Statements (LOS) 457
Introduction 457
Definition 457
Tests for the weak-form EMH 458
Tests for the semistrong-form EMH 459
Anomalies to the semistrong-form EMH 459
Tests for the strong-form EMH 460
STUDY SESSION 13 463
Equity Investments: Industry and Company Analysis 463
Overview 463
Reading Assignments 463
55 An Introduction to Security Valuation 464
Learning Outcome Statements (LOS) 464
Table of Contents XIX

Introduction 464

Approaches to the valuation of securities 464
Top-down approach 465

Bottom-up approach 465
Value of preferred stock 466
Dividend discount model 467
Earnings multiplier model (or P/E) 468
Calculation of k, the required rate of return 469
Estimating the growth rate, g 470
56 Stock-Market Analysis 472
Learning Outcome Statements (LOS) 472
Introduction 472
The calculation of EPS for a stock market series 472
57 Industry Analysis 476
Learning Outcome Statements (LOS) 476
Introduction 476
Structural economic changes 476
58 Equity: Concepts and Techniques 477
Learning Outcome Statements (LOS) 477
Introduction 477
The business cycle 477
Industry analysis and return 478
Industry life cycle 479
Competitive environment 480
Industry analysis and risk 482
Five forces 483
59 Company Analysis and Stock Selection 484
Learning Outcome Statements (LOS) 484
Introduction 484
Estimating a company’s earnings per share 485
Estimating a company’s earnings multiplier 485
The calculation of the expected rate of return of a stock 486
60 Technical Analysis 487

Learning Outcome Statements (LOS) 487
Introduction 487
Assumptions of technical analysis 487
Contrary-opinion technical analysts 489
Follow the smart money 490
Other indicators 490
Price and volume analysis 491
61 Introduction to Price Multiples 492
Learning Outcome Statements (LOS) 492
Introduction 492
Price to earnings (P/E) 492
Price to book value (P/B) 495
Price to sales (P/S) 496
XX Table of Contents

Price to cash flow (P/CF) 496

STUDY SESSION 14 499
Fixed Income Investments: Basic Concepts 499
Overview 499
Reading Assignments 499
62 Features of Debt Securities 500
Learning Outcome Statements (LOS) 500
Introduction 500
Indentures 501
Covenants 501
Coupon rate structures 503
Floating-rate securities 504
Accrued interest 506
Early retirement provisions 507

Regular and special redemption prices 508
Embedded options 509
63 Risks Associated with Investing in Bonds 511
Learning Outcome Statements (LOS) 511
Introduction 512
Risks in bond investment 512
Interest rate risk 514
Interpretation of duration 516
Computation of duration 516
Yield curve risk 517
Reinvestment risk 519
Prepayable amortizing securities 519
Credit risk 519
Credit ratings 520
Liquidity risk 520
Exchange rate risk 521
Inflation risk 522
Volatility risk 522
Event risk 523
64 Overview of Bond Sectors and Instruments 524
Learning Outcome Statements (LOS) 524
Introduction 525
International bonds 525
United States Treasury securities 526
On-the-run and off-the-run Treasury securities 528
How stripped Treasury securities are created 529
Mortgage-backed securities 530
Cash flows for mortgage-backed securities 530
Prepayments and their risk 532
Federal agency securities 532

Motivation for creating a collateralized mortgage obligation 532
Table of Contents XXI

Municipal bonds 533

General obligation and revenue bonds 533
Bankruptcy 534
Credit ratings 535
Structured notes 536
Motivation of issuing a structured note 537
Commercial Paper 537
The uses and limitations of bank obligations 537
Asset-backed securities 538
Special purpose vehicles 538
Motivation for asset securitization 538
External credit enhancement 539
Primary vs. secondary markets in bonds 540
65 Understanding Yield Spreads 542
Learning Outcome Statements (LOS) 542
Introduction 542
Basic theories of term structure of interest rates 545
Implications of the theories 545
Yield measures 546
Intermarket and intramarket spread 548
Credit spread 548
The relationship between the size of an issue, liquidity and yield spread 549
STUDY SESSION 15 553
Fixed Income Investments: Analysis and Valuation 553
Overview 553
Reading Assignments 553

66 Introduction to the Valuation of Debt Securities 554
Learning Outcome Statements (LOS) 554
Introduction 554
Bond valuation 555
The appropriate interest rate in valuing a bond 556
Computation value of a bond given expected cash flows and appropriate discount rate556
How the value of a bond changes with the discount rate’s increase or decrease 557
Zero-coupon bonds 558
Arbitrage-free valuation approach 559
Under or overvaluation 560
Generating an arbitrage profit 560
67 Yield Measures, Spot Rates and Forward Rates 561
Learning Outcome Statements (LOS) 561
Introduction 561
Yield measures 562
Underlying assumptions in traditional yield measures 565
Factors that affect reinvestment risk 567
Forward rates 571
68 Introduction to the Measurement of Interest Rate Risk 575
XXII Table of Contents

Learning Outcome Statements (LOS) 575

Introduction 575
Convexity 577
Price volatility characteristics 578
Price volatility characteristics of putable bonds 578
Calculating effective duration 579
Approximate Percentage Price Change 580
Types of duration 581

Effective duration versus modified duration or Macaulay duration 582
Why duration is best interpreted as a measure of a bond’s or portfolio’s sensitivity to
changes in interest rates? 583

The limitations of the portfolio duration measure 584
Convexity 584
How do we use the convexity measure to adjust the percentage price change? 585
STUDY SESSION 16 589
Derivative Investments 589
Overview 589
Reading Assignments 589
69 Derivative Markets and Instruments 590
Learning Outcome Statements (LOS) 590
Introduction 590
Definition of a derivative 590
Exchange-traded versus over-the-counter derivatives 590
Definition of forward commitment 591
Forward commitments 591
Contingent claims 591
Purposes of derivative markets 592
Criticisms of derivative markets 593
70 Forward Markets and Contracts 594
Learning Outcome Statements (LOS) 594
Introduction 594
Long and short parties 594
Expiration 595
Termination of a contract 595
Equity forwards 596
Bond forwards 597
Eurodollar time deposits 597

Currency forwards 599
71 Futures Markets and Contracts 600
Learning Outcome Statements (LOS) 600
Introduction 600
Futures versus forwards 601
Margin requirements 602
Limit moves 603
Financial and currency futures 605
Table of Contents XXIII

72
Option Markets and Contracts 607
Learning Outcome Statements (LOS) 607
Introduction 608
Intrinsic value 609
Financial options 610
Option pricing 613
Lower bounds 616
Exercise price 617
Time to expiry 618
Put-call parity 618
Interest rates 621
73 Swap Markets and Contracts 622
Learning Outcome Statements (LOS) 622
Introduction 622
Swap contracts 622
Termination of swaps 623
Currency swaps 623
Currency swap payments 625
Interest rate swaps 625

Interest rate swap payments 625
Equity swaps 627
Equity swap payments 627
74 Risk Management Applications of Option Strategies 628
Learning Outcome Statements (LOS) 628
Introduction 628
Profit on call options 629
Profit on put options 630
Covered call 631
Protective put 633
STUDY SESSION 17 637
Alternative Investments 637
Overview 637
Reading Assignments 637
75 Alternative Investments 638
Learning Outcome Statements (LOS) 638
Introduction 639
Investment companies 639
Fees 641
Exchange traded funds (ETFs) 643
Advantages of ETFs 644
Disadvantages of ETFs 645
Risks 646
Real estate 646
Forms of real estate investment 646
Characteristics of real estate 647