Members' Guide To 2023 Refresher Readings: in The Mainland of China, CFA Institute Accepts CFA® Charterholders Only

MEMBERS’ GUIDE TO
2023 REFRESHER
READINGS
In the mainland of China, CFA Institute accepts CFA® charterholders only.

© 2022 CFA Institute. All rights reserved.
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In the mainland of China, CFA Institute accepts CFA charterholders

only.
Contents
Foreword 1
Derivatives 5
Readings 5
What Is Changing in the 2023 Curriculum, and Why Does
It Matter? 6
Derivative Instrument and Derivative Market Features 11
Forward Commitment and Contingent Claim Features
and Instruments 13
Derivative Benefits, Risks, and Issuer and Investor Uses 16
Arbitrage, Replication, and the Cost of Carry in Pricing
Derivatives 18
Pricing and Valuation of Forward Contracts and for an
Underlying with Varying Maturities 21
Pricing and Valuation of Futures Contracts 24
Pricing and Valuation of Interest Rate and Other Swaps 27
Pricing and Valuation of Options 30
Option Replication Using Put–Call Parity 33
Valuing a Derivative Using a One-Period Binomial Model 36
Economics 39
Reading 39
It Matter? 40
Introduction to Geopolitics 41
Corporate Issuers 49
Readings 49
Contents

It Matter? 50
Corporate Structures and Ownership 54
Introduction to Corporate Governance and Other ESG
Considerations 59
Business Models & Risks 63
Capital Investments 66
Working Capital& Liquidity 71
Capital Structure 74
Financial Statement Modeling 78
Cost of Capital: Advanced Topics 83
Corporate Restructuring 85
Alternative Investments 89
Readings 89
It Matter? 90
Categories, Characteristics, and Compensation Structures
of Alternative Investments 92
Performance Calculation and Appraisal of Alternative
Investments 100
Private Capital, Real Estate, Infrastructure, Natural
Resources, and Hedge Funds 103
Overview of Types of Real Estate Investment 106
Investments in Real Estate through Private Vehicles 110
Investments in Real Estate through Publicly Traded
Securities 112
Portfolio Management 117

Reading 117
iv Members’ Guide to 2023 Refresher Readings

Contents
What Is Changing in the 2023 Curriculum, and

Why Does It Matter? 118
Fintech in Investment Management 119
Quantitative Methods 123

Readings 123
It Matter? 124
Basics of Multiple Regressionand Underlying Assumptions 127
Evaluating Regression Model Fit and Interpreting Model
Results 131
Model Misspecification 134
Extensions of Multiple Regression 137
Ethics 141
Reading 141
It Matter? 142
Application of the Code and Standards: Level II 143
© 2022 CFA Institute. All rights reserved. v

Foreword
As the investment industry continues to evolve, our Professional
Learning team remains committed to delivering flexible learning
opportunities in formats that fit our member’s needs across a wide
variety of topic areas to help you upskill and reskill throughout your
career. We encourage you to take advantage of these opportunities—
ranging from online self-paced courses and live instructor-led
trainings, to the latest research and industry insights and more—
and to access high-quality, practitioner-relevant content that will
help you reach your personal and professional goals.
Year after year, our Refresher Readings have proven to be one of
our most popular Professional Learning products. This popularity
shows our members’ commitment to keeping their skills and knowl-
edge current. We are excited to share the latest developments in the
CFA® Program curriculum—the source of the Refresher Readings you
can access as an exclusive member benefit.
Last year, we made comprehensive changes to the CFA Program
curriculum. The 2023 readings build on those improvements by
evolving the structure of the curriculum, improving key topic areas,
and reflecting the extensive work coming out of Practice Analysis
and curriculum development.
A significant change in the curriculum in recent years comes at
Level I. By revising the material to a learning module structure, we
have aligned the content with best practice to meet adult learners’
needs. Each module is designed to be completed in one sitting, and
practice questions are included throughout. The modules incorpo-
rate more visuals and realistic content, plus expert demonstrations
followed by opportunities for CFA charterholders and CFA Institute
members to practice the skills.
© 2022 CFA Institute. All rights reserved. 1

Foreword
In addition to modernizing the format and presentation, key

changes from the 2023 curriculum appear in the following categories:
• An updated and expanded analysis explains the use of deriva-
tives in the investment industry and how investment profession-
als navigate derivative markets.
• A new “Introduction to Geopolitics” reading at Level I in the
economics topic area provides a structure for thinking about a
wide range of geopolitical issues and assessing their risks.
• New and updated readings in the corporate issuers (formerly
corporate finance) topic area include refreshed environmental,
social, and governance (ESG) content, general partner and lim-
ited partner structures, and more. In particular, the “Corporate
Restructuring” reading at Level II covers all types of corporate
restructurings and explains how to model them using spread-
sheet modeling.
• Alternative investments readings have been modularized
and now reflect greater depth and detail. For Level II, three
integrated modules cover various topics in real estate, includ-
ing investments through private vehicles and publicly traded
securities.
• New content highlights decentralized finance and blockchain in
the portfolio management topic area.
• Multiple regression content has been updated with investment-
focused datasets in the quantitative methods topic area. At
Level II, the material now includes information on evaluating
outliers and influential observations as well as expanded content
on logistic regression, an important foundation for neural net-
work estimation.
2 Members’ Guide to 2023 Refresher Readings

Foreword
• A new vignette in the “Application of the Code and Standards”

reading at Level II helps members refine their ethics expertise.
I hope you find these Refresher Readings applicable to
your day-to-day work. We welcome your feedback on our
Professional Learning program and resources. Please contact us at
[email protected].
Barbara Petitt, PhD, CFA

Managing Director, Professional Learning

Derivatives
Readings
Reading Level PL Credits Link
Derivative Instrument and I 0.75 cfainst.is/
Derivative Market Features derivatives
Forward Commitment and I 1 cfainst.is/

Contingent Claim Features forward
and Instruments commitment
Derivative Benefits, Risks, I 0.75 cfainst.is/deriva-
and Issuer and Investor Uses tivebenefitsrisks
Arbitrage, Replication, and I 0.75 cfainst.is/
the Cost of Carry in Pricing arbitrage
Derivatives
Pricing and Valuation of I 1 cfainst.is/
Forward Contracts and for forwardcontracts
an Underlying with Varying
Maturities
Pricing and Valuation of I 0.75 cfainst.is/futures
Futures Contracts
Pricing and Valuation of I 0.75 cfainst.is/swaps
Interest Rates and Other Swaps
Pricing and Valuation of I 0.75 cfainst.is/options
Options
Option Replication Using I 0.5 cfainst.is/putcall
Put–Call Parity
Valuing a Derivative Using a I 0.75 cfainst.is/binomial
One-Period Binomial Model

What Is Changing in the
2023 Curriculum, and Why
Does It Matter?
The biggest change to the curriculum for 2023 is an updated and
expanded analysis of the use of derivatives in the investment indus-
try and explanation of how investment managers navigate derivative
markets. This new content is designed around learning modules that
can be mastered in an evening of study. The expanded derivatives
content incorporates a wealth of visuals and realistic content, plus
expert demonstrations and opportunities for learners to practice
their skills.
The new “Derivative Instrument and Derivative Market
Features” learning module defines derivatives and describes their
basic features. It presents an overview of derivative markets and com-
pares over-the-counter and exchange-traded markets.
This reading shows how derivatives expand the set of investment
opportunities beyond the cash market to create or modify exposure
to an underlying security. Given that derivatives are increasingly
centrally cleared today, the discussion of how central counterpar-
ties (CCPs) assume the counterparty credit risk and provide clearing
and settlement services is an important new addition for readers to
understand.
The “Forward Commitment and Contingent Claim Features
and Instruments”reading defines forward contracts, futures con-
tracts, swaps, options (calls and puts), and credit derivatives; com-
pares their characteristics; and shows how to determine their value at

What Is Changing in the 2023 Curriculum, and Why Does It Matter?
expiration. This reading also sets out how investors can profit from a
long or a short position in a call or put option.
Users of forward commitments should be able to calculate their
values at maturity and this reading demonstrates how to do this. It
highlights how credit default swap (CDS) contracts allow an inves-
tor to manage the risk of loss from issuer default separately from a
cash bond. The reading focuses on how market participants can cre-
ate similar exposures to an underlying asset using firm commitments
and contingent claims.
The new “Derivative Benefits, Risks, and Issuer and Investor
Uses”reading describes the benefits and risks of using derivatives
and compares their use among issuers and investors.
Derivatives can offer greater operational and market efficiency
than cash markets and allow investors to create exposures unavail-
able in cash markets. It is important, however, to understand the risk
these derivative positions can entail. Excessive risk taking by mar-
ket participants has contributed to market destabilization and sys-
temic risk in the past. As the reading makes clear, users of derivative
instruments must be able to manage risks, including a high degree
of implicit leverage and less transparency, along with basis, liquidity,
and counterparty credit risks.
How the price of a forward commitment is related to the
spot price of an underlying asset is explored in the “Arbitrage,
Replication, and the Cost of Carry in Pricing Derivatives” reading.
This reading also demonstrates how costs or benefits associated with
owning an underlying asset affect the forward price.
Knowing the key features of derivatives is necessary, but not suf-
ficient, to use them successfully. This reading explains the pricing
and valuation of forward commitments on a mark-to-market basis
from inception through maturity. This analysis is essential for issu-
ers, investors, and financial intermediaries to assess the value of any

Derivatives
asset or liability portfolio that includes these instruments. It also

addresses forward pricing for the special case of underlying assets
with different maturities, such as interest rates, credit spreads, and
volatility. The prices of these forward commitments across the term
structure are an important building block for pricing swaps and
related instruments.
How the value and price of a forward contract are determined
at initiation, during the life of the contract, and at expiration are all
detailed in “Pricing and Valuation of Forward Contracts and for
an Underlying with Varying Maturities.” This reading sets out how
forward rates are determined for an underlying asset with a term
structure and describes the uses of forwards. Furthermore, the read-
ing explains what distinguishes futures from other forward commit-
ments and how they are used by issuers and investors.
The “Pricing and Valuation of Futures Contracts” reading
places a particular focus on the interest rate futures market and its
role in interest rate derivative contracts. Analysts need to understand
how daily settlement and margin requirements give rise to differ-
ent cash flow patterns between futures and forwards, resulting in a
pricing difference between the two contract types. In addition, the
emergence of derivatives central clearing has introduced futures-
like margining requirements for over-the-counter (OTC) derivatives,
such as forwards.
While financial intermediaries often use forward rate agree-
ments or short-term interest rate futures contracts to manage inter-
est rate exposure, issuers and investors usually prefer swap contracts
because they better match rate-sensitive assets and liabilities. The
“Pricing and Valuation of Interest Rate and Other Swaps” read-
ing explores how swaps are related to other forward commitment
types.
It is important for market participants not only to be able to
match expected future cash flows using swaps but also to ensure that

their change in value is consistent with existing or desired underly-

ing exposures. This reading compares swap contracts with forward
contracts and contrasts the value and price of swaps.
“Pricing and Valuation of Options” outlines three features
unique to contingent claims related to an option’s value versus the
spot price of the underlying asset. This reading then turns to how
arbitrage and replication concepts can be applied to contingent
claims with an asymmetric payoff profile. It also identifies the key
factors determining the value of an option.
The nonlinear or asymmetric payoff profile of an option, a con-
tingent claim, means analysts must approach these derivative instru-
ments different from a forward, firm commitment. This reading
explains how to determine the value of an option from the value of
the underlying, the exercise price, the time to maturity, the risk-free
rate, the volatility of the underlying price, and any income or cost
associated with owning the underlying asset.
The new “Option Replication Using Put–Call Parity” reading
shows how the value of a European call may be used to derive the
value of a European put option with the same underlying details, and
vice versa, under a no-arbitrage condition referred to as put–call par-
ity. It then demonstrates how this value can be extended to forward
commitments.
This reading shows how to combine options to have an equiva-
lent payoff to that of the underlying and a risk-free asset as well as
a forward commitment. As the reading explains, the insights estab-
lished by the put–call parity relationship go well beyond option
trading strategies, extending to modeling the value of a firm to
describe the interests and financial claims of a firm’s equity and debt
owners.
Forward commitments can be priced without making assump-
tions about the underlying asset’s price in the future. The pricing
of options and other contingent claims requires a model for the

Derivatives
evolution of the underlying asset’s future price. The “Valuing a

Derivative Using a One-Period Binomial Model” reading presents
just such a model. The one-period binomial model can be extended
to multiple periods as well to value more complex contingent claims.

Derivative Instrument and
Derivative Market Features
• Level I
• 0.75 PL Credits
• Access the full reading: cfainst.is/derivatives
Learning Outcomes
The member should be able to:
• define a derivative and describe basic features of a derivative
instrument;
• describe the basic features of derivative markets; and
• contrast over-the-counter (OTC) and exchange-traded derivative
(ETD) markets.
Introduction
Earlier lessons described markets for financial assets related to equi-
ties, fixed income, currencies, and commodities. These markets are
known as cash markets or spot markets in which specific assets are
exchanged at current prices referred to as cash prices or spot prices.

Derivatives
Derivatives involve the future exchange of cash flows whose value is

derived from or based on an underlying value. The following lessons
define and describe features of derivative instruments and derivative
markets.
Summary
• A derivative is a financial contract that derives its value from the
performance of an underlying asset, which may represent a firm
commitment or a contingent claim.
• Derivative markets expand the set of opportunities available to
market participants beyond the cash market to create or modify
exposure to an underlying.
• The most common derivative underlying assets include equities,
fixed income and interest rates, currencies, commodities, and
credit.
• OTC derivative markets involve the initiation of customized,
flexible contracts between derivatives end users and financial
intermediaries.
• ETDs are standardized contracts traded on an organized
exchange, which requires collateral on deposit to protect against
counterparty default.
• For derivatives that are centrally cleared, a central counterparty
(CCP) assumes the counterparty credit risk of the derivative
counterparties and provides clearing and settlement services.

Forward Commitment and
Contingent Claim Features
and Instruments
• Level I
• 1 PL Credit
• Access the full reading: cfainst.is/forwardcommitment
Learning Outcomes
• define forward contracts, futures contracts, swaps, options
(calls and puts), and credit derivatives and compare their basic
characteristics;
• determine the value at expiration and profit from a long or a
short position in a call or put option; and
• contrast forward commitments with contingent claims.

Derivatives
Introduction
An earlier lesson established a derivative as a financial instrument
that derives its performance from an underlying asset, index, or other
financial variable, such as equity price volatility. Primary derivative
types include a firm commitment in which a predetermined amount
is agreed to be exchanged between counterparties at settlement and
a contingent claim in which one of the counterparties determines
whether and when the trade will settle. The following lessons define
and compare the basic features of forward commitments and contin-
gent claims and explain how to calculate their values at maturity.
Summary
• Forwards, futures, and swaps represent firm commitments, or
derivative contracts that require counterparties to exchange an
underlying in the future based on an agreed-on price.
• Forwards are a flexible over-the-counter (OTC) derivative
instrument, whereas futures are standardized and traded on an
exchange with a daily settlement of contract gains and losses.
• Swap contracts are a firm commitment to exchange a series of
cash flows in the future. Interest rate swaps are the most com-
mon type and involve the exchange of fixed interest payments for
floating interest payments.
• Option contracts are contingent claims in which one of the
counterparties determines whether and when a trade will settle.
The option buyer pays a premium to the seller for the right to
transact the underlying in the future at an agreed-upon exercise
price.

Forward Commitment and Contingent Claim Features and Instruments
• Credit default swap (CDS) contracts allow an investor to manage

the risk of loss from issuer default separately from a cash bond.
• Market participants often create similar exposures to an under-
lying using firm commitments and contingent claims, although
these derivative instrument types involve different payoff and
profit profiles.

Derivative Benefits, Risks,
and Issuer and Investor
Uses
• Level I
• 0.75 PL Credits
• Access the full reading: cfainst.is/derivativebenefitsrisks
Learning Outcomes
• describe benefits and risks of derivative instruments, and
• compare the use of derivatives among issuers and investors.
Introduction
Earlier lessons described how derivatives expand the set of oppor-
tunities available to market participants to create or modify expo-
sure or to hedge the price of an underlying. This learning module
describes the benefits and risks of using derivatives and compares
their use among issuers and investors.

Derivative Benefits, Risks, and Issuer and Investor Uses
Summary
• Derivatives allow market participants to allocate, manage, or
trade exposure without exchanging an underlying in the cash
market.
• Derivatives also offer greater operational and market efficiency
than cash markets and allow users to create exposures unavail-
able in cash markets.
• Derivative instruments can involve risks, such as a high degree of
implicit leverage and less transparency in some cases than cash
instruments, as well as basis, liquidity, and counterparty credit
risks. Excessive risk taking in the past by market participants
through the use of derivatives has contributed to market destabi-
lization and systemic risk.
• Issuers typically use derivative instruments to offset or hedge
market-based underlying exposures that affect their assets, lia-
bilities, and earnings.
• Issuers usually seek hedge accounting treatment for derivatives
to minimize income statement and cash flow volatility.
• Investors use derivatives to modify investment portfolio cash
flows, replicate investment strategy returns in cash markets, and
create exposures unavailable to cash market participants.

Arbitrage, Replication, and
the Cost of Carry in Pricing
Derivatives
• Level I
• 0.75 PL Credits
• Access the full reading: cfainst.is/arbitrage
Learning Outcomes
• explain how the concepts of arbitrage and replication are used in
pricing derivatives, and
• explain the difference between the spot and expected future
price of an underlying and the cost of carry associated with hold-
ing the underlying asset.
Introduction
Earlier derivative lessons established the features of derivative
instruments and markets and addressed both the benefits and risks

Arbitrage, Replication, and the Cost of Carry in Pricing Derivatives
associated with their use. Forward commitments and contingent

claims were distinguished by their different payoff profiles and other
characteristics. We now turn our attention to the pricing and valu-
ation of these instruments. As a first step, we explore how the price
of a forward commitment is related to the spot price of an under-
lying asset in a way that does not allow for arbitrage opportunities.
Specifically, the strategy of replication shows that identical pay-
offs to a forward commitment can be achieved from spot market
transactions combined with borrowing or lending at the risk-free
rate. Finally, the second lesson demonstrates how costs or ben-
efits associated with owning an underlying asset affect the forward
commitment price.
Summary
• Forward commitments are an alternative means of taking a long
or short position in an underlying asset. A link between forward
prices and spot prices exists to prevent investors from taking
advantage of arbitrage opportunities across cash and derivative
instruments.
• A forward commitment may be replicated with a long or short
spot position in the underlying asset and borrowing or lending
at a risk-free rate. Investors can recreate a variety of positions
by using appropriate combinations of spot, forward, and risk-free
positions.
• The risk-free rate provides a fundamental link between spot and
forward prices for underlying assets with no additional costs or
benefits of ownership.

Derivatives
• The cost of carry is the net of the costs and benefits related to
owning an underlying asset for a specific period and must be fac-
tored into the difference between the spot price and a forward
price of a specific underlying asset.
• The cost of carry may include costs, such as storage and insur-
ance for physical commodities, or benefits of ownership, such
as dividends for stocks and interest for bonds. Foreign exchange
represents a special case in which the cost of carry is the interest
rate differential between two currencies.
• Forward prices may be greater than or less than the underlying
spot price, depending on the specific cost of carry associated
with owning the underlying asset.

Pricing and Valuation of
Forward Contracts and for
an Underlying with Varying
Maturities
• Level I
• 1 PL Credit
• Access the full reading: cfainst.is/forwardcontracts
Learning Outcomes
• explain how the value and price of a forward contract are deter-
mined at initiation, during the life of the contract, and at expira-
tion; and
• explain how forward rates are determined for an underlying with
a term structure and describe their uses.

Derivatives
Introduction
Earlier lessons introduced forward commitment features, payoff pro-
files, and concepts used in pricing these derivative instruments. In
particular, the relationship between spot and forward commitment
prices was established as the opportunity cost of owning the underly-
ing asset (represented by the risk-free rate) as well as any additional
cost or benefit associated with holding the underlying asset. This
price relationship both prevents arbitrage and allows a forward com-
mitment to be replicated using spot market transactions and risk-free
borrowing or lending.
In the first lesson, we explore the pricing and valuation of for-
ward commitments on a mark-to-market (MTM) basis from incep-
tion through maturity. This analysis is essential for issuers, investors,
and financial intermediaries to assess the value of any asset or lia-
bility portfolio that includes these instruments. The second lesson
addresses forward pricing for the special case of underlying assets
with different maturities, such as interest rates, credit spreads, and
volatility. The prices of these forward commitments across the so-
called term structure are important building blocks for pricing swaps
and related instruments in later lessons.
Summary
• A forward commitment price agreed upon at contract inception
remains fixed and establishes the basis on which the underlying
asset (or cash) will be exchanged in the future versus the spot
price at maturity.

Pricing and Valuation of Forward Contracts and for an Underlying
• For an underlying asset that does not generate cash flows, the
value of a long forward commitment before expiration is equal
to the current spot price of the underlying asset minus the pres-
ent value of the forward price discounted at the risk-free rate.
The reverse is true for a short forward commitment. Foreign
exchange represents a special case in which the spot versus for-
ward price is a function of the difference between risk-free rates
across currencies.
• For an underlying asset with additional costs and benefits, the
forward contract MTM value is adjusted by the sum of the pres-
ent values of all additional cash flows through maturity.
• Underlying assets with a term structure, such as interest rates,
have different rates or prices for different times-to-maturity.
These zero or spot and forward rates are derived from coupon
bonds and market reference rates and establish the building
blocks of interest rate derivatives pricing.
• Implied forward rates represent a breakeven reinvestment rate
linking short-dated and long-dated zero-coupon bonds over a
specific period.
• A forward rate agreement (FRA) is a contract in which counter-
parties agree to apply a specific interest rate to a future period.

Futures Contracts
• Level I
• 0.75 PL Credits
• Access the full reading: cfainst.is/futures
Learning Outcomes
• compare the value and price of forward and futures contracts,
and
• explain why forward and futures prices differ.
Introduction
Many of the pricing and valuation principles associated with forward
commitments are common to both forward and futures contracts.
For example, previous lessons demonstrated that forward commit-
ments have a price that prevents market participants from earning
riskless profit through arbitrage. It was shown that long and short
forward commitments may be replicated using a combination of long

Pricing and Valuation of Futures Contracts
or short cash positions and borrowing or lending at the risk-free rate.

Finally, both forward and futures pricing and valuation incorporate
the cost of carry, or the benefits and costs of owning an underlying
asset over the life of a derivative contract.
We now turn our attention to futures contracts. We discuss what
distinguishes these contracts from other forward commitments and
how they are used by issuers and investors. We expand on the daily
settlement of futures contracts’ gains and losses introduced earlier
and explain the differences between forwards and futures. We also
address and distinguish the interest rate futures market and its role
in interest rate derivative contracts.
Summary
• Futures are standardized, exchange-traded derivatives (ETDs)
with zero initial value and a futures price f 0(T) established at
inception. The futures price, f 0(T), is equal to the spot price com-
pounded at the risk-free rate as in the case of a forward contract.
• The primary difference between forward and futures valuation is
the daily settlement of futures gains and losses through a margin
account. The daily settlement resets the futures contract value
to zero at the current futures price f t(T). This process continues
until contract maturity and the futures price converges to the
spot price, ST.
• The cumulative realized mark-to-market (MTM) gain or loss on
a futures contract is approximately the same as that for a compa-
rable forward contract.

Derivatives
• Daily settlement and margin requirements give rise to different

cash flow patterns between futures and forwards, resulting in a
pricing difference between the two contract types. The differ-
ence depends on both interest rate volatility and the correlation
between interest rates and futures prices.
• The futures price for short-term interest rate futures is given by
(100 – yield), where yield is expressed in percentage terms. There
is a price difference between interest rate futures and forward
rate agreements (FRAs) because of a convexity bias.
• The emergence of derivatives central clearing has introduced
futures-like margining requirements for over-the-counter (OTC)
derivatives, such as forwards. This arrangement has reduced the
difference in the cash flow impact of ETDs and OTC derivatives
and the price difference in futures versus forwards.

Interest Rates and Other
Swaps
• Level I
• 0.75 PL Credits
• Access the full reading: cfainst.is/swaps
Learning Outcomes
• describe how swap contracts are similar to but different from a
series of forward contracts, and
• contrast the value and price of swaps.
Introduction
Swap contracts were introduced earlier as a firm commitment to
exchange a series of cash flows in the future. Interest rate swaps in
which fixed cash flows are exchanged for floating payments are the
most common type. Subsequent lessons addressed the pricing and

Derivatives
valuation of forward and futures contracts across the term structure,

which form the building blocks for swap contracts.
In this lesson, we will explore how swap contracts are related to
these other forward commitment types. Although financial inter-
mediaries often use forward rate agreements or short-term interest
rate futures contracts to manage interest rate exposure, issuers and
investors usually prefer swap contracts, because they better match
rate-sensitive assets and liabilities with periodic cash flows, such
as fixed-coupon bonds, variable-rate loans, or known future com-
mitments. It is important for these market participants not only to
be able to match expected future cash flows using swaps but also
to ensure that their change in value is consistent with existing or
desired underlying exposures. The following lessons compare swap
contracts with forward contracts and contrast the value and price of
swaps.
Summary
• A swap contract is an agreement between two counterparties to
exchange a series of future cash flows, whereas a forward con-
tract is a single exchange of value at a later date.
• Interest rate swaps are similar to forwards in that both contracts
are firm commitments with symmetric payoff profiles and no
cash is exchanged at inception, but they differ in that the fixed
swap rate is constant, whereas a series of forward contracts has
different forward rates at each maturity.
• A swap is priced by solving for the par swap rate, a fixed rate that
sets the present value of all future expected floating cash flows
equal to the present value of all future fixed cash flows.

Pricing and Valuation of Interest Rates and Other Swaps
• The value of a swap at inception is zero (ignoring transaction and

counterparty credit costs). On any settlement date, the value of a
swap equals the current settlement value plus the present value
of all remaining future swap settlements.
• A swap contract’s value changes as time passes and interest rates
change. For example, a rise in expected forward rates increases
the present value of floating payments, causing a mark-to-market
(MTM) gain for the fixed-rate payer (floating-rate receiver) and
an MTM loss for the fixed-rate receiver (floating-rate payer).

Options
• Level I
• 0.75 PL Credits
• Access the full reading: cfainst.is/options
Learning Outcomes
• explain the exercise value, moneyness, and time value of an
option;
• contrast the use of arbitrage and replication concepts in pricing
forward commitments and contingent claims; and
• identify the factors that determine the value of an option and
describe how each factor affects the value of an option.
Introduction
Option contracts are contingent claims in which one of the coun-
terparties determines whether and when a trade will settle. Unlike a
forward commitment with a value of zero to both counterparties at

Pricing and Valuation of Options
inception, an option buyer pays a premium to the seller for the right
to transact the underlying in the future at an agreed-upon price. The
contingent nature of options affects their price as well as their value
over time.
In the first lesson, we explore three features distinct to contingent
claims related to an option’s value versus the spot price of the under-
lying: (1) the exercise, or intrinsic, value; (2) the relationship between
an option’s spot price and its exercise price, referred to as “money-
ness”; and (3) the time value. We then turn to how the arbitrage and
replication concepts introduced earlier for forward commitments
differ when applied to contingent claims with an asymmetric payoff
profile. Finally, we identify and describe factors that determine the
value of an option. These lessons focus on European options, which
can be exercised only at expiration.
Summary
• An option’s value includes its exercise value and its time value.
The exercise value is the option’s value if it were immediately
exercisable, whereas the time value captures the possibility that
the passage of time and the variability of the underlying price
will increase the profitability of exercise at maturity.
• Option moneyness expresses the relationship between the
underlying price and the exercise price. A put–call option is “at
the money” when the underlying price equals the exercise price.
An option is more likely to be exercised if it is “in the money”—
with an underlying price above (for a call) or below (for a put) the
exercise price—and is less likely to be exercised if it is “out of the
money.”

Derivatives
• Because of their asymmetric payoff profile, options are charac-

terized by no-arbitrage price bounds. The lower bound is a func-
tion of the present value of the exercise price and the underlying
price, whereas the upper bound is the underlying price for a call
and the exercise price for a put.
• As in the case of forward commitments, the replication of option
contracts uses a combination of long (for a call) or short (for a
put) positions in an underlying asset and borrowing or lending
cash. The replicating transaction for an option is based on a pro-
portion of the underlying, which is closely associated with the
moneyness of the option.
• The underlying price, the exercise price, the time to maturity,
the risk-free rate, the volatility of the underlying price, and any
income or cost associated with owning the underlying asset are
key factors in determining the value of an option.
• Changes in the volatility of the underlying price and the time to
expiration usually will have the same directional effect on put
and call option values. Changes to the exercise price, the risk-
free rate, and any income or cost associated with owning the
underlying asset have the opposite effect on call options versus
put options.

Option Replication Using
Put–Call Parity
• Level I
• 0.5 PL Credits
• Access the full reading: cfainst.is/putcall
Learning Outcomes
• explain put–call parity for European options, and
• explain put–call forward parity for European options.
Introduction
Previous lessons examined the payoff and profit profiles of call
options and put options, the upper and lower bounds of an option’s
value, and the factors impacting option values. In doing so, we con-
trasted the asymmetry of one-sided option payoffs with the linear or
symmetric payoff of forwards and underlying assets.
We now extend this analysis to show how to combine options
to have an equivalent payoff to that of the underlying and a risk-
free asset as well as a forward commitment. In the first lesson, we

Derivatives
demonstrate that the value of a European call may be used to derive

the value of a European put option with the same underlying details,
and vice versa, under a no-arbitrage condition referred to as put–call
parity. In the second lesson, we show how this may be extended to
forward commitments and how the put–call parity relationship may
be applied to option and other investment strategies. We will focus
on European options on underlying assets with no income or benefit.
Summary
• Put–call parity establishes a relationship that allows the price of
a call option to be derived from the price of a put option with the
same underlying details and vice versa.
• Put–call parity holds for European options with the same exer-
cise price and expiration date, representing a no-arbitrage rela-
tionship between put option, call option, underlying asset, and
risk-free asset prices.
• If put–call parity does not hold, then riskless arbitrage profit
opportunities may be available to investors.
• Put–call forward parity extends the put–call parity relationship
to forward contracts given the equivalence of an underlying asset
position and a long forward contract plus a risk-free bond.
• Under put–call forward parity, we may demonstrate that a pur-
chased put option and a sold call option are equivalent to a long
risk-free bond and short forward position, and a sold put and
purchased call are equivalent to a long forward and short risk-
free bond.

Option Replication Using Put–Call Parity
• Put–call parity may be applied beyond option-based strategies

in finance—for example, to demonstrate that equityholders have
a position equivalent to a purchased call option on the value of
the firm with unlimited upside, while debtholders have a sold put
option position on firm value with limited upside.

Valuing a Derivative Using a
One-Period Binomial Model
• Level I
• 0.75 PL Credits
• Access the full reading: cfainst.is/binomial
Learning Outcomes
• explain how to value a derivative using a one-period binomial
model, and
• describe the concept of risk neutrality in derivatives pricing.
Introduction
Earlier lessons explained how the principle of no arbitrage and repli-
cation can be used to value and price derivatives. The put–call parity
relationship linked put option, call option, underlying asset, and risk-
free asset prices. This relationship was extended to forward contracts
given the equivalence of an underlying asset position and a long for-
ward contract plus a risk-free bond.

Valuing a Derivative Using a One-Period Binomial Model
Forward commitments can be priced without making assump-

tions about the underlying asset’s price in the future. However, the
pricing of options and other contingent claims requires a model for
the evolution of the underlying asset’s future price. The first lesson
introduces the widely used binomial model to value European put
and call options. A simple one-period version is introduced, which
may be extended to multiple periods and used to value more complex
contingent claims. In the second lesson, we demonstrate the use of
risk-neutral probabilities in derivatives pricing.
Summary
• The one-period binomial model values contingent claims, such as
options, and assumes the underlying asset will either increase by
Ru (up gross return) or decrease by Rd (down gross return) over a
single period that corresponds to the expiration of the derivative
contract.
• The binomial model combines an option with the underlying
asset to create a risk-free portfolio in which the proportion of
the option to the underlying security is determined by a hedge
ratio.
• The hedged portfolio must earn the prevailing risk-free rate of
return; otherwise, riskless arbitrage profit opportunities would
be available.
• Valuing a derivative through risk-free hedging is equivalent to
computing the discounted expected payoff of the option using
risk-neutral probabilities rather than actual probabilities.

Derivatives
• Neither the actual (real-world) probabilities of underlying price

increases or decreases nor the expected return of the underlying
are required to price an option.
• The one-period binomial model can be extended to multiple peri-
ods as well to value more complex contingent claims.

Economics
Reading
Introduction to Geopolitics I 1.5 cfainst.is/
geopolitics

Does It Matter?
There is no shortage of ways in which geopolitical risk can affect a
portfolio. Some investment firms employ analysts whose principal
job is to study how individuals, organizations, companies, and gov-
ernments carry out political, economic, and financial activities—and
how they interact with one another. The relationships among these
various actors matter to analysts because they contribute to key driv-
ers of investment performance—including economic growth, busi-
ness performance, market volatility, and transaction costs. These
relationships matter all the more at a time of heightened geopolitical
risk, which affects the peaceful course of international relations.
The brand new “Introduction to Geopolitics” reading provides
a structure for thinking about a wide range of geopolitical issues,
ranging from changes in policy to natural disasters, terrorist acts,
and, of course, war. This reading explains the difficulties of identify-
ing, assessing, and tracking geopolitical risk. A helpful framework is
presented that is designed to match potential risks to tangible invest-
ment outcomes. Using this framework, investors can better measure,
assess, track, and react to geopolitical risk, with the goal of improving
portfolios.

Introduction to Geopolitics
• Level I
• 1.5 PL Credits
• Access the full reading: cfainst.is/geopolitics
Learning Outcomes
• describe geopolitics from a cooperation versus competition
perspective,
• describe geopolitics and its relationship with globalization,
• describe tools of geopolitics and their impact on regions and
economies, and
• describe geopolitical risk and its impact on investments.
Introduction
The international environment is constantly evolving. Such trends
as the growth of emerging market economies, globalization, and the
rise of populism affect the range of opportunities and threats that
companies, industries, nations, and regional groups face. They can

Economics
be affected by changes in regulation, disrupted trade flows, and even

conflict.
Geopolitics is the study of how geography affects politics and
international relations. Within the field of geopolitics, analysts study
actors—the individuals, organizations, companies, and national
governments that carry out political, economic, and financial
activities—and how they interact with one another. These relations
matter for investments because they contribute to important driv-
ers of investment performance, including economic growth, business
performance, market volatility, and transaction costs.
Geopolitical risk is the risk associated with tensions or actions
between actors that affect the normal and peaceful course of interna-
tional relations. Geopolitical risk tends to rise when the geographic
and political factors underpinning country relations shift. A shift
could arise from a change in policy, a natural disaster, a terrorist act,
a theft, or war.
Investors study geopolitical risk because it has a tangible impact
on investment outcomes. At the macroeconomic level, these risks
affect capital markets conditions, including economic growth, inter-
est rates, and market volatility. Changes in capital markets condi-
tions, in turn, can have an important influence on asset allocation
decisions, including an investor’s choice of geographic exposure. At
the portfolio level, geopolitical risk can influence the appropriateness
of an investment security or strategy for an investor’s goals, risk tol-
erance, and time horizon. A higher likelihood of geopolitical risk can
raise or lower an asset class’s expected return or have an impact on
a sector’s or a company’s operating environment, affecting its attrac-
tiveness for an investment strategy.
There is no shortage of ways in which geopolitical risk can
affect a portfolio, so identifying, assessing, and tracking geopolitical
risk can be difficult and time consuming. It is important for inves-
tors to map these potential risks to tangible investment outcomes.

In this reading, we build a framework by which investors can measure,

assess, track, and react to geopolitical risk, with a goal of improving
investment outcomes.
Summary
• Geopolitics is the study of how geography affects politics and
international relations. Within the field of geopolitics, analysts
study actors—the individuals, organizations, companies, and
national governments that carry out political, economic, and
financial activities—and how they interact with one another.
• State actors can be cooperative or noncooperative. A country
may want to cooperate with its neighbors or with other state
actors for many reasons, which typically are defined according to
a country’s national interest.
• National security or national defense involves protecting a coun-
try, its citizens, economy, and institutions, from external threats.
These threats may be broad in nature—ranging from military
attack and terrorism, to crime, cyber-security, and even natural
disasters.
• Geographic factors play an important role in shaping a country’s
approach to national security and the extent to which it will
choose a cooperative approach. Landlocked countries rely exten-
sively on their neighbors for access to vital resources. Countries
highly connected to trade routes or countries acting as a conduit
for trade may use their geographic location as a lever of power.
• Generally, strong institutions contribute to more stable internal
and external political forces. Countries with strong institutions,

Economics
including organizations and structures promoting government

accountability, rule of law, and property rights, allow them to act
with more authority.
• Globalization is marked by economic and financial cooperation,
including the active trade of goods and services, capital flows,
currency exchange, and cultural and information exchange.
Conversely, antiglobalization or nationalism is the promotion of
a country’s economic interests to the exclusion or detriment of
the interests of other nations. Nationalism is marked by limited
economic and financial cooperation.
• Globalization provides potential gains, such as:
■■ increased profits—through increasing sales and/or reducing
costs,
■■ access to resources—market access and investment oppor-
tunities, and
■■ intrinsic gains—an improved quality of life.
• Globalization also has some potential drawbacks, such as:
■■ unequal economic and financial gains,
■■ interdependence that can lead to supply chain disruption,
and
■■ possible exploitation of social and environmental resources.
• In general terms, regions, countries, and industries that are more
dependent on cross-border goods and capital flows will have
higher levels of cooperation.
• The interdependent nature of globalization may reduce the like-
lihood that collaborative countries levy economic, financial, or

political attacks on one another. Interdependence, however, can

make cooperative actors more vulnerable to geopolitical risk
than those that are less dependent on cooperation and trade.
• A geopolitical framework for analysis includes four archetypes of
country behavior: autarky, hegemony, multilateralism, and bilat-
eralism. Each archetype has its own costs, benefits, and tradeoffs
with respect to geopolitical risk.
• The tools of geopolitics may be separated into three types:
■■ national security tools,
■■ economic tools, and
■■ financial tools.
• The most extreme example of a national security tool is that of
armed conflict. Espionage is an indirect national security tool.
Military alliances often are used either to aid in direct conflict or
to deter conflict from arising in the first place.
• Economic tools are used to reinforce a cooperative or nonco-
operative stance through economic means. Among state actors,
economic tools can include multilateral trade agreements or the
global harmonization of tariff rules. Economic tools also can be
noncooperative in nature. Nationalization is a noncooperative
approach to asserting economic control.
• Financial tools are the actions used to reinforce a cooperative or
noncooperative stance through financial mechanisms. Examples
of cooperative financial tools include the free exchange of curren-
cies across borders and allowing foreign investment. Examples
of noncooperative financial tools include limiting access to local
currency markets and restricting foreign investment.

Economics
• Geopolitical risk is the risk associated with tensions or actions

between actors (state and nonstate) that affect the normal and
peaceful course of international relations. Geopolitical risk tends
to rise when the geographic and political factors underpinning
country relations shift.
• The three basic types of geopolitical risk are as follows:
■■ event risk,
■■ exogenous risk, and
■■ thematic risk.
• Event risk evolves around set dates known in advance. Political
events, for example, often result in changes to investor expec-
tations related to a country’s cooperative stance. Brexit is an
example of event risk.
• Exogenous risk is a sudden or unanticipated risk that can affect
either a country’s cooperative stance, the ability of nonstate
actors to globalize, or both. Examples include sudden uprisings,
invasions, or the aftermath of natural disasters.
• Thematic risks are known risks that evolve and expand over a
period of time. Climate change, cyber threats, and the ongoing
threat of terrorism fall into this category.
• To make an assessment, an investor considers geopolitical risk in
terms of the following three areas:
■■ likelihood it will occur,
■■ velocity (speed) of its impact, and
■■ size and nature of that impact.

• Geopolitical risks seldom develop in linear fashion, making it

difficult to monitor and forecast their likelihood, velocity, and
size and nature of impact on a portfolio. As a result, many inves-
tors deploy an approach that includes scenario building and sign-
posting rather than a single-point forecast.
• Scenario analysis is the process of evaluating portfolio outcomes
across potential circumstances or states of the world. Scenarios
can take the form of qualitative analysis, quantitative measure-
ment, or both.
• Investors study geopolitical risk because it has a tangible impact
on investment outcomes. On a macroeconomic level, these risks
can affect capital market conditions, such as economic growth,
interest rates, and market volatility.
• Changes in capital markets conditions can have an important
influence on asset allocation decisions, including an investor’s
choice of geographic exposures.
• At the portfolio level, geopolitical risk can influence the appro-
priateness of an investment security or strategy for an investor’s
goals, risk tolerance, and time horizon.

Corporate Issuers
Readings
Corporate Structures and I 1.25 cfainst.is/
Ownership corpstructures
Introduction to Corporate I 1.5 cfainst.is/
Governance and Other ESG corpgovandesg
Considerations
Business Models & Risks I 1.25 cfainst.is/

businessmodels
Capital Investments I 1 cfainst.is/capital-

investments
Working Capital& Liquidity I 1 cfainst.is/

workingcapital
Capital Structure I 1.75 cfainst.is/

capitalstructure
Financial Statement Modeling II 4.5 cfainst.is/

modeling
Cost of Capital: Advanced II 1.75 cfainst.is/

Topics costofcapital
Corporate Restructuring II 2.25 cfainst.is/

corprestructuring

Does It Matter?
A new reading sets out the organizational forms used throughout
the curriculum, with an emphasis on corporate structure, but also
features the general partnership (GP) and limited partnership (LPs)
structures used primarily for alternative investments. Through
the prism of Tesla, and how the car company was co-founded and
then taken over by Elon Musk, the “Corporate Structures and
Ownership” reading shows how a corporate structure can evolve
over time. A company may, as with Tesla, be founded by serial entre-
preneurs who lack the skills to manage the business as it grows and
requires ever larger amounts of capital. This reading shows how such
companies professionalize to raise capital and attract investors. It
also shows how analysts compare the financial claims and motiva-
tions of lenders and owners. The section on GP and LP relationships
and interactions is key to understanding the structure and risks of
many alternative investment vehicles.
Investor interest in sustainable investing has led to increased
corporate disclosures of ESG activities and to a whole new indus-
try that collects and analyzes ESG data. Refinements in the identi-
fication and analysis of ESG factors, as well as increased corporate
disclosures, have resulted in increasingly quantifiable ESG infor-
mation that can be used alongside financial information to value a
company. The “Introduction to Corporate Governance and Other
ESG Considerations” reading has been updated to describe new ESG
disclosure requirements for publicly traded companies. The reading

describes the range of nonfinancial information now available, typi-

cally including annual reports, proxy statements, disclosures on
company websites, investor relations departments, and social media.
The types of business models and how they can be modeled by
analysts have been added to the new “Business Models & Risks”
reading. The reading also includes a new section on alternative busi-
ness models and the risks associated with these models. An under-
standing of a company’s business model enables analysts to identify
key drivers of firm performance as well as key sources of risk to a
company’s performance and value. The reading explains why analysts
should not rely on management’s description of its business model
but rather should develop their own understanding of key drivers and
risks facing the firm.
A major revision to the “Capital Investments” reading examines
capital budgeting from the point of view of an external investment
analyst. The reading features a discussion of advantages and disad-
vantages of using net present value (NPV) and internal rate of return
(IRR) to assess how well capital has been allocated. A company’s
investments are measured against the value created and potential
changes in the share price. Common capital allocation pitfalls are
presented.
Given that corporate disclosure of capital investments is typically
at a high level and lacking in specifics, the evaluation of a company’s
capital investments is often challenging for analysts. This reading
provides practical guidance for analysts to address this challenge.
Analysts need to assess whether a firm is operating at an opti-
mal level of working capital and financed at the lowest possible cost.
Excess levels of working capital can have a harmful effect on share-
holder returns. At the same time, insufficient levels of working capi-
tal can harm a company if it cannot meet its short-term obligations,
leading to product shortages, sales slowdowns, and, in the extreme,
bankruptcy. Methods of financing working capital are compared in a

Corporate Issuers
revised “Working Capital & Liquidity” reading. The reading delves

into the short-term funding choices available to companies and the
expected relationships between working capital, liquidity, and short-
term funding needs. In particular, sources of primary and secondary
liquidity and factors are explained, as well as how analysts can com-
pare a company’s liquidity position with that of peers.
An updated “Capital Structure” reading ties capital struc-
ture theory to the real world, making it more relevant for analysts.
In theory, companies seek an optimal mix of equity and debt that
minimizes the firm’s weighted average cost of capital and maximizes
company value. In reality, a range of practical considerations affect
capital structure, leading to wide variations in capital structures
among otherwise similar companies.
Furthermore, it is common to think of capital structure as
the result of a conscious decision by management. As the reading
explains, it is not always that simple. For example, financial dis-
tress can arise because a company’s capital structure policy was too
aggressive, or because operating results or prospects deteriorate
unexpectedly. Analysts also need to watch for capital structure deci-
sions that are not in the interests of other stakeholders, including
debtholders, suppliers, customers, and employees.
The former “Industry and Company Analysis” reading has been
significantly revised and renamed “Financial Statement Modeling”
to reflect new content about how to conduct financial modeling with
spreadsheets. The reading focuses on how spreadsheets can be used
to analyze the most important drivers of a firm’s performance to
forecast its free cash flows and profitability. A section on behavioral
biases in forecasting outlines five key biases that can adversely affect
the modeling process and strategies to mitigate them.
A new reading focuses on how to estimate required rates of
return for equities and fixed income as well as how to construct
the weighted average cost of capital (WACC). The “Cost of Capital:

Advanced Topics” reading explains top-down and bottom-up factors

that affect the cost of capital and compares methods to estimate the
cost of debt. It explains historical and forward-looking approaches
for estimating an equity risk premium and estimates the cost of debt
or required return on equity for both public and private companies.
For analysts and investors, as explained in the reading, WACC
is a critical input used in company valuation, but poses a challeng-
ing task for an analyst. Many different methods can be used and key
assumptions must be made about the capital structure and the com-
pany’s marginal tax rate.
The former “Mergers and Acquisitions” reading has been heav-
ily revised to widen the topic to all types of corporate restructurings
and how to model them. Renamed “Corporate Restructuring,” this
reading sets out types of corporate restructurings and issuers’ moti-
vations for pursuing them. The reading explains, with the aid of case
studies, how to evaluate a corporate restructuring and proposes
a three-step process that an investment analyst could deploy. The
emphasis of the reading is on understanding how and why compa-
nies evolve over time, as well as how this evolution affects the finan-
cial modeling and forecasting process.

Corporate Structures and
Ownership
• Level I
• 1.25 PL Credits
• Access the full reading: cfainst.is/corpstructures
Learning Outcomes
• compare business structures and describe key features of corpo-
rate issuers,
• compare public and private companies, and
• compare the financial claims and motivations of lenders and
owners.
Introduction
In 1997, Martin Eberhard and Marc Tarpenning, an engineer and a
computer scientist, started a company called NuvoMedia to make an
electronic book reader they called the Rocket eBook, a precursor to
the Kindle eBook popularized by Amazon. Three years after it was
founded, NuvoMedia was sold for USD187 million.

Corporate Structures and Ownership
Soon after, the two entrepreneurs formed a new company, this

one focused on making electric cars. They named this company in
honor of the inventor Nikola Tesla. Because this was a high-risk,
capital-intensive endeavor, they used only some of their newfound
wealth and sought other investors with expertise in electric vehicles
and fundraising capabilities. Elon Musk, an entrepreneur with a
shared vision in the commercialization of electric sports cars, joined
the team.
In addition to making an initial investment of USD6.3 million
in Tesla, Musk also helped raise more money from other venture
capitalists. Due to conflicts that were not disclosed, Eberhard and
Tarpenning resigned just before Tesla came out with its first vehicle,
the Roadster, in 2008. Musk took over as CEO and led Tesla’s initial
public offering in 2010, which raised USD226 million.
In many ways, Tesla’s story is typical of how businesses begin
and succeed. They are often started by founders with signifi-
cant knowledge or technical expertise but who may lack the skills
required to manage a business as it grows larger. Capital is needed to
fund growth and is initially raised through private channels. Private
investors often get involved in the management of the company,
especially if they have a large investment at stake. Eventually, even
larger amounts of capital are required, and the company is acquired
or taken public.
We examine different forms of business structures, focusing on
corporations and the securities they issue to capital providers.
Summary
• Common forms of business structures include sole proprietor-
ships, general and limited partnerships, and corporations.

Corporate Issuers
• Sole proprietorships and partnerships are considered extensions

of their owner or partner(s). This largely means that profits are
taxed at the individual’s personal rates and individuals are fully
liable for all of the business’s debts.
• Limited partnerships and corporations allow for the specializa-
tion of expertise in operator roles, in addition to the redistribu-
tion of risk and return sharing between owners, partners, and
operators.
• The corporate form of business structure is preferred when capi-
tal requirements are greater than what could be raised through
other business structures.
• A corporation is a legal entity separate and distinct from its
owners. Owners have limited liability, meaning that only their
investment is at risk of loss.
• Corporations raise capital by selling an ownership interest and
by borrowing money. They issue stocks, or shares, to equity
investors who are owners. Debt represents money borrowed
from lenders. Long-term lenders are issued bonds.
• Nonprofit corporations are formed to promote a public benefit,
religious benefit, or charitable mission. They do not have share-
holders, they do not distribute dividends, and they generally do
not pay taxes.
• For-profit corporations can be public or private.
• In many jurisdictions, corporate profits are taxed twice: once at
the corporate level and again at the individual level when profits
are distributed as dividends to the owners.
• Public corporations usually are listed on an exchange, and own-
ership is easily transferable.

Corporate Structures and Ownership
• Private corporations are not listed on an exchange and, therefore,

have no observable stock price, making their valuation more
challenging. Transactions between buyers and sellers are negoti-
ated privately, and ownership transfer is much more difficult.
• The market capitalization of a public company is equal to share
price multiplied by the number of shares outstanding.
• Enterprise value represents the total value of the company and
is equal to the sum of the market capitalization and the market
value of net debt. (Net debt is debt less cash.)
• Public companies are subject to greater regulatory and disclo-
sure requirements—most notably, the public disclosure of finan-
cial information through periodic filings with their regulator.
Private companies are not required to make such disclosures to
the public.
• Given greater risks, only accredited investors are permitted to
invest in private companies.
• Corporations have a life cycle with four distinct stages: start-up,
growth, maturity, and decline.
• Although corporations begin as private companies, many even-
tually choose to go public or are acquired by public companies.
Initial public offerings (IPOs) typically occur in the growth
phase and usually are driven by capital needs to fund growth.
• In many industrial countries, it has become easier for private
companies to access the capital they need without having to go
public. As a result, the number of listed (public) companies in
industrial countries has been trending downward. The number
of listed companies in emerging economies continues to grow.

Corporate Issuers
• Debt (bonds) represents a contractual obligation on the part of

the issuing company. The corporation is obligated to make the
promised interest payments to the debtholders and to return
the principal. Equity (stock) does not involve a contractual
obligation.
• Interest payments on debt are typically a tax-deductible expense
for the corporation. Dividend payments on equity are not tax
deductible.
• Debtholders have claim priority, but they are entitled only to
the interest payments and the return of principal. Equityholders
have no priority in claims.
• Therefore, from the investor’s perspective, investing in equity is
riskier than investing in debt. Equityholders do have a residual
claim, meaning that they are entitled to whatever firm value
remains after paying off the priority claim holders, which grants
them unlimited upside potential.
• From the corporation’s perspective, issuing debt is riskier than
issuing equity. A corporation that cannot meet its contractual
obligations to the debtholders can be forced into bankruptcy and
liquidation.
• Potential conflicts can occur between debtholders and equity-
holders. Debtholders would prefer the corporation to invest in
safer projects that produce smaller, more certain cash flows that
are large enough to service the debt. Equityholders would prefer
riskier projects that have much larger return potential, which
they do not share with the debtholders.

Introduction to Corporate
Governance and Other ESG
Considerations
• Level I
• 1.5 PL Credits
• Access the full reading: cfainst.is/corpgovandesg
Learning Outcomes
• describe a company’s stakeholder groups and compare their
interests;
• describe the principal–agent relationship and conflicts that may
arise between stakeholder groups;
• describe corporate governance and mechanisms to manage
stakeholder relationships and mitigate associated risks;
• describe both the potential risks of poor corporate governance
and stakeholder management and the benefits from effective cor-
porate governance and stakeholder management;
• describe environmental, social, and governance (ESG) consider-
ations in investment analysis; and
• describe ESG investment approaches.

Corporate Issuers
Introduction
All companies operate in a complex ecosystem composed of inter-
ested stakeholder groups that are dependent on the company as well
as each other for economic success. Key stakeholder groups include
the company’s capital providers, otherwise referred to as its debt- and
equityholders. In addition, companies have a number of other inter-
ested parties.
These stakeholder groups do not necessarily share the same goals
for, nor seek the same ends from, the company. The interests of any
one stakeholder group may diverge or conflict with that of others and,
in some cases, with the interests of the company itself. A company’s
ability to maximize long-term value for shareholders and generate
sufficient profitability to make its debt obligations is compromised
if one stakeholder group is able to consistently extract benefits to the
detriment of another group. Therefore, the controls and mechanisms
to harmonize and safeguard the interests of the company’s stakehold-
ers are key areas of both interest and risk for financial analysts.
Summary
The investment community is increasingly recognizing and quan-
tifying environmental and social considerations and the impacts
of corporate governance in the investment process. Analysts who
understand these considerations can better evaluate their associated
implications and risks for an investment decision. Following are the
core concepts covered in this reading:
• The primary stakeholder groups of a corporation consist of
shareholders, creditors, the board of directors, managers and
employees, customers, suppliers, and government and regulators.

Introduction to Corporate Governance and Other ESG Considerations
• A principal–agent relationship (or agency relationship) entails

a principal hiring an agent to perform a particular task or ser-
vice. In a company, both the board of directors and management
act in an agent capacity to represent the interests of shareholder
principals.
• Conflicts occur when the interests of various stakeholder groups
diverge and when the interests of one group are compromised for
the benefit of another.
• Stakeholder management involves identifying, prioritizing, and
understanding the interests of stakeholder groups and managing
the company’s relationships with stakeholders.
• Mechanisms to mitigate shareholder risks include company
reporting and transparency, general meetings, investor activism,
derivative lawsuits, and corporate takeovers.
• Mechanisms to mitigate creditor risks include bond indenture(s),
company reporting and transparency, and committee
participation.
• Mechanisms to mitigate board risks include board or manage-
ment meetings and board committees.
• Remaining mechanisms to mitigate risks for other stakeholder
(employees, customers, suppliers, and regulators) include poli-
cies, laws, regulations, and codes.
• Executive (internal) directors are employed by the company and
are typically members of senior management. Nonexecutive
(external) directors have limited involvement in daily operations
but serve an important oversight role.
• Two primary duties of a board of directors are duty of care and
duty of loyalty.

Corporate Issuers
• A company’s board of directors typically has several commit-

tees that are responsible for specific functions and report to the
board. Although the types of committees may vary across orga-
nization, the most common are the audit committee, governance
committee, remuneration (compensation) committee, nomina-
tion committee, risk committee, and investment committee.
• Shareholder activism encompasses a range of strategies that may
be used by shareholders when seeking to compel a company to
act in a desired manner.
• From a corporation’s perspective, risks of poor governance
include weak control systems; ineffective decision making; and
legal, regulatory, reputational, and default risk. Benefits include
better operational efficiency, control, and operating and financial
performance, as well as lower default risk (or cost of debt), which
enhances shareholder value.
• Key analyst considerations in corporate governance and stake-
holder management include economic ownership and voting
control, board of directors’ representation, remuneration and
company performance, investor composition, strength of share-
holders’ rights, and the management of long-term risks.
• Environmental and social issues, such as climate change, air pol-
lution, and societal impacts of a company’s products and services,
historically have been treated as negative externalities. Increased
stakeholder awareness and strengthening regulations, however,
are internalizing environmental and societal costs into the com-
pany’s income statement by responsible investors.
• ESG investment approaches are value based or values based. The
six common ESG investment approaches are negative screening,
positive screening, ESG integration, thematic investing, engage-
ment or active ownership, and impact investing.

Business Models &
Risks
• Level I
• 1.25 PL Credits
• Access the full reading: cfainst.is/businessmodels
Learning Outcomes
• describe key features and types of business models;
• describe expected relations between a company’s external envi-
ronment, business model, and financing needs; and
• explain and classify types of business and financial risks for a
company.
Introduction
A clearly described business model helps the analyst understand a
business, including how it operates, its strategy, target customers,
key partners, prospects, risks, and financial profile. Rather than rely
on management’s description of its business model, analysts should
develop their own understanding.

Corporate Issuers
Many firms have conventional business models that are easily

understood and described in simple terms, such as manufacturer,
wholesaler, retailer, professional firm, or restaurant chain. However,
many business models are complex, specialized, or new. Digital tech-
nology, in particular, has enabled significant business model innova-
tion, bringing business models into the spotlight. It has spawned new
services and markets and has changed the way most businesses oper-
ate. In many cases, technology has enabled the disruption of existing
business models, allowing new players to win against large and well-
established players who lack the capabilities or agility to respond.
Summary
• A business model describes how a business is organized to deliver
value to its customers:
■■ who its customers are,
■■ how the business serves them,
■■ key assets and suppliers, and
■■ the supporting business logic.
• The firm’s “value proposition” refers to the product or service
attributes valued by a firm’s target customer that lead those cus-
tomers to prefer a firm’s offering over those of its competitors,
given relative pricing.
• Channel strategy may be a key element of a business model, and
it addresses how the firm is reaching its customers.
• Pricing is often a key element of the business model. Pricing
approaches are typically value or cost based.

Business Models & Risks
• In addition to the value proposition, a business model should

address the “value chain” as well as “how” the firm is structured
to deliver that value.
• Although many firms have conventional business models that
are easily understood and described in simple terms, many busi-
ness models are complex, specialized, or new.
• Digital technology has enabled significant business model inno-
vation, often based on network effects.
• To understand the profitability of a business, the analyst should
examine margins, break-even points, and “unit economics.”
• Businesses have different financing needs and risk profiles,
depending on both external and firm-specific factors, which will
determine the firm’s ability to raise capital.

Capital Investments
• Level I
• 1 PL Credit
• Access the full reading: cfainst.is/capitalinvestments
Learning Outcomes
• describe types of capital investments made by companies;
• describe the capital allocation process and basic principles of
capital allocation;
• demonstrate the use of net present value (NPV) and internal rate
of return (IRR) in allocating capital and describe the advantages
and disadvantages of each method;
• describe common capital allocation pitfalls;
• describe expected relations among a company’s investments,
company value, and share price; and
• describe types of real options relevant to capital investment.
Introduction
Capital investments, also referred to as capital projects, are invest-
ments with a life of one year or longer made by corporate issuers.

Capital Investments
Issuers make capital investments to generate value for their stake-

holders by returning long-term benefits and future cash flows greater
than the associated funding cost of the capital invested. How compa-
nies allocate capital between competing priorities and the resulting
capital investment portfolio are central to a company’s success and
together constitute a fundamental area for analysts to understand.
Given that corporate disclosure of capital investments typically is
given at a very high level and often lacks specifics, the evaluation of a
company’s capital investments is often challenging for analysts.
Capital investments describe a company’s future prospects bet-
ter than its working capital or capital structure, which are often
similar for companies, and provide insight into the quality of man-
agement’s decisions and how the company is creating value for stake-
holders. Although the focus of this coverage is on capital investments,
companies also make other investments in increased working capital,
information technology (IT), and human resources projects. These
investments might not be capitalized and therefore affect near-term
operating profit, but they are made for similar long-term benefit as
capital investments.
Summary
Capital investments—those investments with a life of one year or
longer—are key in determining whether a company is profitable and
generating value for its shareholders. Capital allocation is the pro-
cess companies use to decide their capital investment activity. This
reading introduces capital investments, basic principles underlying
the capital allocation model, and the use of NPV and IRR decision
criteria.

Corporate Issuers
• Companies invest for two reasons: to maintain their existing

businesses and to grow them. Projects undertaken by compa-
nies to maintain a business including operating efficiencies
are (1) going concern projects and (2) regulatory/compliance
projects, while (3) expansion projects and (4) other projects are
undertaken by companies to strategically expand or grow their
operations.
• Capital allocation supports the most critical investments for
many corporations—their investments in long-term assets. The
principles of capital allocation are also relevant and can be
applied to other corporate investing and financing decisions and
to security analysis and portfolio management.
• The typical steps companies take in the capital allocation process
are (1) idea generation, (2) investment analysis, (3) capital alloca-
tion planning, and (4) postaudit and monitoring.
• Companies should base their capital allocation decisions on the
investment project’s incremental after-tax cash flows discounted
at the opportunity cost of funds. In addition, companies should
ignore financing costs because both the cost of debt and the cost of
other capital are captured in the discount rate used in the analysis.
• The NPV of an investment project is the present value of its after-
tax cash flows (or the present value of its after-tax cash inflows
minus the present value of its after-tax outflows) or
n
CF
NPV = ∑ (1 + tr )t ,
t =0
where the investment outlays are negative cash flows included in
CFt and r is the required rate of return for the investment.
• Microsoft Excel functions to solve for the NPV for both conven-
tional and unconventional cash flow patterns are

Capital Investments
■■ NPV or =NPV(rate, values) and

■■ XNPV or =XNPV(rate, values, dates),
where “rate” is the discount rate, “values” are the cash flows, and
“dates” are the dates of each of the cash flows.
• The IRR is the discount rate that makes the present value of all
future cash flows of the project sum to zero. This equation can be
solved for the IRR:
n
CFt
∑ (1 + IRR) t
= 0.
t =0
• Using Microsoft Excel functions to solve for IRR, the functions
are
■■ IRR or =IRR(values, guess) and
■■ XIRR or =XIRR(values, dates, guess),
where “values” are the cash flows, “guess” is an optional user-
specified guess that defaults to 10%, and “dates” are the dates of
each cash flow.
• Companies should invest in a project if the NPV > 0 or if the
IRR > r.
• For mutually exclusive investments that are ranked differently by
the NPV and IRR, the NPV criterion is the more economically
sound approach that companies should use.
• The fact that projects with positive NPVs theoretically increase
the value of the company and the value of its stock could explain
the use and popularity of the NPV method by companies.
• Real options allow companies to make future decisions con-
tingent on future economic information or events that change
the value of capital investment decisions the company has made

Corporate Issuers
today. These can be classified as (1) timing options; (2) sizing

options, which can be abandonment options or growth (expan-
sion) options; (3) flexibility options, which can be price-setting
options or production-flexibility options; and (4) fundamental
options.

Working Capital& Liquidity
• Level I
• 1 PL Credit
• Access the full reading: cfainst.is/workingcapital
Learning Outcomes
• compare methods to finance working capital;
• explain expected relations between working capital, liquidity,
and short-term funding needs;
• describe sources of primary and secondary liquidity and factors
affecting a company’s liquidity position;
• compare a company’s liquidity position with that of peers; and
• evaluate short-term funding choices available to a company.
Introduction
Working capital (also called net working capital) is defined simply as
current assets minus current liabilities:

Corporate Issuers
(Net) Working capital = Current assets – Current liabilities

It includes both operating assets and liabilities, such as accounts
receivable, accounts payable, and inventory, as well as financial
assets and liabilities, such as short-term investments and short-term
debt. Working capital management is the management of a firm’s
short-term assets and liabilities and an important aspect of a firm’s
operations. The goal of working capital management is to ensure the
company has adequate, ready access to funds necessary for day-to-
day operations, while avoiding excess reserves that can be a costly
drag on the business’ profitability and returns. Having excess levels
of working capital can have a harmful effect on shareholder returns.
At the same time, insufficient levels of working capital can harm a
company if it cannot meet its short-term obligations, leading to prod-
uct shortages, sales slowdowns, and, in the extreme, bankruptcy.
An analyst should carefully evaluate the working capital posi-
tion of the firm to make an informed decision about the firm’s ability
to meet its short-term needs as it works to implement its long-term
plans. To assess whether a firm is operating at an optimal level of
working capital, financed at the lowest possible cost, an analyst
should begin by asking two fundamental questions:
• What are the required investments in working capital for the firm?
• How should those investments be financed?
Understanding this provides the analyst with a basis for sound valu-
ation analysis.
Summary
We consider key aspects of short-term financial management: the
choices available to fund a company’s working capital needs and

Working Capital & Liquidity
effective liquidity management. Both are critical in ensuring a com-

pany’s day-to-day operations and ability to remain in business. Key
points of coverage included the following:
• Internal and external sources available to finance working capi-
tal needs and considerations in their selection.
• Working capital approaches, their considerations, and their
impact on the funding needs of the company.
• Primary and secondary sources of liquidity and factors that can
enhance a company’s liquidity position.
• The evaluation of a company’s liquidity position and comparison
to peers.
• The evaluation of short-term financing choices based on their
characteristics and effective costs.

Capital Structure
• Level I
• 1.75 PL Credits
• Access the full reading: cfainst.is/capitalstructure
Learning Outcomes
• explain factors affecting capital structure;
• describe how a company’s capital structure may change over its
life cycle;
• explain the Modigliani–Miller propositions regarding capital
structure;
• describe the use of target capital structure in estimating WACC,
and calculate and interpret target capital structure weights; and
• describe competing stakeholder interests in capital structure
decisions.
Introduction
Capital structure refers to the specific mix of debt and equity used
to finance a company’s assets and operations. From a corporate

Capital Structure
perspective, equity represents a more expensive, permanent source of

capital with greater financial flexibility. Financial flexibility allows a
company to raise capital on reasonable terms when capital is needed.
Conversely, debt represents a cheaper, finite-to-maturity capital
source that legally obligates a company to make promised cash out-
flows on a fixed schedule with the need to refinance at some future
date at an unknown cost.
As we will show, debt is an important component in the “opti-
mal” capital structure. The trade-off theory of capital structure tells
us that managers should seek an optimal mix of equity and debt that
minimizes the firm’s weighted average cost of capital, which in turn
maximizes company value. That optimal capital structure represents
a trade-off between the cost-effectiveness of borrowing relative to the
higher cost of equity and the costs of financial distress.
In reality, many practical considerations affect capital struc-
ture and the use of leverage by companies, leading to wide varia-
tion in capital structures even among otherwise-similar companies.
Practical considerations affecting capital structure include the
following:
• business characteristics: features associated with a company’s
business model, operations, or maturity;
• capital structure policies and leverage targets: guidelines set by
management and the board that seek to establish sensible bor-
rowing limits for the company based on the company’s risk appe-
tite and ability to support debt; and
• market conditions: current share price levels and market interest
rates for a company’s debt. The prevalence of low interest rates
increases the debt-carrying capacity of businesses and the use of
debt by companies.

Corporate Issuers
Because we are considering how a company minimizes its overall

cost of capital, the focus is on the market values of debt and equity.
Therefore, capital structure is also affected by changes in the market
value of a company’s securities over time.
We tend to think of capital structure as the result of a conscious
decision by management, but it is not that simple. For example,
unmanageable debt, or financial distress, can arise because a compa-
ny’s capital structure policy was too aggressive, but it also can occur
because operating results or prospects deteriorate unexpectedly.
Finally, in seeking to maximize shareholder value, company
management may make capital structure decisions that are not in the
interests of other stakeholders, such as debtholders, suppliers, cus-
tomers, or employees.
Summary
• Financing decisions typically are tied to investment spending
and are based on the company’s ability to support debt given the
nature of its business model, assets, and operating cash flows.
• A company’s stage in the life cycle, its cash flow characteristics,
and its ability to support debt largely dictate its capital structure,
because capital not sourced through borrowing must come from
equity (including retained earnings).
• Generally speaking, as companies mature and move from start-
up through growth to maturity, their business risk declines as
operating cash flows turn positive with increasing predictability,
allowing for greater use of leverage on more attractive terms.
• Modigliani and Miller’s work, with its simplifying assumptions,
provides a starting point for thinking about the strategic use of

Capital Structure
debt and shows us that managers cannot change firm value sim-
ply by changing the firm’s capital structure. Firm value is inde-
pendent of capital structure decisions.
• Given the tax-deductibility of interest, adding leverage increases
firm value up to a point but also increases the risk of default for
capital providers who demand higher returns in compensation.
• To maximize firm value, management should target the optimal
capital structure that minimizes the company’s weighted average
cost of capital.
• “Optimal capital structure” involves a trade-off between the
benefits of higher leverage, which include the tax-deductibility
of interest and the lower cost of debt relative to equity, and the
costs of higher leverage, which include higher risk for all capital
providers and the potential costs of financial distress.
• Managers may provide investors with information (“signaling”)
through their choice of financing method. For example, commit-
ments to fixed payments may signal management’s confidence in
the company’s prospects.
• Managers’ capital structure decisions affect various stakeholder
groups differently. In seeking to maximize shareholder wealth or
their own, managers may create conflicts of interest in which one
or more groups are favored at the expense of others, such as a
debt-equity conflict.

Financial Statement
Modeling
• Level II
• 4.5 PL Credits
• Access the full reading: cfainst.is/modeling
Learning Outcomes
• compare top-down, bottom-up, and hybrid approaches for devel-
oping inputs to equity valuation models;
• compare “growth relative to GDP growth” and “market growth
and market share” approaches to forecasting revenue;
• evaluate whether economies of scale are present in an industry
by analyzing operating margins and sales levels;
• demonstrate methods to forecast cost of goods sold and operat-
ing expenses;
• demonstrate methods to forecast nonoperating items, financing
costs, and income taxes;
• describe approaches to balance sheet modeling;
• demonstrate the development of a sales-based pro forma com-
pany model;

Financial Statement Modeling
• explain how behavioral factors affect analyst forecasts and rec-

ommend remedial actions for analyst biases;
• explain how competitive factors affect prices and costs;
• evaluate the competitive position of a company based on a
Porter’s five forces analysis;
• explain how to forecast industry and company sales and costs
when they are subject to price inflation or deflation;
• evaluate the effects of technological developments on demand,
selling prices, costs, and margins;
• explain considerations in the choice of an explicit forecast hori-
zon; and
• explain an analyst’s choices in developing projections beyond the
short-term forecast horizon.
Introduction
Financial statement modeling is a key step in the process of valuing
companies and the securities they have issued. We focus on how ana-
lysts use industry information and corporate disclosures to forecast a
company’s future financial results.
An effective financial statement model must be based on a thor-
ough understanding of a company’s business, management, strategy,
external environment, and historical results. Thus, an analyst begins
with a review of the company and its environment—its industry,
key products, strategic position, management, competitors, suppli-
ers, and customers. Using this information, an analyst identifies key

Corporate Issuers
revenue and cost drivers and assesses the likely impact of relevant
trends, such as economic conditions and technological developments.
An analyst’s understanding of the fundamental drivers of the busi-
ness and assessment of future events provide the basis for forecast
model inputs. In other words, financial statement modeling is not
merely a quantitative or accounting exercise, it is the quantitative
expression of an analyst’s expectations for a company and its com-
petitive environment.
We begin our discussion with an overview of developing a rev-
enue forecast. We then describe the general approach to forecasting
each of the financial statements and demonstrate the construction
of a financial statement model, including forecasted revenue, income
statements, balance sheets, and statements of cash flows. Then, we
describe five key behavioral biases that influence the modeling pro-
cess and strategies to mitigate them. We turn to several important
topics on the effects of micro- and macroeconomic conditions on
financial statement models: the impact of competitive factors on
prices and costs, the effects of inflation and deflation, technological
developments, and long-term forecasting considerations. The reading
concludes with a summary.
Most of the examples and exhibits used throughout the reading
can be downloaded as a Microsoft Excel workbook. Each worksheet
in the workbook is labeled with the corresponding example or exhibit
number in the text.
Summary
Industry and company analysis are essential tools of fundamental
analysis. The key points include the following:

Financial Statement Modeling
• Analysts can use a top-down, bottom-up, or hybrid approach to

forecasting income and expenses. Top-down approaches usually
begin at the level of the overall economy. Bottom-up approaches
begin at the level of the individual company or unit within the
company (e.g., business segment). Time-series approaches are
considered bottom-up, although time-series analysis can be a
tool used in top-down approaches. Hybrid approaches include
elements of top-down and bottom-up approaches.
• In a “growth relative to GDP growth” approach to forecasting
revenue, the analyst forecasts the growth rate of nominal GDP
and industry and company growth relative to GDP growth.
• In a “market growth and market share” approach to forecasting
revenue, the analyst combines forecasts of growth in particular
markets with forecasts of a company’s market share in the indi-
vidual markets.
• Operating margins that are positively correlated with sales pro-
vide evidence of economies of scale in an industry.
• Some balance sheet line items, such as retained earnings, flow
directly from the income statement, whereas accounts receivable,
accounts payable, and inventory are closely linked to income
statement projections.
• A common way to model working capital accounts is to use effi-
ciency ratios.
• Return on invested capital (ROIC), defined as net operating profit
less adjusted taxes divided by the difference between operating
assets and operating liabilities, is an after-tax measure of profit-
ability. High and persistent levels of ROIC are often associated
with having a competitive advantage.

Corporate Issuers
• Competitive factors affect a company’s ability to negotiate lower

input prices with suppliers and to raise prices for products and
services. Porter’s five forces framework can be used as a basis for
identifying such factors.
• Inflation (deflation) affects pricing strategy depending on indus-
try structure, competitive forces, and the nature of consumer
demand.
• When a technological development results in a new product that
threatens to cannibalize demand for an existing product, a unit
forecast for the new product combined with an expected can-
nibalization factor can be used to estimate the impact on future
demand for the existing product.
• Factors influencing the choice of the explicit forecast horizon
include the projected holding period, an investor’s average port-
folio turnover, the cyclicality of an industry, company-specific
factors, and employer preferences.
• Key behavioral biases that influence analyst forecasts are over-
confidence, illusion of control conservatism, representativeness,
and confirmation bias.

Cost of Capital: Advanced
Topics
• Level II
• 1.75 PL Credits
• Access the full reading: cfainst.is/costofcapital
Learning Outcomes
• explain top-down and bottom-up factors that impact the cost of
capital,
• compare methods used to estimate the cost of debt,
• explain historical and forward-looking approaches to estimating
an equity risk premium,
• compare methods used to estimate the required return on equity,
• estimate the cost of debt or required return on equity for a pub-
lic company and a private company, and
• evaluate a company’s capital structure and cost of capital relative
to peers.

Corporate Issuers
Introduction
A company’s weighted average cost of capital (WACC) represents
the cost of debt and equity capital used by the company to finance
its assets. The cost of debt is the after-tax cost to the issuer of debt,
based on the return that debt investors require to finance a company.
The cost of equity represents the return that equity investors require
to own a company, also referred to as the required rate of return on
equity or the required return on equity.
A company’s WACC is used by the company’s internal decision
makers to evaluate capital investments. For analysts and investors, it
is a critical input used in company valuation. Equation (1) shows how
a company’s WACC is driven by the proportions, or weights (the wi),
of the different capital sources used in its capital structure, applied to
the costs of each source (the ri):
WACC = wdrd(1 – t) + wprp + were, (1)
where d, p, and e denote debt, preferred equity, and common equity,
respectively. These weights are all non-negative and sum to 1.0.
Determining a company’s WACC is an important, albeit chal-
lenging, task for an analyst given the following:
• Many different methods can be used to calculate the costs of
each source of capital; there is no single, “right” method.
• Assumptions are needed regarding long-term target capi-
tal structure, which might or might not be the current capital
structure.
• The company’s marginal tax rate must be estimated and might be
different from its average or effective tax rate.
Estimating the cost of capital for a company thus involves
numerous, sometimes complex, assumptions and choices, all of
which affect the resulting investment conclusion.

Corporate Restructuring
• Level II
• 2.25 PL Credits
• Access the full reading: cfainst.is/corprestructuring
Learning Outcomes
• explain types of corporate restructurings and issuers’ motiva-
tions for pursuing them;
• explain the initial evaluation of a corporate restructuring;
• demonstrate valuation methods for, and interpret valuations of,
companies involved in corporate restructurings;
• demonstrate how corporate restructurings affect an issuer’s
earnings per share (EPS); net debt to earnings before inter-
est, taxes, depreciation, and amortization (EBITDA) ratio; and
weighted average cost of capital;
• evaluate corporate investment actions, including equity invest-
ments, joint ventures, and acquisitions;
• evaluate corporate divestment actions, including sales and spin-
offs; and
• evaluate cost and balance sheet restructurings.

Corporate Issuers
Introduction
Corporate issuers change over time. Although many changes are evo-
lutionary, such as launching new products and expanding capacity,
others involve more revolutionary changes to the legal and account-
ing structure of the issuer. The most well-known among these struc-
tural changes is acquisitions, in which one company buys another.
Other well-known changes include divestitures and spin-offs, in
which an issuer sells or separates a segment of its business. Common
features among these changes are that they tend to attract significant
press and analyst attention and their announcement is associated
with increased securities trading volume.
This reading explains how to evaluate corporate restructurings
from the perspective of an independent investment analyst. The dis-
cussion begins in Section 2 with an overview of corporate restructur-
ings, including putting these events in the context of the corporate
life cycle, and corporate issuers’ motivations for pursuing them.
Sections 3 and 4 feature a three-step process for evaluating corporate
restructurings as an investment analyst. Sections 5–7 demonstrate
the evaluation process with case studies for each major type of cor-
porate restructuring. The reading concludes with a summary and
practice problems.
Summary
• Corporate issuers seek to alter their destiny, as described by the
corporate life cycle, by taking actions known as restructurings.
• Restructurings include investment actions that increase the
size and scope of an issuer’s business, divestment actions that

Corporate Restructuring
decrease size or scope, and restructuring actions that do not

affect scope but improve performance.
• Investment actions include equity investments, joint ventures,
and acquisitions. Investment actions are often made by issuers
seeking growth, synergies, or undervalued targets.
• Divestment actions include sales and spin-offs and are made by
issuers seeking to increase growth or profitability or reduce risk
by shedding certain divisions and assets.
• Restructuring actions, including cost cutting, balance sheet
restructurings, and reorganizations, do not change the size or
scope of issuers but are aimed at improving returns on capital to
historical or peer levels.
• The evaluation of a corporate restructuring is composed of four
phases: initial evaluation, preliminary evaluation, modeling, and
updating the investment thesis. The entire evaluation generally is
done only for material restructurings.
• The initial evaluation of a corporate restructuring answers the
following questions: What is happening? When is it happening?
Is it material? And why is it happening?
• Materiality is defined by both size and fit. One rule of thumb for
size is that large actions are those that are greater than 10% of
an issuer’s enterprise value (e.g., for an acquisition, consideration
in excess of 10% of the acquirer’s preannouncement enterprise
value). Fit refers to the alignment between the action and an ana-
lyst’s expectations for the issuer.
• The three common valuation methods for companies involved
in corporate restructurings, during the preliminary valuation

Corporate Issuers
phase of the evaluation, are comparable company, comparable

transaction, and premium paid analysis.
• Corporate restructurings must be modeled on the financial
statements based on the situational specifics. Estimated financial
statements that include the effect of a restructuring are known
as pro forma financial statements.
• The weighted average cost of capital for an issuer is determined
by the weights of different capital types and the constituent costs
of capital. The costs of capital are influenced by both bottom-up
and top-down drivers. Bottom-up drivers include stability, prof-
itability, leverage, and asset specificity. Corporate restructurings
affect the cost of capital by affecting these drivers.

Alternative
Investments
Readings
Categories, Characteristics, I 0.75 cfainst.is/
and Compensation Structures altcategories
of Alternative Investments
Performance Calculation I 0.75 cfainst.is/
and Appraisal of Alternative perfcalculation
Investments
Private Capital, Real Estate, I 2.25 cfainst.is/
Infrastructure, Natural alternatives
Resources, and Hedge Funds
Overview of Types of Real II 1.25 cfainst.is/
Estate Investment realestate
Investments in Real Estate II 0.75 cfainst.is/
through Private Vehicles reprivatevehicles
Investments in Real Estate II 1.25 cfainst.is/
through Publicly Traded resecurities
Securities

Does It Matter?
One of the key features of alternative investments is that investing
in them requires special skills and information. Investing in alter-
native assets requires an understanding of illiquidity, transacting on
private markets, operating sophisticated investment strategies, and
managing risk–return profiles that are considerably different from
those of traditional long-only investments. The new “Categories,
Characteristics, and Compensation Structures of Alternative
Investments” reading provides insights into types and categories of
alternative investments. It introduces key characteristics of direct
investments, co-investments, and fund investments into alternatives.
The reading also tackles the investment and compensation structures
commonly used by alternative investment managers.
The challenges in calculating and interpreting returns from
alternative investments, both before and after fees, is addressed in
the new “Performance Calculation and Appraisal of Alternative
Investments” reading. This reading examines why traditional risk
and return measures—such as mean return, standard deviation of
returns, and beta—may not provide an adequate picture of alternative
investments’ risk and return given the nature of these investments.
As this reading makes clear, evaluating returns from an alter-
native investment is not a purely quantitative, one-size-fits-all pro-
cess, but it can be a subtle, qualitative exercise. Much of the nuance
revolves around volatility, in addition to total net return. Conducting
performance appraisal on alternative investments also can be

challenging when there is an asymmetric risk–return profile, limited

portfolio transparency, illiquidity, product complexity, or complex
fee structures.
The new “Private Capital, Real Estate, Infrastructure, Natural
Resources, and Hedge Funds” reading refreshes learners about the
key characteristics of these asset classes. The reading explains how
private funds are bought and sold and how they affect public markets.
Given the strong growth in private assets in recent years, this
reading assesses what has driven their growth. The expansion of
the private debt market, for instance, has been largely driven by pri-
vate lending funds filling the gap between borrowing demand and
reduced lending supply from traditional lenders. Meanwhile, more
infrastructure projects are being financed privately, with the increas-
ing use of public–private partnerships (PPPs) by local, regional, and
national governments.
Investor allocations to public and private real estate have
increased significantly over the past 20 years. Three integrated
modules—“Overview of Types of Real Estate Investment,”
“Investments in Real Estate through Private Vehicles,” and
“Investments in Real Estate through Publicly Traded Securities”—
cover various topics in real estate. These replace and consolidate the
material that appeared in the previous two real estate readings at
this level. The modules describe the unique risk and diversification
characteristics of real estate investments that distinguish real estate
from other asset classes. As a series, the modules bring together the
ways that both public and private real estate management operate
and are managed. The content describes the due diligence process
for real estate investments, explain which factors affect their value,
and outline how real estate is used in portfolios. The material also
discusses real estate investment indexes, including their construction
and potential biases.

Categories, Characteristics,
and Compensation
Structures of Alternative
Investments
• Level I
• 0.75 PL Credits
• Access the full reading: cfainst.is/altcategories
Learning Outcomes
• describe types and categories of alternative investments;
• describe characteristics of direct investment, co-investment, and
fund investment methods for alternative investments; and
• describe investment and compensation structures commonly
used in alternative investments.
Introduction
“Alternative investments” is a label applied to a disparate group of
investments to distinguish them from “traditional investments”—that

Categories, Characteristics, and Compensation Structures of Alternative
is, investments in long-only, publicly traded investments in stocks,

bonds, and cash. We can think about three major categories of
alternative investments based on how they differ from “traditional
investments”:
• private capital
• real assets
• hedge funds
One of the key features of alternative investments is that invest-
ing in them requires special skills and information. Investing in
alternative assets can require handling illiquidity, transacting on pri-
vate markets, operating sophisticated investment strategies, or risk–
return profiles that are different from those of traditional long-only
investments.
Why Investors Consider Alternative Investments

Alternative investments offer a variety of advantages:
• broader diversification through accessing a larger universe of
investments or because of their lower correlation with tradi-
tional asset classes;
• opportunities for enhanced returns by improving the portfolio’s
risk–return profile; and
• potentially increased returns through higher yields, particu-
larly compared with traditional investments in low–interest rate
periods.
The 2019 annual report for the Yale University endowment
provides one institutional investor’s reasoning for investing in
alternatives:

Alternative Investments
The heavy [75.2%] allocation to nontraditional asset

classes stems from the diversifying power they provide
to the portfolio as a whole. Alternative assets, by their
very nature, tend to be less efficiently priced than tradi-
tional marketable securities, providing an opportunity
to exploit market inefficiencies through active manage-
ment. Today’s portfolio has significantly higher expected
returns and lower volatility than the 1989 portfolio.
This quote neatly illustrates the expected characteristics of alter-
native investments: diversifying power, higher expected returns, and
illiquid and potentially less efficient markets. The quote also high-
lights the importance of having the willingness and the ability to
take a long-term perspective. Endowments, pension funds, sovereign
wealth funds, and even family offices allocate increasing portions of
their portfolios to alternative investments seeking to benefit from
diversification and return opportunities.
Alternative investments are not free of risk, of course, and their
returns may be correlated with those of other investments, especially
in periods of financial crisis. Over a long historical period, the aver-
age correlation of returns from alternative investments with those of
traditional investments may be low, but in any particular period, the
correlation can differ from the average. During periods of economic
crisis, correlations among many assets (both alternative and tradi-
tional) can increase dramatically.
Alternative investments often have many of the following
characteristics:
• narrow specialization of the investment managers,
• relatively low correlation of returns with those of traditional
investments, and

• less regulation and less transparency than traditional investments.

As a result of these characteristics, alternative investments often
exhibit the following:
• limited reliable historical risk and return data;
• unique legal and tax considerations;
• higher fees, often including performance or incentive fees;
• concentrated portfolios; and
• restrictions on redemptions (i.e., “lockups” and “gates”).
Categories of Alternative Investments

Considering the variety of alternative investments, it is not surpris-
ing that consensus has not been reached on a definitive list of groups
or categories. Considerable debate even surrounds the use of catego-
ries versus subcategories. For the purpose of this reading, we classify
alternative investments three categories and several subcategories, as
follows:
• Private Capital
■■ Private Equity (PE)
■■ Private Debt
• Real Assets
■■ Real Estate
■■ Infrastructure
■■ Natural Resources

Commodities
Agricultural land and Timberland
• Hedge Funds
Summary
The following section provides an overview of the three main catego-
ries and their subcategories.
Private Capital
• Private equity. PE funds generally invest in companies, whether
startups or established firms, that are not listed on a public
exchange, or they invest in public companies with the intent to
take them private. The majority of PE activity, by value, involves
leveraged buyouts of established profitable and cash-generating
companies with solid customer bases, proven products, and
high-quality management.
• Venture capital funds, a specialized form of PE that typically
involves investing in or providing financing to startup or early-
stage companies with high growth potential, represent a small
portion of the PE market by value.
• Private debt. Private debt largely encompasses debt provided to
private entities. Forms of private debt include the following:
■■ direct lending (private loans with no intermediary),
■■ mezzanine loans (private subordinated debt),

■■ venture debt (private loans to startup or early-stage compa-

nies that may have little or negative cash flow), and
■■ distressed debt (debt extended to companies that are “dis-
tressed” because of such issues as bankruptcy or other com-
plications with meeting debt obligations).
Real Assets
• Real estate. Real estate investments are made in buildings or
land, either directly or indirectly. They include private commer-
cial real estate equity (e.g., ownership of an office building) and
private commercial real estate debt (e.g., directly issued loans or
mortgages on commercial property). Securitization has broad-
ened the definition of real estate investing to include public real
estate equity (e.g., real estate investment trusts, or REITs) and
public real estate debt (e.g., mortgage-backed securities).
• Infrastructure. Infrastructure assets are capital-intensive, long-
lived real assets, such as airports, roads, dams, and schools, that
are intended for public use and provide essential services. An
increasingly common approach to infrastructure investing is
a public–private partnership (PPP) approach, in which govern-
ments and private investors each have a stake. Infrastructure
investments provide exposure to asset cash flows, but the asset
generally returns to public authority ownership. Infrastructure
can be thought of as “real estate for the public,” with cash flows
from landing rights and road tolls.
• Natural resources
■■ Commodities. Commodity investments may take place in
physical commodity products, such as grains, metals, and

crude oil, either through owning physical assets, using

derivative products, or investing in businesses engaged in
the exploration and production of physical commodities.
■■ Agricultural land (or farmland). Agricultural land involves
the cultivation of livestock or plants, and agricultural land
investing covers various strategies, including the purchase
of farmland to lease it back to farmers or to receive a stream
of income from the growth, harvest, and sale of crops (e.g.,
corn, cotton, wheat) or livestock (e.g., cattle).
■■ Timberland. Investing in timberland generally involves
investing capital in natural forests or managed tree plan-
tations to earn a return when the trees are harvested.
Timberland involves a longer investment cycle than that
of agriculture. Timberland investors often rely on various
drivers, such as biological growth, to increase the value of
the trees so the wood can be sold at favorable prices in the
future.
• Other. Other “real asset” investments may include tangible
assets, such as fine wine, art, antique furniture and automobiles,
stamps, coins, and other collectibles, and intangible assets, such
as patents and litigation actions. “Digital assets” are an emerging
investment opportunity. Some include these assets in the “other”
category. Since 2015, however, the Commodity Futures Trading
Commission (CFTC) has defined digital assets as a “digital com-
modity” and regulates them accordingly.
Hedge Funds
• Hedge funds are private investment vehicles that manage port-
folios of securities or derivative positions using a variety of

strategies. They may involve long and short positions and may
be highly leveraged. Some hedge funds try to deliver investment
performance that is independent of broader market performance.
Although hedge funds may be invested entirely in traditional
assets, these vehicles are considered alternative because of their
specialized approach.

Performance Calculation
and Appraisal of Alternative
Investments
• Level I
• 0.75 PL credits
• Access the full reading: cfainst.is/perfcalculation
Learning Outcomes
• describe issues in performance appraisal of alternative invest-
ments, and
• calculate and interpret returns of alternative investments both
before and after fees.
Introduction
Investors frequently look to alternative investments for diversifica-
tion and a chance to earn relatively high returns on a risk-adjusted
basis. Investors also value low correlation and a more risk-neutral
source of alpha.

Performance Calculation and Appraisal of Alternative Investments
Evaluating an alternative investment can be a subtle, qualitative

exercise—one that depends on the initial objectives of the investor—
as opposed to a purely quantitative, one-size-fits-all exercise. Much
of the nuance revolves around not only the total net return created by
an alternative investment but also the path and volatility (drawdown
risk) required to create the total return as well as how an alternative
investment fits into and benefits a larger portfolio of assets—in other
words, its portfolio-level correlation benefit.
The attraction to alternative investments is often focused on their
expected returns, but investors often neglect to consider the atypical
risks they present—risks we can examine on both a standalone and
portfolio basis:
• limited transparency
• low portfolio liquidity
• high leverage and use of derivatives
• high product complexity
• mark-to-market issues, especially for specialized products
• limited redemption availability
• difficulty in manager selection and diversification
• high fees, which can have a nontrivial impact on performance
Summary
• Conducting performance appraisal on alternative investments
can be challenging because these investments are often char-
acterized by asymmetric risk–return profiles, limited portfolio

transparency, illiquidity, product complexity, and complex fee

structures.
• Traditional risk and return measures (such as mean return, stan-
dard deviation of returns, and beta) may provide an inadequate
picture of alternative investments’ risk and return characteris-
tics. Moreover, these measures may be unreliable or not repre-
sentative of specific investments.
• A variety of ratios can be calculated to review the performance of
alternative investments, including the Sharpe ratio, Sortino ratio,
Calmar ratio, and mean adequacy ratio (MAR). The internal rate
of return (IRR) and multiple on invested capital (MOIC) calcula-
tions are often used to evaluate private equity investments, and
the cap rate is often used to evaluate real estate investments.
• Redemption rules, lockup periods, and timing differences in
reporting can bring special challenges to performance appraisal
of alternative investments.

Private Capital, Real Estate,
Infrastructure, Natural
Resources, and Hedge
Funds
• Level I
• 2.25 PL Credits
• Access the full reading: cfainst.is/alternatives
Learning Outcomes
• explain investment characteristics of private equity,
• explain investment characteristics of private debt,
• explain investment characteristics of real estate,
• explain investment characteristics of infrastructure,
• explain investment characteristics of natural resources, and
• explain investment characteristics of hedge funds.

Introduction
Private capital is the broad term for funding provided to companies
that is sourced neither from the public markets, such as from the
sale of equities, bonds, and other securities on exchanges, nor from
traditional institutional providers, such as a government or bank.
Capital raised from sources other than public markets and tradi-
tional institutions and in the form of an equity investment is called
private equity (PE). Similarly sourced capital extended to companies
through a loan or other form of debt is referred to as private debt.
Private capital relates to the entire capital structure, including PE and
private debt.
Private capital largely consists of private investment funds and
entities that invest in the equity or debt securities of privately held
companies, real estate, or other assets. Many private investment
firms have PE and private debt arms; however, these teams typically
refrain from investing in the same assets or businesses to avoid over-
exposure to a single investment and to avoid the conflict of interest
that arises from being invested in both the equity and debt of an
issuer. Private investment firms, even those with private debt arms,
typically are referred to as PE firms. Although PE is the largest com-
ponent of private capital, PE as a comprehensive generic category is
inaccurate because other forms of private alternative finance have
grown considerably in size and popularity.
Summary
• Private capital is a broad term used for funding provided to
companies sourced from neither the PE nor public debt markets.

Private Capital, Real Estate, Infrastructure, Natural Resources, and Hedge Funds
Capital provided in the form of equity investments is called PE,

whereas capital provided as a loan or other form of debt is called
private debt.
• PE refers to investment in privately owned companies or in pub-
lic companies intended to be taken private. Key PE investment
strategies include leveraged buyouts (e.g., management buyouts
[MBOs] and management buy-ins [MBIs]) and venture capital.
Primary exit strategies include trade sale, initial public offerings
(IPO), and recapitalization.
• Private debt refers to various forms of debt provided by inves-
tors to private entities. Key private debt strategies include direct
lending, mezzanine debt, and venture debt. Private debt also
includes specialized strategies, such as collateralized loan obliga-
tion (CLOs), unitranche debt, real estate debt, and infrastructure
debt.

Overview of Types of Real
Estate Investment
• Level II
• 1.25 PL Credits
• Access the full reading: cfainst.is/realestate
Learning Outcomes
• compare the characteristics, classifications, principal risks, and
basic forms of public and private real estate investments;
• explain portfolio roles and economic value determinants of real
estate investments;
• discuss commercial property types, including their distinctive
investment characteristics;
• explain the due diligence process for both private and public
equity real estate investments; and
• discuss real estate investment indexes, including their construc-
tion and potential biases.

Overview of Types of Real Estate Investment
Introduction
Real estate property is an asset class that plays a significant role in
many investment portfolios and is an attractive source of current
income. Investor allocations to public and private real estate have
increased significantly over the last 20 years. Because of the distinct
characteristics of real estate property, real estate investments tend
to behave differently from other asset classes—such as stocks, bonds,
and commodities—and thus have different risks and diversification
benefits. Private real estate investments are further differentiated
because the investments are not publicly traded and require analytic
techniques different from those of publicly traded assets. Because
of the lack of directly comparable transactions, an appraisal pro-
cess is required to value real estate property. Many of the indexes
and benchmarks used for private real estate also rely on appraisals.
Because of this characteristic, they behave differently from indexes
for publicly traded equities, such as the S&P 500, MSCI Europe,
FTSE Asia Pacific, and many other regional and global indexes.
Summary
General Characteristics of Real Estate
• Real estate investments can occur in four basic forms: private
equity (direct ownership), publicly traded equity (indirect own-
ership claim), private debt (direct mortgage lending), and pub-
licly traded debt (securitized mortgages).
• Many motivations exist for investing in real estate income prop-
erty. The key factors are current income, price appreciation,
inflation hedge, diversification, and tax benefits.

• Adding equity real estate investments to a traditional portfo-

lio will potentially have diversification benefits because of the
less-than-perfect correlation of equity real estate returns with
returns to stocks and bonds.
• If the income stream can be adjusted for inflation and real estate
prices increase with inflation, then equity real estate investments
may provide an inflation hedge.
• Debt investors in real estate expect to receive their return from
promised cash flows and typically do not participate in any
appreciation in value of the underlying real estate. Thus, debt
investments in real estate are similar to other fixed-income
investments, such as bonds.
• Regardless of the form of real estate investment, the value of the
underlying real estate property can affect the performance of the
investment with location being a critical factor in determining
the value of a real estate property.
• Real estate property has some unique characteristics compared
with other investment asset classes. These characteristics include
heterogeneity and fixed location, high unit value, management
intensiveness, high transaction costs, depreciation, sensitivity
to the credit market, illiquidity, and difficulty of value and price
determination.
• There are many different types of real estate properties in which
to invest. The main commercial (income-producing) real estate
property types are office, industrial and warehouse, retail, and
multifamily. Other types of commercial properties typically are
classified by their specific use.
• Certain risk factors are common to commercial property, but
each property type is likely to have a different susceptibility to

Overview of Types of Real Estate Investment
these factors. The key risk factors that can affect commercial real
estate include business condition, lead time for new development,
excess supply, cost and availability of capital, unexpected infla-
tion, demographics, lack of liquidity, environmental issues, avail-
ability of information, management expertise, and leverage.
• Location, lease structures, and economic factors—such as eco-
nomic growth, population growth, employment growth, and
consumer spending—affect the value of each property type.

Investments in Real Estate
through Private Vehicles
• Level II
• 0.75 PL Credits
• Access the full reading: cfainst.is/reprivatevehicles
Learning Outcomes
• discuss the income, cost, and sales comparison approaches to
valuing real estate properties;
• compare the direct capitalization and discounted cash flow valu-
ation methods;
• estimate and interpret the inputs (e.g., net operating income,
capitalization rate, and discount rate) to the direct capitalization
and discounted cash flow valuation methods;
• calculate the value of a property using the direct capitalization
and discounted cash flow valuation methods; and
• calculate and interpret financial ratios used to analyze and eval-
uate private real estate investments.

Investments in Real Estate through Private Vehicles
INTRODUCTION
Direct property ownership and investment through private vehicles
has long been the preferred choice of institutional investors, includ-
ing insurance companies, pension funds, sovereign wealth funds,
foundations, endowments, and high-net-worth families and indi-
viduals. Investors consider private real estate for capital gain, income,
tax benefits, and low correlation with other asset classes. Long-term
investors expect to earn an illiquidity premium, as same-property
transactions are relatively rare. Direct property ownership allows
owners to decide where and when to invest and when to sell.
Summary
• Generally, three different valuation approaches are used by
appraisers: income, cost, and sales comparison.
• The income approach includes direct capitalization and dis-
counted cash flow methods. Both methods focus on net operat-
ing income as an input to the value of a property and indirectly
or directly factor in expected growth.
• The cost approach estimates the value of a property based on adjusted
replacement cost. This approach typically is used for unusual proper-
ties for which market comparables are difficult to obtain.
• The sales comparison approach estimates the value of a property
based on what price comparable properties are selling for in the
current market.
• When debt financing is used to purchase a property, additional
ratios and returns calculated and interpreted by debt and equity
investors include the loan-to-value ratio, the debt service coverage
ratio, and leveraged and unleveraged internal rates of return.

Investments in Real Estate
through Publicly Traded
Securities
• Level II
• 1.25 PL Credits
• Access the full reading: cfainst.is/resecurities
Learning Outcomes
• discuss types of publicly traded real estate securities;
• justify the use of net asset value per share (NAVPS) in valuation
of publicly traded real estate securities and estimate NAVPS
based on forecasted cash net operating income;
• describe the use of funds from operations (FFO) and adjusted
funds from operations (AFFO) in real estate investment trust
(REIT) valuation;
• calculate and interpret the value of a REIT share using the net
asset value, relative value (price-to-FFO and price-to-AFFO), and
discounted cash flow approaches; and
• explain advantages and disadvantages of investing in real estate
through publicly traded securities compared to private vehicles.

Investments in Real Estate through Publicly Traded Securities
Introduction
Historically, real estate investing was reserved for the wealthy and
for institutions. REITs were initially conceived of as a way for small
investors to gain exposure to a professionally managed, diversified
real estate portfolio. REITs were viewed as a type of (closed-end)
mutual fund and income passthrough vehicle through which the
portfolio manager would acquire attractively valued properties, occa-
sionally sell fully valued properties, and distribute property earnings
to the trust’s investors. Legislation was passed in the United States in
1960 to authorize REITs, and the Netherlands followed suit in 1969.
The US model and other types of tax-advantaged real estate invest-
ment vehicles have been adopted worldwide. The S&P 500 Index
added REITs as a separate Global Industry Classification Standard
sector in 2016.
REITs are held by individuals and institutions alike. As of
October 2020, more than 35 countries have REITs or REIT-like
structures and more are considering adopting similar vehicles.
Summary
• The principal types of publicly traded real estate securities
include REITs, real estate operating companies (REOCs), and
residential and commercial mortgage-backed securities (RMBS
and CMBS).
• Compared with other publicly traded shares, REITs typically
offer higher-than-average yields and greater stability of income
and returns. They are amenable to a net asset value approach to

valuation because of the existence of active private markets for

their real estate assets.
• Compared with REOCs, REITs offer higher yields and income
tax exemptions but have less operating flexibility to invest in a
broad range of real estate activities and less potential for growth
from reinvesting their operating cash flows because of their high
income-to-payout ratios.
• In assessing the investment merits of REITs, investors analyze
the effects of trends in general economic activity, retail sales, job
creation, population growth, and new supply and demand for
specific types of space. Investors also pay particular attention to
occupancies, leasing activity, rental rates, remaining lease terms,
in-place rents compared with market rents, costs to maintain
space and re-lease space, tenants’ financial health and tenant
concentration in the portfolio, financial leverage, debt maturities
and costs, and the quality of management and governance.
• Analysts make adjustments to the historical cost-based financial
statements of REITs and REOCs to obtain better measures of
current income and net worth. The three principal figures they
calculate and use are (1) funds from operations or accounting net
earnings, excluding depreciation, deferred tax charges, and gains
or losses on sales of property and debt restructuring; (2) adjusted
funds from operations, or funds from operations adjusted to
remove straight-line rent and to provide for maintenance-type
capital expenditures and leasing costs, including leasing agents’
commissions and tenants’ improvement allowances; and (3) net
asset value or the difference between a real estate company’s
asset and liability ranking before shareholders’ equity, all valued
at market values instead of accounting book values.

Investments in Real Estate through Publicly Traded Securities
• REITs and some REOCs generally return a significant portion

of their income to their investors as required by law and, as a
result, tend to pay high dividends. Thus, dividend discount or
discounted cash flow models for valuation also are applicable.
These valuation approaches are applied in the same manner as
they are for shares in other industries. Usually, investors use two-
or three-step dividend discount models with near-term, inter-
mediate-term, or long-term growth assumptions. In discounted
cash flow models, investors often use intermediate-term cash
flow projections and a terminal value based on historical cash
flow multiples.

Portfolio
Management
Reading
Fintech in Investment I 1 cfainst.is/fintech
Management

Does It Matter?
The revised “Fintech in Investment Management” reading includes
a new analysis of how blockchain is affecting the investment indus-
try. This reading describes financial applications of distributed ledger
technology (DLT), including how DLT is creating new ways to record,
track, and store transactions for financial assets.
DLT could provide secure ways of tracking ownership of finan-
cial assets on a peer-to-peer (P2P) basis. By allowing P2P interac-
tions—in which individuals or firms transact directly with each
other without mediation by a third party—DLT reduces the need for
financial intermediaries. DLT could bring efficiencies to post-trade
and compliance processes through automation, smart contracts, and
identity verification. The reading explores how DLT transactions
work and how they can improve efficiency in the investment industry.

Fintech in Investment
Management
• Level I
• 1 PL Credit
• Access the full reading: cfainst.is/fintech
Learning Outcomes
• describe fintech;
• describe Big Data, artificial intelligence (AI), and machine learn-
ing (ML);
• describe fintech applications to investment management; and
• describe financial applications of distributed ledger technology.
Introduction
The meeting of finance and technology, commonly known as fintech,
is changing the landscape of investment management. Advancements
include the use of Big Data, AI, and ML to evaluate investment

Portfolio Management
opportunities, optimize portfolios, and mitigate risks. These devel-

opments are affecting not only quantitative asset managers but also
fundamental asset managers who make use of these tools and tech-
nologies to engage in hybrid forms of investment decision making.
Investment advisory services are undergoing changes with
the growth of automated wealth advisers or “robo-advisers.” Robo-
advisers might assist investors without the intervention of a human
adviser, or they might be used in combination with a human adviser.
The desired outcome is the ability to provide tailored, actionable
advice to investors with greater ease of access and at lower cost.
In the area of financial record keeping, blockchain and distrib-
uted ledger technology (DLT) are creating new ways to record, track,
and store transactions for financial assets. An early example of this
trend is the cryptocurrency bitcoin, but the technology is being con-
sidered in a broader set of applications.
This reading is divided into ten main sections, which together
define fintech and outline some of its key areas of impact in the field
of investment management. Section 1 explains the concept and areas
of fintech. Sections 2 and 3 discuss Big Data, AI, and ML. Section 4
discusses data science, and Sections 5–8 provide applications of fin-
tech to investment management. Sections 9 and 10 examine DLT. A
summary of key points completes the reading.
Summary
• The term “fintech” refers to technological innovation in the
design and delivery of financial services and products.

Fintech in Investment Management
• Areas of fintech development include the analysis of large datas-

ets, analytical techniques, automated trading, automated advice,
and financial record keeping.
• Big Data is characterized by the three Vs—volume, velocity, and
variety—and includes both traditional and nontraditional (or
alternative) datasets.
• Among the main sources of alternative data are data generated
by individuals, business processes, and sensors.
• AI computer systems are capable of performing tasks that tra-
ditionally required human intelligence at levels comparable (or
superior) to those of human beings.
• ML seeks to extract knowledge from large amounts of data by
“learning” from known examples and then generating structure
or predictions. Simply put, ML algorithms aim to “find the pat-
tern, apply the pattern.” The main types of ML include super-
vised learning, unsupervised learning, and deep learning.
• Natural language processing (NLP) is an application of text ana-
lytics that uses insight into the structure of human language to
analyze and interpret text- and voice-based data.
• Robo-advisory services are providing automated advisory ser-
vices to increasing numbers of retail investors. Services include
asset allocation, portfolio optimization, trade execution, rebal-
ancing, and tax strategies.
• Big Data and ML techniques could provide insights into real-
time and changing market circumstances to identify weakening
or adverse trends in advance, allowing for improved risk man-
agement and investment decision making.

Portfolio Management
• Algorithmic traders use automated trading programs to deter-

mine when, where, and how to trade an order on the basis of
specified rules and market conditions. Benefits include speed of
executions, lower trading costs, and anonymity.
• Blockchain and DLT might offer a new way to store, record, and
track financial assets on a secure, distributed basis. Applications
include cryptocurrencies and tokenization. Additionally, DLT
could bring efficiencies to post-trade and compliance processes
through automation, smart contracts, and identity verification.

Quantitative
Methods
Readings
Basics of Multiple Regression II 0.75 cfainst.is/
and Underlying Assumptions multipleregression
Evaluating Regression Model II 0.75 cfainst.is/
Fit and Interpreting Model regressionmodel
Results
Model Misspecification II 0.75 cfainst.is/

modelmisspec
Extensions of Multiple II 1 cfainst.is/
Regression extensionsmr

Does It Matter?
Multiple regression content has been divided into four learning mod-
ules and updated with investment-focused datasets.
The “Basics of Multiple Regression and Underlying
Assumptions” module examines the role that multiple regression
estimation can play in investment management. This module sets out
the basic assumptions of multiple regression and provides an overall
estimation process to arrive at a regression model that best charac-
terizes the data. New content involves the role that scatterplots and
residual plots play in validating a potential regression model as well
as presenting code snippets in Python and R software used to esti-
mate a regression model on a specific investment-related dataset.
The second module in the series, “Evaluating Regression Model
Fit and Interpreting Model Results” augments standard goodness-
of-fit measures with new coverage of their relation to analysis of
variance (ANOVA) tables and a discussion of information criterion
metrics that can be used to determine the most parsimonious models.
Coverage on joint hypothesis tests of multiple regression coefficients
is expanded using the concept of “restricted” versus “unrestricted”
regression models and the use of F-tests to determine when joint
restrictions are supported by the data.
The third multiple regression module, “Model Misspecification,”
provides an enhanced and updated evaluation of the types of model
misspecification an analyst might encounter. The focus is on the
estimated regression residuals and their use in identifying omitted

variables, nonlinearities in functional form, and problems in scal-

ing or pooling data inappropriately. Tests are provided for omitted
variables, serial correlation, and heteroskedasticity along with guid-
ance on how these tests can be interpreted. Multicollinearity—where
explanatory variables are highly related to one another—is explained
and the use of the variance inflation factor (VIF) in identifying these
situations is provided.
“Extensions of Multiple Regression,” the final module, exam-
ines three important extensions of the multiple regression model:
(1) outliers and influential observations, (2) qualitative variables as
explanatory variables, and (3) logit regression for qualitative depen-
dent variables. Outliers and influential observations can have out-size
impacts on regression estimates. New content on measures for iden-
tifying influential observations are provided along with a discussion
of how an analyst can evaluate their impacts. Qualitative or dummy
explanatory variables are used to capture categorical or qualitative
data in a regression model. A visual discussion of their impacts on a
regression model, testing of their significance and their use in char-
acterizing mutual fund returns is provided. The final section looks at
logistic regression, a fundamental tool in machine learning, which is
useful when an analyst needs to explain a binary dependent variable,
such as bankruptcy or an action taken or not. The within-module
example looks at estimating the probability of whether or not a com-
pany undertakes a share repurchase based on certain characteristics.
Each module contains code snippets in Python and R to support
the results presented. In addition, each module contains examples
and end-of-reading practice problems that highlight the use of mod-
ule content in an investment setting. Taken together, the readings
show how an analyst specifies a model by answering key questions,
such as the following: What is the dependent variable of interest?
What independent variables are important? What form should the

Quantitative Methods
model take? What is the goal of the model: prediction or an under-

standing of the relationship?
Multiple linear regression allows analysts to estimate using more
complex models with multiple explanatory variables that, if used cor-
rectly, may lead to better predictions, better portfolio construction,
and better understanding of the drivers of security returns. If used
incorrectly, however, multiple linear regression may yield spurious
relationships, lead to poor predictions, and offer a poor understand-
ing of relationships. These modules explore the pitfalls and measures
to mitigate these potential problems.

Basics of Multiple
Regressionand Underlying
Assumptions
• Level II
• 0.75 PL Credits
• Access the full reading: cfainst.is/multipleregression
Learning Outcomes
• describe the types of investment problems addressed by multiple
linear regression and the regression process;
• formulate a multiple linear regression model, describe the rela-
tion between the dependent variable and several independent
variables, and interpret estimated regression coefficients; and
• explain the assumptions underlying a multiple linear regression
model and interpret residual plots indicating potential violations
of these assumptions.

Introduction
Multiple linear regression uses two or more independent variables
to describe the variation of the dependent variable rather than just
one independent variable, as in simple linear regression. It allows
the analyst to estimate using more complex models with multiple
explanatory variables and, if used correctly, may lead to better pre-
dictions, better portfolio construction, or better understanding of
the drivers of security returns. If used incorrectly, however, multiple
linear regression may yield spurious relationships, lead to poor pre-
dictions, and offer a poor understanding of relationships.
The analyst must first specify the model and make several
decisions in this process. The analyst must answer the following
questions: What is the dependent variable of interest? What inde-
pendent variables are important? What form should the model take?
What is the goal of the model—prediction or understanding of the
relationship?
The analyst specifies the dependent and independent variables
and then employs software to estimate the model and produce
related statistics. The good news is that the software does the esti-
mation (see Exhibit 1). The analyst’s primary tasks are to specify the
model and interpret the output from this software, which are the
main subjects of this content.
Exhibit 1. Examples of Regression Software
Software Programs/Functions
Excel Data Analysis > Regression
Python scipy.stats.linregress
statsmodels.lm
sklearn.linear_model.LinearRegression

Basics of Multiple Regression and Underlying Assumptions
Software Programs/Functions
R lm
SAS PROC REG
PROC GLM
STATA regress
Summary
• Multiple linear regression is used to model the linear relation-
ship between one dependent variable and two or more indepen-
dent variables.
• In practice, multiple regressions are used to explain relationships
between financial variables, to test existing theories, or to make
forecasts.
• The regression process covers several decisions the analyst must
make, such as identifying the dependent and independent vari-
ables, selecting the appropriate regression model, testing if the
assumptions behind linear regression are satisfied, examining
goodness of fit, and making needed adjustments.
• A multiple regression model is represented by the following
equation:
Yi = b0 + b1 X1i + b2 X2i + b3 X3i + … + bk Xki + εi, i = 1, 2, 3, …, n,
where Y is the dependent variable, Xs are the independent
variables from 1 to k, and the model is estimated using n
observations.

• Coefficient b 0 is the model’s “intercept,” representing the

expected value of Y if all independent variables are zero.
• Parameters b1 to bk are the slope coefficients (or partial regres-
sion coefficients) for independent variables X1 to Xk. Slope coef-
ficient bj describes the impact of independent variable Xj on Y,
holding all the other independent variables constant.
• Five main assumptions underlying multiple regression models
must be satisfied: (1) linearity, (2) homoskedasticity, (3) indepen-
dence of errors, (4) normality, and (5) independence of indepen-
dent variables.
• Diagnostic plots can help detect whether these assumptions
are satisfied. Scatterplots of dependent versus and independent
variables are useful for detecting nonlinear relationships, while
residual plots are useful for detecting violations of homoskedas-
ticity and independence of errors.

Evaluating Regression
Model Fit and Interpreting
Model Results
• Level II
• 0.75 PL Credits
• Access the full reading; cfainst.is/regressionmodel
Learning Outcomes
• evaluate how well a multiple regression model explains the
dependent variable by analyzing analysis of variance (ANOVA)
table results and measures of goodness of fit;
• formulate hypotheses on the significance of two or more coef-
ficients in a multiple regression model and interpret the results
of the joint hypothesis tests; and
• calculate and interpret a predicted value for the dependent vari-
able, given the estimated regression model and assumed values
for the independent variable.

Summary
• In multiple regression, adjusted R2 is used as a measure of model
goodness of fit because it does not automatically increase as
independent variables are added to the model. Rather, it adjusts
for the degrees of freedom by incorporating the number of inde-
pendent variables.
• Adjusted R2 will increase (decrease) if a variable is added to the
model that has a coefficient with an absolute value of its t-statis-
tic greater (less) than 1.0.
• Akaike’s information criterion (AIC) and Schwarz’s Bayesian
information criteria (BIC) also are used to evaluate model fit and
select the “best” model among a group with the same dependent
variable. AIC is preferred if the purpose is prediction, whereas
BIC is preferred if goodness of fit is the goal; lower values of both
measures are better.
• Hypothesis tests of a single coefficient in a multiple regression,
using t-tests, are identical to those in simple regression.
• The joint F-test is used to jointly test a subset of variables in a
multiple regression, where the “restricted” model is based on
a narrower set of independent variables nested in the broader
“unrestricted” model. The null hypothesis is that the slope coef-
ficients of all independent variables outside the restricted model
are zero.
• The general linear F-test is an extension of the joint F-test, where
the null hypothesis is that the slope coefficients on all indepen-
dent variables in the unrestricted model are equal to zero.

Evaluating Regression Model Fit and Interpreting Model Results
• Predicting the value of the dependent variable using an esti-

mated multiple regression model is similar to that in simple
regression. First, sum, for each independent variable, the esti-
mated slope coefficient multiplied by the assumed value of that
variable, and then add the estimated intercept coefficient.
• In multiple regression, the confidence interval around the fore-
casted value of the dependent variable reflects both model error
and sampling error (from forecasting the independent variables);
the larger the sampling error, the larger is the standard error of
the forecast of Y and the wider is the confidence interval.

Model Misspecification
• Level II
• 0.75 PL Credits
• Access the full reading: cfainst.is/modelmisspec
Learning Outcomes
• describe how model misspecification affects the results of
a regression analysis and how to avoid common forms of
misspecification;
• explain the types of heteroskedasticity and how it affects statisti-
cal inference;
• explain serial correlation and how it affects statistical inference;
and
• explain multicollinearity and how it affects regression analysis.
Summary
• Principles for proper regression model specification include
economic reasoning behind variable choices, parsimony, good

Model Misspecification
out-of-sample performance, appropriate model functional form,

and no violations of regression assumptions.
• Failures in regression functional form typically are due to omit-
ted variables, inappropriate form of variables, inappropriate vari-
able scaling, and inappropriate data pooling; these may lead to
the violations of regression assumptions.
• Heteroskedasticity occurs when the variance of regression errors
differs across observations. Unconditional heteroskedasticity
exists when the error variance is not correlated with the inde-
pendent variables, whereas conditional heteroskedasticity exists
when the error variance is correlated with the values of the
independent variables.
• Unconditional heteroskedasticity creates no major problems for
statistical inference, but conditional heteroskedasticity is prob-
lematic because it results in underestimation of the regression
coefficients’ standard errors, so t-statistics are inflated and Type
I errors are more likely.
• Conditional heteroskedasticity can be detected using the
Breusch–Pagan (BP) test, and the bias it creates in the regression
model can be corrected by computing robust standard errors.
• Serial correlation (or autocorrelation) occurs when regression
errors are correlated across observations and may be a serious
problem in time-series regressions. Serial correlation can lead
to inconsistent coefficient estimates, and it underestimates
standard errors, so t-statistics are inflated (as with conditional
heteroskedasticity).
• The Breusch–Godfrey (BG) test is a robust method for detect-
ing serial correlation. The BG test uses residuals from the origi-
nal regression as the dependent variables run against the initial

regressors plus the lagged residuals, and H0 is the coefficient of

the lagged residuals are zero.
• The biased estimates of standard errors caused by serial correla-
tion can be corrected using robust standard errors, which also
correct for conditional heteroskedasticity.
• Multicollinearity occurs with high pairwise correlations between
independent variables or if three or more independent variables
form approximate linear combinations that are highly correlated.
Multicollinearity results in inflated standard errors and reduced
t-statistics.
• The variance inflation factor (VIF) is a measure used to quantify
multicollinearity. If VIFj = 1 for X j, then there is no correlation
between X j and the other regressors. VIFj > 5 warrants further
investigation, and VIFj > 10 indicates serious multicollinearity
requiring correction.
• Solutions to multicollinearity include dropping one or more of
the regression variables, using a different proxy for one of the
variables, or increasing the sample size.

Extensions of Multiple
Regression
• Level II
• 1 PL Credit
• Access the full reading: cfainst.is/extensionsmr
Learning Outcomes
• describe influence analysis and methods of detecting influential
data points;
• formulate and interpret a multiple regression model that includes
qualitative independent variables; and
• formulate and interpret a logistic regression model.
Summary
• Two kinds of observations may potentially influence regression
results: (1) a high leverage point, an observation with an extreme
value of an independent variable; and (2) an outlier, an observa-
tion with an extreme value of the dependent variable.

• A measure for identifying a high-leverage point is leverage. If

 k + 1
leverage is greater than 3   where k is the number of inde-
 n 
pendent variables, then the observation is potentially influential.
A measure for identifying an outlier is studentized residuals. If
the studentized residual is greater than the critical value of the
t-statistic with n – k – 2 degrees of freedom, then the observa-
tion is potentially influential.
• Cook’s distance, or Cook’s D (Di), is a metric used to identify
influential data points. It measures how much the estimated
values of the regression change if observation i is deleted. If
Di > 2 2 k / n then it is highly likely to be influential. An influence
plot visually presents leverage, studentized residuals, and Cook’s
D for each observation.
• Dummy, or indicator, variables represent qualitative independent
variables and take a value of 1 (for true) or 0 (for false) to indicate
whether a specific condition applies, such as whether a company
belongs to a certain industry sector. To capture n possible cat-
egories, the model must include n – 1 dummy variables.
• An intercept dummy adds to or reduces the original intercept if
a specific condition is met. When the intercept dummy is 1, the
regression line shifts up or down parallel to the base regression
line.
• A slope dummy allows for a changing slope if a specific condi-
tion is met. When the slope dummy is 1, the slope changes to
(dj + bj) × Xj, where dj is the coefficient on the dummy variable
and bj is the slope of Xj in the original regression line.
• A logistic regression model is one with a qualitative (i.e., categor-
ical) dependent variable, so logistic regression is often used in

Extensions of Multiple Regression
binary classification problems, which are common in machine

learning and neural networks.
• To estimate a logistic regression, the logistic transformation
of the event probability (P) into the log odds, ln[P/(1 − P)], is
applied, which linearizes the relationship between the trans-
formed dependent variable and the independent variables.
• Logistic regression coefficients typically are estimated using the
maximum likelihood estimation (MLE) method, and slope coef-
ficients are interpreted as the change in the log odds that the
event happens per unit change in the independent variable, hold-
ing all other independent variables constant.

Ethics
Reading
Application of the Code and II 1.5 PL/1.5 cfainst.is/code-
Standards: Level II SER andstandardsl2

Does It Matter?
The “Application of the Code and Standards: Level II” reading
includes a new vignette illustrating how the CFA Institute Code
of Ethics and Standards of Professional Conduct (the Code and
Standards) can be applied to ensure professional and ethical judg-
ment. The vignette centers on Serengeti Advisory Services (Serengeti),
a hypothetical equity research firm based in Tanzania. The firm
faces a variety of potential conflicts of interest with clients and must
decide how to act.
The vignette, like others in the reading, helps investment indus-
try professionals to focus on identifying when and how violations of
the Code and Standards may have occurred. This reading includes
considerable discussion and a rationale as to why or why not a vio-
lation might have taken place to guide professionals. The vignette
illustrates how applying the framework might have helped each indi-
vidual make decisions. By identifying where the Code and Standards
might be relevant and considering actions and consequences within
this framework, investment professionals can make ethically sound
decisions.

Application of the Code and
Standards: Level II
• Level II
• 1.5 PL/1.5 SER Credits
• Access the full reading: cfainst.is/codeandstandardsl2
Learning Outcomes
• evaluate practices, policies, and conduct relative to the CFA
Institute Code of Ethics and Standards of Professional Conduct;
and
• explain how the practices, policies, and conduct do or do
not violate the CFA Institute Code of Ethics and Standards of
Professional Conduct.
Introduction
This reading presents vignettes to illustrate how the CFA Institute
Code of Ethics and Standards of Professional Conduct (the Code and
Standards) can be applied in situations requiring professional and

Ethics
ethical judgment. Exhibit 1 presents a useful framework to guide

individuals in their ethical decision-making process and applica-
tion of the Code and Standards. By identifying where the Code and
Standards might be relevant and considering actions and conse-
quences within this framework, individuals can make more ethically
sound decisions.
Although the framework’s components do not need to be
addressed in the sequence shown, a review of the outcome should
conclude the process. This review provides insights for improved
decision making in the future.
Exhibit 1. A Framework for Ethical Decision Making
• Identify: Relevant facts, stakeholders and duties owed, ethical

principles, conflicts of interest
• Consider: Situational influences, additional guidance, alternative
actions
• Decide and act
• Reflect: Was the outcome as anticipated? Why or why not?
Summary
This reading presents a number of scenarios involving individuals
in private and institutional asset management. The first five cases
focus on identifying whether violations of the Code and Standards
occurred, with discussion and rationale as to why or why not a

Application of the Code and Standards
violation might have taken place. The last two cases focus on iden-
tifying violations of the Code and Standards, taking necessary cor-
rective actions, and developing a policy statement to prevent future
violations by a firm’s employees. These cases illustrate how applying
the framework might have helped each individual make decisions.

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MEMBERS’ GUIDE TO

In the mainland of China, CFA Institute accepts CFA® charterholders only.

This copyright covers material written expressly for this volume by

CFA®, Chartered Financial Analyst®, AIMR-PPS®, and GIPS® are just a

This publication is designed to provide accurate and authoritative

All trademarks, service marks, registered trademarks, and registered

In the mainland of China, CFA Institute accepts CFA charterholders

What Is Changing in the 2023 Curriculum, and Why Does

Portfolio Management 117

iv Members’ Guide to 2023 Refresher Readings

What Is Changing in the 2023 Curriculum, and

Quantitative Methods 123

© 2022 CFA Institute. All rights reserved. v

© 2022 CFA Institute. All rights reserved. 1

In addition to modernizing the format and presentation, key

2 Members’ Guide to 2023 Refresher Readings

• A new vignette in the “Application of the Code and Standards”

Barbara Petitt, PhD, CFA

© 2022 CFA Institute. All rights reserved. 3

Forward Commitment and I 1 cfainst.is/

© 2022 CFA Institute. All rights reserved. 5

6 Members’ Guide to 2023 Refresher Readings

© 2022 CFA Institute. All rights reserved. 7

asset or liability portfolio that includes these instruments. It also

8 Members’ Guide to 2023 Refresher Readings

their change in value is consistent with existing or desired underly-

© 2022 CFA Institute. All rights reserved. 9

evolution of the underlying asset’s future price. The “Valuing a

10 Members’ Guide to 2023 Refresher Readings

© 2022 CFA Institute. All rights reserved. 11

Derivatives involve the future exchange of cash flows whose value is

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© 2022 CFA Institute. All rights reserved. 13

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• Credit default swap (CDS) contracts allow an investor to manage

© 2022 CFA Institute. All rights reserved. 15

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© 2022 CFA Institute. All rights reserved. 17

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associated with their use. Forward commitments and contingent

© 2022 CFA Institute. All rights reserved. 19

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© 2022 CFA Institute. All rights reserved. 21

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© 2022 CFA Institute. All rights reserved. 23

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or short cash positions and borrowing or lending at the risk-free rate.

© 2022 CFA Institute. All rights reserved. 25

• Daily settlement and margin requirements give rise to different

26 Members’ Guide to 2023 Refresher Readings

© 2022 CFA Institute. All rights reserved. 27

valuation of forward and futures contracts across the term structure,

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• The value of a swap at inception is zero (ignoring transaction and

© 2022 CFA Institute. All rights reserved. 29

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© 2022 CFA Institute. All rights reserved. 31

• Because of their asymmetric payoff profile, options are charac-

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Business Models & Risks I 1.25 cfainst.is/

Capital Investments I 1 cfainst.is/capital-

Working Capital& Liquidity I 1 cfainst.is/

Capital Structure I 1.75 cfainst.is/

Corporate Restructuring II 2.25 cfainst.is/

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