Answers to the Top 10 Mistakes of the CFA® Level 1 Exams




Throughout our experience working with CFA candidates and finance students in general, we have noticed that some mistakes are more recurrent than others. Some of these mistakes are also the same as we have fallen into as candidates in the past. This is why we tried to list out and provide a thorough answer to the most frequent pitfalls in which candidates tend to fall for the CFA level 1.

We have actually compiled the top 100 Pitfalls of the CFA Level 1 Exam and included it in our brand new CFA Level 1 Starter Kit. This starter kit is essential for anyone planning to write the December 2014 CFA level 1 exam since it includes a customizable study schedule, Exam strategies, concentration tips as well as the 100 common pitfalls to avoid (along with their explanation obviously!)

CFA Level 1 - Starter Kit

Without further ado, here are the 10 most common mistakes made by candidates for the CFA level 1 exam. They are not in order of complexity or importance but in order of study session topics.

1)     Going for the apparently “safest” or obviously most ethical answer.

This is the main mistake level 1 candidates make and it is also the reason why the ethics section is probably the most underestimated section of the CFA curriculum. Many candidates just assume that they can use their common sense and get away with the correct answer. This is a vastly incorrect assumption since the question often features grey areas where the candidate must really know the exact application of the code of standard rather than just select the most conservative answer.

 

2)     Not understanding Bayes Law.

This formula is used to update probability given the addition of new information. The result is the updated probability of an event and is expressed as:

top 10 mistakes 1

For example, in an equity investment context, an event could be the imminent takeover of a firm. Say a pharmaceutical firm had a 23% probability of being taken over. However there is a chance that they are secretly developing a new drug that could be very profitable. The chance that the firm will announce the development of the new drug is 30% and if they are taken over, there is an 80% chance that they will announce it. The new probability of a takeover given a drug announcement is therefore:

top 10 mistakes 2

3)     Not knowing how income and substitution effect impacts each type of goods.

The Substitution effect states that as the price of a good falls, consumers will buy more of that good. This is the concept on which discounts are based. The substitution effect is always positive regardless of the type of goods.

The Income effect is more complex since it could push consumers to buy more or less of a good given a price decrease.

For an Inferior good (including Giffen goods): the income effect will decrease the quantity demanded of that good as explained in the previous point. This is known as a negative income effect.

For a Normal good: the income effect will increase the quantity demanded of that good if the price falls. The income effect is therefore positive.

Since substitution effect is always positive and income effect can be positive or negative, candidates need to the three resulting scenarios:

a)      Normal goods: Substitution and Income effects are positive. Therefore, a decrease in price will lead to an increase in consumption.

b)      Giffen goods: Positive substitution effect is smaller than negative income effect. Therefore, a decrease in price will lead to a decrease in consumption.

c)       Inferior goods: Positive substitution effect is larger than negative income effect. Therefore, a decrease in price will lead to an increase in consumption.

 

LIFO inventory accounting is only permitted under U.S. GAAP.

However, firms reporting using LIFO must also report a LIFO reserve which allows for financial statement users to convert to FIFO.

LIFO Reserve =  FIFO Inventory – LIFO Inventory

COGSFIFO =COGSLIFO – (LIFO Reserve YEAR X – LIFO Reserve YEAR X-1)

4) Being unclear about the levered vs. Unlevered beta and when to use them

In the pure play method, the beta used to compute a project’s cost of capital should reflect the risk of the project. The more debt a company has in their capital structure, the higher the risk which will cause beta of equity to increase. This is consistent with the Modigliani and Miller theorem on capital which says that a higher D/E ratio will increase the cost of equity.

The beta used to find the cost of equity should reflect the capital structure of that specific project. Since the capital structure of the project may be different from the company’s it is necessary to adjust beta. The appropriate beta for a project is found in three steps under the pure play approach:

Find the beta for similar project

Since these other projects likely have different capital structures, unlever the beta to find the asset beta for this project:

beta

Use the project’s own D/E ratio to re-lever beta. The result will be the equity beta for that project which can be used in CAPM to find the cost of equity:

beta 2

5) Not fully grasping how ETF are different than closed end funds.

The key differences between ETFs and closed end funds is that while ETF are passive investment tools that replicates an index, closed end funds are actively managed.

In addition, closed end funds usually trade at a different price than their NAV while ETF do not significantly deviate from their NAV since it would create an arbitrage opportunity.

6) When performing Porter competitive analysis, failing to properly identify the supplier.

One of Porter’s five forces to determine industry’s competitiveness is the bargaining power of suppliers. In an industry that sells a product, the supplier is often easy to identify. However, for service industries, candidates often have a hard time to identify the supplier.

For example, banking is a service industry where the supplier is not necessarily obvious. The easiest way to identify the supplier is to look at the main costs firms in the industry must incur. For a bank, one of their main costs is the interest that is paid on clients’ deposits. Therefore, the depositors would be one of the suppliers to the banking industry. Their bargaining power would be determine to their ability to exert pressure on the financial institution, maybe by switching to a different bank. For other services, the supplier could be the human capital or knowledge. This would be the case for accounting firms, lawyers or other professionals.

7)     Confusing the different types of ADRs

The following table shows the various types of depository receipts, along with an example for each.

Adr

8)     Failure to understand prepayment risk and how it relates to interest rate risk.

Prepayment risk is the risk that the prepayment speed of a mortgage backed security (MBS) will be different than the one originally forecasted. Note that the prepayment could be faster or slower than predicted.

If the interest rate increases, people will be less tempted to prepay their mortgages, therefore, the prepayment rate of the MBS will slow down. Alternatively, when interest rate decreases, individuals pay down their mortgages faster to potentially refinance at a lower rate.

The decrease of the interest rates not only accelerate prepayment, which is captured in the prepayment risk, but also creates interest risk since MBS holders are forced to reinvest their proceeds at a lower interest rate.

9)     Confusing the spreads (Z-spread, OAS and nominal).

Nominal Spread

As outlined earlier, the nominal spread is simply the difference between the YTM of two bonds. It does not take the shape of the yield curve into consideration.

For example, the YTM of our TD Bank bond is 2.306% and the YTM of a Treasury note of the same three years maturity is 0.95%. Therefore the nominal spread is 2.306% – 0.95% = 1.356%

Zero-Volatility Spread (Z-spread)

When we actually computed the price of out TD Bank bond, we added a spread of 0.71% to all treasury spot rates to discount all six cash flows from this bond. This is actually the zero volatility spread which is a spread that is added to all maturities. This spread is superior to the nominal spread since it accounts for the structure of the yield curve.

For the level 1 exam, you are not expected to be able to compute the Z-spread. However, you know how to interpret it and use it to find the price of a bond just like we did in the TD Bank bond example.

Option-Adjusted Spread (OAS)

Since the addition of a call feature is detrimental to the bondholders, a higher yield will be required on a callable bond relative to an option-free bond. This extra yield will be captured in the Z-spread but is not related to the credit risk of the bond. Therefore we cannot compare the Z-spread of a callable bond and regular bond. The OAS takes the option component out of the Z-spread for a callable or putable bond so that it can be compared to the Z-spread of option-free bonds.

For a callable bond:

Z-spread – option cost in % = option adjusted spread
For a putable bond: Z-spread  + option cost in % = option adjusted spread

 

When the bond is putable, the OAS adds the put component to the Z-spread. Remember that the put feature is favorable to bondholders and is therefore decreasing the yield required, thus decreasing the spread. To compare it to a normal bond, the spread must be increased to what it would have been without the embedded put.

10)     Solving future questions for the wrong party (long vs. short).

Candidates should remember that for futures the long is the buyer of the underlying commodity or security and the short is the seller. Therefore, if the price of the future increases the long gains and the short loses. This is straightforward for futures on commodities or indices but gets confused when talking about interest rate futures.

When an investor is long and interest rate future, he is the making money when the interest rate goes down which could be counter-intuitive at first. However, it all makes sense when you realize that the underlying security in an interest rate future is a bond. When interest rate falls, the value of the bond increases, hence the long interest rate future holder makes money.

 


 

To read the rest of the 90 most common mistakes on the CFA ® Level 1 exam, we invite you to purchase our latest CFA® Level 1 Starter Kit.

We created this CFA® Level 1 Starter Kit to help you better prepare for the upcoming CFA® exam.

CFA Level 1 - Starter Kit

We want to help you maximize your study efficiency and avoid the most common mistakes candidates make on the CFA ® Level 1 exam.

CFA ®Level 1 Starter Kit includes:

  • Top 100 Pitfalls (mistakes) to avoid on the CFA ® Level 1 exam (+50 pages PDF eBook)
  • Exam Strategies (9 pages PDF article)
  • Concentration Tips (9 pages PDF article)
  • 3 study schedules : 16 weeks, 14 weeks and 10 weeks study plans (customizable in Excel)

By using the resources found in this Study Kit, you will be able to better focus on your studies knowing that you will have enough time to cover everything before the exam. You will also the learn the most frequent errors CFA® Level 1 Candidates make and how to avoid them on the exam day. Learn more.