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2013CFAII
GoldenFuture

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Content
SS1&2EthicalandProfessionalStandards............................................4
Practice....................................................................................................................5

SS3QuantitativeMethods...................................................................6
Reading11:CorrelationandRegression.................................................................6
Reading12:MultipleRegressionandIssuesinRegressionAnalysis.......................7
Reading13:timeseriesanalysis.............................................................................9
Practice..................................................................................................................10

SS4Economics...................................................................................12
Reading14:Currencyexchangerate:determinationandforecasting.................12
Reading15:EconomicGrowthandinvestmentdecision.....................................13
Reading16:EconomicsofRegulation...................................................................14
Practice..................................................................................................................15

SS5~7FinancialReportingandAnalysis.............................................16
Reading17:Inventories.........................................................................................16
Reading18:LongLivedAssets..............................................................................18
Reading19:IntercorporateInvestments..............................................................23
Reading20:Employeecompensation...................................................................27
Reading21:Multinationaloperations..................................................................30
Reading22:Thelessonswelearn.........................................................................32
Reading23:Evaluatingfinancialreportingquality...............................................33
Reading24:integrationoffinancialstatementanalysistechniques....................35
V2P417 3 CASE ...............................................36
Practice..................................................................................................................38

SS8&9CorporateFinance.................................................................40
Reading25:CapitalBudgeting..............................................................................40
Reading26:CapitalStructure...............................................................................42
Reading27:DividendandShareRepurchase:Analysis........................................43
Reading28:CorporateGovernance......................................................................44
Reading29:MergerandAcquisition.....................................................................45
Practice..................................................................................................................46

SS1012Equity...................................................................................47
Reading30:EquityValuation:ApplicationsandProcesses...................................47
Reading31:ReturnConcepts................................................................................47
Reading32:TheFiveCompetitiveForcesthatShapeStrategy............................48
Reading33:DiscountedDividendValuation.........................................................49
2

Reading34FreeCashFlowValuation...................................................................51
Reading35:MarketBasedValuation:PriceMultiples..........................................53
Reading36:ResidualIncomeValuation................................................................55
Reading37:PrivateCompanyValuation...............................................................56
Practice..................................................................................................................58

SS13Alternativeasset.......................................................................60
Reading38:PrivateRealEstateInvestment..........................................................60
Reading39:PubliclyTradedRealEstateSecurities...............................................62
Reading40:PrivateEquityValuation....................................................................63
Reading41:InvestinginHedgeFundsASurvey................................................65
Practice..................................................................................................................66

SS14&15FixedIncome.......................................................................67
Reading42:FundamentalsofCreditAnalysis.......................................................67
Reading43:TermStructureandVolatilityofInterestRates.................................69
Reading44:ValuingBondswithEmbeddedOptions............................................71
Reading45:MortgageBackedSectoroftheBondMarket..................................72
Reading46:AssetBackedSectoroftheBondMarket.........................................75
Reading47:ValuingMortgageBackedandAssetBackedSecurities...................79
Practice..................................................................................................................81

SS1617Derivativeinvestment..........................................................82
Reading48:ForwardMarketsandContracts........................................................82
Reading49:FuturesMarketsandContracts.........................................................84
Reading50:OptionMarketsandContracts..........................................................86
Reading51:SwapMarketsandContracts.............................................................89
Reading52:InterestRateDerivativeInstruments................................................90
Reading53:UsingCreditDerivatives:AnOverview..............................................91
Practice..................................................................................................................92

SS18PortfolioManagements.............................................................94
Reading54:PortfolioConcepts.............................................................................94
Reading55:Thetheoryofactiveportfoliomanagement.....................................97
Reading 56: The portfolio Management process and the investment policy
statement..............................................................................................................99
Practice..................................................................................................................99


SS1&2EthicalandProfessionalStandards
Ethics 10th Handbook

1.

(B113 1 )Code Except

2.

(B11472 )ExplainethicalresponsibilityrequiredbyCodeandStandards.

I(B)independenceandobjectivity

II(A)materialnonpublicinformation,

III(A)dutiestoclients,

IV(A)dutiestoemployer,

VI(A)disclosureofconflictinterest

3.

(B191 1 ) soft dollar general principles (best execution, min. cost,


propertyofclients,benefitclients)

4.

(B192 1 )softdollar,generalprinciple requirements recommendation

5.

(B198 2 )3levelanalysisdeterminePermissibleResearch

6.

(B1100 1 )ResearchObjectivityStandards(ROS),objectives

7.

(B1101 1 )ROS, definitions

8.

(B1101 1 )ROS,requirements recommendedcomplianceprocedure

research objective policy, investment banking, research analyst compensation,


relationship with subject company, personal investment trading, disclosure

9.

(B1110)GlenarmCompany Standards CorrectActions.

(B1112)PrestonPartners Standards CorrectActions.

(B1115)SuperSelection Standards CorrectActions.

10. (B1118 1 )TradeAllocation

DutiestoClients
11. (B1119 1 ) TradeAllocation
12. (B1120) response,DutytoClient
4

13. (B1121) PrudentInvestorRule principles


14. (B1122) Prudent Investor Rule
loyalty,impartiality
15. (B1123) PrudentRule return,risk,evaluation,restriction,delegation

Practice
( R2 3,14,16,23,28,32,33,34,39,40,41-46,47-52,53-58,59-64
( R3 1-6)
( R4 1-6)
( R10 1-6,7-11)

SS3QuantitativeMethods
Reading11:CorrelationandRegression
16. (B1138)samplecovariance,samplecorrelationcoefficient,ascatterplot

TheCovariance

Positivenegativecovariance

samplecorrelationcoefficient

correlationcoefficient Figure2

Scatterplot Figure35
17. (B1142)limitationstocorrelationanalysis

limitation

outliers,spuriouscorrelation,Nonlinearrelationships

correlationbetweenthepopulationof2variables=0

18. (B1144)

19. (B1146)

linearequation

SSE slopecoefficientintercept,

slopecoefficientintercept

interpretingregressioncoefficients
20. (B1150)SEE

SEE

coefficientofdetermination

coefficientintervalforregressioncoefficient
21. (B1152)ttest

ttestwithn2degreeoffreedoms
22. (B1153)apredictedvalueofdependentvariable

apredictedvalueofdependentvariable

confidenceintervalforapredictedYvalue
23. (B1154)ANOVA

ANOVA
6

SSTRSSSSE

SST=RSS + SSE

Figure8componentsofthetotalvariation
Figure9ANOVAtable
R2 SEE
Ftest,
F

24. (B1159)

Reading 12: Multiple Regression and Issues in


RegressionAnalysis
25. B2172Multipleregressionbasics

26. B2173 Multipleregressionequation

Interceptterm

Slopecoefficient

27. B1175

Tstatistictotestsignificanceofindividualcoefficients

Testingstatisticalsignificance

pvalue

pvalue

Oneandtwotailedtests
28. B1179ConfidenceIntervalsforaregressioncoefficient

confidenceintervalforaregressioncoefficient


29. B1181
30. B1181Fstatistic

Fstatistic


31. B1183R2 adjustedR2

32. B1185ANOVAtables

ANOVA

ANOVAtable

ANOVAtable R2FSEE
33. B1190dummyvariables

dummyvariables

quarterlyEPS

Example:Hypothesistestingwithdummyvariables
34. B1194heteroskedasticity

Heteroskedasticity

uncoditionalandconditionalheteroskedasticity?

4effectsofheteroskedasticity

2 detectheteroskedasticity

BPchisquaretest,

generalizedleastsquares

serialcorrelation,positiveandnegative,

Effectofserialcorrelationonregressionanalysis

TYPEIerrors

serialcorrelation?

figure5residualplotsforserialcorrelation

DW

35. B1200multicollinearity

Multicollinearity

Multicollinearity
8

Multicollinearity

36. B1203modelmisspecification

modelmisspecification

modelmisspecification Figure7

sixcommonmisspecificationsoftheregressionmodel
37. B1206qualitativedependentvariables

qualitativedependentvariables

Severaltypesofmodelswhichusequalitativedependentvariable
38. B1207

Economic meaning of the results of regression estimation focuses on the slope


coefficient

UnderstandFigure8:assessmentofamultipleregressionmodel

Reading13:timeseriesanalysis
39. B1219Timeseries
40. B1219Lineartrend
41. B1223exponentialgrowth,positiveandnegative
42. B1225linearorloglineartrend

linearorloglineartrend?

linearandloglineartrend figure1

Trendmodel
43. B1226requirementforatimeseriestobecovariancestationary

AR

Covariancestationary

TimeseriesisCovariancestationary
44. B1227ARmodelstructure

HowVariablexregressedonitselfwithalagofoneortwoperiod

Secondorderautoregressivemodel

chainruleofforecasting

AR(1)AR(2)model
45. B1228meanreversion,meanrevertinglevel

meanreversion

meanrevertinglevel

proceduretotestwhetheranARtimeseriesmodeliscorrectlyspecified
46. B1231 insampleandoutofsampleforecast

insampleandoutofsampleforecast

RMSE
9

47. B1231instabilityofcoefficientsoftimeseriesmodels

instabilityofcoefficientsoftimeseriesmodels

48. B1232randomwalkprocess

randomwalk

randomwalkwithadrift

Covariancestationarity

Finitemeanrevertinglevel

unitroot
49. B1233unitroottestingfornonstationarity

timeseriesiscovariancestationary

DickeyFullertest

Firstdifferencing
50. B1237Seasonality

Seasonality

Seasonality

Seasonality

Forecastingwithanautoregressivemodel
51. B1241ARCH

ARCH

ARCH(1)model

ARCH(1)model
52. B1242

Totestwhether2timeserieshaveunitroots,theanalystrunsseparateDFtests
with5possibleresults, 5

Cointegration

Howtotestwhether2timeseriesarecointegrated

DFEGtest

figure2P244

Todeterminewhattypeofmodelisbest 6

Practice
Notes: R11 7,19
Notes: R12 1,9,10,16,17,20
Notes: R13 8,9,12,14,16,17,19,21,22,23
R11 2,8,10,11,12,13,15-20,21-26
R12 3,5,8,11,12,13,15,17-22,23-28

10

R13 1,6,8,9,13,14,15,17,18,19

11

SS4Economics
Reading14:Currencyexchangerate:determinationand
forecasting
53. (B1262)spotexchangerate forwardrate
54. (B1263)dealer spread interbankspread

55. (B1265) bid askprice crossrate


bid ask dealer bid price<ask price

56. (B1265)

57. (B1268)forwardpremium/discount
58. (B1269)forwardcontract
P270271

59. (B1272)coveredinterestrateparity
IRP rates

60. (B1274)uncoveredinterestrateparity coveredIRP


61. (B1275)

P277
62. (B1278) exantePPP

expectedinflation?

RelativePPP

Realexchangerate
P280 PPPIRP

63. (B1281)

Capitalflow

Current account BOP flow mechanism, portfolio composition


mechanism debtsustainabilitymechanism

Capitalaccount BOP
12

64. (B1284)IMF longtermequilibriumrealexchangerate

Macroeconomic balance, External sustainability, Reducedform econometric


model
65. (B1285)FXCarryTrade return

66. (B1286)MundellFlemingModel

67. (B1288) PortfolioBalance

puremonetary Dornbuschovershooting

MundellFlemingModel

PortfolioBalance MundellFlemingModel
68. (B1289)

69. (B1290) PortfolioBalance

puremonetary Dornbuschovershooting

MundellFlemingModel

PortfolioBalance MundellFlemingModel
70. (B1290)
71. (B1290)

Reading15:EconomicGrowthandinvestmentdecision
72. (B1306) 6
73. (B1307)

notes %P = %GDP + %(E/GDP) + %(P/E)


GDP

P308 GDP

74. (B1309) CobbDouglasproductionfunction

Alpha constantreturntoscale

Capitaldeepening

SteadystateMPK=Y/K=r

13

P310

75. (B1311) Growthaccountingrelations

P311

76. (B1312)

77. (B1312)

78. (B1314) HumancapitalPhysicalcapital


79. (B1315)

GDP

80. (B1315)

Longtermsteadystategrowthrate
Sustainable growth of output per capita Sustainable growth rate of output

P316

81. (B1317)

82. (B1317)ConvergenceHypotheses

83. (B1318)

R&D knowledgecapital
84. (B1318)

Reading16:EconomicsofRegulation
85. (B1327)Regulation regulator
Independent regulators not funded by the government
SRO Independent regulators Independent regulators SRO
Regulator
14

86. (B1328)

SRO regulator

FINRA SRO

Civallawcountries independentSROs commonlaw

87. (B1328)

(P329)

(P329)

88. (B1329) RegulatoryInterdependence

RegulatorycapturetheoryRegulatorycompetition Regulatoryarbitrage

89. (B1329) RegulatoryIntervention

Intervention
90. (B1330) CommerceAndFinancialMarkets

91. (B1331)
92. (B1332) cost&benefit

regulatoryburden

sunsetclause
93. (B1332)

Practice
(Notes B1 P297-4,5)
(Notes B1 P298-8)
(Notes B1 P300-15-20)
(Notes B1 P323-1-6)
(Notes B1 P336-1-7)

( R14 1-67-13)
( R15 7-15,16-21)
( R16 1-6)

15

SS5~7FinancialReportingandAnalysis
Reading17:Inventories
94. (B211)

IFRS , 3

GAAP 4

:LIFO IFRS
95. (B211) SpecificIdentificationMethod

jewelryandautomobiles
96. (B211) LIFO

UStaxcoderequiresfirmsthatuseLIFOfortaxpurposesalsouseLIFOforfinancial
reporting.
97. (B212) 3

98. (B214) InflationandDeflation FIFO LIFO

99. (B214) PeriodicinventorySystem PerpetualSystem


16

FIFO specificidentification 2
LIFO weightedaveragecost 2

100. (B215) LIFO FIFO

LIFOReserve,footnotes

LIFO FIFO

FIFOinventory=LIFOinventory+LIFOreserve
101. (B215) LIFO BS FIFO BS

LIFO BS FIFO BS P15


102. B216 LIFO FIFO
FIFO COGS = LIFO COGS (ending LIFO reserve beginning LIFO reserve)

103. (B217) LIFOBSIS FIFOBSIS


In B/S:
Asset: +LIFO Reserve ,
Equity: +LIFO Reserve0 (1- t past) +LIFO Reserve (1- t current )
Increase in DTL (or decrease in cash) + LIFO Reserve0 t past +LIFO Reserve t current
In I/S:
NI:

+ LIFO Reserve 1-t current

P17 LIFO FIFO

104. (B220) LIFOliquidation

LIFOliquidation

liquidation LIFO
liquidation,
105. (B222) LIFOBSIS FIFOBSIS

LIFOBSIS FIFOBSIS
FIFO BS current
asset and total asset

106. (B223)IFRS IFRS GAAP

IFRS lowerofcostandNRV
NRV= S selling cost completion cost

107. (B223) GAAP

GAAP, lowerofcostandMarket
17

Market = replacement cost


NRV-normal profit< replacement cost< NRV

108. (B224) 2
109. (B225)

BS NRV unrealizedG/L
110. (B225)LIFOFIFO

111. (B227)

S g >gSale,

Reading18:LongLivedAssets
112. (B234)anexpenditure, capitalized,
113. (B234) BS
114. (B234) NI CFO
115. (B235) NIequity

NI NI
18

116. (B236)

IS

CFI


117. (B237)
118. (B238)

119. (B240) R&D


120. (B240) R&D IFRS GAAP
121. (B241)SoftwareDevelopmentcost GAAP
122. (B241)

123. (B242)

MACRS

DTL
124. (B242) 3

NI
125. (B243)3
19

3 NIMargin

Over the entire period, depreciation expense, tax expense, pretax income, net income, and net
profit margin are unaffected by the depreciation method chosen

126. (B243)

127. (B245)
128. (B245)
129. (B245)

130. (B245)
131. (B246) IFRS

IFRS carryingvalue recoverableamount

recoverableamountFVsellingcost valueinuse

IFRS
132. (B246) GAAP

GAAP 2

recoverabilitytest

measuringtheloss
133. (B247) 2
134. (B247)
135. (B248)

136. (B248) GAAP IFRS


137. (B248)

GAIN BS OCI

LOSS IS
138. (B249)
139. (B250)averageageaveragedepreciablelife
140. (B251) Financelease operatinglease
141. (B251) leasing
142. B251 IFRS GAAP financelease
20

143. B252 operatinglease


144. B252 financelease
145. B253

PV
146. B254 operatingleaseandfinancelease

147. B255 operatingleaseandfinancelease

148. B255 operatingleaseandfinancelease

21

149. B256

GAAP 5 5
150. B257

implicitinterestrate,

D/E
IRR NPV

151. B258GAAP 4 2

lessorhassubstantiallycompletedperformance

152. B258Saletypeleaseanddirectfinancinglease

Saletypelease:PVofleasepayment>carryingvalueofasset

directfinancinglease:PVofleasepayment=carryingvalueofasset
153. B258 Saletypelease

CF CF
154. B259 directfinancinglease

CF CF
155. B259 directfinancinglease


156. B260OperatingleaseandDirectfinancinglease
P61 leasee
In the early years of the lease, the income reported from the direct financing lease is higher than
the income reported from the operating lease. Just like an amortizing loan, the interest is higher
in the early years. This situation reverses in the later years of the lease.

22

Reading19:IntercorporateInvestments
157. B267 IntercorporateInvestments

financialasset Associatesbusiness Combination


158. B267 financialasset 2

20%

IFRS financialasset 3 :

HTM AFS FairvaluethoughtP/L: HFTSecuritiesdesignatedatfairvalue

GAAP financialasset 4 :

HTMAFSHFTDesignatedatfairvalue
159. B268 Investmentinassociates

Investmentinassociates 20%50%,
20%

160. B268 Businesscombination

Businesscombination 50%

50%

50%
161. B268 JointVentures

JointVentures:2
IFRS
GAAP

162. B268 4 ownership

23

163. B269HTM BS
164. B269HFT

BSIS
165. B269Designatedatfairvalue: BSIS
166. B269AFS BSIS
167. B270 UnrealizedG/LforAFSfromforeignexchangemovement 2

GAAP IFRS

Unrealized G/L for AFS from foreign exchange movementGAAP


equity IFRS I/S
168. B2703

HFT unrealizedG/L
169. B271

170. B271IFRS reclassification


IFRS typically does not allow reclassification of investments into and out of fair value through
profit or loss category and reclassification of investments out of held-for-trading category
GAAP does permit reclassification.
IFRS AFS HTM, FV OCI I/S
IFRS HTM AFS, FV FV OCI

171. B272GAAP reclassification

24

GAAP dose permit reclassification.


AFS trading, OCI I/S
AFS HTM OCI I/S
HTM AFS, unrealized G/L OCI

172. B272 GAAP financialasset


173. B272 IFRS financialasset

atleastonelosseventhasoccurred

itseffectonthesecuritysfuturecashflowscanbeestimatedreliably
liquid market

174. B272Equitysecurity
175. B272HTM
176. B272AFS

IFRS GAAP
177. B273 financialasset
178. B273

20%50%

proportionateshareofearningDividend
179. B274

180. B275 GOODWILL=


181. B276 GOODWILL
FV BV
25

30%

182. B277 investmentinassociate 2

FV

writtenup
183. B277 Investorandinvestee

upstreamsale investee investor goods

downstreamsale ,
184. B278 NImarginratio

Investee 100%

Investee marginratio
185. B278 GAAP 4
186. B279 Poolingofinterestmethod Acquisitionmethod

Poolingofinterestmethod
2001 2

Acquisitionmethod

187. B282partialandfullgoodwill

USGAAP

IFRS
188. B283 GOODWILL
GOODWILL=- FV of

189. B284 partialgoodwillandfullgoodwill

Fullgoodwillmethod: FV

Partialgoodwillmethod: FV

Goodwill
2 goodwill
IFRS: > recoverable amount
GAAP

190. B285 GAAP IFRS Impairdgoodwill

GAAP FV FV
191. B286 Barginpurchase

IFRSGAAP 2008 12 15
gain
26

192. (B286)JV

IFRS GAAP
193. (B287)SPE VIE

SPE

VIE

SPE VIE
194. (B288) SPE

sponsorentity SPE SPE,

SPE

sponsor
195. (B288) QSPE 2

QSPE,GAAP: sponsor ,

QSPE,IFRS:
196. (B289) 3

Reading20:Employeecompensation
197. (B2102)DCplan DBplan
198. (B2103) DBplan
199. (B2103)fundedstatusoverfundedunderfunded
200. (B2103)otherpostemploymentbenefit

DB
201. (B2103)PBO

currentservicecost

interestcost

pastprior servicecost

changesinactuarial
27

Benefitpaid

202. (B2104)PBO

203. (B2107)funded status ,GAAP IFRS

fundedstatus assetceiling
presentvalueoffutureeconomic fundedstatus

204. B2108 Totalperiodicpensioncost

totalperiodicpensioncost
205. B2108currentsevicecost interestcost

currentcost

interest cost PBO PBO discount rate

IFRS intersetexpense/income fundedstatus discountrate


206. B2108Expectedreturnonplanassets

Expectedreturnonplanassets
28

IFRS Expectedreturnonplanassets discountrate


GAAP expectedreturn actualreturn actuarialgains
andlosses

207. (B2109)AmortizationofactuarialG/L:

OCI IFRS GAAP


corridorapproach
actuarial G/L>10% of greater of beginning of PBO or plan asset

208. (B2109)Amortizationofpastservicecost:

GAAP: OCI

IFRS
209. (B2109)GAAP actuarial gain or loss or past service cost
smoothed
210. (B2110)

211. (B2110)pensionexpensepresentation

GAAP singleline

IFRS

212. (B2110)capitalizingpensioncost

213. (B2110)discount rate :discount rate Compensation growth Expected


returnonplanassets

discountrate discountrate Expectedreturnonplanassets

PBO
214. (B2111)Figure5Effectofchangingpensionassumptionsonpensionexpense
215. (B2111)Ultimatehealthcaretrendrate
29

postemploymentbenefitobligation?
Postemploymenthealthcareplans

216. (B2112)

//

IFRS GAAP

217. (B2113)Reclassifyingpensionexpense
218. (B2114)cashflowrelatedinformation

contribution totalpensioncost overallpensionobligation

219. (B2115)Sharebasedcompensation
220. (B2115) sharebasedcompensation

AccountingforsharebasedcompensationissimilarunderIFRSandU.S.GAAP.

stock option compensation expense for stock options was typically based on the
intrinsicvaluemethod.

FVofoption optionpricingmodel, 6 inputs

6 input FV
221. (B2116)stockgrants,stockappreciationrightsphantomstock

StockgrantsbasedonFV, 3

Reading21:Multinationaloperations
222. (B2125)localfunctionalfunctionalcurrency presentationreporting currency

223. (B2126) , G/L

G/L

unrealizedG/L I/S
224. (B2127)
225. (B2127)2
226. (B2128)Figure12
227. (B2129)3
228. (B2129) currentmethodandtemporalmethod,

2
229. (B2130)currentmethodI/SBS

30

CTA, BS

230. (B2130)temporalmethodI/SBS
remeasurement G/L
current

231. (B2130)2

Currentmethod: netassetposition

Temporalmethod: netmonetaryassetorliability
232. (B2131) figure2
233. (B2133)2 ISBS , figure3
234. (B2133) Currentratemethod
NI, BS RE CTA

235. (B2137) temporalmethod


BS RE IS Remeasurement gain

236. (B2138) 2 Figure4


237. (B2142) Comparing Subsidiary Results to Translated Results Under the Current Rate
Method
238. (B2140)pureI/Sratios,pureB/Sratios

Pure income statement and pure balance sheet ratios are unaffected by the
applicationofthecurrentratemethod.
239. (B2141)MixedB/SorI/Sratios

mixedratioscalculatedfromfinancialstatementstranslatedusingthecurrentrate
method will be different than the same ratio calculated from the local currency
statementsbeforetranslation.

Mixedratios
P143 3
Pure balance sheet and pure income statement ratios will be the same.
If the foreign currency is depreciating, translated mixed ratios (with an income statement item in
the numerator and an end-of-period balance sheet item in the denominator) will be larger than
the original ratio.
If the foreign currency is appreciating, translated mixed ratios (with an income statement item in
the numerator and an end-of-period balance sheet item in the denominator) will be smaller than
the original ratio.

240. (B2143) 2 BSIS


31


241. (B2145)Hyperinflationaryenvironment
242. (B2145)GAAPIFRS

IFRSBS nonmonetary current


current
P146 IFRS

243. (B2147) remeasuring


244. (B2147)

CTA NI

Cleansurplusanddirtysurplus

Reading22:Thelessonswelearn
245. B2160 transparency

When applied to financial reporting, transparency involves disclosures that are


understandableandreliable
246. B2160firstlesson:

The financial footnotes and the management discussion and analysis (MD&A)
sectionarewheremostofthedetailandexplanationsarefound.

NostandardsastotheformatandreadabilityofthefootnotesandMD&A.
247. B2161SecondLesson:BeSkeptical

Beskepticalwhenafirmsearningsaregrowingfasterthantheindustryandthe
economyoverthelongrun.

Earnings growth is not sustainable in the long run without growth in operating
cashflow
248. B2161ThirdLesson:EvaluatetheDisclosures:

The terms earnings and net income are often used synonymously. However, the
termsarenotnecessarilythesame.

EBITDAEBITIncomefromcontinuingoperationsNetincome
249. B2162FourthLesson:CheckforCashFlow

trends in cash flow from operations can be more reliable than trends in
earnings
250. B2162FifthLesson:UnderstandtheRisks

ThemorecommonbusinessandfinancialrisksFirmsface
251. B2163

Firmsoftenusederivativestomanagetheserisks.
32

G/L IS
hedge
hedge FVhedge CFhedge Netinvestmenthedgeofforeignsubsidiary

UnrealizedG/L BS

252. (B2164) hedge G/L


Figure1

Reading23:Evaluatingfinancialreportingquality
253. (B2169) cashbasisandaccrualbasisaccounting
P169

254. (B2171)Accrualaccounting commonestimates


255. (B2171)accrualbasedincome

accrual based income accrual

applylowerweighttoaccrualcomponent

Lowerpersistencyisnotalwaystheresultofstrategicmanipulation

256. (B2171) Unearned revenue/accrued revenue/deferred expenses/accrued expenses

257. (B2172)
258. (B2173)Mechanismsdesignedtopreventstrategicmanipulation
259. (B2174) earningquality

earningquality

2 earningquality

BSapproachNOA/operatingassets/operatingliabilities

CFapproach
260. (B2176) BSCFapproach

thehighertheaccrualratio,thelowertheearningquality
261. (B2178)meanreversioninearning,

meanreversioninearning,

Becauseofmeanreversion,analystsmustunderstandthatextremeearnings(high
orlow)shouldnotbeexpectedtocontinueindefinitely

Whenearningsarelargelycomprisedofaccruals,meanreversionwilloccureven
faster.
262. (B2179) 3
33

misstating revenue/accelerating
Nonoperatingrevenue

revenue/Misclassifying

Nonrecurring

or

263. (B2180) 3 warningsign


264. (B2181) BS low quality FS 2
GOODWILL
265. (B2182) CFS lowqualityFS 2 CF

IgnoringCF,ManagingCF
266. (B2183)

misstatingrevenue/acceleratingrevenue/MisclassifyingNonrecurringor
Nonoperatingrevenue

DSO

cash collections = revenue increase in receivables + increase in unearned


revenue

Implementing a bill and hold arrangement.


Channel stuffing.
Use of barter transactions
Abnormal sales growth as compared to the economy, industry, or peers.
Disproportionate fourth quarter revenues for a non-seasonal firm.

267. (B2185)Delayedexpenses

Delayedexpenses

DOH
Coreoperatingmargin
268. (B2187) offbalancesheetfinancing

offbalancesheetfinancing
implicitinterestrate
269. (B2189) GOODWILL

Immediate write-off of purchased in-process research and development (IPR&D).


Use of special purposes entities (SPE)
Revaluing deferred tax assets.
Receivable sale with recourse
Use of the equity method when substantial ownership exists

270. (B2190) CFS


34

Analysts should compare the growth of operating leases with the firms asset
growth.
Bealertforadecreaseindiscretionaryspending,especiallynearyearend.

Reading 24: integration of financial statement analysis


techniques
271. (B2197) financialanalysisframework
272. (B2199)TheextendedDuPontequation

Financialleverage investmentasset,

273. (B2201) assetbase

Analysisoftheassetbaserequiresanexaminationofchangesinthecomposition
ofbalancesheetassetsovertime.
274. (B2202)

Determine if the capital structure can support future obligations and strategic
plans by analyzing the components of longterm capital. Some liabilities dont
necessarilyresultinanoutflowofcash.

DTL
DTL
275. (B2204)Segmentdisclosures

Segment disclosures are valuable in identifying the contribution of revenue and


profitbyeachsegment,therelationshipbetweencapitalexpendituresandratesof
return,andidentifyingsegmentsthatshouldbedeemphasizedoreliminated.

Figure810,
276. (B2206) Earning

Earnings can be disaggregated into cash flow and accruals using a balance sheet
approach and a cash flow statement approach. The lower the accruals ratio, the
highertheearningsquality.

Earningquality

Earnings are considered higher quality when confirmed by cash flow. Cash flow
can be compared to operating profit by adding back cash paid for interest and
taxestooperatingcashflow.

Figure1112, accrualratios

P207accrualratios

CF EBIT Figure1315

277. (B2209) MVdecomposition


35

Thestandalonemarketvalueofafirm
AnimpliedP/Emultiple P213
P210 25 NI
P210 211 Thunderbird support and concerns,

278. (B2211)

Thebalancesheetshouldbeadjustedforoffbalancesheetfinancingactivities.

Capitalize operating leases for analytical purposes by increasing assets and


liabilities by the present value of the remaining lease payments. Also, adjust the
income statement by replacing rent expense with depreciation expense on the
leaseassetandinterestexpenseontheleaseliability.

P212 Figure16

P212
279. (B2213)

Usersmustbeawareoftheproposedchangesinaccountingstandardsbecauseof
thefinancialstatementeffectsandthepotentialimpactonafirmsvaluation.

GAAP eliminateoperatinglease,leverage raise


additionalequity.

FASB eliminate QSPE, AR leverage


,Figure17

V2P417 3 CASE
280. (V2362)

EXHIBIT1
NOTE200

281. (V2363)CASE1

NESTLE

6
Phase1
Phase2
Phase3 7

282. (V2364)

P364

removetheeffectofinvestmentinassociatesfromBS
andIS
36

04 P423
EXHIBIT24
EXHIBIT5
EXHIBIT6ExpandedDuPontAnalysis

Associate effect on net profit margin, effect of associates investment


P426
P427 financial leverage
P428 EXHIBIT7 ROE ASSOCIATE

283. (V2371)AssetBasecomposition

EXHIBIT8

P372 so much investment in intangible asset,


significantinvestmentsincurrentassets,inventory,andPPE

P372 EXHIBIT9
284. (V2372)capitalstructureanalysis

EXHIBIT10 financialleverage

EXHIBIT11
285. (V2374)SegmentanalysisandCapitalallocation

EXHIBIT1214 2007

EXHIBIT15 concerns,

EXHIBIT1621
286. (V2380)accrualandearningquality

EXHIBIT2223 accrualratios
287. (V2381)CashflowRelationships

EXHIBIT2427

P384 EXHIBIT27
288. (V2384)Decompositionandanalysisofthecompanyvaluation

EXHIBIT28 EXHIBIT28

P385 2 EBIT

EXHIBIT2930 ASSOCIATE
289. (V2388)Phase5:conclusionsandrecommendation

Supportandcauses
37

290. (V2389)Followup

291. (V2389)Case2

Phase12 ratio of estimated incremental assets and liabilities to


totalasset,

Phase34EXHIBIT3132 leasemultiplier11%

EXHIBIT3334

Phase5conclusionandrecommendation

Phase6Followup
292. (V2393)Case3

QSPE BS

Phase1

Phase2 MD&A

Phase34EXHIBIT3536 MD&A

leverage

Phase5

Phase6Followup

Practice
(Notes B2 P31-3,4,5,6)
(Notes B2 P64-2,3,5,7)
(Notes B2 P92-1,2,11,13,16,17,24,25)
(Notes B2 P119-3,5,7,8,10,11,14,15,17-19
(Notes B2 P151-3,4,5,7-9,14,17
(Notes B2 P166-2,3,4,5)
(Notes B2 P193-2,5,6,11)
(Notes B2 P215-3,5,6,7,8,10)
( V2 p36-4-6,7,8,12,13,15,19,20)
( V2 p96-1,4,8,9,12,13)
( V2 p158-2,4-6,7,9,11,12,16-18,19,20,26,27,29,30)
( V2 p205-2,5,6,7,9,,11,12,13,14-19))
( V2 p268-1,5,6,9,11,15,19,20,21,24))
38

( V2 p293-1-6)
( V2 p355-2,4,6-8, 9,10,14,15,16-19,21)
V2 p398-4,5,8, 9,10-15,20)

39

SS8&9CorporateFinance
Reading25:CapitalBudgeting
293. (B3226)Capitalprojectscanbeclassifiedas

Replacementdecisiontomaintainthebusiness

Replacementdecisionforcostreductionpurpose

Expansionprojectsforexitingproduct

Expansionprojectsfornewproduct

Mandatoryinvestment

Otherprojects
Expansion project & Replacement project

294. (B3227) 5

Decisionarebasedoncashflows,notaccountingincome

Cashflowarebasedonopportunitycosts

Thetimingofcashflowsisimportant

Cashflowareanalyzedonanaftertaxbasis

Financingcostsarereflectedintheprojectsrequiredrateofreturn
295. (B3228)ModifiedAcceleratedCostRecoverySystem(MACRS)
296. (B3229) expansion capital project replacement capital project initial
investment outlay, aftertax operation cash flows terminal year aftertax
nonoperatingcashflow
investment in net working capital ()

297. (B3236) (5 )
298. (B3237) ,EAA ,
P237-239

299. (B3240) , ?capitalrationing

Hardcapitalrationing

Softcapitalrationing
300. (B3241)

Sensitivityanalysis

Scenarioanalysis

MonteCarlosimulation
40

301. (B3244)CAPM projectrequiredrateofreturn,

R project R f project [ E ( Rmkt R f ]

WACC project (P249 )

302. (B3245) realoption budgetingdecisionsvaluationrealoption

Timingoptions

Abandonmentoptions

Expansionoptions

Flexibilityoptions

Fundamentaloptions
303. (B3246) realoption NPV
overall NPV = project NPV (based on DFC) option cost + option value
P246

304. (B3248) commoncapitalbudgetingmistakes


305. (B3249) economicincome accountingincome,

Economicincome=cashfloweconomicdepreciation

Economicdepreciation=beginningmarketvalueendingmarketvalue

economicincome=PV1+CF1PV0=PV0*r

306. (B3253) economicprofit,residualincomeandclaimsvaluation

economicprofit=NOPAT$WACC=EBIT(1t)WACC*capital

economicprofit NPV MVA


economic income economic profit cash basis accrual basis

Residualincome=netincomeequitycharge=NItreBt1
Residualincome accrualbasis
Claimvaluationapproach: debt equity CF ,

Equity Residual Income

NPV MVA
t 1

NPV
t 1

41

RI t
(1 re )t

EPt
(1 WACC )t

Reading26:CapitalStructure
307. (B3273)MMtheory

MMproposition1withouttaxes:capitalstructureirrelevance5 (P274)

MMproposition2withouttaxes:higherleverageraisesthecostofequity

re WACC (WACC rd )(

debt
)
equity V EBIT
WACC

MMproposition1(withtaxes):valueismaximizedat100%debt

VL VU td

MMproposition2(withtaxes):WACCisminimizedat100%debt

re R 0 ( R0 rd ) 1 TC (

EBIT (1 - t )
debt
) VL =
WACC
equity

308. (B3277) capitalstructure

Costoffinancialdistress

Agencycostofequity

Costofasymmetricinformation

Peckingordertheory

309. (B3279) Static tradeoff theory, . financial


distress, financialdistress tradeoff.
P279 , optimal capital structure

VL = VU + (t d ) - PV(Costs of Financial Distress)


42

310. (B3281)targetcapitalstructure, actualcapitalstructure

target (P283)
311. (B3281)Roleofdebtrating,D/Edebtratingdefaultriskcostofequity
312. (B3282) 3
Scenario analysis

313. (B3283)

Institutionalandlegalfactors

Financialmarketsandbankingsystemfactors

Microeconomicfactors
P284 common law civil law N/A

Reading27:DividendandShareRepurchase:Analysis
314. (B3292)

Dividendirrelevancetheory

Birdinhand

Taxaversion

315. (B3293)

Unexpecteddividendincreasepositivesignal

Unexpecteddividenddecreaseoromissionsnegativesignal
316. (B3294)Clienteleeffect
Tax consideration

DP = Pw - Px = D(1 - TD ) / (1 - TCG )
3

317. (B3295)Agencyissues
318. (B3296) 6
319. Tax

Doubletaxation

Effectivetaxrate=corporatetaxrate+(1corporatetaxrate)X(individualtaxrate)

Splittaxratesystem

Taximputationsystem

43

P299-301

320. (B3299)

Stabledividendpolicy;

Constantdividendpayoutratiopolicy;

Residualdividendpolicy
321. (B3300)Stabledividendpolicy Targetpayoutadjustmentmodel
Expected dividend=(previous dividend)+ [(expected increase in EPS) X (target payout ratio) X
(adjustment factor)]

322. (B3300)Constantdividendpayoutratiopolicy

323. (B3301)Residualdividendmodel

Longtermresidualdividendmodel
324. (B3302)Cashdividendsv.s.Repurchasingshares

(P305)
325. (B3305) ()
326. (B3306)Dividendsafety

Dividendpayoutratio&dividendcoverageratio

FCFEcoverageratio

Reading28:CorporateGovernance
327. (B3318)corporategovernance 4
328. (B3319)

Soleproprietorships

Partnerships

Corporations
4 (P320)

329. (B3320)principleagentproblem

managers&shareholders, directors&shareholders

principalagentproblem
330. (B3322)boardofdirectors

8
44

boardofdirector

331. (B3325) /(7 )


332. (B3322) corporate governance ; corporate
governance
P328 best practice

333. ESGfactors
2013

Reading29:MergerandAcquisition
334. (B3338)M&A

Typesofmergers

Formsofintegration
335. (B3339)merger
Tax benefit tax benefit

336. (B3341)EPSBootstrapping
P342

337. (B3344) merger


338. (B3345) Formofacquisition stockpurchase assetpurchase
339. (B3346) cashofferings securitiesofferings
(P346)

340. (B3346) targetmanagement :


Bear hug, tender offer, proxy battle

341. (B3347)takeoverdefensemechanisms

Preoffer: poisonpill,poisonput,goldenparachutes

Postoffer: greenmail, share repurchase, crown jewel defense, white


knightdefense,whitesquiredefense
white squire defense

342. (B3351) HHI


P351

343. (B3352) ,3
45

P352DCF : FCFF adjustedWACC


P357: multiplier , current
stockprice multiplier, takeoverpremium
P361: ,
3 dealstockprice multiplier,
takeoverpremium,

P364

344. (B3365) cashpayment stockpayment 2

345. (B3369) cash payment stock payment 2

346. (B3370) reducesize

Divestitures

Equitycarveouts

Spinoffs

Splitoffs

Liquidations
347. (B3371) Divestitures (4 )

Practice
( R25 1,5,6-8,9-14,15-20,21-26,27-32,33-38,39-44,45-50)
( R26 3,6,8-13,14-19)
( R27 4,6,9,11,12-14)
( R28 9-14,15-19,20-25)
( R29 1-6,7-12,13-18,19-24)

46

SS1012Equity
Reading 30: Equity Valuation: Applications and
Processes
348. (B3P9,Los30a)Intrinsicvalue

IVanalyst price ( IVactual price) ( IVanalyst IVactual )

349. (B310,Los30b) goingconcernassumption&liquidationvalue


350. (B310,Los30c) Fairmarketvalue&Investmentvalue
351. (B310,Los30d) valuation (8 )
352. (B312,Los30e)

353. (B313,Los30f)Absoluteandrelativevaluationmodels.
( Benchmark)
Multiples( Benchmark)

354. (B314,Los30g) sumofthepartsvaluation conglomeratediscount


355. (B315,Los30h)

Reading31:ReturnConcepts
356. (B321,Los31a)

holdingperiodreturn

realizedreturnandexpectedreturn

requiredreturn,discountrate

internalrateofreturn
the return from convergence of price to intrinsic value price value

47

internal rate of return;

357. (B323Los31b) ERP(Equity Risk Premium)

Historicalestimates

Forwardlooking (GGM/Supply Side EstimatesMacroeconomoic/Survey)

historical forward-looking

358. (B327Los31c)

CAPM ()

multifactormodels(FFM,PSM)()

thebuildupmethod
FFM PSM PSM
FFM 3

359. (B332,Los31d)(3 )

forpubliccompanies,adjustedbetaforpubliccompanies

forthinlytradedstocksandnonpubliccompanies.
adjusted beta for public companies Beta drift(P33)
unlevered beta levered beta (P34)

360. (B334,Los31e)
361. (B334,Los31f).

countryspreadmodel

countryriskratingmodel
362. (B335,Los31g) WACC
363. (B335,Los31h) WACC
RequiredReturn
WACC Equity required rate of return

Reading 32: The Five Competitive Forces that Shape


Strategy
364. (B343,Los32a)

365. (B346,Los32b) industrygrowthrate,technology&innovation,government


48

complementaryproducts services
366. (B347Los32c)
( Los 3
)
367. (B348Los32d)

Altering the Firms Existing Position(customer power;supplier power; availability of


substitutes;distribution;threatofentry;rivalry)

CapitalizingonChangesintheIndustry(forward/backwardintegration;externalforces)

CreatingChangesintheIndustryStructure.(industryvalueaddedoverall)

Reading33:DiscountedDividendValuation
368. (B361Los33a) DDM,FCF,Residualincome
model,

369. (B364Los33b)DDM ()

one-period =

V0

D1 P1
1 r

V0

D1 D 2 P 2
2
2
1 r 1 r

V0

D1 D 2 ...... D n P n
1
2
n
1 r 1 r
1 r

two-period =

multi-period =
370.

DDM
GGM
Twostaged
HModel
ThreeStaged

371. (B367Los33c) Gordonconstantgrowthmodel= V0

D1

rg

V, D1, r, g

372. (B368Los33d) GGM impliedgrowthrate


price=value

373. (B369Los33e) PVGO


49

P102

374. (B370Los33f) justifiedleadingandtrailingP/Es


justified?
justified leading P/E justified trailing P/E

justified leading P/E=

P0 D1 / E1 1 b

E1
rg
rg

justified trailing P/E=

P0 D0 1+g/E 0 (1 b) g

E0
rg
rg

375. (B372Los33g) noncallablefixedrateperpetualpreferredstock(D/P)


376. (B373Los33h) GGM
377. (B374Los33i) twostage DDM, threestage DDM, Hmodel, spreadsheet
modeling

n D 1 g S t D0 1 g S n 1 g L
V0 0


t
n

1
r
1
r
r
g
t

1
L

, ,

378. (B377Los33j)

initialgrowthphase

transitionphase

maturephase.
Earnings growth, Capital investment, Profit margin, FCFE, ROE v.s. Required Return, Dividend
Payout, Model

379. (B378Los33k) terminalvalue

GGM

Marketmultipleapproach
380. (B379Los33l)/ DDM HModel
H-model , high growth for a short period + immediately fall back to a long-run level

V0

50

D0 1 g L D0 H g S g L

r gL
r gL

r 0 1 g L H g S g L g L
P0

(H = t/2)

381. (B383)threestageDDM 2 , 3 , 2
; Hmodel.
P83

382. (B384Los33m) DDM/GGM/HModel requiredreturn


383. (B387Los33n)spreadsheetmodeling
384. (B388Los33o) SGR Dupont SGR
385. (B390Los33p) V overvalued, fairly valued or
undervalued

Reading34FreeCashFlowValuation
386. (B3107 ) FCFF FCFE
387. (B3108Los34a) FCFF WACC , FCFE re , equity value = firm
valuemarketvalueofdebt
FCFF WACC FCFE
re

388. (B3109Los34b)FCF

FCFE ;

FCFE , , FCFF
389. (B3109Los34c) FCFF FCFE

NI

EBIT

EBITDA

CFO

1.Non Cash Charge


2.FCINV
3.WCINV
4.Net Borrowing
FCFF:
FCFF = NI + NCC WCInv FCInv + Int(1-t)
51

FCFF = EBIT(1-t) + Dep WCInv FCInv


FCFF = EBITDA(1-t) + Dept WCInv - FCInv
FCFF = CFO FCInv + Int(1-t)

390. (B3110)NCC ( depreciation)


391. (B3111) FCInv
392. (B3112)WCInv

currentasset cash&equivalent

currentliability notespayable&currentportionoflongtermdebt
FCFE:
FCFE = FCFF Int(1-t) + Net Borrowing
FCFE = NI +NCC WCInv FCInv + Net Borrowing
Net Borrowing = DR (FCInv Dept) + DR WCInv
(B3-115) FCFE = NI (1 DR)(FCInv Dept) (1 DR) WCInv

393. (B3115) preferredstock, preferredstock

394. (B3116Los34d) FCFF&FCFE


395. (B3120Los34e) FCFF&FCFE 1.historical free cash flow, 2.forecast
theunderlyingcomponentsoffreecashflow
396. (B3121Los34f)FCFE&DDM

FCFEControl

DDMMinority.
397. (B3121Los34g) FCFF&FCFE (dividends/share
repurchase/shareissues/changeinleverage)
FCFF FCFE
FCFE/FCFF

398. (B3121Los34h) NI FCFE EBITDA FCFF


399. (B3122Los34i) singlestage,twostageandthreestage FCFF FCFE
DDM Multistage FCF FCF

400. (B3125Los34j) NOTES singlestage, twostage and threestage FCFF


FCFE
401. (B3132Los34k) inputs valuation ,
2 growth forecasts base years choices,
52


402. (B3133Los34l) terminal value 2 : singlestage model multiple
approach

Reading35:MarketBasedValuation:PriceMultiples
403. (B3151Los35a) justifiedpricemultiple :

themethodofcomparables

themethodbasedonforecastedfundamentals(valueisequaltothepresentvalueof
expectedfuturecashflowdiscountedattheappropriateriskadjustedrateofreturn)
404. (B3153Los35b) justifiedpricemultiple?
actual multiple justified price multiple ? ( stock )

405. (B3153Los35c) pricemultiples dividendyield


406. (B3153Los35d)P/Eratio

trailingP/E leadingP/E
407. (B3154Los35d)P/Bratio

trailingP/B leadingP/B
408. (B3156Los35d)P/Sratio

P/Sratio
409. (B3158Los35d)P/CFratio

P/CFratio .
: cash flow
Earnings-plus-noncash-charges (CF) = NI + depreciation + amortization
Adjusted CFO = CFO + [(net cash interest outflow) * (1-tax rate)]
FCFF
EBITDA

410. (B3158Los35d)DividendYieldratio

trailingD/P leadingD/P
411. (B3159Los35e)underlyingEPS normalizedEPS

MethodsofhistoricalEPS

MethodsofaveragereturnonEquitypreferred
53

412. (B3161Los35f) earningsyield E/Pratio


413. (B3162Los35g,h) fundamental factors? multiples
dividendyield justifiedP/E,P/B,P/S,P/CFD/P
414. (B3166Los35i) predictedP/E limitations(3 )
415. (B3168Los35j,r) benchmark value of multiple (peer group, sector, or industry
benchmark;equityindexbenchmark;historicalaveragemultiple).
multiples (P/E,P/B,P/SEV/EBITDA,D/P)Firmswithmultiplesbelowthebenchmark
areundervalued,andfirmswithmultiplesabovethebenchmarkareovervalued.
416. (B3170Los35k) PEGratio

highPEGratio

PEG ratio

P/E ratio
g

417. (B3171Los35l) multistageDCF , pricemultiples terminalvalue,


ratio leading trailing pricemultiples terminalvalue

Terminal value in year n = leading P/E ratio forecasted earnings in year n+1
Terminal value in year n = trailing P/E ratio forecasted earnings in year n

418. (B3172Los35m)CF pricemultiples

1. earnings-plus-charges(CF)
2. Adjusted cash flow(adjusted CFO)
3. Free cash flow to equity(FCFE)
4. Earnings before interest,taxes,depreciation and amortization (EBITDA)

419. (B3174Los35n) EV/EBITDAratio( EV);EV/EBITDAratio


(B3-208) EV/EBITDA EV cash and investment

420. (B3176Los35o) ()

421. (B3176Los35p) momentumindicators

1.Unexpectedearnings(orearningssurprise)=reportedEPSexpectedEPS

2.Standardizedunexpectedearnings(SUE)=earningssurprise/standarddeviationof
earningssurprise

3. 1 Relativestrengthindicators
54

422. (B3177Los35q) mean central tendency


?(arithmetic mean/harmonic
mean/weightedharmonicmean)
Portfolio P/E

Reading36:ResidualIncomeValuation
423. (B3195Los36a) residual income, , residual income
accounting income ( accounting income equity investors
return)
424. (B3196Los36a) EVA
Economic value added (EVA) = NOPAT (WACC invested capital) = [EBIT (1 t)] - $WACC
free cash flow NOPLAT
NOPAT , operating lease capital lease

425. (B3197Los36a) MVA


Market value added (MVA) = market value invested capital (market value LT debt &
equity)

426. (B3198Los36b)residualincomemodel

427. (B3198Los36c) RImodel


forecasting residual income

RI t E t r B t 1 ROE r B t 1

DDM,

FCFF,FCFE
P198 , RI, RI , forecast BV
per share
, P198 2010 Div

428. (B3201Los36d) RImodel

ROE r B0
V0 B0

rg

&

55

ROE r B0


rg

and ROE are the fundamental drivers

429. (B3202Los36e)ResidualIncome RI JustifiedP/B


430. (B3202Los36f) RIModel
431. (B3203Los36g) impliedgrowthrate

B ROE r
gr 0
P/B,
V0 B0

V0 = current BV per shareP/B

432. (B3204Los36h) continuing residual income (4 ); life cycle


RI (0,1)

1.RIisexpectedtopersistatitscurrentlevelforever.

2.RIisexpectedtodropimmediatelytozero

3.RIisexpectedtodeclinetoalongrunavglevelconsistentwithmatureindustry

4.RIisexpectedtodeclineovertimeasROEfallstothecostofequity

V0 B0 PV of interim high - growth RI PV of continuing RI


GGM 1+g
RI LOS
P.207
RI
: terminal value

433. (B3209Los36i)RI/DDM/FCF
434. (B3210Los36j) RI RI
435. (B3210Los36k)RI

1.CleanSurplusViolations

2.ValuationsfromFairValue

3.IntangibleAssetEffectonBookValue

4.NonrecurringItemsandOtherAggressiveAccountingPractices

5.InternationalAccountingDifferences.
436. (B3213Los36l) RI overvalued, fairly valued or
undervalued?

Reading37:PrivateCompanyValuation
437. (B3227Los37a)
Company-Specific Factors, Stock-Specific Factors.

438. (B3229Los37b)
56

()

439. (B3230Los37c)

1.FairMarketValue

2.FairValueforFinancialreporting

3.Fairvalueforlitigation

4.MarketValue

5.InvestmentValue

6.IntrinsicValue

440. (B3231Los37d)

(incomeapproaches)

(Marketapproaches)

(AssetBasedapproaches)
DDM/FCF
P232 (Early in Life~asset-based
approach/High Growth Phase~income approach/Mature~market approach)

441. (B3232Los37e) NormalizedEarnings&StrategicandNonstrategicBuyers


controlling noncontrolling

P233 Normalized Earnings


P234 Strategic and Nonstrategic Buyers

442. (B3237Los37f) incomeapproaches?:

1.TheFCFMethod

2.TheCapitalizedCashFlowMethod(P239 )

3.TheExcessEarningsMethod( intangiblevalue )(P240 )


443. (B3241Los37g)

SizePremiums

Availabilityandcostofdebt

Acquirerv.s.Target

ProjectionRisk

LifecycleStage
444. (B3241Los37h) Requiredrateofreturn

1.CAPM

2.ExpandedCAPM

3.BuildUpMethod
57

445. (B3243Los37i)

Publiccompanymethod(GPCM)( controlpremium
MI)

Guidelinetransactionsmethod(GTM)

Priortransactionmethod(PTM)
446. (B3249Los37j)assetbasedmodel

447. (B3249Los37k)(P283 )

1
DLOC 1

1 control premium
total discount=1- (1 DLOC )(1 DLOM )
448. (B3287Los37l)
1

Practice
(Notes B3 R30-4,6)
(Notes B3 R31-1,5)
(Notes B3 R32-4,5,11,12,14,15,16,17,18,20)
(Notes B3 R33-2,6,9,12,17,18,19,20,21,22,24)
(Notes B3 R34-1,3,5,6,9,10,13,14,15)
(Notes B3 R35-5,5,7,8,13,15)
(Notes B3 R36-2,6,7,8,9,10)
(Notes B3 R37-4,5,9,10,16)
( R30 8)
( R31 1,3,4,5)
( R32 1,2)
( R33 1,2,6,8,10,12,21)
( R34 1.C,2,5,13,14,20)
( R35 1,2,3,6.B,8,11.B,17)
( R36 2,7,11)
58

( R37 1,4,5,6,13)

59

SS13Alternativeasset
Reading38:PrivateRealEstateInvestment
449. (B49)

PrivateinvestmentCREForpublicmarketinvestmentREITREOC

DebtorEquity

(B410)

450.

REIT REIT

451.

(B411) property
Residentialproperties
Nonresidentialrealestateproperties:

452.

(B414)

453.

(B412)

454.

(B415) incomecostandsalesapproach
Highestandbest:useofavacantsiteistheusethatproducesthehighestimplied
landvalue.

P16 highest and best use

455.

60

(B417) Directcapitalizationmethod

NOIP18

cap rate discount rate

cap rate discount rate - growth rate


NOI1
NOI1
value
value
cap rate
NOI1
cap rate
comparable sales price
cap rate

value

ARYallriskyield

rent 1
ARY
StabilizedNOI P20
grossincomemultiplier

gross income multiplier

sales price
gross income

(B421) Discountedcashflowmethod

456.

NOI1
NOI1

value V0
r - g cap rate
r rate required by equity investors for similar properties
g growth rate of NOI
r - g cap rate

61

Terminalcaprate
differentleasestructure termandreversionapproach layer
method

P22P23P24

457.

(B424) DCF 7

458.

(B425) Directcapitalizationmethod Discountedcashflowmethod


CommonerrorsmadeusingtheDCFmethod:

459.

(B426) costapproach
Replacementcost&Reproductioncost

obsolescenceFunctional obsolescenceLocational obsolescence


Economicobsolescence
(B429) salescomparisonapproach

460.

P29 sales comparison approach

461.

(B430) reconciliationofvalue

462.

(B431)

463.

(B431) appraisalbasedindices taansactionindices

Repeatsalesindex hedonicindex

(B432) privaterealestateinvestment

464.

LeveragedIRR UnleveragedIRR

Reading39:PubliclyTradedRealEstateSecurities
465.

62

(B442) publiclyTradedRealEstateSecurities
REITs REOCs

466.

MBSCMBS RMBS mortgageREITs

(B443) publicly Traded Real Estate Securities 7 7


REITspecific 3 1

467.

(B445) REITs 5
GDP

468.

(B446) REITs

469.

(B446) REITs 9

470.

(B447) REITs 8

471.

(B451) NAVPS REITs forecastedcashnetoperating


income NAVPS

NAVPS REITs

P52

472.

(B454) FFO AFFO

473.

(B455) REITs REOCs pricetoFFO pricetoAFFO 3

PE

Reading40:PrivateEquityValuation
474.

(B469) PE privateequityinvestorprivateequityfurmfund
portfoliocompany

475.

(B471) PE 3 PE portfolio
companies 7 controlmechanism
(B472) venturecapital buyout (P73Figure2)

476.

VC Buyout

477.

63

(B474) PE Buyout( LBO)


PE DCFrelative value or market approachReal option analysisVC
methodleveragedbuyoutmethod

Buyout LBO

(B476) Exitvalue

478.
P77

Buyout

(B478) PreandPostMoneyValuation

479.

PRE+INV=POST
The ownership proportion of the VC is =INV/POST

480.

(B479) VC Buyout

481.

(B480) exitroutes

IPO2nd market saleMBO--Liquidation

482.

(B481) waterfalls
LimitedPartnership
PrivateEquityFundTerms:(P8182)

1. Economic 2. Corporate Governance P81-84


P83P84

NetAssetValue:

1. Determine NAV
2. Issues in calculations
3. Due diligence of PE fund investments
64

483.

(B486) :
PostInvestmentInvestorExpectations(JCurve)
GeneralRiskFactors

P87 10

CostsofPEinvesting

P87-88

(B488)

484.

Gross IRR Net IRR


( Quantitive Measures: PIC/DPI/RVPI/TVPI/)
(P91 )

485.

(B493)
singlefinancingrounds
multiplefinancingrounds
intermsofIRR

pre-money valuation, post-money valuation, ownership fraction price per share(P95P97 )

486.

(B498) VC :
1.AdjustingDiscountRate
2.AdjustingTerminalValueusingScenarioAnalysis.

Reading41:InvestinginHedgeFundsASurvey
487.

488.

(B4117) hedgefund mutualfund leverage,derivatives,disclosure


requirements,lockupperiods
(B4118)hedgefund (14 )

489.

(B4120)hedgefundperformance biases:BiasesinHFindices(3 )
StyleindicesasInappropriateBenchmark

490.

(B4121)hedgefund factormodels?Alpha

491.

(B4122) HF nonnormalityreturn performanceappraisal

492.

(B4123)HF replicationstrategies (3 )

493.

(B4124) HF (3 )

494.

(B4125) FOF HF

65

Practice
(Notes B4 P38-4,5,6,8,9,10)
(Notes B4 P63-1,3,7,9)
(Notes B4 P106-4,5,6,7,9,10,11,16,30,37)
(Notes B4 P129-1,3,6,7,9,10)
( P65-1,2,5,6,9,13,14,17,20,23,26,27)
( P125-1,3,4,6,8,10)
( P174- 7-12)
( P206- 1-6)

66

SS14&15FixedIncome
Reading42:FundamentalsofCreditAnalysis
495. (B4136)crediriskandcreditrelatedrisks

Creditrisk

Defaultrisk

Lossseverity,orlossgivenfault

Spreadriskcreditmigration(ordowngraderisk,marketliquidityrisk)
Expected loss = Default probability * Loss severity given default
Loss severity given default = 1 Recovery rate

496. (B4137)seniorityrankingsofcorporatedebt

Secureddebt

Unsecureddebt
497. (B4138)issuercreditratingsandissuecreditratings

Threemajorcrditratingsagencies:Moodys,S&P,Fitch

Differentcreditratings:TripleA,investmentgrade,noninvestmentgrade

Issuercreditrating

Issueratings

notching
498. (B4139)risksinrelyingonagencyratings

Creditratingsaredynamic

Ratingagenciesarenotperfect.

Eventriskisdifficulttoassess.

Creditratingslagmarketpricing.
499. (B4140)4C

Capacity
P140 Industry fundamentals & Company fundamentals

Covenants

affirmative/negative covenants
negative covenants

Collateral

ABS
67

Character

500. (B4P142)Financialratiosusedincreditanalysis
P142 CF ratio
a)

Profitability and cash flow measures

EBITDA = operating income + dep. & amor.


FFO = NI from continuing operations + dep. & amor. + deferred income taxes + other non-cash
items
FCF before div. = NI + dep. & amor. capital expenditure increase (plus decrease) in non-cash
working capital non-recurring items
FCF after div. = FCF before div. div.
b)

Leveraged ratios

Debt/capital, Capital = total debt + shareholders equity


Debt/EBITDA
FFO/debt
c)

Coverage ratios

EBITDA/interest expense
EBIT/interest expense

501. (B4148)yieldspread

Yieldspread=liquiditypremium+creditspread

Factorsaffectthespreadsoncorporatebonds
502. (B4148)Returnimpactofspreadchanges

Forsmallspreadchanges:Returnimpactmodifieddurationspread

For larger spread changes: Return impact modified duration spread +


0.5convexity(spread)2

Creditcurves
503. (B4150)Highyielddebt
(P151-P154) Special considerations of high-yield credit analysis:
a)

Greater foucs on issuer liquidity and cash flow

b)

Detailed financial projections

c)

Detailed understanding and analysis of the debt structure

d)

Understanding of an issuers corporate structure

68

e)

Covenant analysis

504. (B4154)Sovereigndebt
Framework for evaluating sovereign credit and assigning sovereign debt ratings:

Institutional effectiveness

Economic prospects

International investment

Fiscal flexibility

Monetary flexibility

505. (B4155)Municipaldebt

Gobonds

Revenuebackedbonds

Reading 43: Term Structure and Volatility of Interest


Rates
506. (B4166) parallel/nonparallelshift?(twist,butterfly)

Changes in Level rates 90%


Duration/convexity
Slope changes8.5%
Key rate duration
Parallel shift

Steepened
Twists
Flattened

Nonparallel
shift

Positive
Butterfly
Negative

Curvature changes1.5%
507. (B4167) US Treasury security returns
(level/slope/curvature) bootstrapping
508. (B4169) curve
69

AllOntheRun
AllOntheRunandSomeOfftheRun
AllTreasuryCouponSecurities/Bills
TreasuryStrips

509. (B4171) curve curve governmentbond


yield benchmark?

1.No regulation on the swap market, swap rates in different countries more
comparable

2.Thesupplyandequilibriumpricingdependsonlyonthenumberofparticipants;
notaffectedbytechnicalmarketfactors

3.Swapcurvesacrosscountriesaremorecomparablebecauseofreflectingcredit
risk,nosovereignriskrelatedtogovernmentrisk

4.Swap curvehas 11 maturities while US government bond only has 4 (2/5/10/30


year)
510. (B4172)termstructuretheory:

pureexpectationtheory
forward rates expected future spot rate

liquiditypreferencetheory

reflect investors expectation of future spot rates plus a liquidity premium.

PreferredHabitatTheory

expected future spot rates plus a premium to compensate them for exposure to price and or
reinvestment rate risk in the less-than-preferred habit.

511. (B4176)KeyRateDuration
P146
(B4-147-Los49f) key rate duration.
Barbell/Ladder/Bullet

512. (B4179) yieldvolatility:

( X t X )2
var iance
T 1
t 1
T

annual standard deviation daily standard deviation


Implied Yield Volatility/Forecasting Yield Volatility
expected changes in yield=0, forecast yield volatility, ARCH .

70

Reading44:ValuingBondswithEmbeddedOptions
513. (B4192)5 arbitragefreebinominaltree
P194-195 .

514. (B4196) spreadmeasures:

NominalSpread

ZSpread

OAS

515. (B4197) benchmarkinterestrates spreadmeasure

1.UStreasurysecurities

2.Aspecificsectorofthebondmarketwithacertaincreditratinghigherthanthe
issuevalued

3.Aspecificissuer
516. (B4198)backwardinduction binomialinterestratetree .
517. (B4198)callablebondvaluation :
P198 callable bond valuation
P206 putable bond valuation
option free bond valuation .

518. (B4199)optionvalue:
Vcall=Vnoncallable-Vcallable
Vput=Vputable-Vnonputable

519. (B4200) CallOption/Callablebondvalue


71

OAS

p.201-202 OAS (, OAS )

520. (B4202) benchmark ,Zspread OAS risk


Treasury Benchmark/Bond Sector Benchmark/Issuer-Specific Benchmark
Relative OAS Valuation:()

521. (B4204) effectiveduration effectiveconvexity

bondvalue 6 ( OAS )

522. (B4206) putablebond ,


p206-207

523. (B4208) option convertiblebond


(: option ) p209-211

524. (B4211) callableconvertiblebond

Increaseinstockpricevolatility

Increaseininterestratevolatility
525. (B4213) convertiblebond commonstock return/risk

Reading45:MortgageBackedSectoroftheBondMarket
526. (B4227) mortgage loan fixedrate/levelpayment/fullyamortized mortgaged
72

loan/PrepaymentRisk

Mortgagerate/contractrate

Conventionalmortgage

Fixedrate,levelpayment,fullyamortizedmortgageloans (P197 )

Prepaymentrisk (P198)
527. (B4229) Mortgagepassthroughsecurities

investment/paymentcharacteristics risk
WAM/WAC
agency pass-through?(Ginnie Mae/Freddie Mac/Fannie Mae)
(: Ginnie Mae G, government g, Ginnie Mae
guarantee by )

528. (B4231)measureprepaymentspeeds:

CPR is a function of past prepayment rates and expected future economic


conditions

convert the CPR into a monthly prepayment rate called the single monthly
mortalityrate(SMM):
SMM=1-(1-CPR)1/2

The PSA benchmark is expressed as a monthly series of CPRS, the PSA standard
benchmarkisreferredtoas100%PSA,100PSAassumesthefollowinggraduated
CPRs for 30 year mortgages: CPR=0.2% for the first month after origination,
increasingby0.2%permonthupto30months.CPR=6%formonths30to360.

( CPR SMM , p232-233 ) ( PSA )

529. (B4234)
Prepayment amount = SMM * (mortgage balance at beginning of month m - scheduled principal
payment for month m)
p234

530. (B4234)factorsaffectingprepayments

1.Prevailingmortgagerates

2.HousingTurnover

3.CharacteristicsofUnderlyingmortgageSeasoning/Propertylocation)
531. (B42235)PrepaymentRisk

ContractionRisk
negative convexity/reinvestment rate risk

73

Extensionrisk.

interest rate prepayment rate

532. (B4235) averagelifeofaMBS maturity


533. (B4236)CMO: thecashflowshave beenreallocated todifferent bondclassescalled
tranches,whichrepresentsadifferentmixtureofcontractionandextensionrisk.
Trenches

534. (B4236)sequentialPayCMO

(P237239 )
Principal pay down windows & Z-trench(accrual trench)(P208)

535. (B4240)PlannedAmortizationClass(PAC)CMO

PAC prepayment risk (P211)

536. (B4243) CMOtranche

537. (B4244) two types of stripped MBS are PO strips and IO strips, the price/yield
relationshipforIOandPOsecurities

StripedMBS

IOstrips

POstrips

IOs&POs (P245)

74

538. (B4245)agencyandnonagencymortgagebackedsecurities keydifference


539. (B4247)residentialandcommercialMBSdifference

Debttoservicecoverageratio

LoantoValueratio

540. (B4248)CMBS

CMBS

loanlevelcallprotection

CMBSlevelcallprotection

Reading46:AssetBackedSectoroftheBondMarket
541. (B4258)ABS

ABS

ABS prepaymentandcredittranchingofanABS(P148)

creditenhancement

externalcreditenhancements internalcreditenhancements(
)

75

Fred Motor ABS


: seller/issuer,trust/servicer

542. (B4259) prepaymentranching/credittranching

ABS

543. (B4260) amortizing assets nonamortizing assets payment/collateral


structure
lockout period/revolving structure

544. (B4261) creditenhancement?

External:Corporateguarantees/LetterofCredit/Bondinsurance

Internal:Cashreservefunds/ExcessservicingspreadfundsOvercollateralization
76

( p262 )/SeniorSubordinated Structure


Internal credit enhancement
shifting interest mechanism, trade-off

545. (B4264) ABS

HEL

AUTOLOANABS

SLABS

SBA

CREDITCARD

RECEIVABLEBACKEDSECURITIES

77

P269

78

546. (B4270)CDO cashflow prepaymentstructure.

CDO.
CDO are collateralized by a pool of debt obligations comprised of one or more kind of assets.
Cash CDOs can be arbitrage driven or balance-sheet driven. In synthetic CDOs, bondholders
take on the economic risks of the underlying assets but do not take legal ownership of them.
synthetic CDOs (P272)

547. (B4272)CDO :

1.arbitragedriven
( p273-274)

2.balancesheetdriven

Reading47:ValuingMortgageBackedandAssetBacked
Securities
548. (B4283)cashflowyield MBS ABS .

cashflowyield

cashflowyield

cashflowyield MBS ABS (P252 )

cashflowyield (P253)
549. (B4284)thenominalspread
Differences between cash flow yield on MBS and YTM on treasury security
The limitation of using nominal spread to analyze MBS is that we don't know how much of the
nominal spread reflects the signifiant prepayment risk associated with MBS.

550. (B4285)Zspread
The key limitation of the Z-srpead is that it only considers one path of interest rates: the current
Treasury spot rate curve)
MBS ABS (P285)

551. (B4285) fivesteps


552. 79(B4286) MBS

MBScashflow pathdependence,

MBSpathdependency
553. (B4286) OAS
additional compensation for credit risk, liquidity risk and modeling risk
79

Option cost=zero-volatility spread-option-adjusted spred


Modeling risk?

554. (B4290) OAS .

Cheap

Rich
555. (B4291) Effective Duration dealers/vendors
why?(diff.in4 :deltay/prepaymentmodel/OAS/spread)
556. (B4292) convexity
p292-293

557. (B4293) 3

1.Cashflowduration

2.Couponcurveduration

3.Empircalduration
558. (B4295) spread(nominal/Z/OAS)

80

Practice
( R42 5,7,9,10,14,15,16,17,18)
( R43 24,25,26)
( R44 1,5,14,15,18,21,22,23,27-32,33-38)
( R45 1,2,4,5,10,11,13,14,22,23,24,25,29,42-47)
( R46 39-44)
( R47 26-31)

81

SS1617Derivativeinvestment
Reading48:ForwardMarketsandContracts
Los Forward
1. forward (Equity/T-Bond/Currency/FRA)
2.No-Arbitrage Principle
3. Cost-of-Carry Model (Cash and Carry Arbitrage/Reverse Cash and Carry
Arbitrage) Cash and Carry arbitrage when the forward contract is overprice; Forward overpriced
short forward long spot asset borrow money
Cash and Carry arbitrage when the forward contract is underpriced; forward underpriced long
forward short spot asset invest money
(p9-13)derivatives

559. (B513Los48a)FPofzerocouponbond

t=0
t=t<T long short long

FP S 0 (1 R f )T

Vlong St

OR

S0

FP
(1 R f )T

FP
(1 R f )T t

( derviatives Time Value )

560. (B515Los48b)FPofequityforwardcontracts(dividendandnondividend)

Dividend Long

82

stockindex

p16-20

Vt (long position)=[St PVCt ] [

Vt (of the long position)=[

FP
]
(1 Rf )(T t)

St
e

e (T t )

][

FP
e

Rfc ( T t)

FP(on an equity security)=(S0 -PVD) (1+R f )T


FP(on an equity security)=[(S0 (1+R f )T ]-FVD
FP(on an equity index)=S0 e

( Rcf c )T

( S 0 e

)e

R cf T

where :
R cf continuously compounded risk-free rate

c continuously compounded dividend yield


561. (B519Los48c)

1.Forwardcontractonafixedincomesecurity

2.FRA

3.Forwardcontractonacurrency
( t=0/t=t/t=1 )
FRA FRA (P22)

562. (B520)FPandcontractvalueofforwardcontractoncouponpayingbond:

FP(on a fixed income security)=(S0 PVC ) (1 Rf )T


or =S0 (1 Rf )T FVC
Vt (long position)=[St PVCt ] [

FP
]
(1 Rf )(T t)

563. (B521 4 )FRA 23FRA,


(B5-22) Pricing FRA .
(B5-23-24) Valuing an FRA at Maturity
(B5-25-26) Valuing an FRA prior to Maturity

564. (B526)Pricingcurrencyforwardcontracts
FT (currency forward contract)=S0
83

(1 RDC )T
(1 RFC )T

FT (currency forward contract)=S0 e( RDC RFC )T


565. (B528)Valuingcurrencyforwardcontracts

Vt (currency forward contract)=[

Vt (currency forward contract)=[

St
Ft
][
]
(T t )
(1+R FC )
(1+R DC )(T t )

t
R CFC (T t )

][

t
R CDC (T t )

566. (B529Los28d) ForwardContract CreditRisk


the larger is the value or the forward to one party, the greater the credit(default)risk to that party.

Reading49:FuturesMarketsandContracts
(Future Market Los ) future/forward

567. (B536Los48a): maturity (S0,Ft)

: price must converge

568. (B537Los48b) futurecontract value


futures contract value = current futures price - futures price at last mark to market time

569. (B539Los48c ) Future price forward price


FutureArbitrage(cashandcarry/reversecashandcarry)
p40-41

84

570. (B542Los48d) monetaryandnonmonetary benefit cost

netcosts=storagecostsconvenienceyield

netbenefit=yieldontheasset+convenienceyield
571. (B543Los48e,f) backwardation/Contango normalbackwardation/normal
contango
Normal backwardation: futures price< expected spot price
Normal contango: futures price>expected spot price.

572. (B544) EURODOLLAR/TREASURYBOND/STOCKINDEX/CURRENCYFUTURE


(/)
573. (B546Los48g)difficultiesinpricingEurodollarfutures
Because Eurodollar futures are based on 90-day LIBOR, the asset value (the deposit) is not
perfectly hedged by the contract value as it is with the T-bill contract.
Euro dollar is better hedge instrument than T-bill, since it include partial credit risk. (Eurodollar
)

574. (B547Los48h)futurespricing

1.TreasuryBondFutures

2.StockFutures

3.EquityIndexFutures

4.CurrencyFutures
575. (B547) treasurybondfutures

Conversionfactor

CTD
P48 Conversion Factor
85

576. (B548) stockfutures


P49

FP (on an individual stock)=S0 (1 Rf ) T -FVD=(S0 -PVD) (1 Rf ) T


577. (B549) equityindexfutures
P237
C

FP (on an equity index)=S0 e( Rf

C )T

578. (B550) currencyfutures


P237

(1 RDC )T
FT (currency futures contract)=S0
(1 RFC )T
C

FT (currency futures contract)=S0 e( RDC RFC )T

Reading50:OptionMarketsandContracts
( option los ) fiduciary call/Protective put (p57-58)

579. (B558Los50a) putcallparitytocreatesyntheticsecurities


(: + long position, - short position)

C0 [

X
] P0 S0
(1 Rf )T

580. (B559)tworeasonsforsyntheticpositionsinthesecurities:

priceoption

earnarbitrageprofits.
p60-61 Put-Call Parity Arbitrage

581. (B561Los50b)

U,D,U,D

oneperiodbinomialtree optionvalue
P63
86

582. (B564)hedgeratio .

C1 C1
Delta
S1 S1
583. (B565)

584. (B569)

(B5-70) , (, )
.

585. B571 OptiononInterestRates:

Cap/Floorvalue
caps or floors: the value of a cap or floor is the sum of the values of the individual caplets or
floorlets.
A caplet is similar to a call option on interest rates, and a floorlet is equivalent to a put option on
interest rates.
P72

exp irationvalue of caplet

max{0,[(one-year rate-cap rate) notional principal]}


1+one-year rate

exp irationvalue of floorlet

max{0,[(floor rate - one-year rate) notional principal]}


1+one-year rate

586. (B574Los50c) BSM

6 (P75 )
587. (B576Los50d)BSM 5 :

Delta:assetprice

Vega:assetpricevolatility

Theta:timetoexpiration

Rho:theriskfreerate.

exerciseprice

87

588. (B579Los50e) Delta

CalloptionsdeltaforsmallchangesinSisN(d1)fromtheBSMmodel.

AputoptionsdeltaisN(d1)1

C1 C1
Delta
C N (d1 ) S P [ N (d1 ) 1] S
S1 S1
589. (p81 )InterpretingDelta:

Calloptiondeltawillincreasefrom0to1asstockpriceincreases.

Putoptiondeltawillincreasefrom1to0asstockpriceincreases.
590. (p82 Dynamichedging )Dynamichedging:

,akeyconsiderationindeltaneutralhedgingisthatthedeltaneutralpositiononly
holdsforverysmallchangesinthevalueoftheunderlyingstock.

number of options needed to delta hedge=

number of shares hedged


delta of call option

=number of shares hedged hedge ratio


591. (B584Los50f)(p85 call/putgamma )Gamma

Gammameasurestherateofchangeindeltaastheunderlyingstockpricechanges.

Itislargestwhenacallorputoptionisatthemoneyandclosetoexpiration.

Thatisdeltaisverysensitivetochangesintheunderlyingstockpricewhencallandput
optionsareatthemoneyandclosetoexpiration.
592. (B584Los50g)

cashflowsontheunderlyingassetwilldecreasecalloptionvalueorincreaseputoption
value.
593. (B585Los50h)Historicalvolatilityorimpliedvolatility
BSM

594. (B586Los50i) putcallparityforoptions forwards/futures


88

C0 +

X-FT
=P0
(1+R f )T

595. (B588Los50j) BSM American/European forward/future


Because of mark to market for futures, early exercise of options on futures can be more valuable
(American option).
As for forward, the value of American and European are the same.
The black model can only be used to price the European option.

Reading51:SwapMarketsandContracts
596. (B598Los51a)

Swaprate
Interest rate swap is a series of off-market forward rate agreement. It can also be replicated by
interest rate call and put option (with some measure of difference, the equity and currency swaps
can be equivalent to the call-put combination)
Swap swap rate

597. (B5100Los57b) equivalenceofswapin

1.FRA

2.Options

598. (B5101Los57c) plainVanillaSwap , fixedrateandperiodicpayment

1
1

1 R4

C
1
1
1
1
1 R 1 R 1 R 1 R
1
2
3
4

p102
p105-107
The market value of a swap is the difference between the value of a floating-rate bond and the
value of a fixed-rate bond.

599. (B5107Los51d)currencyswap

swaprate
currency swap , :
89

, , notional principal .
108

600. (B5111Los51e) fixed rate? equity swap


value?
p111-112

601. (B5113Los57f)swaption FRA

payerswaption

receiverswaption

swaption .

swaption :
1.Lock in fixed rate
2. Interest rate speculation
3. Swap termination

602. (B5113Los57g) Swaption


Notes P120 8-9 Swaption 9
swap rate

603. (B5114Los51h) valueofaninterestrateswaptionatexpiration


( option ,swap )
p114-115

604. (B5115Los57i)thecreditriskishighestinthemiddleoftheswapterm.
At inception of a swap contract and toward the end of the interest rate swap, the credit risk is low
again.
1.without netting 2. With netting/marking to market

605. (B5116Los57j) Swapspread creditrisk

Reading52:InterestRateDerivativeInstruments
606. (B5126Los52a) Cap/Floor

1.optioninterestrate

2.optiononfixedincome
(notes p127 payoff )

90

607. (B5128Los52b) acap afloor

interestratecollar
P129, 130.
:

periodic payment=max[0, (notional principal) (index rate-cap strike) (

actual days
)]
360

periodic payment=max[0, (notional principal) (floor strike-index rate) (

actual days
)]
360

Reading53:UsingCreditDerivatives:AnOverview
608. (B5134Los53a)CDS

creditdefaultswap(CDS)

CDS CorporateBonds /
CDS long CDS=

609. (B5136Los53b)CDSProtectionbuyer seller

Buyer:doubledefaultrisk,replacementrisk,basisrisk

Seller:counterpartyrisk
610. (B5137Los53c) CDStotalreturnswaps,assetswaps creditspreadoptions

CDS:

Total return swaps:

91

Asset swaps:

611. (B5138Los53d)CDS

Hedgeexposure

Speculate

Arbitrageopportunities
612. (B5139Los53e) CDS Spreadexpected spread payments expected default
losses

PVexpected CDS spread payments

PV (expected credit losses)

PVexpected CDS stread payments

An estimate of the probability of survival for each periodic payment (1- the cumulative
probability of default)

An estimate of default probabilities and the dollar amount of loss

613. (B5140Los53f) Dealerriskmanagement

Practice
(Notes B5 R48 4,6,7,8,10,11)
(Notes B5 R49 1,3,6,7,8)
(Notes B5 R50 1,2,3,7,8,12,13,14,15,16)
(Notes B5 R51 1,2,4,6,10,11,12,13,14,15)
(Notes B5 R52 3)
(Notes B5 R53 1,3)
( R48 5,6,7,8,9,11,13A,14,15)
( R49 1,11,13,14)
( R50 2,3,4B,6,9,10)
92

( R51 6,7)
( R52 1,3)
( R53 1,2,3,6)

93

SS18PortfolioManagements
Reading54:PortfolioConcepts
614. (B5149)Meanvarianceanalysis
615. (B5149)Meanvarianceanalysis
616. (B5150)2 expectedreturn

2 expectedreturn

Covariance,,

2
617. (B5152) 2
618. (B5153)
619. (B5154)MinimumVarianceportfolio
620. (B5155) MinimumVariancefrontier

MinimumVariancefrontier
figure5

621. (B5157) efficientportfolio


622. (B5157) efficientfrontier
623. (B5158) Portfoliodiversification

Portfoliodiversification

Portfoliodiversification
P157 figure6-9

624. (B5161) EquallyWeightedPortfolioRisk


Variance of Equally-Weighted Portfolio

625. (B5163) CALCML

CALCML

marketportfolio

riskfreeasset,
626. (B5163) CAL figure111213

Figure111213

rewardtoriskratio
94

CAL

627. (B5167)CAL

slopeIntercept
CAL P168

628. (B5169) CAL


629. (B5169)CML


630. (B5170)CML CAL
631. (B5171)CAPM

CAPM
632. (B5172)SML

SML

slopeIntercept

marketriskpremium

SML Figure15
633. (B5174) Betacoefficient

B=1B>1B<1

P175 Figure16

634. B5175 FinancialMarketEquilibrium

FinancialMarketEquilibrium

CAPM Equilibriummodel

P176 Standalonerisk
635. (B5176)CML SML

Figure17

636. (B5178) meanvarianceframework


637. (B5179)marketmodel

Marketmodel
638. (B5181)adjustedBeta
95

betainstability
adjustedBeta?
adjustedBeta closeto1overtime
adjustedBeta

639. (B5183) reasons for and problems related to instability in the minimumvariance
frontier

Reasons

Instabilityproblem
640. (B5184)Multifactormodel

Multifactormodel
(1) macroeconomic factor models,
(2) fundamental factor models

641. (B5185)Macroeconomicfactormodels

Macroeconomicfactormodels

PricedRiskfactors?

FactorSensitivities?
642. (B5187)fundamentalfactormodels

macroeconomicfactormodels fundamentalfactormodels
643. (B5188) Calculate the expected return on a portfolio of two stocks, given the
estimatedmacroeconomicfactormodelforeachstock.

644. (B5190)APT

APT

arbitragepricingmodel

APT

APT multifactormodel
645. (B5192)Activeriskandactivereturn

Activeriskandactivereturn

ActivefactorriskandActivespecificrisk
646. (B5194)InformationRatio
647. (B5196)Factorandtrackingportfolio
648. (B5196) CAPMAPTmodel

CAPMAPT

96

Reading55:Thetheoryofactiveportfoliomanagement
649. (B5214)activeportfoliomanagement

The theory of active portfolio management can be justified based on economic


and empirical arguments 2
in order to implement this passive investment strategy, an active portfolio
management theory is needed to
650. (B5215)TreynorBlackmodel

MODEL

ThespecificstepsforTreynorBlockmodel
Step 1: Develop capital market expectations for the passively managed market index portfolio M.
Step2: Identify the limited set of mispriced securities, which are securities with large predicted
alphasdefined as thee analysts forecast return minus the CAPM required return:

Predicted alpha for security i ( i ) forecast return for security i - {RF i [ E ( RM RF )]}
Step3: Determine weightings across the mispriced securities to form the actively managed
portfolio, A. The weight for security i in the actively managed portfolio equals:
i
2 ( i )
wi

2 (j )
j

Step 4: Determine weightings to the actively managed Portfolio A and to the passively managed
market index M to form optimal Portfolio P. Portfolio P is the combination of portfolios A and M
that will have the highest possible Sharpe Ratio (higher than both Portfolio A or M).

Step 5: Allocate funds to Portfolio P and to the risk-free asset that satisfy the investor's risk
aversion. The investor's optimal investment (combination of risk-free asset and risky Portfolio P)
is represented by the tangency point of the investor's indifference curve with the capital
allocation line (point C).

97

TBmodel oprtimalportfolio
Informationratio

2A

A
( A )2 ,
is called the information ratio
2
( A ) ( A )
( A )

TreynorBlackCalculations

1.Stock alphas i forecast return for stock i - {RF i [ E ( RM RF )]}


2.weights within the actively managed portfolio A:

1
(1 )
w1
, w2 1 w1
1
2

2 (1 ) 2 ( 2 )
2

3.Portfolio A Alpha:

A forecast return for portfolio A - {RF i [ E ( RM RF )]}, or , A w11 w2 2


Portfolio A standard deviation forecast A [ A 2 M 2 2 ( A )]

4.Portfolio A expected return:


E ( RA ) w1 E ( R1 ) w2 E ( R2 ), or , E ( RA ) A RF A [ E ( RM ) RF ]
5.Covariance of active portfolio A with passive market index M:
cov AM A M M 2

TBMODEL

651. (B5221)Analystsaccuracyinforecastingalphas

TBMODEL alphas

specificsteps

98

Reading56:TheportfolioManagementprocessandthe
investmentpolicystatement
652. (B5228) portfoliomanagementselements
653. (B5229)explaintheimportanceofportfolioperspective

riskreturntradeoff

PM 2
654. (B5229)PM 3
655. (B5230)IPS

IPS elements
656. (B5230)strategicassetallocation

strategicassetallocation

3approachestoimplementstrategicassetallocation

longerinvestmenttimehorizon
657. (B5231)investmentobjectives,riskobjectives

Somespecificfactorsaffectabilitytoacceptrisk

Figure1willingnessvsabilitytotakerisk

absoluteandrelativeriskobjective

returnobjective
658. (B5233)Investmentconstrains

fivecommonconstraints

constraint riskreturnobjective

briefsummaryofriskreturnobjectiveFigure2
659. (B5235)Investmenttimehorizons

timehorizon

Investmenttimehorizons
660. (B5235) ethicalconductasarequirementformanaginginvestmentportfolio

Practice
Notes: R54

1-6 8 9 11 13 14 16 20-23

Notes: R55

1 2 3 5 7 14 15 17 18 19

Notes: R56 2 6 9
R54 1 5 7 11 13 15 17 18
99

R55 1 2 4-9
R56 1 2 3 4 5-10 11-16 17-22

100