CFA Level II Glossary

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Binomial Option Pricing Model: Binomial option pricing model values options by constructing a discrete-time lattice of possible future underlying asset prices, calculating option values at expiration and working backward through the tree using risk-neutral probabilities. $c = \frac{\pi c_u + (1-\pi) c_d}{1+r}$
Black-Scholes-Merton Model: Black-Scholes-Merton model is a continuous-time options pricing formula for European options that derives the option value as a function of the underlying price, strike price, time to expiration, risk-free rate, and volatility. $c = S_0 N(d_1) - X e^{-rT} N(d_2)$
Bond Spread Analysis: Bond spread analysis measures the yield difference between a bond and a benchmark (typically a government bond), decomposed into components reflecting credit risk, liquidity risk, and optionality to assess relative value.

Convexity: Convexity is the second derivative of a bond's price with respect to yield divided by the bond price, measuring the curvature of the price-yield relationship and improving the accuracy of duration-based price change estimates for large yield shifts. $\text{Convexity} = \frac{1}{P} \frac{d^2P}{dy^2}$
Credit Default Swap: Credit default swap (CDS) is a derivative contract in which the protection buyer makes periodic payments to the protection seller in exchange for a contingent payment if a specified credit event (such as default) occurs on a reference entity.

DuPont Analysis (Extended): Extended DuPont analysis decomposes return on equity into five factors: tax burden, interest burden, operating profit margin, asset turnover, and financial leverage, providing granular insight into the drivers of profitability. $\text{ROE} = \frac{\text{NI}}{\text{EBT}} \times \frac{\text{EBT}}{\text{EBIT}} \times \frac{\text{EBIT}}{\text{Revenue}} \times \frac{\text{Revenue}}{\text{Assets}} \times \frac{\text{Assets}}{\text{Equity}}$

Effective Duration: Effective duration estimates the sensitivity of a bond's price to parallel shifts in the benchmark yield curve, calculated using the bond's prices under upward and downward yield shifts, and is appropriate for bonds with embedded options. $D_{\text{eff}} = \frac{P_{-} - P_{+}}{2 \cdot P_0 \cdot \Delta y}$
Enterprise Value: Enterprise value (EV) is the total value of a firm, calculated as market capitalization plus total debt plus preferred stock plus minority interest minus cash and cash equivalents, representing the theoretical takeover price. $\text{EV} = \text{Market Cap} + \text{Debt} + \text{Preferred} + \text{Minority Interest} - \text{Cash}$
Equity Method: Equity method is an accounting treatment for intercorporate investments where the investor has significant influence (typically 20-50% ownership), recording the investment at cost and adjusting for the investor's share of the investee's earnings and dividends.

Forward P/E: Forward price-to-earnings ratio is a valuation multiple calculated by dividing the current market price by the consensus estimate of earnings per share for the next twelve months, reflecting market expectations of future profitability. $\text{Forward P/E} = \frac{P_0}{E_1}$
Forward Rate Agreement: Forward rate agreement (FRA) is an over-the-counter derivative in which two parties agree to exchange interest payments based on a notional principal for a future period, with settlement based on the difference between the agreed rate and the reference rate at expiration.
Free Cash Flow to Equity: Free cash flow to equity (FCFE) is the cash flow available to common equity holders after covering operating expenses, capital expenditures, working capital needs, and debt payments. $\text{FCFE} = \text{CFO} - \text{FCInv} + \text{Net Borrowing}$
Free Cash Flow to the Firm: Free cash flow to the firm (FCFF) is the cash flow available to all capital providers (equity and debt) after accounting for operating expenses, taxes, and reinvestment needs. $\text{FCFF} = \text{EBIT}(1-t) + \text{Dep} - \text{FCInv} - \Delta\text{WC}$

Gordon Growth Model: Gordon growth model values a stock as the present value of a perpetually growing stream of dividends, assuming a constant growth rate that is less than the required rate of return. $V_0 = \frac{D_1}{r - g}$

Interest Rate Swap Valuation: An interest rate swap is valued after initiation as the difference between the present value of remaining fixed-rate payments and the present value of expected floating-rate payments, using current spot rates for discounting.

Justified P/E: Justified P/E is the theoretically correct price-to-earnings ratio derived from a fundamentals-based model, such as the Gordon growth model, reflecting the payout ratio, required return, and expected growth rate. $\text{Justified } \frac{P_0}{E_1} = \frac{1-b}{r-g}$

Multinational Operations: Multinational operations analysis involves translating foreign subsidiary financial statements into the parent's reporting currency using the current rate method or the temporal method, with translation gains and losses reported in OCI or net income respectively.

Private Company Valuation: Private company valuation applies income, market, and asset-based approaches to estimate the value of a firm whose equity is not publicly traded, typically incorporating discounts for lack of marketability and lack of control.

Residual Income Model: Residual income model values equity as book value plus the present value of expected future residual incomes, where residual income is net income minus an equity charge (required return times beginning book value). $V_0 = B_0 + \sum_{t=1}^{\infty} \frac{\text{RI}_t}{(1+r)^t}$

Securitization: Securitization is the process of pooling financial assets (such as mortgages or receivables) and issuing asset-backed securities whose cash flows are derived from the underlying pool, transferring credit risk from the originator to investors.
Structural Credit Models: Structural credit models (such as the Merton model) treat a company's equity as a call option on its assets, modeling default as occurring when asset value falls below the face value of debt at maturity.
Swap Rate: Swap rate is the fixed interest rate in an interest rate swap that equates the present value of fixed payments to the present value of expected floating payments at initiation, making the swap's initial value zero.

Two-Stage Dividend Discount Model: Two-stage DDM values a stock by separately discounting dividends during a high-growth phase and a stable-growth terminal phase, accommodating companies transitioning from above-normal to sustainable growth. $V_0 = \sum_{t=1}^{n} \frac{D_t}{(1+r)^t} + \frac{V_n}{(1+r)^n}$

Volatility Smile: Volatility smile is the pattern observed when plotting implied volatility against strike prices for options with the same expiration, showing that deep in-the-money and out-of-the-money options tend to have higher implied volatility than at-the-money options.

Weighted Average Cost of Capital: Weighted average cost of capital (WACC) is the blended required rate of return across all sources of capital, weighted by their target proportions, used to discount free cash flow to the firm. $\text{WACC} = w_d\,r_d(1-t) + w_e\,r_e$