CFA® glossary

226 terms, each written to be read cold. The same glossary is free in the app, with search.

Accrual accounting

Recognising revenue when it is earned and expenses when they are incurred, regardless of when cash moves.

Exam angle: The gap between accrual earnings and cash flow is where most accounting-quality questions live. Persistently high accruals are a warning sign.

Active share

The proportion of a portfolio’s holdings that differs from its benchmark, from 0% for an index fund to 100% for no overlap.

Exam angle: Measures how different a portfolio is; tracking error measures how differently it behaves. A high active share with low tracking error means many small off-benchmark bets that cancel.

Adverse selection

The problem that arises when the party with better information self-selects into a transaction, leaving the counterparty with the worse risks.

Exam angle: Distinct from moral hazard: adverse selection happens before the contract, moral hazard after it.

Agency problem

The conflict that arises when managers act in their own interest rather than that of the owners who employ them.

Exam angle: Also runs between shareholders and bondholders — asset substitution after a leveraged deal is the classic case.

Alpha

Return in excess of what the asset’s risk exposures would predict.

Exam angle: Alpha is defined relative to a model. Change the benchmark or add a factor and alpha frequently disappears, which is the whole argument about active management.

Annuity

A series of equal cash flows at equal intervals. An ordinary annuity pays at the end of each period; an annuity due pays at the beginning.

Exam angle: An annuity due is worth exactly (1 + r) times the ordinary annuity of the same flows — one extra period of compounding on every payment.

Arbitrage pricing theory

Also: APT

A model deriving expected returns from exposures to multiple systematic factors, assuming no arbitrage rather than a single market portfolio.

Exam angle: More general than CAPM but silent about what the factors are. That silence is both its strength and its practical weakness.

Arithmetic mean

Also: average

The sum of the observations divided by their number.

Exam angle: The right estimate of a single future period’s return. For growth already achieved over several periods, the geometric mean is the honest number.

Asset location

Deciding which account type holds which asset, so that heavily taxed returns sit in tax-sheltered accounts.

Exam angle: Distinct from asset allocation, and one of the few reliably free sources of after-tax return.

Balance sheet

Also: statement of financial position

A statement of what a company owns and owes at a single point in time.

Assets = Liabilities + Equity

Basis risk

The risk that a hedge and the exposure it hedges do not move together, leaving a residual.

Exam angle: Arises from mismatched underlying, maturity or location. A hedge is a swap of price risk for basis risk, not an elimination of risk.

Behavioural bias

A systematic departure from rational decision-making, either cognitive — an error of reasoning that education can correct — or emotional, which usually has to be accommodated.

Exam angle: The cognitive/emotional split determines the adviser’s response, and that distinction is what gets tested rather than the list of bias names.

Beta

The sensitivity of an asset’s return to the market’s return — its share of systematic risk.

β = Cov(R_i, R_m) / Var(R_m)

Exam angle: A beta above one amplifies market moves in both directions. Estimated betas are unstable and are often adjusted toward one.

Black–Scholes–Merton model

Also: BSM, Black-Scholes

A closed-form model for European option prices, assuming lognormal prices, constant volatility and continuous frictionless trading.

Exam angle: Its assumptions are known to be wrong — constant volatility most obviously, which is why the implied volatility smile exists at all.

Book value

The accounting value of equity: assets less liabilities as reported.

Exam angle: Price-to-book works best where assets are marked near fair value — banks — and worst where value is intangible.

Bootstrap

Resampling the observed data with replacement to estimate the sampling distribution of a statistic, without assuming a parametric form.

Exam angle: Distinct from bootstrapping a spot curve in fixed income, which is a different operation entirely under the same word.

Bootstrapping (yield curve)

Deriving spot rates sequentially from the prices of coupon bonds, using each solved rate to strip the next.

Exam angle: A different operation from the statistical bootstrap, which resamples data. Same word, unrelated technique.

Business cycle

The recurring pattern of expansion, peak, contraction and trough in economic activity.

Exam angle: Sector rotation questions follow directly from cycle position — defensives late, cyclicals early.

Business risk

The uncertainty in operating income arising from the nature of the business itself, before any financing decision.

Exam angle: Financial risk is what leverage adds on top. Keeping the two separate is the point of the distinction.

Call option

The right, without the obligation, to buy an asset at the strike price by expiry.

Exam angle: The buyer’s loss is capped at the premium; the naked writer’s loss is unbounded. That asymmetry drives most option exam questions.

Callable bond

A bond the issuer may redeem early, usually when rates have fallen.

Value of callable = Value of straight bond − Value of call

Exam angle: The investor is short the option, so a callable bond yields more and its upside is capped near the call price.

Capital allocation line

Also: CAL

The set of risk–return combinations available by mixing a risky portfolio with the risk-free asset.

Exam angle: Its slope is the Sharpe ratio of the risky portfolio, so the steepest CAL identifies the optimal risky portfolio for everyone.

Capital asset pricing model

Also: CAPM

A model stating that an asset’s expected return equals the risk-free rate plus beta times the equity risk premium.

E(R) = R_f + β × [E(R_m) − R_f]

Exam angle: Prices systematic risk only. Its empirical record is poor, which is why multifactor models exist — but it remains the exam’s default.

Capital budgeting

The process of deciding which long-term investments a company should make.

Exam angle: Use incremental after-tax cash flows. Sunk costs are excluded; opportunity costs and externalities are included.

Capital call

Also: drawdown

The general partner’s demand that limited partners transfer part of their committed capital.

Exam angle: Commitments are not investments. The gap between committed and drawn capital is the origin of the denominator problem and of the J-curve.

Capital structure

The mix of debt and equity a company uses to fund itself.

Exam angle: Modigliani–Miller says the mix is irrelevant without taxes, distress costs or information asymmetry. Everything interesting comes from relaxing those assumptions.

Capitalisation rate

Also: cap rate

Net operating income divided by property value — a property’s unlevered income yield.

Value = NOI / cap rate

Exam angle: Functions like the inverse of a P/E ratio. A falling cap rate means prices rising faster than income.

Carried interest

Also: carry

The general partner’s share of a private fund’s profits, typically around 20%.

Carry trade

Borrowing in a low interest rate currency to invest in a high interest rate one, profiting if the exchange rate does not move against you.

Exam angle: Returns are negatively skewed: long stretches of small gains punctuated by sharp unwinds. A textbook case of a strategy whose Sharpe ratio flatters it.

Cash conversion cycle

The time between paying for inventory and collecting cash from the customer.

CCC = Days inventory + Days receivable − Days payable

Exam angle: A negative cycle means suppliers fund the business. Retailers and marketplaces often run one.

Cash flow from operations

Also: CFO, operating cash flow

Cash generated by the core business, before investment and financing.

Exam angle: The indirect method starts at net income and adds back non-cash charges and working capital movements. Classification of interest paid differs between IFRS and US GAAP.

Central limit theorem

Also: CLT

For a large enough sample, the distribution of the sample mean approaches normal regardless of the shape of the underlying population.

Exam angle: Thirty observations is the conventional threshold. It justifies using normal-based confidence intervals on means — not on individual observations.

Code of Ethics

The aspirational statement of how members and candidates should conduct themselves. It sets the principles; the Standards of Professional Conduct are what is actually enforced.

Coefficient of determination

Also: R-squared, R2

The fraction of the dependent variable’s variation explained by the regression.

Exam angle: Never falls when a variable is added, however useless that variable is. Adjusted R² penalises extra regressors and is the honest comparison between models of different size.

Collar

Holding the underlying, buying a put and writing a call, bounding the outcome between a floor and a cap.

Exam angle: A zero-cost collar chooses strikes so the premiums offset. Nothing is free — the cost is the upside given away.

Common share

Also: ordinary share, common stock

An ownership claim on a company’s residual cash flows and assets, normally carrying a vote and ranking last in liquidation.

Composite

All portfolios managed to the same strategy or objective, grouped together for GIPS reporting.

Exam angle: Every fee-paying discretionary portfolio must be in at least one composite. That requirement is what stops a firm from showing only its winners.

Confidence interval

A range that will contain the true parameter in a stated proportion of repeated samples.

Exam angle: It is a statement about the procedure, not about this one interval. “95% probability the mean is in this range” is the classic misreading.

Contango and backwardation

Contango is a futures price above the spot price; backwardation is a futures price below it.

Exam angle: A long roll in contango loses as the contract converges to spot. This is why commodity index returns diverge so far from spot commodity prices.

Continuous compounding

Compounding over infinitely small intervals. The limit of periodic compounding as the number of periods per year goes to infinity.

FV = PV × e^(r × t)

Exam angle: The default convention in derivatives pricing and in most FRM formulas, which is why the same position can look differently priced in two parts of the curriculum.

Convexity

The curvature of the price–yield relationship — how duration itself changes as yields move.

Exam angle: Positive convexity is good for the holder: prices rise more than duration predicts and fall less. Callable bonds and MBS exhibit negative convexity as rates fall.

Core inflation

Inflation excluding food and energy prices, which are volatile and often driven by supply rather than demand.

Exam angle: Central banks watch core for the signal and headline for the mandate.

Corporate governance

The system of controls by which a company is directed and held accountable to its stakeholders.

Correlation

Also: correlation coefficient

Covariance divided by the product of the two standard deviations, giving a unit-free number between −1 and +1.

ρ = Cov(X, Y) / (σₓ × σᵧ)

Exam angle: Measures linear association only. A perfect non-linear relationship can show near-zero correlation, and correlation tends to rise sharply in a crisis — exactly when diversification was being relied on.

Cost of equity

The return equity holders require for bearing the residual risk of the business.

Exam angle: Usually estimated with CAPM, sometimes with a dividend discount rearrangement or a build-up model for private firms. All three are estimates, and they rarely agree.

Coupon rate

The annual interest a bond pays, as a percentage of par.

Exam angle: Fixed for the life of a plain vanilla bond. A floater resets against a reference rate plus a quoted margin.

Covariance

A measure of how two variables move together. Positive means they tend to move the same way; its size depends on the units of both variables.

Exam angle: Unbounded and therefore hard to interpret on its own. Correlation is covariance scaled to [−1, 1], which is why correlation is what gets quoted.

Covered call

Holding the underlying and writing a call against it, collecting the premium in exchange for capping the upside.

Exam angle: Not a hedge. It gives up the right tail to earn income and leaves the downside almost fully intact.

Credit default swap

Also: CDS

A contract in which the buyer pays a periodic premium and receives compensation if a specified borrower suffers a credit event.

Exam angle: Buying protection is economically like shorting the credit. The spread is a market-implied view of default probability and recovery together, not of default alone.

Credit spread

The extra yield a borrower pays over a risk-free benchmark of the same maturity, compensating for default and liquidity risk.

Exam angle: Widening spreads hurt even when the issuer never defaults, and spread duration measures that exposure separately from rate duration.

Currency hedging

Using forwards, futures or options to reduce a portfolio’s exposure to exchange rate movements on foreign assets.

Exam angle: The hedge ratio is a deliberate choice, not a binary. Hedging cost is driven by the interest rate differential, not by any view on the currency.

Current ratio

Current assets divided by current liabilities, a rough test of short-term solvency.

Exam angle: The quick ratio strips out inventory, which is the least liquid current asset and the one most likely to be stale.

Current yield

A bond’s annual coupon divided by its current market price — the cash income it throws off this year per unit invested.

Exam angle: Ignores any pull to par, so it overstates return on a premium bond and understates it on a discount bond.

Data mining

Also: data snooping

Searching a dataset repeatedly until a relationship appears, then presenting it as though it had been hypothesised in advance.

Exam angle: Test on out-of-sample data. A relationship with no economic rationale that only shows up after many passes is the definition of the problem.

Deferred tax

Tax arising from timing differences between accounting profit and taxable profit, recognised as an asset or a liability.

Exam angle: A deferred tax liability that never reverses behaves like equity. Analysts often reclassify it for that reason.

Delta

The change in an option’s value for a small change in the underlying price.

Exam angle: Ranges 0 to 1 for a call and −1 to 0 for a put. Roughly the hedge ratio, and loosely read as the risk-neutral probability of finishing in the money.

Delta hedging

Offsetting an option position with the underlying so the combined position is insensitive to small price moves.

Exam angle: Only holds locally and only for an instant. Gamma is precisely the reason it has to be rebalanced, and rebalancing is what costs money.

Depreciation

The systematic allocation of a tangible asset’s cost over its useful life.

Exam angle: Accelerated methods shift expense forward, lowering early income and raising later income. Useful life and salvage value are management estimates and are a standard quality-of-earnings lever.

Derivative

A contract whose value depends on the price of something else — an asset, a rate, an index or an event.

Derivatives overlay

Adjusting a portfolio’s exposures with derivatives while leaving the underlying holdings untouched.

Exam angle: Cheaper and faster than trading the physicals, and it keeps the manager’s selection intact. It introduces basis risk and a margin obligation.

Diligence and reasonable basis

The requirement that any recommendation or action rest on adequate research and analysis that could be defended if challenged.

Exam angle: Relying on a third-party model is acceptable only after making reasonable enquiries into its soundness. Delegation does not transfer the duty.

Distribution waterfall

The agreed order in which a private fund’s proceeds are shared between limited and general partners.

Exam angle: European waterfalls return all capital before any carry is paid; American ones pay deal by deal. The difference is worth a great deal to the GP and is what clawbacks correct.

Diversification

Combining imperfectly correlated assets so that portfolio risk falls below the weighted average of the individual risks.

Exam angle: The benefit comes from correlation below one, not from the number of holdings. Twenty correlated positions diversify less than five uncorrelated ones.

Dividend discount model

Also: DDM, Gordon growth model

Valuing a share as the present value of its expected future dividends.

V₀ = D₁ / (r − g)

Exam angle: Requires r > g and a dividend that actually grows at a constant rate. Extremely sensitive to the denominator — a half-point change in g can move the value by a third.

Dividend policy

How a company decides to return cash to shareholders, and in what form.

Exam angle: A cut is read as a signal about future earnings, which is why firms smooth dividends and prefer buybacks for variable returns of capital.

DuPont analysis

Decomposing ROE into its drivers — profitability, efficiency and leverage — to identify what is actually moving it.

Duration

The sensitivity of a bond’s price to a change in yield, and equivalently the weighted average time to receiving its cash flows.

Exam angle: Macaulay duration is in years; modified duration is the percentage price change per one percent yield move. Effective duration is the one to use when cash flows are not fixed.

DV01

Also: PV01, basis point value, BPV

The change in a position’s value for a one basis point change in yield, expressed in currency.

Exam angle: The practitioner’s hedging unit: hedge ratios are DV01 of the exposure divided by DV01 of the hedge. FRM uses it far more than duration.

Earnings per share

Also: EPS

Net income available to common shareholders, divided by the weighted average shares outstanding.

Exam angle: Diluted EPS assumes every in-the-money convertible, option and warrant converts. It is the conservative figure and the one that gets compared.

Earnings quality

The degree to which reported earnings are sustainable and backed by cash rather than by estimates and one-offs.

Exam angle: Standard flags: earnings persistently above cash flow, rising days sales outstanding, and repeated “non-recurring” charges.

EBITDA

Earnings before interest, tax, depreciation and amortisation — a rough proxy for operating cash generation.

Exam angle: Ignores capital intensity and working capital entirely. Two firms with identical EBITDA and very different capex are not comparable.

Effective annual rate

Also: EAR, annual equivalent rate

The rate that, compounded once a year, gives the same growth as a stated nominal rate compounded more often.

EAR = (1 + r_nominal / m)^m − 1

Exam angle: EAR rises with compounding frequency and converges on e^r − 1 under continuous compounding. Comparing two quoted rates of different frequencies without converting to EAR is a trap.

Effective duration

Duration measured by repricing the bond under small parallel shifts in the benchmark curve, so that changes in cash flows are captured.

Exam angle: The only valid duration for callable, putable and mortgage-backed bonds, where the cash flows themselves depend on rates.

Efficient frontier

The set of portfolios offering the highest expected return for each level of risk.

Exam angle: Estimated from expected returns, variances and covariances — all of which are noisy. Small input changes produce wildly different “optimal” portfolios.

Enterprise value

Also: EV

The value of the whole business regardless of how it is financed: market capitalisation plus debt and minorities, less cash.

EV = Market cap + Debt + Minority interest − Cash

Exam angle: Pair EV with pre-interest metrics such as EBITDA or EBIT; pair market cap with post-interest metrics such as net income.

Factor investing

Also: smart beta

Building portfolios around systematic return drivers — value, size, momentum, quality, low volatility — rather than around individual security selection.

Exam angle: Factor premia are long-horizon and endure long stretches of underperformance. A factor that never hurts is usually a factor that has been fitted.

Fair dealing

Treating all clients fairly when disseminating recommendations or taking investment action. Fair does not mean identical.

Exam angle: Different service levels are allowed if disclosed and available to all. What is not allowed is giving some clients a head start on a change of recommendation.

Fiduciary duty

The obligation to act in another party’s interest ahead of your own, with the care and loyalty that relationship demands.

Exam angle: Identify who the client actually is before applying it. For a pension, the duty runs to the beneficiaries, not to the company that hired you.

Financial leverage

Also: gearing

The use of debt to finance assets, magnifying returns to equity in both directions.

Fiscal policy

Government use of spending and taxation to influence aggregate demand.

Exam angle: Faster to take effect than monetary policy once enacted, but slower to enact. That asymmetry is the usual discussion point.

Forward contract

A private agreement to buy or sell an asset at a set price on a future date. Customisable, and settled once at expiry.

Exam angle: Carries counterparty risk that builds over the life of the contract, because nothing is exchanged until the end.

Forward rate

The interest rate agreed today for borrowing or lending over a future period, implied by today’s spot curve.

Exam angle: Implied forwards are break-even rates, not forecasts. A curve that implies rising rates is telling you what must happen for two strategies to tie, not what the market predicts.

Free cash flow

Also: FCF, FCFF, FCFE

Cash available after the investment needed to maintain the business. FCFF is available to all capital providers; FCFE is what remains for equity holders after debt service.

FCFF = CFO + Interest × (1 − tax rate) − CapEx

Exam angle: Discount FCFF at WACC, FCFE at the cost of equity. Mixing the two is the most common valuation error in the exam.

Free float

The portion of a company’s shares actually available to public investors, excluding strategic and locked-up holdings.

Exam angle: Index providers weight by free float so the index remains replicable.

Front-running

Trading ahead of a client order to benefit from the price move that order will cause.

Fundamental law of active management

Expected active return is a function of skill, the number of independent decisions taken, and how fully those decisions are expressed in the portfolio.

IR ≈ IC × √Breadth × Transfer coefficient

Exam angle: Breadth must be independent bets. Applying the same macro view to two hundred stocks is one decision, not two hundred.

Future value

Also: FV

What a sum invested today grows to by a stated date at a stated rate.

FV = PV × (1 + r)^n

Futures contract

A standardised, exchange-traded forward, marked to market daily through a clearing house.

Exam angle: Daily settlement is the whole difference: it strips out counterparty risk and it makes the cash flow timing different from an otherwise identical forward.

Gamma

The rate at which delta changes as the underlying moves.

Exam angle: Highest at the money and near expiry. High gamma means a delta hedge goes stale quickly and must be rebalanced more often.

General partner

Also: GP

The manager of a private fund, responsible for investment decisions and bearing unlimited liability for the partnership.

Exam angle: Limited partners commit capital and are liable only for their commitment. The split of economics between them is the fund’s central negotiation.

Geometric mean

The constant rate that would produce the observed compound growth over the whole period.

Geometric mean = [(1 + r₁)(1 + r₂)…(1 + rₙ)]^(1/n) − 1

Exam angle: Always ≤ the arithmetic mean, and strictly less whenever returns vary. The gap widens with volatility — which is why volatile strategies advertise the arithmetic figure.

GIPS

Also: Global Investment Performance Standards

Voluntary standards for calculating and presenting investment performance, designed so that a prospective client can compare firms on a like-for-like basis.

Exam angle: Compliance is claimed by the firm as a whole — never by a single composite, product or individual.

Goals-based investing

Structuring wealth into separate portfolios for separate objectives, each with its own horizon and risk tolerance, rather than one portfolio for one risk number.

Exam angle: Mentally sub-optimal by mean-variance standards and behaviourally far more durable, because clients abandon a plan they cannot connect to anything.

Goodwill

The excess of a purchase price over the fair value of the identifiable net assets acquired.

Exam angle: Not amortised; tested for impairment. A large impairment is an admission that the acquisition was overpriced.

Gross domestic product

Also: GDP

The market value of all final goods and services produced within a country in a period.

Exam angle: Final goods only. Counting intermediate output as well is double-counting, which is exactly what the value-added method exists to avoid.

Harmonic mean

The reciprocal of the average of reciprocals. Used for averaging ratios over a fixed money amount, such as the cost of shares bought at different prices.

Exam angle: Harmonic ≤ geometric ≤ arithmetic, always. Cost averaging is the standard exam application.

Hedge fund

A privately offered pooled vehicle with broad freedom over strategy, leverage and short selling.

Exam angle: A legal structure and fee model, not a strategy. “Hedge fund” says nothing about what the fund actually does.

Heteroskedasticity

Regression errors whose variance is not constant across observations.

Exam angle: Coefficients stay unbiased; the standard errors do not. So t-statistics are wrong and inference is unreliable — the fix is robust standard errors, not a different slope.

High-water mark

The highest value an investor’s holding has previously reached, above which incentive fees are charged.

Exam angle: Stops the manager charging twice for recovering the same losses. It does not stop them closing the fund and starting again.

Human capital

The present value of an individual’s expected future earnings, treated as an asset alongside their financial wealth.

Exam angle: Bond-like for a tenured professional and equity-like for a commission earner. The financial portfolio should lean against it, which is why concentration in an employer’s stock is doubly wrong.

Hurdle rate

The minimum return a fund must deliver before the manager earns an incentive fee.

Exam angle: A hard hurdle charges only on returns above it; a soft hurdle charges on the whole gain once it is cleared.

Illiquidity premium

The extra expected return demanded for holding an asset that cannot be sold quickly at a fair price.

Exam angle: Reported private-market volatility is understated because valuations are smoothed and infrequent, which flatters risk-adjusted measures.

Immunisation

Structuring a bond portfolio so that price and reinvestment effects cancel, locking in a return over a horizon.

Exam angle: Requires matching duration to the horizon and rebalancing as time passes and yields move. It protects against parallel shifts, not twists.

Implementation shortfall

The difference between the return on a paper portfolio and the return actually achieved, capturing delay, market impact, commissions and unfilled orders.

Exam angle: The honest measure of execution cost, because it counts the trades that never happened at the price that was wanted.

Implied volatility

The volatility that, put into an option pricing model, returns the option’s observed market price.

Exam angle: A price quoted in volatility units rather than a forecast. Plotting it against strike gives the smile or skew.

Income statement

Also: profit and loss, P&L

A statement of revenue, expenses and profit over a period.

Independence and objectivity

The requirement to use reasonable care and judgement to keep independence, and to refuse any gift or pressure that could compromise it.

Exam angle: Modest, customary token gifts from clients may be accepted with disclosure to the employer; anything from a company you cover is the problem case.

Inflation

A sustained rise in the general price level, reducing the purchasing power of money.

Exam angle: Distinguish demand-pull from cost-push: the policy response differs, and a central bank tightening into a supply shock is a recognised error.

Information ratio

Active return divided by tracking error — value added per unit of benchmark-relative risk.

Exam angle: The natural measure for a benchmarked active manager, where the Sharpe ratio would mostly reflect the benchmark.

Initial and variation margin

Initial margin is the good-faith deposit required to open a futures position; variation margin is the daily cash transfer that settles the day’s gain or loss.

Exam angle: Falling below the maintenance margin triggers a call back to the initial level, not to the maintenance level.

Interest coverage ratio

EBIT divided by interest expense — how many times earnings cover the interest bill.

Exam angle: A primary input to credit ratings and to covenant tests.

Interest rate parity

Also: covered interest rate parity, IRP

The condition that the forward exchange rate differs from the spot rate by exactly the interest rate differential, so hedged returns are equal across currencies.

Exam angle: Covered parity is an arbitrage relationship and holds tightly. Uncovered parity is an expectation and does not — that gap is what the carry trade harvests.

Internal rate of return

Also: IRR

The discount rate at which a project’s NPV is zero.

Exam angle: A cash flow stream that changes sign more than once can have more than one IRR, or none. That is the whole reason NPV is the preferred rule.

Investment policy statement

Also: IPS

The written agreement setting out an investor’s objectives, constraints and the rules the portfolio will be run by.

Exam angle: Objectives are return and risk. Constraints are liquidity, time horizon, tax, legal and regulatory, and unique circumstances — memorise the five.

J-curve

The typical shape of a private fund’s returns: negative early, as fees are paid before value is realised, then rising.

Key rate duration

Also: partial duration

Sensitivity to a change in one segment of the yield curve, holding the other segments fixed.

Exam angle: Needed because real curves twist and steepen. A portfolio can be duration-neutral overall and still lose heavily on a curve reshaping.

Kurtosis

Also: excess kurtosis, fat tails

The weight of a distribution’s tails. Excess kurtosis is kurtosis minus 3, so a normal distribution has excess kurtosis of zero.

Exam angle: Leptokurtic — positive excess kurtosis — means extreme outcomes are likelier than normal. Financial returns are reliably leptokurtic, which is why normal-based VaR understates the tail.

Leveraged buyout

Also: LBO

Acquiring a company using a large proportion of borrowed money, secured against the target’s own assets and cash flows.

Exam angle: Returns come from deleveraging, operational improvement and multiple expansion. Separating the three is the standard analysis.

Liability-driven investing

Also: LDI

Managing a portfolio against the liabilities it must fund rather than against a market index.

Exam angle: Risk becomes the mismatch between asset and liability sensitivities, so a “safe” cash portfolio can be highly risky against long-dated liabilities.

LIFO and FIFO

Inventory cost-flow assumptions. FIFO expenses the oldest costs first; LIFO expenses the newest.

Exam angle: LIFO is permitted under US GAAP and prohibited under IFRS. When prices rise, LIFO gives lower income and lower inventory — the LIFO reserve converts between the two.

Linear regression

Also: ordinary least squares, OLS

Fitting a straight line through data by minimising the sum of squared residuals, to explain a dependent variable by one or more independent variables.

Lock-up period

The period during which an investor may not redeem from a fund.

Exam angle: Gates and side pockets do a similar job in a crisis, and all three are liquidity risk rather than fine print.

Lognormal distribution

The distribution of a variable whose natural logarithm is normally distributed. Bounded below by zero and right-skewed.

Exam angle: Used for asset prices because a price cannot go negative, while continuously compounded returns can be modelled as normal. That pairing is the basis of Black–Scholes–Merton.

Loyalty to employer

The duty to act for the employer’s benefit, not to deprive it of your skills, and not to divulge confidential information.

Exam angle: Preparing to leave is allowed; taking client lists, models or records built on the employer’s time is not. Nothing changes once notice is served.

Margin (equity trading)

Borrowing from a broker to buy securities, using the securities as collateral.

Exam angle: A margin call comes when equity falls below the maintenance margin. Leverage magnifies both the return and the speed of the call.

Market capitalisation

Also: market cap

Share price multiplied by shares outstanding — the market value of a company’s equity.

Exam angle: Not the value of the firm. Enterprise value adds net debt, and is what you compare against EBITDA or EBIT.

Market efficiency

Also: efficient market hypothesis, EMH

The proposition that prices already reflect available information, so consistently beating the market on that information is not possible.

Exam angle: Three forms: weak (past prices), semi-strong (all public information), strong (all information, public and private). Technical analysis fails under weak-form; fundamental analysis fails under semi-strong.

Market impact

The adverse price move caused by the act of trading itself.

Exam angle: Rises with order size relative to normal volume. Trading more slowly reduces impact and increases the risk of the price moving away meanwhile.

Market manipulation

Transactions or information intended to distort prices or artificially inflate trading volume, in order to mislead other participants.

Exam angle: Split into information-based and transaction-based. Intent is what is examined, and it is usually established by what the person expected to happen.

Market-capitalisation-weighted index

An index in which weights are proportional to constituents’ market values.

Exam angle: Self-rebalancing, and the only weighting every investor could hold at once. Its criticism is that it systematically holds more of whatever has already risen.

Material non-public information

Also: MNPI, inside information

Information that has not been released to the market and that a reasonable investor would want before trading. Acting or causing others to act on it is prohibited.

Exam angle: Materiality and non-publicity are separate tests and both must hold. Selective disclosure to analysts does not make information public.

Modified duration

The approximate percentage change in a bond’s price for a one percentage point change in yield.

Modified duration = Macaulay duration / (1 + y/m)

Exam angle: A linear approximation. It always overstates the loss from a rise in yields and understates the gain from a fall, because the true relationship is convex.

Monetary policy

A central bank’s management of money supply and interest rates to pursue price stability and, in some mandates, employment.

Exam angle: Works with long and variable lags, which is why policy is set on forecasts rather than on today’s data.

Money-weighted return

Also: MWR, dollar-weighted return

The IRR of a portfolio including the timing and size of every contribution and withdrawal.

Exam angle: Measures the investor’s experience, not the manager’s skill, because the client controls the cash flows. Use it to judge an account, never to compare managers.

Moneyness

Whether exercising an option now would pay: in-the-money, at-the-money or out-of-the-money.

Exam angle: Intrinsic value is what exercise would yield today; time value is everything else in the premium, and it decays to zero at expiry.

Monte Carlo simulation

Estimating a distribution of outcomes by repeatedly drawing random inputs from assumed distributions and recomputing the result.

Exam angle: The output is only as good as the assumed input distributions and correlations. It generates precision, not accuracy.

Moral hazard

The incentive to take more risk once someone else bears the consequences.

Exam angle: Central to both economics and risk management: deposit insurance, bailouts and bonus structures are the standard examples.

Mosaic theory

Combining public information with non-material non-public information to reach a material conclusion. Doing so is permitted.

Exam angle: The defence of a good analyst. Keep the notes: the file showing how the conclusion was assembled is what distinguishes a mosaic from an inside tip.

Multicollinearity

Two or more independent variables in a regression that are highly correlated.

Exam angle: The giveaway is a high R² with individually insignificant t-statistics. The regression as a whole explains plenty; it cannot attribute the explanation.

Multifactor model

A model explaining returns by exposure to several systematic factors rather than to the market alone.

Exam angle: Fama–French adds size and value to the market factor; Carhart adds momentum. Each factor is a claim that a risk is priced, and each is contested.

Net present value

Also: NPV

The present value of a project’s cash inflows less the present value of its outflows. A positive NPV adds to shareholder wealth.

Exam angle: NPV and IRR agree on accept/reject for a conventional independent project, and can disagree on ranking mutually exclusive ones. Where they disagree, NPV wins.

Neutral rate

Also: natural rate of interest, r-star

The real policy rate that neither stimulates nor restrains the economy when output is at potential.

Exam angle: Unobservable and estimated. Most arguments about whether policy is tight are really arguments about where neutral sits.

Normal distribution

Also: Gaussian distribution, bell curve

A symmetric, bell-shaped distribution fully described by its mean and variance.

Exam angle: Approximately 68% of outcomes fall within one standard deviation, 95% within two and 99% within 2.58. Those three numbers appear constantly in VaR and confidence-interval questions.

Notional principal

The reference amount used to compute a derivative’s payments, which is usually never exchanged.

Exam angle: Notional wildly overstates economic exposure. Comparing a derivatives book’s notional with a balance sheet is a category error.

Null hypothesis

Also: H0

The statement a test assumes true until the data give sufficient reason to reject it. Always the one containing equality.

Exam angle: Failing to reject is not the same as proving. The null survives for want of evidence, not because it was shown to be true.

Off-balance-sheet financing

Arrangements that give a company the use of an asset or the benefit of borrowing without showing the liability on its balance sheet.

Exam angle: Largely curtailed for leases by IFRS 16 and ASC 842, which brought most operating leases on balance sheet.

Operating leverage

The sensitivity of operating income to a change in sales, driven by the proportion of fixed costs.

Exam angle: High fixed costs amplify both directions. Pair it with financial leverage and small revenue moves produce very large earnings moves.

Opportunity cost

The value of the best alternative given up by choosing one course of action.

Option-adjusted spread

Also: OAS

The spread over the benchmark curve once the value of any embedded option has been stripped out, making bonds with and without options comparable.

Exam angle: Model-dependent: it moves with the volatility assumption. Two desks can compute different OAS on the same bond and both be right.

Output gap

The difference between actual and potential output, as a percentage of potential.

Exam angle: A positive gap signals inflationary pressure. Potential output is estimated, so the gap is revised heavily after the fact.

p-value

The smallest significance level at which the null could be rejected — the probability of a result at least this extreme if the null were true.

Exam angle: Not the probability the null is true. Reject when p < α.

Par value

Also: face value, principal

The amount a bond repays at maturity, and the base on which the coupon is calculated.

Pecking order theory

The observation that firms prefer internal funds first, then debt, and issue equity last.

Exam angle: Driven by information asymmetry: issuing equity signals that management thinks the shares are expensive, so the announcement itself moves the price.

Performance attribution

Decomposing a portfolio’s return relative to its benchmark into the decisions that produced it — typically allocation, selection and interaction.

Exam angle: Brinson attribution is the standard framework. Returns-based attribution infers exposures from return series; holdings-based uses the actual positions.

Perpetuity

An annuity with no end date — a level cash flow received forever.

PV = C / r

Exam angle: Only valid where r > 0 and the payment is level. A growing perpetuity uses C / (r − g), and requires r > g or the value is meaningless.

Preference share

Also: preferred stock

A share with a stated dividend that ranks ahead of common equity but behind all debt, usually without a vote.

Exam angle: Economically a hybrid. Cumulative preference shares accrue missed dividends; non-cumulative do not.

Prepayment risk

The risk that borrowers repay mortgage principal early, most often when rates fall and refinancing becomes attractive.

Exam angle: The cause of negative convexity in MBS: exactly when a normal bond would rally, the cash flows come back to be reinvested at the new lower rate.

Present value

Also: PV, discounted value

What a future cash flow is worth today, found by discounting it at a rate that reflects its risk and timing.

PV = FV / (1 + r)^n

Exam angle: Match the rate to the period. A quarterly cash flow discounted at an annual rate is the single most common arithmetic slip in the exam.

Price elasticity of demand

Also: elasticity

The percentage change in quantity demanded for a one percent change in price.

Exam angle: Demand is elastic when the magnitude exceeds one. Revenue rises with a price cut only where demand is elastic — the standard exam application.

Price-to-earnings ratio

Also: P/E, PE ratio

Share price divided by earnings per share.

Exam angle: Meaningless when earnings are negative or near zero, and heavily affected by accounting choices. Trailing uses reported earnings; forward uses forecasts.

Price-weighted index

An index in which each constituent’s weight is proportional to its share price.

Exam angle: A high-priced share dominates regardless of company size, and a split changes the weights without changing anything real. The Dow is the famous example.

Private credit

Also: direct lending

Lending to companies outside the public bond and syndicated loan markets, usually at floating rates with bespoke covenants.

Exam angle: Return comes from illiquidity and complexity as much as from credit risk. Marks are infrequent, so reported volatility understates the real thing.

Private equity

Equity investment in companies that are not publicly traded, typically through a closed-end fund with a fixed life.

Protective put

Holding the underlying and buying a put, which sets a floor under the position at the cost of the premium.

Exam angle: Economically insurance. The premium is a certain cost paid to remove an uncertain one, and over time it is a drag.

Purchasing power parity

Also: PPP

The proposition that exchange rates adjust so that identical goods cost the same across countries.

Exam angle: A long-run anchor, badly violated in the short run. Relative PPP — that the exchange rate moves with the inflation differential — is the testable version.

Put option

The right, without the obligation, to sell an asset at the strike price by expiry.

Put–call parity

The no-arbitrage relationship linking a European call, a European put, the underlying and a risk-free bond of the same strike and expiry.

c + PV(X) = p + S₀

Exam angle: Rearranging it constructs synthetic positions, and a violation is a textbook arbitrage. European options only.

Putable bond

A bond the holder may sell back to the issuer early, usually when rates have risen.

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

Real versus nominal

A nominal figure is measured in current prices; a real figure has been adjusted for inflation and so measures actual volume or purchasing power.

Rebalancing

Trading back to target weights after market moves have shifted them.

Exam angle: Mechanically it sells what rose and buys what fell. Calendar and percentage-band rules trade off transaction costs against drift.

Record retention

The requirement to keep the records supporting analysis, recommendations and actions. Seven years is the recommended minimum where no regulation says otherwise.

Exam angle: Records belong to the employer. They do not travel with you to the next firm.

Reinvestment risk

The risk that coupons and principal must be reinvested at a lower rate than expected.

Exam angle: Moves opposite to price risk. Setting a horizon equal to Macaulay duration is what makes the two offset — the basis of immunisation.

REIT

Also: real estate investment trust

A listed vehicle holding income-producing property, generally required to distribute most of its income to keep favourable tax treatment.

Exam angle: Correlates with equities in the short run and with property in the long run — a recurring point in diversification questions.

Required rate of return

The minimum return an investor demands for holding an asset, given its risk.

Return on equity

Also: ROE

Net income as a percentage of average shareholders’ equity.

ROE = Net margin × Asset turnover × Financial leverage

Exam angle: That three-part split is the DuPont decomposition. A rising ROE driven only by leverage is a different story from one driven by margin.

Return smoothing

Understated volatility caused by infrequent or appraisal-based valuations rather than by genuinely stable prices.

Exam angle: Inflates Sharpe ratios and depresses measured correlation with public markets. Unsmoothing the series usually removes most of the apparent diversification benefit.

Rho

The sensitivity of an option’s value to a change in the risk-free rate.

Risk budgeting

Allocating a portfolio’s total risk across strategies or managers, rather than allocating its capital.

Exam angle: Two managers with equal capital rarely consume equal risk. Budgeting by capital and reviewing by risk is how concentration arrives unnoticed.

Risk tolerance

How much risk an investor is both able and willing to take. Ability comes from the balance sheet and horizon; willingness comes from temperament.

Exam angle: Where the two conflict, the prudent course is the lower of them, plus client education. That is an examinable judgement.

Roll yield

The return from rolling a futures position forward as contracts expire, positive in backwardation and negative in contango.

Securitisation

Pooling loans and issuing securities backed by their cash flows, usually through a bankruptcy-remote special purpose vehicle.

Serial correlation

Also: autocorrelation

Regression errors correlated with their own past values.

Exam angle: Common in time series. Positive serial correlation deflates standard errors, which inflates t-statistics and manufactures significance that is not there.

Share repurchase

Also: buyback

A company buying its own shares, reducing the share count.

Exam angle: Equivalent to a dividend in cash terms but more flexible and often tax-advantaged. Raises EPS mechanically, which is not the same as creating value.

Sharpe ratio

Excess return over the risk-free rate, per unit of total risk.

Sharpe = (R_p − R_f) / σ_p

Exam angle: Uses total risk, so it judges a portfolio held on its own. It flatters strategies with negatively skewed returns, because standard deviation does not see the tail.

Short selling

Selling borrowed securities in the expectation of buying them back cheaper.

Exam angle: Loss is theoretically unlimited, and the borrow can be recalled at the worst moment. That asymmetry is what makes a short squeeze possible.

Skewness

The asymmetry of a distribution. Positive skew has a long right tail; negative skew has a long left tail.

Exam angle: Returns on short-volatility and credit strategies are negatively skewed: many small gains, occasional large losses. Mean and standard deviation alone hide that.

Special situations

Investing around a specific corporate event — restructuring, distress, spin-off or litigation — where the outcome depends more on the event than on the market.

Spot rate

Also: zero rate, zero-coupon rate

The yield on a single cash flow received at one future date, with no intervening coupons.

Exam angle: Valuing a bond off the spot curve rather than a single YTM is what removes the reinvestment assumption.

Stakeholder

Any party with an interest in the company — shareholders, creditors, employees, customers, suppliers, regulators and the wider community.

Standard deviation

Also: volatility, vol, sigma

The square root of variance, in the same units as the data. In finance it is the usual proxy for total risk.

Exam angle: Penalises upside and downside equally, which is its main criticism and the motivation for downside measures like semi-deviation and VaR.

Standard error

The standard deviation of a sample statistic, usually of the sample mean.

SE = σ / √n

Exam angle: Falls with the square root of sample size, so quartering the standard error needs sixteen times the data.

Standards of Professional Conduct

The seven enforceable standards covering professionalism, integrity of capital markets, duties to clients, duties to employers, investment analysis and recommendations, conflicts of interest, and responsibilities as a member or candidate.

Exam angle: Questions usually turn on which standard applies rather than on whether something felt wrong. Learn the seven headings in order.

Statement of cash flows

A statement reconciling opening and closing cash, split into operating, investing and financing activities.

Exam angle: Cash flow is much harder to manipulate than earnings, which is why analysts start here when something looks wrong.

Straddle

Buying a call and a put at the same strike and expiry — a position on the size of a move rather than its direction.

Exam angle: A long straddle needs a move larger than the combined premium. Buying one into an announcement usually means buying already-elevated implied volatility.

Strategic asset allocation

Also: SAA, policy portfolio

The long-run target mix of asset classes, set from the investor’s objectives and constraints.

Exam angle: Explains the large majority of the variation in a portfolio’s returns over time — far more than security selection.

Style drift

A manager gradually moving away from the strategy the mandate describes.

Exam angle: Often invisible in returns until the market turns, because drifting toward whatever is working flatters performance while it lasts.

Suitability

The requirement to judge an investment against the client’s objectives, constraints and circumstances before recommending or making it.

Exam angle: For a portfolio the test is the effect on the total portfolio, not the merits of the security in isolation.

Sunk cost

A cost already incurred and unrecoverable, and therefore irrelevant to any decision now.

Survivorship bias

Distortion caused by studying only the entities that lasted long enough to appear in the sample.

Exam angle: Inflates measured fund returns, because closed and merged funds drop out of the index. A staple of both ethics and quant questions.

Sustainable growth rate

The rate at which a firm can grow without changing its capital structure or issuing new equity.

g = ROE × retention ratio

Swap

An agreement to exchange one stream of cash flows for another over time.

Exam angle: A plain vanilla interest rate swap is a series of forward rate agreements, and can also be read as being long one bond and short another.

Systematic risk

Also: market risk, non-diversifiable risk

Risk affecting the whole market, which cannot be diversified away.

Exam angle: The only risk investors are compensated for. That claim is the foundation of CAPM.

Tactical asset allocation

Also: TAA

Short-term deliberate deviation from the strategic allocation to exploit a perceived opportunity.

Tax-loss harvesting

Realising losses deliberately to offset gains elsewhere, while keeping the portfolio’s economic exposure broadly intact.

Exam angle: Defers tax rather than avoiding it, because the replacement asset carries a lower basis. Wash-sale rules restrict repurchasing the same security.

Theta

The change in an option’s value from the passage of one day, all else equal.

Exam angle: Negative for a long option: time decay works against the buyer and accelerates into expiry.

Time value of money

Also: TVM

The principle that a sum available today is worth more than the same sum later, because today’s sum can be invested. Every discounting and compounding formula in the curriculum is an application of it.

Time-weighted return

Also: TWR

The compound growth of one unit of currency in a portfolio, with the effect of external cash flows removed by chain-linking sub-period returns.

Exam angle: The GIPS-required basis for comparing managers, precisely because it is immune to client cash flow timing.

Tracking error

Also: active risk

The standard deviation of the difference between portfolio and benchmark returns.

Exam angle: A mandate constraint as much as a statistic. A tight tracking error budget limits how much a manager can differ from the index at all.

Tranche

One slice of a securitisation with a defined priority of payment, so that losses hit the junior slices before the senior ones.

Exam angle: Subordination is the credit enhancement. Correlation between the underlying loans is what determines whether the senior tranche is really safe.

Treynor ratio

Excess return per unit of systematic risk, using beta in the denominator.

Exam angle: The right measure when the portfolio is one component of a diversified whole, where only its beta matters.

Two and twenty

Also: management and incentive fee

The classic alternative fee model: an annual management fee of around 2% of assets plus around 20% of profits.

Exam angle: Compounding fees matter enormously over a fund life. Whether the incentive fee is computed before or after the management fee changes the answer.

Type I error

Also: false positive, alpha error

Rejecting a true null hypothesis. Its probability is the significance level, α.

Exam angle: Type I and Type II trade off against each other at a fixed sample size. Only more data improves both.

Type II error

Also: false negative, beta error

Failing to reject a false null hypothesis. One minus its probability is the power of the test.

Unsystematic risk

Also: idiosyncratic risk, specific risk

Risk specific to one company or sector, which diversification can remove.

Exam angle: Not rewarded, because it can be eliminated for free. Bearing it is a choice, not a risk premium.

Value at Risk

Also: VaR

The loss that will not be exceeded over a stated horizon with a stated confidence — for example, a 1-day 99% VaR of £1m means losses should exceed £1m on about one day in a hundred.

Exam angle: Says nothing about how bad the breach is when it happens, and is not subadditive, so the VaR of a combined book can exceed the sum of its parts. Both failings motivate expected shortfall.

Variance

The average squared deviation from the mean — the standard measure of dispersion.

Exam angle: A sample variance divides by n − 1, not n. Dividing by n gives a biased estimate, and the correction is examined directly.

Vega

The change in an option’s value for a one point change in implied volatility.

Exam angle: Always positive for a plain long option, call or put. Long options are long volatility.

Venture capital

Equity investment in early-stage companies with high failure rates and highly skewed outcomes.

Exam angle: Returns are driven by a handful of holdings. Median fund performance is a poor guide to what a top-quartile fund does.

Vintage year

The year a private fund makes its first investment, and the basis on which its performance is compared with peers.

Exam angle: Comparing across vintages compares market conditions, not skill. Entry valuations dominate private returns.

Wealth transfer

Moving assets to the next generation or to charity, structured for tax efficiency and for the family’s intentions.

Exam angle: Lifetime gifting transfers future growth out of the estate. The trade-off is control, and it is usually the real obstacle rather than the tax.

Weighted average cost of capital

Also: WACC

The blended required return on a company’s capital, weighting each source by its share of the total at market value.

WACC = w_d × r_d × (1 − t) + w_e × r_e

Exam angle: Use market weights and target weights, not book values. The tax shield applies to debt only, which is why debt looks cheap before considering the distress it brings.

Working capital

Current assets less current liabilities — the short-term capital tied up in operations.

Exam angle: Growing revenue with faster-growing receivables means the growth is being funded by the balance sheet, not the customer.

Working capital management

Managing receivables, payables, inventory and cash so the business has liquidity without tying up more capital than it needs.

Yield curve

The relationship between yield and maturity for bonds of the same credit quality.

Exam angle: Inversion — short rates above long — has preceded most recent recessions and is treated as a leading indicator rather than a cause.

Yield curve strategy

Positioning a bond portfolio for an expected change in the shape of the curve — bullet, barbell or ladder structures expressing different views.

Exam angle: A barbell outperforms a duration-matched bullet when the curve flattens, and has more convexity. Duration alone cannot express a curve view.

Yield to maturity

Also: YTM, redemption yield

The single discount rate that equates a bond’s price to the present value of its cash flows.

Exam angle: Assumes every coupon is reinvested at the YTM and the bond is held to maturity. Both assumptions usually fail, which is why realised return differs from YTM.

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