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Title: CFA Level I Curriculum Notes - Complefe
Description: CFA Level I curriculum notes from original CFAI text. 148 pages. Helped me pass level I with >70 in every single section!
Description: CFA Level I curriculum notes from original CFAI text. 148 pages. Helped me pass level I with >70 in every single section!
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CFA LEVEL I - REVIEW
BOOK 1
Study Session I: Ethical and Professional Standards
CFA Institute Professional Conduct Program
- Professional Conduct staff, under direction of CFAI, conducts professional conduct inquiries
...
Members and candidates must self-disclose on the annual Professional Conduct Statement all matters
that question their professional conduct, such as involvement in civil litigation, a criminal investigation, or
the subject of a written complaint
...
Secondly, written complaints received by Professional Conduct staff can bring about an investigation
...
CFAI staff may become aware of questionable conduct by a member or candidate through the media or
other public source
...
CFA examination proctors can submit a violation report for any candidate suspected to have
compromised his or her professional conduct during the examination
...
If Designated
Officer finds a violation of Code and Standards has occurred, the DO may propose disciplinary sanction, which may
be rejected or accepted by member or candidate
...
The Code of Ethics
• Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients,
prospective clients, employers, employees, colleagues in the investment profession, and other
participants in the global capital markets
...
• Use reasonable care and exercise independent professional judgment when conducting investment
analysis, making investment recommendations, taking investment actions, and engaging in other
professional activities
...
• Maintain and improve their professional competence and strive to maintain and improve the
competence of other investment professionals
...
Professionalism
A
...
In the event of
conflict, members and candidates must comply with the more strict law, rule, or
regulation
...
- Members and candidates must comply with applicable law or regulation related to their
professional activities
...
- In the absence of any applicable law or regulation or when the Code and Standards
impose a higher degree of responsibility than applicable laws and regulations,
members
and candidates must adhere to the Code and Standards
...
Stay informed – establish or encourage their employers to establish a procedure by which employees are
regularly informed about changes in applicable laws, rules, regulations and case law
...
Review Procedures – review or encourage their employers to review written compliance procedures on a
regular basis to ensure that they reflect current law and provide adequate guidance
...
Maintain Current files – maintain or encourage employers to maintain readily accessible current
reference copies or applicable statutes, rules, regulations and important cases
...
Firms:
1
...
2
...
3
...
Independence and Objectivity – Members and candidates must use reasonable care and
judgment to achieve and maintain independence and objectivity in their professional
activities
...
- Analysts must distinguish between fact and opinion in their reports
...
1
...
2
...
3
...
When attending meetings at an issuer’s headquarters, members and
candidates should pay for commercial transportation and hotel chargers
...
4
...
5
...
6
...
7
...
C
...
1
...
2
...
3
...
D
...
1
...
2
...
3
...
II
...
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
...
g
...
g
...
); orders for large trades before they are
executed
...
38) – An analyst gathers and interprets large quantities of information from many
sources
...
Under the “mosaic theory”, financial analysts are free to act on this
collection, or mosaic, of information without risking valuation
...
Companies should construct information “firewall” including
- Substantial control of relevant interdepartmental communications
- Review of employee trading through the maintenance of watch or restricted and rumor lists
- Documentation of the procedures designed to limit the flow of information between departments and
of the enforcement actions taken pursuant to those procedures
- Heightened review or restriction of proprietary trading while a firm is in possession of material
nonpublic information
...
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
...
Duties to Clients
A
...
Members and
candidates must act for the benefit of their clients and place their clients’ interests before
their employer’s or their own interests
...
(read page 51)
1
...
Establish the investment objectives of the client
...
Diversify
4
...
Send out all info to all your clients, then you
can contact your largest clients first
...
Disclose conflicts of interest
6
...
Vote proxies in the best interest of the clients and ultimate beneficiaries
8
...
Seek best execution
10
...
B
...
Each member or
candidate is obligated to ensure that information is disseminating in such a manner that
all clients have a fair opportunity to act on every recommendation
...
1
...
Shorten the time frame between decision and dissemination
3
...
Simultaneous dissemination
5
...
Develop written trade allocation procedures that ensure fairness to advisory clients, both in execution of
orders and in the allocation of the price obtained in execution on block orders or trades; timliness and
efficiency in the execution of orders; accuracy of the member’s or candidates records as to trade orders and
client account positions
...
Disclosing trade allocation procedures
...
Establish systematic Account Review
9
...
Suitability –
1
...
Make a reasonable inquiry into a client’s or
prospective client’s investment experience,
risk and return objectives, and financial
constraints prior to making any investment
recommendation or taking investment action
and must reassess and update this
information regularly
...
Determine that an investment is suitable to the
client’s financial situation and consistent
with the client’s written objectives,
mandates, and constraints prior to making an
investment recommendation or taking
investment action
...
Judge the suitability of investments in the
context of the client’s total portfolio
...
When members and candidates are responsible for managing a portfolio to a specific
mandate, strategy, or style, they must only make investment recommendations or take investment actions
that are consistent with the stated objectives and constraints of the portfolio
...
62)
1
...
Investor objectives – (a) return objectives (b) risk tolerance
3
...
Performance measurement benchmarks
D
...
1
...
Presenting performance of the weighted composite of similar portfolios rather than using a single
representative account
3
...
Including disclosures that would fully explain the performance results being reported (if model used
in simulation, indicate if performance record is of prior entity, disclose whether gross of fees, net of
fees, or after tax)
5
...
Preservation of Confidentiality – Members and candidates must keep information about
1
...
3
...
current, former, and prospective clients confidential unless:
The information concerns illegal activities on the part of the client;
Disclosure is required buy law; or
The client or prospective client permits disclosure of the information
When permissible under applicable law, members and candidates shall consider the PCP and
extension of themselves when requested to provide information about a client in support of a
PCP investigation into their own conduct
...
Duties to Employers
A
...
Independent Practice – members and candidates should abstain from independent activity that could
conflict with the interests of their employer
...
Activities constituting a violation when Leaving an Employer
- misappropriation of trade secrets
- misuse of confidential information
- solicitation of employer’s clients prior to cessation of employment
- self-dealing (appropriating for one’s own property a business opportunity, or
information belonging to one’ employer
- misappropriation of clients or client lists
Whistle blowing: - such action would be permitted only if the intent is clearly aimed at protecting
clients or the integrity of the market and not for personal gain
...
Abide by terms of agreement
B
...
- Members and candidates should make immediate written report to their employers
specifying any compensation or benefits received from their employers
...
C
...
– READ PAGE 78
V
...
Diligence and Reasonable Basis – Members and candidates must:
1
...
2
...
a
...
An individual employee (supervisory
analyst) or a group of employees (review committee) should be appointed to review and
approve all research reports and recommendations to determine whether they meet the
criteria as established in the policy
b
...
c
...
B
...
Disclose to clients and prospective clients the basic format and general principles of the
investment processes used to analyze investments, select securities, and construct portfolios
and must promptly disclose any changes that might materially affect those processes
...
Use reasonable judgment in identifying which factors are important to their investment
3
...
Distinguish between fact and opinion in the presentation of investment analysis and
recommendations
...
Record Retention – Members and candidates must develop and maintain appropriate
records to support their investment analysis, recommendations, actions, and other
investment-related communications with clients and prospective clients
...
Conflicts of Interest
A
...
Members and candidates must ensure that such disclosures are prominent, are delivered
in plain language, and communicate the relevant information effectively
...
Member or candidate may dissociate from activity if firm does
not permit such disclosure
...
Priority of Transactions – Investment transaction for his clients and employers must have
priority over investment transactions in which a member or candidate is the beneficial
owner
...
Referral Fees - Members and candidates must disclose to their employers, clients, and
prospective clients, as appropriate, any compensation, consideration, or benefit received
from, or paid to, others for the recommendation of products or services
...
Responsibilities as a CFA Institute Member
A
...
B
...
Reading 3: Introduction to Global Investment Performance Standards
I
...
Ensure fair presentation and full disclosure of performance information
...
Who Can Claim Compliance
- any investment management firm who actually manages assets
...
Fully comply or don’t claim compliance
...
Who Benefits from Compliance
- investment management firms and investors
IIII
...
V
...
Test:
a
...
whether the firm’s processes and procedures are designed to calculate and present performance results in
compliance with the GIPS standards
...
The Structure of GIPS Standards
Divided into Eight Sections:
1
...
Input Data
3
...
Composite Construction
5
...
Presentation and Reporting
7
...
Private Equity
Reading 4 – Global Investment Performance Standards
I
...
Preamble – Why is a Global Standard Needed
- Prospective clients and investment management firms will benefit from an established standard
...
- standardized global performance criteria will assure that all investment management firms will be able to
compete fairly for business when compared to “local” investment management firms that have not previously
adopted standards
...
Vision Statement leads to
- Present performance results that are readily comparable among investment management firms without regard
to geographical location
- Facilitate a dialogue between investment managers and their prospective clients about the critical issues of
how firm achieved results and determine future investment strategies
...
Objectives
- obtain worldwide acceptance of the standard and ensure accurate and consistent investment performance data
for reporting, recording keeping, presentations, marketing
- promote fair, global competition amount management firms and foster the notion of industry “self-regulation”
D
...
After presenting at least 5 years of compliant history, firm
must add annual performance each year going forward up to ten (10) years, at a minimum
...
Scope
- Firms required to present, 5 years (min) of annual investment performance (or since inception)
- After 5 years, firms must present additional annual performance up to 10 years, at a minimum
...
F
...
- Firms must take all steps necessary to ensure that they have satisfied all the requirements of the GIPS
standards before claiming compliance
...
0
...
- total firm assets must be the aggregate of the MARKET VALUE of all discretionary and nondiscretionary
AUM, including both fee-paying and non fee-paying accounts
- must include assets assigned to sub advisor in a composite provided the FIRM has discretion over selection
- document in writing policies and procedures used in establishing and maintaining compliance
- firms must make every reasonable effort to give compliance presentation to client
...
- firms encouraged to undertake the verification process (FIRM-wide)
...
Study Session II: Quantitative Methods: Basic Concepts
Reading 6 – Discounted Cash Flow Applications
NPV vs IRR
- the NPV rule for decision making is to accept all projects with positive NPV or, if projects are mutually
exclusive, to accept the project with the higher positive NPV
...
- The IRR rule is to accept all projects with an internal rate of return exceeding the required rate of return
...
Money-Weighted vs
...
- Time weighted rate of return is standard in the investment management industry
...
The money-weighted rate of return is the IRR calculated with end-of-period
account values and is also the discount rate that makes the PV of the cash inflows equal to the PV of cash
outflows
...
- the time weighted rate of return removes the effects of timing and amount of withdrawals and additions to
the portfolio and reflects the compound rate of growth of one unit of currency invested over a stated
measurement period
...
Reading 7 – Statistical Concepts and Market Returns
2
...
Descriptive Statistics: is the study of how data can be summarized effectively to describe the important
aspects of large data sets
...
Inferential Statistics: Involves making forecasts, estimates, or judgments about a larger group from the
smaller group actually observed
...
2 Populations and Samples
a
...
Parameter: any descriptive measure of a population characteristic
c
...
Sample Statistic: is a quantity computed from or used to describe a sample
2
...
Nominal Scales – represent the weakest level of measurement
...
Ex
...
Ordinal Scales – reflect a stronger level of measurement
...
(i
...
Morningstar “stars” rating system)
...
c
...
As a result, scale values can be added and subtracted meaningfully
...
Important to note that 0 point does not indicate absence of what’s being measured
...
Ratio Scales – represent the strongest level of measurement
...
With ratio scales, we can meaningfully
compute ratios as well as meaningfully add and subtract amounts within the scale
...
0 Summarizing Data Using Frequency Distributions
a
...
Constructing a Frequency Distribution:
1
...
Calculate the range of data, defined as Range = max
...
value
3
...
Determine interval width as Range / k
...
Determine the intervals by successively adding the interval width to the
minimum value, to determine the ending points of intervals, stopping
after reaching an interval that includes the maximum value
6
...
Construct a table of the intervals listed from smallest to largest that
shows the number of observations falling in each amount
...
Interval – is a set of values within which an observation falls
...
c
...
Relative frequency – is the absolute frequency of each interval divided by the total number of
observations
...
Cumulative frequency – sum of the relative frequencies as we move from the first interval to the last,
thus giving the fraction of the observations that are less than the upper limit of each interval
4
...
Histogram – is a bar chart of data that have been grouped into a frequency distribution
...
1
...
Cross-Sectional Data – when we examine the characteristics of all units in sample at a specific point in
time
...
Time-Series Data – when we examine the characteristics of all units in sample across the entire time
frame
...
4
...
Median is not affected by extreme values
...
7
...
Variance: the average of the squared deviations around the mean
b
...
Mean Absolute Deviation will ALWAYS be less than or equal to the standard deviation because the
standard deviation gives more weight to large deviations than to small ones (because the deviations are
squared)
...
5 Semivariance, Semideviation, and Related Concepts
...
Sample Semivariance: is defined as the average squared deviation below the mean
b
...
To Compute Sample Semivairance
i
...
Identify the observations that are smaller than the mean (discarding observations equal to and
greater than the mean); suppose there are n* observations smaller than the mean
iii
...
iv
...
6 Chebychev’s Inequality
A
...
- permits us to make probabilistic statements about the proportion of observations within various intervals
around the mean for any distribution
7
...
Relative Dispersion – in the amount of dispersion relative to a reference value or benchmark
...
units free measure
...
Use arithmetic mean
...
0 Symmetry and Skewness in Return Distributions
A
...
Its mean and median are equal
ii
...
Roughly 68 percent of its observations lie between plus and minus one standard deviation from
the mean; 95% lie between plus and minus two standard deviations from the mean; and 99 percent
lie between plus and minus three standard deviations from the mean
...
Negative Skew Distribution
- Frequent small gains and a few extreme losses
- long tail on left side
- mode > median > mean
9
...
Kurtosis is the statistical measure that tells us when a distribution is more or less peaked than a normal
distribution
...
A distribution that is less
peaked than normal is call platykurtic
...
More peaked as df increases and tails become less fat
...
Confidence interval
becomes narrower
...
0 Probability, Expected Value, and Variance
a
...
Probability – The two defining properties of a probability are:
1
...
The sum of the probabilities of any set of mutually exclusive and exhaustive events equals 1
...
Mutually Exclusive – means that only one event can occur at a time
...
Exhaustive – means that the events cover all possible outcomes
...
Empirical Probability – the probability of an event as a relative frequency of occurrence based on
historical data
...
Subjective Probability – a probability drawing on personal or subjective judgment
g
...
Based on logical analysis
h
...
Pairs Arbitrage Trade: a trade in two closely related stocks involving the short sale of one and the
purchase of the other
...
Unconditional Probability – What is the probability of event A, P(A) – ratio where numerator is the sum
of the probabilities of an event
k
...
l
...
M
...
N
...
For a random variable X, the expected value of X is denoted
E(X)
...
Conditional Expected Value – The expected value of a random variable X given an event or scenario S
is denoted E (X | S)
...
Conditional Variance – 1
...
2
...
Main Points – Variance, like expected value, has a conditional counterpart to the unconditional concept and that we
can use variance to asses risk given a particular portfolio
...
We can interpret the Sign of Covariance as follows:
a
...
b
...
Covariance of returns is positive when the returns on both assets tend to be on the same side (above or
below) their expected values at the same time (an average position relationship between returns)
...
The covariance of a random variable with itself (own covariance) is its own variance:
Cov(R, R) = E{[R-E(R)][R-E(R)]} = E[{R-E(R)]^2] = σ^2(R)
Q
...
Correlation: is a number between -1 and +1 for two random variables, X and Y:
-1 ≤ ρ(X,Y) ≤ +1
2
...
Increasingly positive correlation indicates an increasingly strong positive linear
relationship(up to 1, which indicates a perfect linear relationship)
...
R
...
T
...
4
...
Bayes’ Formula – given a set of prior probabilities for an event of interest, if you receive new
information, the rule for updating your probability of the event is
Update probability of even given the new information = [(Probability of the new information given event /
unconditional probability of the new information)] x Prior probability of event
Standard Deviation – is the positive square root of the variance
...
Study Session III: Quantitative Methods: Application
Reading 9 – Common Probability Distributions
2
...
Random Variable – is a quantity whose future outcomes are uncertain
...
Discrete Random Variable – can take on at most at most a countable number of possible values
...
Because we can count all the possible outcomes of X and Y (even if we go on forever in the
case of Y), both X and Y satisfy the definition of a discrete random variable
...
Continuous Random Variable – Outcomes that cannot be counted, in contrast to above
...
Rate of return is an example of a continuous random
variable
...
Bernoulli Random Variable – a random variable having the outcomes 0 and 1
...
Bernoulli Trial – a trial that produces on of two outcomes
...
Binomial Random Variable – A binomial random variable X is defined as the number of success in n
Bernoulli trials
...
Tracking Error - total return on a portfolio (gross of fees) minus the total return on the benchmark
index
...
0 Continuous Random Variables
- a normal distribution is completely described by its mean and variance
...
The
mean, median and mode are all equal for a normal random variable that is normally distributed
...
a
...
b
...
Multivariate Distribution – specifies the probabilities for a group of related random variables
e
...
the list of hetman returns on the individual securities (n means in total)
2
...
the list of all the distinct pair wise return correlations: n(n-1)/2 distinct correlations in total
...
65s to Xbar + 1
...
96s to Xbar + 1
...
58s to Xbar + 2
...
395 Values
3
...
Can still hold when either assumption 1 or 2 is violated
...
3
...
CCR = 1e^
x*n
4
...
Running a Monte Carlo Simulation
1
...
Specify a time grid
...
Specify distributional assumptions for the risk factors that drive the underlying variables
...
Using a computer program or spreadsheet function, draw K random values of each risk
factor
5
...
6
...
Iteratively go back to Step 4 until a specified number of trials, I, is completed
...
Lognormal Variable – follows a lognormal distribution in the natural logarithm of the random variable is normally
distributed
...
The lognormal distribution is bounded below by 0 and skewed to the right
...
Reading 10 – Sampling and Estimation
a
...
b
...
th
c
...
d
...
e
...
2
...
Simple random samples are then drawn from each stratum in
sizes proportional to the relative size of each stratum in the population
...
2
...
3
...
- the CLT allows us to make quite precise probability statements about the population mean by using the
sample mean, whatever the distribution of the population, because the sample mean follows an
approximate normal distribution for large-size samples
...
According to the CLT –
- the distribution of the sample mean Xbar will be approximately normal
- the mean of the distribution of Xbar will be equal to the mean of the population from which the
samples are drawn
- the variance of the distribution of Xbar will be equal to the variance of the population divided by the
sample size
4
...
Characteristics:
- Unbiasedness – an unbiased estimator is one whose expected value (the mean of its sampling
distribution) equals the parameter it is intended to estimate
...
- Consistency – a consistent estimator is one for which the probability of estimates close to the
value of the population parameter increases as sample size increases
...
2 Confidence Intervals
- Confidence Interval – a confidence interval is a range for which one can assert with a given probability 1
– a, called the degree of confidence, that it will contain the parameter it is intended to estimate
...
Construction of CI
- A (1-a)% confidence interval for a parameter has the following structure
▪ Point Estimate ±Reliability factor x Standard Error
Point Estimate = a point estimate of the parameter (a value of a sample statistic)
Reliability Factor = a number based on the assumed distribution of the point estimate and the degree of
confidence (1-a) for the confidence interval
Standard Error – the standard error of the sample statistic providing the point estimate
- As we increase the degree of confidence, the confidence interval becomes wider and gives us less
precise information, and vice versa
...
3 Confidence interval width
- affected by the choice of statistic (t or z), wider with t statistic and affected by choice of degree of
confidence (affecting which specific value of t or z is used
...
- standard error varies inversely with the square root of the sample size
...
-large sample size, greater precision we can estimate population parameter
5
...
Data-mining – is the practice of determining a model by extensive searching through a dataset for
statistically significant patterns
...
out-of-sample – test that uses a sample that does not overlap the time period(s) of sample(s) on which a
variable, strategy, or model, was developed
...
intergenerational data mining – involves using information developed by previous researchers using a
dataset to guide current research using the same or a related dataset
...
Sample Selection Bias – when the data availability leads to certain assets being excluded from the
analysis
e
...
f
...
h
...
Reading 11 – Hypothesis Testing
Steps in Hypothesis Testing
1
...
When such evidence is
present, we are led to the alternative hypothesis
...
Formulation of Hypothesis
1
...
Ho: 0 <= 0o versus Ha: 0 > 0o (a “greater than” alternative hypothesis)
3
...
Formulation 2 and 3, or Ho: 0 <= 0o versus Ha: 0 > 0o and Ho: 0 => 0o versus Ha: 0 < 0o are each
one-sided hypothesis tests
...
The alternative hypothesis has one side
...
Identifying the appropriate test statistic and its probability distribution – a test statistic is a
quantity, calculated based on a sample, whose value is the basis for deciding whether or
not to reject the null hypothesis
...
Specifying the significance level –
Rule (pg
...
This is a correct decision
We reject a true null hypothesis
...
(Denoted by alpha)
We do not reject a false null hypothesis
...
We do not reject a true null hypothesis
...
01
rather than 0
...
- The only way to avoid the trade-off between the two types of errors is to increase sample size;
increasing sample size (all else equal) reduces the probability of both types of errors)
...
10 level, we have some evidence the null is false
If we reject a null hypothesis at the 0
...
01 level, we have very strong evidence the null is false
4
...
462
Rejection Point (Critical Value) for the Test Statistic – a rejection point (critical value) for a test statistic is a
value with which the computed test statistic is compared to decided whether to reject or not reject the null
hypothesis
...
Collecting the data and calculating the test statistic
6
...
Making the economic or investment decision
P-value – the p-value is the smallest level of significance at which the null hypothesis can be rejected
...
468 example
z-test
- good for large samples concerning a mean because in large samples, the sample mean should follow the normal
distribution, at least approximately, fulfilling the normality assumption of the z-test
...
Pg
...
Read pg
...
Nonparametric Test – is a test that is not concerned with a parameter, or a test that makes minimal assumptions
about the population from which the sample comes
...
0
Price Elasticity of Demand – is a units-free measure of the responsiveness of the quantity demanded of a good to a
change in its price when all other influences on buyers’ plans remain the same
...
Quantity Demanded
% Change in Avg
...
- Insulin -> is perfectly inelastic
...
Perfectly Elastic – if the quantity demanded changes by an infinitely large percentage in response to a tiny price
change, then price elasticity of demand is infinity and the good is said to have a perfectly elastic demand
Inelastic Demand – if price elasticity is between zero and 1
Elastic Demand – if the price elasticity is greater than 1
Unit Elastic – if the price elasticity = 1
Total Revenue and Elasticity
- If demand is elastic, a 1 percent price cut increases the quantity sold by more than 1 percent and total
revenue increases
- If demand is inelastic, a 1 percent price cut increases the quantity sold by less than 1 percent and the
total revenue decreases
- If demand is unit elastic, a 1 percent price cut increases the quantity sold by 1 percent and so total
revenue does not change
...
- Proportion of Income Spent on the Good – the greater proportion of income spent on a good, the
more elastic is the demand for it
...
3
...
Cross Elasticity of Demand =
% Change in Avg
...
Price of Substitute or complementary good
- Can be positive or negative
...
Income Elasticity of Demand
Income Elasticity of Demand = % Change in Avg
...
Income
- Greater than 1 – luxury good, income elastic; demand increases faster than income (cruises, art,
international travel)
- Positive and less than 1 – normal good, income inelastic; income increases faster than demand (food,
clothing, newspapers)
- Negative – Inferior good; when quantity demanded decreases with increased income (rice, potatoes)
4
...
Elasticity of Supply =
% Change in Avg
...
Price
Factors that Influence the Elasticity of Supply
- Resource Substitution Possibilities – some goods and services can be produced only by using unique
or rare productive resources
...
Other goods and services can be produced by using commonly available resources that
could be allocated to a wide variety of alternative tasks
...
Momentary Supply – when the price of a good rises or falls, the momentary supply curve
2
...
shows the response of the quantity supplied immediately following a price change
...
long distance phone calls, elastic)
Long-run supply - shows the response of the quantity supplied to a change in price after all
the technologically possible ways of adjusting supply have been exploited
...
First
adjustment to increase output in short term is to increase labor force hours/size
Reading 14
2
...
Allocative Efficiency – occurs when it is not possible to produce more of one good without giving up the
production of some other good that is valued more highly; not possible to make someone better off without
making someone else worse off
...
Marginal Benefit – is the benefit that a person receives from consuming one more unit of a good or
service
c
...
Efficiency and Inefficiency:
Marginal benefit exceeds marginal cost - inefficient
Marginal cost exceeds marginal benefit - inefficient
Marginal benefit equals marginal cost – resource allocation EFFICIENT
3
...
Value – the value of one more unit of a good or service is its marginal benefit
...
Relative Price – the relative price measures the number of dollars’ worth of other goods and services
forgone to obtain one more unit of the good in question
- A demand curve is a marginal benefit curve
...
Equilibrium = occurs when sum of consumer and producer surplus is maximized
...
Producer Surplus – is the price of a good minus the opportunity cost of producing it, summed over the quantity sold
...
4
...
Price Ceilings and Price Floors – a price ceiling is a regulation that makes it illegal to charge a price above a
specified level
...
1
...
Sometimes block the price adjustments that
balance the quantity demanded and the quantity supplied and lead to underproduction
...
2
...
Subsidies are payments by the government to decrease the price paid by buyers and increase the prices received by
sellers
...
Quotas – are limits to the quantity that a firm is permitted to produce,
restrict output below the quantity that a competitive market produces
...
2
...
Burning coal by
an electric company produces an external cost as it creates acid rain and leads to crop damage
...
3
...
It can set the price to achieve its self-interested goal
...
4
...
External benefit is a benefit that accrues to people other than the buyer of a good
...
5
...
Common resources are resources that
no one owns and that everyone can use – parasites
...
Underproduction
2
...
Utilitarianism – is a principle that states that we should strive to achieve “the greatest happiness for the greater
number”
...
Income transferred from rich to poor
...
Symmetry Principle – is the requirement that people in similar situations be treated similarly
...
Reading 15: Markets in Action
- when a rent ceiling creates a housing shortage, two developments occur:
1
...
factoring in opportunity cost to find the apartment, the opportunity cost may be higher
than the rent ceiling
...
Bumper harvest – revenue decreases for farmers
Poor harvest – revenue increase because of decreased supply
...
A lottery
2
...
Discrimination
4
...
Tax Incidence – is the division of the burden of a tax between the buyer and the seller
Tax Division and Elasticity of Demand
- Perfectly Inelastic Demand – buyers pay: insulin case
...
The quantity demanded does not change because of the tax
...
Curve
shifts down and left
...
The supply curve is less (shifts left) at S + tax
...
Sellers pay the entire tax amount
...
- Perfectly Inelastic Supply – sellers pay: bottled water flowing from an uncontrolled stream
...
-
Supply doesn’t change, Price received by sellers declines by tax amount
...
The tax has increased
the price buyers pay by the full amount of the tax and has decreased the quantity sold
...
The more elastic the supply, the larger is the amount of the tax paid by buyers
...
0 Subsidies and Quotas
Subsidy – payment made by government to a producer
...
0 Markets for Illegal Goods
- when a good is illegal, the cost of trading in the good increases
...
Penalties on Sellers – bring decrease in supply – leftward shift in supply curve
...
Leftward shift in
supply curve
...
Penalties on Buyers – Cost of breaking law must be subtracted from the value of the good to determine the
maximum price buyers are willing to pay for the drugs
...
- if penalties are imposed on both sellers and buyers, both supply and demand decrease and both supply curve and
demand curve shift
...
0
Opportunity Cost: the opportunity cost of any action is the highest-valued alternative forgone
...
A firm incurs implicit costs when it uses its own capital, and uses its owner’s time or financial
resources
...
e
...
Economic depreciation, normal profit, owner’s wages forgone, owner’s
interest on own capital foregone
...
Economic Depreciation: is the change in the market value of capital over a given period
...
Interest Foregone
- Foregone costs must be added to regular costs to determine opportunity costs
...
What goods and services to produce and in what quantities
2
...
How to organize and compensate its managers and workers
4
...
What to produce itself and what to buy from other firms
The firm’s constraints:
1
...
2
...
Market – what each firm can sell and the price it can obtain are constrained by its
customers’ willingness to pay and by the prices and marketing efforts of other firms
...
0 Tech and Economic Efficiency
Technological Efficiency – occurs when the firm produces a given output by using the least amount of
inputs
...
- A process can be technologically efficient but not be economically efficient
...
4
...
Incentive Systems: is a method of organizing production that uses a market-like mechanism inside the firm
...
Three Ways of Attempting to cope with the principal-agent problem are:
1
...
Incentive Pay
3
...
Proprietorship – firm with a single owner with unlimited liability
2
...
Corporation – a firm owned by one or more limited liability stockholders
...
5
...
Perfect Competition – many firms, each selling an identical product, many buyers, and no restrictions on
the entry of new firms into the industry
2
...
Marketing costs affect firms
...
Oligopoly - is a market structure in which a small number of firms compete
...
4
...
Measures of Concentration
- The four-firm concentration ratio – is the sum of the percentages of the value of sales accounted for
by the four largest firms in an industry
...
▪ HHI < 1800 is usually an example of monopolistic competition
▪ HHI > 1800 is usually an example of oligopoly
Limitations of Concentration Measures
- the geographical scope of the market
- Barriers to entry and firm turnover
- The correspondence between a market and an industry
6
...
lower transaction costs – are the costs that arise from finding someone with whom to do business, of
reaching an agreement about the price and other aspects of the exchange, and of ensuring that the terms of
the agreement are fulfilled
...
economies of scale – when the costs of producing a unit of a good falls as its output rate increases,
economies of scale exist
...
diseconomies of scale – factors of a firm’s technology that lead to rising long-run average costs as output
increases
d
...
e
...
0 Decision Time Frames
a
...
For most, the fixed
resources are the firm’s technology, buildings, equipment and management organization
...
Decisions are easily reversed in short run
...
b
...
The firm can
change its plant in the long run
...
Sunk costs are irrelevant to the
firm’s decisions
...
0 Short-Run Technology Constraint
Output and quantity of labor employed is explained by using three related concepts:
1
...
- Total Product Curve is similar to the production possibilities frontier that separates the attainable
output levels from those that are unattainable
...
Marginal Product of Labor – is the increase in total product that results from a one-unit increase in the
quantity of labor employed with all other inputs remaining the same
...
Increasing Marginal Returns Initially – occur when the marginal product of an
additional
worker exceeds the marginal product of the previous worker
...
2
...
- Law of Diminishing Returns states that as a firm uses more of a variable input, with a given
quantity of fixed inputs, the marginal product of the variable input eventually diminishes
...
Average Product – tells how productive laborers are
...
- The marginal product curve cuts the average product curve at the point of maximum average
product
...
0 Short Run Cost
Output and Cost relationship can be explained by
1
...
a
...
Includes NORMAL PROFIT – the opportunity cost of entrepreneurship
2
...
It’s the increase in total cost divided by the increase in output
...
Marginal cost decreases at low outputs because of economies from
greater specialization
...
b
...
3
...
Average Fixed Cost – is total fixed cost per unit of output (AFC)
...
Average Variable Cost – is total variable cost per unit of output (AVC)
...
Average Total Cost – is total cost per unit of output (ATC)
...
The U-Shape of the ATC curve arises from the influence of
a
...
Eventually diminishing returns
The position of a firm’s short-run cost curves depends on two factors:
a
...
b
...
A fixed cost increase shifts
the fixed cost curves (TFC and AFC) upward and the TC upward but
AVC and TVC and MC unchanged
...
139 Summary chart
5
...
- Marginal product of capital – is the change in total product / change in capital when the quantity of
labor is constant
...
- Long-Run average cost curve – is the relationship between the lowest attainable average total cost
and output when both the plant size and labor are varied
Scales
- Economies of Scale – are features of a firm’s technology that lead to falling long-run average cost as
output increases
...
- Constant Returns to Scale – are features of a firm’s technology that lead to constant long-run average
cost as output increases
- Minimum Efficient Scale – is the smallest quantity of output at which long-run average cost reaches
its lowest level
- Economies of scope – result from specialization
Study Session 5: Market Structure and Macroeconomic Analysis
Reading 18: Perfect Competition – downward sloping demand curve
Perfect competition is an industry in which
- many firms sell identical products to many buyers
- there are no restrictions on entry into the industry
- established firms have no advantage over new ones
- sellers and buyers are well informed about prices
- firm elasticity is infinite and market elasticity >0
...
Economic Profit – is equal to total revenue minus total cost
...
Marginal Revenue – is the one-unit change in total revenue that results from a one-unit increase in the quantity sold
...
Whether to produce or to shut down
2
...
Long Run
1
...
Whether to stay in an industry or leave it
Marginal Analysis
- If marginal revenue exceeds marginal cost (if MR > MC), then the extra revenue from selling one
more unit exceeds the cost to produce it
...
- if marginal revenue is less than marginal cost (if MR < MC), then the extra revenue from selling one
more unit is less than the extra cost incurred to produce it
...
MR = MC
...
0
External Economies – are factors beyond the control of an individual firm that lower the firm’s costs as the industry
output rises
...
Long-run Industry Supply Curve – shows how the quantity supplied by an industry varies as the market price varies
after all the possible adjustments have been made, including changes in plant size and the number of firms in the
industry
...
0
Resource use is in inefficient when marginal benefit equals marginal cost
...
External Costs – are costs that are borne by someone other than the producer of a good or service
...
- efficient is when consumer surplus and producer surplus is MAXIMIZED
...
Monopoly – is a firm that produces a good or service for which no close substitutes exists and which is protected by
a barrier that prevents other firms from selling that good or service
...
Patent – valid for 20 years – encourage invention of new products and production
methods and stimulate innovation
Natural Barriers – natural monopoly, which is an industry in which one firm can supply the entire
market at a lower price than two or more firms can
...
- In Monopoly, demand is ALWAYS elastic
...
Consumer Surplus – is the triangle under the demand curve and above the equilibrium price
...
Rent Seekers pursue their goals in two main ways
1
...
2
...
5
...
Identify and separate different buyer types
2
...
To
extract as much as possible, firms discriminate
▪ among units of a good
▪ among groups of buyers
Perfect Price Discrimination – when firm is able to sell each unit of output for the highest price anyone is willing to
pay for it
...
Efficiency and rent seeking with Price Discrimination
- The more perfectly the monopoly can price discriminate, the closer its output gets to the competitive
output and the more efficient is the outcome
...
Economies of Scope – when an increase in the range of goods produced brings a decrease in
average total cost
...
Maximizes total surplus in a regulated industry
...
Most used regulation of monopolies
...
- each firm produces a differentiated product
- firms compete on product quality, price, and marketing
- firms are free to enter and exit
Key Differences between Monopolistic Competition and Perfect Competition
- Excess Capacity – a firm has excess capacity if it produces below its efficient scale, which is the
quantity at which ATC is a minimum
...
- Markup – the amount by which price exceeds marginal cost – exists in monopolistic competition
...
The firms
in oligopoly might produce an identical product and compete only on price, or they might produce
a differentiated product and compete on price, product quality, and marketing
...
Oligopoly Models
Traditional Models
1
...
2
...
Game Theory Models – is a tool for studying strategic behavior – behavior that takes into account the experienced
behavior of others and the recognition of mutual interdependence
...
Rules
2
...
Payoffs
4
...
In Nash equilibrium, both firms cheat and output and price are the same as in perfect competition
...
0
Four Factors of Production
1
...
Capital
3
...
Entrepreneurship
Derived Demand – the demand for a factor of production
3
...
MR = MC
...
- If the wage rate is less than marginal revenue product, the firm can increase its profit by employing one more
worker
...
257 Chart)
- maximized when
▪ marginal revenue product equals the wage (W) rate
▪ marginal revenue equals marginal cost
Recall
MRP = MR x MP
MRP = W
MR x MP = W
MR = W / MP
Demand For Labor Factors (Pg
...
the price of the firm’s output – higher price of firm’s output, the greater is its demand for
labor
2
...
Technology – an advance in technology that changes the marginal product of labor changes
the demand for labor
...
- An increase in supply (of labor) brings a lower wage rate
...
Elasticity for Labor Depends on
1
...
2
...
Substitutability of capital for labor – the more easily capital can be used instead of labor in
production; the more elastic is the long-run demand for labor
...
- Substitution Effect – the tendency for a higher wage rate to induce someone to work longer hours
- Income Effect – an increase in income creates an increase in the demand for leisure, and creates a
decrease in the quantity of labor supplied
...
At low wage rates, sub
...
Market Supply
Changes in the Supply of Labor – changed by
▪ Adult Population
▪ Technological change and capital accumulation
4
...
- The higher the interest rate, the smaller is the quantity of financial capital demanded
The Supply of Capital
Factors that determine savings are:
- Income – saving is the act of converting current income into future consumption
- Expected future income – if current income is low and expected future income is high, person will
have a low (perhaps even negative) level of saving
...
0
Natural Resource Markets
Renewable – resources repeatedly replenished by nature
...
Nonrenewable – natural resources that nature does not replenish
...
- the supply of land is perfectly inelastic
- The supply of nonrenewable natural resources is perfectly elastic at a price equal to the present value
of the expected future price
...
0 Income, Economic Rent, and Opportunity Cost (graphs on page 277)
Economic Rent – is the income received by the owner of a factor of production over and above the amount
required to induce that owner to offer the factor for use; it is a component of the income received by any
factor of production
Reading 22: Monitoring Cycles, Jobs, and the Price Level
2
...
0 Jobs and Wages
Population Survey
- Working-age population – is the total number of people aged 16 years and over who are not in jail, a
hospital, or some other form of institutional care
...
To be counted as Unemployed, a person must be available for work and must be in one of three categories
1
...
waiting to be called back to a job from which he or she has been laid off
3
...
Three Labor Market Indicators
1
...
2
...
The Employment-to-Population Ratio = Number of people employed
Working-age Population
- is the percentage of people of working age who have jobs
...
Real Wage Rate – is the quantity of goods and services that an hour’s work can buy
...
The second measure of the real wage rate is calculated by dividing total wages and salaries in the National
Income and Product Accounts by aggregate hours
...
0 Unemployment and Full Employment
People become unemployed if they
1
...
Leave their jobs and search for another job
3
...
are hired or recalled
2
...
Frictional – the unemployment rate that arises from normal labor turnover-from people
entering and leaving the labor force and from the ongoing creation and destruction of jobs
2
...
Cyclical – the fluctuating unemployment over the business cycle
4
...
No cyclical
...
0 CPI
- CPI – is a measure of the average of the prices paid by urban consumers for a fixed “basket” of consumer goods
and services
Constructing the CPI
a
...
b
...
Calculating the CPI
Calculating the CPI
1
...
Find the cost of the CPI basket at current period prices
3
...
new goods bias
2
...
commodity substitution bias – chicken v
...
4
...
0
Aggregate Supply-Aggregate demand model enables us to understand three features of macroeconomic performance
1
...
inflation
3
...
the quantity of labor (L)
2
...
The state of technology (T)
Aggregate Production Function
Y = F(L, K, T)
Labor Market States – at full employment, above full employment, below full employment
Full Employment – quantity of labor demanded = quantity supplied
...
- ALWAYS VERTICAL because potential GDP is independent of price level
...
Short Run-Aggregate Supply Curve – is the relationship between the quantity of real GDP supplied and the price
level in the short run where the money wage, the process of other resources, and potential GDP remain constant
Changes in Aggregate Supply
- Changes in Potential GDP – increase in any of the below factors increases potential GDP
...
change in the full-employment quantity of labor
2
...
advance in technology
3
...
the price level
2
...
fiscal policy and monetary policy
4
...
Wealth effect – when the price level rises but other things remain the same, real wealth
decreases
2
...
Changes in Aggregate Demand (Pg
...
Expectations – an increase in expected future income increases the amount of consumption
goods that people plan to buy today and increases aggregate demand
...
Fiscal Policy and Monetary Policy
Fiscal – the government’s attempt to influence the economy by setting and changing taxes, making
transfer payments, and purchasing goods and services
Monetary – consists of changes in interest rates and in the quantity of money in the economy
...
The World Economy – the two main influences that the world economy has on aggregate
demand are foreign exchange rate and foreign income
4
...
The Business Cycle – occurs because aggregate demand and short-run aggregate supply fluctuate but the money
wage rate does not adjust quickly enough to keep real GDP at potential GDP
...
This difference is called the recessionary gap
...
328 graphs)
Above full-employment equilibrium – is a macroeconomic equilibrium in which real GDP exceeds
potential GDP
...
5
...
S
...
0 Macroeconomic Schools of Thought
Keynesian – believes that if left alone, the economy would rarely operate at full employment and that to achieve and
maintain full employment, active help from fiscal policy and monetary policy is required
- Aggregate Demand Fluctuations – in Keynesian, expectations are the most significant influence on
aggregate demand
...
Basically, the money wage rate doesn’t fall
...
- Aggregate Demand Fluctuations – in this view, technological change is the most significant influence on
both aggregate demand and aggregate supply
...
Monetarist - is a macroeconomist who believes that the economy is self-regulating and that it will normally operate
at full employment, provided that monetary policy is not erratic and that the pace of money is kept steady
...
- Aggregate Supply Response – is the same as the Keynesian view - the money wage is sticky
...
0
Money – is any commodity or token that is generally acceptable as a means of payment, which is a method of
settling debt
...
Medium of Exchange – any object that is generally accepted in exchange for goods and
services
...
Unit of Account – is an agreed measure for stating the prices of goods and services
...
Store of Value – in the sense that it can be held and exchanged later for goods and services
Money in the US Today
1
...
Deposits at Banks and other depository institutions – savings and loan associations Can be
converted into money
M1: consist of currency and traveler’s checks plus checking deposits owned by individuals and businesses
(does not include currency held by banks, or currency and checking deposits owned by the U
...
government) M1 is
money
...
These are liquid assets
...
0
Depository Institutions – a firm that takes deposits from households and firms and makes loans to other households
and firms
...
Commercial Banks
Assets of Commercial Banks:
1
...
S
...
T-Bills and commercial bills
2
...
S
...
bonds and other bonds
3
...
Riskiest asset of bank carrying highest interest rate
2
...
Savings and Loan Associations – is a depository institution that receives
3
...
Savings Banks – is a depository institution that accepts savings deposits
and makes mostly mortgage loans
...
Credit Unions – depository Institution owned by a social or economic
group that accepts savings deposits and makes mostly consumer loans
...
S
...
Depository Institutions provide four main services:
1
...
Minimizing the Cost of obtaining funds
3
...
Pooling Risk
Financial Regulation
- FDIC Deposit Insurance
- Balance Sheet Rules
1
...
Reserve requirements – rules setting minimum percentages of deposits that must be held in
currency or other safe, liquid assets
...
Deposit rules – restrictions on different type of deposits that institutions may accept
4
...
Financial Innovation is influenced by
1
...
technology
3
...
0 How Banks Create Money – pg
...
0 Federal Reserve System
Goals of Fed
1
...
maintain full employment
3
...
contribute towards achieving long-term growth
Federal Funds Rate – the interest rate that the banks charge each other on overnight loans of reserves
...
The Board of Governors – 7 members, 14 year terms, appointed by President
2
...
to commercial banks and other depository institutions, hold reserve accounts of
commercial banks, lend reserves to banks, and issue bank notes that circulate as currency
The Federal Open Market Committee – main policy making organ of Federal Reserve
System
Fed’s Policy Tools – main responsibility is to regulate the amount of money floating around in the US
Policy Tools
1
...
Discount Rate
3
...
S
...
bonds
...
Most often used
...
Verbal Persuasion for banks to lend – happening in USA right now
...
Gold and Foreign Exchange
2
...
S
...
loans to banks
Fed’s Liabilities
1
...
Bank’s deposits
Monetary Base – the sum of Federal Reserve notes, coins, and banks’ deposits at the Fed
6
...
Higher Required Reserve – decreases the quantity of money
b
...
When the Fed sells securities in open market operation, bank reserves decrease, banks decrease their
lending, and the quantity of money decreases
...
365 example
Money Multiplier – determines the change in the quantity of money that results from a given change in the monetary
base
...
367 example
Reading 25: Money, Interest, Real GDP, and the Price Level
2
...
The Price Level – the quantity of money measured in dollars is nominal money,
proportional to price level
...
Real money is independent of price level
...
The Interest Rate – when interest rates rise, the opportunity cost of holding money rises
and the quantity of real money demanded decreases
3
...
A decrease in real GDP decreases the demand for
money and shifts the demand curve leftward
...
378)
...
Financial Innovation – decreases demand for money, increases real GDP
4
...
Investment and consumption expenditure decrease
2
...
A multiplier Process Unfolds – a multiplier process occurs because the decrease in
expenditure that we’ve just described brings a decrease in income, which induces a
further decrease in consumption expenditure
...
Velocity of Circulation – is the average number of times a dollar of money is used annually to buy goods and
services that make up GDP
...
The velocity of circulation is not influenced by the quantity of money
2
...
- Pg
...
Persistent increase in the price
level
...
Growth of quantity of money is the main
source of persistent increase in AD and persistent inflation
...
0
Demand-Pull Inflation – an inflation that results from an initial increase in aggregate demand is called demand-pull
inflation
...
increase in the quantity of money
2
...
increase in exports
- Aggregate demand increases if the Fed loosens its grip on the quantity of money, govt
...
- Increase in aggregate demand that is not fully anticipated increases both the price level and real GDP
and decreases unemployment
...
4
...
Two main sources of increases are:
1
...
an increase in the money prices of raw materials
Stagflation – the combination of a rise in the price level and a fall in real GDP
5
...
Redistribution of income – if an unexpected aggregate demand increases the inflation rate,
the money wage rate will not have been set high enough, which results in higher profits,
real wages buy less than expected and employers gain
...
2
...
Also, workers incur job search costs looking for a
job that pays a real wage rate closer to the one that prevailed before
...
redistribution of income – redistributes income between borrowers and lenders; when
inflation is unexpected, interest rates are not set high enough and borrowers gain
2
...
Rational Expectation – is the bet forecast available
...
If expected growth rate of aggregate demand is different from its
actual growth rate, the expected aggregate demand curve shifts by an amount that is different from the actual
aggregate demand curve
...
Increases
in unanticipated inflation coincide with decrease in unemployment
...
These adverse consequences arise for
three major reasons:
1
...
2
...
But dollar
returns are taxed, so the effective tax rate rises
...
The
higher the inflation rate, the higher is the effective tax rate on income from capital
...
Increased uncertainty – increased uncertainty misallocates resources
...
If the inflation rate is greater than anticipated, lenders lose and borrowers gain
...
0
Philips Curve – shows the relationship between inflation and unemployment
Short-Run Philips Curve – shows the relationship between inflation and unemployment, holding constant:
1
...
the natural unemployment rate
- Negative relationship between inflation and unemployment along the short-run Philips curve; If inflation rises
above its expected rate, unemployment falls below its natural rate
...
LRPC is VERTICAL at the natural unemployment rate
...
- A change in the natural rate of unemployment shifts both the SR and LR Philips curves
...
7
...
Reading 27: Fiscal Policy
- at full employment, the real wage rate adjusts to make the quantity of labor demanded equal to the
-
quantity of labor supplied
...
Tax wedge – the gap between the before-tax and after-tax wage rates
Taxes effect the level of real GDP, but not its growth rate
...
Taxes and Incentive to Save
– taxes on interest income weakens the incentive to save
- taxes on capital income lowers the quantity of saving and investment and slows the growth rate of
real GDP, known as Lucas wedge
...
Real Rate = Nominal Rate adjusted for inflation
- higher the inflation rate, the higher is the true tax rate on interest income
...
Crowding-Out Effect – the tendency for a government budget deficit to decrease investment; the quantity of private
saving changes because the real interest rate changes
...
- a government deficit increases the real interest rate and partly crowds out private investment, but it
also induces an increase in private saving in anticipation of lean times later when taxes will rise to
pay the interest on the increasing debt
...
0 Generational Effects of Fiscal Policy
Generational Accounting – an accounting system that measures the lifetime tax burden and benefits of each
generation
Fiscal Imbalance – is the present value of the government’s commitments to pay benefits minus the present
value of its tax revenues
...
6
...
recognition lag – time it taxes to figure out that fiscal policy actions are
needed
2
...
impact lag – is the time it taxes from passing a tax or spending change to
implementing the new arrangements and their effects on real GDP
being felt
...
Induced Taxes – taxes that vary with real GDP
...
Needs-Tested Spending – the spending by the govt
...
Tax Multiplier – is the magnification effect of a change in taxes on aggregate demand
-a decrease in taxes increase disposable income, which increases consumption expenditure
...
Positive effect
...
- when real GDP shifts, this creates surpluses or deficits
Cyclical Surplus or Deficit – is the actual surplus or deficit minus the structural surplus or deficit
...
0
Instruments, Goals, Targets, and the Fed’s Performance
Instruments – open market operations, the discount rate, and required reserve ratios, verbal persuasion
...
The Fed’s primary goal is to maintain price level stability
...
Intermediate Targets – possible targets include monetary aggregates such as M1 and M2, the monetary base
– the sum of notes, coins, and banks’ deposits at the Fed – and the federal funds rate – the interest rate
overnight loans among banks
...
Inflation between 0 and 3 percent a year as being consistent with price level stability
...
- Contributes to potential GDP growth by creating a climate that favors a high rate of saving and
investment
...
shocks to the price level – positive shocks (such as lower oil prices) lowers price level and
+GDP
2
...
0 Achieving Price Level Stability
Fixed-Rule Policy – specifies an action to be pursued independently of the state of the economy – keeps the quantity
of money constant regardless of what happens to the price level and real GDP
Feedback-Rule Policy – specifies how policy actions respond to changes in the state of the economy
...
”
Stabilizing Aggregate Supply Shocks
1
...
2
...
Feedback Rules – read pages 468 – 477
...
Feedback Rules with Cost-Push Inflation Shock
1
...
feedback rule to stabilize the price level
A Credible Announced Inflation Reduction
- no change in GDP or unemployment (pg
...
0 New Monetarist and New Keynesian Feedback Rules
McCallum Rule – adjusts the growth rate of the monetary base to target the inflation rate but also to take
into account changes in the trend productivity growth rate and fluctuations in aggregate demand
...
Taylor Rule – adjusts the federal funds rate to target the inflation rate and to take into account deviations of
the inflation rate from its target and deviations of real GDP from potential GDP
...
5% plus on half of the gap between the actual inflation rate
and the target inflation rate plus one half of the percentage deviation of real GDP from potential GDP
...
Strength of response to output fluctuations – McCallum rule focuses almost exclusively on
the goal of price stability and downplays the role of monetary policy in stabilizing the
business cycle while the Taylor rule pursues its basic goal of price stability but pays a lot
of attention to the current state of the business cycle
...
Targeting money versus the interest rate – McCallum rule targets the monetary base
...
Set monetary policy – by directly changing interest rates
2
...
Respond to economic and financial market conditions within their jurisdiction
4
...
Regulate the banking system
6
...
The U
...
Treasury prints U
...
currency while the Fed puts
it into circulation)
...
Discount Rate – is the rate at which central banks lend or discount eligible paper
Repo Rate – generally used to refer to the interest rate on securities repurchase agreements used by central banks to
influence domestic money markets
...
Cash Rate – is the rate charged on overnight loans between financial intermediaries and exerts a powerful influence
on other interest rates
...
2
...
That is, a specific number or range in
which inflation or price increases must remain is set
...
S
...
The ECB was established by the Maastricht treaty
...
0 Inter-Central Bank Cooperation
BIS – Bank of International Settlements – an international organization that fosters international monetary and
financial cooperation and serves as a bank for central banks
...
Financial Statement Analysis
- to take past current and prospective performance and financial position of a company for the purpose
of making investment, credit, and other economic decisions
...
1
...
14 for accounts)
Basic EPS – uses weighted-average number of common shares outstanding during the period
Diluted EPS – uses the number of shares that would be outstanding if potentially dilutive claims on
common shares (stock options) were exercised by their holders
...
1
...
16 for accounts)
Minority Interest – represents an ownership in a subsidiary company by others (not the parent company)
...
1
...
17 for accounts)
Financial Flexibility – is the ability to react and adapt to financials adversities and opportunities
Operating Activities – involve transactions that enter into the determination of net income and are primarily
activities that comprise the day-to-day business functions of a company
...
3
...
4 – Statement of Owners’ Equity / Statement of retained earnings – primarily serves to report changes in the
owners’ investment in the business over time and assists the analyst in understanding the changes in financial
position reflected on the balance sheet
...
1
...
business acquisitions and disposals,
b
...
legal proceedings
d
...
related-party transactions
f
...
subsequent events
h
...
quarterly financial data
3
...
6 MD & A Section
- Management must highlight any favorable or unfavorable trends and identify significant events and
uncertainties that affect the company’s liquidity, capital resources, and results of operations
...
- must include critical accounting policies that have required management to make subjective judgments
that have a significant impact on reported financial results
3
...
7 Auditor’s Reports
- provides reasonable assurance that the financial statements are fairly presented and free from material
error, fraud, or illegal acts that have a direct effect on the financial statements
...
New Publically traded companies requirements and Sarbanes-Oxley Act Requirements (pg
...
0 FSA Framework (pg
...
1 Articulate the Purpose and Context of Analysis
4
...
3 Process Data
4
...
5 Develop and Communicate Conclusions/recommendations
Typically Include
a
...
business summary
c
...
valuation
e
...
6 Follow Up
Reading 30: Financial Reporting Mechanics
2
...
37 example)
Operating – day-to-day business function of an entity
- Sales of goods and services to customers
- Costs of providing the goods and services
- Income tax expense
- Holding short-term assets or incurring short-term liabilities directly related to operating activities
Investing – activities associated with acquisition and disposal of long-term assets
Financing – activities related to obtaining or repaying capital
...
Issuance or repayment of debt
...
e
...
0 – pg
...
e
...
2 Accounting Equations
30-1a
Assets = Liabilities + Owners Equity
30-1b
Assets – Liabilities = Owners’ Equity
30-2
Owners’ equity = Contributed capital + Retained earnings
30-3
Revenue – Expenses = Net Income (loss)
30-4a
Ending RE = Beginning RE + NI - Dividends
30-4b
Ending RE = Beginning RE + Revenues – Expenses – Dividends
30-5a
Assets = Liabilities + Contributed Capital + Ending RE
Assets = Liabilities + Contributed Capital + Beginning RE + Rev
...
- Dividends
30-5b
Unclassified Balance Sheet – one that does not show subtotals for current assets and current liabilities
...
i
...
advertising expense paid in advance for 5 years, you would capitalize
the unused portion to the balance sheet
...
0 Accrual and Valuation Adjustments
Accrual – record revenue when earned and expenses when incurred – (pg
...
Liability
...
Prepaid Expense – arises when a company makes a cash payment prior to recognizing an expense
...
Cash Movement after Accounting
Recognition
Accrued (Unbilled) Revenue
- Originating Entry –
record revenue and
establish an asset
(such as unbilled
revenue)
- Adjusting Entry – when
billing occurs, reduce
unbilled revenue and
increase AR
...
69 example of accounting system flow
...
IOSCO – International Organization of Securities Commissions – capital markets regulation in the EU
...
protecting investors
2
...
reducing systematic risk – risk factors common to the whole economy; cannot be
eliminated through diversification
3
...
1 Significant Securities-Related Legislation
- Securities Act of 1933 – specified information all investors must receive when securities are sold
- Securities Act of 1934 – Created SEC
- Sarbanes-Oxley Act of 2002 – created Public Company Accounting Oversight Board (PCAOB)
...
3
...
2 SEC Filings
10-K - Annual Report (not required by SEC)
Def-14A Proxy Statement – contains executive compensation, must be filed before any vote
8k – material corporate events
Form 144 – notice of the proposed sale of restricted securities or securities held by an affiliate of the issuer in
reliance on Rule 144
Forms 3, 4, 5 – required to report beneficial ownership of securities (>10%)
11-k – annual report of employee stock purchase, savings, and similar plans
...
1 Qualitative Characteristics of Financial Statements
1
...
Relevance
3
...
Comparability
5
...
For example, to be
relevant, information must be timely; however, it may take considerable time to ensure the information is
error free
...
By necessity, they omit information that is no quantifiable
5
...
1 Underlying Assumptions in Financial Statements
Fair Presentation – faithful representation of the effects of transactions, events and conditions in accordance
with the definitions and recognition criteria for assets, liabilities, income and expenses set out in framework
Going Concern – refers to the assumption that the company will continue in business for the foreseeable
future
...
Consistency – classification of items in financial statements are usually retained from one period to the next
Materiality – Any material item shall be presented separately
5
...
3 Presentation Requirements
- Aggregation – each material class of similar items is presented separately
- No Offsetting – Assets and Liabilities, and income and expenses, are not offset unless required or
permitted by IFRS
- Classified Balance Sheet
-Minimum information on the face of the financial statements
- Minimum information in the footnotes
- Comparative information
5
...
3 Measurement of Financial Statement Elements
Historical Cost –
A- amount of cash or cash equivalents paid to purchase an asset
L- the amount of proceeds received in exchange for the obligation
Current Cost –
A - Amount of cash or cash equivalents that would have to be paid to buy the same or an equivalent asset
today
L – The undiscounted amount of cash or cash equivalents that would be required to settle the obligation
today
...
L – “settlement value’ – is the undiscounted amount of cash or cash equivalents expected to be p[aid to
satisfy the liabilities in the normal course of business
Present Value –
A – Present discounted value of the future net cash inflows that asset will generate
L – Present discounted value of the net cash outflows that are expected to be required to settle the liabilities
Fair Value – The amount at which an asset could be exchanged or a liability settled, between
knowledgeable, willing parties in an arm’s length transaction
...
112 chart
Comprehensive Income – includes all changes in equity during a period except those resulting from investments by
and distribution to owners
...
1 Characteristics of an Effective Financial Reporting Framework
- Transparency
- Comprehensiveness
- Consistency
7
...
0 Components and Format of the Income Statement
Net Revenue – means that the revenue number is shown after adjustments (e
...
for estimated returns or for amounts
unlikely to be collected)
...
Grouping by nature – grouping depreciation on manufacturing equipment and on administrative facilities in one
Grouping by function – grouping together expenses into a category such as COGS which would include some
salaries, materials costs, depreciation, etc related to those sales
Consolidation (in reference to minority interest) – means that companies include all of the revenues and expenses of
subsidiaries even if they own less than 100 percent
...
3
...
Pg
...
2
...
(i
...
construction contracts)
Percentage-of-Completion – in each accounting period, the company estimates what percentage of the
contract is complete and then reports that percentage of the total contract revenue in its income statement
...
Completed Contract Method – the company does not report any revenue until the contract is finished
...
Installment Method – the portion of the total profit to sales price [(Sales Price – Purchase Price) / Sales
Price] of the sale that is recognized in each period is determined by the percentage of total sales price for
which the seller has received cash
...
first calculate [(Sales Price – Purchase Price) / Sales Price] = x
2
...
- Pg
...
2
...
3
...
4 Gross versus Net reporting – the company is the primary obligor under the contract, bears inventory risk and
credit risk, can choose its supplier, and has reasonable latitude to establish price
...
4
...
g
...
Period Costs – expenditures that less directly match the timing of revenues are reflected in the period when a
company makes the expenditure or incurs the liability to pay
...
e
...
FIFO – it is assumed that the earliest items purchased were sold first
...
(Method not permitted under
IFRS)
...
Pg
...
2 Issues in Expense Recognition
4
...
1 Doubtful Accounts
- Direct Write-Off Method – when a company waits until a customer defaults to recognize the loss
- under matching principle – at the time revenue is recognized on a sale, a company is required to record an estimate
of how much of the revenue will ultimately be uncollectible, usually based on previous experience and expressed as
a proportion of overall sales, the overall amount of receivables, or the amount of receivables overdue by a specific
amount of time
...
4
...
2 Warranties – only actual warranty expenses are deductible on tax return…can create a DTA or DTL
...
4
...
3 Depreciation and Amortization
Long-lived assets – assets expected to provide economic benefits over a future period of time greater than one year
...
Amortization – is the term commonly applied to this process for intangible long-lived assets with a finite useful life
...
Accelerated Methods of Depreciation – allocate a greater proportion of the cost to the early years of an asset’s useful
life
...
Diminishing Balance Method aka Declining Balance Method – Pg
...
Determine the straight-line rate of the depreciable cost (Cost – Residual Value = Depreciable Cost)
Straight Line Rate = (Depreciation Expense / Depreciable Cost)
2
...
3
...
Apply that rate to the remaining undepreciatied balance (purchase price or cost of the asset) of the net
book value of the asset at each period
...
Depreciate ONLY until the accumulated depreciation = residual (salvage) value
...
- Goodwill and intangible assets with indefinite life are NOT amortized
...
1 Discontinued Operations – disposed or plan to dispose one of its component operations
5
...
6
...
Complex Capital Structure – when convertible bonds, convertible preferred stock, employee options or warrants are
present
...
- Complex capital structure could result in dilution upon conversion
32-1 Basic EPS = (NI – Preferred Dividends) / Weighted Average Shares Outstanding
- Time Weighted Average by number of months a given amount of stock existed
...
- if a 2:1 split occurs, just multiply the weighted average shares outstanding at year end
...
32-3 Diluted EPS – Convertible Debt Outstanding
Diluted EPS = (NI + After-Tax Interest on Convertible Debt – Preferred Dividends) / (Weighted Average
Number of Shares Out + New Common Share that could have been issued at conversion)
32-4 Diluted EPS – Treasury Stock Method - When Co
...
These new “inferred” shares
would be disregarded in the computation of diluted EPS, but the excess of the new shares issued
under options contracts over the new “inferred” shares would be added into the weighted average
number of shares outstanding
...
- Convertible preferred shares have the ability to be anti-dilutive
...
Anti-dilutive securities are NOT included in
diluted EPS
...
1 Common-size analysis – stating each line item on the income statement as a % of revenues
...
7
...
0 Comprehensive Income – is defined as the “change in equity [net assets] of a business enterprise during a period
from transactions and other events and circumstances from non-owner sources
...
Reading 33: Understanding the Balance Sheet
Balance Sheet – discloses what an entity owns and what it owes at a specific point in time
...
Liabilities – represents obligations of a company arising from past events, the settlement of which is
expected to result in an outflow of economic benefits from the entity
...
Revenue reported on IS before cash is received – accrued revenue or AR
...
1
...
1
...
1
...
Is the residual interest in the
assets of an equity after deducting liabilities, also referred to as NAV
...
Permanent
2
...
Should allow for legal subordination of the rights of creditors
2
...
Current Assets – assets expected to be liquidated or used up within one year or one operating cycle of the
business, whichever is greater
Non-current Assets – represent the infrastructure from which the entity operates and are not consumed or
disposed in the current period
...
Working Capital – the excess of current assets over current liabilities
Current Liability – is expected to be settled in the entity’s normal operating cycle
- is held primarily for the purpose of being traded
- is due to be settled within one year after the balance sheet date
- the entity does not have an unconditional right to defer settlement of the liability for at least one
year after the balance sheet date
- financial liabilities are classified as current if they are due to be settled within one year after the balance
sheet date
Minority Interest – represents the portion of consolidated subsidiaries owned by others
...
Fair Value – fair market value – able to be exchanged at arm’s length transaction
2
...
Current Cost – cost to replace an asset
4
...
209 information
3
...
Assets held primarily for trading
2
...
Cash or cash equivalents, unless restricted for use for at least 12 months
4
...
Trade receivables – amounts owed to a business by its customers
6
...
Other current assets – short-term items not easily classifiable into the above categories
...
1
...
Include in Inventory Costs:
- all costs of purchase
- costs of conversion
- other costs incurred in bringing the inventories to their present location and condition
Exclude from inventory costs:
- abnormal amounts of wasted materials, labor and overheads
- storage costs, unless they are necessary prior to a further production process
- administrative overheads
- selling costs
NRV = Estimated Selling Price – Estimated Costs of Completion and Costs Necessary to make sale
The following techniques can be used to measure the cost of inventories if the resulting valuation amount
approximates cost
Standard Cost – which should take into account the normal levels of materials, labor and actual capacity
Retail Method – in which the sales value is reduced by the gross margin to calculate cost
Prepaid Expenses – are normal operating expenses that have been paid in advance
...
2 Current Liabilities – are those liabilities that are expected to be settled in the entity’s normal operating cycle,
held primarily for trading and due to be settled within 12 months after the balance sheet date
...
the original term for the liability is greater than 12 months
2
...
the agreement to refinance or reschedule the obligation is completed on or before the balance sheet date
...
Current Portion of Noncurrent Borrowings – CPLTD – liabilities expected to be repaid or liquidated within one year
or one operating cycle of the business
...
Accrued Liabilities – expenses that have been reported on a company’s income statement but have not yet been paid
Unearned Revenue – is the collection of money in advance of delivery of the goods and services associated wit the
revenue
...
3 Tangible Assets – are long-term assets with physical substance that is used in company operations
...
Ex
...
4 Intangible Assets – amounts paid by a company to acquire certain rights that are not represented by the
possession of physical assets
...
Patents and trademarks
...
Accounting goodwill for example
...
3
...
1 Specifically Identifiable Intangibles
IFRS:
Research Phase – includes activities that seek new knowledge of products
...
All costs related to
project can be capitalized
All other expenses related top the following categories are expensed;
- Internally generated brands, mastheads, publishing titles, customer lists, etc
...
overhead costs, advertising and promotion, relocation
and reorganization expenses, redundancy and other termination costs
...
3
...
2 Goodwill – the excess of the cost of acquisition over the acquirer’s interest in the fair value of the identifiable
assets and liabilities acquired
Economic Goodwill – is based on the economic performance of the entity
Accounting Goodwill – is based on accounting standards and only reported for past acquisitions
...
Goodwill is not
amortized
...
221 process
3
...
Mark-to-market – is the process whereby the value of most trading assets and trading liabilities are adjusted to
reflect current fair value
...
224 Chart
Pg
...
4
...
4
...
Capital Contributed by owners – common or preferred stock
2
...
3
...
4
...
5
...
Comprehensive Income = Net Income + Other Comprehensive Income
OCI = foreign currency translation adjustments, minimum pension liability adjustments,
and unrealized gains or losses on available-for-sale investments, net unrealized losses on
derivatives
4
...
Must Include:
1
...
Gains or losses from derivatives that qualify a net investment hedges or cash flow hedges
3
...
Foreign currency translation adjustments on foreign subsidiary companies
...
228 Chart
5
...
Vertical Common-size analysis is useful in cross-sectional analysis
...
2 Balance Sheet Ratios
Liquidity Ratios – measure companies ability to meet its short-term obligations
Solvency – measure companies ability to meet long-term and other obligations
Liquidity Ratios
Calculation
Measurement
Current
Current Assets / Current Liabilities
Ability to meet current liabilities
Quick (Acid Test)
(Cash + Marketable Securities + Receivables) /
Current Liabilities
(Cash + Marketable Securities) / Current L’s
Ability to meet current liabilities
Cash
Solvency Ratios
Long-term debt to
Equity
Debt to Equity
Ability to meet current liabilities
Calculation
Measurement
Total Long-term Debt / Total Equity
Financial Risk and Financial
Leverage
Financial Risk and Financial
Leverage
Financial Risk and Financial
Leverage
Financial Risk and Financial
Leverage
Total Debt / total equity
Total Debt
Total Debt / total assets
Financial Leverage
Total Assets / Total Equity
Reading 34: Understanding the Cash Flow Statement
2
...
Under
GAAP, interest received and paid is reported as operating activities
...
Investing Activities – include purchasing and selling investments
...
Financing Activities – include obtaining or repaying capital, such as equity or long-term debt
...
Dividends paid are a
financing activity
...
252
Topic
IFRS
U
...
GAAP
Interest received
Operating or Investing
Operating
Interest paid
Operating or Financing
Operating
Dividends received
Dividends paid
Operating or Investing
Operating or Financing
Operating
Financing
Bank Overdrafts
Considered part of cash equivalents Not considered part of cash and
cash equivalents and classified as
financing
Classification of Cash Flows
Taxes Paid
Generally Operating, but a portion
can be allocated to investing or
financing if it can be specifically
identified with these categories
Operating
2
...
Indirect – shows how cash flow from operations can be obtained from reported net income as the result of a
series of adjustments
...
2
...
1Cash Received from Customers
Revenue
$23,598
Less: Increase in AR
(55)
= Cash Received from Customers
$23,543
Ending AR Balance Calculation
Beginning AR
$957
23,598
(23,543)
$1,012
+ Revenue
- Cash Collected from customers
= Ending AR
Cash Collected from Customers
Beginning AR
+ Revenue
23,598
$957
- Ending AR
(1,012)
= Cash Collected
$23,543
*If AR increase during the year, revenue on an accrual basis is higher than cash receipts from customers, vice versa
...
2
...
2 Amount of Cash Paid to Suppliers Affecting AR and AP
COGS
$11,456
+ Increase in Inventory
= Purchases from Suppliers
707
$12,163
- Increase in AP
(263)
= Cash paid to suppliers
$11,900
*If inventory increased during the year, then purchases during the year exceeded COGS, vice versa
...
2
...
3 Cash Paid to Employees
$4,123
Salary and Wage Expense
- Increase in Salary and Wage Pay
(10)
$4,113
= Cash Paid to Employees
Amount of Cash Paid to Employees Affecting Wages Payables
Beginning Salary and Wages Pay
+ Salary and Wage Expense
$75
4,123
- Cash Paid to Employees
(4,113)
= Ending Salary and Wages Payable
$85
*If salary and wage payable increased during the year, then salary and wage expense on an accrual basis is higher
than the amount of cash paid, vice versa
...
2
...
4 Cash Paid for Other Operating
Other Operating Expenses
- Decrease in prepaid Expenses
- Increase in other Accrued Liabilities
$3,577
23
(22)
= Cash paid for other operating expenses $3,532
*If prepaid expenses increased during the year, other operating expenses on a cash basis were higher than on an
accrual basis, vice versa
...
2
...
5 Cash Paid for Interest
Interest Expense
+ Decrease in Interest Payable
= Cash Paid for Interest
$246
12
$258
Effect on Interest Payable
Beginning Interest Payable
$74
+ Interest Expense
246
(258)
$62
- Cash Paid for Interest
= Ending Interest Payable
*If interest payable increases during the year, then interest expense on an accrual basis is higher than the amount of
cash paid for interest, and vice versa
3
...
1
...
3
...
2 Investing Activities
Proceeds from Sale of Equipment:
Beginning Balance Equipment (from BS)
$8,555
+ Equipment Purchased (from IS)
1,300
- Ending Balance Equipment (BS)
(8,798)
= Historical Cost of Equipment Sold
$1,057
Accumulated Depreciation on said equipment
Beginning Accum Depr (BS)
$2,891
+ Depreciation Expense (IS)
$1,052
- Ending Balance Accum Depr (BS)
= Ending Accum Depr
...
On Equip Sold
$500
= BV of Equipment Sold
$557
+ Gain on Sale of Equipment (IS)
= Cash From Sale
$762
3
...
3 Financing Activities
3
...
3
...
275)
START:
Additions
NET INCOME
Non Cash Items
Depreciation Expense of tangible assets
Amortization expense of intangible assets
Depletion expense of natural resources
Amortization of Bond Discount
Nonoperating losses
Loss on sale or write down of assets
Loss on retirement of debt
Loss on investments accounted for under the equity method
Increase in deferred income tax liability
Changes in working capital resulting from accruing higher expenses than cash payments, or lower
revenues than cash receipts
Increase in current operating liabilities (AP and Accrued Expenses Liability)
Decrease in current operating assets (AR, Inventory, PPE)
Subtractions
Noncash items (eg amortization of bond premiums)
Nonoperating Items
Gain on sale of assets
Gain on retirement of debt
Income on investments accounted for under equity method
Changes in working capital resulting from accruing lower expenses than cash payments, or higher
Decrease in deferred income tax liability
revenues than cash receipts
Decrease in current operating liabilities (e
...
AP and Accrued Expenses Liability)
Increase in current operating assets (e
...
AR, Inventory, and PPE)
3
...
Aggregate all revenue and all expenses
Total Revenues
Total Expenses
Net Income
2
...
Convert accrual accounts to cash flow amounts by adjusting for working capital changes
Cash received from customers
Cash paid to suppliers
Cash paid to employees
Cash paid for other operating expenses
Cash paid for interest
Cash paid for income tax
Read Pg
...
2 Common-Size Analysis of Statement of Cash Flows – Pg
...
- Second approach is to express each line item as a % of net revenue
4
...
FCFF = NI + NCC + Int (1-Tax rate) – FCInv - WCInv
NI = Net Income
NCC =Noncash charges (such as depreciation and amortization)
Int = Interest expense
FCInv = Capital Expenditures (fixed capital, such as equipment)
WCInv = Working capital expenditures
Also,
FCFF = CFO + Int(1-Tax rate) - FCInv
CFO = cash flow from operating activities under GAAP or IFRS (if co
...
Under IFRS, if company has placed interest and dividends received in investing activities, these should be added
back to CFO to determine FCFF
...
Positive
FCFE means excess cash available for distribution to owners (shareholders)
...
4 Cash Flow Ratios
Performance Ratios Calculation
What it Measures
Cash Flow to Revenue CFO / Net Revenue
Cash return on assets CFO / Average total assets
Cash generated per dollar of revenue
Cash generated from all resources
Cash return on equity
CFO / Average SHE
Cash generated from owner resources
Cash to income
Cash flow per share
CFO / Operating Income
(CFO-Preferred Dividends) / # of
Common Shares Outstanding
Cash-generating ability of operations
Operating cash flow on a per-share
basis
Coverage Ratios
Debt Coverage
Calculation
CFO / total debt
What it Measures
Financial risk and financial leverage
Interest Coverage
(CFO + Interest paid + Taxes Paid) /
Interest paid
Ability to meet interest obligations
Reinvestment
CFO / Cash paid for long-term assets
Ability to acquire assets with operating
cash flows
Debt payment
CFO / Cash paid for long-term debt
repayment
CFO / Dividends paid
Ability to pay debts with operating
cash flows
Dividend Payment
Ability to pay dividends with operating
cash flows
Investing and financing CFO / Cash outflows for investing and Ability to acquire assets, pay debts, and
financing activities
make distributions to owners
Study Session 9: FSA: Inventories, Long-term Assets, Deferred Taxes, and
On-and Off-Balance Sheet Debt
Reading 35: Analysis of Inventories
Inventory Account is affected by two events: purchase of goods (P) and their subsequent sale (COGS)
...
Results in a higher inventory balance on BS
LIFO – assumes that items last purchased are assumed to be the ones first sold and the ending inventory is made up
of the earliest costs incurred
...
Cannot be combined with LCM
...
Weighted-Average Cost – average cost method applied to all purchases
- from a balance sheet prospective, therefore, inventories based on FIFO are preferable to those presented under
LIFO, as carrying values most closely reflect current cost
...
- GAAP requires use of the lower-of-cost-or-market valuation basis (LCM) for inventories, with market value
defined as replacement costs (which cannot exceed net realizable value or be below t he net realizable value less the
normal profit margin)
- income should be measured after providing for the replacement of inventory, aka going concern
...
4
...
When LIFO is a permitted method for income
taxes, however, lower income translates into lower taxes and thus higher operating cash flows
...
Effects on financial statements for: LIFO
FIFO
COGS
Income before taxes
Higher Lower
Lower Higher
Income taxes
Net Income
Lower Higher
Lower Higher
CASH FLOW
Higher Lower
Inventory balance
Working capital
- pg 310 example
Lower Higher
Lower Higher
Income Difference = (1-Tax Rate) x COGS Difference
Cash Flow Difference = Tax Rate x COGS Difference
Working Capital Difference = COGS Difference – Cash Flow Difference
- LIFO results in misleading liquidity measures for the LIFO firm as its working capital is under-stated
Adjustments between LIFO and FIFO are necessary to:
1
...
obtain the measure(s) most relevant for their analytical purpose
5
...
312 example
LIFO Reserve – is the difference between the inventory balance shown on the balance sheet and the amount that
would have been reported had the firm used FIFO
...
Adjusting LIFO Inventory to FIFO
Inventories carried at LIFO
+ LIFO Reserve
= Inventories adjusted to FIFO
B
...
0 Adjustments of Income to Current Cost Income
To adjust COGS(f) to COGS(l)
COGS(l) = COGS(f) + (BI(f)*r)
COGS(l) = COGS(w) + (BI(w)*r/2) – weighted average COGS adjustment
r = specific inflation rate appropriate for the products in which the firm deals
r = Change in LIFO Reserve / BI(f)
- provides a reasonable approximation of r as long as the LIFO firm has not had a significant reduction of
its inventory from year to year
7
...
- FIFO/LIFO choice impacts reported profitability, liquidity, activity and leverage ratios
...
Profitability: Gross Profit Margin
- FIFO accounting, in terms of rising (falling) prices, will tend to overstate (understate) reported profit
margins
...
As the purpose of the current ratio is to compare a firm’s cash or near-cash
assets and liabilities, use of the current value of inventory (FIFO) results in the better measure
Activity: Inventory Turnover
Inventory turnover = COGS/average inventory
- the turnover ratio under LIFO, will, when prices increase, trend higher irrespective of the trend of
physical turnover
- to arrive at a reasonable approximation of the inventory turnover ratio for a LIFO firm, we must first
convert stated inventory to FIFO
...
324 example
Economic Order Quantity (EOQ) Inventory Ordering
- the EOQ model argues that the optimal level of inventory is proportionate to the square root of
demand
Just in Time (JIT) Inventory Ordering:
- carried to its ultimate conclusion, this would argue for a turnover ratio approaching infinity with zero
inventories held
...
Consistent with;
1
...
2
...
3
...
Solvency: Debt-to-Equity Ratio
- CFAI text has argued that, to compute liquidity ratios, understated LIFO inventory balances should
be restated to current cost by adding the LIFO reserve
...
8
...
Liquidation of inventories – when more goods are sold than are purchased, goods held in opening
inventory are included in COGS
...
- to postpone taxes indefinitely, purchases (production) must always be greater than or equal to sales
...
2
...
- the LIFO amounts on the balance sheet are not current and require adjustment, whereas the income
statement amounts are current and do not need adjustment
...
0 Acquiring the Asset: The Capital
- the costs of acquiring resources that provide services over more than one operating cycle are capitalized and
carried as assets on the balance sheet
...
0
Income Variability – firms that capitalize costs and depreciate them over time show smoother patterns of reported
income
...
Profitability – expensing lowers profitability in early years
...
Because they report lower assets, their ROA and ROE measures can be
higher than those of firms that capitalize costs
...
Thus, the capitalization of long-lived assets results in a permanent shift of expenditures from CFO to CFI
...
4
...
Specific borrowing to that asset is also capitalized
...
Under SFAS 34, interest is capitalized only if the firm is leveraged
...
capitalized interest should be added back to interest expense
b
...
c
...
Interest capitalization as part
of the cost of fixed assets will never be reported as CFO, but as an investment outflow
...
International - all borrowing costs are expensed unless those costs are directly attributable to the acquisition,
construction, or production of qualifying assets, which may be expensed
...
Recognition and Measurement Issues
- the cost of acquiring intangible assets from unrelated entities is capitalized at acquisition, measured
by the amount paid to acquire them
...
IAS 9 – requires the expensing of research costs but requires capitalization of development costs when all criteria
are met:
1
...
costs can be clearly identified
3
...
the firm intends to produce the product (use the process)
5
...
the firm has sufficient resources to complete the project
- example 2
Adjusting for Capitalized
1
...
2
...
Reduce equity by the closing balance of unamortized R&D expense, net of tax effect
R&D Affiliates – SFAS 2 does not permit the capitalization of R&D costs
...
Only the legal fees incurred in registering internally developed patents and copyrights can
be capitalized
...
Franchises and Licenses – the franchisee or licensee capitalized the costs of purchasing these rights
Brands and Trademarks – the cost of acquiring brands and trademarks in arm’s-length transactions is capitalized
...
- Direct-Response Advertising and Probably Future Benefits (Practice Bulletin 13), requires
capitalization
of the costs of direct-response advertising that result in probable future
benefits
...
Capitalization is not allowed when the advertising
produces leads that
requires additional marketing efforts to convert into sales
...
Computer Software Development Costs
SFAS 86 requires that all costs incurred to establish the technological and/or economic feasibility of software be
viewed as R&D costs and expensed s incurred
...
Straight-Line Depreciation = results in an increasing rate of return rather than the actual rate of return earned over
the life of the asset
...
Accelerated depreciation methods compensate for the rising trend of maintenance and repair costs that total asset
costs are level over the asset’s life
...
sum-of-years’ digits
2
...
Straight Line
Depreciation in Year i = (1/n) * (Original Cost – Salvage Value)
2
...
Double-Declining-Balance
Depreciation in Year i = (2/n) * (Original Cost – Accumulated Depreciation)
or
= (2/n) * (Net Book Value)
1
...
Determine an acceleration factor that approximates the pattern of the asset’s wear
...
Multiply that rate by the straight line rate
4
...
5
...
4
...
387
- these methods make depreciation expense a variable rather than a fixed cost, decreasing the volatility
of
reported earnings as compared to straight-line or accelerated methods
...
Cost per Service Hour
= (Original Cost – Salvage Value) / Expected Service Hours
Depreciation Expense = (Cost/Service Hours)*Hours worked in period
***accumulated depreciation cannot exceed (Original Cost – Salvage Value)
6
...
These costs may be capitalized or expensed as a
function of the firm’s accounting policies
...
Amortization
- amortization of intangible assets may be based on useful lives as defined by law or regulation;
companies use either straight-line or units-of-production methods
Impact of Depreciation Methods on Financial Statements
- Accelerated depreciation methods tend to depress both NI and SHE when compared with the
straight-line
method
...
Changes in Depreciation Method
1
...
2
...
The cumulative effect of the change must be reported
separately and net of taxes
...
Change in Asset Lives or Salvage Value – changes in asset lives and salvage value are changes in
accounting estimates and are not considered changes in accounting principle
- when analyzing firms that change depreciation methods or assumptions, it is important to remember
that the effect of such changes persists, as depreciation on both old and new fixed assets is
stretched out, increasing reported income
...
0 Analysis of Fixed Asset Disclosures
Estimating Relative Age and Useful Lives
Average or Relative Age (%) = Accumulated Depreciation / Ending Gross Investment
- Accurate as long as straight-line depreciation is used
Average Depreciable Life = Ending Gross Investment / Depreciation Expense
- This calculation is only a rough approximation as it can be affected by changes in asset mix
...
- Falling average age may suggest that machinery is modern
4
...
Must be separated into impairment (noncash write downs of past cash outflows) and those with cash flow
implications
Impairment of Assets Held for Sale
- be written down to fair value less cost to sell when lower than the carrying amount
...
Costs to sell exclude costs
associated with the ongoing operations of assets held for sale
...
- Subsequent increases in fair value less cost to sell would be recognized as gains only to the extent of
previously recognized write downs
...
This reduction increases the firm’s debt-toequity ratio and decreases reported book value per share
...
ROA and
ROE increase
Effects of SFAS 143
- increase in the carrying value of fixed assets
- Increase in liabilities due to recognition of the ARO
- Lower NI due to recognition of additional appreciation and accrued expense (on the ARO)
- Lower asset turnover (due to higher asset levels)
- Higher debt-to-equity ratio as equity is depressed by lower net income
- Lower ROA (lower income, higher assets)
- Lower Interest coverage (lower income due to higher depreciation, higher interest expense)
...
Taxable Income – Income subject to tax
...
Taxes payable (current tax expense) – tax return liability resulting from current period taxable income
3
...
Tax loss carryforward – tax return loss that can be used to reduce taxable income in future years
Amounts in Financial Statements;
1
...
Income Tax Expense - expense based on current period pre-tax income; includes taxes payable and deferred
income tax expense
3
...
Under SFAS 109, the amount depends on changes in
deferred tax assets and liabilities
4
...
- may be indicator of future cash flow, reported income, or both
- result from an excess of taxes payable over income tax expense
5
...
The net deferred tax liability will increase over time; in effect, it will never be paid
- result from an excess of income tax expense over taxes payable
- created when more expense is applied to the tax return relative to the income statement (e
...
more
depreciation)
...
6
...
Timing difference – the difference between tax return and financial statement treatment (timing or amount) of a
transaction
8
...
Temporary difference – difference between tax and financial statement reporting, which will affect taxable income
when those differences reverse; similar to but broader than timing differences
...
Permanent Differences – are items of income or expense that affect either tax return income or financial income,
but not both
...
3
...
Taxes payable or refundable for the current year
2
...
4
...
If they will
not, then it is highly debatable whether deferred taxes are assets or liabilities (that is, have cash flow consequences);
it may be more appropriate to consider them as decreases or increases to equity
...
Future tax rates and tax laws – under liability method, when a new tax law is enacted its effects must be
recognized immediately
...
2
...
the firm’s growth rate (real or nominal) – for growing firms, increased or higher-cost investments in
fixed assets result in ever-increasing deferred tax liability due to the use of accelerated depreciation
methods for tax reporting
...
Nonrecurring items and equity adjustments -
Extraordinary items – early retirement of debt
Unrealized gains or losses on marketable securities
Currency translation adjustments
Liability or Equity?
- to the extent that deferred taxes are not a liability, they are SHE
- if deferred tax liability is not expected to reverse, there is no expectation of a cash outflow and the
liability should be considered as equity
...
0 Temporary versus Permanent Differences
- the income of affiliates is taxable on the parent’s (U
...
) tax return only when dividends are received or the affiliate
is sold, not when earnings are recognized
...
0 Analysis of Income Tax
A forecast of future income tax expense should start with estimated pretax income and apply a statutory rate, then be
adjusted for a
...
effects of the lower tax rate on U
...
possession
operations c
...
Frequent Examples of Deferred Income Tax Expense Differences
1
...
Impairment – write downs do not generate tax deductions unless assets are sold
3
...
Inventories
5
...
Deferred compensation
Deferred Tax Expense Ratio – reflects the difference between taxable income reported to tax authorities and pretax
income reported to shareholders
Difference = Deferred Tax Expense / Statutory tax rate
Analysis of Deferred Tax Assets and Liabilities
- The most significant deferred tax asset relates to accrued employee benefits
...
Explain in which of the following categories deferred taxes can be found & examples:
1
...
Long-term liabilities – deferred income tax credits resulting from the use of accelerated
3
...
5
...
Reading 39: Analysis of Financing Liabilities
2
...
Operating and trade liabilities – result of credit granted to the company by its suppliers and
employees
- reported at expected cash flow and is the exception to the rule that liabilities are reported at present
value
2
...
- Increases in advances should be viewed favorable as advances are a prediction of future revenues
rather than cash outflows
...
Short-term debt represents amounts borrowed from banks or the credit markets that are
expected to be repaid within one year or less
2
...
Long Term Debt
1
...
The BV reported in the
financial statements use the discount rate (market interest rate) in effect when the debt was
incurred
...
2
...
Even when the total amount of interest paid over time is known, its allocation to individual time
periods (both cash outflows and accrual of expense in periodic income statements) may vary with
the form of debt
...
467 Example
- The amount borrowed (the proceeds received on issuance) depends on the market rate of interest for
bonds of a similar maturity and risk as well as the payment stream
- It is the current market interest rate that allocates payments between interest and principal
...
the initial liability is the amount paid to the issuer by the creditor (PV of the stream of payments
discounted at market rate), not necessarily the face value of debt
...
the effective interest rate on the bond is the market (not the coupon) rate at the time of issuance, and
interest expense is that market rate times the bond liability
3
...
total interest expense is equal to- the payments by the issuer to the creditor in excess of the amount
received
...
the balance sheet liability over time is a function of (a) the initial liability and the relationship of (b)
periodic interest expense to (c) the actual cash payments
...
the balance sheet liability at any point in time is equal to the present value of the remaining
payments, discounted at the market rate in effect at the time of the issuance of the bonds
...
471 example for below
Market Rate = Coupon Rate - PAR BOND
- Liability is $100,000 at issuance
Market Rate < Coupon Rate … = PREMIUM BOND
- part of coupon payment goes towards both principal and interest
...
At maturity, the balance will have been reduced to the FACE
VALUE of the bond
...
- For bonds sold at a premium, part of the coupon payment is a reduction of principal and should be
treated as financing cash (out) flow
...
As a result, a higher liability is used to calculate interest
expense for the second period, increasing interest expense, increasing the shortfall, and further
increasing liability
...
When bonds are issued at a discount, part of the discount amortization represents additional interest
expense, and CFO is overstated and CFF is understated by the same amount
...
- The cash flow classification of the debt payments depends on the coupon rates, not the effective
interest rate
...
Lump-sum
payment at maturity includes all unpaid interest (equal to face value minus proceeds) from the time of issuance
...
Debt with Equity Features
Convertible Bonds – optional to bondholder to convert into equity
Analytical Judgment - when the sock price is (significantly) great than the conversion price, it is likely that
the debt will not have to be repaid, and the convertible bond should be treated as equity rather than debt
when calculating solvency ratios such as debt-to-equity
...
Bonds with Warrants – fair value of bond portion is the recorded liability and the fair value of the warrants is
included in equity and has no income statement impact
...
lowers interest expense
2
...
Results in a balance sheet liability equal to or below that of a conventional bond
INTEREST EXPENSE BALANCE SHEET LIABILITY OPERATING CASH FLOW
Conventional bond
greater than
Conventional bond
equal to
Conventional bond
less than
Bonds with warrants
Convertible bond
Convertible bond
greater than
Convertible bond
greater than
Bond with warrants
equal to
Bond with warrants
- such debt appears less costly but when convertible debt is issued, there is a systematic
understatement of interest expense
Commodity Bonds – a higher commodity price increases the payments to bondholders but is offset by higher
operating profitability of firms that deal in commodities, who usually issue such bonds
...
When calculating net worth of company with preferred shares outstanding:
1
...
Subtract any cumulative dividends that are in arrears
...
Effects of Changes in Interest Rates
- Increases (decreases) in the current market rate decrease (increase) the market value of debt
...
- A firm that issued bonds when rates were lower than a comparable firm issuing the same bond size
has higher borrowing capacity as the economic value of its debt is lower
Estimating Market Value of Debt – Pg
...
Debt Denominated in Foreign Currency – PV calculations should be based on interest rates for the currency
in which the debt is denominated
Debt: Market or Book Value
Debt Maturities: if a firm’s debt is mostly short term, changes in interest rates will not appreciably affect its
market value
...
Fixed rate debt does require adjustment
Embedded Rate – average outstanding coupon rate of all debt
...
- Debtor recognizes gain when undiscounted gross cash flows due after restructuring are lower than t he
carrying amount
...
- For CFA purposes, both impaired and restructured debt should be restated to fair market value using a
current market value interest rate to discount the cash flows required by the (actual or expected)
restructured obligation
...
Declining interest rates permit reduction of interest cost
2
...
Sale of assets of additional equity generates funds and the firm decides to reduce financial leverage
- Gain or loss of retired debt treated as component of continuing operations
- Economically it is beneficial to refinance debt, but the income statement reports a loss
...
0 Bond Covenants
Nature of Covenants – what they may limit
1
...
Production and investment (including M&A, sale and leaseback, or outright disposal of certain assets)
3
...
Payoff patterns (includes sinking fund requirements and the priorities of claims on assets)
Interest Expense during Bond Decline
= Annual Interest Amount + Change in unamortized bond discount
...
Lessee
accounts for such leases as contracts, reporting (as rental expense) only the required rental payments as they are
made
- allow lessees to avoid recognition of asset and report higher profitability ratios and indicators of operating
efficiency
...
- lessor prefers to structure leases as capital lease because it allows earlier recognition of revenue and
income by reporting transactions that are in substance installment sales or financing arrangements as
completed sales
...
Are treated
for accounting purposes as sales
...
Lessee depreciates asset and treats
lease payments as payments of P&I
...
Under GAAP the lessee
must classify a lease meeting any one of the following SFAS 13 criteria at inception of lease as capital lease if:
1
...
Lease contains bargain purchase option
3
...
(not applicable to
land where lease begins within the final 25% of the economic life of the asset)
...
Present value of the minimum lease payments (MLPs) equals or exceeds 90% of the fair value of leased
property to the lessor
...
Assets: Leased Assets, Accumulated Depreciation
Liabilities: Current portion of lease obligation, Long Term Debt Section, residual of lease obligation
Effects on ratios
- Capital Leases: Increases asset balances resulting in lower asset turnover and ROA
...
Decreases operating outflow and increase financing outflow
...
0 Off-Balance Sheet Financing Activities
Take-or-Pay and Throughput Arrangements
Take-or-pay – used to ensure the long-term availability of raw material and other inputs necessary for
operations
...
Receivable Sales / Securitization provide that the seller retains the effective credit risk by either:
- retaining a portion of the receivables and receiving payment only after the securitized amount has
been repaid
- providing other collateral, or agreeing to replace delinquent receivables with current receivables
Sales of receivables should be adjusted as follows:
Balance Sheet – both AR and CL should be increased by the amount of receivables sold that have not yet
been collected
Cash Flow Statement – CFO must be adjusted; the change in the uncollected amount should be classified as
cash from financing rather than CFO
...
e
...
5
...
Collectibility of the MLPs is reasonably predictable
2
...
Net cash flow remains zero
...
Under sales-type, its allocated between CFO and
CFI
...
- Operating lease method reports higher CFO after inception
...
Only
financing income is reported
...
0 Analysis Tools and Techniques
Net Profit Margin = NI / Revenue
- indicates profitability of a firm
ROA (variation) = Operating Income / Average Total Assets
ROA = Net Income / Average Total Assets or NI / Total Assets
ROE = NI / Average Shareholders Equity
General Rule – is that when an income statement or cash flow statement number is in the numerator of a ratio and a
balance sheet number is in the denominator, then an average should be used for the denominator
...
1
...
Microeconomic relationships within a company that help analysts project earnings and FCF
2
...
Management’s ability
Limitations of Ratio Analysis:
1
...
the need to determine whether the results of the ratio analysis are consistent
3
...
The use of alternative accounting methods
- Receivables growing faster than revenue can indicate operational issues, such as lower credit
standards or aggressive accounting policies for revenue recognition
...
4
...
Company goals and strategy
2
...
Economic Conditions
Activity Ratios – measures how efficiently a company performs day-to-day tasks, such as the collection of
receivables and management of inventory
Inventory Turnover = COGS / Average Inventory
- Indicates the resources (money) tied up in inventory and can therefore be used to indicate inventory
management effectiveness
...
- alternatively, high inventory turn and LOW DOH could indicate not enough inventory on hand which
could hurt revenues in event of inventory shortage
- Slower growth combined with higher inventory turnover could indicate inadequate inventory levels
...
Days of Sales Outstanding (DSO) = Number of Days in Period / Receivables Turnover
- represents the elapsed time between a sale and cash collection, representing how fast the company collects
cash from customers it offers credit
...
- If purchases info is not available, use COGS + Ending Inventory – Beginning Inventory
- COGS sold is sometimes used as approximation of purchases
- A high ratio could indicate that the company is not making full use of available credit facilities or
that the company could be making use of early payment discounts
...
High ratio indicates greater efficiency
...
- A higher ratio indicates greater efficiency
...
Sales / Turnovers = AR Balance
Liquidity Ratios – measure the company’s ability to meet its short-term obligations
Current Ratio = Current Assets / Current Liabilities
- Higher ratio indicates higher liquidity
Quick Ratio = (Cash + Short-term marketable investments + receivables) / current liabilities
- More conservative than current ratio, higher ratio indicates higher liquidity
Cash Ratio = (Cash + Short-term marketable investments) / current liabilities
- Entity’s liquidity in a crisis situation
Defensive Interval Ratio = (Cash + Short-term marketable investments + receivables) / Daily Cash Expenditures
Daily Cash Expenditures = Total Cash Expenditures for Period / Number of Days in Period
Total Cash Expenditures = COGS + SG&A + R&D Expenses – Depreciation - Amortization
- Measures how long the company can continue to pay its expenses from its existing liquid assets without
receiving any additional cash inflow
...
Subsets of these ratios are also
known as “leverage” and “long-term debt” ratios
Debt Ratios
***Total debt = interest-bearing short-term and long-term debt
...
Measures the number of
times a company’s earnings (EBIT and Lease Payments) can cover the company’s interest and lease
payments
- Sometimes used as an indication of the quality of the preferred dividend, with a higher ratio indicating a
more secure preferred dividend
...
The greater the use
of operating leverage, the greater the risk of the operating income stream available to cover debt payments
Profitability Ratios – measure the company’s ability to generate profitable sales from its resources (assets)
...
Reinvested earnings enhance solvency
and provide a cushion against short-term problems
Return on Sales
Gross Profit Margin = Gross Profit / Revenue
- indicates the percentage of revenue available to cover operating and other expenditures
- Higher gross profit margin can indicate that a company has a competitive advantage in product costs
Operating Profit Margin = Operating Income (or EBIT) / Revenue
Operating Income = Gross Margin – Operating Costs
- An operating income increasing faster than the gross margin can indicate improvements in controlling
operating costs
Pretax Margin = EBT / Revenue
- reflects the effects on profitability of leverage and other (nonoperating) income and expenses
Net Profit Margin = Net Income / Revenue
Return on Investment
ROA = Net Income / Average Total Assets
- measures return earned by a company on its assets
Adjusted ROA = [NI + Interest Expense (1-Tax Rate)] / Average Total Assets
Operating ROA = Operating Income or EBIT / Average Total Assets
Return on Total Capital = EBIT / Short-and Long-term Debt and Equity
- Measures the profits a company earns on all of the capital that it employs (short and long term debt and
equity)
ROE = Net Income / Average Total Equity
- measures the return earned by a company on its equity capital, including minority equity, preferred
equity,
and common equity
...
6
...
608 tree
41-1a
ROE = NI / Average SHE = (NI/Average Total Assets) * (Average Total Assets/Average SHE)
ROE = ROA * Leverage
41-1b
Net Income/Average SHE = (NI/Revenue)*(Revenue/Average Total Assets)*(Average Total Assets / Average SHE)
ROE = Net Profit Margin * Asset Turnover * Leverage
41-1c
Net Income / Average SHE = (Net Income / EBT) * (EBT / EBIT) * (EBIT / Revenue) * (Revenue/Average Total
Assets) * (Average Total Assets / Average SHE)
ROE = Tax Burden * Interest Burden * EBIT margin * Asset Turnover * Leverage
Tax Burden = NI / EBT
- An increasing tax burden indicates that taxes declined as a percentage of pretax profits
Interest Burden = EBT / EBIT
- An interest burden factor greater than 100% means that nonoperating income exceeded interest expense
5
...
g
...
g
...
Valuation Ratios
P/E = Price per Share / Earnings per Share
P/CF = Price per Share / Cash Flow per Share
P/S = Price per Share / Sales per Share
- Profit margin is related to justified price-to-sales
P/BV = Price per Share / Book value per Share
- Theoretically linked to ROE, growth, and the required return
Per-Share Quantities
Basic EPS = (NI – Preferred Dividends) / Weighted Average Number of Ordinary Shares Outstanding
Diluted EPS = Adjusted Income Available for Ordinary Shares, Reflecting Conversion of Dilutive Securities /
Weighted Average Number of Ordinary and Potential Ordinary Shares Outstanding
Cash Flow per Share = Cash Flow from Operations (aka CFO) / Average number of shares outstanding
EBITDA per share = EBITDA / Average Number of Shares Outstanding
Dividends per Share = Common Declared Dividends / Weighted Average Number of Ordinary Share
- To calculate diluted EPS, earnings are adjusted for the after-tax effects assuming conversion with the following
adjustments:
a
...
Potential ordinary shares are treated as dilutive when their conversion
would decrease net profit per share from continuing ordinary operations
b
...
Options, warrants (and their equivalents), convertible instruments, contingently issuable shares, contracts
that can be settled in ordinary shares or cash, purchased options, and written put options should be
considered
Dividend-Related Quantities
Dividend Payout Ratio = Common Share Dividends / Net Income Attributable to Common Shares
- Measures the percentage of earnings that the company pays out as dividends to shareholders
Retention Rate (b) = Net Income Attributable to Common Shares – Common Share Dividends / Net Income
Attributable to Common Shares
- is the percentage of earnings that a company retains
...
614
Business Risk Ratios
Coefficient of Variation of Op
...
618
Selected Credit Ratios Used by S&P
EBIT Interest Coverage = EBIT / Gross Interest (Prior to deductions for capitalized interest or interest income)
EBITDA Interest Coverage = EBITDA / Gross Interest (Prior to deductions for capitalized interest or interest
income)
Funds from Operations to Total Debt = FFO (NI adjusted for non-cash items) / Total Debt
Free Operating Cash Flow to Total Debt = CFO (adjusted) less CAPEX / Total Debt
Total Debt to EBITDA = Total Debt / EBITDA
Return on Capital = EBIT / Capital, which = Average Equity (common and preferred) and short-term portions of
debt, noncurrent deferred taxes, and minority interest)
Total Debt to Total Debt Plus Equity = Total Debt / (Total Debt + Equity)
Pg
...
365/15 = 24
...
2
b
...
$300,000,000 / 19
...
$320,000,000 / 24
...
Find Difference
$15,625,000 - $13,168,724 = $2,456,276 decline necessary to meet new ratio
Reading 40B: Financial Reporting Quality: Red Flags and Accounting Warnings
2
...
g
...
operating lease)
- Using unrealistic or inappropriate estimates and assumptions (really long depreciable lives)
- Stretching accounting principles to achieve desired outcome (consolidation of SPEs)
- Engaging in fraudulent financial reporting
3
...
Incentives or pressures exist that can lead to fraudulent financial reporting
2
...
The individuals themselves are able to rationalize their behavior, such as a desire to get the
company through a difficult time, after which they plan to undo their accounting games
Four Classes of Improper Accounting Practices
1
...
Improper expense recognition
3
...
other accounting and reporting issues
Common Accounting Warning Signs
1
...
Bill-and-hold sales arrangements
b
...
Recording revenue at contract signing but before delivery of goods
d
...
Using swaps or barter arrangements to generate sales
2
...
Growth in revenues out of sync with economy, industry, or peer companies and with
4
...
Inventory management
b
...
Inappropriate overstatement of inventory ot increase gross and net profits
5
...
Deferral of expenses
7
...
Classification of expenses or losses as extraordinary or nonrecurring
9
...
Gross margins or operating margins out of line with peer companies
11
...
Use of aggressive pension plan assumptions
13
...
Equity method of accounting/frequent use of off-balance-sheet SPEs or Variable interest
entities
15
...
0 Dispelling the Myth about Cash Flows
- Lack of regulation on cash flow pr3esentation and categorization
...
0 Stretching out Payables
- Simplest thing a company can do to improve reported operating cash flow
- Vendors will eventually put pressure on company to pay and therefore, any benefit may be unsustainable
or, at a minimum, any YoY improvement in operating cash flow may be unsustainable
4
...
0 Securitizing Of Receivables
- occurs when companies package their receivableds, most often those that have a longer term and higher
credit quality, and transfer them to a financial institution or a variable interest entity (VIE)
...
- GAAP does not prescribe where on the income statement this gain is to be recorded
...
6
...
7
...
Consequently, as option exercises grow, so does the boost to operating cash flows
for the tax benefit, but the outflows for stock buybacks to offset dilution of earnings are recorded in the
financing section of the cash flow statement
...
0 Other Means
- increasing the use of capital lease transactions, accounting for outstanding checks and financing
receivables are additional ways to influence cash flow
Reading 42: Financial Statement Analysis: Applications
3
...
- pg
...
0 Application: Assessing Credit Risk
Credit Risk – is the risk of loss caused by a counterparty’s or debtors failure to make a promised payment
...
Scale and Diversification – related to a company’s sensitivity to adverse events and economic conditions
as well as to other factors – such as market leadership, purchasing power with suppliers, and access to
capital markets-that can affect debt-paying ability
2
...
Operational Stability – relates to cost structure: companies with lower costs are better positioned to deal
with financial stress
4
...
5
...
654 example for calculating how many stocks meets requirements if criteria were independent
= Percentage of Total Screen A * Percentage of Total Screen B … * Percentage of Total Screen n
Growth Investors - focused on investing in high earnings-growth companies
Value Investors – focused on paying a relatively low share price in relation to earnings or assets per share
Market-Orientated Investors – and intermediate group for investors whose investment disciplines cannot be clearly
categorized as value or growth
Back-testing – applies the portfolio selection rules to historical data and calculates what returns would have been
earned if a particular strategy had been used
...
Survivorship Bias
b
...
Data-Snooping Bias
6
...
2 Analyst Adjustments Related to Investments
-when securities are classified as “trading” securities, unrealized gains and losses are reported on the income
statement
...
IFRS requires that those unrealized gains and losses on available-for-sale debt securities that arise due to exchange
rate movements be recognized in the income statement, whereas GAAP does not
...
3 Adjustments Related to Inventory
FIFO to LIFO = Add LIFO reserve to FIFO costs
LIFO to FIFO = subtract LIFE reserve from LIFO to get to FIFO
-for balance sheet costs
FIFO to LIFO = Add net change in LIFO reserve to COGS on IS
LIFO to FIFO = subtract LIFO reserve from LIFO COGS to get to FIFO COGS
- for IS adjustments to NI
LIFO COGS to FIFO COGS = subtract change in the amount of LIFO reserve from COGS
Pg
...
1 Key Aspects of IFRS Framework
- Relevance
- Predictive value
- Faithful representation (an emphasis on economic substance over form, reliability, and completeness)
- Neutrality (absence of bias) – qualitative characteristic
- Verifiability
3
...
5 Goodwill Adjustments
1
...
Excluding goodwill impairment charges from income and use of this adjusted data when reviewing
operating trends
3
...
5 Depreciation Expenses
- whether the straight line depreciation method or an accelerated method is used, the method complies with IFRS
only if it reflects the pattern of expected consumption of the assets
...
0 Cash Flow Statement
Category
Classification of Interest and Dividends under IFRS
and GAAP
Cash Flows From Operating
Interest Received
IFRS: operating or investing section
GAAP: mandated operating section
Dividends Received
IFRS: operating or investing section
GAAP: mandated operating section
Interest Paid
IFRS: operating or investing section
GAAP: mandated operating section
Dividends Paid
IFRS: operating or financing
GAAP: mandated financing section
Cash Flows from Investing
Interest Received (IFRS only)
Dividends Received (IFRS only)
IFRS: operating or investing section
IFRS: operating or investing section
Cash Flows from Financing Activities
Dividends Paid
Interest Paid
- re-read reading 43
IFRS: operating or financing section
GAAP: mandated financing section
IFRS: operating or financing section
BOOK 4
Study Session 11: Corporate Finance
Reading 44: Capital Budgeting
Types of Projects
1
...
Expansion
3
...
Regulatory, Safety, and Environmental Projects
5
...
0 Basic Principles of Capital Budgeting
Required Rate of Return – is the discount rate that investors should require given the riskiness of the project
Sunk Cost – is one that has already been incurred
Opportunity Cost – is what a resource is worth in its next-best use
Use of Idle Property – opportunity cost is current market value of land
Replace an old Machine with new – opportunity cost is the cash flows the old machine would generate
If you invest $10million – opportunity cost is the $10million (which you could invest elsewhere)
Externality – is the effect of an investment on other things besides the investment itself
Cannibalization – is one externality
...
When cash flows change signs more than once multiple IRR’s are possible
...
Pick higher NPV project in this situation
Project Sequencing – many projects are sequenced through time, so that investing in a project creates the option to
invest in future projects
Unlimited Funds – environment that assumes that the company can raise the funds it wants for all profitable projects
simply by paying the required rate of return
Capital Rationing – exists when the company has a fixed amount of funds to invest
4
...
2 IRR
IRR > r, invest
IRR < r, do not invest
r = cost of capital
4
...
4 Discounted Payback
- The number of years it takes for the cumulative discounted cash flows from a project to equal the original
investment
- Accounts for TVM and risk but it ignores cash flows after the discounted payback is reached
...
5 Average Accounting Rate of Return
AAR = Average NI / Average BV
- AAR does not account for the TVM and there is no conceptually sound cutoff for the AAR that
distinguishes between profitable and unprofitable investments
...
6 Profitability Index
- indicates the value you are receiving in exchange for one unit of currency invested
PI = PV of future Cash Flows / Initial Investment = 1+ NPV / Initial Investment
PI > 1
...
0, do not invest
4
...
NPV is graphed vertically (y-axis)
Discount rate graphed horizontally (x-axis)
4
...
9 The Multiple IRR Problem and the No IRR Problem
- pg
...
- the IRR equation is essentially an nth degree polynomial
...
- also the opportunity cost of funds to the suppliers of capital
2
...
Assume the company’s current capital structure, at market value weights for the
components, represents the company’s target capital structure
2
...
Use averages of comparable companies’ capital structures as the target capital structure
2
...
- the optimal capital budget is that amount of capital raised and invested at which the marginal cost of capital is
equal to the marginal return from investing
- if we use the company’s WACC in the calculation of the NPV of a project, we are assuming the project:
a
...
will have a constant target capital structure throughout its useful life
Analyst uses WACC when cash flows are cash flows to the company’s suppliers of capital
FCFF – cash flow available to the company’s suppliers of capital after all operating expenses (including taxes) have
been paid and necessary investments in working capital (inventory) and fixed capital (PPE) have been made
Analyst uses Cost of Equity Capital if cash flows are strictly those belonging to equity owners
FCFE – cash flow available to holders of the company’s common equity after all operating expenses, interest, and
principal payments have been paid and necessary investments in working capital and fixed capital have been made
3
...
1 Cost of Debt
Cost of debt is the cost of debt financing to a company when it uses a bond or takes out a bank loan
...
yield to maturity approach – pg
...
debt rating approach – when a reliable market price for a company’s debt is not available,
we estimate the before-tax cost of debt by using the yield on comparable rated bonds for
maturities that close match that of the company’s existing debt
3
...
In the case of nonconvertible, noncallable preferred stock that has a fixed dividend and no maturity date, use
Pp = Dp / rp
- For example, if company has callable, convertible preferred stock outstanding, yet it is expected to
issue only noncallable, nonconvertible preferred stock in the future, we would have to either use
the CURRENT yields on comparable companies’ noncallable, nonconvertible preferred stock or
estimate the yield on preferred equity (N/A for Level I)
3
...
3
...
1 CAPM
E(Ri) = Rf + Bi[E(Rm) – Rf]
Bi = return sensitivity of stock i to changes in the market return
Rm = expected return on the market
E(Rm) = expected market risk premium or equity risk premium
Multifactor Model – pg
...
Estimating Equity Risk Premium Types
1
...
Dividend Discount Model Approach (Gordon Growth Model)
3
...
Bond Yield plus Risk Premium Approach
3
...
2 Dividend Discount Model Approach
DDM – in general this model states that the intrinsic value of a share of stock is the PV of the shares future
dividends
Estimate Growth Rate for Gordon Growth Model
1
...
Use a relationship between the growth rate, the retention rate, and the ROE
...
3
...
re = rd + Risk Premium (45-8)
4
...
1 Estimating Beta and Determining a Project Beta
Business Risk – of a company or project is the risk related to the uncertainty of revenues, referred to as sales risk,
and operating risk, which is the risk attributed to the company’s operating cost structure
...
Estimating company beta or project beta that is not publicly traded
1
...
Select the comparable
b
...
Unlever the comparable’s beta (equation 45-9)
d
...
Comparable Company – is a company that has similar business risk
4
...
4 Flotation Costs
Reading 46: Working Capital Management
Liquidity – is the extent to which a company is able to meet its short-term obligations using assets that can be
readily transformed into cash
...
- Uncollected receivables, obsolete inventory, tight credit
...
Making payments early
2
...
Limits on short-term lines of credit
4
...
0 Investing in Short-Term Funds
Discount Interest – the difference between the purchase price and the face value
Nominal Rate = a rate of interest based on the security’s face value
Yield = is the actual return on the investment if it is held to maturity
Pg
...
2 Working Capital Strategies
Passive – characterized by one or two decision rules for making daily investments
Active – involves constant monitoring and may involve matching, mismatching, or laddering strategies
Matching – is the more conservative of the two (timing of cash outflows with investment maturities) and
uses many of the same investment types as are used with passive strategies
Mismatching – is riskier and requires very accurate and reliable cash forecasts
Laddering – is another form of active strategy, which entails scheduling maturities on a systematic basis
within the investment portfolio such that investments are spread out equally over the term of the ladder
...
0 Managing AR
Captive Finance Subsidiary – is a wholly owned subsidiary of the company that is established to provide financing
of the sales of the parent company
Types of Credit Accounts
Open Book
Documentary, with or without lines of credit
Installment Credit
Revolving Credit
Float Factor – gives the average number of days it took deposited checks to clear
6
...
Safety Stock – is a level of inventory beyond anticipated needs that provides a cushion in the event that it
takes longer to replenish inventory than expected or in the case of greater demand than expected
Anticipation Stock – is inventory in excess of that needed for anticipated demand, which may fluctuate
with the company’s sales or production seasonality
...
6
...
Ordering – procurement or replenishment costs
2
...
Stock-out – opportunity or real costs
4
...
0 Managing Short-Term Financing
Borrower Considerations
1
...
Sufficient Access
3
...
0 Dupont Analysis
ROA = (NI / Average Total Assets) = (NI / Revenue) * (Revenues / Average Total Assets)
Or
ROA = Net Profit Margin * Total Asset Turnover
Net Profit Margin = NI / Revenues
= (Operating Income / Revenues) * (Income Before Taxes / Operating Income) * (1 – (Taxes/Income Before Taxes))
ROE = (NI / Average SHE) = (NI / Revenue) * (Revenues / Average Total Assets) * (Avg Total Assets / Avg
...
0 Pro Forma Analysis
Step 1: Estimate typical relation between revenues and sales-driven accounts
Step 2: Estimate fixed burdens, such as interest and taxes
Step 3: Forecast revenues
Step 4: Estimate Sales-drive accounts based on forecasted revenues
Step 5: Estimate fixed burdens
Step 6: Construct future period income statement and balance sheet
3
...
COGS
2
...
Working Capital Accounts included in current assets and current liabilities
3
...
3 Forecasting Revenues
- average growth rate of past few years
- linear regression
- adjust for recent acquisitions or divestitures
Reading 48: The Corporate Governance of Listed Companies: A Manual For Investors
- good corporate governance leads to better results for companies and for investors
...
160 – 161
Corporate Governance – is the system of internal controls and procedures by which individual companies are
managed
...
Prevent one group
from expropriating the cash flows and assets more than other groups
...
Board Members
Executive – members of executive management sitting on the board
Independent Board Members
Non-executive board members – may represent the interests that may conflict with those of shareowners
Two-Tier Board
a
...
Supervisory Board
Unitary Board – board may include executive, non-executive, and independent board members
Corporate Auditors System in Japan – includes board of independent and non-executive and a board of corp
...
Independence – refers to the degree to which they (board) are not biased or otherwise controlled by
company management or other groups who exert control over management
2
...
Resources
Board Committees
1
...
2
...
Nominations Committee – responsible for recruiting new board members, regularly examining the
performance, independence, skills, and expertise of existing board members, creating nominations policies
and procedures, preparing for the succession of executive management and the Board
...
Other Board Committees
Management – implements the strategic, ethical, and financial course of a company and also has the responsibility to
communicate to investors and the public about the company’s performance, financial condition and any changes in
strategy or corporate initiatives in an effective and timely manner
...
Study Session XII: Portfolio Management
Reading 49: The Asset Allocation Decision
Asset Allocation – is the process of deciding how to distribute an investor’s wealth among different countries and
asset classes for investment purposes
...
Life Cycle Net Worth
1
...
Consolidation Phase – past midpoint of their careers, have paid off much or all of their
debts and college bills
...
Spending Phase – typically beings when individuals retire
...
Gifting Phase – similar too and may be congruent with, the spending phase
...
Long-term, high priority goals- include some form of financial independence, such as the ability to retire at a certain
age
...
0 The Portfolio Management Process
1
...
The investor’s needs, as reflected in the policy statement, and financial
market expectations will jointly determine investment strategy
...
Examine current and projected financial, economic, political, and social conditions
3
...
Feedback loop
4
...
0 Input to the Policy Statement
- a careful analysis of the client’s risk tolerance should precede any discussion of return objectives
Investment Objectives – are his or her (investor’s) goals expressed in terms of both risk and return
...
Accomplished through capital
gains and reinvesting current income
Investment Constraints
Liquidity Needs, Time Horizon, Tax Concerns, legal, unique needs and preferences
...
Legal and Regulator Factors
Fiduciary – or trustee, supervises an investment portfolio of a third party, such as a trust account or
discretionary account
...
0 Constructing the Policy Statement
7
...
What asset classes should be considered for investment?
2
...
What is the allowable allocation ranges based on policy weights?
4
...
0 Markowitz Portfolio Theory
Markowitz Model Based On Assumptions Regarding Investor Behavior
1
...
Investors maximize one-period expected utility, and their utility curves demonstrate diminishing marginal utility
of wealth
3
...
Investors base decisions solely on expected return and risk, so their utility curves are a function of expected return
and the expected variance (or standard deviation) of returns only
...
For a given risk level, investors prefer higher returns to lower returns
...
Variance (Std
...
Correlation – a number between -1 and 1 that measures the co-movement (linear association) between to random
variables
Standard Deviation of a Portfolio
- The important thing to remember when adding an investment to a portfolio that contains a number of
other investments is not the new security’s own variance but its average covariance with all other
investments in the portfolio
...
0, indicates the ultimate benefits of diversification
...
This would be a risk free portfolio
...
- The benefits of diversification are critically dependent on the correlation between assets
The Efficient Frontier
- Represents that set of portfolios that has the maximum rate of return for every given level of risk or
the minimum risk for every level of return
...
Reading 51: An Introduction to Asset Pricing Models
2
...
All investors are Markowitz efficient investors who want to target points on the efficient frontier
2
...
All investors have homogenous expectations; they estimate identical probability distributions for future rates of
return
4
...
All investments are infinitely divisible; meaning it is possible to buy or sell fractional shares of any asset or
portfolio
6
...
There is no inflation or any change in interest rates, or inflation is fully anticipated
8
...
259
- Because the market is in equilibrium, it is also necessary that all assets are included in this portfolio
in proportion to their market value
...
- Separation Theorem – the proposition that the investment decision, which involves investing in the market
portfolio on the CML, is separate from the financing decision, which targets a specific point on the CML based on
the investor’s risk preference
- reading 51 shows that the only important consideration for any individual risky asset is its average covariance with
all the risk assets in the M portfolio, or simply, the asset’s covariance with the market portfolio (versus covariance
with other stocks in the portfolio as shown in reading 50)
...
0 CAPM: Expected Return and Risk
Beta – the standardized measure of systematic risk
...
Assets with estimated rates of return that plot below the SML would be considered overpriced
...
Positive if stock is undervalued or negative if stock is overvalued
...
When Expected Return < Required Return (CAPM), stock is overvalued
When Expected Return = Required Return (CAPM), stock is properly valued
When Expected Return > Required Return (CAPM), stock is undervalued
Characteristic Line - An asset’s characteristic line is a regression model used to derive the asset’s beta (systematic
risk input)
...
BOOK 5
Study Session 13: Analysis of Equity Investments, Security Markets
Reading 52: Organization and Functioning of Securities Markets
Market Attributes
- timely and accurate information
- liquidity
▪ marketability – an asset’s likelihood of being sold
- low transaction costs, including the cost of reaching the market, the actual brokerage costs, and the
cost of transferring the asset (internal efficiency)
- Prices that rapidly adjust to new information, so the prevailing price is fair since it reflect all
available information regarding the asset (external efficiency)
- Price Continuity – prices don’t change much from one transaction to the next unless substantial new
info is available
- Continuous Market is a characteristic of a liquid market
3
...
T-Bills – negotiable, non-interest bearing securities with original maturities of one year or less
T-Notes – maturities of 2 to 10 years
T-Bonds – original maturities of 10+ years
Muni Sales
- Competitive Bid – sealed bids sold to underwriter that submit bid with lowest interest costs
- Negotiated Sales – contractual arrangements
- Private placements - sale of bond issue by the issuer directly to investor or group of investors
Corporate Stock Issues
- Seasoned Equity Issues – new issues offered by firms that already have stock outstanding
- IPOs
- New Issues – underwritten by IBankers, and sold to interested investors
Rule 415 – allows large firms to register security issues and sell them piecemeal during the following two years (aka
shelf registration)
Private Placement – firm registers and IBanker sells to a small group of institutions
...
Rule 144A made this possible
...
- Provides liquidity to the individuals who acquired these securities in primary markets
...
Price Discovery – prevailing market price of securities
...
14 example
Stop-Loss Order: are limit sell orders that are placed below market price
...
For long position
...
Basic Trading Systems
Pure Auction Market – in which interested buyers and sellers submit bid-ask prices for a given stock to a central
location
Dealer Market – where individual dealers provide liquidity for investors by buying and selling the shares of stock
themselves
Call Market – intent is to gather all bids and asks for the stock at a point in time and attempt to arrive at a single
price where the quantity demanded is as close as possible to quantity supplied
Continuous Market – trades occur at any time the market is open wherein stocks are priced either by auction or by
dealers
5
...
Fourth Market Trading:
ECN – electronic facility that matches buy and sell orders via computer, for retail and small institutional trading
...
6
...
S
...
Specialists are expected to buy or sell against the market when prices are clearly moving in one
direction
...
Specialists ensure prices change in an orderly fashion
- numerous limit buy orders (bids) close to the current market and few limit sell orders (asks) might indicate a
tendency toward higher prices because demand is apparently heavy and supply is limited
CQS – Consolidated Quotation System – an electronic service that provides quotations on issues listed on the
NYSE, the AMEX, and regional exchanges
Intermarket Trading System – centralized quotation and routing system
Computer-Assisted Execution System – automates order routing and transaction execution for securities listed on
domestic exchanges that are part of ITS
...
DJIA – price weighted index of 30 large companies
Nikkei – arithmetic mean of prices for 225 stocks on the Tokyo stock exchange
...
Value-Weighted Index – is generated by deriving the total market value of all stocks used in the index
- Automatic adjustment for stock splits and other capital changes with a value-weighted index because
the decrease in the stock price is offset by an increase in the number of shares outstanding
...
Using geometric return to calculate performance causes
downward bias
...
Bond Price Volatility – affected by duration, which is likely changing because of changes in maturity, coupon, and
market yield
GSMI – is the most diversified benchmark available with a weighting scheme that approaches market values
...
Reading 54: Efficient Capital Markets
Efficient Capital Market – is one in which security prices adjust rapidly to the arrival of new information and
therefore, the current prices of securities reflect all information about the security
...
In terms of CAPM, all stocks should lie on SML
...
0 Efficient Market Hypothesis
Weak-Form EMH – assumes that current stock prices fully reflect all security market information, including the
historical sequence of prices, rates of return, trading volume data, and other market-generated information
...
Therefore, this hypothesis contends that
you should gain little from using any trading rule that decides whether to buy or sell a security
...
This hypothesis contends that investors who base their
decisions on any important new information after it is public should not derive above-average risk-adjusted profits
from their transactions
...
Means no
group of investors has monopolistic access to information relevant to the formation of prices and no group of
investors should be able to consistently derive above-average risk adjusted rates of return
...
0 Tests and Results of EMH
Statistical Tests of Independence:
Weak Form Tests:
1
...
Autocorrelation tests
b
...
Tests of Trading Rules
▪ require lots of subjective interpretation of data to simulate mechanically
▪ almost infinite number of rules makes it impossible to test them all
▪ more trading in a security should promote market efficiency
Results:
- Small filters yield above-average profits before taking account of trading commissions
...
- Test results generally support the weak-form EMH
- If capital markets are weak form efficient, then prices reflect all relevant market information so technical tradingsystems that depend only on past trading data cannot have any value
...
Semistrong-Form Tests:
4
...
Involves time-series analysis or cross-sectional analysis of returns
▪ Time series analysis assumes that in an efficient market the best estimate of future
returns will be historical rates of return
...
The
results generally indicated abnormal returns during the 13 or 26 weeks following the announcement of
large unanticipated earnings change, a surprise
...
Firms
gain abnormally in the first few days of January
...
On the other hand, the
return on the first trading day of the week is usually negative
...
PEG Ratios – mixed results to support semi-strong form
...
Neglected Firms and Trading Activity
Book Value – Market Ratio – studies that have used publicly available ratios to predict the cross section of
expected returns for stocks have provided substantial evidence in conflict with the semi-strong form EMH
...
Event Studies - examine how fast stock prices adjust to specific significant economic events
...
Exchange Listing – listing studies that provide some evidence of short-run profit opportunities for investors
using public information would not support the semistrong-form EMH
...
0 Behavioral Finance
- considers how various psychological traits affect the ways individuals or groups act as investors, analysts, and
portfolio managers
Biases
Prospect Theory – which contends that utility depends on deviations from moving reference points rather than
absolute wealth
...
Overconfidence Bias – overconfidence in forecasts, which causes analysts to overestimate growth rates for growth
companies and overemphasize good news and ignore negative news for these firms
Confirmation Bias – whereby investors look for information that supports their prior opinions and decisions
...
Averaging down
...
Portfolio Management without Superior Analysts
- manager should measure the risk preferences of his or her clients, then build a portfolio to match this
risk level by investing a certain proportion of the portfolio in risky assets and the rest in a risk-free
asset
...
minimize taxes
2
...
when you trade, minimize liquidity costs by trading relatively liquid stocks
If you lack access to superior analysts:
1
...
Construct the appropriate risk portfolio by dividing the total portfolio between risk-free assets and a risky asset
portfolio
3
...
Maintain the specified risk level by rebalancing when necessary
5
...
Cost of Information – prices take time to reflect new information because obtaining and processing that
information is costly
2
...
If short
selling is more difficult than buying long, then prices are likely to be biased upward
...
Limits of Arbitrage – in an instance where no close substitutes are available, mispricing of a security may persist
indefinitely
Mispricing – is any predictable deviation from a normal or expected return
...
Causes of Discovered Market Anomalies:
Data Mining – the practice of determining a model by extensive searching through a dataset for statistically
significant patterns
Out-of-Sample Test – testing the same relationship using data from a different country or an entirely different
period
...
Why Does a Mispricing Exist
1
...
2
...
Profit Potential is Insufficient
4
...
Behavioral Biases may affect investment decisions
Study Session 14: Analysis of Equity Investments, Industry And Co
...
116 chart
- a restrictive monetary policy that reduced the growth rate of the money supply reduces the supply of funds for
working capital and expansion for all businesses
...
Three-Step Valuation Process
1
...
Analyze Industry Influences
3
...
What proportion of your portfolio will be invested in various nations economies?
2
...
your industry selections, based on which industries are expected to prosper in the projected economic
environment?
Required Rate of Return Determined By
1
...
I ~ the expected rate of inflation during the holding period, PLUS
3
...
Rf + I + Rp
If Estimated Intrinsic Value > Market Price, Buy
If Estimated Intrinsic Value < Market Price, Don’t Buy or Sell if you own it
Valuation of Preferred Stock
Price = Dividend
kp
kp = return on preferred stock
kp = Dividend
Price
Discounted Cash Flow Techniques
Approaches to Equity Valuation
Relative Valuation Techniques
Present Value of Dividends (DDM)
Price/Earning Ratio (P/E)
Present Value of Operating Free Cash Flow Price/Cash Flow Ratio (P/CF)
Present Value of Free Cash Flow to Equity Price/Book Value Ratio (P/BV)
Price/Sales Ratio (P/S)
Infinite Period DDM and Growth Companies Assumptions:
1
...
The constant growth rate will continue for an infinite period
3
...
6
...
the expected dividend payout ratio (dividends divided by earnings)
2
...
the expected growth rate of dividends for the stock (g)
Price/Cash Flow Ratio
P/CFj = Pt
CFt+1
Price/Book Value Ratio
Book Value = SHE – Total Value of Equity Claims Senior to Common Stock = Common SHE
Book Value Per Share = Common SHE / Common Outstanding
P/BVj = Pt
BVt+1
Price/Sales Ratio
Sales per Share =Net Sales / Shares Outstanding
P/Sj = Pt
St+1
7
...
The economy’s real risk-free rate (RRFR)
2
...
A risk premium
Nominal Risk Free Rate of Return (NRFR)
NRFR = [1 = RRFR][1 + E(I)] - 1
Estimating NRFR for a Foreign Country
NRFR = (1 + Real Growth) x (1 + Expected Inflation) - 1
Expected Growth Rates
g = (Retention rate) x (Return on Equity)
= RR x ROE
= (1 – Payout Ratio) x ROE
= (1 – Div/EPS) x ROE
ROE =
Net Income
Sales
x
Sales
x
Total Assets
Total Assets
Equity
= (Profit Margin)
x
(Total Asset Turnover) x
(Financial Leverage)
Reading 57: Industry Analysis
1
...
Demographics
2
...
Changes in Technology
4
...
Defensive Company – those whose future earnings are likely to withstand an economic downturn
...
Second, it may be a stock with a low or negative systematic risk
Cyclical Company – is one whose sales and earnings will be heavily influenced by aggregate business activity
...
estimate P/E relationships between company, its industry, and the market
2
...
the number of stock holders
2
...
number of shares traded
4
...
Reading 59: An Introduction to Price Multiples
- the critical relationship that determines the value of a stock is the spread between the required rate of
return (k) and the expected growth rate of dividends (g)
...
Price / Earnings
Rationales for Using Price to Earnings Ratios:
- Earning power is a chief driver of investment value, and EPS is perhaps the chief focus of security analyst
attention
...
Earnings often have volatile, transient components, however, making the analyst’s task difficult
...
Distortions can affect the comparability of P/Es across
companies
...
Price / Cash Flow
Rationales for Using Price to Cash Flow Ratios:
- cash flow is less subject to manipulation by management than earnings
- cash flow is generally more stable than earnings, P/CF is generally more stable than P/E
...
We can us P/FCFE ratios,
but FCFE does have the possible drawback of being more volatile compared to CF, for many
business
...
3
...
For such companies, book values of assets may
approximate market values
- Book value has also been used in valuation of companies that are not expected to continue as a going
concern
- Differences in P/Bs may be related to differences in long-run average returns, according to empirical
research
Drawbacks to using P/B in practice include:
- Other assets besides those recognized in accounting may be critical operating factors (human capital)
- P/B can be misleading when significant differences exist among companies examined in terms of the level
of assets used
...
BV can understate shareholders’ investment as a result of the expensing of investment in R&D
- book value largely reflects the historical purchase costs of assets including accumulated depreciation
...
As a result, BV can poorly reflect the value of shareholder investments
...
Price / Sales
Rationales for Using Price to Sales:
- Sales are generally less subject to distortion or manipulation than are other fundamentals, such as EPS or
book value
...
- Because sales are more stable than EPS, P/S is generally more stable than P/E
...
- P/S has been viewed as appropriate for valuing the stock of mature, cyclical, and zero-income companies
- Differences in P/S ratios may be related to differences in long-run average returns, according to empirical
research
...
To have value as a going concern, a business must ultimately generate
earnings and cash
...
- Although relatively robust with respect to manipulation, revenue recognition practices offer the potential
to distort P/S
...
Factors influencing company’s rate required rate of return
1
...
expected rate of inflation
3
...
Trailing P/E (TTM) = current market price / most recent four quarters EPS
Forward P/E = current market price / next years expected earnings
Normal EPS Calculations
The method of historical average EPS – Normal EPS is calculated as average EPS over the most recent full cycle
The method of average ROE – normal EPS is calculated as the average ROE from the most recent full cycle,
multiplied by the current book value per share
...
- one of the advantages of using both P/BV and P/S is that they are well suited to situations involving negative EPS
or when EPS is highly variable because both book value and sales tend to be more stable than EPS
...
- both sales and CF are less subject to distortion or manipulation by management than earnings
...
Study Session 15: Fixed Income: Basic Concepts
Reading 60: Features of Debt Securities
2
...
Affirmative Covenants – set forth what activities the borrower promises to do
Negative Covenants – sets forth limitations and restrictions on the borrower’s activities
...
0 Maturity
Term to Maturity – is the number of years the debt is outstanding or the number of years remaining prior to final
principal payment
4
...
0 Coupon Rate
Coupon Rate – also called the nominal rate, is the interest that the issuer agrees to pay each year
...
Step-Up Notes – bonds that have a coupon rate that increases over time
...
Call Provision – the right of the issuer to retire the issue prior to the stated maturity date
...
Single Call Price Regardless of Call Date - pg
...
Call Price Based on Call Schedule – pg
...
Call Price Based on Make-Whole Premium – provides a formula for determining the premium that an
issuer must pay to call an issue
...
249
Par-Call Problem – an investor’s concern that an issuer will use all means possible to maneuver a call so that the
special redemption price applies
Sinking Fund Provision – issuer’s requirement to retire a specified portion of the issue each year
Accelerated Sinking Fund Provision – issuer’s requirement to retire more than specified portion of issue
Convertible Bond – is an issue that grants the bondholder the right to convert the bond for a specified number of
shares of common stock
Exchangeable – exchangeable for another company’s stock
Put Provision – grants bondholder right to sell issue back to issuer at specified price on designated dates
...
Common Embedded Options to Issuers
1
...
the right of the underlying borrowers in a pool of loans to prepay principal above the scheduled principal
provision – more valuable (to issuer)
3
...
the cap on a floater – becomes more valuable (to issuer) when interest rates rise
Common Embedded Options to Bondholders
1
...
Right to put the issue – benefits bondholder if interest rates rise above the issue’s coupon rate
3
...
Repo rate – the borrowing rate for a repurchase agreement which is less than the cost of bank borrowing
...
0 Interest Rate Risk – the risk an investor faces is that the price of a bond held in a portfolio will decline if market
interest rates rise
...
General Bond Rules for Interest Rates:
1
...
A bond will trade at a price below par (sell at a discount) or above par (sell at a premium) if the coupon rate is
different from the yield required by the market
...
The price of a bond changes in the opposite direction to the changes in interest rates
...
Impact of Coupon Rate – all else equal, the lower the coupon rate, the greater the bond’s price sensitivity to changes
in interest rates
...
Impact of Embedded Options:
- as interest rates decline, the price of a callable bond may not increase as much as an otherwise option free bond
...
- when interest rates rise, the price of a callable bond will not fall as much as an otherwise option free bond because
the price of the embedded call option declines
...
Price of Callable Bond = Price of Option-free Bond – price of call option
- the reason for subtracting the price of the embedded call option from the price of the option free bond is that the
call option is a benefit to the issuer which reduces the price of a callable bond relative to an option-free bond
...
Duration = Price if Yields Decline – Price if Yields Rise
2 x (Initial Price) x (Change in Yield in Decimal)
- it is important to note that the computed duration of a bond is only as good as the valuation model used to get the
prices when the yield is shocked up and down
...
3
...
The implication is that any measure of interest
rate risk that assumes that the interest rates changes by an equal number of basis points for all maturities is only an
approximation
4
...
the cash flow pattern of a callable bond is not known with creativity
2
...
3
...
5
...
- Reinvestment risk is even greater with amortizing securities (which pay interest and principal monthly)
- zero coupon bonds have NO reinvestment risk
6
...
Default risk – the risk that the issuer will fail to satisfy the terms of the obligation with respect to timely payment
of interest and principal
2
...
The part of the risk
premium or yield spread attributable to default risk is called the credit spread
...
Downgrade risk – a reduction in the quality of an debt issue or issuer’s debt profile
Non-investment grade bonds (Below BBB)
7
...
- is the risk that the investor will have to sell a bond below its indicated value, where the indication is revealed by a
recent transaction
...
8
...
0 Inflation Risk – all investors exposed to this except those holding inflation protection bonds
...
10
...
Price of Callable Bond = Price of option-free bond – Price of embedded call option
- if expected yield volatility increases, the price of the embedded call option increases, and the price of the callable
bond declines
Price of Putable Bond = Price of option-free bond + Price of embedded put option
- if the expected yield volatility decreases, the price of the embedded put option decreases, and the price of the
putable bond declines
Type of Embedded Option Volatility Risk Due to:
Callable Bonds
Putable Bonds
An increase in expected yield volatility
A decrease in expected yield volatiltiy
11
...
0 Sovereign Risk – is the risk that, as a result of actions of the foreign government, there may be either a default
or an adverse price change even in the absence of a default
...
Changes in slope of yield curve – highlight the need for risk measures such as “rate duration” and “key rate
duration”
Bonds financed by repurchases agreements have more liquidity risk than bonds held as part of a buy-and-hold
strategy
...
- yield volatility increases price of embedded option
Reading 62: Overview of Bond Sectors and Instruments
Yankee Bonds – A bond denominated in U
...
dollars and is publicly issued in the U
...
by foreign banks and
corporations
...
Eurodollar – dollar deposited outside the United States
3
...
regular auction cycle/multiple-price method
2
...
ad hoc auction method
4
...
Coupon is called the “real rate”
Brady Bonds – represent a restructuring of nonperforming bank loans to emerging market governments into
marketable securities
Collateralized Mortgage Obligation (CMO) – the motivation for creation of a CMO is to distribute prepayment risk
among different classes of bonds
...
0 State and Local Governments
5
...
Includes:
1
...
Unlimited is stronger because it is secured by the
issuer’s unlimited taxing power
...
Appropriation-Backed Obligations – bonds requiring legislative approval
3
...
2 Revenue Bonds – are issued for enterprise financings that are secured by the revenues generated by the
completed projects themselves, or for general purpose financing in which the issuers pledge to the shareholders the
tax and revenue resources that were previously part of the general fund
5
...
1 Insured Bonds – muni-bond insurance usually extends for the term of the bond issue and cannot be canceled by
the insurance company
...
Chapter 7 – liquidation of company
Chapter 11 – reorganization of company
4 C’s of Credit – character, capacity, collateral, covenants
Collateral Trust Bonds – a mortgage bond wherein the assets backing the bond are financial assets like stocks and
bonds
Debenture Bonds – unsecured debt
Negative Pledge Clause – found in most senior unsecured debt issues, prohibits a company from creating or
assuming any lien to secure a debt issue without equally securing the subject debt issue (s) with certain exceptions
...
Structured Notes – MTNs created when the issuer simultaneously transacts in the derivative market
Deleveraged Floater – is a floater that has a coupon formula where the coupon rate is computed as a fraction of the
reference rate plus a quoted margin
Dual-Indexed Floater – fixed percentage between two reference rates
Range Note – a floater whose coupon rate is equal to the reference rate as long as the reference rate is within a
certain range at the reset date
Index Amortizing Note – is a structured note with a fixed coupon rate but whose principal payments are made prior
to the stated maturity date based on the prevailing value for some reference interest rate
...
5 Commercial Paper – is a short-term unsecured promissory note that is issued in the open market and represents
the obligation of the issuing corporation
...
Rolling over risk is mitigated by
unused bank credit lines
...
Created for the importing of
goods, the exporting of goods to foreign entities and the storing and shipping of goods between two foreign
countries where neither the importer nor the exporter is a U
...
firm and the storing and shipping of goods between
two U
...
entities in the US
...
Liquidity risk
is not a concern though to investors who plan to hold the note to maturity
...
0 Asset-Backed Securities
Special Purpose Vehicle – a legal entity that a corporation sells the assets to
...
Created as a form of credit enhancement, although is not cheap so it doesn’t always make sense
to set up an SPV
...
8
...
It is a product backed by a diversified pool of one or more types of debt obligations
...
0 Primary and Secondary Market for Bonds
Primary Market – involves the distribution to investors of newly issued securities by central govts, its agencies,
muni govts, and corporations
...
Each
coupon would be a treasury strip, and the principal would form the basis of the fifth strip
...
- Mortgage passthrough securities show some reduction in prepayment risk due to diversification, but
prepayment risk is not eliminated
- Debentures are unsecured
9
...
- Secondary markets offer bond investors liquidity as well as information about fair or consensus values
...
- bond can trade on an exchange or in an OTC market
Reading 63: Understanding Yield Spreads
2
...
Open market operations – Fed’s buying and selling of U
...
Treasury securities
...
2
...
3
...
Verbal persuasion to influence how bankers supply credit to businesses and consumers
3
...
S Treasury Rates
T-Bills – zero coupon issues with a maturity at issuance of one year or less
...
T-Notes – coupon securities with issue greater than one year but not greater than 10 years
...
interest rate risk
2
...
yield curve risk
4
...
credit risk – perception is that Treasury securities have no credit risk
6
...
exchange-rate risk
8
...
inflation on purchasing power risk
10
...
3
...
1
...
Asserts that the yield premium increases with maturity
...
Expectations about future interest rates
2
...
3
...
1
...
Preferred Habitat Theory – argues that investors prefer to invest in particular maturity sectors as dedicated
by the nature of their liabilities
...
0 Yields on Non-Treasury Securities
Yield Spread = Yield on Bond X – Yield on Bond Y
Absolute Yield Spread = Yield on Bond X – Yield on On-The-Run Treasury
Relative Yield Spread = Yield on Bond X – Yield on Bond Y
Yield on Bond Y
Yield Ratio = Yield on Bond X
Yield on Bond Y
*Yield on Bond Y = Yield on On-The-Run Treasury when comparing bond’s to the Treasury (reference bond)
...
relative credit risk of the two issues
2
...
liquidity of the two issues
4
...
For a bond with an option favorable to an investor, the interest rate may even be less than that
on a comparable Treasury security
...
- the higher the marginal tax rate, the higher the taxable equivalent yield
...
4
...
A measure of the degree
to which a bond’s price-yield curve departs from a straight line
...
Coupon rate = yield required by market, therefore price = par value
Coupon rate < yield required by market, therefore price < par value (discount)
Coupon rate > yield required by market, therefore price > par value (premium)
As a bond moves closer to its maturity date, its value changes
...
bond value decreases over time if the bond is selling at a premium
2
...
is unchanged if the bond is selling at par
2
...
divide coupon rate by 2
b
...
multiply t by 2
2
...
Interest earned by the seller (before settlement date) – accrued interest
2
...
Determine the fractional periods between settlement date and the next coupon date
w periods = Days between settlement date and next coupon payment date
Days in Coupon Period
2
...
Days in Accrued Interest Period = Days in Coupon Period – Days between settlement and next coupon
B
...
AI = Semiannual Coupon Payment x (1 – W)
Or
AI = (Annual Coupon / 2 ) x ( Days in AI Period / Days in Coupon Period)
D
...
The current yield will be greater than
the coupon rate when the bond sells at a discount
...
Considers the coupon income and any capital gain or loss
...
The
YTM is only realizable if:
1
...
The bond is held to maturity
Bond Equivalent Yield – the market convention adopted to annual the semiannual YTM is to double the regular
YTM
Par Bond
Coupon rate = current yield = yield to maturity
Discount Bond Coupon rate < current yield < yield to maturity
Premium Bond
Coupon rate > current yield > yield to maturity
3
...
3 Factors Affecting Reinvestment Risk
1
...
2
...
- a bond selling at a discount will be less dependent on reinvestment income than a bond selling at par because a
portion of the return is coming from the capital gain due to accrediting the price discount when holding the bond to
maturity
- for zero coupon bonds, none of the bond’s total dollar return is dependent on reinvestment income
...
Yield to Call assumes:
1
...
the issuer will call the bond on that date
Yield to Put – is the interest rate that will make the PV of the cash flows to the first put date equal to the price plus
accrued interest
Yield to Worst – given a bond with multiple potential maturity dates and prices due to embedded call options, the
practice is to calculate a YTM for each of the call dates and prices and select the lowest yield
4
...
e
...
Z-Spread – represents a spread to compensate for the non-Treasury security’s credit risk, liquidity risk, and any
option risk
...
OAS – in the case of a putable bond, the OAS is greater than the Z-Spread so that the option cost is negative
...
Negative
means one has been purchased
...
Spread Measure Benchmark
Reflects Compensation For
Nominal
Treasury yield curve
Credit risk, option risk, liquidity risk
Zero-volatility Treasury spot rate curve Credit risk, option risk, liquidity risk
Option-adjusted Treasury spot rate curve Credit risk, liquidity risk
- the short term forward rate curve lies above the other t-yield curve and the treasury theoretical spot
rate curve if the par yield curve is upward sloping
...
Reading 66: Introduction to the Measurement of Interest Rate Risk
Properties Concerning the Price Volatility of an Option-Free Bond:
1
...
2
...
Underestimates increases in price, overestimates decrease in price when
using duration for valuation of option free
...
For larger changes in yield, the percentage price change is not the same for an increase in yield as it is
for a decrease in yield
4
...
- Exhibits negative convexity at low yield levels and positive convexity at high yield levels
...
As rates rise, the price of the putable bond declines, but the price decline is
less than that for an option free bond
...
IT is the approximate
percentage change in price for a 100bps change in rates
...
- the higher the level of yields, the lower the price volatility of a bond to changes in interest rates
- the greater the expected yield volatility, the greater the interest rate risk for a given duration and current value of a
position
Value at Risk (VaR) – risk in this framework is defined as the maximum estimated loss in market value of a given
position that is expected to occur with a specified probability
...
2 Approximating the Percentage Price Change Using Duration
Approximate percentage price change = -Duration x DeltaY x 100
DeltaY = the yield change (in decimal) for which the estimated percentage is sought
4
...
0 Price Value of a Basis Point
PVPB = │Initial Price – Price if Yield is changed by 1 basis point │
BOOK 6
Study Session XVII: Derivative Instruments
Reading 67: Derivative Markets and Instruments
Derivative – is a financial instrument that offers a return based on the return of some other underlying asset
...
Price set in advance
...
NO MONEY CHANGES HANDS AT START
- subject to default
- constructed with idea that participants will hold on to their positions until the contract expires
...
Standardized in the sense that the exchange determines the expiration dates, the underlying, how many
units of the underlying are included in one contract and various other terms and conditions
...
Have a secondary market
...
Private transactions
Option – gives party the right, but not the obligation, to buy or sell an underlying asset from one party at a fixed
price over a specific period of time
- Options do not so much reveal prices as they reveal volatility!
Contingent Claim – Derivatives in which the payoffs occur if a specific event occurs; generally referred to as
options
...
0 Purpose of Derivative Markets
Price Discovery – serve to provide information about an asset’s worth in the future
Risk Management – the process of identifying the desired level of risk, identifying the actual level of risk, and
altering the latter to equal the former
...
0 Elementary Principle of Derivative Pricing
Arbitrage – occurs when equivalent assets or combinations of assets sell for two different price
Law of One Price – the principle that no arbitrage opportunities should be available
- Disbelief and skepticism concerning the absence of arbitrage opportunities are required in order that it holds as a
legitimate principle
...
1 Delivery and Settlement of a Forward Contract
Delivery - A deliverable forward contract stipulates that the long will pay the agreed-upon price to the short,
who in turn will deliver the underlying asset to the long
Cash Settlement – permits the long and short to pay the net cash value of the position on the delivery date
NDF – nondeliverable forwards, also known as cash-settled forward contracts
1
...
1
...
Long can enter into offsetting contract with same counterparty as original contract, or a new
counterparty
...
0 Types of Forward Contracts
Equity Forwards
- Some equity forwards on stock indices are based on total return indices
...
Payoff of any forward contract based on it, reflects the payment and reinvestment of dividends
into the underlying index
...
Discount Interest: If a 180-Day T-bill is selling at a discount of 4%, its price per $1 par will be
$1 – 0
...
98
Interest Rate Forwards
- forward rate agreement (FRA) or interest rate forward are contracts in which the underlying is neither a bond nor a
Eurodollar or Euribor deposit but simply an interest payment made in dollars
...
Euribor – rate at which foreign banks lend euros
...
2 Public Standardized Transactions
Exchange Stipulates: expiration date, how far the expirations go out into the future, decides which
expiration months are appropriate for trading, specific day of expiration, contract size, what hours of the
day trading takes place, at what physical location on the exchange the contract will be traded
...
3 Homogenization and liquidity
- standardizing the instrument makes it more acceptable to a broader group of participants, with the
advantage being that the instrument can then more easily trade in a type of secondary market
...
1
...
- gains and losses on each party’s position are credited and charged on a daily basis, daily settlement or
marking to market
...
5 Regulation
- In mot countries, futures contracts are regulated at the federal government level
Offsetting – at some point in the life of the contract prior to expiration, the long may wish to re-enter the market and
close out the position
...
Maintenance Margin Requirement – is lower than the initial margin requirement
...
The amount of funds deposited (variation margin) at end of trading day when
account balance falls below the maintenance margin requirement will bring the account back up to the
initial margin requirement
...
0 Delivery and Cash Settlement
- When the exchange designs a futures contract, it specifies whether the contract will terminate with delivery or cash
settlement
...
Short often has other
choices regarding delivery, a major one being exactly which underlying asset is delivered
...
0 Futures Exchanges Participants:
Scalper – offers to buy or sell futures contracts, holding period open for only a brief period of time (seconds
or minutes)
Day Trader – holds a position open longer than scalper but closes all positions at end of day
Position Traders – holds positions open overnight
- a clearinghouse in futures contracts allows for the offsetting of contracts prior to delivery
- a clearinghouse in futures contracts collects initial margin (performance bonds) from both the long and short sides
of the contract
- the short initiates the delivery process
- for many such business contracts, delivery can take place any business day during the delivery month
Types of Futures Contracts - Commodity and financial futures
1
...
Eurodollar Futures
Futures Price = 100 – (Rate/100)(Days to Expriation/360)
3
...
Conversion Factor – an adjustment used to facilitate delivery on bond futures
b
...
4
...
Currency Futures Contracts
- Currency futures contracts call for actual delivery, through book entry, of the underlying currency
...
Always true for American options but not
always for European options
...
- one would not necessarily exercise an in-the-money option, but one would never exercise an out-of-themoney option
LEAPS – long-term equity anticipatory securities – options with expirations of several years
Interest Rate Call – is an option in which the holder has the right to make a known interest rate payment and receive
an unknown interest payment
...
Interest Rate Floor – combination of interest rate puts; is a series of put options on an interest rate, with each option
expiring at the date on which the floating loan rate will be reset, and with each option having the same exercise rate
...
Can eliminate
upfront cash outlay for the option premium, known as zero-cost collar
...
1 Payoff Values
Intrinsic Value – is what the option is worth to exercise it based on current conditions
...
OPTIONS:
- Generally, we can say that the higher the exercise price, the lower the price of a call and the higher the price of a
put
...
Because this statement is always true, the longer-term call, European or American, is worth no less than the
shorter-term call at any time prior to expiration
- as long as there is a possibility of bankruptcy, the American put will be worth more than the European put
Options Strategies:
Fiduciary Call – consists of a European call and a risk-free bond
...
Protective Put – consists of a European put and the underlying asset
Put-Call Parity – an equation expressing the equivalency (parity) of a portfolio of a call and a bond with a portfolio
of a put and the underlying, which leads to the relationship between put and call prices
...
Call Options
- at expiration, a call option is worth either zero or the difference between the underlying price and the exercise
price, whichever is greater:
c0, cT = Max(0, ST -X)
C0,CT = Max(0, ST -X)
- the minimum value of any option is 0
...
- When interest rates are higher, call options prices are higher and put option prices are lower
...
- Upside effect helps calls and does not hurt puts
- Downside effect does not hurt calls and helps puts
...
Put Options
- at expiration, a put option is worth either zero or the difference between the exercise price and the underlying price,
whichever is greater:
p0, pT = Max(0, X - ST)
P0,PT = Max(0, X - ST)
- the minimum value of any option is 0
...
T
p0 ≤ X / (1 + r)
- The maximum value of an American put is the exercise price
P0 ≤ X
- The lower bound on a European put is the greater of either zero or the present value of the exercise price minus the
underlying price
T
p0 ≤ [0, X / (1 + r) - S0]
P0 ≤ X- pg
...
- for European puts, either the longer-term or the shorter-term option can be worth more
...
- Higher volatility increases call and put option prices because it increases possible upside value and increases
possible downside values of the underlying
...
- does not hurt because when its already out-of-the-money, being more or less outside of the money at
expiration is indifferent
...
- with respect to put-call parity, a protective put consists of a European put option and the underlying asset
- if too high an estimate of volatility is interest into a computer program, both the put and the call values given by
the program would be too high
...
The entire premium of the $60 call reflects
time value, only a part of the $50 strike call’s premium is time value, the rest is intrinsic value
Reading 71: Swap Markets and Contracts
Swap – an agreement between two parties to exchange a series of future cash flows
...
When a swap is initiated, neither party pays any amount to the other
...
Swap market is almost exclusively an OTC market
...
2 Terminating a Swap Early
1
...
Sell the swap to another counterparty
3
...
Thus,
a party could use a swaption to enter into an offsetting swap
...
Interest Rate Swaps:
Plain Vanilla Swap – is simply an interest rate swap in which one party pays a fixed rate and the other pays a
floating rate, with both sets of payments in the same currency
...
The party making the fixed-rate payment could also have to make a variable payment based on the equity return
2
...
Rate of return is often structured to include both dividends and capital gains
...
Reading 72: Risk Management Applications of Option Strategies
Call Option Buyer
Call Option Seller
CT = max(0, St – X)
CT = max(0, St – X)
Value at expiration: CT
Value at expiration: -CT
Profit: Π = CT – C0
Profit: Π = -CT – C0
Maximum Profit: ∞
Maximum Profit: C0
Maximum Loss: C0
Maximum Loss: ∞
Breakeven: St* = X + C0
Breakeven: St* = X + C0
Put Option Buyer
Put Option Seller
PT = max(0, X - ST)
Ct = max(0, X – ST)
Value at expiration: PT
Value at expiration: - PT
Profit: PT – P0
Profit: -PT – P0
Maximum Profit: X – P0
Maximum Loss:
Maximum Profit: P0
P0
Breakeven: St* = X - P0
Maximum Loss: X – P0
Breakeven: St* = X - P0
- Seller of a call can incur an infinite loss
...
Summary Option Pricing Pages
152, 153, 156, 160, 164
Covered Call – is a position in which you own the underlying and sell a call
Value at Expiration: Vt = St – Max(0, St – X)
Profit: Π = Vt – S0 – C0
Maximum Profit: X – S0 + C0
Maximum Loss: S0 - C0
Breakeven: St* = S0 - C0
Protective Put - holding an asset and a put on the asset
...
Value at Expiration: Vt = St + Max(0, X - St)
Profit: Π = Vt – S0 – P0
Maximum Profit: ∞
Maximum Loss: S0 + P0 - X
Breakeven: St* = S0 + P0
Collar – selling a call to generate premium income to pay for the purchase of the put
...
Price is determined in the secondary markets in which
they trade, and, consequently, can be at a premium or discount to NAV
...
Open-End Investment Company – a type of investment fund where the number of investors and the total committed
capital is not fixed (open for subscriptions and redemptions)
...
Liquidity provided by
management company
...
- only management fees can be considered a portfolio management incentive fee
- by setting an initial selling price above the NAV, the unmanaged company charges a fee for the effort of setting up
the fund
...
Discourage quick trading turnover and decline over
time (sometimes called contingent deferred sales charges)
12-B1 Fees – distribution expenses
...
Share
value usually equals NAV in open-end fund
...
Legal Structures of ETFs in United States
1
...
Sector SPDRs, iShares and WEBS
2
...
3
...
When there is excess demand for ETF shares, an
authorized participant will create a creation unit by depositing with the trustee of the fund the specified portfolio of
stocks used to track the index
...
Redemption is simply reversed
...
Does not create a tax
burden for the remaining ETF shareholders under current U
...
tax law
...
Redemption in cash by individual ETF shareholders is discouraged in two ways:
1
...
So, the redemption value is unknown when the investor decides to redeem
...
2
...
It is more advantageous for individual shareholders to
sell their shares on the market than to redeem them in cash
...
Diversification can be easily obtained with a single ETF transaction
...
Trade similar to a stock on an organized exchange and can be sold short and bought on margin
3
...
4
...
5
...
6
...
7
...
8
...
Dividends are reinvested immediately for open end ETFs (but not for UIT ETFs)
...
in many countries, ETFs are only available for large market cap stocks
...
many investors do no require intraday trading opportunity provided by ETFs
3
...
for institutional investors, they can invest directly in an indexed or actively managed international portfolio with
costs that could be less, and a tax situation equivalent or better
Types of ETFs:
1
...
Style ETFs
3
...
Country or Region
5
...
Market Risk – affects all
2
...
Trading Risk - affects all
4
...
Derivatives Risk
6
...
Implementing Asset Allocation
2
...
Gaining Exposure to International Markets
4
...
It is also used to take a given amount of cash and turn it
into an equity position while maintaining the liquidity provided by the cash
5
...
Completing Overall Investment Strategies
7
...
Applying Relative Value, long/short strategies
...
0 Real Estate
REIT – are a type of closed-end investment company traded on the stock market that issue shares
...
Do not issue shares
...
Free and Clear Equity
2
...
Mortgage – a form of real estate investment because lender may end up owning real-estate
...
Aggregation Vehicles
Characteristics of Real Estate as an Investible Class:
1
...
Though unique, even art is movable and thus not as unique
as real estate
...
Properties are only approximately comparable to other properties
3
...
There is no national, or international, auction market for properties
...
5
...
Real estate markets suffer inefficiencies because of the nature of real estate itself and because information is not
freely available
...
Sales Comparison Approach – market value is estimated relative to a benchmark value
Hedonic Price Estimation – in this method, the major characteristics of a property that can affect its value
are identified
...
Discounted After-Tax Flow Steps:
1a
...
To get after-tax cash flow from after-tax net income
After-Tax NOI + Depreciation – (Mortgage Payment – Interest Portion)
4
...
Seed-stage – financing provided for business idea
...
Early-stage – capital provided for companies moving into operation and before commercial manufacturing and
sales have occurred
...
Start-Up – for companies just moving into operation but without any commercial product or service
sales
...
First-Stage – financing is capital provided to initiate commercial manufacturing and sales
3
...
Later Stage – financing is capital provided after commercial manufacturing and sales have begun but before any
IPO
a
...
Third-Stage – is capital provided to prepare for major expansion, such as physical plant expansion,
product improvement, or a major marketing campaign
c
...
2 Venture Capital Investment Characteristics
1
...
Long-term commitment required
3
...
Limited Historical risk and return data
5
...
Fund manager incentive mismatches
7
...
Vintage Cycles – some years are better than others
...
Extensive Operations Analysis and Advice may be required
Parameters that enter into valuing a venture capital project
1
...
an assessment of the time it will take to exit the venture successfully
3
...
5
...
Long/Short Funds – taking short and long bets in common stocks
b
...
Could involve simultaneous long and short positions in closely related securities with a zero net exposure to the
market itself
...
Global Macro Funds – take bets on the direction of a market, a currency, an interest rate, a commodity, or any
macroeconomic variable
1
...
Emerging-market Funds – primarily take bets on all types of securities in emerging markets
d
...
Distressed Securities Funds – manager invests in debt and/or equity of companies having financial
difficulty
2
...
5
...
Retailing
b
...
Diversification
d
...
Due Diligence Process
5
...
2 Unique Hedge Fund Risks
1
...
Pricing Risk
3
...
Settlement Risk – refers to failure to deliver the specified security or money by one of the parties to the
transaction on the settlement day
5
...
Financing Squeeze
5
...
1 Hedge Fund Track Records
- tend to have net return after fees that are higher than equity markets and bond markets
- tend to have lower risk (measured by standard deviation)
- Sharpe ratio not really appropriate
...
Correlation of hedge funds with conventional investments is generally low, though still positive
...
Hedge Fund Reporting Biases
1
...
Backfilling Bias
3
...
Survivorship Bias: Risk - understated
5
...
Option-like Investment Strategies
7
...
0 Closely Held Companies and Inactively Traded Securities Valuation Alternatives:
1
...
The Comparable Approach
3
...
7
...
Reading 74: Investing in Commodities
1
...
Contango – a situation in a futures market where the current futures price is greater than the current spot price for
the underlying asset
...
- Frequently occurs when commodity’s price is high and volatile
...
At the same time, investors are attempting to hedge inflation risk
...
- roll-yield negative to long investor when market is in contango
Backwardation – the opposite of contango is when the forward price of futures price of a commodity is below its
spot price
...
- roll yield return to the long investor is positive when the market is in backwardation
Sources of Return for LONG-ONLY investments in commodities –
1
...
Roll or convenience yield – return from rolling forward the maturity of the derivatives position
3
...
0 Commodity Controversies
- commodity prices decline because of the introduction of new supplies and new production technology,
substitution of one commodity for another when prices rise, and reduction of certain commodities in
technological processes
- Most of the fluctuation in commodity prices come from the demand side of the equation
Roll Yield – is the yield that has historically existed in situations when the forward price is below the spot price
...
The rolling cost is the cost to sell the maturing contract and buy a new one
...
Return Premium
- in case where commodity basket has higher geometric return than the components, the crucial point is that the
primary driver of return in commodities is not simply the rebalancing process
Approximate Relationship:
G=M–
σ
2
2
G – geometric return
M – arithmetic return
σ – volatility
3
...
0 Implantation of Commodity Strategies
- Commodity index strategies, unlike U
...
equity index strategies, are active strategies because of
high
turnover
...
Four ways to enhance the return of the index
are through:
1
...
Roll-management – involves a tactical approach to the timing of the roll on commodity futures
contracts
3
...
Maturity management
Active Long-Only – built around several unique characteristics of commodities markets
1
...
2
...
0 Conclusion
- commodity investment improves portfolios not just from return but from reducing the risk of losing
money when stressful market environments occur
...
61
Title: CFA Level I Curriculum Notes - Complefe
Description: CFA Level I curriculum notes from original CFAI text. 148 pages. Helped me pass level I with >70 in every single section!
Description: CFA Level I curriculum notes from original CFAI text. 148 pages. Helped me pass level I with >70 in every single section!