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04/25/2012

The Formula to Approaching CFA Level II Formulas


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CFA Exam Prep

The Level II curriculum is chock-full of formulas which makes it very easy to jumble it into a massive helping of Greek alphabet soup in your head on exam day. Here are some tips to avoid this exam-day scenario:

DO NOT Memorize

Instead of memorizing, find ways to understand and categorize the cirriculum at a functional level.

Prof. John Veitch, PhD, CFA teaches candidates to eliminate memorizing almost all formulas in the foreign exchange section (Level II SS 4) by conceptualizing cross-currency calculations as triangles and covered interest rate parity as boxes. If you know what the sides of the triangles and boxes mean, all that’s left is to plug in the variables. This technique can be used for calculating rates and arbitrage opportunities. For exchange rate predictions, he "standardizes" the approach as the beginning rate times an adjustment factor that has a common form regardless of whether it's inflation or interest rates doing the adjustment.

RUN THE NUMBERS

Regardless of how you conceptualize the formulas, there is no substitute for actually putting pencil to paper. You must do many calculations with actual numbers to ensure you really know how to use the formulas.

KNOW THYSELF (AND THY MISTAKES)

Level II is not difficult just because of the plethora of formulas. It is also easy to provide incorrect answers that mirror common errors. Many Level II calculation questions contain the right answer, AND the two most common errors. Here are a number of ways “common” errors arise.

  1. Calculations that involve a correct answer of (x-y)/y will give (y-x)/x and (y-x)/y as the two alternative answers. This is often seen in bid-ask calculations, forward premium/discount questions.

  2. Several calculations involve “compound calculations” where the correct answer requires that you solve for Z = X x Y. However, often both X and Y are complex calculations on their own. The correct answer choices will often include Z and the two components, X and Y. Under the time pressure of the exam, it is easy to partially solve the question and think you have the right answer because one of the (wrong) answer choices, Y or X, showed up on your calculator.

  3. When calculations involve bid-ask spreads, candidates will see the correct answer (say Bid/Ask) plus two wrong answers such as (Bid/Bid and Ask/Bid). Rather than memorize the formula, memorize the principle. With Bid-Ask spreads, the customer always gets the rate that gives them the least of what they want, (the “you always get screwed” principle). Now you do not need the formula. If you are a customer, you take the rate you like the least. If you are the bank, you take the rate you like the most. Note the incorrect multiple choice answers will have a mix of the incorrect rates.

  4. Many calculations involving forwards or futures rely on interest rates. The interest rate must match the period of the forward or future. Candidates are given an annual rate, which must be adjusted to the period of the forward or future contract. A 90-day forward must adjust the annual rate down by 90/360 = .25 while a two-year forward must adjust it up by 720/360 = 2. The incorrect answers will use the correct formula but the incorrect interest rate.

Do not be the proverbial ‘candidate caught in the headlights on exam day. Plan your approach to formulas now.

–Linda Lam

Linda Lam has worked with CFA Society of San Francisco’s Candidate Review Program since 2000.

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