2017 Level II Formulas

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Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute.
Reproduced and republished with permission from CFA Institute. All rights reserved.
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 Comments and Instructions
This document is a compilation of what I believe are the most important formulas for Level II. It
does not list the facts which you must know in order to clear the exam. These facts are covered in
our Level II crash course which is available for sale.

No formula sheet can be 100% comprehensive. This formula sheet is no exception. However, it can
serve as a good starting point. Print this document and add your notes/comments. Specifically,
after every practice test look at this sheet and add formulas or comments which you think will be
helpful. This document might start out as an IFT formula sheet but it should end up with many of
your notes. If you have suggestions for improving this document please write to us at:
support@ift.world

Do a lot of practice over the last few days and good luck on your exam.

Regards,
Arif Irfanullah, CFA

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 Quant (1/3)
Correlation H0: ρ = 0 versus Ha: ρ ≠ 0

Regression Confidence interval for

regression coefficients

Yi = b0 + b1Xi + εi, i = 1, ..., n

Prediction interval for

sf = Standard deviation of prediction error
regression equation:

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 Quant (2/3)
SEE = Square root of mean square error.

Use the F-test to test: H0 : b1 = b2 = … = bk = 0

against the alternative hypothesis that at
least one slope coefficient is not equal to 0.

Test for serial correlation: DW ≈ 2 (1 – r)

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 Quant (3/3)

Test whether the autocorrelations of the error term (error autocorrelations) differ significantly from 0.
H0: error autocorrelation at a specified lag equals 0
Standard error of the residual correlation = 1 / 𝑇 where T is the number of observations
Test-stat = residual autocorrelation / standard error

𝑏0
Consider an AR(1) model: xt = b0 + b1xt-1 + εt Mean-reverting level is given by: xt =
(1 −𝑏1)

Example of first differencing:

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 Econ (1/2)
Ask = 1 / Bid

Covered
interest rate Forward points represent the difference
parity between the forward rate and the spot rate.

Uncovered interest rate parity: Expected % change in spot rate (P/B) ≈ ip - iB

Ex ante purchasing power parity: Expected % change in spot rate (P/B) ≈ ∏p - ∏B

International Fisher relationship: ip - iB = ∏p - ∏B

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 Econ (2/2)

A is the total factor

P represented aggregate price (value) of
productivity
stocks; E represents aggregate earnings
Labor productivity:

Growth accounting:

Growth rate in potential GDP = Long-term growth rate of labor force + Long-term growth rate in labor productivity

Neo-classical model: ϴ is growth rate of TFP

α is the share of GDP paid out to the
suppliers of capital
n is the growth rate of labor

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 FRA (1/2)
Equity method: Value of investment = beginning value + share of profits – share of dividends

Acquisition method:
Partial goodwill = fair value of the acquisition - acquirer’s share of the fair value of acquiree’s net assets
Full goodwill = fair value of the entity as a whole - the fair value of all acquiree’s assets and liabilities

Funded status (net liability) = present value of defined benefit obligation – fair value of plan assets

Total periodic pension cost = contributions + (ending funded status – beginning funded status)

Under US GAAP actuarial gains and losses have two components:

1. Actual return – (plan assets × expected return)
2. Changes in a company’s pension obligation arising from changes in actuarial assumptions

Under IFRS: Net return on plan assets = actual return – (plan assets × interest rate)
Actuarial gains and losses = changes in a company’s pension obligation arising from changes in actuarial
assumptions

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 FRA (2/2)
Category Measures Example Activity Ratios Numerator / Denominator

Activity ratios Efficiency Revenue / Assets Inventory turnover Cost of good sold / Average
inventory
Liquidity ratios Ability to meet its short Current Assets /
Days of inventory on Number of days in period /
term obligations Current Liabilities
Hand Inventory turnover
Solvency Ability to meet long Assets / Equity
ratios term debt obligations 1) Name tells you balance sheet item
Profitability Profitability Net Income / 2) Balance sheet item income statement item
ratios Assets 3) Income statement item in the numerator
Valuation Quantity of an asset or Earnings / Number 4) Average value of balance sheet number in
ratios flow per share of Shares denominator

ROE = Return on assets × Leverage = Net profit margin × Asset turnover × Leverage
ROE = EBIT margin × Tax burden × Interest burden × Asset turnover × Leverage

Balance sheet accruals ratio for time t = (NOAt - NOAt -1) / [(NOAt + NOAt-1)/2]
Cash flow accruals ratio for time t = [NIt - (CFOt + CFIt)]/[(NOAt + NOAt-1)/2]

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 Corporate Finance (1/3)
Capital Budgeting Comparing projects with unequal lives:
LCM and EAA
Initial outlay for new investment
Outlay = FCInv + NWCInv NPV of project with real option = NPV based on DCF along +
value of option – cost of option
Initial outlay for replacement project
Economic Income = Cash Flow + Change in Market Value
Outlay = FCInv + NWCInv – Sal0 + T(Sal0 – B0)

Economic Profit = NOPAT - $WACC

Annual after-tax operating cash flow
CF = (S – C)(1 – T) + TD
MVA = PV of economic profit
Terminal year after-tax non-operating cash flow
Residual Income = Net Income – Equity Charge
TNOCF = SalT + NWCInv – T(SalT – BT)

Link between nominal rate, real rate and inflation:

1 + n = (1 + r) (1 + Inflation)

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 Corporate Finance (2/3)
Capital Structure Dividend and Share Repurchase

rWACC = wdrd + were Impact on share price of different tax rates:

Prop 1 and 2 with NO taxes:

VL = VU
Double taxation:
re = r0 + (r0 –rd) D/E
Effective Tax Rate = Corporate Tax Rate + (1 – corporate tax
rate)(individual marginal tax rate on dividends)
Prop 1 and 2 with taxes:
VL = VU + tD Stable dividend policy:
re = r0 + (r0 – rd) (1 – t) D/E Expected increase in dividends = Increase in earnings × Target
payout ratio × Adjustment factor
Residual dividend policy:
Static tradeoff theory Dividend = Earnings – (Capital budget × Equity percent in
VL = VU + TD - PV (Cost of Financial Distress) capital structure)

FCFE coverage ratio = FCFE / (dividends + share repurchases)

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 Corporate Finance (3/3)
Mergers and Acquisitions

Securities Offering
Exchange ratio: number of shares of acquirers stock per
target share; Cost = exchange ratio x number of shares of
target x value of stock given to target shareholders

HHI: If post-merger HHI is between 1,000 and 1,800 and

change in HHI is 100+ then government might challenge
merger; If post-merger HHI is greater than 1,800 and change
in HHI is 50+ then government will challenge merger.

Comparable company analysis: PRM = (DP – SP)/SP

Bid valuation:
Target Shareholder’s Gain = Premium = PT – VT
Acquirer’s Gain = Synergies – Premium
VA* = VA + VT + S – C

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 Equity (1/4)
VE – P = VE – P + V – V = (V – P) + (VE – V)
E(Ri) = RF + βi [E(RM) – RF]
Adjusted beta = (2/3) (Unadjusted beta) + (1/3) (1.0)
ri = RF + βimkt RMRF + βisize SMB + βivalue HML
ri = RF + βimkt RMRF + βisize SMB + βivalue HML+ βiliq LLQ
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Macroeconomic multifactor model
ri = T-bill rate
+ (Sensitivity to confidence risk × 2.59%)
− (Sensitivity to time horizon risk × 0.66%)
− (Sensitivity to inflation risk × 4.32%)
+ (Sensitivity to business-cycle risk × 1.49%)
+ (Sensitivity to market-timing risk × 3.61%)
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 Equity (2/4)
FCFF = NI + Dep + Int(1 – Tax rate) – FCInv – WCInv
WCInv = Change in working capital, excluding cash and short term debt
FCInv = Change in gross fixed assets
FCFF = CFO + Int(1 – Tax rate) – FCInv If interest is not categorized in CFO then do not add back.

NI = (EBIT – Int) (1 – Tax rate) = EBIT(1 – Tax rate) – Int(1 – Tax rate)
FCFF = EBIT(1 – Tax rate) + Dep – FCInv – WCInv
FCFF = (EBITDA – Dep)(1 – Tax rate) + Dep – FCInv – WCInv
FCFF = EBITDA (1 – Tax rate) + Dep (Tax rate) – FCInv – WCInv
FCFE = FCFF - Int(1 – Tax rate) + Net Borrowing
FCFE = NI + NCC – FCInv – WCInv + Net Borrowing

Value of firm = Value of operating assets + Value of non-operating assets

Equity value = Firm value – Market value of debt
Enterprise Value / EBITDA

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 Equity (3/4)
Residual income = Net income – (Equity capital x Cost of equity)
Residual income = EBIT (1 – Tax rate) – (Total capital x WACC)

EVA = NOPAT – (C% x TC) NOPAT and TC are adjusted

MVA = Market Value – Book Value

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 Equity (4/4)
Leading Price / Earnings P0 = E0 (1+I) / (r−I)

P0 = E0 (1+λI) / (r − λI) = E1 / (r − λI)

Trailing Price / Earnings
P0 = E1 / (ρ + (1−λ)I) and P0/E1 = 1 / (ρ + (1−λ)I)

Price / Book

Price / Sales

Discount due to lack of control:

Trailing D/P = 4 x most quarterly divided / Price DLOC = 1 − *1 / (1 + Control premium)]

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 FIS (1/5)
Forward Pricing Model: P(T* + T) = P(T*)F(T*,T)

Relationship between spot rate and forward rates: (1+xS0)x = (1 + 1s0)(1 + 1f1)(1 + 1f2)…(1+1fx-1)

Forward Rate model:

Cox-Ingersoll-Ross (CIR) Model:

Vasicek model: dr = a(b – r)dt + ςdz  

Value of callable bond = Value of straight bond – Value of issuer call option

Value of issuer call option = Value of straight bond – Value of callable bond

Value of putable bond = Value of straight bond + Value of investor put option

Value of investor put option = Value of putable bond – Value of straight bond

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 FIS (2/5)

Conversion value = Underlying share price × Conversion ratio

Market conversion premium per share = Market conversion price – Underlying share price
Market conversion price = convertible bond price / conversion ratio
Premium over straight value = (convertible bond price / straight value) - 1

Value of convertible bond = Value of straight bond + Value of call option on the issuer’s stock

Value of callable convertible bond = Value of straight bond + Value of call option on the issuer’s stock – Value of
issuer call option

Value of callable putable convertible bond = Value of straight bond + Value of call option on the issuer’s stock –
Value of issuer call option + Value of investor put option

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 FIS (3/5)
Expected loss = Probability of default x Loss given default

Holding equity is economically equivalent to

owning a European call option on the
company’s assets with a strike price of K.

Owning the company’s debt is economically

equivalent to owning a riskless bond that pays
K dollars with certainty at time T, and
simultaneously selling a European put option
on the assets of the company with strike price
K and maturity T.

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 FIS (4/5)

Credit Spread = yD(t,T) – yP(t,T) = E(Percentage loss) + Liquidity premium

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 FIS (5/5)
Payout ratio = 1 – Recovery rate (%) Payout amount = Payout ratio x Notional Amount

Expected Loss = PD x LGD

Upfront payment = present value of protection leg – present value of premium leg

Present value of credit spread = Upfront premium + Present value of fixed coupon
Upfront premium ≈ (Credit spread – Fixed coupon) x Duration
Credit spread ≈ (Upfront premium/Duration) + Fixed coupon
Price of CDS in currency per 100 par = 100 – Upfront premium %
Upfront premium % = 100 – price of CDS in currency per 100 par

Profit for the protection buyer = Change in spread in bps x Duration x Notional amount
Percentage change in CDS price = change in spread in bps x Duration

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 Derivatives (1/6)
If underlying has no cash flows: F = S × (1 + r)T

If underlying has cash flows: F = S (1 + r)T + Future Value of Costs – Future Value Benefits

F = Future value of underlying adjusted for carry cash flows = FV (S0 + θ0 - γ0) where θ0 represents
present value of costs at time 0 and γ0 represents present value of benefits at time 0.

Vt = Present value of difference in in forward prices

F0 T  S0e c
r T
Using continuous compounding:

1+ 𝐿0 ℎ+𝑚 ×𝑡ℎ+𝑚
FRA(0,h,m) = ( − 1)/𝑡𝑚
1+ 𝐿0 ℎ ×𝑡ℎ

𝐹𝑅𝐴 𝑔,ℎ−𝑔,𝑚 −𝐹𝑅𝐴 0,ℎ,𝑚 𝑡𝑚

FRA value per unit of notional principal is 𝑉𝑔 0, 𝑕, 𝑚 =
1+𝐷𝑔 ℎ+𝑚−𝑔 𝑡ℎ+𝑚−𝑔

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 Derivatives (2/6)
Fixed-income forward or futures price :
𝐹0 𝑇 = 𝐹𝑉0,𝑇 𝐵0 𝑇 + 𝑌 + 𝐴𝐼0 ) − 𝐴𝐼𝑇 − 𝐹𝑉𝐶𝐼0,𝑇
The quoted price which includes the conversion factor is: 𝑄𝐹0 𝑇 = 𝐹0 (𝑇)/𝐶𝐹 𝑇

𝐵0 𝑇 + 𝑌 is the quoted price observed at Time 0 for a fixed-rate bond that matures at time T + Y, 𝐴𝐼0 is the accrued interest
at Time 0, 𝐴𝐼𝑇 is the accrued interest at Time T and 𝐹𝑉𝐶𝐼0,𝑇 is the coupons paid over the life of the futures contract.

𝑉𝑡 𝑇 = 𝑃𝑉𝑡,𝑇 (𝐹𝑡 𝑇 − 𝐹0 𝑇 )

Currency contracts:
𝐹0 𝑇 = 𝑆0 (1 + 𝑟𝑝 )𝑇 /(1 + 𝑟𝑏 )𝑇
where, 𝑟𝑝 is the interest rate in the price currency and 𝑟𝑏 is the interest rate in the base currency
𝑉𝑡 𝑇 = 𝑃𝑉𝑡,𝑇 (𝐹𝑡 𝑇 − 𝐹0 𝑇 )

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 Derivatives (3/6)
Interest rate swap:
1 − 𝑑𝑛
Swap fixed rate: 𝑟𝐹𝐼𝑋 = where, 𝑑𝑖 is the discount factor of the given period.
𝑑1 +𝑑2 +𝑑3+ …+𝑑𝑛

Swap value: 𝑉 = 𝑁𝐴 𝐹𝑆0 − 𝐹𝑆𝑡 𝑑1 + 𝑑2 + 𝑑3 + ⋯ + 𝑑𝑛

Currency swaps:
𝐹𝐵𝑘 = 𝑁𝐴𝑘 (𝑟𝐹𝐼𝑋,𝑘 𝑑1 + 𝑑2 + 𝑑3 + ⋯ 𝑑𝑛 + 𝑑𝑛 ) where, k represents the currency.
𝑉𝑎 = 𝐹𝐵𝑎 − 𝑆𝑡 𝐹𝐵𝑏 where, FB is the fixed-rate bond value in its own currency and 𝑆𝑡 is the exchange
rate at Time t.

Equity swaps:
Vt = FBt(C0) – (St/St–)NAE – PV(Par – NAE) where FBt(C0) denotes the Time t value of a fixed-rate bond
initiated with coupon C0 at Time 0, St denotes the current equity price, St– denotes the equity price
observed at the last reset date, NA denotes the notional amount and PV() denotes the present value
function from Time t to the swap maturity time.

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 Derivatives (4/6)
Exercise value: cT = Max(0, ST – X) pT = Max(0, X – ST) BSM Model (no carry benefit):
𝑐+ − 𝑐− c = SN(d1) – e–rTXN(d2)
For call options, hedge ratio, h =
𝑆+− 𝑆−
p = e–rTXN(–d2) – SN(–d1)
c = hS + PV(–hS– + c–) = hS + PV(–hS+ + c+)

𝑝 + − 𝑝−
BSM Model (with carry benefit):
For put options, hedge ratio, h = ≤0 c = Se–γTN(d1) – e–rTXN(d2)
𝑆+− 𝑆−
p = hS + PV(–hS– + p–) = hS + PV(–hS+ + p+) p = e–rTXN(–d2) – Se–γTN(–d1)

Using the expectations approach: Currency call option:

c = PV*πc+ + (1 – π)c–] and
p = PV*πp+ + (1 – π)p–]
π = the risk-neutral probability of an up move
= (1 + r – d) / (u – d)
Expectations approach and 2-period model:
c = PV*π2c++ + 2π(1 – π)c+– + (1 – π)2c– –]
p = PV*π2p++ + 2π(1 – π)p+– + (1 – π)2p– –]
c = Se− rf TN(d1 ) - e–rTXN(d2)
S is the currency exchange rate, rf is risk-free rate in the base currency
and r is the risk-free rate in the price currency.
Replicating strategy cost = nSS + nBB
For calls: nS = N(d1) > 0, and nB = –N(d2) < 0
For puts: nS = –N(–d1) < 0 and nB = N(–d2) > 0
The price of the zero-coupon bond is B = PV(X) = e–rTX

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 Derivatives (5/6)
When underlying instrument is a futures contract:
c = e–rT[F0(T)N(d1) – XN(d2)]; p = e–rT[XN(–d2) – F0(T)N(–d1)] F0(T) = the futures price at Time 0 that expires at Time T.

Futures option put–call parity: c = e–rT[F0(T) – X] + p

Interest rate options: c = (AP)e−rT [FRA(0, tj−1, tm) N(d1) − RXN(d2)]. AP = Accrual period; for 90-day Libor the AP is
90/360. FRA(0,1,0.25) = FRA rate at Time 0 that expires at Time 1 and is based 0.25 year Libor, R X= Exercise rate

Payer swaption for $1 notional amount: PAYSWN = (AP)PVA[RFIXN(d1) – RXN(d2)]

Receiver swaption for $1 notional amount: RECSWN = (AP)PVA[RXN(–d2) – RFIXN(–d1)]
AP stands for the accrual period. PVA refers to the present value of an annuity.
RFIX is the market swap fixed rate at expiration of the option. RX is the exercise rate.

Option deltas for calls: Deltac = e–δTN(d1). For puts: Deltap = – e–δTN(–d1); δ is the dividend yield on the underlying.
New value of call ≅ c + Deltac (Ŝ − S) ; new value of put ≅ p Deltap (Ŝ − S). Ŝ represent new value the stock.
− Original Portfolio delta
Number of units of the hedging instruments, NH =
𝐷𝑒𝑙𝑡𝑎𝐻
𝑒 −𝛿𝑇
Gammac = Gammap = 𝑛(𝑑1 )
𝑆𝜎 𝑇

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 Derivatives (6/6)
Covered call: short call + stock
• Maximum gain = (X – S0) + c0
• Maximum loss = S0 – c0
• Breakeven point = S0 – c0
• Expiration value = ST – Max[(ST – X),0]
• Profit at expiration = ST – Max[(ST – X),0] + c0 – S0
Protective put: stock + long put
• Maximum profit = ST – S0 – p0 = Unlimited
• Maximum loss = S0 – X + p0
• Breakeven point = S0 + p0
• Expiration value = Max(ST,X)
• Profit at expiration = Max(ST,X) – S0 – p0
Long N shares and short N ATM call options = long
N shares and short forward position on N/2 shares
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Bull spread: buy call option with low exercise price and sell call
option with high exercise price.
Max profit: XH - XL - (cL – cH); Breakeven: XL + (cL – cH)
Bear spread: buy put option with high exercise price and sell put
option with a low exercise price.
Max profit: XH - XL – cost; Breakeven: XH - (pH – pL)
Long calendar spread: sell near-dated call, buy long-dated call
Short calendar spread: sell long-dated call, buy near-dated call
Long straddle: buy put, buy call; Short straddle: sell put, sell call
Long straddle strategy has two breakeven point:
• Exercise price + cost of buying the call and put options
• Exercise price - cost of buying the call and put options
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 Alternative Investments (1/2)
Value = NOI / Cap rate Value = GIM x Gross Income
“All risk yield” = cap rate
Debt service coverage ratio = first year NOI / debt service
Cap rate = Discount rate - Growth rate
Loan to value ratio = loan amount / value

V5 = NOI6 / (r – g)

FFO is accounting net earnings excluding:
1. Depreciation charges on real estate
2. Deferred tax charges (deferred portion of tax
expenses)
3. Gains/losses from sale of property and debt
Restructuring
NAV = Estimated value of operating real estate + cash and A/R
– debt and other liabilities
NAVPS = NAV / # of shares outstanding
NAVPS = FFO/share x P/FFO multiple

AFFO = FFO - straight line adjustment – recurring NAVPS = AFFO/share x P/AFFO multiple
maintenance type capital expenditures and leasing
commissions Can value REIT share

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 Alternative Investments (2/2)
Venture capital valuation method:
1. Post-Money Valuation POST = V/(1 + r)t
2. Pre-Money Valuation PRE = POST−I
3. Ownership Fraction F = I/POST
4. Number of Shares y = x * F / (1−F) +
5. Price of Shares P1 = I/y

Hedge fund return = Alpha + Risk free rate + 𝑖 𝐵𝑒𝑡𝑎𝑖 𝑥 𝐹𝑎𝑐𝑡𝑜𝑟𝑖

Futures price = spot price + direct storage costs - convenience yield

Total return on a commodity futures position = price return + roll return + collateral return

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 Portfolio Management (1/3)
E R p = R F + λ1 βp ,1 + ⋯ + λK βp ,K

E R p = R F + βp ,1 RMRF + βp ,2 SMB + βp ,3 HML + βp ,4 WML

Active Return: RA = RP – RB Active Weight: Δwi = wP,i – wB,i RA = ∑ΔwiRAi

K
Active return = j=1 Portfolio sensitivity j − Benchmark sensitivity j ∗ Factor return j + Asset selection

R A = (Δwstocks R B ,stocks + Δwbonds R B ,bonds ) + (wP ,stocks R A ,stocks + wP ,bonds R A ,bonds )

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 Portfolio Management (2/3)
Rp −RB
IR = Active return / Active risk =
s Rp −RB

R Ai μi μi
IR IC = COR , TC = COR
STD R A = STD R B ∗ σi σi σi , Δwi σi
SR B

SR2P = SR2B + TC 2 IR∗ 2

E RA ∗ = IC BR σA IR = IC BR

E R A ICR = TC ICR BR σA

Risk premium = Yield on the nominal bond – yield on real bond – inflation expectation

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 Portfolio Management (3/3)
Using the parametric method:
1% VaR = (Expected Return – 1.65 ς) (-1) (Notional Amount)
5% VaR = (Expected Return – 2.33 ς) (-1) (Notional Amount)

Bond price (B) sensitivity to changes in yield (y) can be expressed in terms of duration (D) and convexity (C):

∆𝐵 ∆𝑦 1 ∆𝑦 2
≈ −𝐷 + 𝐶 2
𝐵 1+𝑦 2 1+𝑦

Option price sensitivity to changes in value of underlying:

𝐶𝑕𝑎𝑛𝑔𝑒 𝑖𝑛 𝑣𝑙𝑎𝑢𝑒 𝑜𝑓 𝑜𝑝𝑡𝑖𝑜𝑛 𝐶𝑕𝑎𝑛𝑔𝑒 𝑖𝑛 𝑑𝑒𝑙𝑡𝑎

∆𝑐 𝐷𝑒𝑙𝑡𝑎 = 𝐺𝑎𝑚𝑚𝑎 =
𝐶𝑕𝑎𝑛𝑔𝑒 𝑖𝑛 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑢𝑛𝑑𝑒𝑟𝑙𝑦𝑖𝑛𝑔 𝐶𝑕𝑎𝑛𝑔𝑒 𝑖𝑛 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑢𝑛𝑑𝑒𝑟𝑙𝑦𝑖𝑛𝑔

𝐶𝑕𝑎𝑛𝑔𝑒 𝑖𝑛 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑜𝑝𝑡𝑖𝑜𝑛

𝑉𝑒𝑔𝑎 =
𝐶𝑕𝑎𝑛𝑔𝑒 𝑖𝑛 𝑣𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑢𝑛𝑑𝑒𝑟𝑙𝑦𝑖𝑛𝑔

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Practice, Practice, Practice.

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