Your FREE CFA Level 1 Flashcards 2026 – 300+ Cards

Six. The Code of Ethics has six components covering integrity, competence, diligence, respect, and ethical/professional conduct toward the public, clients, employers, and the profession.

Seven: I Professionalism, II Integrity of Capital Markets, III Duties to Clients, IV Duties to Employers, V Investment Analysis, Recommendations & Actions, VI Conflicts of Interest, and VII Responsibilities as a CFA Member/Candidate.

Members must follow the stricter of applicable law or the Code and Standards. If local law is less strict than the Code, follow the Code; if law is stricter, follow the law.

Four sub-standards: I(A) Knowledge of the Law, I(B) Independence and Objectivity, I(C) Misrepresentation, and I(D) Misconduct.

Members must understand and comply with applicable laws/rules/regulations and the Code; if a conflict exists, follow the more strict. Dissociate from any ongoing illegal or unethical activity.

Use reasonable care and judgment to maintain independence and objectivity. Do not offer, solicit, or accept any gift, benefit, or compensation that could compromise it. Modest gifts are generally acceptable.

Do not knowingly make any misrepresentation relating to investment analysis, recommendations, actions, or other professional activities. This includes plagiarism and guaranteeing returns.

Do not engage in any professional conduct involving dishonesty, fraud, or deceit, or commit any act that reflects adversely on professional reputation, integrity, or competence.

Two sub-standards: II(A) Material Nonpublic Information and II(B) Market Manipulation.

Members who possess material nonpublic information that could affect a security's value must not act or cause others to act on it. Information is material if a reasonable investor would want it before investing.

An analyst may combine public information with nonmaterial nonpublic information to reach a conclusion (even a material one) and act on it, without violating Standard II(A).

Do not engage in practices that distort prices or artificially inflate trading volume with intent to mislead market participants. Includes transaction-based and information-based manipulation.

Five sub-standards: III(A) Loyalty, Prudence, and Care; III(B) Fair Dealing; III(C) Suitability; III(D) Performance Presentation; III(E) Preservation of Confidentiality.

Members have a duty of loyalty to clients and must act with reasonable care and exercise prudent judgment, placing clients' interests before their own and their employer's.

Members must deal fairly and objectively with all clients when providing investment analysis, making recommendations, taking action, or engaging in other professional activities. Fair does not mean identical.

When in an advisory relationship, make a reasonable inquiry into a client's situation and update an IPS regularly. Recommendations must be suitable given the client's objectives, constraints, and the total portfolio.

Make reasonable efforts to ensure investment performance information is fair, accurate, and complete. Do not misstate performance or mislead about past results.

Keep information about current, former, and prospective clients confidential unless it concerns illegal activities, disclosure is required by law, or the client permits it.

Three sub-standards: IV(A) Loyalty, IV(B) Additional Compensation Arrangements, and IV(C) Responsibilities of Supervisors.

Act for the benefit of your employer; do not deprive it of your skills/abilities, divulge confidential information, or cause harm. You may make preparations to start a competing business if you do not breach this duty.

Do not accept gifts, benefits, compensation, or consideration that competes with or may create a conflict with your employer's interest unless you obtain written consent from all parties involved.

Members must make reasonable efforts to detect and prevent violations of laws, rules, regulations, and the Code by anyone subject to their supervision or authority.

Three sub-standards: V(A) Diligence and Reasonable Basis, V(B) Communication with Clients and Prospective Clients, and V(C) Record Retention.

Exercise diligence, independence, and thoroughness in analyzing investments and making recommendations, and have a reasonable and adequate basis, supported by appropriate research and investigation.

Disclose the basic format and general principles of the investment process, identify limitations and risks, distinguish fact from opinion, and communicate significant changes promptly.

Develop and maintain appropriate records to support investment analyses, recommendations, and actions. CFA Institute recommends a minimum record-retention period of seven years absent other requirements.

Three sub-standards: VI(A) Disclosure of Conflicts, VI(B) Priority of Transactions, and VI(C) Referral Fees.

Make full and fair disclosure of all matters that could reasonably impair independence and objectivity or interfere with duties to clients, prospects, and employer. Disclosures must be prominent and in plain language.

Investment transactions for clients and employers must have priority over personal transactions. Personal trades must not adversely affect clients or disadvantage them.

Disclose to employer, clients, and prospects any compensation, consideration, or benefit received from or paid to others for the recommendation of products or services.

Two sub-standards: VII(A) Conduct as Participants in CFA Institute Programs and VII(B) Reference to CFA Institute, the CFA Designation, and the CFA Program.

Do not engage in conduct that compromises the reputation or integrity of CFA Institute or the CFA designation, or the validity, integrity, or security of CFA Institute programs (e.g., cheating, disclosing exam content).

Reference the CFA marks accurately. CFA must be used as an adjective, never a noun, and members must not exaggerate the meaning of membership, the designation, or candidacy.

The CFA designation must be used as an adjective (e.g., 'Jane Doe, CFA' or 'a CFA charterholder'), never as a noun ('a CFA') and never in pseudo-plural form. Candidates may say they are a 'Level I candidate.'

Global Investment Performance Standards — voluntary, ethical standards for calculating and presenting investment performance so results are fair, comparable, and complete across firms.

Only investment management firms (not individuals, plans, or software) may claim compliance, and it must be firm-wide. Partial or composite-only compliance is not permitted.

A composite groups all actual fee-paying, discretionary portfolios managed to a similar strategy, preventing firms from cherry-picking their best accounts when presenting performance.

Using reports, analyses, or models created by others without acknowledgment violates Standard I(C) Misrepresentation. Acknowledged factual data from recognized sources need not be cited.

Acting in the best interest of the client/beneficiary, placing their interests above your own and your employer's. Central to Standard III(A) Loyalty, Prudence, and Care.

Fair dealing means treating clients fairly and objectively, NOT identically. Members may offer different levels of service if disclosed and offered to all clients.

When taking a new position, members must comply with new firm policies but are not held to a higher standard than the Code requires; they should review and follow the employer's compliance procedures.

Acting against an employer's interest may be permissible if necessary to comply with law, protect the integrity of capital markets, or protect clients; loyalty to the employer is not absolute.

Brokerage commissions are an asset of the client and must be used to benefit the client. Using client brokerage to buy research must serve the client's interest (Standard III(A)).

Issuer-paid research is allowed only with thorough due diligence, full disclosure of the arrangement, and flat-fee compensation independent of conclusions or recommendations.

Allocate trades fairly across client accounts using a pre-established, systematic, and fair method (e.g., pro rata at the average execution price) so no client is disadvantaged.

Earnings, M&A activity, dividend changes, new products, management changes, major litigation, and changes in auditor — anything a reasonable investor would want before trading.

When a member cannot stop ongoing illegal/unethical activity, they must dissociate from it; inaction or passive participation can itself be a violation.

Members must not guarantee specific investment returns on volatile investments; doing so is a misrepresentation under Standard I(C).

Conflicts must be disclosed to clients, prospective clients, and the employer, prominently and in plain language so recipients can evaluate the conflict's effect.

Act with integrity/competence/diligence/respect; place the integrity of the profession and clients' interests above your own; use reasonable care and independent judgment; practice professionally and ethically; promote market integrity; maintain competence.

A member may rely on others' research only after determining it has a reasonable and adequate basis (sound methodology, freedom from bias); blind reliance violates Standard V(A).

Under IV(B), accepting compensation from a client that competes with the employer's interest requires written consent from all parties before accepting the arrangement.

Members may make preparations to compete (e.g., obtain office space) before resigning, but may not take client lists, records, or trade secrets, or solicit clients before leaving.

Confidential client information may be disclosed when it concerns illegal activities by the client, when disclosure is required by law, or when the client/prospect permits disclosure.

FV = PV × (1 + i)ⁿ, where i is the periodic rate and n is the number of periods. Compounding more frequently raises FV for a given stated rate.

PV = FV ÷ (1 + i)ⁿ. Discounting brings a future cash flow back to today using the periodic discount rate.

An ordinary annuity pays at the END of each period; an annuity due pays at the BEGINNING. The value of an annuity due equals the ordinary annuity × (1 + i).

NPV = sum of all cash inflows and outflows discounted to the present at the required rate of return. Accept a project if NPV > 0.

The discount rate that makes a project's NPV equal to zero. Accept a project if IRR exceeds the required rate of return.

For mutually exclusive projects, NPV and IRR can rank differently due to scale or cash-flow timing; NPV is preferred because it measures value added in currency terms.

HPR = (ending value − beginning value + income) ÷ beginning value. It is the total return over the holding period, including price change and income.

The IRR of a portfolio's cash flows; it is influenced by the timing and size of contributions/withdrawals, so it reflects the investor's actual experience.

Compounds period-by-period sub-returns and removes the effect of cash flow timing, so it is the standard for comparing manager performance (GIPS preferred).

EAR = (1 + periodic rate)ᵐ − 1, where m is the number of compounding periods per year. More frequent compounding raises the EAR above the stated annual rate.

CV = standard deviation ÷ mean. It measures risk per unit of return (or dispersion per unit of mean); lower CV means less relative risk.

Sharpe = (Rp − Rf) ÷ σ, the portfolio's excess return over the risk-free rate per unit of total risk (standard deviation). Higher is better.

Variance is the average squared deviation from the mean; standard deviation is its square root (√variance), expressed in the same units as the data.

The probability-weighted average of all possible outcomes: E(X) = Σ [P(xi) × xi]. It is the long-run mean of a random variable.

Covariance measures how two variables move together (unbounded); correlation = covariance ÷ (σ1 × σ2), standardizing it to a range of −1 to +1.

Symmetric and bell-shaped; fully described by mean and variance; about 68% of observations fall within ±1σ, 95% within ±2σ (≈1.96σ), and 99% within ±3σ (≈2.58σ).

z = (observation − mean) ÷ standard deviation. It standardizes a value to the number of standard deviations from the mean of a normal distribution.

A Type I error rejects a true null hypothesis (false positive); its probability equals the significance level α. A Type II error fails to reject a false null (false negative).

The null (H0) is the statement to be tested (often 'no effect'); the alternative (Ha) is what you conclude if you reject the null. Tests can be one- or two-tailed.

Models Y = b0 + b1X + ε, estimating the intercept (b0) and slope (b1) to describe the linear relationship between a dependent and an independent variable.

The proportion of the variation in the dependent variable explained by the independent variable(s); ranges from 0 to 1. In simple regression, R² equals the squared correlation.

(1 + nominal) = (1 + real) × (1 + expected inflation). The nominal rate compensates for both the real return and expected inflation.

Permutations count ordered arrangements (order matters); combinations count selections where order does not matter. Combinations = permutations ÷ r!.

All else equal, as a good's price rises, the quantity demanded falls, and vice versa, producing a downward-sloping demand curve.

% change in quantity demanded ÷ % change in price. Demand is elastic if |elasticity| > 1, inelastic if < 1, and unit elastic if = 1.

Demand is more elastic when close substitutes exist, the good is a large share of the budget, the good is a luxury, and the time horizon is longer.

The substitution effect shifts consumption toward relatively cheaper goods; the income effect reflects the change in real purchasing power when a price changes.

Many firms, identical products, no pricing power (price takers), and easy entry/exit. Firms earn zero economic profit in the long run.

A single seller with no close substitutes and high barriers to entry; the firm is a price maker and can earn long-run economic profit.

Many firms selling differentiated products with some pricing power and low barriers to entry; long-run economic profit tends toward zero.

A few large firms that are interdependent; outcomes are analyzed with game theory (e.g., the Nash equilibrium and the Cournot/Stackelberg models).

The market value of all final goods and services produced within a country in a period. Nominal GDP uses current prices; real GDP adjusts for inflation.

Expansion, peak, contraction (recession), and trough. The cycle reflects fluctuations in economic activity around the long-term growth trend.

Government use of spending and taxation to influence the economy. Expansionary fiscal policy increases spending or cuts taxes to boost aggregate demand.

Central bank actions on the money supply and interest rates. Expansionary policy lowers rates to stimulate the economy; contractionary policy raises them to curb inflation.

Open market operations (buying/selling government securities), the policy/discount rate, and reserve requirements. Open market operations are the most-used tool.

Inflation is a sustained rise in the general price level. The Consumer Price Index (CPI) tracks the cost of a representative basket of consumer goods and services.

Demand-pull inflation comes from rising aggregate demand; cost-push inflation comes from rising input costs (e.g., wages, energy) that reduce aggregate supply.

A direct quote gives the domestic price of one unit of foreign currency; an indirect quote gives the foreign price of one unit of domestic currency (the reciprocal).

The nominal rate is the stated currency price; the real exchange rate adjusts for relative price levels and reflects relative purchasing power.

Aggregate demand is total spending at each price level (downward sloping); short-run aggregate supply is upward sloping; equilibrium sets the price level and real output.

The ratio of the change in real GDP to the change in government spending. A larger marginal propensity to consume produces a larger multiplier.

Government borrowing to fund deficits can raise interest rates and reduce private investment, partially offsetting the expansionary effect of fiscal policy.

Firms maximize profit where marginal revenue equals marginal cost (MR = MC). Producing beyond that point reduces total profit.

Falling average total cost as output rises, due to specialization and spreading fixed costs. Diseconomies of scale occur when costs rise with size.

The balance sheet (financial position), the income statement (profitability over a period), and the cash flow statement (cash inflows/outflows). The statement of changes in equity links them.

Assets = Liabilities + Owners' Equity. The balance sheet always balances because every transaction affects at least two accounts.

Revenues are recognized when earned and expenses when incurred, regardless of cash timing. This matches expenses to the revenues they help generate.

Identify the contract, identify performance obligations, determine the transaction price, allocate it to obligations, and recognize revenue as each obligation is satisfied.

Revenue − COGS = gross profit; minus operating expenses = operating income (EBIT); minus interest and taxes = net income.

First-in, first-out assumes the oldest costs are expensed in COGS first, leaving newer costs in ending inventory. In rising prices, FIFO gives lower COGS and higher net income.

Last-in, first-out expenses the newest costs in COGS first. In rising prices, LIFO gives higher COGS, lower net income, lower taxes, and lower ending inventory. LIFO is permitted under US GAAP but not IFRS.

COGS and ending inventory use the average cost of all units available for sale; results fall between FIFO and LIFO under changing prices.

Rising prices → FIFO: higher net income, higher inventory, higher taxes. LIFO: lower net income, lower inventory, lower taxes, higher cash flow (lower taxes).

(Cost − salvage value) ÷ useful life, expensing an equal amount each year. It produces stable expense and higher early-year income than accelerated methods.

Methods like double-declining balance expense more in early years, lowering early net income and taxes. Total depreciation over the asset's life is the same as straight-line.

Current assets ÷ current liabilities. A liquidity measure; a value above 1 indicates current assets cover current liabilities.

(Cash + marketable securities + receivables) ÷ current liabilities, or (current assets − inventory) ÷ current liabilities. A stricter liquidity test that excludes inventory.

(Cash + marketable securities) ÷ current liabilities. The most conservative liquidity ratio, using only the most liquid assets.

COGS ÷ average inventory. Higher turnover suggests efficient inventory management; days of inventory on hand = 365 ÷ inventory turnover.

Revenue ÷ average receivables. Days sales outstanding (DSO) = 365 ÷ receivables turnover, showing how long it takes to collect.

Total debt ÷ total shareholders' equity. A solvency measure of financial leverage; higher values indicate greater reliance on debt financing.

Net income ÷ average shareholders' equity. It measures the return generated on owners' capital.

ROE = net profit margin × asset turnover × financial leverage = (NI ÷ revenue) × (revenue ÷ assets) × (assets ÷ equity).

Gross profit ÷ revenue. It shows how much of each sales dollar remains after the cost of goods sold.

Net income ÷ revenue. It shows the percentage of revenue remaining after all expenses, including interest and taxes.

EBIT ÷ interest expense. A solvency measure of how easily a firm can pay interest from operating earnings; higher is safer.

Arises when taxable income is temporarily lower than pretax accounting income (e.g., accelerated tax depreciation), so taxes are payable in future periods.

Arises when taxable income temporarily exceeds pretax accounting income (e.g., warranty accruals), creating future tax savings; assessed for a valuation allowance.

High-quality earnings are sustainable and backed by cash flow. Red flags include earnings far above operating cash flow, frequent one-time items, and aggressive accruals.

Basic EPS = (net income − preferred dividends) ÷ weighted-average common shares. Diluted EPS also includes the effect of options, warrants, and convertibles (if dilutive).

Cash from a firm's core business operations. Under the indirect method, it starts from net income and adjusts for non-cash items and working-capital changes.

Operating (CFO), investing (CFI — capital assets and securities), and financing (CFF — debt and equity issuance/repayment, dividends).

Both yield the same CFO. The direct method lists actual cash receipts/payments; the indirect method reconciles net income to cash flow. Indirect is more common.

Each line item is expressed as a percentage of revenue, enabling comparison across time and across firms of different sizes.

Capitalizing a cost spreads it over future periods (higher early income, an asset), while expensing recognizes it immediately (lower current income).

Under current standards both put a right-of-use asset and lease liability on the balance sheet; a finance lease front-loads expense (interest + amortization), an operating lease has straight-line expense.

LIFO is prohibited under IFRS but allowed under US GAAP. IFRS values inventory at the lower of cost or net realizable value (with reversals allowed); GAAP uses lower of cost or market (no reversals).

The excess of purchase price over the fair value of identifiable net assets in an acquisition. It is not amortized but tested at least annually for impairment.

Current assets minus current liabilities; it measures short-term liquidity and the funds available to run day-to-day operations.

Held-to-maturity (amortized cost), trading (fair value through profit/loss), and available-for-sale (fair value through other comprehensive income).

An accrual records revenue/expense before cash changes hands (e.g., accrued wages); a deferral delays recognition after cash is exchanged (e.g., prepaid rent, unearned revenue).

Revenue ÷ average total assets. An efficiency ratio showing how well a firm uses its assets to generate sales.

Reconciles beginning and ending equity, showing net income, dividends, share issuance/repurchase, and other comprehensive income.

Net income plus other comprehensive income (OCI), which includes items like certain foreign currency translation gains/losses and pension adjustments bypassing the income statement.

The system of internal controls and procedures by which a company is managed; it balances the interests of shareholders, management, the board, and other stakeholders.

Shareholders, the board, management, employees, creditors, suppliers, customers, and governments/regulators. Governance manages conflicts among their competing interests.

A conflict where managers (agents) may act in their own interest rather than that of shareholders (principals); governance mechanisms align incentives to mitigate it.

Business risk is uncertainty in operating income from operations and industry factors; financial risk is added uncertainty from using debt (fixed financing costs).

The sensitivity of operating income to changes in sales; it rises with higher fixed operating costs. DOL = % change in EBIT ÷ % change in sales.

The sensitivity of net income to changes in operating income; it rises with more fixed financing (interest) costs. DFL = % change in net income ÷ % change in EBIT.

DTL = DOL × DFL; the combined sensitivity of net income to a change in sales, reflecting both operating and financial leverage.

Managing current assets and liabilities (cash, receivables, inventory, payables) to ensure liquidity and operational efficiency while minimizing the cost of capital.

The weighted average of after-tax costs of debt and equity, weighted by their market-value proportions: WACC = wd × kd × (1 − t) + we × ke.

kd × (1 − tax rate). Interest is tax-deductible, so the effective cost of debt is reduced by the tax shield.

ke = Rf + β × (Rm − Rf), the risk-free rate plus a beta-adjusted equity risk premium.

The process of evaluating long-term investment projects using methods such as NPV, IRR, payback period, and the profitability index.

Accept independent projects with positive NPV; for mutually exclusive projects, choose the one with the highest positive NPV.

The time to recover the initial investment from cash flows. Simple but ignores the time value of money and cash flows beyond the payback point.

The cost of raising one additional unit of capital; it rises as a firm exhausts cheaper sources, and the optimal budget is where MCC equals the investment opportunity return.

In a world without taxes or costs, capital structure is irrelevant; firm value depends on its assets and earning power, not on how it is financed.

The cost of equity rises linearly with the debt-to-equity ratio, offsetting the benefit of cheaper debt so WACC is unchanged (no taxes). With taxes, debt adds value via the tax shield.

The mix of debt and equity that minimizes WACC and maximizes firm value, balancing the tax benefits of debt against financial distress and agency costs.

Internal (retained earnings) and external — debt (loans, bonds), equity (common, preferred), and hybrids (convertibles). Each has a different cost and claim priority.

Static trade-off theory (balance tax shield vs. distress costs) and pecking-order theory (firms prefer internal funds, then debt, then equity, due to information asymmetry).

The increase in non-cash current assets minus the increase in non-debt current liabilities; an outflow in capital budgeting that is often recovered at project end.

Independent projects can all be accepted if they meet criteria; mutually exclusive projects compete, so only one can be chosen (use NPV to rank).

V = D1 ÷ (r − g), where D1 is next year's dividend, r is the required return, and g is the constant dividend growth rate (requires r > g).

D1 = D0 × (1 + g), the current dividend grown by one period at the constant growth rate g.

Values a stock as the present value of its expected future dividends discounted at the required rate of return.

g = retention ratio × ROE = b × ROE, where b = 1 − dividend payout ratio. It is the growth a firm can sustain without external equity.

Share price ÷ earnings per share. A widely used relative valuation multiple; trailing uses past EPS, forward (leading) uses expected EPS.

P0 ÷ E1 = payout ratio ÷ (r − g). A higher growth rate or payout, or a lower required return, raises the justified P/E.

Share price ÷ book value per share. Useful for capital-intensive firms and financials; reflects how the market values net assets.

Share price ÷ sales per share. Useful for firms with negative earnings; less subject to accounting manipulation than P/E.

Market value of equity + market value of debt + preferred − cash and equivalents. It is the cost to acquire the entire firm; EV/EBITDA is a common multiple.

For fixed-rate perpetual preferred, value = annual dividend ÷ required return (Dp ÷ kp), the present value of a perpetuity.

Weak form (prices reflect past price/volume data), semi-strong form (prices reflect all public information), and strong form (prices reflect all public and private information).

Technical analysis cannot consistently generate abnormal returns because all past price and volume information is already in prices.

Fundamental analysis of public information cannot consistently produce abnormal returns; prices adjust quickly to new public information.

Even insider information cannot consistently earn abnormal returns; most evidence rejects strong-form efficiency in real markets.

An index where each stock is weighted by its price (e.g., the DJIA); high-priced stocks dominate, and stock splits change the weights.

Stocks are weighted by market capitalization (price × shares), so large firms have more influence (e.g., the S&P 500); a float-adjusted version uses only freely traded shares.

Each stock has the same weight regardless of size or price; it requires periodic rebalancing and tilts toward smaller firms.

The primary market is where new securities are issued (IPOs, the firm raises capital); the secondary market is where existing securities trade among investors.

Market orders execute immediately at the best price; limit orders execute only at a specified price or better; stop orders trigger once a price level is reached.

Buying securities partly with borrowed funds. The initial margin and maintenance margin set how much equity must be posted; a price drop can trigger a margin call.

1 ÷ initial margin requirement. It magnifies both gains and losses relative to the investor's own equity.

Stages of embryonic, growth, shakeout, mature, and decline. Each stage has different growth, competition, profitability, and risk characteristics.

Threat of new entrants, bargaining power of suppliers, bargaining power of buyers, threat of substitutes, and rivalry among existing competitors — used in industry analysis.

Cyclical firms' earnings track the business cycle (autos, luxury); defensive (non-cyclical) firms have stable demand regardless of the cycle (utilities, staples).

Models near-term high or variable dividend growth explicitly, then applies the Gordon growth model to value the stable, constant-growth terminal phase.

Values equity (FCFE) or the firm (FCFF) as the present value of expected future free cash flows; useful when firms pay no dividends.

r = Rf + β × (Rm − Rf). The expected return investors demand for bearing the stock's systematic risk.

Book value is accounting equity per share; market value is the trading price. The P/B ratio compares them and reflects growth/profitability expectations.

Payout ratio = dividends ÷ net income; retention ratio = 1 − payout. Retained earnings fund growth, lowering the need for external financing.

EPS ÷ price, the inverse of the P/E ratio. It is comparable to bond yields and used in relative-value comparisons.

Common shareholders have voting rights and a residual claim with variable dividends; preferred shareholders have priority on dividends/liquidation but usually no vote and fixed dividends.

Negotiable certificates representing shares of a foreign company, traded on a domestic exchange, letting investors hold foreign equity in their home market and currency.

A narrow bid-ask spread and high trading volume indicate a liquid market with lower transaction costs; illiquid securities have wider spreads.

Serve as market gauges, performance benchmarks, proxies for asset classes in models, and the basis for index funds and ETFs.

Anomalies and biases (overreaction, momentum, January effect) challenge market efficiency, but some disappear after discovery or vanish after transaction costs.

Value stocks trade at low multiples relative to fundamentals (low P/E, P/B); growth stocks have high expected earnings growth and command higher multiples.

If the expected return (from analysis) exceeds the required return (CAPM), the stock is undervalued and should be bought; the reverse signals overvaluation.

The first sale of a company's shares to the public, typically underwritten by investment banks; it provides capital and a public market for the stock.

The portion of shares available for public trading, excluding closely held or restricted shares. Float-adjusted indexes weight by free float.

Both increase share count without changing total equity value; a split changes par/price proportionally (e.g., 2-for-1), and a stock dividend issues additional shares to holders.

Bond prices and yields move inversely: when market interest rates (yields) rise, existing bond prices fall, and when yields fall, prices rise.

A bond trades at par when coupon = market yield, at a premium when coupon > yield (price above face), and at a discount when coupon < yield (price below face).

The coupon rate is fixed on face value; YTM is the market's required return, the IRR if the bond is held to maturity and all coupons are reinvested at the YTM.

Annual coupon payment ÷ current bond price. It ignores capital gains/losses and reinvestment, so it differs from yield to maturity.

The discount rate that equates the present value of a bond's cash flows to its price; the total return if held to maturity with coupons reinvested at the YTM.

The yield assuming a callable bond is called at the first (or specified) call date. For a premium callable bond, investors use the yield to worst (lower of YTM and YTC).

The yield on a zero-coupon bond for a specific maturity; bond prices can be valued by discounting each cash flow at its corresponding spot rate.

An interest rate agreed today for a loan/investment beginning at a future date; forward rates are derived from the spot-rate (term) structure.

The weighted-average time (in years) to receive a bond's cash flows, weighted by their present values. It is the basis for modified duration.

Approximate % change in a bond's price for a 1% change in yield: Macaulay duration ÷ (1 + yield per period). Higher duration means greater interest-rate risk.

Measures price sensitivity to a change in the benchmark yield curve; the appropriate measure for bonds with embedded options whose cash flows can change.

The curvature of the price-yield relationship. Duration alone underestimates price changes for large yield moves; positive convexity adds value and improves the estimate.

Longer maturity, a lower coupon rate, and a lower yield all increase a bond's duration (and thus its interest-rate sensitivity).

A zero-coupon bond's Macaulay duration equals its time to maturity, giving it the highest interest-rate sensitivity for a given maturity.

The risk that an issuer fails to make timely interest or principal payments. It includes default risk, credit spread risk, and downgrade (migration) risk.

Investment-grade bonds are rated BBB−/Baa3 or higher; high-yield ('junk') bonds are rated below that, with higher default risk and higher yields.

The yield difference between a corporate (risky) bond and a comparable-maturity government (risk-free) bond; it widens when perceived credit risk or risk aversion rises.

The relationship between yields and maturities (the yield curve). It can be upward sloping (normal), flat, or inverted (often signaling a slowdown).

Pure expectations (curve reflects expected future short rates), liquidity preference (adds a term premium for longer maturities), and market segmentation.

Pooling illiquid assets (e.g., mortgages, loans) and issuing tradable securities backed by their cash flows, often through a special purpose entity (SPE).

A security backed by a pool of mortgage loans. Holders bear prepayment risk — borrowers may repay early when rates fall, returning principal at an inopportune time.

A security backed by a pool of non-mortgage assets such as auto loans, credit-card receivables, or student loans, with credit enhancement to improve ratings.

The risk that borrowers repay principal earlier (contraction risk when rates fall) or later (extension risk when rates rise) than expected, affecting MBS cash flows.

Fixed-rate (level coupon), floating-rate (resets to a reference rate plus a spread), and zero-coupon (no periodic coupon, issued at a discount).

A callable bond lets the issuer redeem early (benefits the issuer; lower price/higher yield). A putable bond lets the holder sell back early (benefits the investor).

A bond that the holder can convert into a set number of the issuer's shares. It offers downside bond protection plus equity upside, so it carries a lower coupon.

The risk that coupon or principal cash flows must be reinvested at lower rates than the original yield; higher coupons and callable bonds increase it.

The risk that bond prices fall as market rates rise. Duration measures the magnitude; longer-duration bonds have greater interest-rate risk.

The dirty (full) price = clean (quoted) price + accrued interest. Accrued interest is the coupon earned since the last payment, paid to the seller.

Short-term instruments quote on a discount basis (bank discount yield) or add-on basis; the bond-equivalent yield converts them for comparison with longer-term bonds.

Government debt: Treasury bills (≤1 year, zero-coupon discount), notes (2–10 years), and bonds (>10 years). They are considered nearly default-free.

The legal contract between issuer and bondholders specifying the coupon, maturity, covenants, collateral, and other terms governing the bond.

Affirmative covenants require the issuer to do certain things (e.g., maintain ratios); negative covenants restrict actions (e.g., limit additional debt) to protect bondholders.

A bond whose coupon resets periodically to a reference rate plus a quoted margin; its price stays near par because the coupon adjusts to market rates.

G-spread (over government yield), I-spread (over swap rate), Z-spread (constant spread over the spot curve), and OAS (option-adjusted spread for embedded options).

The Z-spread after removing the value of any embedded option, allowing comparison of bonds with and without options on a like-for-like basis.

Requires the issuer to retire part of a bond issue periodically before maturity, reducing credit risk but introducing some reinvestment risk for holders.

In default, senior secured debt is paid first, then senior unsecured, then subordinated debt, then preferred and common equity (the priority of claims).

The percentage of a bond's value creditors recover after default. Loss given default = 1 − recovery rate; expected loss = probability of default × loss given default.

The market-value-weighted average of the durations of the individual bonds; it estimates the portfolio's sensitivity to a parallel yield-curve shift.

A customized, over-the-counter agreement to buy/sell an asset at a set price on a future date. No money changes hands at initiation; it carries counterparty risk.

Futures are standardized, exchange-traded, and marked to market daily through a clearinghouse (reducing counterparty risk); forwards are customized OTC contracts settled at expiry.

Daily settlement of futures gains and losses to margin accounts, which reduces counterparty credit risk and can trigger margin calls.

Gives the holder the right, not the obligation, to BUY the underlying at the strike price. The buyer profits when the underlying rises above strike + premium.

Gives the holder the right, not the obligation, to SELL the underlying at the strike price. The buyer profits when the underlying falls below strike − premium.

For a call, max(0, S − X); for a put, max(0, X − S). It is the value if exercised immediately, where S is the spot price and X the strike.

Option premium − intrinsic value. It reflects the chance the option moves further in-the-money before expiry and decays to zero at expiration (time decay).

A call is in-the-money when S > X, at-the-money when S = X, and out-of-the-money when S < X (reversed for puts). It describes the strike relative to the spot price.

American options can be exercised any time up to expiration; European options only at expiration. American options are worth at least as much as European.

c + PV(X) = p + S, where c is the call price, p the put price, X the strike, and S the spot. It links call, put, the underlying, and a risk-free bond.

F0 = S0 × (1 + r)ᵀ for an asset with no costs/benefits. Arbitrage forces this; adjust for carrying costs (add) and benefits like dividends (subtract).

An OTC agreement to exchange cash-flow streams over time. A plain-vanilla interest-rate swap exchanges fixed for floating payments on a notional principal.

A derivative can be replicated with a portfolio of the underlying and a risk-free bond; if its price differs from the replicating cost, arbitrage forces convergence (the law of one price).

A long position benefits from a price increase (buyer/holder); a short position benefits from a price decrease (seller/writer).

An option seller receives the premium but takes on obligation: a covered/naked call writer faces large upside loss; a put writer must buy if exercised. Profit is capped at the premium.

Call value rises with a higher underlying price, lower strike, more time to expiration, higher volatility, and higher interest rates.

Put value rises with a lower underlying price, higher strike, higher volatility, and (usually) more time; it falls as interest rates rise.

Risk management (hedging), price discovery, lower transaction costs, leverage/efficiency, and creating exposures otherwise hard to achieve. They can also amplify risk if misused.

The reference amount used to calculate swap or derivative payments; it is generally not exchanged, only used to compute the cash flows.

A derivative in which the buyer pays a premium for protection against a reference entity's default; the seller compensates the buyer if a credit event occurs.

Hedge funds, private equity, real estate, commodities, infrastructure, and other 'real' assets. They offer diversification but are often illiquid and less transparent.

A typical fee structure: a 2% annual management fee on assets plus a 20% performance (incentive) fee on profits, often above a hurdle rate and high-water mark.

The highest value a fund has reached, used so investors are not charged performance fees twice on the same gains after a decline and recovery.

A minimum return that must be earned before a hedge fund manager can collect a performance fee; can be hard (fee only on returns above it) or soft.

Acquiring a controlling stake in an established company, often using leverage (LBO), to improve operations and exit at a profit via sale or IPO.

Investing in early-stage, high-growth private companies in exchange for equity, accepting high failure rates for potentially large returns on winners.

Exposure via physical assets, futures, or commodity-linked products. Returns come from price changes, the roll yield, and collateral yield rather than income.

Contango: futures price > spot (upward-sloping curve), producing a negative roll yield. Backwardation: futures price < spot, producing a positive roll yield.

Direct ownership, mortgages, REITs (publicly traded property companies), and real estate limited partnerships; each differs in liquidity, leverage, and management.

A real estate investment trust that owns or finances income-producing property; it must distribute most of its taxable income to shareholders and trades like a stock.

Investing in long-lived public-use assets (toll roads, utilities, airports). Cash flows are typically stable, inflation-linked, and have low correlation with other assets.

The extra expected return investors demand for holding assets that cannot be sold quickly without a price concession; common in private equity and real estate.

Indices that drop failed funds overstate average returns because only surviving (better-performing) funds remain, biasing reported performance upward.

When a fund joins an index, its strong past returns are added retroactively, inflating the index's historical performance.

A time during which hedge fund investors cannot redeem their capital; a related notice/gate provision limits how quickly investors can withdraw.

The share of profits (typically ~20%) paid to private equity or hedge fund general partners as a performance incentive, after returning capital to limited partners.

Buying the securities of companies in or near bankruptcy at deep discounts, aiming to profit from restructuring or recovery; a high-risk hedge fund/PE strategy.

The pattern where a PE fund shows early negative returns (fees and write-downs) before investments mature and returns turn positive later in the fund's life.

Potential for higher returns and, importantly, low correlation with traditional stocks and bonds, improving portfolio diversification. They add liquidity and valuation risk.

Many alternatives are illiquid and infrequently traded, so reported values rely on estimates/appraisals, smoothing returns and understating true volatility and correlations.

A hedge fund strategy holding long positions in undervalued stocks and short positions in overvalued stocks to profit from relative performance and reduce market exposure.

A hedge fund strategy taking directional bets on macroeconomic trends across currencies, rates, commodities, and equities, often using significant leverage.

A hedge fund strategy profiting from corporate events such as mergers (merger arbitrage), restructurings, or spin-offs.

Total return = spot price return + roll yield (from rolling futures) + collateral yield (interest on margin/collateral).

Because of limited transparency and regulation, investors must assess the manager, strategy, valuation methods, leverage, liquidity terms, and operational controls carefully.

In private equity, investors commit capital that the fund 'calls' (draws down) over time as it finds investments, rather than receiving it all upfront.

E(Ri) = Rf + βi × (Rm − Rf), the risk-free rate plus beta times the market (equity) risk premium. It prices an asset's systematic risk.

A measure of an asset's systematic (non-diversifiable) risk relative to the market. The market's beta is 1.0; beta > 1 is more volatile than the market, beta < 1 less.

β = covariance of the asset with the market ÷ variance of the market = (ρ × σi × σm) ÷ σm² = ρ × (σi ÷ σm).

Systematic (market) risk affects all assets and cannot be diversified away; unsystematic (firm-specific) risk can be eliminated through diversification.

A graph of expected return versus beta from the CAPM. Assets above the SML are undervalued; assets below it are overvalued.

Plots expected return against total risk (standard deviation) for efficient portfolios combining the risk-free asset and the market portfolio. Its slope is the market Sharpe ratio.

Combines a risk-free asset with a risky portfolio; its slope is the Sharpe ratio. The optimal CAL is tangent to the efficient frontier.

The set of portfolios offering the highest expected return for each level of risk (or lowest risk for each return). Rational investors choose portfolios on it.

The weighted average of the expected returns of its assets: E(Rp) = Σ wi × E(Ri), where wi are the portfolio weights.

Variance = w1²σ1² + w2²σ2² + 2w1w2ρ1,2σ1σ2. Lower correlation between assets reduces portfolio variance more strongly.

Combining assets with correlation less than +1 lowers portfolio risk below the weighted average of individual risks; the lower the correlation, the greater the benefit.

Maximum diversification occurs at a correlation of −1 (risk can theoretically be eliminated); a correlation of +1 offers no diversification benefit.

The governing document that defines a client's objectives and constraints; it guides portfolio decisions and serves as a benchmark for evaluation.

Return objective states the required/desired return; the risk objective covers risk tolerance — both the ability (capacity) and willingness to bear risk.

Liquidity, Time horizon, Taxes, Legal/regulatory, and Unique circumstances (mnemonic 'TTLLU' or 'LLTUT'). They shape the feasible portfolio.

Ability depends on financial capacity (wealth, horizon, goals); willingness reflects attitude. When they conflict, advisers generally use the lower of the two and educate the client.

Planning (set the IPS), execution (asset allocation and security selection), and feedback (monitoring, rebalancing, and performance evaluation).

Strategic allocation sets long-term target weights based on the IPS; tactical allocation makes short-term deviations to exploit perceived market opportunities.

The assumption that investors prefer less risk for a given return and require higher expected return to take on more risk; it underlies the upward-sloping efficient frontier.

Investor utility increases with return and decreases with risk, scaled by risk aversion; the optimal portfolio is where the highest indifference curve touches the CAL.

(Rp − Rf) ÷ σp, excess return per unit of total risk. It is used to rank portfolios, including non-diversified ones.

(Rp − Rf) ÷ βp, excess return per unit of systematic risk. Best for well-diversified portfolios where unsystematic risk has been removed.

Rp − [Rf + βp(Rm − Rf)], the portfolio's return in excess of its CAPM-required return. Positive alpha indicates outperformance on a risk-adjusted basis.

A theoretical portfolio of all risky assets weighted by market value; in CAPM it is the only efficient risky portfolio investors should hold.

An asset with a certain return and zero standard deviation (and zero correlation with risky assets); combining it with risky assets forms the CAL.

Studies how cognitive errors and emotional biases cause investors to deviate from rational decisions, challenging traditional finance's rational-investor assumption.

Cognitive errors are faulty reasoning (anchoring, framing, availability) and are correctable with information; emotional biases (loss aversion, overconfidence) are harder to fix and must be managed.

The tendency to feel losses more strongly than equivalent gains (roughly twice as much), which can cause investors to hold losers too long and sell winners too early.

Investors overestimate their knowledge or forecasting ability, leading to excessive trading, under-diversification, and underestimation of risk.

Investors follow the crowd rather than their own analysis, which can drive asset bubbles and crashes and momentum effects.

Periodically adjusting portfolio weights back to strategic targets after market moves; it enforces a buy-low/sell-high discipline and controls risk drift.

Allocating a portfolio's total risk tolerance among asset classes or strategies to ensure risk is taken where it is most expected to be rewarded.

Most unsystematic (firm-specific) risk can be diversified away with roughly 20-30 well-chosen stocks; beyond that, the marginal benefit diminishes.