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Title: CFA Level 1 - Equity Investments
Description: I create this summary of knowledge related to CFA level 1 for my 2017 December exam. I got into the top 10% with this. Hope this can help you. Please note that this does not guarantee for your pass, which requires dedication, hardwork and consistency. In case having trouble with any part, please refer to CFA notebook/Schwesser.
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Concepts

Description

Main functions of the financial
system

Market organisation and structure
1
...
Determine return at equilibrium interest rate (rate at which the amount of lending = the amount of borrowing)
3
...
Real assets (real estate, equipment)
- Debt securities vs
...
private securities
- Physical derivative contracts (contract on rice, metals) vs
...
Future delivery market
- Primary market (issuance of new securities) vs
...
Capital market (LT debt instruments and equities)
- Traditional investment market (bonds, stocks) vs
...
Securities
- Fixed income securities (e
...
: Bonds, Notes, Commercial paper, Bills, Certificates of Deposit, Repurchase agreeements, convertible bonds)
- Equity securities (e
...
: Common stocks, Preferred stocks, Warrants)
- Pooled investment vehicles (e
...
: Mutual funds, depositories, hedge funds, Exchange-traded funds, asset-backed securities)
2
...
g
...
)
3
...
Not traded on exchanges or via dealers
- Futures: Similar to forward
...
Commodities: agricultural products, industrial and precious metals and energy products, traded in spot, forward and future markets
5
...
Investors could buy real assets directly, or indirectly via Real estate investment trust (REIT) or master limited partnership
(MLP) or buy stock of firms with large ownership of real assets

Financial intermediaries

- Brokers / Exchanges / Alternative trading system : connect buyers and sellers of the same security at the same location and time
- Dealers : Match buyers and sellers of same security at different points in time, buy buying security or selling from their own inventory
- Arbitrageurs : Connect buyers and sellers of the same security at the same time, but in different locations
...
Arbitrageurs buy assets in one market and sell in another market at a higher price
...
Clearinghouses reduce counterparty risk and promote market integrity

Long position /
Short position

Long position : Investor who owns an asset, or has right / obligation under a contract to buy an asset
...
A short position benefits when the asset decreas in value
Note:
Long position a call option β†’ profit from increase in the value of underlying asset ; while the party short the op on has losses
Long position a put option β†’ profit from decrease in the value of underlying asset ; while the party short the op on has losses

Leverage position

Definition: Borrow funds to purchase an asset
Buy on margin : Buy securities by borrowing from brolers
In which:
Borrowed funds = called margin loan ;
interest rate = call money rate ;
required minimum of initial amount of equity = initial margin requirement

πΏπ‘’π‘£π‘’π‘Ÿπ‘Žπ‘”π‘’ π‘Ÿπ‘Žπ‘‘π‘–π‘œ π‘œπ‘“ π‘Ž π‘šπ‘Žπ‘Ÿπ‘”π‘–π‘› π‘–π‘›π‘£π‘’π‘ π‘‘π‘šπ‘’π‘›π‘‘ =

π‘£π‘Žπ‘™π‘’π‘’ π‘œπ‘“ π‘Žπ‘ π‘ π‘’π‘‘π‘ 
π‘£π‘Žπ‘™π‘’π‘’ π‘œπ‘“ π‘’π‘žπ‘’π‘–π‘‘π‘¦ π‘π‘œπ‘ π‘–π‘‘π‘–π‘œπ‘›

Maintenance margin requirement : to ensure the loan is covered by the value of the asset, investor must maintain a minimum equity %
...

Investor could satisfy the margin call by deposit additional funds / unmargined securities, or sell the position

π‘šπ‘Žπ‘Ÿπ‘”π‘–π‘› π‘π‘Žπ‘™π‘™ π‘π‘Ÿπ‘–π‘π‘’ = 𝑃 Γ—
Bid / Ask price

1 βˆ’ π‘–π‘›π‘–π‘‘π‘–π‘Žπ‘™ π‘šπ‘Žπ‘Ÿπ‘”π‘–π‘›
1 βˆ’ π‘šπ‘Žπ‘–π‘›π‘‘π‘’π‘›π‘Žπ‘›π‘π‘’ π‘šπ‘Žπ‘Ÿπ‘”π‘–π‘›

Bid price = price that dealer buy a security
Ask price = price that dealer sell a security
Bid price < Ask price

Execution / Validity / Clearing
instruction

Execution instructions : Specify how to trade
...
Appropriate when the trader wants to execute a transaction quickly
...
Could avoide price uncertainty, but limit order might not be filled
...
g
...
Public offerings: Issue with the assistance of an investment bank
- Underwritten offering : investment bank guarantees that the issue will be sold at a price that is negotiatd between the issuer and the bank
...
Private placement : firm sells securitiess directly to qualified investors, without the disclosures of public offering
3
...
Right offering : give right to existing shareholders to buy new shares at a discount β†’ Dilu on
5
...
Quote-driven market : Traders transact with dealers, who maintain an inventory of securities and post bid and ask price
2
...
Brokered markets : brokers find the counterparty to execute the contract
Pre-trade transparent : investors could obtain pre-trade information regarding quotes and orders
Post-trade transparent : investors could obtain post-trade information regarding completed price and sizes
Transparency allows investors to better understand securities value and trading costs β†’ Buy side value transparency ; while dealers prefer opaque market

Transparency of market
information

Characteristics of well-functioning
financial system

Characteristics of well-functioning financial system:
- Complete markets : savers receive a return, borrowers could obtain capital, hedgers could manage risks, and traders could acquire needed assets
- Operational efficiency : Low trading costs
- Information efficiency : Prices reflec fundamental information quickly
- Allocation efficiency : Capital is directed to its highest value use

Objectives of market regulations

Objectives of market regulations:
- Protect unsophisticated investors β†’ preserve trust in the markets
- Establish minimum standard of competency β†’ easier for investors to evaluate performance
- Prevent insiders from exploiting other investors
- Promote common financial reporting requirement β†’ less expensive informa on gathering
- Require minimm levels of capital β†’ market par cipants will be able to honor their commitments, and be more careful about their risks

Concepts
Securitiy market index

Price index / Total return index

Description
Security market indeces
- Represent performance of an asset class, security market or segment of a market
- Created as portfolios of individual securities (constituent securities of the index)
Index return : % change in the index's value over a period of time
Price index : Only include the price of constituent securities in return calculation
...


𝑅 = 1+𝑅

Decisions during the construction
and management of index

Weighting method in index
construction

Γ— 1+𝑅

Γ—β‹―Γ— 1 +𝑅

βˆ’1

In which:
𝑅 = π‘π‘œπ‘Ÿπ‘‘π‘“π‘œπ‘™π‘–π‘œ π‘Ÿπ‘’π‘‘π‘’π‘Ÿπ‘› π‘‘π‘’π‘Ÿπ‘–π‘›π‘” π‘‘β„Žπ‘’ π‘π‘’π‘Ÿπ‘–π‘œπ‘‘
π‘˜ = π‘‘π‘œπ‘‘π‘Žπ‘™ π‘›π‘’π‘šπ‘π‘’π‘Ÿ π‘œπ‘“ π‘ π‘’π‘π‘π‘’π‘Ÿπ‘–π‘œπ‘‘π‘ 
𝑅 = π‘π‘œπ‘Ÿπ‘‘π‘“π‘œπ‘™π‘–π‘œ π‘Ÿπ‘’π‘‘π‘’π‘Ÿπ‘› π‘‘π‘’π‘Ÿπ‘–π‘›π‘” π‘‘β„Žπ‘’ π‘ π‘’π‘π‘π‘’π‘Ÿπ‘–π‘œπ‘‘ π‘˜
- The target the index will measure
- Which securities from the target market to include
- The appropriate weighting method
- How frequent to rebalance the index to its target weights
- How frequent to re-examine the selection and weighting of securities
1
...

π‘ƒπ‘Ÿπ‘–π‘π‘’ βˆ’ π‘€π‘’π‘–π‘”β„Žπ‘‘π‘’π‘‘ 𝑖𝑛𝑑𝑒π‘₯ =

π‘ π‘’π‘š π‘œπ‘“ π‘ π‘‘π‘œπ‘π‘˜ π‘π‘Ÿπ‘–π‘π‘’π‘ 
π‘›π‘’π‘šπ‘π‘’π‘Ÿ π‘œπ‘“ π‘ π‘‘π‘œπ‘π‘˜π‘  𝑖𝑛 𝑖𝑛𝑑𝑒π‘₯ π‘Žπ‘‘π‘—π‘’π‘ π‘‘π‘’π‘‘ π‘“π‘œπ‘Ÿ 𝑠𝑝𝑙𝑖𝑑

2
...
Market capitalisation-weighted index (or value-weighted index) : weights based on the proportion of total market value of each index stock

π‘€π‘Žπ‘Ÿπ‘˜π‘’π‘‘ π‘π‘Žπ‘π‘–π‘‘π‘Žπ‘™π‘–π‘ π‘Žπ‘‘π‘–π‘œπ‘› βˆ’ π‘€π‘’π‘–π‘”β„Žπ‘‘π‘’π‘‘ 𝑖𝑛𝑑𝑒π‘₯ =

π‘π‘’π‘Ÿπ‘Ÿπ‘’π‘›π‘‘ π‘‘π‘œπ‘‘π‘Ž π‘šπ‘Žπ‘Ÿπ‘˜π‘’π‘‘ π‘£π‘Žπ‘™π‘’π‘’ π‘œπ‘“ 𝑖𝑛𝑑𝑒π‘₯ π‘ π‘‘π‘œπ‘π‘˜π‘ 
Γ— π‘π‘Žπ‘ π‘’ π‘¦π‘’π‘Žπ‘Ÿ 𝑖𝑛𝑑𝑒π‘₯ π‘£π‘Žπ‘™π‘’π‘’
π‘π‘Žπ‘ π‘’ π‘¦π‘’π‘Žπ‘Ÿ π‘‘π‘œπ‘‘π‘Žπ‘™ π‘šπ‘Žπ‘Ÿπ‘˜π‘’π‘‘ π‘£π‘Žπ‘™π‘’π‘’ π‘œπ‘“ 𝑖𝑛𝑑𝑒π‘₯ π‘ π‘‘π‘œπ‘π‘˜π‘ 

4
...
Fundamental weighting : weights based on fundamental (e
...
: earnings, dividends, CF)
Rebalancing / Reconstitution of an Rebalancing : adjust the weights of securities in a portfolio to their target weights after price chanes have affected the weights
...
Broad market equity index : represents the majority of stocks in a market
2
...
Multi-market index with fundamental weighting uses market capitalisation weighting for country indexes, but weights
the country index returns in the global index by fundamental factor (e
...
: GDP)
3
...
Some sectors do better than others in certain business cycle phase
...
Style index : Measure returns to market capitalisation / value / growth strategies

Types of fixed-income index

Could be classified by issuer, collateral, coupon, maturity, credit risk (e
...
: investment grade vs
...

Broad market index, sector index, style index, etc
...


Types of index representing
alternative investments

1
...
g
...
Problems with commodity index are:
- Weighting method : Different indexex could have different commodity weight β†’ different risk and return
- Future vs
...
actual
commodity
2
...
Hedge fund index : equaly weight the returns of the hedge funds included in the index
...
of constituent securities

Weighting method

Notes

Concepts
Informationally efficient capital
market

Description
Market efficiency
Definition: market where current price security fully, quickly and ratonally reflects all available information about that security
More efficient market β†’ quicker reac on to new informa on
Only unexpected information should move prices
In perfectly efficient market, Active investment strategies will underperform - compared to passive investment strategy - due to transaction costs and management fees

Market value / Intrinsic value

Market value : current price of an asset
Intrinsic value : value that a rational investor with full knowledge of asset's characterisitics would willingly pay

Factors that affect market's
efficiency

1
...
Availability of information : More information available to investors β†’ more efficient market
3
...
Transaction and information costs : High costs of trading and costs of gathering information β†’ make market less efficient

Weak-form / Semi-strong-form /
Strong-form market efficiency

1
...
Semi-strong-form market efficiency : Current securities prices fully reflect all current available security market data and non-market data
3
...
g
...
g
...
Common shares :
- Have residual claim on firm assets
- Govern the corporation thru voting right
- Have variable dividends, which firm is under no legal obligation to pay
2
...
Putable common shares : allow shareholder the right to sell the share back to firm at a pre-specific price
4
...
Cummulative preferred shares : Require any missed dividend in the past to be paid before common sharehoders receive any dividends
6
...
Convertible preferred stocks : could be converted to common stock at a pre-specified conversion ratio

Equity classes

Firm might have different classes, with :
- Different voting power ;
- Seniority if firm's assets are liquidated;
- Different treatment with respect to dividends, stock split, etc
...
Compare to public equity securities, private equity securities have:
- Less liquidity : no public market
- Share price is negotiated between firm and its investors, not determined by the the market
- More limited financial disclosure
- Lower reporting costs
- Weaker corporate governance
- No public pressure for ST results β†’ Greater ability to focus on LT prospects
- Potentially greater return for investors once the firm goes public

Types of equity investments

1
...
Leverage buyout (LBO) : Investors by all of firm's equity using debt financing
3
...
Private investment in public equity : Public firm that needs capital, quicky sells private equity to investors

Method for investing in nondomestic equity securities

1
...
Problems with direct investing are:
- Investment and return are denominated in foreign currency
- Illiquid foreign stock exchange
- Reporting requirements of foreign stock exchange are not strict β†’ impeding analysis
- Investors have to be familiar with regulations and procedures of each market
2
...
DRs are affected by exchange rate, firm
fundamentals, economic events, etc
...
Global depository receipts (GDRs) : issued outside US and the issuer's home country ; usually denominated in USD
...
American depository receipts (ADRs) : traded in US and denominated in USD
5
...
Basket of listed depository receipts (BLDR) : an exchange-traded fund (ETF) with a collection of DRs
...
Market value of equity reflects expectation of investors about the firm's future
performance
Return on equity (ROE)

𝑅𝑂𝐸 =

𝑁𝑒𝑑 π‘–π‘›π‘π‘œπ‘šπ‘’ βˆ’ π‘ƒπ‘Ÿπ‘’π‘“π‘’π‘Ÿπ‘Ÿπ‘’π‘‘ 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
𝑁𝑒𝑑 π‘–π‘›π‘π‘œπ‘šπ‘’ βˆ’ π‘ƒπ‘Ÿπ‘’π‘“π‘’π‘Ÿπ‘Ÿπ‘’π‘‘ 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
=
π΄π‘£π‘’π‘Ÿπ‘Žπ‘”π‘’ π΅π‘œπ‘œπ‘˜ π‘£π‘Žπ‘™π‘’π‘’
(π΅π‘œπ‘œπ‘˜ π‘£π‘Žπ‘™π‘’π‘’ + π΅π‘œπ‘œπ‘˜ π‘£π‘Žπ‘™π‘’π‘’ ) Γ· 2

Alternatively, ROE could be calculated using only Beginning Book value of equity

𝑅𝑂𝐸 =

𝑁𝑒𝑑 π‘–π‘›π‘π‘œπ‘šπ‘’ βˆ’ π‘ƒπ‘Ÿπ‘’π‘“π‘’π‘Ÿπ‘Ÿπ‘’π‘‘ 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
π΄π‘£π‘’π‘Ÿπ‘Žπ‘”π‘’ π΅π‘œπ‘œπ‘˜ π‘£π‘Žπ‘™π‘’π‘’

Higher ROE generally viewed as positive, but reason for increase should be examine

Price-to-book ratio

π‘ƒπ‘Ÿπ‘–π‘π‘’ βˆ’ π‘‘π‘œ βˆ’ π‘π‘œπ‘œπ‘˜ π‘Ÿπ‘Žπ‘‘π‘–π‘œ =

πΉπ‘–π‘Ÿπ‘š 𝑠 π‘šπ‘Žπ‘Ÿπ‘˜π‘’π‘‘ π‘£π‘Žπ‘™π‘’π‘’ π‘œπ‘“ π‘’π‘žπ‘’π‘–π‘‘π‘¦
πΉπ‘–π‘Ÿπ‘š 𝑠 π‘π‘œπ‘œπ‘˜ π‘£π‘Žπ‘™π‘’π‘’

Low price-to-book ratio : Value stocks
High price-to-book ratio : Growth stocks
Cost of equity

Cost of equity : expected equilibrium total return (including dividends) on its shares in the market
Expected return > Cost of equity β†’ the shares are an a rac ve investment

Concepts
Industry analysis

Industry classification

Description
Introduction to Industry and Company Analysis
- provide framework to understand the firm
- Better understand the business conditions firms in the industry face
- Provide insight about the firm's potential growth, competition and risks
- Provide information about whether the firm could meet its obligations during the next recession
- Identify undervalued / overvalued industries
- Component in a performance attribtion analysis of a portfolio's return
1
...
Group companies by their sensitivit to business cycle : cyclical vs
...
Statistical method : group firms with highly correlated returns
...
Cyclical firm : earnings are highly dependent on the business cycle (e
...
: basic material and processing ; consumer discretionary ; energy ; financial services ; industrial and producer
durables ; technology)
2
...
g
...
In which:
- Defensive : demand tends not to fluctuatewith business cycle (e
...
: food producer ; drug stores)
- Growth : demand is so strong that it is largely unaffected by the business cycle
Limitation:
- Cyclical industries often include growth firms
- Non-cyclical indstries could be affected by severe recesions
- Defensive industries ae not always safe investments
- Business cycle timing differs across countries and regions
- Classificaion of firms is somewhat arbitrary

Peer group

Peer group : set of similar companies used for valuation comparisons, consist of companies with similar business activities, demand drivers, cost structure drivers, and availability of capital
Steps to form a peer group:
- Use commercial classification providers to determine which firms are in the same industry
- Examine firm's annual report β†’ iden fy key compe tors
- Examine competitors' annual report β†’ iden fy other compe tors
- Use trade publicationns to identify competitors
- Confirm that comparable firms have similar source of sales and earnings, similar source of demand, and in similar geographic markets
- Adjust financial statements of non-financial companies for any financial subsidiary data included

Elements of an industry analysis

- Evaluate relationship between macroeconomic variables and industry trends using information from industry groups, firms in the industry, competitors, suppliers and customers
- Estimate industry variables using different approaches and scenarios
- Compare with other analysts' forecast of industry variables to confirm the validity of the analysis, and find industries that are misvalued
- Determine the relative valuation of different industries
- Compare the valuations of industries across time to determine the performance's volatility over the long-run and in different phases of the business cycle
- Analyse industry propects based on strategic groups (groups of firms that are distinct from the rest of the industry due to delivery or complexity of their products or barriers to entry)
- Classify industries by life cycle stages (embryonic, growth, shakeout, mature, decline)
- Position the industry on the experience curve (cost per unit relative to output ; curve declines due to ↑ produc vity and economies of scale)
- Consider the forces that affect industries (demographic, macroeconomic, governmental, social, technological)
- Examine the forces that determine competition within an industry

Strategic analysis principles

5 forces - Michael Porter
1
...
Threat of entry : Significant barriers to entry β†’ easier to maintain premium pricing
3
...
Power of buyers : Buyers' ability to bargain for lower prices / higher quality β†’ influence industry profitability
5
...
Switching costs are higher for specialised / differentiated products

Industry Life Cycle

Embryonic

Growth

Shakeout

Mature

Decline

- Slow growth
- High product prices
- Large investment
required
- High risk of failure

- Rapid growth
- Falling product
prices
- Increase
profitability

- Slowing growth
- Increase costs
cutting
- Declining
profitability

- Slow growth
- Stable pricing

- Negative growth
- Declining prices

- Limited
competitive
pressure

- Intense
competition

- Superior firms gain
market share
- High barrier to
entry
- Consolidation

- Increased failure

- Consolidation

Effect of macroeconomic,
Macroeconomic factors : could be cyclical or structural trends
technological, demographical,
- Interest rates : affect financing costs for firms and individual, and financial institution profitability
governmental and social factors on
- Credit availability : affect consumer / business expenditures and funding
industry growth, profitability and
- Inflation : affect costs, prices, interest rate, and confidence level of business / individual
risk
- Education level of workforce : Higher education level β†’ ↑ produc vity and real wages β†’ ↑ demand for consumer goods
Technological factors : introduction of new / improved products β†’ change the industry drama cally
Demographic factors : include age distribution, population size, other changes in composition of the population
Governmenta factors : include taxes and reguation
...
g
...
Cost leadership (low-cost) strategy : firm seeks to have the lowest costs of production in the industry β†’ offers lowest prices and generate enough volume to make superior return
2, Product / service differentiation strategy : Product / service should be distinctive in term of type, quality, and delivery
...
The price premium should also be sustainable over time

Concepts
Categories of equity valuation
models

DCF models - Dividend discount
model

Description
Equity valuation : Concepts and basic tools
1
...

2
...
g
...
g
...
Asset-based models : Total FV of assets - (Total FV of liabilities + Total FV of preferred stocks)
Finite holding period - Dividend discount model
𝐷
𝐷
𝐷
𝑃
𝑉 =
+
+β‹―+
+
(1 + π‘˜ )
(1 + π‘˜ )
1+π‘˜
1+π‘˜

In which:
𝑉 = π‘π‘’π‘Ÿπ‘Ÿπ‘’π‘›π‘‘ π‘ π‘‘π‘œπ‘π‘˜ π‘π‘Ÿπ‘–π‘π‘’
𝐷 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 π‘Žπ‘‘ π‘‘π‘–π‘šπ‘’ 𝑑
𝑃 = π‘Œπ‘’π‘Žπ‘Ÿ 𝑒𝑛𝑑 π‘π‘Ÿπ‘–π‘π‘’ π‘Žπ‘Ÿ π‘‘π‘–π‘šπ‘’ 𝑑
π‘˜ = π‘Ÿπ‘’π‘žπ‘’π‘–π‘Ÿπ‘’π‘‘ π‘Ÿπ‘Žπ‘‘π‘’ π‘œπ‘“ π‘Ÿπ‘’π‘‘π‘’π‘Ÿπ‘› π‘œπ‘› π‘π‘œπ‘šπ‘šπ‘œπ‘› π‘’π‘žπ‘’π‘–π‘‘π‘¦
Infinite holding period - Dividend discount model

𝑉 =

𝐷
π‘˜ βˆ’π‘”

If no growth (e
...
: preferred stocks):
𝐷
𝑉 =
π‘˜
DCF models - FCFE models

FCFE = Net income + Depreciation - Increase in Working Cap - Fixed Capital Investment - Debt principal repayment + New debt issues
FCFE = CFO - Fixed capital investment + Net borrowing

𝑉 =

𝐹𝐢𝐹𝐸
(1 + π‘˜ )

In which:
π‘˜ = 𝑅 + 𝛽 Γ— [𝐸 𝑅

βˆ’π‘… ]

DCF models - Estimates of growth
rate

Methods to estimate growth rate:
1
...
Use industry median of dividend growth rate
3
...
Price multiple (Price - Earnings ; Price - Sales ; Price - Book value ; Price - Cash flow)
2
Title: CFA Level 1 - Equity Investments
Description: I create this summary of knowledge related to CFA level 1 for my 2017 December exam. I got into the top 10% with this. Hope this can help you. Please note that this does not guarantee for your pass, which requires dedication, hardwork and consistency. In case having trouble with any part, please refer to CFA notebook/Schwesser.
Buy These NotesPreview