Changes to the Level II CFA curriculum in 2017 are heavily focused on Derivatives, a topic that has been entirely rewritten. However there are also two new readings on Portfolio Management (yes, in addition to the three new PM readings in 2016), and the Commodities chapter in Alternative Investments has been rewritten with a big focus on derivatives, mostly commodity futures.
Financial Reporting & Analysis has seen the reading on the analytical framework rewritten, plus the first two readings (inventories, long-lived assets) dropped altogether. Equity has also lost two short readings, on Porter’s Five Forces and “Your Strategy”. Readings in a few other topics have had minor, mostly cosmetic, updates too. For good measure, the reading on Credit Default Swaps has shifted from Derivatives to Fixed Income, fitting in as it does with Credit Analysis Models.
The list and sequence of Study Sessions has been updated: FRA (without the first two chapters) has dropped from three Study Sessions to two, with Derivatives falling from two to one. Portfolio Management has grown from one to two, and Alternative Investments has moved to the end of the Asset Valuation section. In total there are now 17 Study Sessions instead of 18, but don’t expect an easier ride.
Quite a lot to think about, so here’s the list in detail:
– Deleted: Inventories
– Deleted: Long-lived Assets
= Rewritten: Integration of Financial Statement Analysis Techniques
– Deleted: The Five Competitive Forces That Shape Strategy
– Deleted: Your Strategy Needs a Strategy
– Deleted: Forward Markets and Contracts
– Deleted: Futures Markets and Contracts
– Deleted: Option Markets and Contracts
– Deleted: Swaps Markets and Contracts
– Deleted: Interest Rate Derivative Instruments
+ Added: Pricing and Valuation of Forward Commitments
+ Added: Valuation of Contingent Claims
+ Added: Derivative Strategies
– Deleted: A Primer on Commodity Investing
+ Added: Commodities and Commodity Derivatives: An Introduction
+ Added: Measuring and Managing Market Risk
+ Added: Algorithmic Trading and High-Frequency Trading
Financial Reporting and Analysis
The good news is that the two chapters that almost entirely overlap with Level I, Inventories and Long-lived Assets, have now dropped, with FRA losing that entire Study Session.
The reading describing an analytical framework (Integration of Financial Statement Analysis Techniques) has been rewritten. Most of the content is similar with the focus being on a long-term equity investment. One of the previous case studies, the shortest, has been dropped.
The two deleted readings were both fairly simple – Porter’s Forces and Your Strategy. Their loss will save you not very much time so don’t get too excited.
This is the biggest overhaul for 2017.
Up until 2016 there were separate readings on forwards, futures, options and swaps. These have been merged into two readings, Forward Commitments and Contingent Claims.
Reading 40: Pricing and Valuation of Forward Commitments
This reading combines forwards, futures and swaps contracts. The concepts of pricing and valuing are largely along similar lines to the previous versions, so your knowledge in this area will continue to be useful.
Pricing is based on a no-arbitrage concept (lots of cash flow descriptions here), with the basic forward/future price being the old familiar Forward/future price = spot plus costs of carry minus benefits of carry. Valuation of forward contracts is presented in a clear logical way: present value of new minus original contract prices.
Lots of examples are presented: equities, interest rates (yes it’s those forward rate agreements), fixed income and currencies.
Swaps are presented using similar calculations to the previous version, though the valuation of swaps is a little simpler. Interest rate, currency and equity swaps are all covered.
Reading 41: Valuation of Contingent Claims
This chapter focuses mostly on options, but also includes variations such as caps, floors and swaptions.
No-arbitrage and the law of one price are the fundamental building blocks for option pricing. The binomial model is presented using one and two-period structures. Although the description is a little different, the results are the same as what you saw last year, with many links to put-call parity. American-style options are given more consideration than before. Interest rate options are covered briefly too, though in less depth.
Black-Scholes-Merton is a different story. Instead of last year’s lip-service (a solitary LOS on the assumptions), BSM is now described thoroughly. Don’t worry about the algebra of the normal distribution, the top-level equation is what you need. Looking at option pricing as a combination of the underlying and a bond, BSM presents a description of how these two fit together with different underlying instruments. The Black model is used for options on futures, forwards and interest rates, and is considered in similar fashion to BSM.
Swaptions fall into this reading now. Although considered lightly, the Black model rears its head again.
The option Greeks get quite a bit more analysis than before, especially gamma and vega. Vega is linked to implied volatility and the level of the VIX index.
Reading 42: Derivative Strategies
Some of the Derivative Strategies reading will be familiar from last year: covered calls and protective puts, plus synthetic positions using put-call parity. Many more equivalences are presented now, along with techniques for risk management using various derivative contracts. If you understood the previous two readings, this section is a logical extension. Covered calls and protective puts are analysed from a number of angles – investment objectives and strategies, as well as a collar combination.
The next part of the reading has come down from Level III: using options to create bull and bear spreads, calendar spreads, and straddles. The reading ends with analysis of different objectives and techniques – when do you use each strategy?
Alternative Investments – Commodities and Commodity Derivatives: An Introduction (Reading 46)
Compared to the previous reading, dropped this year, you will learn all about the energy, mining, livestock and softs markets. If you have a farming background, your time has come. Commodity derivatives are heavily affected by the nature of the underlying assets – are they seasonal, storable, affected by the weather?
The commodity futures market is described – who the participants are, and what their respective objectives are. Pricing can be contango or backward, linking to supply and demand. The returns on futures contracts are broken down, similarly to last year, and various theories on pricing are presented, again mostly familiar.
Two new sections are introduced to end the reading: commodity swaps (don’t worry, no complex calculations), and commodity indices. Sorry – indexes.
As mentioned above, two new readings have pushed Portfolio up from one to two Study Sessions – expect a broader coverage in your Level II exam.
Reading 49: Measuring and Managing Market Risk
Measuring market risk is an essential forerunner to managing that risk.
We begin with value at risk, or VaR, including calculating and interpreting the figures. VaR can be estimated from parameters (e.g. assuming a normal distribution), from historic data or from Monte Carlo simulation.
A variety of sensitivity risk measures are discussed – many of these should be fully familiar to you: beta for equity; duration and convexity for bonds; and delta, gamma and vega for options. In fact the Greeks lead to some calculations that we have not met in the Derivatives section.
Three types of risk measure – VaR, sensitivity and scenario – are compared, with the reading wrapping up with applications that may suit the various market participants, and constraints that may apply.
Reading 52: Algorithmic Trading and High-Frequency Trading
Here is a trend that is worthy of mention: computers instigating trades!
Ok it’s been around for a while, and automated trading has been blamed for all sorts of evils, from market crashes and front-running to generally just putting mere mortals (quite literally) at a disadvantage to machines.
Algorithmic trading takes two forms. Execution algorithms are methods of doing big trades without anyone noticing. The large order is broken down into lots of small trades and fed into the market according to various algorithms. High-frequency trading attempts to get an advantage over other algorithms (and, of course, people) though speed of analysis and order execution. If your machine gets to the market a millionth of a second before the next machine, you win the prize. The speed can be applied to comparing different markets, identifying small mis-pricings, or just responding to news items at the speed of light. In fact the speed of light is itself a consideration, with some firms having algorithms hosted on the exchange’s premises to be as close as possible. The lethargy of those pesky electrons.
Algo trading and HFT are then considered from evolutionary, risk management, regulatory, and market impact viewpoints.
To wrap up, 2017 brings significant updates to your Level II curriculum, though it’s not all new content. The inclusion of derivative contracts within new Alternative and Portfolio readings has led us at Quartic to re-sequence our Education and online classes. You will find they follow a clear logic, almost exactly following Study Session sequence now.
All of the Quartic materials are being fully updated to reflect the new content, and of course as a candidate you have the full 2017 CFA curriculum.