If you are reading this post, chances are you’ve passed the Level 1 exam. If that’s the case, congratulations, that’s a great achievement! Give yourself a pat on the back before you start worrying about how to tackle level 2.

In the Level 2 exam you are tested in the form of 20 case studies or item sets (10 in the morning and 10 in the afternoon). Each item set has 6 questions so that’s a total of 120 questions in 6 hours. The topic weights can be found here.

Compared to the level 1 exam, level 2 goes into much more detail in terms of testing concepts. If the theme of the questions in level 1 were “Do you know it?” level 2 instead asks “Can you apply it?”. A lot of candidates end up failing this exam as they find the number of formulas overwhelming and intimidating. In this post I have summarised some advice that I received when preparing for the exam, advice that I hope helps you pass the exam.

(1) Don’t try to memorise the formulas but try to see the big picture.

I’ve seen so many candidates trying to just blindly memorise and apply formulas, losing sight of the big picture. This is dangerous in my opinion. If you are the type who does well in memorising and applying formulas, then I’m not here to dispute your exam technique. If you have tried doing a few mocks and have been constantly scoring +60% then by all means please stick to your way. What I am trying to say is that from my experience, I struggled when I attempted to memorise all the formulas and when I applied a more intuitive approach in solving questions that worked for me. This might sound a bit abstract so let me give you an example.

Let’s say you are looking at Economics where you might be asked to adjust the exchange rate using PPP (Purchasing Power Parity). In our example we will use Japan and the US, the exchange rate is USD/JPY = 110 JPY and the inflation rate in the respective countries is 1% and 2%. The essence of PPP is that whether you buy goods in Japan or the US it shouldn’t make a difference.  If goods are becoming more expensive in the US compared to Japan, i.e. higher inflation, this will be reflected in the expected exchange rate where Japan is the domestic currency and the inflation is for a 1 year horizon.

OK, you might ask what’s so hard about applying such a seemingly innocent formula. To start with, I have seen a lot of candidates spending a lot of time in trying to figure out how the exchange rate is quoted, which currency is domestic and which one is foreign (others used quoted and base); add the pressure under exam conditions and you are prone to make mistakes. The way I used to approach this question was to tell myself: OK, inflation rates are higher in the US and that means that their currency will have to weaken against the Yen. I would apply the formula and check my result. I can see that indeed 108.92 < 110. At first 1 USD could get you 110 JPY, now it can get you only 108.92 JPY. Indeed the Yen has strengthened (or the Dollar has weakened). Should I have accidentally flipped the numerator and the denominator, this check would have allowed me to detect my mistake. This was just a simple example but this way of thinking can be applied to many other questions on the CFA exam. There are a lot of red herrings on the exams so being able to spot and avoid them is a key factor in your exam success.

(2) Tips for Level 1 are still valid.

What I covered in my CFA level 1 post is also applicable to Level 2. Pay attention to the exam weightings in your preparation to ensure that you are scoring well in heavy topics like accounting and equity. Decide whether you want to pay a training provider or whether you have the time and discipline to self-study; this is definitely something you want to consider if your job is taking up a lot of revision time. The competition in Level 2 is fierce and chances are slim that you will pass with just 1-2 months of cramming.  This is an exam where candidates who put in 200+ hours of studying end up failing.   

(3) Don’t read the whole item set before attempting the questions

When I first started tackling exam questions I used to read the whole case study before moving on to the questions. My mind was bombarded with information and the questions were very detailed so I found myself going back to the item set and looking for key piece of information, then going back to the questions, going back and forth. Needless to say, I was struggling with time. It was only throughout my revision that I realised the obvious; item sets are very often divided into paragraphs and there tends to be a one to one map between paragraphs and corresponding questions. Just to be clear, if there are 3 paragraphs and 3 questions, paragraph 1 will have the information that you need for question 1, paragraph 2 will have the information for question 2 and so on. My advice is to first read the questions and then start reading the item set; when you are reading the item set, if you think you have identified some information that will help you solve any of the questions, then solve the questions before moving on. This approach also helped me from a mental perspective as when I was done reading the item set I wouldn’t be going back to 6 blank questions.

(4) Find a topic where you can differentiate yourself from other candidates

In order to pass the CFA exam you will need to achieve what they call a minimum passing score; the CFA institute uses the Angoff Standard Setting Method in determining this. If you are getting the bulk of your points from easy questions, chances are that other people sitting the exam will be getting those as well. If overall the exam was an easy exam the pass rate will be set higher and therefore even if you do average or just slightly below average, chances are that you will fail the exam. You obviously need to get points in the easy questions but you also need to score in questions where other candidates struggle to get an edge over them. In my case, for level 2, derivatives was the area that helped me. A lot of candidates around me had given up hope on derivatives as they found a lot of the questions challenging. I persevered and I was rewarded on exam day.  

I hope you found this advice useful and don’t forget to leave your comments. Good luck with your preparation and with your CFA journey!

Throughout your studies of fixed income, very often you will have come across the concept of Duration. So why is it so important? Duration measures the sensitivity of your bond to changes in interest rate. Let’s say interest rates drop 1%, by using duration you can get a rough approximation of how much your bond price changes.

Bond Price and Interest Rates

Before we get started with Duration, let’s talk about bond prices and interest rates. You might have heard the expression that bond prices and interest rates are negatively related. Interest rates go down and your bond price rises, interest rates rise and your bond price drops. This is because the value of your bond is the summation of the present value of all future cash flows, so the higher your discount rate (interest rate) the lower the price of your bond.

Let’s assume that we have a bond that pays a 5% yearly coupon with a face value of 100, prevailing yields are 6% across all tenures. For simplicity, I am assuming that we have a flat yield curve with interest rates constant across all tenures.

As the the coupon rate of 5% is lower than the prevailing 6% rates, the bond is trading under par. Given the above assumptions we will calculate two key duration measures, the Macaulay Duration and the Modified Duration.

The formula for Macaulay Duration is as follows:

Where is the price of the bond, is the yield to maturity and is the year. Applying the formula in our example we get that the Macaulay Duration is 4.53 years. We can interpret this figure as the average number of years that it would take for the bond to repay the initial investment.

The formula for the Modified Duration is as follows:

Applying the formula we obtain 4.32 for the Modified Duration.

Now that we have the Modified Duration for this bond we can evaluate its sensitivity to changes in interest rates. The expected change in the bond price can be approximated by Modified Duration * Change in Rate * Bond Price. Looking at our example, if we assume that interest rates drop from 6% to 4%, then -4.32 * -0.02 * 95.79 = 8.27 is our estimated change in bond price and in reality we saw that the bond did rise by 8.66 so we can see that our approximation was quite accurate.

Duration however is only accurate for small changes in interest rates as it is only a linear approximation; we can see from the below graph that the relationship between interest rates and price is convex.

If Duration is the first order derivative between price and interest rates, we can better approximate the actual change in price by adding a second order term in the form of Convexity. I will be covering this in future posts in addition to other Duration measures such as Key Rate Duration and Effective Duration.