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Title: CFA Level 2 Self-prepared notes
Description: Summarised notes for CFA Level 2 2020/2021 syllabus
Description: Summarised notes for CFA Level 2 2020/2021 syllabus
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Topic 1 STANDARDS OF PROFESSIONAL CONDUCT I–VII
Proceedings:
●
●
●
●
●
●
●
●
●
fairness of the process to members and candidates
confidentiality of the proceedings
CFA Institute Board of Governors maintains oversight and responsibility for the Professional Conduct Program
Professional Conduct Programme & Disciplinary Review Committee are responsible for enforcement of the
Codes of Ethics and Standards
Standards of Practice Council - maintain and interpret Standards
Source of professional conduct inquiries:
○ self-disclosure
○ written complaints
○ public sources, e
...
media article
○ report by CFA exam proctor of a possible violation during the examination
Once inquire is initiated:
○ Investigate
○ Propose a disciplinary sanction - public censure < suspend membership < revocation of CFA charter
○ Email candidate
○ if reject, refer to a panel composed of DRC members & volunteers
Asset Management Code(AMC) > for firms, voluntary
Codes of Ethics & Standards > for individuals, compulsory to CFA charter holder/member/candidate
CODE OF ETHICS
a
...
e
...
g
...
req
...
● Use reasonable care and exercise independent professional judgment when conducting investment analysis,
making investment recommendations, taking investment actions, and engaging in other professional activities
...
● Promote the integrity and viability of the global capital markets for the ultimate benefit of society
...
STANDARDS
● Fair Dealing - between clients; Priority of Transaction - clients > employer > personal
● Additional Compensation Arrangements - for employer; Disclosure of COI - for client/public
Standard I: Professionalism
Standard I (A) Knowledge of the Law
Members and Candidates must understand and comply with all applicable laws, rules, and regulations (including CFA
Institute's Code of Ethics and Standards of Professional Conduct) of any government, regulatory organization, licensing
agency, or professional association governing their professional activities
...
Members and candidates must not knowingly participate or assist in and must dissociate from any violation of such laws,
rules, or regulations
...
Relationship between the Code and Standards and local law
...
● if laws in different countries have different standards, choose the stricter regulations
...
Don't participate or assist in violations
...
If a member:
Topic 1 STANDARDS OF PROFESSIONAL CONDUCT I–VII
●
Feels a violation may happen, seek the advice of the firm's counsel
...
● Knows a violation happens, report the incident to the appropriate supervisory person in the firm
...
He or she may also seek legal advice to see if other actions
should be taken
...
However, if the law requires an individual to report, he or she must do so
...
Example
● whistleblowing > if unsuccessful > dissociate and document > quit
● suspect > consult > if the consulted knowledge is incorrect, still liable for noncompliance
Procedures for compliance
Members and candidates can acquire and maintain knowledge about applicable laws, rules, and regulations by:
● Maintaining current files of applicable statutes, rules, regulations and important cases in a readily accessible
manner and encouraging the employer to distribute such information to members for this purpose
...
Counsel can provide assistance in this regard
...
Compliance procedures should be reviewed on a regular basis to ensure that they reflect
current laws
...
Members and Candidates must not offer, solicit, or accept any gift, benefit, compensation, or consideration that
reasonably could be expected to compromise their own or another’s independence and objectivity
...
g
...
● Gifts from clients are deemed less likely to impair a member's independence than gifts from other parties seeking
to influence the member's outlook
...
Example
● not acceptable - allocate shares in oversubscribed IPOs to investment managers’ personal accounts
● analyst following a firm; it’s acceptable for the firm to pay for travel expenses as long as it doesn’t impinge I&O
● gifts from clients need to be disclosed; gifts after investment is more acceptable
● buy-side clients(e
...
fund managers) may try to pressure sell-side analysts
● analysts can promise to cover the firm, but should not promise favourable report
● credit rating agency/issuer-paid research should abide by standards of conduct; prefer a flat fee
● compensation shall not be linked to no
...
g
...
● Protect integrity of opinions
...
● Firms should also design compensation systems that protect the integrity of the investment decision process by
maintaining the independence and objectivity of analysts
...
If unwilling to permit dissemination of adverse opinions about a corporate client, the firm
should remove the controversial company from the research universe and put it on a restricted list so that the
firm disseminates only factual information about the company, no opinions shall be offered
...
No corporate issuer should reimburse a member for transportation
...
Members should take particular care that when frequent meetings are held between an individual issuer and an
individual member the issuer is not always the host of the member
...
● Review procedures
...
Topic 1 STANDARDS OF PROFESSIONAL CONDUCT I–VII
Standard I (C) Misrepresentation
Members and Candidates must not knowingly make any misrepresentations relating to investment analysis,
recommendations, actions, or other professional activities
...
Misrepresentation
any untrue statement of a fact, omission of a fact, or any statement that is otherwise false or misleading:
● member’s qualifications and services,
● guarantees about investments and their returns -e
...
superior returns can be expected based on member’s past
success; while it does not rule out correct statements that some investments are actually guaranteed in some
way with guaranteed returns, e
...
insurance contracts, short-term treasury securities
...
g
...
Firms can also designate which employees are authorized to speak on behalf of the firm
...
Members should use written resumes and job descriptions of firm services when making presentations to clients or
prospective clients to help each member focus on the firm's and the member's own strengths and limitations
...
B
...
g
...
C
...
Exception which can be used without acknowledgement:
● factual & public information from recognized sources (S&P, Moody's)
● recognized financial and statistical reporting services
Members should always attribute quotations, projections, data, model/product ideas, and methodologies to their sources
and/or authors
...
developed by people within their firms when speaking
with clients and prospects
...
g
...
Members and candidates should keep copies of materials used in preparing research reports
...
● if invest in areas outside the firm’s core competencies through outside managers, disclosure is needed
● if providing benchmark, choose the most appropriate benchmark
● citing ‘leading analysts’ / ‘investment experts’ without naming specific reference > violation
● Copies computer spreadsheets without obtaining the permission of the owner(s) > violation
Standard I (D) Misconduct
Members and Candidates must not engage in any professional conduct involving dishonesty, fraud, or deceit or commit
any act that reflects adversely on their professional reputation, integrity, or competence
...
A
...
Any act that involves
lying, cheating, stealing, or other dishonest conduct, if the offence reflects adversely on a member or candidate's
professional (not personal) activities, would violate the standard
...
Absence of appropriate conduct and sufficient effort
Members are expected to conduct the necessary due diligence to understand the nature and risks of investment before
making recommendations
...
Topic 1 STANDARDS OF PROFESSIONAL CONDUCT I–VII
Example
● An investment advisor executes excessive trading volume to generate fees
...
If this statement is
misrepresentative, the advisor is clearly engaging in professional misconduct
...
Make clear that any personal behavior that
reflects poorly on the individual involved, the institution, or the investment industry will not be tolerated
...
● Conduct background checks
Standard II: Integrity of Capital Markets
Standard II (A) Material Nonpublic Information
Members and Candidates who possess material nonpublic information that could affect the value of an investment must
not act or cause others to act on the information
...
Material
if its disclosure may affect the price of a security, or if reasonable investors would want to know the information before
investing:
● dividend declaration, tender offer, substantial increases or decreases in earnings projections
...
● Knowledge of forthcoming press coverage of a company's affairs, whether positive or negative
...
The less reliable a source, the less likely
the information provided would be considered material
...
Nonpublic
if it has not been disseminated to the marketplace in general, or if investors have not had an opportunity to react to the
information
...
e
...
a disclosure made to a room full of
analysts does not make the disclosed information "public
...
Mosaic Theory
It is allowed when a perceptive analyst reaches a conclusion about a corporate event through an analysis of public
information and items of non-material nonpublic information (i
...
, a "mosaic" of information), even if that conclusion would
have been material inside information had it been communicated directly to the analyst by a company
...
g
...
e
...
Members and their firms should adopt written compliance procedures to prevent trading while in the possession of MNPI,
e
...
Chinese Wall
...
● Review of employee trading through effective maintenance of combinations of "watch", "restricted", "rumor" lists
...
g
...
● Restricting or prohibiting personal and proprietary employee trading
...
Standard II (B) Market Manipulation
Members and Candidates must not engage in practices that distort prices or artificially inflate trading volume with the
intent to mislead market participants
...
It includes practices
that distort security prices/ volume with the intent to deceive people or entities that rely on information in the market
...
● transactions done for tax purposes (e
...
, selling and immediately buying back a particular stock)
● increase liquidity with proper disclosure - e
...
futures exchange to insure min
...
Price manipulation
...
B
...
Trade near the close of the day's trading, with the objective of affecting published prices, particularly the reported closing
price, in order to:
● avoid margin calls (when the trader's position is not self-financed)
● support a flagging price
● affect the valuation of a portfolio (called "window dressing")
...
C
...
● A wash trade is a trade in which there is no change in the beneficial ownership of the securities - the buyer is, in
reality, also the seller
...
"Pooling or churning" can involve wash sales or pre-arranged trades executed in order to give an impression of active
trading, and therefore investor interest, in the stock
...
False or misleading information
...
In some cases this includes unrealistic, unsubstantiated, or incorrect data, projections,
evaluations
...
"
E
...
A trader writes an option, which obliges the
trader to sell to/ buy from the option holder a specified number of shares at a specified price
...
Standard III: Duties to Clients
Standard III (A) Loyalty, Prudence, and Care
Members and Candidates have a duty of loyalty to their clients and must act with reasonable care and exercise prudent
judgment
...
This standard relates principally to members who have discretionary authority over the management of client's assets
...
Fiduciary duty
obligations of loyalty and care in regard to the responsibility of managing someone else's assets
...
Topic 1 STANDARDS OF PROFESSIONAL CONDUCT I–VII
●
●
A heightened level of fiduciary duty arises if the fiduciary has "custody" or effective control of the client's assets
...
g
...
Fiduciary standards apply in varying capacities, depending on the nature of the relationship with the client or the type of
account under which the assets are managed:
● When managing personal assets of an individual, loyalty is to that individual
...
● When managing funds, loyalty to mandates/defined strategy
The fiduciary should thoroughly consider the risk of loss, potential gains, diversification, liquidity and returns
...
Soft dollars
The broker may provide research services that provide a broad benefit to the manager, to attract managers direct clients’
trades to the broker
...
Since the manager would expect to purchase research services anyway, the soft
dollar arrangement is not necessarily inappropriate
...
C
...
Cost-benefit analysis may show that voting all proxies may not benefit clients; need to disclose their proxy voting policies
Example
● hard dollar is a violation - i
...
cash from broker to investment managers for directing trades
● manager is for large cap, broker’s research is for small cap > violation; as it does not benefit investors directly
● even clients direct managers to a broker, the manager is still responsible for seeking the best ex / price, unless
obtaining written consent
...
A
...
Fairness is not equality, as it would be physically
impossible to reach all customers at the same exact instant, and not all recommendations or investment actions are
suitable for all clients
...
● simultaneous dissemination of recommendations; all clients must be informed at approximately the same time,
so all clients have a fair opportunity to act on every recommendation
● material changes in prior recommendations should be communicated to all current clients simultaneously, with
particular care taken to those clients who acted on the earlier advice
...
B
...
e
...
you can give more
information and research to discretionary clients than to transaction-only clients; need to disclose to all clients
Selection process by which customers receive information should be based on suitability and known interest, not on any
preferred or favored status
...
Oversubscription
If an issue is oversubscribed, members should forgo any sales to themselves or their immediate families(夫妻)
...
Disclosure should be made to clients/ prospects on the allocation procedures, and how they are affected
...
Develop and disclose written trade allocation procedures, block trades and new issuance procedures
...
● Adopt a pro rata or similar objective method or formula for allocating trades
...
Standard III (C) Suitability
When Members and Candidates are in an advisory relationship with a client, they must:
1
...
2
...
3
...
When Members and Candidates are responsible for managing a portfolio to a specific mandate, strategy, or style, they
must make only investment recommendations or take only investment actions that are consistent with the stated
objectives and constraints of the portfolio
...
A
...
● Investor objectives:
○ Return objectives (income, growth in principal, maintenance of purchase power)
...
● Investor constraints: Liquidity needs, expected cash flows (patterns of additions and/or withdrawals), investable
funds (A&L, other commitments), time horizon, tax considerations, regulatory and legal circumstances, investor
preferences, unique needs, and proxy voting responsibilities and guidance
...
B
...
g
...
isolate to execute trade in a new unmanaged account
2
...
Do not state or imply to obtain what was achieved in the past
...
When presentation to clients is brief, the detailed supporting information needs to be provided on request
...
Topic 1 STANDARDS OF PROFESSIONAL CONDUCT I–VII
Example
● Representative accounts - only the best results are presented
...
● Portability of investment results - if results from previous employment, disclosure is needed
...
● simulated performance is acceptable with proper disclosure
...
Encourage compliance with GIPS
...
The information concerns illegal activities on the part of the client or prospective client,
2
...
The client or prospective client permits disclosure of the information
4
...
If applicable law requires maintaining confidentiality, even if the information concerns illegal activities, should not disclose
...
The analyst must preserve confidentiality when the following two criteria are met:
● The analyst must be in a relationship of trust with the client who has engaged him or her
...
Information received out of scope of confidential relationship may be disclosed
...
Members and candidates who will not
provide necessary information because of confidentiality will be seen as failing to cooperate with the investigation and will
be subject to summary suspension of membership under CFA Institute's bylaws
...
Standard IV: Duties to Employers
Standard IV (A) Loyalty
In matters related to their employment, Members and Candidates must act for the benefit of their employer and not
deprive their employer of the advantage of their skills and abilities, divulge confidential information, or otherwise cause
harm to their employer
...
Independent Practice
Should abstain from independent competitive activity that could result in COI - type of services, expected duration,
compensation
...
B
...
Unless approved
with written permissions
...
Whistleblowing
Only allowed for: integrity of markets and interests of clients
Topic 1 STANDARDS OF PROFESSIONAL CONDUCT I–VII
Standard IV (B) Additional Compensation Arrangements
Members and Candidates must not accept gifts, benefits, compensation, or consideration that competes with or might
reasonably be expected to create a conflict of interest with their employer’s interest unless they obtain written consent
from all parties involved
...
Members should make an immediate written report to their employer specifying any compensation they receive or
propose to receive for services in addition to compensation or benefits received from their primary employer
● Nature of the compensation
...
● Duration of the agreement
...
Standard IV (C) Responsibilities of Supervisor
Members and Candidates must make reasonable efforts to ensure that anyone subject to their supervision or authority
complies with applicable laws, rules, regulations, and the Code and Standards
...
Delegation
When supervising too many employees, you can delegate supervisory duties, but not supervisory responsibilities
...
Procedure
If a firm does not have a compliance system, or the system is not adequate, members or candidates should decline in
writing to accept supervisory responsibility until the firm adopts reasonable procedures to allow them to adequately
exercise such responsibility
...
● Review & Update - Periodically update procedures to ensure that the measures are adequate under the law
...
● Monitor - Review employees to ensure compliance and identify violators
...
C
...
● If a supervisor was unable to detect violations, it may not be a violation if the supervisor has taken steps to
institute an effective compliance program AND adopts reasonable procedures to prevent and identify violations
...
Exercise diligence, independence, and thoroughness in analyzing investments, making investment
Topic 1 STANDARDS OF PROFESSIONAL CONDUCT I–VII
recommendations, and taking investment actions
...
Have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment
analysis, recommendation, or action
...
Demonstrate diligence, thoroughness
Three factors determine the nature of the diligence, thoroughness of the research, and level of investigation:
● Investment philosophy followed
...
● The support and resources provided by the employer
...
e
...
When working together on a report, if the opinion is suspected to lack a sound basis, members and candidates should
refrain from relying on it
...
B
...
● Third-party research: research conducted by entities outside the member or candidate's firm
...
Using Quant model
● need to understand the parameters used in the model
● though not required to be experts in technical aspects of models, must understand assumptions and limitations
● if model builder - accuracy, reliability of data; testing of model
D
...
You advise your clients to buy this security and tell them that a full report will be
available shortly
...
Disclose to clients and prospective clients the basic format and general principles of the investment processes
they use to analyze investments, select securities, and construct portfolios and must promptly disclose any
material changes
...
Disclose to clients and prospective clients significant limitations and risks in the investment process
...
Use reasonable judgment in identifying which factors are important to their investment analyses,
recommendations, or actions and include those factors in communications with clients and prospective clients
...
Distinguish between fact and opinion in the presentation of investment analysis and recommendations
...
A report can be given in many forms: a written report, in-person communication, telephone, email
...
Components of Research report/Investment Recommendation
● Expected annual rate of return = cash flow + capital appreciation
● Annual amount of income expected (current and future)
...
Topic 1 STANDARDS OF PROFESSIONAL CONDUCT I–VII
●
●
type and nature of risks
○ leverage, complex financial instruments
○ business, financial, political, sovereign, sector, and market risks
known limitations in the analysis and conclusions in the report
○ Degree of uncertainty associated with cash flows
○ degree of marketability / liquidity
○ capacity - amount beyond which returns will be negatively affected by new investments
B
...
Past = facts, while the forecast on future = opinions
...
C
...
● Reliability, accuracy, and appropriateness of the data included in each report
...
g
...
● Acknowledgement of the source(s) should be made when appropriate
...
g
...
Standard V (C) Record Retention
Members and Candidates must develop and maintain appropriate records to support their investment analyses,
recommendations, actions, and other investment- related communications with clients and prospective clients
...
● Records can be maintained either in hardcopy or electronic form (soft copy)
...
● Records are the property of the member's or candidate's firm
...
● Leaver of the firm reuses the prior recommendation based on memory > Violation, as it’s not supported by
record
...
Members and Candidates must ensure that such disclosures are prominent, are delivered in plain language, and
communicate the relevant information effectively
...
In the investment industry, a conflict or the perception of a conflict often cannot be avoided and full
disclosure is required
...
Disclosure to Clients, prospects, employer
Members shall disclose to their clients all matters that reasonably could be expected to impair the members' ability to
make unbiased and objective recommendations
...
Topic 1 STANDARDS OF PROFESSIONAL CONDUCT I–VII
● Market-making or corporate financing relationships
...
Best practice is to assign other analyst to follow up the stock when COI is significant - e
...
top 10 shareholders
Disclosure to Employers should include restricted personal trading, outside board membership
...
Owning stocks in a company that they recommend to their clients
● Sell-side members must disclose any material beneficial ownership in a security
...
● Buy-side members should disclose their procedures for reporting requirements for personal transactions
...
The sales division may ask an analyst to recommend the stock in order to obtain business from that
company
...
Directorships
● director's fiduciary duty to his or her clients VS the director's duty to the shareholders of the firm
...
This may entice the director to push up the price of the firm's securities
...
Special compensation arrangements
Members should also disclose, with approval from their employers, special compensation arrangements with the
employer that might conflict with clients' interests, such as bonuses based on short-term performance, commissions,
performance fees, incentive fees, and referral fees
...
Two approaches to avoid potential COI:
● Avoidance: Personal investment through "blind trust"/ "mutual fund," in which an investment manager has no
influence on investment decisions
...
Standard VI (B) Priority of Transactions
Investment transactions for clients and employers must have priority over investment transactions in which a Member or
Candidate is the beneficial owner
...
For purposes of the Code and Standards, a member is a "beneficial owner" if the member has:
● A direct or indirect pecuniary interest in the securities
...
● The power to dispose or direct the disposition of the security or investment
...
● Family accounts that are also client accounts should be treated like any other firm accounts
...
Example
● if the investment manager combines her personal transactions with clients’, it’s still a violation
...
In general, procedures should do the following:
Topic 1 STANDARDS OF PROFESSIONAL CONDUCT I–VII
●
●
●
●
Limited participation in equity IPOs
...
Restriction on private placements
...
Establish blackout/ restricted periods
...
They should not be allowed to do "front running
...
○ Disclosure of holdings in which the employee has a beneficial interest
...
Investment professionals should ask their brokers to
supply duplicate copies to their firms of all their personal securities transactions and copies of periodic
statements
...
Standard VI (C) Referral Fees
Members and Candidates must disclose to their employer, clients, and prospective clients, as appropriate, any
compensation, consideration, or benefit received from or paid to others for the recommendation of products or services
...
- disclosure should be made at least quarterly
● Describe the nature of the consideration and its estimated dollar value in this disclosure
...
● Consult a supervisor and legal counsel concerning any prospective arrangement regarding referral fees
...
Example
● giving/receiving assistance(cheating) for CFA exam
...
A
...
● Receive the charters
...
● Due-paying (every year) and good standing
...
Members should reference membership in a dignified and judicious manner; if necessary, this would include an accurate
explanation of the requirements for obtaining membership
...
Using the Chartered Financial Analyst designation
CFA charterholders may use the term "Chartered Financial Analyst" or "CFA" in a proper, dignified, and judicious manner
(if necessary, with an accurate explanation of the requirements for obtaining the right to use the designation)
...
Referencing candidacy in the CFA Program
CFA candidates may reference their participation in the CFA Program, but the reference must clearly state that an
individual is a CFA candidate and cannot imply that the candidate has achieved any type of partial designation
...
● Candidates may indicate that they have completed Level I, II or III of the CFA program in sentence
...
About the CFA mark
● It is registered in many countries (along with Chartered Financial Analyst)
...
● Only CFA or Chartered Financial Analyst should appear after the charterholder's name
...
● The designation "CFA" cannot be listed in a typeset larger than that used for the charterholder's name
...
distinguish between the dependent and independent variables in a linear regression;
b
...
calculate and interpret the standard error of estimate, the coefficient of determination, and a confidence interval for a
regression coefficient;
Variation
•
df
Sum of squares
Mean Sum of Square
Regression k
RSS
MSR = RSS/k
Error
n-k-1
SSE = sum of squared error
MSE = SSE/ n-k-1
Total
n-1
SST
Notes
SEE=σ =
2
𝑠𝑢𝑚 𝑜𝑓 𝑠𝑞𝑢𝑎𝑟𝑒𝑑 𝑒𝑟𝑟𝑜𝑟
𝑛−𝑘−1
coefficient of determination = R2=RSS/SST
2
•
sample correlation between X and Y is 𝑅 for regression with 1 independent variable
d
...
calculate and interpret a confidence interval for the predicted value of the dependent variable;
g
...
calculate the predicted value for the dependent variable, given an estimated regression model and a value for the
independent variable;
*
•
𝑝𝑟𝑒𝑑𝑖𝑐𝑡𝑖𝑜𝑛 𝑖𝑛𝑡𝑒𝑟𝑣𝑎𝑙 = 𝑦 ± 𝑡𝑛−2 * 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑒𝑟𝑟𝑜𝑟 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑜𝑟𝑒𝑐𝑎𝑠𝑡
•
𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑒𝑟𝑟𝑜𝑟 𝑜𝑓 𝑓𝑜𝑟𝑒𝑐𝑎𝑠𝑡 =
𝑆𝑆𝐸
𝑛−2
*
h
...
1+
1
𝑛
2
+
(𝑋−𝑋)
2
(𝑛−1)𝑠𝑥
Topic 2 Quantitative Methods
LOS 5 Multiple Regression
a
...
interpret estimated regression coefficients and their p-values;
c
...
interpret the results of hypothesis tests of regression coefficients;
e
...
explain the assumptions of a multiple regression model;
•
assumptions from simple linear regression
•
no exact linear relation between any two or more independent variables
g
...
distinguish between and interpret the R2 and adjusted R2 in multiple regression;
•
2
𝑅𝑎 = 1 −
𝑆𝑆𝐸/(𝑛−𝑘−1)
𝑆𝑆𝑇/(𝑛−1)
> inflate SSE term to adjust for increase in explanatory variables
•
adjusted R-squared is smaller than R-squared
•
If the new variable has only a small effect on R-square, adjusted R-square decrease and less than 0
i
...
formulate a multiple regression equation by using dummy variables to represent qualitative factors and interpret the
coefficients and regression results;
k
...
describe multicollinearity and explain its causes and effects in regression analysis;
Heteroskedasticity
1
...
conditional
> variance of error term is
conditional on independent variables
> unreliable s
...
estimates
> if s
...
too small > rejects H0 too
often > t/F statistics are unreliable
one-tail test, with H0 as no hetero
2
2
𝐵𝑟𝑒𝑢𝑠𝑐ℎ𝑒 − 𝑃𝑎𝑔𝑎𝑛 χ 𝑡𝑒𝑠𝑡 = 𝑛 * 𝑅𝑟𝑒𝑠𝑖𝑑𝑢𝑎
2
- 𝑅𝑟𝑒𝑠𝑖𝑑𝑢𝑎𝑙 is from regressing the squared
residuals from original model on
independent variables
- df is k, i
...
number of independent
variables
- H0: homoskedasticity
1) robust standard error
- white-corrected s
...
using ei instead
of σ𝑖
2) Generalised Least Squares
- modify original regression equation
2
if 𝑣𝑎𝑟(ε𝑖) = 𝑓(𝑥𝑖, 𝑥𝑗)σ
divide each term by
𝑓(𝑥𝑖, 𝑥𝑗)
Serial Correlation:
+ve: +ve error term in one period ↑
probability of observing a +ve
regression error next period
> coefficient s
...
being too small >
often reject > type I error
-ve: +ve regression error in one
period ↑ probability of observing a
-ve regression error next period
> coefficient s
...
being too large >
reject too little > type II error
Durbin-Watson statistics
𝑇
𝐷𝑊 =
2
∑ (ε𝑡 − ε𝑡−1)
𝑡=2
𝑇
2
≈ 2(1 − 𝑟)
∑ ε𝑡
1) adjust coefficient standard errors
- e
...
Hansen s
...
if both
heteroskedasticity and serial
correlation are present
𝑡−1
df is n
H0: no serial correlation
2) incorporate the time-series nature
0 to dl: reject for +ve serial correlation;
du to 4-du: do not reject H0
4-dl to 4: reject for -ve serial correlation
Multicollinearity:
s
...
of slope coefficient are artificially high R square and significant F, but
inflated > incorrectly conclude that a insignificant t-statistic for coefficients
variable is not statistically significant
remove one or more of the correlated
variables
Topic 2 Quantitative Methods
> type II error
m
...
describe models with qualitative dependent variables;
•
Discriminant models - linear function which generates an overall score/ranking
•
Probit/Logit models - estimates the probability that the event occurs
o
...
calculate and evaluate the predicted trend value for a time series, modeled as either a linear trend or a log-linear trend,
given the estimated trend coefficients;
•
𝑏0+𝑏1𝑡
Log-linear trend model: 𝑙𝑛𝑌𝑡 = 𝑏0 + 𝑏1𝑡 + ε𝑡 𝑌𝑡 = 𝑒
b
...
explain covariance stationary and describe the significance of a series that is not stationary;
•
covariance stationary: 1
...
constant and finite variance
3
...
describe an autoregressive (AR) model of order p and calculate one- and two-period-ahead forecasts given the
estimated coefficients;
𝐴𝑅(𝑝): 𝑥𝑡 = 𝑏0 + 𝑏1 * 𝑥𝑡−1 + 𝑏2 * 𝑥𝑡−2 + … + 𝑏𝑝 * 𝑥𝑡−𝑝 + ε𝑡
•
•
assumptions:
■
covariance-stationary series > DF test > try first differencing
■
no conditional heteroskedasticity > ARCH(1) has significant beta > use generalised least square
■
no autocorrelation in residuals > t test > if detected, add more lag terms
e
...
explain mean reversion and calculate a mean-reverting level;
g
...
explain the instability of coefficients of time-series models;
i
...
) = 𝑉𝑎𝑟(ε1) + 𝑉𝑎𝑟(ε2) + 𝑉𝑎𝑟(ε3) +
...
describe implications of unit roots for time-series analysis, explain when unit roots are likely to occur and how to test for
them, and demonstrate how a time series with a unit root can be transformed so it can be analyzed with an AR model;
•
Unit root testing for non-stationary
1) run an AR model and examine autocorrelations
> residual autocorrelations should not be different from 0 at all lags and decay to 0 for further lags
2) Dickey Fuller Test
if AR(1) as coefficient of 1, it has a unit root and no finite mean-reverting level
H0: a unit root is present in an autoregressive model
𝑥𝑡 = 𝑏0 + 𝑏1𝑥𝑡−1 + ε𝑡
-
𝑥𝑡 − 𝑥𝑡−1 = 𝑏0 + 𝑏1𝑥𝑡−1 − 𝑥𝑡−1 + ε𝑡 = 𝑏0 + (𝑏1 − 1)𝑥𝑡−1 + ε𝑡
Topic 2 Quantitative Methods
test whether b1-1 is statistically different from 0 > if b1 = 1, unit root is present; if rejecting, no unit root
k
...
explain how to test and correct for seasonality in a time-series model and calculate and interpret a forecasted value
using an AR model with a seasonal lag;
m
...
n
...
•
If both independent & dependent variables are not covariance stationary > cointegration test
•
If cointegration exists between 2 time series, the error term from regression one on the other is covariance stationary
and t-test is reliable
•
Cointegration test: 𝑦𝑡 = 𝑏0 + 𝑏1𝑥𝑡 + ε𝑡
residuals are tested for a unit root using DF test
with critical t-values calculated by Engle and Granger
when H0 is rejected > error terms are covariance stationary
o
...
Topic 2 Quantitative Methods
LOS 7 Machine Learning
a
...
g
...
g
...
g
...
describe overfitting and identify methods of addressing it;
•
overfitting: trained too well for training data that does not generalize well to new data
> out-of-sample R2 will be low
•
create 3 non-overlapping data sets:
1) training sample - training 2) validation sample - tuning 3) test sample - evaluating the model
•
Errors:
1) bias error: in-sample error due to models poor fit 模型过糙 A: error rates converge, but below desired level
2) variance error: out-of-sample error due to overfitted models
B: in-sample accuracy rate converges, out-of-sample accuracy lags
3) base error: residual errors due to random noises
c
...
g
...
not-likely-to-default
K-Nearest Neighbour: classify a new observation by finding similarities to existing data
CART: decision tree; e
...
selecting stocks and bonds
ensemble learning: combing predictions from multiple models for a lower average error rate
1) aggregation of heterogeneous learners: different algos combined via a voting classifier
2) aggregation of homogeneous learners: same algo, different training data
random forest: a variant of classification trees trained using data bagged from same data set
Topic 2 Quantitative Methods
d
...
- screen plots: shows proportion of total variance explained by each principal component
...
describe neural networks, deep learning nets, and reinforcement learning
...
state and explain steps in a data analysis project;
•
conceptualise modeling task > data collection > data preparation and wrangling > EDA > model training
b
...
required data is missing
...
e
...
numbers or dates should fall within a certain range
...
the degree to which the data is close to the true values
...
e
...
a valid age of 10 but with 'divorced' marital status
...
e
...
the currency is sometimes in USD and sometimes in YEN
...
the duplicate entries should be removed
...
Aggregation - cities aggregated into regions, states, countries etc
...
Selection - select a subset of relevant attributes for use in the model
...
describe objectives, methods, and examples of data exploration;
•
EDA: - understand data properties, distributions & other characteristics
- find patterns/relationships, evaluating basic questions & hypothesis
- planning modeling in future steps
•
feature selection
•
feature engineering
d
...
describe preparing, wrangling, and exploring text-based data for financial forecasting;
•
preparing & cleansing - e
...
remove punctuations to /colon, periods/, white spaces, numbers to /numbers//;
•
wrangling - stopwords, lowercasing, stemming(all variation of a word into common value); lemmatization(时态还原)
f
...
of documents containing that token / total number of documents
2
3) χ test: tokens with highest chi-squared test statistics occur more frequently with a specific class
•
feature engineering:
1) identification of numbers - e
...
4 digits > year
2) usage of N-grams - multiword patterns - e
...
expansionary_fiscal_policy as one word
3) name entity recognition - e
...
Microsoft has a ORG token; Europe has a Place token
4) parts of speech, using language structure dictionaries to contextually assign tag - e
...
cat > noun
g
...
•
model fitting - how well the model generalises to new data
•
Error analysis:
> precision = (TP) / (TP+FP)
= % of TP in all predicted positive
> recall/sensitivity = (TP) / (TP+FN)
= % of TP in all actual positive
> accuracy = (TP+TN) / all
> F1 score = harmonic mean of recall & precision
> F1 is the better measure of accuracy when class
distributions in the dataset are unequal
Topic 2 Quantitative Methods
•
Receiver Operating Characteristic
> false positive rate = FP / (TN +FP)
> true positive rate = TP / (TP+FN) = sensitivity
> Area under curve close to 1
...
describe steps in running a simulation;
1) Determine the probabilistic variables
2) Define probability distribution for these variables
a
...
Cross-section Data
c
...
explain three ways to define the probability distributions for a simulation’s variables;
c
...
describe advantages of using simulations in decision making;
•
better input quality
•
provide a distribution of expected value rather than a point estimate
e
...
g
...
describe issues in using simulations in risk assessment;
•
“garbage in, garbage out”
•
inappropriate statistical distribution
•
non-stationary distribution - input variable distribution may change over time - invalid parameters
•
dynamic correlation across inputs - correlation may not be stable
g
...
•
scenario analysis: compute the value of an investment under a finite set of scenarios
•
decision tree: difficult to model risks with correlation at the each node level
•
with all approaches, use expected cash flow to discount with a risk-adjusted discount rate
Topic 3 Economics
LOS 10 Currency Exchange Rates
a
...
bid-offer spread in the interbank fx market for the two currencies involved > affected by liquidity
> factor affecting liquidity: currency pair involved, time of day(no of open market), market volatility
2
...
relationship between dealer and client
b
...
distinguish between spot & forward rates, calculate forward premium/discount for a given currency;
•
1
1 + 𝑖𝑑 = 𝑆𝑓/𝑑(1 + 𝑖𝑓)( 𝐹
)
𝑓/𝑑
•
with date convention of actual/360: 1 + 𝑖𝑑[
𝑎𝑐𝑡𝑢𝑎𝑙
360
] = 𝑆 𝑓 (1 + 𝑖𝑓[
𝑑
𝑎𝑐𝑡𝑢𝑎𝑙
360
1
])( 𝐹 )
𝑓
𝑑
𝐹𝑓 = 𝑆𝑓(
𝑑
𝑑
𝑎𝑐𝑡𝑢𝑎𝑙
360
]
𝑎𝑐𝑡𝑢𝑎𝑙
1+𝑖𝑑[ 360
]
1+𝑖𝑓[
)
•
forward premium of domestic currency, if & only if foreign risk-free i/r exceeds domestic risk-free i/r
d
...
liquidity in the forward market tends to decline
2
...
i/r risk of contract increases
e
...
> as exposures are fully hedged, return from foreigh
exposure = return from domestic investment
•
UIP: change in spot rate over investment the horizon should,
on average, equal differential in i/r between two countries;
i
...
known return from domestic = expected return from
foreign
> assume investors are risk-neutral;
𝑆
> approximation: 𝐸( 𝑆1 − 1) = 𝐸[𝑖𝑓 − 𝑖𝑑]
0
•
•
•
forward rate parity: forward rate is an unbiased estimator of
future spot rate if CIP and UIP hold
absolute PPP - foreign price of good x = exchange ratef/d *
domestic price of good x
relative PPP -
𝑆1
𝑆0
=
1+𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛𝑑
1+𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛𝑓
𝑆
ex ante version at t=0: 𝐸( 𝑆1 − 1) = 𝐸[π𝑓 − π𝑑]
0
•
Fisher: i = E(π) + real i/r > 𝑖𝑓 − 𝑖𝑑 = (𝑟𝑓 − 𝑟𝑑) + (π𝑓 − π𝑑)
> with assumption of real i/r parity: real i/r will converge to the same level across different markets
> international Fisher effect - 𝐸[𝑖𝑓 − 𝑖𝑑] = 𝐸[π𝑓 − π𝑑]
> if ex ante PPP and UIP holds, real yield spread btw i/r is 0
f
...
evaluate use of current spot rate, forward rate, PPP, and UIP to forecast future spot exchange rates;
h
...
g
...
describe the carry trade and its relation to uncovered i/r parity and calculate profit from a carry trade;
•
long high-yield currencies, short low-yield currencies(funding currency)
•
reward: gradual accrual of i/r differential > if UIP holds in short term, carry trade wouldn’t be profitable
•
risk: potential for sudden adverse exchange rate movements
> crash risk: carry trade is a leveraged position; distribution of carry trade return has heavy tails that are negatively
skewed; typically generates a large number of small gain/loss
j
...
current account - flows in real economy, e
...
actual production
2
...
prices of real goods and services tend to adjust more slowly than exchange rates & asset prices
2
...
g
...
current spending decisions reflect only purchase/sales of current production; while investment decisions reflect
bother financing of current expenditures and reallocation of existing portfolios
4
...
flow supply/demand channel: when a country sold more goods, demand for its currency rises
with appreciation in long run, export drops, balance restored
> depends on initial gap btw I&X, price elasticity
2
...
debt sustainability channel: upper limit on persistently large current deficits;
persistent debt > ↓revision in expectation of currency’ LR value
•
financial accounting impact - capital flow:
> with high short-term i/r, local currency is appreciated by capital inflow
> may be risky for emerging markets:
1
...
a huge buildup in external indebtedness by emerging market governments or banks
3
...
consumption binge results in explosive growth in domestic credit/ current account deficit
5
...
g
...
explain the potential effects of monetary and fiscal policy on exchange rates;
•
Mundell - Fleming model: monetary policy affects exchange rate through affecting i/r & output
> assumption: there is capacity in the economy, AD increases without price level increases;
> # short run model to allow P stays the same
2
Topic 3 Economics
1
...
monetary policy: ↓i/r > capital flow to high-yielding market > ↓ domestic currency
↓i/r > consumption & import increases > trade deficit > ↓ domestic currency
- expan
...
Floating exchange rate, low mobility (current account is more impactful)
- expan
...
fiscal policy: finance budget deficit > ↑ i/r > capital inflow > ↑ domestic currency
consumption & import increases > worse trade balance > ↓ domestic currency
=> current account dominates
With low capital mobility
Expansionary Monetary
Restrictive Monetary
Expansionary Fiscal
Domestic Currency ↓
Indeterminate
Restrictive Fiscal
Indeterminate
Domestic Currency ↑
3
...
g
...
fiscal policy > G↑ > finance deficit > i/r ↑ > capital inflow > about to appreciate > sell domestic currency ≈
expansionary monetary policy
•
Pure Monetary model: model is more long-term
- MV = PY; assumes V and Y(output) are stable, monetary policy affects fx via price level & inflation
- rise in domestic money supply ↑ domestic price level
- with relative PPP, money supply-induced ↑ in relative price leads to a proportional ↓ in domestic currency value
•
Dornbusch: prices have limited flexibility in the short run, only fully flexible in the long run
- in short run, domestic price is sticky, increase in monetary supply results in ↓ in i/r > mobile capital outflows > real
domestic currency depreciates below its LR equilibrium; once nominal i/r increases in LR, currency appreciates
to equilibrium
- in long run, ↑ in domestic monetary supply > P↑ > inflation ↑> domestic currency depreciates in nominal terms,
constant in real term
•
Portfolio Balance Model: long run model;
> assume investors hold a diversified portfolio of
domestic & foreign assets
> sustained gov
...
describe objectives of central bank intervention & capital controls and describe effectiveness of intervention & controls;
•
capital inflow is driven by pull and push factors:
pull: developments encourage foreign capital inflows through strong growth in private sector
e
...
privatization of state-owned entities, liberalization of financial markets
push: e
...
low i/r in industrial countries encourages global investors to seek higher return abroad
...
g
...
5
*
*
π: current inflation rate: π*: central bank target inflation rate
y: log of current level of output; y*: log of economy’s potential level of output
m
...
•
prior to a currency crisis, capital markets have been liberalized to allow free flow of capital
•
large inflow of foreign capital relative to GDP, with short-term funding denominated in foreign currency being
particularly problematic
•
often preceded by banking crises or boom-bust cycle in financial asset(equity) price
•
countries with fixed exchange rates are more susceptible to currency crises
•
foreign exchange reserves tend to decline as a crisis approaches, with currency has risen substantially relative to
historical mean
•
term of trade deteriorates > trade deficit
•
broad money growth, and money supply(M2) / bank reserves tend to rise in the 24-month period leading up to crisis
•
inflation tend to be significantly higher in pre-crisis periods
•
nominal private credit growth tends to rise sharply
4
Topic 3 Economics
LOS 11 Economic Growth and Investment Decisions
a
...
screen those seeking funding and monitoring those who obtained funding
2
...
mitigate credit constraints
•
political stability, rule of law and property rights
•
education and health care systems: e
...
brain drain
•
tax and regulatory systems: e
...
limited regulations encourage entry of new companies
•
free trade and unrestricted capital flows
- trades provide residents with more goods at lower costs
- world savings can finance domestic investment through FDI or buy securities issued by domestic
b
...
explain why potential GDP and its growth rate matter for equity and fixed income investors;
•
real i/r is the real return for postponing consumptions
•
to grow potential GDP in LR, higher savings are needed to fund required capital accumulation; anticipating real
income to rise more rapidly, consumers/savers demand higher real return for postponing consumption > only higher
real i/r leads to higher potential GDP growth
•
when actual GDP growth rate > potential growth rate, upward pressure on inflation
•
fixed income: 1
...
central banks’ decisions are affected by resource utilization & slack in the economy
i
...
output gap and difference btw actual GDP growth and sustainable growth rate
3
...
fiscal positions have higher deficits in recessions and improve during expansions
d
...
of output paid to capital
1
...
for capital market: 𝑀𝑃𝑘 = α
𝑌
𝐾
= 𝑀𝐶 = 𝑟𝑒𝑛𝑡𝑎𝑙 𝑝𝑟𝑖𝑐𝑒 𝑟
> α=𝑟*
𝑘
𝐾
𝑌
= proportion paid to
capital
...
diminishing marginal productivity
> if α close to zero > diminishing marginal returns to K are very
significant and marginal output from additional capital ↓ quickly
capital deepening - an increase in the capital-to-labour ratio (k)
- movement along production function
5
Topic 3 Economics
- marginal product of capital declines significantly beyond B
- capital deepening raises per capita growth when economy is below steady state - e
...
developing country
- effect of capital deepening = α%∆𝑘 = %∆𝑦 − %∆𝐴
•
technological progress - an improvement in TFP - proportional upward shift of production function
...
•
Sustained growth in per capita output requires progress in TFP
...
forecast potential GDP based on growth accounting relations;
•
Solow growth accounting equation:
-
•
∆𝑌
𝑌
=
∆𝐴
𝐴
+ α
∆𝐾
𝐾
+ (1 − α)
∆𝑙
𝐿
often used to measure potential growth or sources of growth
labour productivity(y) growth accounting equation: 𝑌 = 𝐿 *
𝑌
𝐿
= 𝐿*𝑦
growth rate in potential GDP = long-term growth rate of labour force
+ long-term growth rate in labour productivity
- effect of capital deepening & technological progress are both in productivity terms, difficult to analyse separately
f
...
may fail to develop economic institutions necessary for growth
2
...
•
Countries that are not self-sufficient in oil or other resources acquire what they need through trade
...
explain how demographics, immigration, labour force participation affect rate and sustainability of economic growth;
•
Labour force is the working age population (16 - 64) that is either employed or available for work but not working (i
...
unemployed)
...
•
Population growth is determined by fertility/mortality rates
...
explain how investment in physical capital, human capital, and technological development affects economic growth;
•
Human capital - labour quality - accumulated knowledge and skills of workers
> increased through investment in education and on the-job training
> spillover or externality impact
•
Capital: higher investment > accumulates physical capital stock > higher rate of GDP growth
- though capital deepening impact may be limited by diminishing marginal return, investment-driven growth
may last for a considerable period
- physical capital is not homogeneous, composition of investment and capital stocks metter
...
g
...
compare classical growth theory, neoclassical growth theory, and endogenous growth theory;
•
classical model: growth of y is only temporary
- assumptions: population growth accelerates when the level of y rises above subsistence income, i
...
min
...
r
...
> Capital deepening occurs with capital per labour k grows at
%∆𝐴
1−α
, but it has no effect on the growth rate of the
economy or on the marginal product of capital once the steady
state is reached
...
saving rate s: ↑ saving rate > ↑ capital-to-labour ratio(k) and
higher output per worker(y); as higher saving rate generates
more investment at every output level, shifting investment curve
upwards
...
2
...
depreciation rate δ: increase in δ reduces steady state k and y
as given rate of gross investment generate less net capital
accumulation
4
...
- before steady state
> if output/capital ratio is above equilibrium, growth rate of o/p per
capita and capital per capita are above steady rate > actual
investment exceeds required investment > capital grows faster
than output > Y/K declines
- conclusion:
1
...
capital deepening vs tech:
- rapid growth above steady state occurs when countries first begin to accumulate capital, but growth will slow
from diminishing marginal return
- long-term sustainable growth is through growth in TFP
3
...
- once at steady state growth, growth rate does not depend on % of income saved or invested
...
4
...
•
endogenous growth: - no steady state
- the model explains tech progress, economy does not necessarily converge to a steady state
- no diminishing marginal returns to capital for economy as a whole > increase saving rate permanently increases
the rate of economic growth
- capital accumulation is the main factor accounting for long-run growth, with capitals including human or knowledge
capital and R&D
...
- R&D expenditures have potentially large positive externalities or spillover effects, as the product of R&D is
essentially ideas, which can be copied by others
...
explain and evaluate convergence hypotheses;
•
absolute convergence: LDC will eventually catch up with DC, regardless of their characteristics
...
Those not in the club need to
make appropriate institutional changes to get out of the non-convergence trap
...
through capital accumulation and capital deepening
2
...
k
...
describe the expected impact of removing trade barriers on capital investment and profits, employment and wages, and
growth in the economies involved
...
borrow/lend in global markets, investment is not constrained by domestic savings
2
...
access to global market to exploit EOS and increasing potential reward for successful innovation
4
...
competition in domestic market > improve productivity while keep costs low
•
neoclassical: convergence should occur more quickly if economies are open with free trade and international
borrowing/lending
...
describe the economic rationale for regulatory intervention;
•
information friction, public good, externalities, weak competition, social objectives
b
...
# financial contagion: financial shock spreads to other sectors/economies
•
commerce: facilitate business environment(protection, privacy,safety of products)
labour market: e
...
workplace safety, employees/employers’ rights
c
...
describe classifications of regulations and regulators;
•
state-backed regulations: 1
...
admin regulations/ admin laws - rules issued by gov agencies/regulators
3
...
governmental departments and agencies
2
...
self-regulating organisations: been given recognition & authority by gov
...
Non-SRO
•
outside bodies - e
...
IASB, FASB, credit-rating
•
Substantive law focuses on the rights/responsibilities of entities and relationships among entities
•
Procedural law focuses on the protection and enforcement of the substantive laws
...
e
...
describe regulatory interdependencies and their effects;
•
regulatory capture theory: regulation can sometimes enhance benefits/interests of the regulated
- regulators may have worked in the industry > reinforce regulatory capture
•
regulatory competition: compete to provide a regulatory environment designed to attract certain entities
•
regulatory arbitrage(from perspective of those being regulated): identify and use some aspect of regulations that
allows them to exploit differences in economic substance or in foreign and domestic regulatory regimes
g
...
> shareholders and creditors pay costs of failure, rather than taxpayers
h
...
unanticipated implementation costs e
...
hiring more lawyers
2
...
9
Topic 3 Economics
i
...
•
likelihood of regulatory change: how likely the proposed regulations actually being implemented
•
impact of regulatory change on a sector, based on investors/analysts opinions
- impact on revenues, costs; e
...
tariff, price caps, costs to compliance with regulations
- business risk: compensation to customers
10
Topic 4 Financial Reporting Analysis
LOS 13 Intercorporate Investments
a
...
business model test: financial assets are being held to collect contractual cash flows
2
...
Method
Instrument Type
Details
Amortised
Cost
Debt Instruments Only
for held to maturity
initial recognition:
IFRS: fair value + transaction cost
GAAP: at cost including transaction cost
FVOCI
available for sale
debt & designated equity
- realised go to I/S, unrealised go to equity via OCI
- debt: in 2nd year, i/r should use market YTM at 1st year end
foreign debt
- under IFRS, fx caused fair value from foreign debt go to I/S
held for trading (equities)
- realised & unrealised P&L go to I/S
debt designated at FV
- debt: in 2nd year, i/r should use market YTM at 1st year end
derivatives
(except for hedging)
- embedded derivatives are not separated from the hybrid contract and
the asset as a whole is measured at FVPL
FVPL
•
•
Reclassification: not permitted for equity instruments
From
To
Details
Amortised
FVOCI
- revalue at fair value; difference go to OCI as unrealised
Amortised
FVPL
- revalue at fair value; difference go to I/S as unrealised
FVOCI/PL
Amortised
- fair value as carrying amount, amortise out of OCI
IFRS: Reclassification of equity instruments is not permitted; debt instruments can only be reclassified between
Amortised cost vs FVOCI, when the business model for the financial assets has changed significantly, which should
be very infrequent
...
There is an earlier
recognition of impairment—12 month expected losses for performing assets and lifetime expected losses for
non-performing assets, to be captured upfront
...
cost of investment > proportionate share of BV of net identifiable assets) due to:
a
...
g
...
g
...
goodwill on acquisition(partial goodwill, proportional to % share acquired):
2
...
Impairment: no reversal of impairment loss
IFRS: objective evidence of impairment e
...
loss events impact on future CF
- impair if recoverable amount < carry; reduce carrying amount or use allowance account
- no separate test for goodwill
GAAP: impair on carrying value, if FV < carry permanently, loss to I/S;
4
...
•
all identifiable tangible and intangible(e
...
brand name) are measured at FV
- e
...
inventory: adjust COGS to FV of inventory
- e
...
PPE: adjust depreciation to account for FV of PPE
- in-process R&D: separate intangible asset measured at fair value;
amortised if successfully completed, impairment if no product results
...
e
...
•
restructuring: expensed in the periods the restructuring costs are incurred
...
distinguish between IFRS and US GAAP in the classification, measurement, and disclosure of investments in financial
assets, investments in associates, joint ventures, business combinations, and special purpose and variable interest
entities;
•
for PPE: IFRS permits historical cost / fair value; GAAP only allows historical cost
•
contingent liability for consolidation:
- IFRS: contingent liability if can be reliably measured; measured at higher of initial recognition or estimate to amount
required to settle; contingent assets are not recognized;
- GAAP: both contingent assets and liabilities are recognized, with assets measured at lower of acquisition date FV
or the best estimate of future settlement amount
...
•
VIE & SPE:
- Sponsoring companies create SPEs to facilitate transfer of assets and liabilities from their own balance sheets,
recognizing revenue and gains while avoiding consolidation; this improves asset turnover & lowers operating and
Topic 4 Financial Reporting Analysis
financial leverage metrics
...
VIE defined by:
1) total equity at risk is insufficient to finance activities without financial support from other parties;
2) or, SPE lacks decision-making ability/ loss absorbing obligations/ right to receive returns
...
analyze how different methods used to account for intercorporate investments affect financial statements and ratios
...
describe the types of post-employment benefit plans and implications for financial reports;
•
Defined contribution pension plans - specific amount agreed is pension expense at I/S
...
g
...
- future pension payments are liability, requiring actuarial assumptions
- employers estimate total cost of benefits promised and allocate to periods of service:
a
...
life expectancy of the employee
c
...
life insurance premiums, healthcare insurance
- classified as DB, more complexity in reporting; regulation is not as restrictive
b
...
e
...
describe the components of a company's defined benefit pension costs;
IFRS
GAAP
expense in I/S
current: expense in I/S
past: reported in OCI, amortised to I/S
over remaining service lives
net interest expense: beginning L * mkt rate
cost/incom
gain
e
expense in I/S
expense in I/S
remeasure actuarial gain/loss
ment
difference between actual return
on plan assets and amount
calculated for interest income
= actual return - (plan asset *
expected return)
OCI
reporting
no specification
service
cost
•
↑in pension obligation due to
employees’ service
beginning asset*market expected return on plan assets
discount rate > I/S
expense in I/S
OCI, no subsequent
amortisation to P&L
OCI, with corridor approach for
subsequent amortisation to I/S:
if cumulative amount of unrecognised
actuarial gain/loss > 10% max(PBO, plan
asset), amortise the exceeding part over
average remaining service lives to I/S
aggregate all I/S expensed as net and
reported as operating expense
Pension benefit obligation = beginning PBO + interest cost + current service cost
■
opening PBO = accumulated benefits, discounted to current period
■
current service cost = incremental PMT due to additional year of service, discounted back
1
...
discount annual unit credit to current period - retirement in 7 years, discount for 6 years
d
...
calculate compensation before retirement - e
...
10 years to retirement > growth for another 9 years
2
...
g
...
discount PMT to retirement time > Value at retirement
4
...
explain and calculate how adjusting for items of pension and other post-employment benefits that are reported in the
notes to the financial statements affects financial statements and ratios;
•
OPB - healthcare inflation rate > similar to compensation growth rate
•
healthcare inflation rate will decrease gradually to healthcare trend rate
f
...
g
...
explain issues associated with accounting for share-based compensation;
•
share-based compensation is an expense, thus a reduction of earnings
•
other cash settled stock compensation: will not dilute control
- stock appreciation rights
- phantom shares - if dividends/appreciation > give gain in cash
•
recipient of share-based compensation may have limited influence over firm’s value, thus ineffective incentives
•
increase ownership lead to risk averse actions, e
...
taking less risky projects
•
options reward excessive risk taking
•
stock options could diluted EPS
h
...
•
stock grants: expense = fair value of stock on the grant date; allocated over service period
- shares contingent on performance may incentivize manipulation of accounting number
•
stock options: vesting date - date than employees can first exercise the stock options
service period = period between grant date and vesting date
- if vest immediately, expense(fair value of option) is recognized on the grant date
- if vest after a specific service period/ contingent on performance/market, expense is allocated over service periods
- reduce retained earnings, increase paid-in capital > no net effect on equity
Topic 4 Financial Reporting Analysis
LOS 15 Multinational Operations
a
...
describe foreign currency transaction exposure, including accounting for and disclosures about foreign currency
transaction gains and losses;
•
foreign currency transactions: those denominated in a currency other than functional currency
•
settlement before BS date: record at spot rate on the date of transaction, not settlement
...
g
...
loss from cash; expense loss as fx loss
•
intervening BS date: e
...
gain before BS date; loss on settlement date
at BS date: unrealized gains are included in P&L; at settlement date: recognize transaction loss
net gain recognized = actual realized gain on the foreign currency transaction
•
issues: 1) fx gains/losses can be recognized as other operating income/expense or non-operating
2) with intervening date, unrealized gain or loss is taken as ultimate net gain or loss
•
disclosure: IFRS - amount of exchange differences recognized in profit or loss(not netted)
GAAP - aggregate transaction gain/loss included in determining net income for the period
c
...
compare the current rate method and the temporal method, evaluate how each affects the parent company's balance
sheet and income statement, and determine which method is appropriate in various scenarios;
•
factors determining functional currency
- currency that mainly influences sales prices
- currency of the country whose competitive forces and regulations mainly influence sales prices
- currency that mainly influences COGS > funds from financing activities > operating activity receipts
•
𝑙𝑜𝑐𝑎𝑙 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
𝑟𝑒−𝑚𝑒𝑎𝑠𝑢𝑟𝑒𝑚𝑒𝑛𝑡
𝑡𝑒𝑚𝑝𝑜𝑟𝑎𝑙 𝑚𝑒𝑡ℎ𝑜𝑑
> 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛𝑎𝑙 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
𝑡𝑟𝑎𝑛𝑠𝑙𝑎𝑡𝑖𝑜𝑛
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑒 𝑚𝑒𝑡ℎ𝑜𝑑
> 𝑟𝑒𝑝𝑜𝑟𝑡𝑖𝑛𝑔 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
1) local currency = functional currency: current rate method
- independent subsidiary: entire investment in foreign entity is exposed to translation gain/loss
2) parent’s reporting currency = functional currency > integrated subsidiary: temporal method
Temporal method
A/L Monetary (fixed future value)
Current
Non-monetary (e
...
inventory) Historical
E
Capitals
Historical
R/E
No OCI:
Balancing > translated A/L - capital at
historical rate
Revenue & Expense
COGS & Depreciation & A
Translation G/L
•
•
Current rate method
Current
With OCI:
translated R/E at start + NI
- Div(rate when declared)
Average > rate when transaction took place
Historical > same as translated related assets Average
I/S: change in R/E + Div - calculated NI
without translation G/L
OCI:
Eq
...
calculate the translation effects and evaluate the translation of a subsidiary's balance sheet and income statement into
Topic 4 Financial Reporting Analysis
the parent company's presentation currency;
•
current methods: pure B/S & I/S ratios e
...
quick ratio, current ratio
mixed B/S & I/S ratios; ROA,ROE, Turnovers:
appreciation
same
lower - I/S use average, B/S use current
depreciation
same
higher
if local depreciation: historical > average > current
Temporal
Current method
current ratio
higher as inventory uses historical rate
lower
quick ratio
current for cash
A/R turnover
average for sales / current for account receivable
inventory turnover
depends on FIFO / LIFO
fixed asset turnover lower as fixed asset in historical is higher
gross profit margin
inventory costs use historical
net profit margin
uncertain as translation gain/loss
interest coverage
lower as lower EBIT due to higher D&A
f
...
analyze how alternative translation methods for subsidiaries operating in hyperinflationary economies affect financial
statements and ratios;
•
IFRS: restate for local inflation using IAS29, then translate to parent’s using current rate
1) monetary A&L are not restated
2) non-monetary are restated by applying change in general purchasing power of the monetary unit
3) some non-monetary can be revalued, e
...
PPE
4) equities are restated by applying change in general price level, pro rata
5) P&L: apply change in GPL pro rata to all; net gain/loss from monetary is included in net income
•
GAAPs: remeasure using temporal methods; hyperinflation - cumulative 3-year inflation > 100%
h
...
explain how changes in the components of sales affect the sustainability of sales growth;
j
...
Topic 4 Financial Reporting Analysis
LOS 16 Analysis of Financial Institutions
a
...
describe key aspects of financial regulations of financial institutions;
•
Basel III: improve banking’s ability to absorb shocks arising from financial and economic stress;
improve risk management & governance;
strengthen transparency and disclosures
...
min
...
g
...
explain the CAMELS (capital adequacy, asset quality, management, earnings, liquidity, and sensitivity) approach to
analyzing a bank, including key ratios and its limitations;
•
•
•
•
•
•
capital adequacy =
𝐶𝑎𝑝𝑖𝑡𝑎𝑙
𝑅𝑖𝑠𝑘−𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐴𝑠𝑠𝑒𝑡
RWA = assets * risk- weighting; higher risk, higher weighting
- e
...
cash/ treasury bill has a risk weighting of 0, thus not included in RWA > no capital is needed to fund cash
- e
...
high-volatility commercial real estate and loans with > 90 days past due, weighting > 100%
- common equity tier 1: common stock + share premium + R/E + cumulative OCI - intangible assets - deferred tax A
- other tier 1: instruments subordinate to deposits/debt obligations, with no fixed maturity and no payments of div/ir
that is not totally at bank’s discretion - e
...
preferred stocks
- tier 2: subordinate to depositors and general creditors, having an original min 5-year maturity
- common equity tier 1 ≥ 4
...
describe other factors to consider in analyzing a bank;
•
Government support: size of bank(too big to fail), status of country’s banking system
•
Government ownership - additional security for bank investor
•
Mission of banking entity/ Corporate culture
•
Competitive environment: regional bank may be more monopolistic; global bank faces more
•
Off-balance-sheet items: e
...
highly engineered financial instruments, SPE/VIE
•
Currency exposure/ Risk factors/ BASEL III disclosures
e
...
describe key ratios and other factors to consider in analyzing an insurance company
...
S - NAIC established minimum capital adequacy standards
...
S, insurance companies’ financial reports use statutory accounting rules, which differ from GAAP/ IFRS
...
g
...
g
...
near-term liabilities
- capitalization: claims are more predictable, do not need as high equity cushion as P&C
Topic 4 Financial Reporting Analysis
life insurance products create material exposure to i/r risk, thus it is accounted for in risk-based
capital calculation and establishing min cap requirement
Topic 4 Financial Reporting Analysis
LOS 17 Evaluating Quality of Financial Reports
a
...
- High reporting quality enables assessment of earnings quality
...
explain potential problems that affect the quality of financial reports;
•
reported amount and timing of recognition
- aggressive/premature/fictitious revenue recognition > overstated NI > overstated equity
- omission/delayed recognition of expense > overstated NI > overstated equity, understated liabilities
- increase CFO by deferring payments on payables/inventory/operational expenditure, accelerating receivables
- conservative revenue recognition > understated
•
classification on I/S
- overstate revenue recognition; understate expense; misclassification
1) channel stuffing/bill and hold - a
...
higher growth in receivables than revenue
2) lessor use of finance leases - avoid depreciation, get i/r income; lessee use of operating leases
3) fictitious revenue
4) capitalise expenditures as assets
5) operating expense to non-recurring; other income to operating income
•
classification on B/S
1) choice of models and assumptions to measure fair value
2) over/under statement of reserve, allowances, goodwill
•
classification on CF
1) misclassify CF to inflate CF from operations - ↑ in payable; ↓ in receivables and inventory
•
quality issues and M&A
- acquisition is reported in investing if paid with cash, not reported if paid with equity > boost CFO
- A&L at FV as of acquisition date & recognize identifiable intangible assets > goodwill
•
reporting diverged from economic reality despite compliance
- restricting charge/impairment loss is often the result of previous operations > non-recurring
- OCI: unrealized on equity securities investment/ PPE with revaluation/ translation of fx
/△in net pension A/L/ gain/losses on derivative financial instruments
c
...
g
...
84 + 0
...
528 (GMI) + 0
...
892 (SGI) + 0
...
679 (Accruals)
– 0
...
327 (LEVI)
Based on normal distribution: higher M, higher probability of fictitious reporting, lower quality
DSR
days sales receivables index
receivables / sales at T / at T-1
higher receivable > inappropriate revenue recognition
GMI
t-1 / t gross margin at T-1 / at T
higher > lower margin > more motivated for fictitious reporting
AQI
asset quality index
% of assets other than PPE & CA at T / at T-1
more intangible assets > may excessively capitalised assets
SGI
sales growth index: sales at T / at T-1
higher probability of fictitious sales
DEPI
t-1 / t depreciation rate at T-1 / at T
depreciation / (depreciation + PPE)
↓ depreciation rate indicate understated depreciation
Topic 4 Financial Reporting Analysis
Accruals (income before extraordinary items - cash from high accruals > earning manipulation
operations) / total assets
SGAI
SGA / Sales at T /at T-1
increase in SGA > lower probability of fake reporting
LEVI
Leverage at T / at T-1; lev = D/A
higher leverage > lower probability of fictitious report
d
...
describe the concept of sustainable (persistent) earnings;
•
earnings at t+1 = a + b * earnings at t + e > higher coefficient represents more persistent earnings
•
earnings at t+1 = a + b1 * cashflow at t + b2 * accruals at t + e > cash flow is more persistent
f
...
Accruals / average NOA
•
beating benchmark: e
...
only narrowly bearing > indicates EM
•
external indicators for poor-quality: enforcement action by regulator; restate previous statements
g
...
evaluate the earnings quality of a company;
•
Revenue:
1) revenue recognition: shipping/return terms, discounts, deferred revenue for multiple deliverables
2) Days Sales Outstanding: receivables/ revenue
3) cash/accruals
4) revenue trends and composition: changes in total revenue vs changes in receivables
5) relationship: transact business with entities owned by shareholders
•
Expense:
1) capitalization of costs, reserve for obsolescence, depreciation policy
2) trend analysis: e
...
change in value of NCA to check improper capitalization of costs
e
...
turnover ratio for total assets/ PPE; relationship between capex and gross PPE
3) relationship
•
Bankruptcy Prediction Models - Altman - Z - score >3, less likely to bankrupt; <1
...
describe indicators of cash flow quality;
•
High quality: Positive OCF with low volatility; derived from sustainable sources;
OCF adequate to cover capital expenditures, dividends, and debt repayments
•
Timing: remove accounts receivables through selling externally or transferring to controlled entity > boost CFO
•
Classification flexibility: operating/ investing
- GAAP: dividend paid in investing cash flow; i/r paid/received, dividend received in operating
- IFRS: dividend & i/r received can be in operating/investing; i/r paid can be in operating/financing
j
...
describe indicators of balance sheet quality;
•
high reporting quality: completeness, unbiased measurement, and clear presentation
- completeness:
Topic 4 Financial Reporting Analysis
1) purchase(take or pay)contracts ( i
...
obligate to buy & pay) are off-bs obligation, adjusted by capitalize purchase
contracts
2) operating lease
3) unconsolidated joint ventures or equity-method may reflect off-bs liabilities
- unbiased: understate impairment charge for inventory/PPE, valuation of securities
- clear presentation: one-line consolidation
•
high results quality: optimal leverage, adequate liquidity, economically successful asset allocation
l
...
describe sources of information about risk
...
demonstrate the use of a framework for the analysis of financial statements, given a particular problem, question, or
purpose (e
...
, valuing equity based on comparables, critiquing a credit rating, obtaining a comprehensive picture of
financial leverage, evaluating the perspectives given in management's discussion of financial results);
Phase1: Define purpose and context of analysis - statement of analysis purpose, questions lists
Phase2: Collect input data: - organized financial statements, financial data tables
Phase3: Process input data into analytical data: - adjusted statements/ common-size/ratios/forecasts
Phase 4: Analyse data
Phase5: Conclusion/Recommendation - analytical reporting answering questions in phase 1
Phase6: Follow-up
b
...
evaluate the quality of a company's financial data and recommend appropriate adjustments to improve quality and
comparability with similar companies, including adjustments for differences in accounting standards, methods, and
assumptions;
•
capital structure: long-term debt vs other liabilities vs equity
•
liquidity and efficiency ratio: defensive interval ratio = current assets / daily cash expense
•
segment analysis and capital allocation: CAPEX/assets by segment vs EBIT margin by segment
•
𝑐𝑎𝑠ℎ − 𝑓𝑙𝑜𝑤 − 𝑏𝑎𝑠𝑒𝑑 𝑎𝑐𝑐𝑟𝑢𝑎𝑙𝑠 𝑟𝑎𝑡𝑖𝑜 =
𝑁𝐼 − 𝐶𝐹𝐼 − 𝐶𝐹𝑂
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑁𝑂𝐴
d
...
analyze and interpret how balance sheet modifications, earnings normalization, and cash flow statement related
modifications affect a company's financial statements, financial ratios, and overall financial condition
...
calculate yearly CFs of expansion & replacement capital projects,how depreciation method affects CFs;
•
initial investment outlays = FC Inv + WC Inv - (cash proceeds from selling old FC - tax * gain from sale)
•
after-tax operating cash flow = (△Sales - △cost - △dep) * (1-t) + △dep
•
terminal year after-tax non-operating CF = sale of machine - tax * gain from sale + NWC Inv
•
convention: double declining with half-year convention
- depreciation = (1/estimated life) * 2 * residual value
- assuming assets is in service for only 6m in first year - bought in the middle of the year
- accelerated depreciation improves NPV as net effect is to reduce tax outflows in early years
b
...
evaluate capital projects in situations of 1) mutually exclusive projects with unequal lives, using either the least
common multiple of lives approach or the equivalent annual annuity approach, and 2) capital rationing;
•
mutually exclusive projects are those competing directly with each other; one or the other
•
project sequencing: investing in a project creates the option to invest in a future project
•
unlimited funds: company can raise any funds it wants for all profitable projects
•
capital rationing: company has a fixed amount of funds to invest
•
least common multiple: extent time horizon so lives of both projects will divide exactly into horizon
•
equivalent annual annuity
d
...
•
scenario analysis takes scenarios that consist of changes in several of the input variable
- often pessimistic, most likely and optimistic
e
...
describe types of real options and evaluate a capital project using real options;
•
timing option: delay investing
•
sizing option: after investing, abandon the project -> abandonment option
additional investments -> growth option
•
flexibility option: once investment is made, other operational flexibilities may be available
- e
...
demand > capacity: price-setting option, e
...
↑ price / production-flexibility option: work overtime
•
fundamental option: e
...
whole investment is an option if payoff is contingent on an underlying asset
•
evaluate projects with real options: 1
...
NPV = DCF without option - cost of option + value of options
3
...
describe common capital budgeting pitfalls;
•
Not incorporating economic responses into the investment analysis
- e
...
in response to successful investment, competitors can enter & reduce investment profitability
•
Misusing capital budgeting templates
•
Pet projects: projects that influential managers want - overly optimistic projections
•
Basing investment decisions on EPS, net income, or ROE - may not be in LR economic interests
•
Basing investment decisions on IRR
•
Bad accounting for cash flows / Handling sunk costs and opportunity costs incorrectly
•
Company beta and project beta can be different, should use project-specific rate
•
Estimation Error: Not using the appropriate risk-adjusted discount rate / Overhead costs
•
Spending all of the investment budget just because it is available
•
Failure to consider investment alternatives
h
...
e
...
distinguish among the economic profit, residual income, and claims valuation models for capital budgeting
...
WC)
NPV = market value added = sum of EP/(1+WACC)
firm value = NPV + investment
•
Value of equity = equity investment(BV) + PV of RI
•
claims valuation: value liabilities and equity - claims against assets
CF to debt = interest payment + principal payment
CF to equity = dividends / share repurchase
2
Topic 5 Corporate Finance
LOS 20 Capital Structure
a
...
Investors have homogeneous expectations on cash flows from a given investment
...
perfect capital markets: no transaction costs/tax/bankruptcy cost, symmetric info
...
borrow and lend at risk-free
4
...
financing decision and investment decision are independent
•
propositions: 1
...
↑ financial leverage > higher risk > ↑ required return on E - 𝑟𝑒 = 𝑟0 + (𝑟 − 𝑟𝑑)( 𝐸 )
0
•
debt provides tax shield : 𝑉𝑙 = 𝑉𝑢 + 𝑡𝐷 =
𝐸𝐵𝐼𝑇(1−𝑡)
𝑟0
𝐷
+ 𝑡𝐷 -> 𝑟𝑒 = 𝑟0 + (𝑟 − 𝑟𝑑)( 𝐸 )(1 − 𝑡)
0
•
cost of financial distress: direct / indirect - impaired ability to conduct business / agency cost
# static trade-off theory - tax saving vs value of financial distress
•
agency cost: 1
...
g
...
bonding cost - cost borne by management to assure owners
3
...
describe target capital structure, explain why actual capital structure may fluctuate around its target;
•
VL = VU + tD – PV(Costs of financial distress)
•
fluctuation: exploit short-term opportunities in financing source; market-value fluctuations
c
...
explain factors an analyst should consider in evaluating effect of capital structure policy on valuation;
•
capital structure over time and of comparable competitors
•
company specific factors - quality of corporate governance - e
...
agency cost
•
regulation
e
...
•
institutional and legal environment: tax policy, regulation, quality of enforcement
- e
...
firms in common law countries(efficient legal system) tend to have longer debt maturity, less debt
•
financial markets and banking: developed markets typically use more long-term debt
•
macro: economic growth(↑ GDP growth, more equity financing), inflation(higher inflation>more debt)
3
Topic 5 Corporate Finance
LOS 21 Dividends and Share Repurchase
a
...
open market DRP: buy share in open market to get extra shares credited to plan participants
2
...
plan that permits to obtain shares through either open market / new issuance
✔ encourage diverse shareholder base by providing small shareholders way to accumulate share
✔ stimulate long-term investment
✔ allows accumulation of shares using cost averaging
✔ new-issue DRP - raises new E without flotation cost via banks; shareholders avoid transaction cost
if DRP participants buy share at discount, dilute holdings of non-participants
extra record-keeping involved in jurisdictions where capital gains are taxed
cash dividends are fully taxed before reinvestment
•
extra/special dividends - often brought by special circumstances
- often used by companies in cyclical industries - dividends only during strong earnings
•
liquidating dividends: 1) stop operating, distribute net assets to shareholders
2) sell a portion for cash and proceeds are distributed
3) pay a dividends that exceeds accumulated retained earnings
- liquidating dividends is a return of capital, rather than a distribution from earnings/RE
•
cash dividends - reduce A&E, no effect on shareholder wealth; liquidity ratios decrease; D/E increases
•
stock dividends - non cash dividends through distribute additional shares
- share price & EPS decreases while total market value of firm & P/E stays same
- no economic impact as reduce in RE is offset by stock dividends issued
•
stock split: no economic effect & no effect on shareholder equity accounts entries;
e
...
two-for-one, one additional share for each one owned
#reverse stock split - increases price and reduces no
...
compare theories of dividend policy and explain implications of each for share value given a description of a corporate
dividend action;
•
theory 1: dividend policy does not matter - Miller & Modigliani theory
- transaction cost: flotation cost in issuing new shares
transaction cost/ capital gain tax in selling shares for homemade dividend
•
theory 2: dividend policy matters - bird in the hand argument
- dividends are perceived as less risky than reinvesting earnings / capital gains
•
theory 3: dividend policy matters - tax argument
- dividend income has a higher tax rate than capital gains
- selling shares before ex-dividend date: 𝐶𝐹 = 𝑃 − (𝑃 − 𝑃𝑏𝑢𝑦) * 𝑡𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛
- selling after: 𝐶𝐹 = 𝑃𝑙𝑜𝑤𝑒𝑟 − ( 𝑃𝑙𝑜𝑤𝑒𝑟 − 𝑃𝑏𝑢𝑦) * 𝑡𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛 + 𝐷 * (1 − 𝑡𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑)
- indifference when (𝑃 − 𝑃𝑙𝑜𝑤𝑒𝑟) * (1 − 𝑡𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛)= 𝐷 * (1 − 𝑡𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑)
- only when dividend tax and capital gain tax equal, price drop equals dividend paid
clientele effect: groups of investors(clienteles) are attracted to companies with specific div policies
- e
...
retired investors may prefer higher current income, thus firms with high div payout
- if demands of clienteles are satisfied by respective companies, change in dividend policy will result only
in a switch in clientele, not affecting equity value
c
...
explain how clientele effects and agency costs may affect a company’s payout policy;
•
paying out all FCF as dividend limits managers’ ability to overinvest and take on -ve NPV projects
•
when firm is financed by debt and equity, paying large dividends to transfer wealth to shareholders, may lead to
•
4
Topic 5 Corporate Finance
underinvestment in profitable projects, increasing default risk of debt
- this can be mitigated by covenants on maximum allowable distributions
e
...
investment opportunities: firms with more profitable opportunities tend to pay out less
2
...
financial flexibility: substantial cash holdings help meet unforeseen operating needs and exploit investment
opportunities with minimum delay
4
...
g
...
flotation cost: companies try to avoid establishing a dividend level such they need to raise new equity
6
...
g
...
g
...
calculate and interpret the effective tax rate on a given currency unit of corporate earnings under double taxation,
dividend imputation, and split-rate tax systems;
g
...
g
...
2, adjustment is to occur over 5 years
•
constant: pay out a constant % of net income > dividends fluctuate with earnings in the short term
•
residual: pay out residual of any internally generated funds after financing positive NPV projects
> rarely used in practice as it results in highly volatile dividend payments
h
...
g
...
calculate and compare the effect of a share repurchase on earnings per share when 1) the repurchase is financed with
the company’s surplus cash and 2) the company uses debt to finance the repurchase;
Via surplus cash
Via debt
B/S
A & E decreases; D/E increases
A constant, E decreases; D/E increases
I/S
EPS ↑ only when funds used to repurchase would
EPS ↑ if earnings yield(E/P) exceeds
5
Topic 5 Corporate Finance
not earn its cost of cap
...
e
...
j
...
explain the choice between paying cash dividends and repurchasing shares;
•
repurchase: > potential tax advantages if tax on dividends are higher than capital gains
> added managerial flexibility
> increase financial leverage
> offsetting dilution from employee stock options
> share price support(signaling firm considers its shares a good investment)
l
...
calculate and interpret dividend coverage ratios based on 1) net income and 2) free cash flow;
•
dividend coverage ratio = net income / dividends = reciprocal of dividend payout ratio
•
FCFE coverage ratio = FCFE / (dividends + share repurchase)
n
...
•
very high dividend yields
6
Topic 5 Corporate Finance
LOS 22 Corporate Governance and other ESG Considerations in Investment Analysis
a describe global variations in ownership structures and the possible effects of these variations on corporate governance
policies and practices;
•
horizontal ownership: involves companies with mutual business interests
...
g
...
g
...
banks: conflict of interest may arise if banks have lending relationship & equity interest, as it may influence firm to
take large loans with less favorable terms, detriment other shareholders
2
...
state-owned: often in sectors strategically important to a sovereign gov
...
- may enhance social/public policies at the expense of max
...
institutional investor: e
...
group companies: shareholders having disproportionately high control
- obstacles for outsider to purchase a significant portion of shares
- high risk for related party transaction at the expense of minority
6
...
foreign investor: if foreign investors face more stringent standards of transparency/investor protection, local
minority shareholders may benefit
8
...
board independence: dispersed ownership > higher % of independent board directors to strengthen board’s
monitoring role over managers
2
...
special voting arrangements: to improve minority shareholders’ position in nomination/election
4
...
stewardship codes: encourage investors to exercise legal rights & gets more engaged in corp gov
b
...
board of directors structure > one/two-tier
policies &
> CEO duality - CEO is board chair - may compromise independence
practices
2
...
board committees: audit, remuneration, nomination - must be independent committee
4
...
board composition - 5 or 7
7
Topic 5 Corporate Finance
executive
remuneratio
n
- transparency of compensation, performance criteria for incentive plans
- link between remuneration & strategy
- pay differential between CEO and average worker
# claw-back policy: recover previously paid remuneration
# say-on-pay: shareholders can vote/feedback on remuneration issues
shareholder
- straight/statutory voting: one vote per share owned
voting rights
- dual class
c
...
proprietary: use own judgments & research companies/news/experts to identify ESG information
2
...
g
...
non-for-profit industry organizations and initiatives: lists ESG-related topics for sector
•
equity vs fixed-income security analysis
> equity analysis: ESG integration is to identify potential opportunities and mitigate downside risk
ESG-related factors are analyzed to forecast financial metrics and adjust variable
> fixed-income: generally focus on mitigating downside risk
> in credit analysis, ESG factors are integrated via internal credit assessments, forecast financial ratios
# stranded assets - assets that are obsolete or not economically viable - e
...
coal company
d
...
•
identify relevant material qualitative and quantitative ESG factors
•
ESG-related adjustments relating to projects - e
...
revenues/COGS for IS
- e
...
impaired assets in BS
•
incorporate adjusted financial performance in valuation
•
green bond
✔ can command a premium over comparable conventional bonds
✔ lower cost of capital due to green bond premium
× risk of greenwashing, i
...
bond’s proceeds are not used for a beneficial environmental/ climate-related project,
leading to additional cost of monitoring/ reporting
× lack of liquidity
8
Topic 5 Corporate Finance
LOS 23 Mergers and Acquisitions
a
...
horizontal - merging companies are in same business, e
...
competitors
- for EOS or gain market power
2
...
g
...
conglomerate - purchase another company that is unrelated to core business - diversify
b
...
g
...
size, rather than shareholder value
...
g
...
exploiting market imperfections: e
...
advantage in relative cost of labour
2
...
g
...
technology transfer: a target with new/superior technology
4
...
follow and support domestic clients more effectively
c
...
explain, based on industry life cycles, the relation between merger motivations and types of mergers;
1
...
rapidly growing:
- require large capital requirement to expand
- conglomerate
high profit margin
capacity
- horizontal
3
...
stabilisation:
- merge for EOS in R&D, marketing to match low
- horizontal
increasing competition
cost and performance
production constraints
- buy smaller ones to improve management
5
...
contrast merger transaction characteristics by form of acquisition, method of payment, and attitude of target
management;
•
form of acquisition:
Stock purchase
Asset Purchase
- approved by at least 50%, legal implications
- shareholder approval might not be required
- target shareholders receive compensation in
- payment is made to the selling company directly;
9
Topic 5 Corporate Finance
exchange for their shares, can circumvent
conducted more quickly and easily
target’s management
- focus on parts of interest, not entire company
- shareholders are taxed on capital gain
- target company pays tax on capital gains
- acquirer assumes target’s liabilities
- acquire often avoids assumption of liabilities
•
method of payment: > mixed offering
> cash offering: from existing assets or debt issue
- preferred if acquirer is highly confident in completing merger and creating value
> securities offering: pay with acquirer’s share, or preferred shares, or even debt securities
- exchange ratio in stock offering: no
...
friendly merger: approach target management directly, negotiate, due diligence
> definitive merger agreement > public announcement via proxy statement
2
...
distinguish among pre-offer and post-offer takeover defence mechanisms;
•
pre-offer defences: rights based / shark-repellents - changes to corporate charter
1
...
flip-in: > common shareholders can buy shares at a discount
> acquirer is subject to a significant level of dilution
> triggered when a specific level of ownership is exceeded
b
...
dead-hand provision: only continuing directors can vote to redeem/cancel the pill
2
...
incorporate in a state with restrictive takeover laws (US)
e
...
Securities Laws: disclosure requirement and a formal process for tender offer
4
...
restricted voting rights: if stockholding level exceeds
...
g
...
supermajority voting provisions
7
...
golden parachutes: significant compensation to executives leaving the target, following a change in corporate
control
•
post-offer: 1
...
litigation - file a lawsuit against acquirer based on antitrust law- often a delaying tactic
3
...
share repurchase - repurchase from any shareholders via a tender offer
- increase potential cost acquirer i
...
to match tender offer price
5
...
crown jewel: sell off a subsidiary which was acquirer’s major motivation
7
...
white knight: seek a 3rd party to purchase the company
9
...
calculate and interpret the Herfindahl-Hirschman Index and evaluate the likelihood of an antitrust challenge for a given
business combination;
•
HHI for competing companies = squared sum of (sales or o/p of firm i / sales or o/p of market * 100)
Post-merger HHI
Concentration
Change in HHI
Government Action
10
Topic 5 Corporate Finance
< 1000
Not concentrated
any amount
no action
1000 - 1800
moderately concentrated
≥ 100
possible challenge
> 1800
highly concentrated
≥ 50
challenge
h
...
unlevered net income = net income + net interest after tax = (i/r expense - i/r income) *(1-t)
- this removes tax shield from interest payments
2
...
add net non-cash charges, minus CAPEX and change in net WC
4
...
terminal value by growth model or multiple
✔ expected change in target’s CF can be readily modelled
✔ estimate intrinsic value based on forecast fundamentals
✔ change in assumptions/estimates are incorporated
🗶 difficult to apply if FCF does not align with profitability e
...
rapidly expanding firm may be profitable, but
have negative FCF due to heavy CAPEX
🗶 estimation error for FCF, discount rate, terminal value
•
comparable company:
✔ reasonable approximation of target’s value; > target intrinsic value = average of comparables
✔ readily available data; estimates are from market
🗶 sensitive to market mispricing
🗶
yields fair stock value, not takeover value; 𝑡𝑎𝑘𝑒 𝑜𝑣𝑒𝑟 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 =
𝑑𝑒𝑎𝑙 𝑝𝑟𝑖𝑐𝑒 − 𝑚𝑎𝑟𝑘𝑒𝑡 𝑠ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒
𝑚𝑎𝑟𝑘𝑒𝑡 𝑠ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒
🗶 data quality
comparable transaction:
✔ not necessary to separately estimate a takeover premium
✔ value estimates come directly from values recently established in market
🗶 real takeover value in past transactions may not be accurate
🗶 adequacy of comparable transactions
i
...
estimate the value of a target company using comparable company and comparable transaction analysis;
k
...
explain how price and payment method affect the distribution of risks and benefits in M&A transactions;
•
The more confident the managers are that the estimated synergies will be realized, the more the acquiring
managers will prefer to pay with cash and the more the target managers will prefer to receive stock
...
•
acquirer & target tend to see higher stock returns surrounding cash acquisition offers, than share
m
...
distinguish among equity carve-outs, spin-offs, split-offs, and liquidation;
•
divestiture: sell/ liquidate/ spin off a division
•
equity carve-out: create a new legal entity and sell equity in it to outsiders
•
spin-off: shareholders of parent company receive a proportional number of shares in a new, separate entity > does
not result in a cash inflow to the parent
•
split-off: some of parent’s shareholders are givens shares in a newly created entity in exchange for their shares of
the parent
•
liquidation: break up a company/division and sell off its assets
...
explain common reasons for restructuring
...
g
...
define valuation and intrinsic value and explain sources of perceived mispricing;
•
Valuation: estimation of asset’s value based on relevant variables, comparisons to comparables and estimates of
immediate liquidation proceeds
•
Intrinsic value: value of assets given a hypothetically complete understanding of asset’s investment characteristics
•
perceived mispricing abnormal return= Ve-P = (V-P) + (Ve - V) = true mispricing + error in estimating intrinsic value
b
...
describe definitions of value & justify which definition is most relevant to public company valuation;
•
for public equities, intrinsic value is typically the relevant concept of value
...
g
...
describe applications of equity valuation;
•
select stocks
•
infer market expectations - reverse engineering from valuation model to get fundamentals
•
evaluate corporate events - M&A, spinoff
•
render fairness opinions and evaluate business strategies/models
•
appraise private business
•
communicate with stakeholders; share-based payment
e
...
contrast absolute and relative valuation models and describe examples of each type of model;
•
absolute: estimate intrinsic value which can be compared with asset’s market price
- 1
...
asset-based valuation: often to natural resource companies; ≈liquidation value
•
relative: estimate value relative to that of another asset
g
...
g
...
explain broad criteria for choosing an appropriate approach for valuing a given company
...
g
...
distinguish among realized holding period return, expected holding period return, required return, return from
convergence of price to intrinsic value, discount rate, and internal rate of return;
•
holding period return = dividend yield + price appreciation return
•
expected alpha(return from convergence of price to intrinsic value) = expected return - required return
•
realised alpha = actual holding period return - contemporaneous required return
•
in efficient market, required rate of return = IRR
b
...
estimate the required return on an equity investment using CAPM, FF model, the Pastor-Stambaugh model,
macroeconomic multifactor models, and the build-up method (e
...
, bond yield plus risk premium);
•
CAPM: assumptions: risk-averse, mean-variance of total portfolio investors;
only for portfolio where idiosyncratic risks are diversified
•
FFM: Rmkt-Rf: return on market-value weighted equity index in excess of risk-free
SMB: market cap
HML: book-to-market: high BTM reflects value bias; growth is riskier
•
PS：FFM + liquidity risk premium
•
Macro: 1) confidence: corporate bond vs gov bond with 20y maturity;
higher confidence > lower reward for bearing risk
2) time-horizon: 20 year government bond vs 30 day treasury bill;
growth stock tends to have more positive exposure
3) inflation: unexpected change - negative exposure for most stocks; returns ↓ with positive surprises
4) business cycle: positive surprise > expect higher growth rate for economy
5) market timing risk: portion of total return unexplained; positive exposure for most
•
build-up: for private business
2
Topic 6 Equity Investments
risk-free + equity risk premium (large-cap takes high portion of index value)
+ size premium (incremental premium for small size)
+ industry risk + company-specific premium (adjust for unsystematic risks not diversified)
- relative value of controlling/minority interests
- lack of ready marketability
•
bond yield + risk premium: companies with publicly traded debt
= YTM on company long-term debt (real i/r + premium for E[inflation] + default risk premium)
+ risk premium (additional risk from equity, compared to debt)
d
...
0, thus adjusted beta = (2/3)raw beta + (1/3) * 1
...
describe strengths/ weaknesses of methods used to estimate required return on an equity investment;
f
...
explain and calculate the weighted average cost of capital for a company;
•
𝑊𝐴𝐶𝐶 =
𝑀𝑉 𝑜𝑓 𝐷
𝑀𝑉 𝑜𝑓 𝐷 + 𝑀𝑉 𝑜𝑓 𝐶𝐸
* 𝑟𝐷 * (1 − 𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒) +
𝑀𝑉 𝑜𝑓 𝐶𝐸
𝑀𝑉 𝑜𝑓 𝐷 + 𝑀𝑉 𝑜𝑓 𝐶𝐸
* 𝑟𝐸
•
marginal tax rate reflects future cost in raising funds
h
...
3
Topic 6 Equity Investments
LOS 26 Industry and Company Analysis
a
...
g
...
"growth relative to GDP growth" & "market growth & market share" approach to forecast revenue;
•
growth relative to GDP growth：forecast nominal GDP growth, compare specific firm to nominal GDP
- real GDP for volume growth; inflation for price projection
- % premium/discount due to industry life cycle/ business cycle sensitivity
•
market growth & market share: estimate share, then growth of industry
c
...
forecast the following costs: cost of goods sold, selling general and administrative costs, financing costs, and income
taxes;
•
COGS: raw materials, direct labour and OH used in production - % of sales
- account for hedging strategy, e
...
commodity-driven firms;
- when sales/COGS by same amount; COGS as % of sales, gross margin
- competitor’s gross margin; yet, franchises have lower COGS, but higher op cost than wholesalers
•
SG&A: variable costs are more linearly related to sales; competitor benchmarking
•
financing: debt level, i/r
•
income tax: statutory tax rate - tax rate applied as domestic tax base
effective tax rate: reported tax / pre-tax income
cash tax rate: tax paid / pre-tax income
- start with tax rate based on normalized operating income, before associates/special items
- effective tax from P&L; cash tax from CF; reconciliation for change in DTA/DTL
e
...
describe the relationship between return on invested capital and competitive advantage;
ROIC =
•
𝑛𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 − 𝑎𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝑡𝑎𝑥(𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝐵𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡))
𝑛𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑠𝑠𝑒𝑡𝑠
not affected by leverage, thus a better measure of
profitability; high ROIC, competitive adv
ROCE =
•
•
𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡
𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
=
𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡
𝐷+𝐸
pre-tax measure for ROIC
from company perspective
g
...
judge the competitive position of a company based on a Porter's five forces analysis;
i
...
g
...
evaluate the effects of technological developments on demand, selling prices, costs, and margins;
•
cannibalisation
k
...
g
...
explain an analyst's choices in developing projections beyond the short-term forecast horizon;
•
normalised earnings: expected mid-cycle earnings in the absence of unusual/temporary factors
•
terminal value: 1) historic multiples: only relevant if future growth/profitability is similar to the past
2) DCF: long-term growth rate; normalise terminal year FCF
•
Inflection: economic disruption, regulation, technology
m
...
•
Industry overview: porter’s 5 forces
•
company overview
•
P&L forecast: 1) revenue forecast: volume; price/mix; forex impact
2) COGS and SG&A as % of sales
3) operating profit by division - leverage competitors’ information as benchmark
4) finance expense from debt and interest income from cash position; income tax
•
CF forecast: 1) CAPEX - % of sales, account for growth prospect; D&A - % of sales/fixed assets
2) working cap: % of sales
•
BS forecast
•
DCF: after tax normalised operating profit + D&A - CAPEX - change in working cap
5
Topic 6 Equity Investments
LOS 27 Dividend Discount Model
a
...
calculate and interpret value of a common stock using DDM for single and multiple holding periods;
•
approach 1: future dividend can be forecast by assigning growth patterns
•
approach 2: finite number of dividends + terminal share price
c
...
calculate and interpret implied growth rate of dividends using Gordon growth model & current stock price;
e
...
investment opportunities;
2
...
calculate and interpret the justified leading and trailing P/Es using the Gordon growth model;
•
justified P/E - fundamental P/E, ratio that is justified on the basis of fundamentals
•
𝑃
leading: 𝐸0 =
1
•
𝑃
trailing: 𝐸0 =
0
𝐷1/𝐸1
𝑟−𝑔
=
1−𝑟𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛
𝑟−𝑔
𝐷0*(1+𝑔)/𝐸0
𝑟−𝑔
=
(1−𝑟𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛)(1+𝑔)
𝑟−𝑔
g
...
describe strengths & limitations of Gordon growth model and justify its selection to value a company's common shares;
•
appropriate for stable dividend and earning growth rate
•
applicable to value market indices
•
broad equity market indexes of developed markets often satisfy the condition
i
...
explain the growth phase, transitional phase, and maturity phase of a business;
•
growth: rapid expansion, high profit %, high growth in EPS, negative FCFE due to CAPEX; low div
•
transition: earnings growth slows down due to competition pressure on price and profit margin
6
Topic 6 Equity Investments
earning growth rate may be above average, but declining towards overall economy
capital requirement declines, +FCF and increasing div payout
•
mature: ROE approaches required return; earnings growth and div payout stablises
k
...
calculate and interpret the value of common shares using the two-stage DDM, the H-model, and the three-stage DDM;
𝑛
•
2-stage:𝑉0 = ∑
•
H-model:𝑉0 =
𝐷𝑡
𝑡
𝑡=1 (1+𝑟)
+
= ∑
𝑛
(1+𝑟)
𝐷0 * (1+𝑔𝑡𝑒𝑟𝑚𝑖𝑛𝑎𝑙)
𝑟−𝑔𝑡𝑒𝑟𝑚𝑖𝑛𝑎𝑙
𝑛
𝑉𝑛
+
𝑛
𝐷𝑡
𝑡
𝑡=1 (1+𝑟)
+
𝐷0(1+𝑔𝑠) (1+𝑔𝑡𝑒𝑟𝑚𝑖𝑛𝑎𝑙)
𝑛
(1+𝑟) (𝑟−𝑔𝑡𝑒𝑟𝑚𝑖𝑛𝑎𝑙)
𝐷0 * 𝐻𝑎𝑙𝑓−𝑙𝑖𝑓𝑒*(𝑔𝑠−𝑔𝑡𝑒𝑟𝑚𝑖𝑛𝑎𝑙)
𝑟−𝑔𝑡𝑒𝑟𝑚𝑖𝑛𝑎𝑙
; Vn may from multiples
; Half-life >in years of high-growth
= PV of div growing at gterminal forever + proxy for extra from supernormal growth
m
...
explain the use of spreadsheet modeling to forecast dividends and to value common shares;
o
...
evaluate whether a stock is overvalued, fairly valued, or undervalued by the market based on a DDM estimate of value
...
compare FCFF and FCFE approaches to valuation;
•
FCFE is more direct than FCFF, but not appropriate if FCFE is negative or firm has changing cap structure
b
...
explain the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest,
taxes, depreciation, and amortization (EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE;
𝐹𝐶𝐹𝐹 = 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 + 𝑎𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑖/𝑟 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 + 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 + 𝐷&𝐴(𝑛𝑜𝑛 𝑐𝑎𝑠ℎ 𝑐ℎ𝑎𝑟𝑔𝑒) − 𝐶𝐴𝑃𝐸𝑋 − ∆𝑖𝑛 𝑊𝐶
•
#WC for FCF should exclude cash and short-term debt
•
𝐹𝐶𝐹𝐹 = 𝐸𝐵𝐼𝑇(1 − 𝑡𝑎𝑥) + 𝐷&𝐴(𝑛𝑜𝑛 𝑐𝑎𝑠ℎ 𝑐ℎ𝑎𝑟𝑔𝑒) − 𝐶𝐴𝑃𝐸𝑋 − ∆𝑖𝑛 𝑊𝐶
= 𝐸𝐵𝐼𝑇𝐷𝐴 (1 − 𝑡𝑎𝑥) + 𝐷&𝐴 * 𝑡𝑎𝑥 − 𝐶𝐴𝑃𝐸𝑋 − ∆𝑖𝑛 𝑊𝐶
𝐹𝐶𝐹𝐹 = 𝐶𝐹𝑂 + 𝑎𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑖/𝑟 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 − 𝐶𝐴𝑃𝐸𝑋
•
•
𝐹𝐶𝐹𝐸 = 𝐹𝐶𝐹𝐹 − 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑖/𝑟 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 + 𝑛𝑒𝑡 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔
= 𝑁𝐼 + 𝑁𝑜𝑛𝑐𝑎𝑠ℎ 𝐶ℎ𝑎𝑟𝑔𝑒 − ∆ 𝑖𝑛 𝑊𝐶 − 𝐶𝐴𝑃𝐸𝑋 + 𝑁𝑒𝑡 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔
= 𝑁𝐼 + 𝑁𝑜𝑛𝑐𝑎𝑠ℎ 𝐶ℎ𝑎𝑟𝑔𝑒 − ∆ 𝑖𝑛 𝑊𝐶 − 𝐶𝐴𝑃𝐸𝑋 + (∆ 𝑖𝑛 𝑊𝐶 + 𝐶𝐴𝑃𝐸𝑋 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛) * 𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜
•
Adjustments:
1) NCC:
- D&A, impairment of intangibles
- non cash restructuring cost (expense - income from reversal) - e
...
adj
...
calculate FCFF and FCFE;
•
uses of FCFF = increase in cash balance
+ payment to debt provider (after-tax i/r, repayment of principal - new borrowing)
+ payment to equity (cash dividend, share repurchase - share issuance)
e
...
compare the FCFE model and dividend discount models;
•
dividend is at the discretion of board, may not signal long-run profitability
•
FCFE is CF available to shareholders, appropriate for analysing a takeover target
g
...
evaluate the use of net income and EBITDA as proxies for cash flow in valuation;
•
EBITDA and dep could differ substantially for different companies/industries, so as depreciation tax shield; EBITDA
is before tax measure, not consistent with WACC
i
...
estimate a company's value using the appropriate free cash flow model(s);
k
...
describe approaches for calculating the terminal value in a multistage valuation model;
•
ESG: project fine on CF or adjust cost of equity by risk premium
m
...
9
Topic 6 Equity Investments
LOS 29 Price and EV Multiples
a
...
earning/net assets
•
method on forecasted fundamentals: multiples derived from forecasted fundamentals
- fundamentals drive cash flow; relating multiples to fundamentals through DCF
b
...
g
...
describe rationales for and possible drawbacks to using alternative price multiples and dividend yield in valuation;
•
P/E - earning is a flow variable
✔ earning power is the chief driver of investment value; widely recognized
✔ empirical research shows difference in P/E may be related to difference in LR average ROI
×
EPS may be zero/negative/insignificantly small - denominator issue
×
difficult to distinguish recurring components from transient components; accounting distortion
×
less stable as it reflects operating and financial leverage
> trailing: prefer diluted EPS for a comparable basis; consider non-recurring/cyclical components
> forward: NTM - next twelve month P/E
•
Price to BV - BV is a level variable from BS = total equity - claims more senior to common equity
✔ BV is a cumulative BS amount, generally positive; BV per share is more stable than EPS
✔ appropriate for firms with liquid assets, such as finance institutions; BV approximate MV
✔ appropriate if liquidation is about to happen
✔ empirical research shows difference in P/B may be related to differences in LR average return
×
intangibles are ignored - human capital, reputation
×
accounting choice distortion - fair value vs historical cost; depreciation method; off-balance sheet
×
BV ≠ MV when there is high inflation or technology progress(old machine becomes obsolete, BV > MV)
×
share repurchase/issuance may distort historical comparisons - BV of equity decreases
×
firms with different business models have different sizes, misleading indicator
> adjustments: excluding intangibles, such as goodwill; mostly use trailing BV
•
Price to Sales:
✔ sales are less subject to distortion; always positive and more stable
✔ appropriate for mature, cyclical, start-up companies; relationship with LR return supported by research
×
high growth in sales may not translate into earnings/cash
×
price reflects effect of debt on profitability and risk, while sales is pre-financing income measure
×
P/S does not account for differences in cost structure
•
Price to CF:
✔ less subject to manipulation; more stable than EPS
✔ address difference in accounting conservatism between companies
×
difficult to estimate true CFO
> CF definitions: 1) CF = NI + D&A - ignore non-cash revenue, change in WC
2) adjusted CFO - GAAP and IFRS have different requirement for CFO
3) FCFE = CFO - FC Inv + Net borrowing - can be negative
4) EBITDA
•
Price to dividend / Dividend yield
✔ a component of total return, less risky than capital appreciation
×
just a component, not using all information related to expected return > suboptimal decision
×
dividend displacement of earnings - trade off future earnings growth
> justified D/P =
𝐷0
𝐷0*(1+𝑔)/(𝑟−𝑔)
=
𝑟−𝑔
1+𝑔
d
...
calculate and interpret underlying earnings, explain methods of normalizing EPS, and calculate normalized EPS;
10
Topic 6 Equity Investments
•
•
underlying earnings is a non-IFRS concept, reflecting core earnings, adjusted for non-recurring
normalized earnings estimates expected earnings for mid-cyclical conditions
- Molodovsky effect: high P/E at bottom of cycle; low P/E at peak of cycle
- method 1 - historical average EPS - does not account for change in business size
- method 2 - average ROE * current book value per share
f
...
describe fundamental factors that influence alternative price multiples and dividend yield;
h
...
g with Gordon Growth: 𝑗𝑢𝑠𝑡𝑖𝑓𝑖𝑒𝑑 𝑃/𝐸 =
•
justified P/B=
𝑃0
𝐵0
=1+ PV of expected future residual income / B0
𝑅𝐼1
𝑟−𝑔
=
•
justified P/S =
𝑃0
𝑆0
𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑜𝑢𝑡
𝑟−𝑔
+𝐵0
𝐵0
=
𝑃0
𝐸0
𝐵0*(𝑅𝑂𝐸 − 𝑟)
=
𝑟−𝑔
𝐵0
+𝐵0
=
𝑅𝑂𝐸−𝑟
𝑟−𝑔
* 𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 =
+1 =
𝑅𝑂𝐸−𝑟
𝑟−𝑔
+
𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑜𝑢𝑡 * (1+𝑔)
𝑟−𝑔
𝑟−𝑔
𝑟−𝑔
=
𝑅𝑂𝐸−𝑔
𝑟−𝑔
* 𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛
> key drivers are profit margin, growth rate, required rate of return
i
...
evaluate a stock by comparables and explain the importance of fundamentals in using the method of comparables;
•
benchmark value of multiples: e
...
average/median of P/E of peer group/industry/sector/historicals
k
...
calculate and explain the use of price multiples in determining terminal value in a multistage DCF model;
•
median/average industry P/E or average of own historical P/E
•
this approach is entirely grounded in market data; while benchmark value may reflect mispricing
m
...
calculate and interpret EV multiples and evaluate the use of EV/EBITDA;
•
EV/EBITDA - EBITDA as a proxy for pre-interest, pretax operating CF
- justified EV/EBITDA positive related to expected growth rate in FCFF/ profitability measured by ROIC
- EV = common equity + preferred equity + debt - cash & equivalents
✔ more appropriate than P/E for comparison between firms with different leverage
✔ controls for differences in D&A, suitable for firms with capital-intensive business; often positive
×
if working capital grows, EBITDA overestimates CFO, as CFO will decrease but EBITDA is unchanged
×
ignore effect of different revenue recognition policy
×
FCFF has a stronger link to valuation theory than EBITDA
•
EV/Sales - comparing firms with diverse capital structures; alternative to P/S
o
...
•
Yardeni model incorporates the consensus five - year earnings growth rate forecast for the market index, a variable
missing in the Fed model
...
describe momentum indicators and their use in valuation;
•
momentum indicators relate price/fundamental to time series of their own past values
11
Topic 6 Equity Investments
1) earning surprises are more meaningful when there is less disagreement between forecasts
...
explain the use of the arithmetic mean, the harmonic mean, the weighted harmonic mean, and the median to describe
the central tendency of a group of multiples;
•
ℎ𝑎𝑟𝑚𝑜𝑛𝑖𝑐 𝑚𝑒𝑎𝑛 =
𝑛
𝑛
∑ (1/𝑥𝑖)
𝑖=1
𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 ℎ𝑎𝑟𝑚𝑜𝑛𝑖𝑐 𝑚𝑒𝑎𝑛 =
1
𝑛
where wi is portfolio value weights
∑ (𝑤𝑖/𝑥𝑖)
𝑖=1
•
Harmonic mean can eliminate effect of large outliers, but exaggerate effect of small ones
r
...
•
look-ahead bias: use of information that was not contemporaneously available
e
...
to base strategy on trailing P/E when the Q4 is not released yet; backtest should account for the fact that EPS is
from Q4 previous year - Q3 current year
12
Topic 6 Equity Investments
LOS 30 Residual Income Model
a
...
describe the uses of residual income models; - RI model did not make assumption about future earnings being positive
c
...
explain fundamental determinants of residual income;
•
𝑃/𝐵 = 1 +
𝑅𝑂𝐸−𝑟
𝑟−𝑔
e
...
calculate and interpret the intrinsic value of a common stock using single-stage (constant-growth) & multistage residual
income models;
(𝑅𝑂𝐸−𝑟)*𝐵0
•
𝑉0 = 𝐵0 +
•
multistage 1: often assumes ROE reverts to required return of equity
𝑟−𝑔
𝑇
𝑉0 = 𝐵0 + ∑
𝑅𝐼𝑡−1
𝑡
𝑡=1 (1+𝑟)
•
> implies RI will grow indefinitely, not realistic
+
𝑅𝐼𝑇+1
𝑇
(𝑟−(𝑤−1))*(1+𝑟)
;
persistence factor ω: 1 - RI will not fade; e
...
low dividend payout, high historical persistence in the industry
0 - no RI after forecast horizon; firm current ROE is extremely high
multistage 2: often assumes ROE reverts to some mean level
𝑃𝑉𝑇 = 𝑃𝑇 − 𝐵𝑇; where PT is from P/B ratio, BT is from clean surplus equation
g
...
explain continuing RI and justify estimated continuing RI at the forecast horizon, given company & industry prospects;
•
continuing residual income = residual income after the forecast horizon;
e
...
premium over book value should be discounted to PV
•
TV may not be a large component, as BV captures it
...
compare residual income models to dividend discount and free cash flow models;
•
In RI model, most of the total value of the stock is attributed to the earlier periods
...
explain strengths/weaknesses of RI models and justify use of a RI model to value a company's common stock;
✔
✔
✔
✔
Terminal values do not make up a large portion of total present
value, relative to other models
...
×
×
×
accounting data that can be subject to
manipulation by management
...
describe accounting issues in applying residual income models;
•
violations of clean surplus relationship - charges directly to stockholders via OCI
1) unrealised FVOCI 2) FX translation for current rate method 3) pension adjustment 4) PnL on CF hedging
IFRS only - 5) revaluation reserve for PPE 6) ∆ liabilities’ FV attributable to change in liabilities credit risk
•
balance sheet adjustments for fair value:
> operating lease, LIFO, deferred tax, allowances
> intangible assets - e
...
goodwill, license assets(amortised after M&A)
•
nonrecurring items; aggressive accounting practices; and international considerations
...
evaluate whether a stock is overvalued, fairly valued, or undervalued based on a residual income model
...
compare public and private company valuation;
•
Company-specific factors:
1
...
Size: tend to be smaller; increasing risk levels, thus risk premium > may reduce growth prospects
3
...
quality/depth of management: limited
5
...
pressure from short-term investors: limited, thus firms can take a longer-term investment focus
7
...
liquidity of equity interests
2
...
agreements restricting liquidity - may have shareholder agreements to restrict sale of shares
b
...
private financing: VC investors invest through multiple rounds of financing tied to milestones
2
...
share-based payment
compliance • It has grown due to the increasing role of fair value estimates in financial reporting under IFRS /GAAP
...
financial reporting: e
...
goodwill impairment tests require valuation of a cash-generating unit(IFRS) /
reporting entity(GAAP)
2
...
explain various definitions of value and demonstrate how different definitions can lead to different estimates of value;
•
fair market value: price at which an asset would change hands between willing and able buyer/seller
- used in a tax reporting context in the US
•
market value: estimated amount for which A/L should exchange;
- used in real estate or tangible asset appraisal when money is borrowed against it
•
fair value(financial reporting/ litigation): exit price, should be less or at most equal to entry price
•
investment value: value to a particular investor based on investor’s requirement and expectations
•
intrinsic value: an investor’s perception, based on evaluation/available facts, to be the “real” value; and to be the
market value when other investors reach the same conclusion
- captures asset value absent any short-term pricing aberrations
d
...
explain cash flow estimation issues related to private companies and adjustments to estimate normalized earnings;
•
normalised earnings: 1
...
expenses ↓ taxable income for a profitable private firm e
...
above average compensation;
3
...
expenses on non operating assets should be removed
5
...
g
...
calculate the value of a private company using free cash flow, capitalized cash flow, and/or excess earnings methods;
14
Topic 6 Equity Investments
•
•
FCF: 2 stage model
capitalised CF: value of a growing perpetuity; e
...
single stage gordon growth model
- 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 =
- 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 =
•
𝐹𝐶𝐹𝐹1
𝑊𝐴𝐶𝐶 − 𝑔
𝐹𝐶𝐹𝐸1
𝑟−𝑔
#denominator = capitalisation rate
= 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 − 𝑀𝑉𝐷
EEM: 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 = 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠 + 𝑊𝐶 + 𝑖𝑛𝑡𝑎𝑛𝑔𝑖𝑏𝑙𝑒 𝑎𝑠𝑠𝑒𝑡𝑠; to find value of intangibles:
1) 𝑒𝑥𝑐𝑒𝑠𝑠 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 = 𝑛𝑜𝑟𝑚𝑎𝑙𝑖𝑠𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 − 𝑟𝑊𝐶 * 𝑊𝐶 − 𝑟𝑓𝑖𝑥𝑒𝑑 * 𝑀𝑉𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠
2) capitalise EEt+1 to estimate intangible assets; with rate from WACC excluding rwc & rfixed
- add back WC and fixed assets
- rarely used in pricing entire private business and small size
g
...
g
...
compare models used to estimate the required rate of return to private company equity;
•
expanded CAPM = CAPM + small stock premium + company-specific risk adjustment
•
build-up = risk free + equity risk premium + small stock + industry-specific + company-specific
i
...
describe the asset-based approach to private company valuation;
•
companies with small size and limited intangible value or in early stage
•
holding companies/financial institutes/resource companies - assets are often valued at fair value; e
...
REITs / CEICs
k
...
g
...
describe the role of valuation standards in valuing private companies
...
More generally, business appraisers are typically not
required by law to adhere to these standards
...
describe relationships among spot rates, forward rates, yield to maturity, expected and realized returns on bonds, and
the shape of the yield curve;
•
YTM = expected rate of return for a bond held to maturity, with coupons reinvested at same rate
b
...
describe how zero-coupon rates (spot rates) may be obtained from the par curve by bootstrapping;
•
par curve: YTM on coupon-paying government bonds, priced at par, over a range of maturities
•
par rate = coupon rate
•
Bootstrapping - use par yields to solve for zero - coupon rates one by one, from earliest to latest maturities
...
describe the assumptions concerning the evolution of spot rates in relation to forward rates implicit in active bond
portfolio management;
•
if spot rate evolves as implied by current forward curve, return on bond over 1yr is always the one-year rate
•
if spot rate in a year later is different from what implied by current forward rate, rate of return would differ when using
longer maturity bonds; e
...
if spot rate after one year is higher, bond will be cheaper, return will be lower
e
...
explain the swap rate curve and why and how market participants use it in valuation;
•
yield curve of swap rate which was set so no money is exchanged at contract initiation
•
wholesale banks frequently use swap curve to value A/L as they hedge many items with swaps
•
swap rate curve are more commonly used than T-bonds as they have more maturity options
g
...
describe the Z-spread;
•
Z-spread: constant basis point spread to be added to the implied spot yield so that DCF of risky bond equal current
market price (often obtained from YTM)
•
reflect the risk in corporate bond
•
not appropriate for valuing bond with embedded options
i
...
explain traditional theories of the term structure of interest rates and describe the implications of each theory for forward
rates and the shape of the yield curve;
•
unbiased expectation theory: assumes risk-neutrality
•
local expectation theory: expected return for every bond over short time periods is the risk-free rate
•
segmented market theory: market participants only purchase maturities that match timing of their liabilities;
participants can’t change maturities group they belong to
•
preferred habitat theory: similar to segmented market theory, but investors deviate from preferred maturities if
expected additional gains become large enough
k
...
explain how a bond's exposure to each of the factors driving the yield curve can be measured and how these exposures
can be used to manage yield curve risks;
•
level: parallel upward/downward shift in the yield curve
•
steepness: non-parallel shift; e
...
long term rise and short term fall
•
curvature: short & long term rise while medium term falls, or vice versa
•
Principal Component Analysis: synthetic factors which are statistically independent
•
long-term rates are mainly affected by real economy and inflation; while short-term rate is mainly affected by
monetary policy
m
...
•
σ(𝑡, 𝑇)is the volatility of rate for a security with maturity T at time t
= annualized s
...
of the proportional change in bond yield over a specified time interval
e
...
=
•
𝑚𝑜𝑛𝑡ℎ𝑙𝑦 𝑠
...
g
...
explain what is meant by arbitrage-free valuation of a fixed-income instrument;
•
Value Additivity: the value of the whole equals the sum of the values of the parts
•
Dominance principle: financial assets with risk-free payoff in future must have positive prices today
...
calculate the arbitrage-free value of an option-free, fixed-rate coupon bond;
c
...
s
...
of one-year rate = 𝑖0σ> higher volatility at higher i/r
𝑖1,𝐻 = 𝑖1,𝐿𝑒
2σ
𝑙𝑜𝑔(𝑖1,𝐻) = 𝑙𝑜𝑔(𝑖1,𝐿) * 2σ
> iL is one s
...
below mean (one-year implied forward rate); iH is one s
...
above mean
•
binomial tree is recombining, i
...
low high node = high low node
d
...
5
•
𝑏𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒𝑇 =
0
...
5 * 𝑏𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒𝑇+1, 𝑙𝑜𝑤𝑒𝑟 𝑓𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒 + 𝑐𝑜𝑢𝑝𝑜𝑛
1+𝑟
, r is known as of time T
e
...
fit the i/r tree to current yield curve by choosing i/r which produces benchmark bond values
2
...
using the relationship between ilow and ihigh, trial and error to find i/r that fits current yield curve
> ilow should be lower than the implied forward rate from yield curve
> middle forward rate in a period is approximately the implied one-period forward rate for that period
> estimated i/rs are for one-year rate in one-year: benchmark will be a 2-year bond
f
...
describe pathwise valuation in a binomial interest rate framework and calculate the value of a fixed-income instrument
given its cash flows along each path;
1
...
determine the PV of bond along each potential path
3
...
describe a Monte Carlo forward-rate simulation and its application
...
describe fixed-income securities with embedded options;
•
callable: most investment-grade corporate bonds are non-refundable
#lockout period: period during which the issuer cannot call the bond
•
putable: bondholder’s option; value of putable bond will not be lower than exercise price
#extendible bond: right to keep the bond for a no
...
explain the relationships between the values of a callable or putable bond, the underlying option-free (straight) bond,
and the embedded option;
•
callable bond = value of straight bond - value of call option
•
putable bond = value of straight bond + value of put option
c
...
explain how interest rate volatility affects the value of a callable or putable bond;
•
value of option increases with i/r volatility; thus value of callable bond falls, value of putable bond rises
e
...
calculate the value of a callable or putable bond from an interest rate tree;
g
...
explain how interest rate volatility affects option-adjusted spreads;
•
for a callable bond, when volatility increases, OAS decreases
...
calculate and interpret effective duration of a callable or putable bond;
•
•
•
𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛 =
(𝑃𝑉−)−(𝑃𝑉+)
2* 𝑃𝑉0*△𝑦
= sensitivity to a parallel shift of benchmark yield curve
when △𝑦approaches 0, effective duration approaches modified duration
1
...
change benchmark yield curve, calculate PV+ and PV-, accounting for OAS
j
...
e
...
annual > effective duration lower than 1
•
when embedded option is deep ITM > effective duration of bond
resembles that of the straight bond maturing on first exercise date;
•
i/r rises, put option is to be exercised, limit price depreciation, decreases
its effective duration
k
...
•
for callable bonds with high coupon rate > likely to be exercised > rate with the highest key rate duration is the
exercise time
...
compare effective convexities of callable, putable, and straight bonds;
•
•
•
𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑐𝑜𝑛𝑣𝑒𝑥𝑖𝑡𝑦 =
𝑃𝑉−+ 𝑃𝑉+−2* 𝑃𝑉0
2
(△𝐶𝑢𝑟𝑣𝑒) * 𝑃𝑉０
straight bond has low positive convexity: rise in value due to i/r ↓ is slightly more than drop in value due to i/r ↑
callable bond: if option is OTM, behave similarly to straight bond, positive convexity;
> turns negative when option is near the money
> as i/r drops, price of callable bond is capped by the call option
> upside is much smaller than downside
•
putable bond: positive convexity
> when option is near the money
> upside is much larger than downside as value is floored by the value of put option
m
...
value of capped floater = value of straight bond - value of embedded caps
n describe defining features of a convertible bond;
•
conversion period: predetermined period during which bondholder can convert debt to equity
•
initial conversion price: price at which debt will be converted to equity at issuance
•
conversion ratio: no of shares received from conversion
•
dilution to existing shareholders when conversion occurs
•
in change-of-control event, an option to bondholder is put;
- hard put: redeem the convertible bond for cash
- soft put: issuer can choose to redeem bond for cash, common stock, subordinated notes, or a mix
o
...
describe how a convertible bond is valued in an arbitrage-free framework;
•
value of convertible bond = straight bond + call option on the issuer’s stock
•
convert
...
for issuer = straight bond + call option on issuer’s stock - issuer call option
q
...
•
when underlying share price is well below
conversion price > ‘busted convertible’ >
risk-return features resemble those of option-free
bond
Topic 7 Fixed Income
LOS 35 Credit Analysis Models
a
...
explain credit scores and credit ratings;
•
credit score: mainly for retail lending market for small business and individuals
■
payment history
■
debt burden - e
...
debt-to-limit ratio
■
length of credit history - e
...
average age of accounts on credit file
■
type of credit used
■
recent searches for credit - hard credit enquiries, e
...
apply for new loans
•
credit rating: wholesale market for bonds issued by corporations and government entities
■
investment grade: Baa3 / BBB- and above
■
The credit rating is relatively stable over time, and is lagging the business cycle
...
calculate the expected return on a bond given transition in its credit rating;
•
sum of (respective transaction probability * (duration * change in spread))
•
typically a reduction in expected return:
1
...
increase in credit spread is much larger for downgrade than decrease for upgrade
d
...
calculate the value of a bond and its credit spread, given assumptions about credit risk parameters;
•
floater: exposure = avg of expected bond value + weighted avg of coupon based on
pre-set i/r
f
...
explain determinants of term structure of credit spreads & interpret a term structure of
credit spreads;
•
credit quality:
- investment grade with highest rating only moves down in credit spread migration as
Topic 7 Fixed Income
lower bound is zero > flat or slightly upward term structure
- lower credit quality > greater sensitivity to credit cycle
> steeper term structure when weaker economy or tighter spread for longer maturity
> demand higher compensation for assuming issuer default over longer periods
- even more distressed > value of distressed debt converges to recovery rate > steep inverted term
•
financial condition: stronger economy > higher benchmark yield, but lower credit spreads
•
dd&ss: size and frequency of trades in bonds across maturity spectrum
•
company specific analysis / valuation:
- high-yield issuer in cyclical industries may have downward sloping credit term structure, if expected recovery
•
relevant benchmark rate: duration and maturity match
•
all-in spread over benchmark: analysis should use bonds with similar credit characteristics; typically senior
unsecured general obligations of the issuer
•
When a bond is very likely to default, it often trades close to its recovery value at various maturities; moreover, the
credit spread curve is less informative about the relationship between credit risk and maturity; the recovery rate
should be used to assess the credit risk
...
compare the credit analysis required for securitized debt to the credit analysis of corporate debt
...
g
...
g
...
g
...
g
...
g
...
Topic 7 Fixed Income
LOS 36 Credit Default Swaps
a
...
g
...
g
...
coupon: 1% for investment-grade, 5% for high-yield or index
2
...
describe credit events and settlement protocols with respect to CDS;
•
credit event:
1
...
failure to pay: on any outstanding obligation
3
...
g reduction/deferral of principal or interest, change in seniority
■
not a credit event in the US
•
succession event: change in the corporate structure of reference entity, e
...
M&A, divestiture
•
settlement:
1
...
cash - seller pays cash to buyer - notional amount *(1-recovery rate)
- recovery rate is based on cheapest-to-deliver
c
...
describe the use of CDS to manage credit exposures and to express views regarding changes in shape and/or level of
the credit curve;
•
to decreases credit exposure: e
...
lender buy a CDS
•
to increase credit exposure:
Topic 7 Fixed Income
- seller of CDS - manage exposure by diversifying credit risks/hedging by contract with another party
•
naked credit default swap: taking a position that entity’s credit quality will deteriorate
•
long/short trade: long one CDS, short another on a different but related entity;
> e
...
long Daimler(sell protection), short BWM
- bet credit quality of Daimler will improve relative to BWM
•
curve trade: buy CDS of one maturity and sell CDS of same reference entity with longer maturity
> upward sloping credit curve: long-term CDS rates are higher than short-term
e
...
•
yield attribute to credit risk should be the same as credit spread on a CDS
•
yield to credit risk = rate - (risk free + funding spread) > Libor
•
basis trade: exploits the differentials in the rates above with assumption that mispricing will be temporary;
e
...
bond implies a credit risk premium of 5%; CDS implies 4%
- buy bond which is priced at lower price, and buy CDS which is equivalent of shorting bond
- when converge occurs, 1% differential generates the profit
•
use CDS market determine whether debt instruments is incorrectly priced relative to CDS and buy the cheaper one
and sell the more expensive one
•
equity-versus-credit trade:
■
LBO:
◆ buy target company share - to rise due to takeover premium
◆ short acquirer’s CDS - buy protection as the credit spread is about to rise with probability of default
•
trade for disparities between CDO and synthetic CDO:
■
CDO: securitise debt obligations > issue claims against portfolio in the form of tranches
■
synthetic CDO: combining default-free securities with CDS(as protection seller)
Topic 9 Derivatives
LOS 37 Pricing and Valuation of Forward Commitments
a
...
calculate & interpret the no-arbitrage value of equity, i/r, FI, currency forward & futures contracts;
Equity
pricing: F0(T) = FV0,T(S0)
𝐹0(𝑇)
Forward
valuation: 𝑉𝑡(𝑇) = 𝑃𝑉𝑡,𝑇(𝐹𝑡(𝑇) − 𝐹0(𝑇)) = 𝑆𝑡 −
𝑇−𝑡
(1+𝑟𝑓)
•
with div/ir/carrying cost - no arbitrage condition; #cash-and-carry: carry product for delivery
T0: short a forward to sell asset at T
TT: payoff = F0(T) - ST
T0: borrow PV(div)
T 0
...
g
...
5)
pricing: fair FRA rate = forward rate for the duration between 3-9 months
𝐹𝑅𝐴(0, ℎ, 𝑚) = (
Currency
Forward
where rc is continuous compounding rate (e
...
equity index
1+𝐿0(ℎ+𝑚)*𝑡ℎ+𝑚
1+𝐿0(ℎ)*𝑡ℎ
− 1) / 𝑡𝑚
valuation: unwind current position by entering an opposite position, discount settlement to present
or: PV(receipt) - PV(payment) with new spot rates - e
...
receive notional in 3m, pay in 9m
- CIP Topic from Economics
- interest from base currency is equivalent of dividend from equity forward/futures
(𝑟𝑝𝑟𝑖𝑐𝑖𝑛𝑔 − 𝑟𝑏𝑎𝑠𝑒)𝑇
- 𝐹 = 𝑆* 𝑒
T-bond
Futures
- underlying are hypothetical 30 year treasury bonds with 6% coupon rate
- can be settled by physical delivery; with a maturity of at least 15yr
- quoting: points - 32nds - 95-18 = 95
...
𝑜𝑓 𝑎𝑐𝑐𝑟𝑢𝑒𝑑 𝑑𝑎𝑦𝑠
𝑑𝑎𝑦𝑠 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡
* 𝑐𝑜𝑢𝑝𝑜𝑛 𝑑𝑢𝑒 𝑛𝑒𝑥𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡
- as future contract settles against the quoted bond price without accrued interest
> payoff of long future position: ST - AI T - F0(T)
pricing: for bond a: 𝐹0,𝑐𝑙𝑒𝑎𝑛(𝑇) = 𝐹𝑉0,𝑐𝑙𝑒𝑎𝑛, 𝑡(𝑆0,𝑐𝑙𝑒𝑎𝑛 + 𝐴𝐼0) − 𝐹𝑉(𝑐𝑜𝑢𝑝𝑜𝑛𝑠 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 0 & 𝑇) − 𝐴𝐼𝑇
to standard: 𝐹0,𝑐𝑙𝑒𝑎𝑛(𝑇) = 𝑞𝑢𝑜𝑡𝑒𝑑 𝐹0,𝑐𝑙𝑒𝑎𝑛(𝑇) 𝑜𝑓 𝑏𝑜𝑛𝑑 𝐴 / 𝐶𝐹 𝑜𝑓 𝑏𝑜𝑛𝑑 𝐴
c
...
calculate and interpret the no-arbitrage value of interest rate, currency, and equity swaps
...
a fixed - for - b floating:
fixed rate for a is set by floating rate of a
1−𝑃𝑉0,𝑡 (1)
𝑛
𝑛
∑ 𝑃𝑉0,𝑡 (1)
𝑖=1
𝑖
2
...
A receives i/r in currency a, discount using spot rates of a
2
...
exchange b to value in a; exchange rate: 1/ initiation rate *current rate
equity swap > equity return to swap with a fixed/floating rate or return of another equity
- fixed rate leg: fix rate is set by
1−𝑃𝑉0,𝑡 (1)
𝑛
𝑛
∑ 𝑃𝑉0,𝑡 (1)
𝑖=1
𝑖
- payment = notional * fixed rate
Vt (pay fixed)= (Receipt of stock return as of t - value of fixed-rate bond at spot rate) *NA
Topic 9 Derivatives
LOS 38 Valuation of Contingent Claims
a
...
calculate the no-arbitrage values of European & American options using a two-period binomial model;
c
...
calculate and interpret the value of an interest rate option using a two-period binomial model;
•
an i/r call option is in the money if the current spot rate is above the exercise rate
•
i/r call option is a cap on i/r
•
payoff = max{0, reference rate-exercise rate} * notional principal
e
...
identify assumptions of the Black–Scholes–Merton option valuation model;
•
Geometric Brownian motion to model price > continuously compounded return is normally distributed
> asset price has a lognormal distribution
•
liquid underlying with continuous trading, no friction, no arbitrage
•
borrowing and lending at known and constant i/r; known and constant volatility
•
only European options, no early exercise
g
...
describe how Black–Scholes–Merton model is used to value European options on equities & currencies;
•
for fx options, γ = risk free rate of foreign currency i
...
the underlying
i
...
describe how the Black model is used to value European interest rate options & European swaptions;
•
i/r option:
> underlying is forward rate/FRA rate
Topic 9 Derivatives
−𝑟(𝑡𝑗−1+𝑡𝑚)
𝐶0 = 𝑁𝑜𝑡𝑖𝑜𝑛𝑎𝑙 * (𝐴𝑃)𝑒
•
[𝐹𝑅𝐴(0, 𝑡𝑗−1, 𝑡𝑚)𝑁(𝑑1) − 𝑅𝑋𝑁(𝑑2)]
where FRA (0, t j-1, tm) is FRA expiring at t j-1, where underlying matures at tj-1 + tm
AP = accrued period based on actual number of days (ACT) / 365 = tm / 365
> used to adjust annual payment rate to relevant period
> with i/r exercise rate = current FRA rate:
- long call + short put = enter a receive-floating, pay fixed FRA
> for binomial model, i/r for node 0 is current spot rate
> interest rate cap is a portfolio of interest rate call options
swaptions:
> underlying is swap rate when swaption expires
1
...
receiver swaption: option to receive fixed, pay floating
k
...
describe how a delta hedge is executed;
m
...
define implied volatility and explain how it is used in options trading
...
•
time to expiration > term structure of volatility (volatility smile)
•
out of money put (low strike price) is more expensive than out of money call(high strike price)
Topic 9 Alternative Investments
LOS 39 Private Real Estate Investments
a
...
g
...
describe the characteristics, the classification, and basic segments of real estate;
•
characteristics:
- heterogeneity & fixed location; no 2 properties are the same
- high unit value; need for debt capital: due to large amounts required to purchase and develop properties
- management intensive: a private real estate equity investor has responsibility for management of real estate
- high transaction cost
- depreciation: as a result of use / passage of time / desirability of its location
- illiquid; price determination: limited number of participants in the property market
•
REITs: - liquid & actively traded shares - price is more likely to reflect market value;
- diversified portfolio;
- professional property managers
•
classifications: 1
...
non-commercial: single-family houses
3
...
explain use, economic value determinants, investment characteristics, principal risks of private real estate;
•
reasons to invest in real estate:
1
...
inflation hedge
3
...
tax benefits
•
investment risk:
1
...
long lead time for new development(risk for developer) - market volatility during this gap
3
...
unexpected inflation: rent rise is lower than actual inflation
5
...
lack of liquidity
7
...
g
...
availability of information
9
...
leverage
d
...
gross lease: owner pays operating expenses
b
...
expense reimbursement: (exists for net lease)
first year - owner pays;
later - owner pays up to the amount paid in year 1;
- tenant pays the rest as ‘expense reimbursement’
Topic 9 Alternative Investments
retail
- demand depends on consumer
spending trend; health of economy; job
growth; saving rate
- length depends on quality of property;
importance of tenant
- percentage lease: additional rent once tenants’ sales reach a
certain level
warehou - depends on overall strength of economy
se
- partly affected by import/export
multi-fa
mily
- depends on population growth, demographics, propensity of rent, ratio of home price to rent, i/r rate,
operating expense
e
...
market value: most probable sale price
2
...
value in use: value to a particular user - e
...
value of a manufacturing plant to the company
4
...
mortgage lending value: the lender ask for a more conservative value
•
value of land - the highest and best use of vacant site; i
...
the highest value added by construction
f
...
calculate the value of a property using the direct capitalization and discounted cash flow valuation methods;
h
...
calculate Net Operating Income
a
...
gross lease: cf = rental income at full occupancy + other income > potential gross income
- vacancy and collection loss > effective gross income
- operating expense > NOI
2a
...
e
...
DCF - 2 stage model:
Term & Reversion = sell off the property at stage 2
Layer = renew lease for different rent at stage 2
Stage 1 PV of NOI for t=1 to t=n; discount using going-in cap rate
Stage 2 PV(𝑉 )
𝑛
where 𝑉𝑛 = 𝑡𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑏𝑦 𝑔𝑟𝑜𝑤𝑡ℎ 𝑚𝑜𝑑𝑒𝑙 =
𝑁𝑂𝐼𝑛+1
current rent + incremental rent, discounted by
its discount rate
𝑟−𝑔
where r-g is residual/terminal cap rate, that’s often
higher as expects lower growth rate
- discount rate for PV should be terminal cap rate
i
...
depends on the risk of CF being discounted, not time
× difficult to select appropriate capitalisation rate
× not applicable for owner-occupied properties that provide other benefits
...
calculate the value of a property using the cost and sales comparison approaches;
•
cost approach: land value + replacement cost + adjustment for differences (age, location)
1
...
if curable defects are fixed, deduct from replacement cost
b
...
g
...
depreciation: incurable physical depreciation - pro rata to age/total economic life
3
...
functional obsolescence (e
...
bad floor plan, adjust based on impact on NOI)
b
...
economic obsolescence
•
sales comparison approach: use comparables on a per area basis
with adding adjustments for factors, such as age, location, date of sale
e
...
9% due to newer + 10% due to better condition
j
...
discuss private equity real estate investment indices, including their construction and potential biases;
•
appraisal-based index: combine valuation information from individual properties in index
- change in index provides a measure of market movements
- 𝑟𝑒𝑡𝑢𝑟𝑛 =
𝑁𝑂𝐼 − 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 + 𝑒𝑛𝑑 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 − 𝑏𝑒𝑔𝑖𝑛 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒
𝑏𝑒𝑔𝑖𝑛 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒
- quarterly data
- value-weighted data based on return of separate properties > single-period IRR
- drawbacks: 1
...
tend to smooth the index and reduce volatility - missing data during the quarter
3
...
repeat-sales index: relies on repeat sales of the same property
b
...
explain the role in a portfolio, major economic value determinants, investment characteristics, principal risks, and due
diligence of private real estate debt investment;
m
...
•
debt service coverage ratio(DSCR) =
𝑓𝑖𝑟𝑠𝑡 𝑦𝑒𝑎𝑟 𝑁𝑂𝐼
𝐷𝑒𝑏𝑡 𝑠𝑒𝑟𝑣𝑖𝑐𝑒
where debt service = interest + principal
𝑙𝑜𝑎𝑛 𝑎𝑚𝑜𝑢𝑛𝑡
𝑎𝑝𝑝𝑟𝑎𝑖𝑠𝑎𝑙 𝑣𝑎𝑙𝑢𝑒
•
LTV =
•
equity dividend rate =
•
•
leveraged IRR: IRR based on equity invested in the property
unleveraged IRR: IRR assuming property was purchased on all-cash basis
𝑓𝑖𝑟𝑠𝑡 𝑦𝑒𝑎𝑟 𝐶𝐹
𝑒𝑞𝑢𝑖𝑡𝑦
Topic 9 Alternative Investments
LOS 40 Publicly Traded Real Estate Securities
a
...
explain advantages and disadvantages of investing in real estate through publicly traded securities;
Advantages
Disadvantages
REITs
vs
direct
a
...
lower investment requirements
c
...
access to superior quality and range
of properties
e
...
diversification by geography and
property type
a
...
control: less control compared to direct property owner
c
...
stock market value of REIT is more volatile that the appraised
net asset value of REIT
e
...
limited future growth due to low rate of income retention
g
...
explain economic value determinants, investment characteristics, principal risks, due diligence considerations for REIT;
d
...
justify net asset value per share (NAVPS) in REIT valuation and estimate NAVPS based on forecasted cash NOI;
Topic 9 Alternative Investments
•
𝑝𝑟𝑜𝑝𝑒𝑟𝑡𝑦 𝑣𝑎𝑙𝑢𝑒 =
𝑁𝑂𝐼 1 𝑤𝑖𝑡ℎ 𝑎𝑑𝑗𝑢𝑠𝑡𝑚𝑒𝑛𝑡𝑠
𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑠𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 ( 𝑟−𝑔)
=
( 𝑐𝑎𝑠ℎ 𝑁𝑂𝐼 = 𝑙𝑎𝑠𝑡 12 𝑚𝑜𝑛𝑡ℎ 𝑁𝑂𝐼 − 𝑛𝑜𝑛 𝑐𝑎𝑠ℎ 𝑟𝑒𝑛𝑡 + 𝑓𝑢𝑙𝑙−𝑦𝑒𝑎𝑟 𝑎𝑑𝑗𝑢𝑠𝑡𝑚𝑒𝑛𝑡 𝑓𝑜𝑟 𝑎𝑐𝑞𝑢𝑖𝑠𝑖𝑡𝑖𝑜𝑛𝑠) * (1+𝑔)
𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑠𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 ( 𝑟−𝑔)
•
assets = real estate + cash & A/R
f
...
•
use comparables to assess if REITs is overvalued or undervalued
g
...
calculate value of a REIT share using net asset value, price-to-FFO and price-to-AFFO, and DCF approaches
...
explain sources of value creation in private equity;
•
VC: invest in early stage; buyout: PE buys entire company
•
special situations: invested in distressed securities, one-time opportunities
•
sources of value:
1
...
access credit markets on favorable terms - PE has better ability for more debt due to better control & reputation
3
...
explain how private equity firms align their interests with those of the managers of portfolio companies;
•
compensation: performance-based compensation for managers of portfolio companies
...
distinguish between the characteristics of buyout and venture capital investments;
Venture Capital
LBO
Target
revenue growth
EBIT or EBITDA growth
CF
low predictability
steady and predictable cash flows
asset base
weak asset base
significant asset base; basis for collateral lending
leverage
primarily equity funded
extensive use of leverage
e
...
large proportion of senior debt
WC
expanding WC required for expansion
low WC requirement
product
market
lack of market history
new market or unproven market
excellent market position; can be a niche player
management
strong individual record as entrepreneurs
strong and experienced management team
operations
significant cash burn rate required for company potential for restructuring and cost reduction
development & commercial viability
risk
difficult to assess risk
measurable risk due to long & mature operation history
return
very high returns from a limited number of
highly successful investments & significant
number of write-offs
lower variance across returns from underlying
investments
revenue for
General
Partner
Carried interest is the main source of variable
revenue to GP at VC; transaction & monitoring
fees are rare in practice
carried interest(i
...
bonus to fund manager)
transaction fee
monitoring fees
transaction
often proprietary, based on relationships
between VC and entrepreneurs
auctions, involving multiple potential acquirers
DD
tends to conduct primarily a tech & commercial full blown dd ( inclusive of financial one)
DD before investing
monitoring
achieving milestones defined in business plan
cash flow management, strategic, business planning
exit
exit difficult to anticipate(IPO, trade sale)
predictable - secondary buyout, sale to strategic buyer
d
...
earnings growth from operation improvements & enhanced corporate governance
b
...
optimal financial leverage and repayment of part of the debt with CFO before exit
- calculation: exit value > payoff to different claimants > IRR for PE and management equity
•
VC valuation
- difficulties for using DCF or comparables
e
...
explain private equity fund structures, terms, valuation, due diligence in context of analysis of PE fund returns;
•
limited partnership is the most common form of ownership
•
due diligence:
- PE funds tend to exhibit a strong persistence of returns over time; top performing tends to continue to outperform,
with large return discrepancy over underperformers
- PE is often illiquid and long-term; but duration is shorter as when a portfolio company is exited, funds are
immediately returned to investors
•
economic terms:
a
...
5% - 2
...
transaction fee: fees paid to GPs in their advisory capacity when they provide IB services for a transaction
- may subject to 50/50 split agreement between LP and GP; if so, management fee is often
deduced
c
...
hurdle rate: IRR that PE fund mush achieve before GP receives any carries interest, 7%-10%
e
...
target fund size / vintage(year that PE fund was launched) / term of fund (~10years, extendable for shorter period)
•
corporate governance terms:
a
...
disclosure and confidentiality: PE firms have no obligation to disclose publicly their financial performance
c
...
distribution waterfall: order of distribution - LPs first, GPs later for carried interest
- deal-by-deal: mostly in US, allow earlier distribution of carried interest to GP after each deal
- total return waterfall: GP receives carried interest:
a
...
or on any distribution as long as investment portfolio value is a certain
threshold above invested capital, ~20%
...
tag-along, drag-along clause: any potential future acquirer of the company may only acquire control by extending
an acquisition offer to all shareholders, including the management of the company
f
...
removal for cause: clause that allows either a removal of GP or an earlier termination of the fund for cause
...
investment restrictions
j
...
explain risks and costs of investing in private equity;
•
risks:
- illiquid & unquoted investment, valuation of investments - price or valuation may not be fair
- competition for attractive investment opportunities
- reliance on the management of investee companies - agency risk
- loss of capital due to high financial and business risk
- government regulation
- taxation risk
- market risk
- lack of investment capital
- lack of diversification - especially for smaller PE funds
•
costs:
- transaction fees: DD, bank financing costs, legal fees
- investment vehicle fund setup cost: legal costs for setting up, often amortised over the life of investment vehicle
- admin cost: custodian, transfer agent
- audit cost
- management and performance fee - 2% + 20% above hurdle
- dilution
- placement fee: placement agents who raise funds for PE firms
h
...
calculate management fees, carried interest, net asset value, distributed to paid in (DPI), residual value to paid in
(RVPI), and total value to paid in (TVPI) of a private equity fund;
•
management fee = 2% * paid-in capital
•
ending NAV = beginning NAV + additional paid-in + operating return - management fee - carried interest
•
DPI = distributed / paid-in = realised return
•
RVPI = undistributed residual value / paid-in = unrealised return
•
TVPI = DPI + RVPI
•
Example calculation
j
...
demonstrate alternative methods to account for risk in venture capital
...
compare characteristics of commodity sectors;
•
benchmark of segments: Reuters / Core Commodity CRB Index developed by Commodities Research Bureau
energy Crude oil
~50% of
traded
volume
- quality: depending on its source, e
...
North Sea, Nigeria
- weather: only a temporary impact
- technology
- geopolitics
- business cycle
Natural gas
- classification: associated gas - from oil well;
unassociated gas - from gas field or shale rock
- supply: driven by oil demand
- demand: weather is a key driver - e
...
cold weather drives up demand
- seasonality and available supplies can radically change natural gas prices
- cost-effective as it can be used directly, but has high storage and transportation costs
Refined
products:
end-use
fuels, jet fuel
- short shelf life: refineries must run continuously
- location of refineries: often located on major coastlines
- weather: typhoon / hurricanes
- environmental impact increasing processing costs
grains
- storage period
- direct consumption; - weather, disease, pests
- fuel / animal feed
- technology and politics
softs(cash crops)
e
...
coffee, cotton
- storage: freshness determines the quality and price of commodity
- weather
livestock
- tied to grain markets and GDP per capita
- low cost inputs
- storage
- weather, disease
- regulation on permitted use of drugs and growth hormones
- substitute proteins, consumer preferences
industrial(base)metal - direction of industrial production and GDP growth
- politics - e
...
labour strike
- environment - e
...
pollution
- weather and seasonal factors: low impact due to long stored-period
precious metals
- gold, silver, platinum > act as stores of value, hedge for paper currency
- technology
- industry needs
- jewelry production
b
...
contrast the valuation of commodities with the valuation of equities and bonds;
•
tangible assets with intrinsic value; have no cash flow; may incur storage and transportation costs
•
valuation - discounted forecast of future possible prices; use future prices to obtain current price
d
...
analyze relationship between spot prices & expected future prices in markets in contango / backwardation;
•
calendar spread = near-term futures contracts - longer term future contracts
•
basis spread = spot price - future price
backwardation
contango
•
•
•
•
term structure has downward sloping trend
spot price > future price, positive basis spread
term structure has upward trend
spot price < future price, negative basis spread
Topic 9 Alternative Investments
•
•
near-term future contracts > longer-term future
•
contracts, positive calendar spread
as contracts near maturity, future price converge to •
spot price, long futures have a positive return
near-term future contracts < longer-term future
contracts, negative calendar spread
as contracts near maturity, future price converge to
spot price, long futures have a negative return
f
...
describe, calculate, and interpret components of total return for a fully collateralized commodity futures contract;
•
total return = price return: change in commodity futures prices, generally the front month contract
+ roll return
+ collateral return: yield for bonds / cash used to maintain futures positions, min
...
contrast roll return in markets in contango and markets in backwardation;
•
roll return =
𝑛𝑒𝑎𝑟−𝑡𝑒𝑟𝑚 𝑓𝑢𝑡𝑢𝑟𝑒 𝑐𝑙𝑜𝑠𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 − 𝑙𝑜𝑛𝑔−𝑡𝑒𝑟𝑚 𝑓𝑢𝑡𝑢𝑟𝑒 𝑐𝑙𝑜𝑠𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒
𝑛𝑒𝑎𝑟−𝑡𝑒𝑟𝑚 𝑓𝑢𝑡𝑢𝑟𝑒𝑠 𝑐𝑙𝑜𝑠𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒
* %𝑜𝑓 𝑝𝑜𝑠𝑖𝑡𝑖𝑜𝑛 𝑏𝑒𝑖𝑛𝑔 𝑟𝑜𝑙𝑙𝑒𝑑
i
...
g
...
describe how the construction of commodity indexes affects index returns
...
explain the creation/redemption process of ETFs and the function of authorized participants;
•
primary market is OTC between authorised participants(AP) and ETF issuer/sponsor
•
ETF is open-end funds as value of fund changes
creation
AP:
pay issuer with the required basket of
institutional investor securities, using inventory/buy shares in
e
...
broker/dealers public market(AP bares transaction cost)
ETF sponsor
/manager
•
•
•
•
redemption
pay ETF shares in return for a basket of
securities, called redemption basket
publish a daily creation basket, i
...
a list of redemption basket provided is often the same
as creation basket, but can be different
required in-kind securities for each ETF
in-kind transaction, the price at which stock is acquired/ closing NAV is not relevant
transactions are done in large blocks called creation unit, usually 50000 shares of ETF
motivation for AP: arbitrage profit from discrepancy between fair value of security baskets and price of ETF share
benefits of ETF:
- low and predictable investment cost:
a
...
ETF sponsor does not bare cost of communicating directly with individual investors
c
...
cost of creation/redemption is borne by AP
- closely track index:
a
...
periodic tracking error: standard deviation of daily difference, often reported for a 12 month period
c
...
rolling difference: moving average of daily difference over n days
- see cumulative effect of portfolio management & expense over an extended period
e
...
yet annual expense ratio is an inferior measure to rolling return assessment
- lowest possible tax exposure
a
...
> for mutual fund, in redemption, fund sells its holding for cash, tax on realised gain affect
other investors;
> for ETF,1) selling in secondary market does not require fund to trade out of its position;
2) redemption by AP via in-kind is not a taxable event
b
...
other distribution: in Europe, ETF can reinvest dividends into the fund
d
...
describe how ETFs are traded in secondary markets;
•
secondary market is between investor and APs; payment via cash
c
...
g
...
g
...
g
...
describe factors affecting ETF bid–ask spreads;
•
ongoing order flow in the ETF
•
competition among market makers
•
actual cost and risk for the liquidity provider
•
spread = creation/redemption fees(cost of AP) + bid-ask of underlying securities held in the ETF profit spread
+ compensation to market maker for risk of carrying/hedging for remaining trading day
Topic 10 Portfolio Management
+ market maker
- discount related to the likelihood of receiving an offsetting ETF order in a short timeframe
e
...
describe costs of owning an ETF;
one-off
explicit
implicit
commission
bid-ask spread, premium/discount to NAV
ongoing management fee, taxable gain/loss to investors tracking error, security lending gains, portfolio turnover
•
mutual fund does not have bid-ask spread & premium/discount to NAV
g
...
settlement risk; e
...
exchange-traded notes(ETN) - unsecured as ETN do not hold underlying securities
b
...
regulation
b
...
corporate action - e
...
M&A between ETF providers
d
...
identify and describe portfolio uses of ETFs
...
•
portfolio efficiency
•
asset class exposure management: main core exposure to key asset class, market segment
•
active and factor investing: use ETF to target specific active/factor exposure
Topic 10 Portfolio Management
LOS 44 Using Multifactor Models
a
...
a factor model describes asset returns
b
...
no arbitrage opportunities
b
...
calculate expected return on an asset given an asset's factor sensitivities and the factor risk premiums;
•
pure factor portfolio for factor i - when factor sensitivity is 1 to factor i, and 0 for other factors
d
...
explain sources of active risk and interpret tracking risk and the information ratio;
2
•
active risk: standard error of active returns = 𝑆(𝑅𝑝−𝑅𝑏) =
•
active risk squared = active factor risk + active specific risk
a
...
return from security selection - skill in individual asset selection
•
information ratio: ratio of mean active return to active risk =
𝑅𝑃−𝑅𝐵
𝑆(𝑅𝑝−𝑅𝑏)
f
...
describe the potential benefits for investors in considering multiple risk dimensions when modeling asset returns
...
explain the use of value at risk (VaR) in measuring portfolio risk;
•
factors affecting VaR: a
...
confidence level
b
...
g
...
d
...
d
✓ can incorporate any assumptions
× quality of output depends on assumptions
c
...
describe advantages and limitations of VaR;
•
subjectivity
•
tail risk - underestimate the frequency of extreme events as it represents the min
...
describe extensions of VaR;
•
conditional VaR: average loss that would be incurred if the VaR cutoff is exceeded = expected loss/ shortfall
•
incremental VaR: how portfolio VaR change if a position size is changed relative to the remaining positions
•
marginal VaR: similar to incremental VaR, but use calculus to reflect the effect of a minimal change
•
relative VaR: ex ante tracking error: to what extend performance of given portfolio might deviate from benchmark
f
...
demonstrate how equity, fixed-income, and options exposure measures may be used in measuring and managing
market risk and volatility risk;
h
...
describe advantages and limitations of sensitivity risk measures and scenario risk measures;
j
...
traditional: ex ante tracking error; redemption risk(% of redemption at peak times); active
share(similarity to benchmark)
b
...
drawdown(最大回撤)
•
pension fund: i/r and curve risk; surplus at risk(VaR for surplus)
•
insurance: P&C: economic capital(capital to cover liability)
Life: asset & liability matching
k
...
e
...
do not allow use of derivatives
•
liquidity limit: dollar cap according to frequency of trading volume
•
scenario limit: limit on the estimated loss for a given scenario; if exceeded, take corrective actions
•
stop-loss limit: absolute dollar limits for losses over a certain period
e
...
drawdown control / portfolio insurance - take hedge if loss if above certain level
l
...
explain the notion that to affect market values, economic factors must affect one/more of the following: (1) default-free
interest rates across maturities, (2) the timing and/or magnitude of expected cash flows, and (3) risk premiums;
•
𝑅𝑓, 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 = 𝑅𝑓, 𝑟𝑒𝑎𝑙 + 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒, θ + 𝑢𝑛𝑐𝑒𝑟𝑡𝑎𝑖𝑛𝑡𝑦, π
•
𝑅𝑖 = 𝑅𝑓, 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 + 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑝𝑟𝑒𝑎𝑑, γ + 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚, κ + 𝑙𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚, φ
•
𝑅𝑓, 𝑟𝑒𝑎𝑙, from TIPS, treasury inflation protected securities:
- similar to decreasing marginal utility from consumption, marginal utility from wealth decreases
- by time value of money,
𝑃0 * 𝑢0(𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑢𝑡𝑖𝑙𝑖𝑡𝑦 𝑎𝑡 0) = 1 * 𝑢1(𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑢𝑡𝑖𝑙𝑖𝑡𝑦 𝑓𝑜𝑟 𝑑𝑒𝑙𝑎𝑦𝑒𝑑 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 𝑎𝑡 𝑡 = 1)
- 𝑃0 =
𝑢1
𝑢0
= 𝑚 = 𝑖𝑛𝑡𝑒𝑟 − 𝑡𝑒𝑚𝑝𝑜𝑟𝑎𝑙 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑠𝑢𝑏𝑠𝑡𝑖𝑡𝑢𝑡𝑖𝑜𝑛, always <1 as investor prefer current over future
consumption
- m is a random variable as people do not know 𝑢1, e
...
may decrease if people have higher wealth
- m is lower at good state of economy as individuals have higher future income, so 𝑢1is lower
- 𝑅𝑓, 𝑟𝑒𝑎𝑙 =
1−𝑃0
=
𝑃0
1−𝑚
𝑚
> higher in good state of economy
- if 𝑃0 is lower than m, 𝑃0𝑢0 < 𝑢1, buy more bond, lower wealth, 𝑢0 increases, m decreases
- price of s-period risk free bond 𝑃𝑡,𝑠 =
𝐸𝑡⎡⎢𝑃𝑡+1,𝑠−1⎤⎥
⎣
⎦
1+𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒𝑡,1
*
+ 𝑐𝑜𝑣𝑡[𝑃𝑡+1,𝑠−1, 𝑚𝑡,1] = PV for price at 1, 𝑃 + covariance term
a
...
𝑐𝑜𝑣(𝑃1, 𝑚): if higher 𝑃1 > bondholder has more wealth at 𝑡1, lower 𝑢1, lower m > negative covariance
c
...
single period bond does not have uncertainty term, thus covariance is zero
...
g
...
inflation environment
b
...
g
...
central bank’s policy rate - towards neutral policy; higher than expected inflation/ output surplus, ↑ policy rate
- breakeven inflation rate = θ𝑡,𝑠 + π𝑡,𝑠
= difference between yield on 1 year default free nominal bond vs real bond
- inverted yield curve when recession; gets LT bond as safe assets, price of LT bond increases, yield decreases
b
...
explain relationship btw long-term growth rate of economy, volatility of growth rate, average level of real short-term i/r;
d
...
5 current inflation - 0
...
5(log of current GDP - log of LR GDP)
•
Real short-term i/r are positively related to both real GDP growth and the volatility of real GDP growth
...
describe the factors that affect yield spreads between non-inflation-adjusted and inflation-indexed bonds;
•
inflation, θ & uncertainty related to future inflation,π
f
...
explain how the characteristics of the markets for a company's products affect the company's credit quality;
h
...
explain the relationship between the consumption-hedging properties of equity and the equity risk premium;
•
when recession, equity risk premium κ increases as equity is a bad consumption hedge
Topic 10 Portfolio Management
j
...
describe implications of business cycle for a given style strategy (value/growth, small/ large capitalization);
•
growth: high P/E, strong earnings growth, have very low or no earnings
•
value: operates in more mature markets with a lower earnings growth; low P/E and high dividend yield
•
small caps are expected to underperform larger ones in bad times; as small caps have less diversified businesses
•
The yield curve typically steepens when the economy is in recession
...
l
...
describe the economic factors affecting investment in commercial real estate
...
value of properties(stock like) b
...
describe how value added by active management is measured;
•
𝑅𝑎𝑙𝑝ℎ𝑎 = 𝑅𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 − 𝑅𝑏𝑒𝑛𝑐ℎ𝑚𝑎𝑟𝑘
•
•
active weights: differences between asset weights in managed portfolios and asset weights in benchmark portfolio
sum of active weights is zero
•
𝑅𝑎𝑙𝑝ℎ𝑎 = ∑ 𝑤𝑃,𝑗(𝑅𝑃,𝑗 − 𝑅𝐵,𝑗) + ∑ (𝑤𝑃,𝑗 − 𝑤𝐵,𝑗) 𝑅𝐵,𝑗
𝑀
𝑀
𝑗=1
𝑗=1
= security selection + asset allocation
b
...
𝑜𝑓 (𝑅𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 − 𝑅𝑏𝑒𝑛𝑐ℎ𝑚𝑎𝑟𝑘)
> higher IR, greater consistency in active return
•
sharpe ratio is unaffected by the addition of cash or leverage in a portfolio
•
information ratio is unaffected by the weight of benchmark portfolio in the overall portfolio
c
...
explain how IR may be useful in investment manager selection and choosing the level of active portfolio risk;
•
information coefficient:
µ
- 𝐼𝐶 = 𝑐𝑜𝑟𝑟𝑒𝑙𝑎𝑡𝑖𝑜𝑛( σ𝑖 ,
𝑖
•
𝑅𝐴𝑖
σ𝑖
) =correlation btw forecasted active returns & realised active returns
- measures signal quality, ability to forecast
- investor with higher IC will add more value over time, but only to the extent that those forecasts are exploited in the
construction of the managed portfolio
transfer coefficient
µ
- 𝑇𝐶 = 𝑐𝑜𝑟𝑟𝑒𝑙𝑎𝑡𝑖𝑜𝑛( σ𝑖 ,
𝑖
∆𝑤𝑖
σ𝑖
) =between risk-weighted forecasted active return and risk-weighted active weights
- measures the degree to which the investors forecasts are translated into active weights
e
...
g
...
limitation on short position; b
...
describe the practical strengths and limitations of the fundamental law of active management
...
explain the components of execution costs, including explicit and implicit costs;
•
fixed trading cost: cost of employing buy-side traders, cost of office
•
variable trading cost:
a
...
implicit:e
...
market impact of trading; bid-ask spread -> market spread = inside spread;
delay cost(inability to complete the desired trade immediately);
oppo
...
calculate and interpret effective spreads and VWAP transaction cost estimates;
buy
sell
✔️
effective spread
trade size *
trade size *
sensible estimate when orders are filled in single trades;
(trade price - mid) (mid - trade price) × for split large orders, bid-ask price will change, effective
*2
*2
spread will not fully identify market impact
× do not measure delay cost and opportunity cost
implementation
shortfall
paper portfolio return - actual return
return using cost vs EOD price
✔️
consider delay cost and opportunity cost
e
...
if unfilled order, the actual return will be lower as unit
overhead will be higher
VWAP
VWAP benchmark = total value of
× when evaluated trades are a significant proportion of all
volume-weighted benchmark trades / total qn of trades trades in VWAP benchmark, trade VWAP and benchmark will
average price
trade VWAP - VWAP benchmark
be nearly equal, misleadingly suggesting trades were not
costly
...
describe the implementation shortfall approach to transaction cost measurement;
d
...
cheap, less prone to error, less prone to disruption(e
...
bad weather)
2
...
support hidden orders
4
...
fast with infinite and wide attention span
e
...
liquidity aggregation > creates super book that present liquidity across markets
2
...
distinguish among types of electronic traders;
•
high frequency /low latency traders
•
electronic news traders: subscribe to high-speed electronic news feeds that report news releases; profit when
execute against stale orders
•
electronic dealers: place bid/ask to profit from round trip at favorable net spreads; e
...
keep track of schedules news
release and cancel orders just before release to avoid offer liquidity to traders who can act faster than they can
•
electronic arbitrageurs
•
electronic front runners: low latency traders use AI to identify when large orders are coming, fill orders on the same
side before the large order comes in; and sell to book gain afterwards
•
electronic quote matchers: exploit standing orders; e
...
limit buy at $10, quote matcher buy at $10
...
01
g
...
advanced order - limit orders with limit prices that change as market conditions change
2
...
g
...
algos - programmed strategies for filling orders
4
...
leapfrog: when bid-ask spread is wide, dealers often are willing to trade at better prices than they quote;
e
...
traders place bids just above the current bid price, that bid is instantly raised to a price just above
the bid placed by the traders
6
...
electronic arbitrage:
a
...
offer liquidity on one side - when obtain a fill in one, take liquidity to the other to complete the construction of
arbitrage portfolio; when trade opportunity disappears, cancel order in first market
c
...
describe comparative advantages of low-latency traders;
•
taking: take advantage of market opportunities before others do
•
making: receive time precedence that allow them to trade sooner when offering liquidity to others
•
cancelling: ensure order cancellation when they no longer want to fill the order
i
...
runaway algo - programming mistakes
2
...
overlarge orders - demand more liquidity than market can provide
4
...
test
2
...
rigorous access controls on software developers
4
...
brokers should surveil all client orders
6
...
describe abusive trading practices that real-time surveillance of markets may detect
...
g
...
The
spoofer then places one or more exposed sell limit orders in the market to convey the impression prices may
soon fall
...
- bluffing: submitting orders and arranging traders to influence other traders’ perceptions of value(not filled)
- gunning the market: selling quickly to push price down to trigger stop-loss sell orders
- quote stuffing: enter large quantities of fictitious orders and instantaneously cancelling them
- squeezing/cornering: force traders to do disadvantages trades:
a
...
unexpected withdraw all resources, causing traders to default on their contracts
c
Title: CFA Level 2 Self-prepared notes
Description: Summarised notes for CFA Level 2 2020/2021 syllabus
Description: Summarised notes for CFA Level 2 2020/2021 syllabus