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Category: Level II
Leases I: Criteria for Classification
A lease is a contract that lets one party use an asset owned by another party, in exchange for periodic payments. The owner of the asset is the lessor; the user of the asset is the lessee. For the purposes of financial reporting, leases are divided into two categories, based on the economic substance of…
Arbitrage
Arbitrage means the ability to earn a profit without risk. One method by which arbitrage is commonly accomplished by buying an asset in one market, and simultaneously selling an identical asset in another market at a higher price (e.g., T-Notes or T-Bonds). Another is by borrowing an asset (e.g., a currency) and investing it at…
Dummy Variables
The idea of a dummy variable is fairly simple: it’s a variable that can take on a value of 0 or 1; it simply shows the absence (0) or presence (1) of some characteristic. Nevertheless, there are some important rules you need to remember about dummy variables. How Dummy Variables are Used Imagine that you’re…
Nominal vs. Effective Interest Rates
The ideas behind nominal and effective interest rates are fairly simple, but you need to be sure that you understand the differences, and that you know which convention is used for which common rate quotes. At the heart of the difference is the idea of compound interest, so let’s start there. Throughout this article, we’ll…
Pricing Forwards and Futures
Remember that the price of a forward/future contract is the agreed price of the underlying at the expiration of the contract, which has to be: \[F_T\ =\ S_0\left(1\ +\ r_f\right)^T\] where: \(T\): expiration of the forward/futures contract \(F_T\): forward/futures price of the underlying (at time \(T\)) \(S_0\): spot price of the underlying today \(r_f\): effective…
Pricing Plain Vanilla Interest Rate Swaps
Remember that the price of a plain vanilla interest rate swap is the fixed rate on the swap. The key to pricing swaps is the realization that a swap is essentially an exchange of bonds. A plain vanilla (fixed-for-floating) interest rate swap can be replicated by the fixed payer issuing a fixed-rate bond to the…
Valuing a Currency Forward: Whence Came That Formula?
The formulae for valuing all derivatives are essentially the same: \[Value\ =\ PV\left(what\ you\ will\ receive\right)\ –\ PV\left(what\ you\ will\ pay\right)\] The one valuing formula that needs some explanation is the formula for valuing a currency forward; it is slightly different from the other formulae, but the difference is never explained. Here goes: Given: \(V_t\):…
How to Approach the Level II CFA Exam
If you’ve never taken the Level II CFA exam, you’re in for a real treat. (If you’ve taken it before, you already know what I mean.) As with the Level I exam, this exam will be six hours – three in the morning, and three in the afternoon – and it will be exhausting, both…