The post Index Weighting Methods appeared first on Financial Analyst Warrior.

]]>A security market index aims at providing a reference for the performance of an asset class, a market or a segment of the market. In other words, it gives market participant an idea of how the market is doing so they can compare the performance of their portfolio. An index is a pool of securities called constituents that are amalgamated as a portfolio.

The value of an index is the sum of its constituents. The return of an index is the geometric mean of its periodic returns. Remember that the geometric mean is calculated as:

The value of the index depends on the weight of its constituents which indicates what proportion of each stock should be included in the index portfolio. There are five methods to measure the weights: price weighting, market capitalization weighting (aka value weighting), float-adjusted market capitalization weighting, fundamental weighting and equal weighting. The most popular method is the market capitalization weighting. We explain in details the price, value and equal weighting methods below.

The value of the price weighted index adds the prices of all the constituent stocks and divides by the number of constituents adjusted for stock splits. The most popular price weighted index are the Dow Jones Industrial Average (30 U.S. stocks) and the Nikkei 225 (225 top Japanese stocks).

The main advantage of the price weighting method is that it is easy to calculate. However, the price of a security does not mean anything and under the price weighting method, the highest priced securities will have a larger weight.

Value weighting uses the proportion of the stock’s market capitalization relative to the total market capitalization of all constituents. Alternatively, only the market float (shares available to the investing public) can be used to compute the weights. The S&P 500 is the most common example of a value weighted index.

The value weighted approach reflects better than the price or equal weighted approach the value of each constituent in the market. For instance, in the Nasdaq 100 index, Apple has a significant weight because the company is very large. It makes sense that it has a larger impact on the index since it does have an impact on the general market and many investors’ portfolios.

The base year index period for the S&P 500 for example is the 1941-1943 and the base level value is 10.

Return of a portfolio that would have equal amount invested in each constituent stock. Since different stocks will surely have different performance, the equal weighting does not last for long. The best performing stock increases more than the others ends up having a larger weight. This is why equal weighting indices need to be rebalanced periodically. An example of an equal weighting equity index is the MSCI World Equal Weighted Index.

They are simple to compute and do not discriminate against smaller companies like the value weighting or low-priced stocks like the price weighting. However, given the periodical rebalancing, one that would try to replicate an equal weighted index would incur large transaction costs.

Since all constituents have the same weights, only their performance matters. Thus, the index performance is simply the average performance of its constituents.

Rebalancing is the adjustment of the weights of the constituents of the index. For price and value weighted indices, the rebalancing is done automatically since the price changes are reflected immediately on the index value. Therefore, rebalancing is performed only for equal weighted indices. Rebalancing is usually done on a quarterly basis.

Reconstitution is the process of adding and deleting securities from an index when they no longer meet the criteria of the index. For example, the S&P 500 recently (June 2013) dropped Heinz from its list of constituents and re-added General Motors which was dropped back in 2009.

- Reflects market sentiment. By looking at the performance of a general market index, investors can have an idea of what the market is doing. For instance, if you hear on the news that the Dow Jones dropped by 3%, you immediately understand that the market is rather gloomy on the prospects for the U.S. economy.
- Serve as a benchmark for asset managers. If you manage a French large capitalization portfolio, you would want to “beat” the CAC 40 index of French stocks.
- Measure the risk and return of asset classes. In study session 12, when we performed the mean variance optimization, we used ETFs that tracked various indices to represent asset classes. For example, to represent the performance of small capitalization stocks, we used the Russell 2000 index.
- Measure the market return and risk of individual stocks. In study session 12 when we performed our Beta analysis, we used the S&P 500 index as the independent variable to assess the systematic risk and expected return of Pfizer and Goldman Sachs. Risk and return was measured relative to the index using the CAPM formula.
- Serve as model portfolio for index funds. Passively managed mutual funds and exchange traded funds replicate an index. For example the SPY SPDR is a widely traded ETF that replicates the S&P 500.

Since fixed income securities trade over-the-counter as opposed to equities that trade on an exchange, there is less transparency and liquidity in trading. Also, the bonds eventually mature and disappear. These factors make the construction of a fixed income index more tricky.

There are various fixed income indices. They can be constructed based on these characteristics, among others:

- Maturity
- Sectors,
- Geographies,
- Embedded options (calls, conversion…)
- Type of issuer
- Collateral
- Default risk
- Coupon rate
- Maturity

Examples of fixed income indices include the NYSE 7-10 Year Treasury Bond Index or the BofA Merrill Lynch Diversified Germany Bond Index.

Most well known and followed indices

As always, we hope this provided you with valuable information in order to help you prepare for the latest CFA Level 1 exam. We also welcome your comments and suggestions and we invite you to share your thoughts in the comments sections below.

If you have not done so already, we invite you to check out our latest eBook Study Guide specifically tailored for the December 2013 CFA Level 1 exam. With over 400 pages of fresh content, this Guide is the ideal companion to your CFA Study Toolbox.

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]]>The post Short Selling Demystified – Clarification of Shorting Strategies appeared first on Financial Analyst Warrior.

]]>Keep in mind that the implication of short selling differ depending on the asset. Lets jump right into it and start with the shorting of a stock.

Short selling a stock involves 2 simultaneous steps:

1) Borrow the stock

2) Immediately sell it on the market

Once the stock has been sold, the short-seller now owes that stock to whoever he borrowed it from (usually the broker). He must eventually purchase the shares back from the market and give it back to the lender. Hence the third step in the shorting process:

3) Buy the stock back from the market (hopefully at a lower price) to give it back to the lender

a) Just like I bought a cappuccino in the above shorting dramatization, short-sellers have to pay interest on the proceeds from the sell. The rate charged is called the *short rebate rate*. For instance, in my example, I would be charged the short rebate rate on the $500.

b) Short-sellers cannot go and spend the proceeds of their sale. The $500 I got from the iPad should remain in my account as collateral until I buy another one back so I would not be able to buy a new flat screen TV with the proceeds for example.

c) If the stock shorted pays dividends, the short must pay them to the lender of the securities. The payment is called payment-in-lieu of dividends.

d) In theory, since the price of a security can increase to infinity, the short-seller is exposed to infinite losses. If there was a war and most iPads get destroyed, I may have to spend $100,000 to purchase one and close out my short iPad position.

Please note that all these things (short rebate, proceeds frozen as collateral, dividend payment) occur automatically in the short-seller brokerage account. In real life, you do not have to actually do anything.

Another distinction causing confusion to some students is between selling and short-selling. Selling assumes you bought the asset previously and you therefore own it. A short-seller never actually owned the asset prior to selling; he borrows it from a broker. You sell a security to close a transaction which was opened when you bought the security.

You short-sell a security to open a transaction which will be closed later by buying the security. Basically, the order of the transaction differs: buy then sell vs. short sell then buy.

The mechanics of shorting a bond is the same as shorting a stock. Borrow the bond, sell it and buy it back eventually. However, since most bonds trade over-the-counter and usually requires larger amounts of capital, only institutional investors typically short bonds. Retail investors forecasting an increase in interest rates (and therefore a decrease in bond prices) can either short a bond exchange-traded fund (ETF) or buy an inverse bond ETF.

The short party of the futures contract agrees to sell the underlying asset at the contracted future price.For example, if I were to short a June 2014 gold futures today (Oct. 4 2013) I would agree to sell gold for $1,313/ounce in June 2014. Unlike shorting stocks, the asset does not change hands at initiation of the contract, the only cash flow required is the margin that the investor needs to post in the investment account.

Shorting of options also have different implications than shorting a stock of bond. Shorting an option means the same thing as writing an option and entails an obligation. Shorting a call obliges the person to sell the underlying asset to the long party at a specific price, should the long exercise his right. Shorting a put obliges the investor to buy the underlying asset from the long party should the long exercise. In other words, in an option transaction, the long side calls the shots and the short side has no choice but to act accordingly.

In various countries,there has been regulations aimed at limiting the use of short selling in order to avoid precipitous fall in the market price of securities. In the U.S. the uptick rule, which was abolished in 2007, prevented short-selling on a downtick. In the wake of the 2008 financial crisis, there were proposals to reintroduce the uptick rule in reaction to the large market decline. Short sellers have often been blamed, especially in European countries, for precipitous fall in stock market. According the the Economist, short-sellers are not to blame for falling markets and should not be hampered by cumbersome regulations.

On the other hand, naked short selling refers to the selling of a security without first borrowing it. This practice is not available to retail investors and is usually not allowed by regulators (SEC banned it in 2008).

We hope this clarified the mystical concept of short-selling which is one of the basic notion CFA candidates should fully grasp. If you have any comments or suggestions of topics for which you need clarification, we encourage you to contact us or leave a comment.

If you have not done so already, we invite you to check out our latest eBook Study Guide specifically tailored for the December 2013 CFA Level 1 exam. With over 400 pages of fresh content, this Guide is the ideal companion to your CFA Study Toolbox.

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]]>The post Financial Returns Demystified: Holding Period Return vs. Arithmetic Return vs. Geometric Return appeared first on Financial Analyst Warrior.

]]>We want to take this opportunity to discuss the main differences between these various return calculations and the main reasons why and when you should use one formula instead of another while analyzing financial data. Although this might sound intuitive for some candidates preparing for the upcoming December 7th, 2013 CFA Level 1 exam, we find that this will be a great refresher for many.

To make all the required calculations, we will use the following table with monthly returns for Pfizer (PFE).

Source: Yahoo.com

HPR is probably the most intuitive and widely used financial return calculation. It is very straightforward, simple and does not leave much room for calculation errors. All you need are three variables: the beginning and end market values of a portfolio (or a share) and the total cash flow received from the portfolio (if any) during the time period analyzed. If we analyze the annual HPR for PFE using the twelve monthly returns and dividends received in the table above, we would use three values: $24.85 (beginning) $28.73 (end) and $0.94 (total cash-flow). Specifically, we write the HPR formula in this way:

The most straight forward way to interpret the formula and the result is to say that an investor made **19.4%** HPR on his investment in PFE held for one year.

HPR is widely used when you want to have a quick and simple overview of your investment in a particular product (stock, portfolio, etc). HPR is simple and quick to calculate so its definitely a great tool to use when you are simply interested in a quick and general return number.

If the stock did not pay any dividends during the period in question, then the Po in the formula would simply result in a $0. One of the main disadvantages of HPR is the fact the the formula ignores any movement in the share price between the beginning and end value of the investment. Sometimes, the investment might have performed very well during a given period, but on the date when the HPR was calculated the ending value was negatively affected by the market forces and the overall return appeared weaker.

Arithmetic return is simply the average of shorter returns. In our example, since we want to calculate the Arithmetic Return for PFE over the 12 months we first need to calculate 12 monthly returns and then calculate the overall average of these monthly returns to arrive at annual return. In a way, we calculate a series of shorter HPR and then calculate the mean of these returns. For example, we would first calculate the HPR for September 2012 as ($24.87 – $24.85 + $0)/$24.85 = 0.001 or 0.1%. Then we would calculate the HPR for October 2012 ($25.02 – $24.87 + $0.22)/$24.87 = 0.0149 or 1.49%. We would proceed calculating monthly HPR until the twelfth month’s return: ($28.73 – $28.21 + $0)/ $28.21 = 0.0184 or 1.84%. Then once we have all the monthly returns, we would proceed to calculate the Arithmetic Return using the following formula:

The results tells us that the investor made an average monthly return of **18.9%** over the previous 12 months investing in PFE.

You can use the Arithmetic Return in you would like to know an average return you made by investing in a particular product. Its interesting to note how Arithmetic Return solves one of the main shortcomings of Holding Period Return. Since the Arithmetic Return uses more data (twelve monthly returns) instead of only one as in the case with HPR, you have a better understanding of the investment’s performance throughout the year.

The primary disadvantage of the Arithmetic Return is the fact that it ignores the effect of compounding returns. Similar to the notion of compounded interest, compounded return results when the return in one month is influenced by the return obtained in the previous month. If you would look at your investment as a series of independent monthly returns, then the effect of compounded returns would not be a concern. However, since your financial returns are all linked together and since your current return depends on your past return, the effect of compounding interest should not be ignored. Thankfully, the Geometric Return (discussed next) solves the main issue faced with Arithmetic Return.

Our final return analysis deals with the concept of Geometric Return. This return concept uses the monthly returns calculated in the previously discussed Arithmetic Return, but then added the effect of compounding between each period (in our case, it’s monthly returns). Instead of adding monthly returns and dividing them by the number of months as we did with Arithmetic Return, we multiply the monthly returns and then we take the twelfths root of the answer to arrive at a monthly return. See the following formula on Geometric Return:

The result indicate that the investor made a compounded monthly return of **19.7%** on his investment in the previous 12 months.

Geometric Return provides the most accurate return result among the three returns covered in this article. In a way, Geometric Return solves the issue found with the Holding Period Return since the Geometric Return analyzes returns throughout the year instead of simply the beginning and the end values like with HPR. In addition, Geometric Return also solves the issue found with Arithmetic Return since it considers the very important power of compounding from one period over to the next period. The result obtained with the Geometric Return is more representative of the return the investor actually received from his investment.

One of the main drawbacks of the Geometric Return is the fact that it required quite a bit of calculations and this increases the possibility of calculation errors on the exam day.

We know that these concepts might appear a bit complex and abstract for some of you, but these different formulas come back on all three levels of the CFA exam. Holding Period Return, Arithmetic Return and Geometric Return are widely used in the financial community and we highly recommend that you take the time to understand them now while preparing for the level 1 exam. Understanding the basics now, will definitely make your overall CFA journey much more pleasant and hopefully more successful as well.

Our goal here at the Financial Analyst Warrior is to help you master the study materials and pass your CFA exams. Use the comments sections below or send us an email and let us know what areas of the required studies you have the most difficulty with and we will gladly help you out.

We also invite you to check out 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.

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

- 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 page 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.

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]]>The post Major differences between Capital Leases and Operating Leases in CFA Level 1 appeared first on Financial Analyst Warrior.

]]>In its simplest form, a lease is a contractual agreement between a lessor and a lessee that gives the lessee the right to use a specific property, owned by the lessor, for a specified period of time in return for a stipulated, and generally periodic, cash payments.

A simple example is You (the lessee) decide to lease a car from the Dealership (the lessor) for 3 years.

- Provides 100% financing at a fixed rate
- Protects against obsolescence
- More flexible than other debt agreements
- Less costly financing for lessee and provides tax incentives for the lessor
- Off-balance-sheet financing

All leases from the lessee’s standpoint are classified as either an operating or a capital lease. Since an operating is not included in assets and liabilities on the balance sheet, it is a form of off-balance-sheet financing. The following diagram shows the three conditions that must be satisfied for the lessee to classify the lease as an operating lease:

Although these criteria pertain to U.S. GAAP, IFRS have similar criteria but less specific.

Reporting of:

**Operating lease: **

- Balance sheet is not affected.
- Rent expense equal to lease payment is recognized on the income statement.
- The lease payment is reported on the cash flow statement in cash flow from operating activities.

Capital (finance) lease:

- The lower of present value of lease payment or fair value of leased asset is recognized as both an asset and liability on the balance sheet.
- Asset is depreciated and both depreciation expense and interest expense is recognized on the income statement. Interest expense = lease liability X lease interest rate
- On the cash flow statement, the lease payment is separated into interest and principal components. The interest goes in the cash flow from operating activities and the principal in financing activities.

The following tables summarizes the impact of the two types of leases on financial statements and key ratios

As a suggestion to help you better remember these different impacts, try to remember the impact for only one of the leases (either the Capital or the Operating), then you’ll know that the other type of lease has the opposite effect on these ratios.

Under IFRS, the accounting by the lessor is the same as the lessee. Under U.S. GAAP the lease can be classified as a operating lease, sales-type lease or direct financing lease:

Reporting of:

Operating lease:

- Asset is kept on the balance sheet and depreciated.
- Lease payments are recognized as rental income.
- Full lease payments is classified as cash flow from operating activities

Sales-type lease:

- Asset is removed from the balance sheet and a lease receivable is created (present value of payments)
- Sale equal to the present value of the asset is recognized on the income statement and cost of goods sold equal to the carrying value. Therefore a gross profit is recognized (sales – COGS)
- Interest portion of lease payments is recognized as income and the principal portion reduces the lease receivable.
- Interest portion is cash inflow from operating activities while the principal is inflow from investing.

Direct financing lease:

- Asset is removed from the balance sheet and a lease receivable is created
- Interest portion of lease payments is recognized as income and the principal portion reduces the lease receivable.
- Interest portion is cash inflow from operating activities while the principal is inflow from investing.

Capital Leases and Operating Leases do not carry a significant weight in the CFA Level 1 exam. They are more likely to show up in order to test your ability to understand when to use which classification and what effect they have on the financial ratios of a given firm. Its always better to understand these concepts while you’re studying for the Level 1 exam, because Capital and Operating Leases also show up on the Level 2 curriculum, but on a much smaller scale.

We also invite you to check out 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.

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

- 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 page 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.

The post Major differences between Capital Leases and Operating Leases in CFA Level 1 appeared first on Financial Analyst Warrior.

]]>The post Probability Concepts On CFA Level 1 appeared first on Financial Analyst Warrior.

]]>- Random variable: uncertain quantity/number
- Outcome: observed value of a random variable
- Event: single outcome or set of outcomes
- Mutually exclusive events: events that cannot occur at the same time
- Exhaustive events: list of events that includes all possible outcomes

If you roll a six-sided die, there are six possible outcomes, and each of these outcomes is equally likely. A six is as likely to come up as a three, and likewise for the other four sides of the die. What, then, is the probability that a one will come up?

Since there are six possible outcomes, the probability is 1/6. What is the probability that either a one or a six will come up? Given that all outcomes are equally likely, we can compute the probability of a one or a six using the formula:

In this case there are two favorable outcomes and six possible outcomes. So the probability of throw- ing either a one or six is 1/3. The above formula has many applications in the investment field and can also be applied to many games of chance.

For example, what is the probability that a card drawn at random from a deck of playing cards will be an ace? Since the deck has four aces, there are four favorable outcomes; since the deck has 52 cards, there are 52 possible outcomes. The probability is therefore 4/52 = 1/13.

If you know the probability of an event occurring, it is easy to compute the probability that the event does not occur. If P(A) is the probability of Event A, then 1 – P(A) is the probability that the event does not occur.

Events A and B are independent events if the probability of Event B occurring is the same whether or not event A occurs.

Let’s take a simple example. A fair coin is tossed two times. The probability that a head comes up on the second toss is 1/2 regardless of whether or not a head came up on the first toss. The two events are (1) first toss is a head and (2) second toss is a head. So these events are independent.

**Probability of A and B**

When two events are independent, the probability of both occurring is the product of the probabilities of the individual events. More formally, if events A and B are independent, then the probability of both A and B occurring is:

**P(A and B) = P(A) × P(B) **

Where:

- P(A and B) is the probability of events A and B both occurring
- P(A) is the probability of event A occurring
- P(B) is the probability of event B occurring

If you flip a coin twice, what is the probability that it will come up heads both times? Event A is that the coin comes up heads on the first flip and Event B is that the coin comes up heads on the second flip. Since both P(A) and P(B) equal 1/2, the probability that both events occur is:

**1/2 × 1/2 = 1/4**

If Events A and B are independent, the probability that either Event A or Event B occurs is:

**P(A or B) = P(A) + P(B) – P(A and B)**

In this discussion, when we say “A or B occurs” we include three possibilities:

- A occurs and B does not occur
- B occurs and A does not occur
- Both A and B occur

For example, if you flip a coin two times, what is the probability that you will get a head on the first flip or a head on the second flip (or both)? Letting Event A be a head on the first flip and Event B be a head on the second flip, then P(A) = 1/2, P(B) = 1/2, and P(A and B) = 1/4. Therefore,

**P(A or B) = 1/2 + 1/2 – 1/4 = 3/4.**

If you throw a six-sided die and then flip a coin, what is the probability that you will get either a 6 on the die or a head on the coin flip (or both)? Using the formula,

**P(6 or head) = P(6) + P(head) – P(6 and head) **

** = (1/6) + (1/2) – (1/6)(1/2)**

** = 7/12**

Often it is required to compute the probability of an event given that another event has occurred. For example, what is the probability that two cards drawn at random from a deck of playing cards will both be aces? It might seem that you could use the formula for the probability of two independent events and simply multiply 4/52 x 4/52 = 1/169. This would be incorrect, however, because the two events are not independent. If the first card drawn is an ace, then the probability that the second card is also an ace would be lower because there would only be three aces left in the deck.

Once the first card chosen is an ace, the probability that the second card chosen is also an ace is called the conditional probability of drawing an ace. In this case, the “condition” is that the first card is an ace. Symbolically, we write this as:

P(ace on second draw | an ace on the first draw)

The vertical bar “|” is read as “given,” so the above expression is short for: “The probability that an ace is drawn on the second draw given that an ace was drawn on the first draw.” What is this probability? Since after an ace is drawn on the first draw, there are 3 aces out of 51 total cards left. This means that the probability that one of these aces will be drawn is 3/51 = 1/17.

If Events A and B are not independent, then:

**P(A and B) = P(A) x P(B|A)**

Applying this to the problem of two aces, the probability of drawing two aces from a deck is:

**4/52 x 3/51 = 1/221**

Tree diagrams can be used to represent an investment problem with various probabilities of outcome:

This tree diagram illustrates the earnings per share of a firm given various economic scenarios. The total probabilities of outcomes should add up to 100% and the expected EPS is given by computing the weighted average of all the end scenarios’ EPS.

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

I hope you found this article on Probability Concepts On CFA Level 1 valuable. If you are currently studying for the upcoming Level 1 exam, I invite you to check out the CFA Level 1 Hacks that covers the most important aspects and concepts on the exam. If you have any questions, I invite you to contact us today.

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]]>The post Episode #11: What is Monte Carlo Simulation appeared first on Financial Analyst Warrior.

]]>On this episode, we cover Monte Carlo Simulation :

- What is Monte Carlo Simulation?
- How likely will the simulation be on the exam?
- Why it is important to understand the principal for the CFA Level 1 exam?
- Practical real life applications.
- Much more

If you are currently studying for the upcoming CFA© Level 1 exam, then we invite you to check out our CFA© Level 1 Study Hacks as well as the CFA© Level 1 Starter Kit that features 100 top mistakes CFA© candidates make on their CFA© Exam.

We hope you enjoy the show and we invite you to leave us feedback and contact us if you have any questions about Financial Analyst Warrior or the CFA® examination.

We invite you to connect with us on:

Facebook | Twitter |Google+

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]]>The post Monte Carlo Simulation in CFA Level 1 appeared first on Financial Analyst Warrior.

]]>Monte Carlo methods are used to handle both probabilistic and deterministic problems according to whether or not they are directly concerned with the behaviour and outcome of a random process. In the case of a probabilistic problem a simple Monte Carlo approach is to observe random numbers, chosen in such a way that they directly simulate the physical random processes of the original problem, and to infer the desired solution from the behaviour of these random numbers.

Monte Carlo simulation has wide application in performing risk analysis by building models of possible results by substituting a range of values (a probability distribution) for any factor that has inherent uncertainty( GDP growth, inflation rate, interest rate, asset performance…). It then calculates results over and over, each time using a different set of random values from the probability functions. Depending upon the number of uncertainties and the ranges specified for them, a Monte Carlo simulation could involve thousands or tens of thousands of recalculations before it is complete.

Monte Carlo simulation produces distributions of possible outcome values. By using probability distributions, variables can have different probabilities of different outcomes occurring. Probability distributions are a realistic way of describing uncertainty in variables of a risk analysis.

In corporate finance for example, a company may need to value a project, which may involve an initial outlay with future expected profits. If these future profits can be estimated accurately then the firm can determine whether these profits will outweigh the costs and can then decide whether to proceed with the project or not. The factors affecting the future profits could consist of many variables, including but not limited to interest rate fluctuations, currency exchange rate changes, macro-economic factors, labour costs, environmental issues or advancements in technology. Since each one of these factors can be multi-dimensional there could be a very large amount of parameters to be estimated, each having its own distribution. Therefore Monte Carlo simulation methods can be implemented.

As we will see in the derivatives section, stock options change in value depending on the price of an underlying stock, which itself can be affected by a very large number of factors. Simulation can be used to generate thousands of possible (but random) price paths in order to estimate the future value of an option. This can then allow a price to be assigned to the option at the current time point.

Yet another investment application is portfolio evaluation, which involves estimating the value of a collection of financial instruments such as stocks or bonds to determine the wealth to be gained. Monte Carlo methods can be used to simulate the correlated behaviour of the components of the portfolio over time in order to assess how the portfolio is affected by certain price level changes in order to estimate the value of the portfolio.

Monte Carlo methods provide flexibility and can handle multiple sources of uncertainty however the techniques are not always appropriate. In general such methods are likely to be preferable when there exist several sources of uncertainty such as in the above cases.

We hope you found this article on Monte Carlo simulation valuable. If you have any question about the CFA © Level 1 exam, we invite you to contact us. If you are preparing for the upcoming CFA © Level 1 exam, we invite you to purchase our CFA © Level 1 Bundle. Although you will not be required to use Monte Carlo simulation on the actual exam. It is still important that you understand the principle behind it.

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]]>The post Episode #10 | How to foster a Warrior mentality to help you study and prepare for the CFA Exam appeared first on Financial Analyst Warrior.

]]>If you are currently studying for the upcoming CFA© Level 1 exam, then we invite you to check out our CFA© Level 1 Study Hacks as well as the CFA© Level 1 Starter Kit that features 100 top mistakes CFA© candidates make on their CFA© Exam.

On this episode, we cover interesting real world questions :

- How to foster a Warrior mentality in order to help you concentrate and study for the upcoming CFA Level 1 exam
- Real world Capital Budgeting application from the CFA Level 1 exam
- Much more

We hope you enjoy the show and we invite you to leave us feedback and contact us if you have any questions about Financial Analyst Warrior or the CFA® examination.

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The post Episode #10 | How to foster a Warrior mentality to help you study and prepare for the CFA Exam appeared first on Financial Analyst Warrior.

]]>The post Episode #9 | Robo Advisors, Future of Investment Advisors, Valuations models and much more appeared first on Financial Analyst Warrior.

]]>If you are currently studying for the upcoming CFA© Level 1 exam, then we invite you to check out our CFA© Level 1 Study Hacks as well as the CFA© Level 1 Starter Kit that features 100 top mistakes CFA© candidates make on their CFA© Exam.

On this episode, we cover interesting real world questions :

- What is an Robo Advisor and what it means for the future of Investment Advisors and CFA candidates
- Main valuation models, their applicabilities, relevances and the holistic approach to choosing investments
- Practical advice for future CFA charterholders
- Much more

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The post Episode #9 | Robo Advisors, Future of Investment Advisors, Valuations models and much more appeared first on Financial Analyst Warrior.

]]>The post How to Foster a Warrior Mentality Ahead of the CFA Exam appeared first on Financial Analyst Warrior.

]]>We have discussed in previous articles that the CFA exam challenges at least as much your mental and emotional fortitude than your knowledge of finance theory. The constant fight that is entailed in studying for a CFA charter is the reason we called this website Financial Analyst Warrior. This is a fight against many enemies, namely:

- Boredom
- Distractions
- Laziness
- Internet
- Social media
- Stress

The human response when facing a danger has been summarized by the three Fs: Flee, Freeze or Fight.

Although it would be a stretch to claim that studying for the CFA exam constitutes a “danger” we can all agree that it is a stressful process. Some will abandon their pursuit along the way (flee), some will be intimidated by the task and constantly postpone their study (freeze) and some will fight on!

The fighting analogy not only describes accurately the warrior mindset that allows us to aggressively pursue our goals, it also provides us with many lessons, learned on the battlefield (the real one) that can be applied to less belligerent tasks, such as studying for an exam.

The warrior image does convey a violent and aggressive vibe to a perfectly academic and intellectual pursuit which some could find curious. However, from my personal experience, this testosterone-injected image is not only the best way to succeed in an exam or competition; but also to accept the any outcome with grace and stoicism.

A good warrior is strong and impassive in the face of danger and doesn’t let his/her emotion get in the way of quick and efficient decision making. Great warrior exudes confidence and control without reeking of cockiness (actually I am sure most great warriors ranged between a bit cocky and humongous douchebags). We believe the warrior image incorporates the perfect mix of calm and aggression that is required to attack the exam while maintaining a discipline and methodical approach to nail all the questions.

We discussed the importance of a ritual in a previous article but its importance cannot be overplayed. The ritual can be seen as a form of meditation that lets your mind transition from whatever you were doing to the new task to tackle which can be studying for the CFA, undergoing a practice exam or writing the actual exam.

A ritual does not have to be an elaborate dance or a goat sacrifice as an offering to the Gods (although it is preferable). It can be as simple as a small routine where you prepare your body and soul for the upcoming task. Back in college, I would always listen to aggressive gangsta rap before an exam. That would put me in the zone and clear my mind off of any other concerns or distraction.

You do not need to be superstitious to perform a warrior ritual. The important thing is to provide you with a buffer between whatever you were doing before and the CFA related study/exam.

Visualization is the practice of playing a scenario in your hear before it happens. Athletes always visualize their upcoming competition in order to be ready for all scenarios and contingencies. Ahead of combat, warriors should also visualize their enemy and see them perish a thousand times. When I say visualization I don’t mean simply seeing yourself sitting down answering questions, that does not take much imagination.

Candidates need to visualize everything that will happen from the morning of the exam onward; how they will wake up, what they will eat, how they will get to the exam facility and enter into the exam room. When you visualize these mundane steps several times in your hand, you will be less prone to distraction and more focused when you actually go for the exam. Imagine going into a new city, you naturally look around because everything is new for you and your attention is all over the place trying to absorb as much information as possible. When you walk in your own neighborhood, you are not distracted by anything since you have been there several times. Your attention is therefore more focused toward whatever you are doing.

This is also the reason why it is always advisable to visit the exam location in advance. It is harder to visualize something you have never seen before…

It is said that Shaolin Kung-Fu was developed as a series of exercise that helped the Shaolin Buddhist Monks stay in shape despite long hours of meditation. The purpose was to maintain strong and healthy bodies to sustain endless sessions of sedentary meditation. These monks understood that it is easier to concentrate when the body has a regular opportunity to move around.

As a rather fidgety guy, I have always found that the most difficult part of the CFA is the requirement to spend long hours sitting in a chair looking at a textbook. Back in college, I barely studied so it was not that much of an issue. To nail the CFA, there is no getting around it, you need to put in a significant amount of hours. The only thing that saved me was that I would train in between study session so that my body was relatively tired and the “down time” provided by the studying was welcomed.

An example of how you can cultivate your body to withstand long hours of studying is by splitting your reading sessions with short workout sessions. Exercise can be as simple as a few push-ups, sit ups or jumps just to get the juices flowing. There are tons of short exercises that does not require any equipment or space (check Youtube). I suggest to place a special focus on back and shoulder exercise since these are the areas that suffer the most from being hunched over books for extend periods.

Discipline is an essential ingredient to succeed at most tasks in life yet it is very difficult to maintain for an extended period. First of all let clear out some misconception about discipline. It is not true that some people have it and some do not; everyone can have discipline if they are properly motivated. Also, discipline is never constant. I may keep to my study schedule for 2 month and then suddenly slack off. It is impossible to be always perfectly discipline but the warrior example gives us a perfect image to strive for.

In the military discipline is imposed from above so there is not many opportunities to deviate and if so there are harsh sanctions. When studying, there is no such authority that imposes a studying regimen and each candidate is left to their own regulations. There are no direct consequences from slacking on the studying since the fact that I forgo my curriculum readings today has arguably a small impact on the pass/fail result on the exam. Given this lack of accountability, some candidates find sources of discipline elsewhere. Some find it in the shame they will have to endure given a failure. Some find comfort in their salary bump once the exam passed. Candidates who already have competitive DNA will find motivation and discipline in the sheer fact that they defeated the dreaded CFA exam single-handedly.

If you have a hard time maintaining discipline when you are studying or trying to perform anything for that matter, try the following mind hack that I have been implementing for many years in various situations.

**Mind-hack to Discipline Yourself**

Whenever you feel like slacking off or watching TV/Internet or doing anything else than what you are supposed to do, imagine that you are being filmed. Imagine that there is a movie being filmed in secret about your life (similar that movie with Jim Carey) and that millions of people will be watching (or are watching live). If you can visualize that, the desire to look good and to give an image of yourself as a hard-working discipline cool guy or girl will usually be stronger than the appeal of laziness. This is a way to remain accountable even when you are alone. In this case you are accountable to millions of imaginary viewers that will potentially judge you and look down on you if you behave like a giant wuss. This is a form of self-imposed imaginary peer pressure and should obviously not be abused since that may lead some people to feel overly guilty and depressed all the time. For my part, thanks to this simple trick, I am usually able to be relatively discipline and look pretty cool even when I’m alone. ..

I read recently somewhere (although I cannot remember where) that fearlessness does not really exist. In reality, those who appear fearless, like warriors, are just better able to control their fears than the rest of us. It makes sense since it is hard to believe that someone who risks not only death but permanent injury and excruciating pain, does not shit his pants, warrior or not. Being able to stand up in the face of danger is not something everyone can accomplish instinctively. However, there are ways to build our fortitude so that we can avoid being overcome with fear.

One way is to visualize, embrace, study and even cherish the fear and its source. The soldier going to battle faces the distinct possibility of losing his life or a limb. He needs to understand that and consciously make effort that it does not happen. Some people do not like to envisage failure as an option. In my case I think you need to visualize the worst case scenario and see what would happen if this scenario does occur. This is a tip that I got from Tim Ferris in his 4-hour workweek book. According to him, most of the time, the worst-case scenario is not as bad as we think … although that certainly does not apply for the warrior since death is the worst-case scenario…

By visualizing and accepting the possibility of failure on the CFA exam, you can reach an inner peace and you may be able to face the exam with calm and impassiveness. Unfortunately, my best advice to overcome fear is failure itself although that is hardly an option in an exam scenario. Although you wouldn’t fail the exam just so that next time around you can be fearless, failure helps tremendously to de-dramatize the “worst-case-scenario”. I have experienced failure several times in all fields of life (school, CFA, business, career, sports, girls, pets, cooking, …) but every time (except with girls) it was a great learning experience and it allowed me to try again without being affected by the fear of failure.

If you don’t wish to fail the CFA just for the sake of becoming fearless (please don’t do that!), you can try building your resistance to fear by attempting any other activity that instills stress. For example if you are afraid of getting your ass kicked, try a mixed martial arts class. Or if you are afraid of heights, go skydiving. This will teach you to familiarize yourself with fear and possibly conquer it.

So far we talk about the pre-war ritual, the pre-war visualization, the physical preparedness, the discipline in your studies and the ability to conquer your fear. However, lets be honest, being a warrior is mostly about eradicating your enemy which requires aggression and combativeness. A soldier needs to keep on fighting despite the injuries and setbacks suffered. For a candidate, this translate into the resilience of answering question after question and not letting a bad streak affect them mentally. This may seem trivial but when you have to face a few questions in a row for which you did not know the answer beyond doubt, it can have a disastrous impact on the rest of your exam. You may enter into a spiral of self-doubt and candidates may get the impression that they are under-prepared for the exam. This is especially true in the level 2 exam where you have 6 consecutive questions on the same topic. If it happens to be your weak topic, your confidence level may drop quickly.

The first step in fighting the spiral of self-doubt is to be aware of it. Each question is a new fight and should be attacked head-on without other results affecting your mindset. Remember that if there are 180 questions and you typically require to get 70% of them correct to pass, that means you are allowed to answer incorrectly on 54 of those and still pass. Unless you get a streak of 54 tough questions, there is no reason for you to be affected by a bad streak.

I hope this helps you to visualize what we mean by adopting a warrior-like attitude. The main takeaway here is to not let the emotional factor squander the effort you spent in studying the material. Visualize yourself as a noble and powerful general going to war with the firm resolve to defeat the enemy….but just visualize it, do not talk about it or you will be seen as a total lunatic…

We also invite you to check out 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.

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

- 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 page 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.

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