All CFA Institute members and candidates are

required to comply with the Code and Standards

The CFA Institute Bylaws
Basic structure for enforcing
Based on two Fair process to member and candidate
the Code and Standards
primary principles
Rules of Procedure Confidentiality of proceedings

Maintains oversight and responsibility

The CFA Institute Is responsible for the
Board of Governors enforcement of the
Through the Disciplinary
Professional Conduct Review Committee (DRC) Code and Standards
program (PCP)
Structure of the CFA The CFA Designated Conducts professional
Institute Professional Officer Directs professional conduct staff conduct inquiries
Conduct Program

Selfdisclosure
Written complaints

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An inquiry can be prompted

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Evidence of misconduct
by several circumstances
Report by a CFA exam proctor

s.
Analysis of exam materials and monitoring
a. of social media by CFA Insitute

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Requesting a written explanation
The Professional from the member or candidate

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Conduct staff conducts
The member or candidate
an investigation that

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may include Interviewing Complaining parties
Third parties

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Collecting documents and records in support of its investigation

1. Code Of Ethics And Conclude the inquiry with no disciplinary sanction

an
Standards Of Issue a cautionary letter
When an
Professional Conduct

in
inquiry is If finding that a violation of
Process for the enforcement Upon reviewing the the Code and Standards
initiated
material obtained during Accepted by member

of
of the Code and Standards occurred, the Designated
the investigation, the Officer proposes a
Designated Officer may The matter is referred to a
disciplinary sanction

t
hearing by a panel of CFA
Continue proceedings Institute members
ay to discipline the
member or candidate
Rejected by member

condemnation by the member's peers

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If sanction is imposed suspension of candidate's continued
participant in the CFA program
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Act with integrity, competence, diligence,

respect and in an ethical manner
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Integrity of investment profession &

interest of clients above personal interest

Six components of Care & judgment

the Code of Ethics Practice ethics & encourage others to practice
Integrity & viability of the global capital markets
Professional competence
b,c.
Professionalism
Integrity of Capital markets
Duties of Clients
Duties to Employers
Seven Standards of
Professional Conduct Investment analysis, Recommendations & Actions
Conflict of interest
Responsibilities as a CFA Institute
member or CFA Candidate

1. Code Of Ethics And Standards Of Professional Conduct - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
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 Understand and comply with
applicable laws and regulations

Code and Standards vs. Local law Follow stricter law and regulation

Responsible for violations in which they

knowingly participate or assist
Dissociate from illegal,
unethical activities Leave employers (in extreme case)

Attempt to stop the behavior by bringing it to the attention of

Guidance employer through a supervisor or compliance department
Participation or association
May consider directly confronting
with violations by others
the involved individuals
Intermediate steps
If not successful,--> step away and Removing their name from written reports
dissociate from the activity by
Asking for a different assignment

A. Knowledge Inaction with continued association may be construed as knowing participation

of the law Not required reporting violations to government, CFAI,
but advisable in some cases or required by laws in others

Stay informed
Review procedures
Members and Maintain current files
candidates
When in doubt, seek advice of
compliance personnel or legal counsel
When dissociating from violations, --> Document
Recommended any violations and urge firms to stop them
procedures for
compliance (RPC) Develop and/or adopt a code of ethics
Make available to employees info that
Firms highlights applicable laws and regulations
Establish written procedures for reporting suspected
violation of laws, regulations or company policies
Application

Maintain independence and

objectivity in professional activities
Gifts, Invitations to lavish
functions, Tickets, Favors, Job referrals,
By benefits Allocation of shares in oversubscribed IPOs...
External
pressures
From public companies To issue favorable reports

From Buyside clients May try to pressure sellside analysts

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From their e.g. to issue favorable research reports/
own firms recommendations for certain companies

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Internal
pressures to issue favorable research on current or
Investmentbanking prospective investmentbanking clients
How to cope with external and
relationships

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internal pressures Conflicts of interest

Modest gifts and entertainment are

acceptable but special care must be taken must disclose to employers

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Guidance
Best practice: reject any offer of gifts,
threatening independence and objectivity
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convey true opinions
--> free of bias from pressures
Recommendations must
be stated in clear
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B. Independence and unambiguous language

and objectivity Portfolio managers must respect and
foster honesty of sellside research
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Is fraught with conflicts

2.1 Standard I Must engage in thorough,
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PROFESSIONALISM independent, and unbiased analysis

Must fully disclose potential conflicts,
including the nature of compensation
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Issuerpaid research Must strictly limit the type of compensation

Analysts they accept for conducting research
to

Accept only flat fee for their

work prior to writing the report
Best practice Without regard to conclusions
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or recommendations

Protect integrity of opinions

Create a restricted list
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Restrict special cost arrangements

Limit gifts
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RPC Equity IPOs

Restrict employee investments
Private placements
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Review procedures
Written policies on independence
and objectivity of research
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Definition of any untrue statement or omission of a fact

"Misrepresentation"
or any false or misleading statement

Must not knowingly make

oral representations, advertising
misrepresentation or give
false impression in electronic communications
written materials

qualifications or credentials, services

performance record
Must not misrepresent Without regard to conclusions or
Guidance any aspect of practice, including recommendations
characteristics of an investment
any misrepresentation relating to
C. Misrepresentation member's professional activities
Must not guarantee clients specific return
on investments that are inherently volatile
Standard I(C) prohibits plagiarism in preparation
of material for distribution to employers, associates,
clients, prospects, general publish

Written list of available services, description of firm's qualification

Designate employees to speak on behalf of firm
Prepare summary of qualifications and experience,
list of services capable of performing
RPC
Maintain copies
To avoid plagiarism Attribute quotations
Attribute summaries

Address conduct related to professional life

Any act involving lying, cheating, stealing, other dishonest conduct that
reflects adversely on member's professional activities would be violation
Conduct damaging trustworthiness or competence (include behaviour may
not be illegal but negatively affect a member to perform responsibility such
Guidance as abusing alcohol during lunch hours)
Violations
D. Misconduct Abuse of the CFA Institute Professional Conduct Program
Involved in personal bankruptcy is not automatically assumed to be in violation but
bankruptcy involve fraudulent or deceitful business conduct may be a violation

Develop and/or adopt a code of ethics

Disseminate to all employee a list of potential violations
RPC
Check references of potential employees

2.1 Standard I PROFESSIONALISM - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
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Definition of "Material
nonpublic information"
its significant impact to the price
of security if it is disclosed
Reasonable investors would like
Material information
to know for making decision
The reliability of the information

disseminated to the market place and

Non-public until
effficient time for investors to react
Must be particularly aware of info
Guidance selectively disclosed by corporations
Analysis of Public info + nonmaterial
nonpublic info --> Investment conclusion
Mosaic Analysts are free to act on this collection
Theory of info without risking violation

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co
Analysts should save and
A. Material non-public document all their research

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information (MNI)
Make reasonable efforts to achieve

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public dissemination of material info

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Must communicate the info only to the designated
If public dissemination supervisory and compliance personnel within the firm
is not possible,

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Must not take investment action on the basis of the info

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Must not knowingly engage in conduct
2.2 Standard II inducing insiders to privately disclose MNI

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INTEGRITY OF RPC adopt compliance procedures

in
CAPITAL MARKETS preventing misuse of MNI
develop & follow disclosure policies

of
Encourage firms to
to ensure proper dissemination

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use "firewall"
ay Prohibition of all proprietary trading while firm
is in possession of MNI may be inappropriate
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Distort prices or artificially inflate trading volume

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with the intent to mislead market participants

Definition
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Transactions that artificially

transactions that deceive
market participants
B. Market
manipulation can be related to
dissemination of false
or misleading info
distort prices or volume
Securing a controlling, dominant position in a
financial instrument to exploit and manipulate
price of a related derivative/or underlying asset
including spreading false rumors
to induce trading by others

prohibit legitimate trading strategies

Standard II(B) not meant to prohibit transactions done for tax purposes
The intent of action is critical to determining
whether it is a violation of this Standard
2.2 Standard II INTEGRITY OF CAPITAL MARKETS - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
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 om
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To be continued

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For MORE CFA Mind Maps, please go to

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http://waytofinancesuccess.com

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to
Click here
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 m
Describe limitations of regression analysis

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A sample covariance, a sample correlation coefficient and a scatter plot

s.
Describe the use of analysis of variance (ANOVA) in regression analysis,

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interpret ANOVA results, and calculate and interpret the F-statistic
Limitation to correlation analysis

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Calculate and interpret a confidence interval for
the predicted value of the dependent variable Uses of correlation Analysis

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9. Correlation and

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Formulate a test of the hypothesis that the population
Calculate the predicted value for the dependent variable, given an
Regression - An Overview correlation coefficient equals zero and determine whether

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estimated regression model and a value for the independent variable
the hypothesis is rejected at a given level of significance

t of
Formulate a null and alternative hypothesis about a population value of
Distinguish between the dependent and
a regression coefficient and determine the appropriate test statistic and
whether the null hypothesis is rejected at a given level of significance ay independent variables in a linear regression
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Calculate and interpret the standard error of Describe the assumptions underlying linear
estimate, the coefficient of determination, and a regression and interpret regression coefficient
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confidence interval for a regression coefficient

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9. Correlation and Regression - An Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
WAY TO FINANCE SUCCESS - Website: http://waytofinancesuccess.com
 A graph that shows the relationship between the observations for two data series in two dimensions

Scatter Plots

Each observation in the scatter plot is represented as a point, and the points are not connected
The scatter shows only the actual observation of both data series plotted as pairs

Correlation analysis expresses the same relationship (between two data series) using a single number
The correlation coefficient measures the direction and extent of linear association between two variables
A correlation coefficient less than 0 indicates a negative linear association

A sample covariance, a sample

correlation coefficient and a scatter plot

A correlation coefficient can

have a maximum value of 1
Correlation Analysis and a minimum value of -1

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A correlation coefficient
greater than 0 indicates a

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positive linear association

A scatter plot of two variables with a correlation of 0; they have no linear relation -> the value of A tells us nothing about the value of B

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The sample covariance of X and Y, for a sample of size n

ce The expression for the sample variance of X, is

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Calculate the Correlation Coefficient
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The sample correlation coefficient

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9. Correlation and
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Regression - Part 1
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Two variables can have a strong nonlinear

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Correlation may be an
relation and still have a very low correlation
unreliable measure when
Limitation to correlation analysis
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Outliers are present in one or both of the series.

Outliers are small numbers of observations at
either extreme (small or large) of a sample

correlation between two variables that reflects chance relationship in a particular data set
correlation induced by a calculation that mixes each of two variables with a third
Spurious correlation correlation between two variables arising not from a direct
relation between them but from their relation to a third variable

In investment decision-making (for example: inflation forecast)

Uses of correlation Analysis Correlation of stock market tells us how successfully the assets can be combined to diversify risk
Used in a financial statement setting

H0: the correlation in the population is 0 (p = 0)

Ha : the correlation in the population is different from 0 (p # 0)

Formulate a test of the hypothesis that the

population correlation coefficient equals zero
and determine whether the hypothesis is
rejected at a given level of significance
The formula for the t-test This test statistic has a t-distribution with n-2
degrees of freedom if the null hypothesis is true
Sampling from the same population, a false null hypothesis H0: is more likely to be rejected as
we increase sample size. The result whether H0 is rejected also depends on significance level

Linear regression with one independent variable (or simple linear regression)
Distinguish between the dependent and models the relationship between two variables as a straight line
independent variables in a linear regression Linear regression provides a simple model for forecasting the value of one variable, known as the
dependent variable, given the value of the second variable, known as the independent variable

9. Correlation and Regression - Part 1 - Copyright by WAY TO FINANCE SUCCESS

 Y: dependent variable b0, b1 are the regression coefficients
X: independent variable
b0: the intercept
b1: a slope coefficient
Slope coefficient The estimated slope coefficient is interpreted as the change
in the dependent variable for a 1-unit change in the
independent variable
The regression equation

The intercept term

The intercept is an estimate of the dependent variable when the independent variable takes on a value of zero

error term (represents the portion of the dependent variable that cannot be explained by the independent variable

The relationship between the dependent variable, Y, and the independent variable, Critical for a valid linear regression. If the relationship
Describe the assumptions between the independent and dependent variables is
underlying linear regression and X is linear in the parameter b0 and b1. b0 and b1 are raised to the first power only
and that neither b0 nor b1 is multiplied or divided by another (for example, b0/b1). nonlinear in the parameters, then estimating that relation
interpret regression coefficient with a linear regression model will produce invalid results
The requirement does not exclude X from being raised to a power other than 1

The independent variable, X, is not random

Ensure that linear regression

produces the correct
The expected value of the error term is 0 estimates

Six classic normal linear The variance of the error term is the
regression model assumptions same for all observations:

use the linear regression model to determine

the distribution of the estimated parameters
The error term is uncorrelated across observations.
and and thus test whether those coefficients
Consequently, E(ei,j) = 0 for all i not equal to j.
have a particular value
The error term is normally distributed

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.c
The formula for the standard error of estimate (SEE) for a The different between the actual and predicted values
linear regression model with one independent variable is of the dependent variable is the regression residual
Calculate and interpret the standard
error of estimate, the coefficient of

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defined as the percentage of the total variation in the dependent variable explained by the independent variable
determination, and a confidence
interval for a regression coefficient The coefficient of determination (R^2) R^2 = r^2 for a regression with one independent variable

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Confidence interval spans the range

Regression coefficient confidence interval

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A confidence interval is an interval of values that we believe includes the true parameter value, , with a given degree of confidence
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the estimated parameter value

A hypothesis test using the confidence interval approach if we know the hypothesized value b0 or b1
a confidence interval around the estimated parameter
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Formulate a null and alternative hypothesis about a

population value of a regression coefficient and determine
the appropriate test statistic and whether the null
9. Correlation and hypothesis is rejected at a given level of significance
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Regression - Part 2 In practice, the most common way to test a hypothesis using a regression model is
with a t-test of significance. To test the hypothesis, we can compute the statistic
This test statistic has a t-distribution with n-2 degrees of freedom. Reject H0 if t> +tcritical or t <-tcritical
fi

The appropriate test structure for the null and alternative hypothesis: H0: b1 = 0 versus Ha: b1 # 0
to

Calculate the predicted value for the dependent

variable, given an estimated regression model If we know
and a value for the independent variable
ay

Where sf = standard eror of the forecast

/w

The prediction interval for a regression equation for a

particular predicted value of the dependent variable Y tc is two-tailed critical t-value at the desired level of significance with df = n-2
:/

Calculate and interpret a confidence interval for

the predicted value of the dependent variable
variance of the residuals = the square of the standard error of estimate
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The formula to calculate sf variance of the independent variable

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X value of the independent variable for which the forecast was made

Analysis of variance (ANOVA) is a statistical procedure for dividing the total variability of a variable into components that can be attributed to different sources
Use ANOVA to determine the usefulness of the independent variable or variables in explaining variation in the dependent variable
The F-test tests whether all the slope coefficients in a linear regression are equal to 0
The null hypothesis H0: b1 =0
The alternative hypothesis Ha: b1 # 1

SSE (The sum of squared errors or residuals)

Describe the use of analysis of variance (ANOVA)
in regression analysis, interpret ANOVA results,
and calculate and interpret the F-statistic
Formula for the F-statistic in a regression
with one independent variable is
RSS (The regression sum of squares)
TSS = SSE + RSS
If there are n observations, the
F-test for the null hypothesis that
the slope coefficient is equal to 0
is hear denoted

Calculate R^2 and SEE

Regression relations can change over time-> the issue of parameter instability
Describe limitations of
Public knowledge of regression relationships may negate their future usefulness
regression analysis
If the regression assumptions are violated, hypothesis tests and predictions based on linear regression will not be valid

9. Correlation and Regression - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
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 m
Introduction

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s.
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Value Definition and

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29. Equity Valuation: Valuation Applications

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Applications and Processes -

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in
An Overview

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Communicating Valuation Results

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The Valuation Process

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29. Equity Valuation. Applications and Processes - Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

WAY TO FINANCE SUCCESS - Website: http://waytofinancesuccess.com

 The estimation of an assets value based on variables perceived to be related to future investment
returns, on comparisons with similar assets, or on estimates of immediate liquidation proceeds
Valuation

What is value?
Introduction
Who uses equity valuations?

Basic questions What is the importance of industry knowledge?

How can the analyst effectively
communicate his analysis?

The value of the asset given a hypothetically complete

understanding of the assets investment characteristics
Reflects investor's view of the true or real value of an asset
Market price and intrinsic
value are identical
Investors will not rationally incur the expenses of
Grossman-Stiglitz paradox gathering information unless they expect to be
Rational efficient rewarded by higher gross returns compared with
markets formulation the free alternative of accepting the market price

Common stock
Difficult to determine especially Trading costs exist
Further room exists for price to diverge from value

A difference between the estimated intrinsic

Analysts often view market prices both
with respect and with skepticism
Seek to identify mispricing value and the market price of an asset
Rely on price eventually converging to intrinsic value
Recognize distinctions among the levels
of market efficiency or tiers of markets

Intrinsic Value Uncertainty is Revaluate by looking for the presence of a

Valuation is an inherent part to attempt positive excess constantly present particular market or corporate event ( catalyst)
risk adjusted returns (abnormal return or alpha)

The error in the estimate of the intrinsic value

(V E -V): the difference between the valuation
estimate and the true but unobservable intrinsic value

VE = estimated value
V E - P = (V - P) + ( V E - V) P = market price
Definition V = intrinsic value

Contribute to the abnormal return

(V-P): the true mispricing, the difference between the true but
unobservable intrinsic value V and the observed market price P

Managers expectations must differ from

consensus expectations and be correct
Combine accurate forecasts and Active security selection
A useful estimate appropriate valuation model
of intrinsic value
Expectational inputs used in valuation models

value maximizing using assets

The assumption that the company will continue
its business activities into the foreseeable future accessing its optimal sources of financing
not appropriate for a company in financial distress
Going-concern assumption
The value added by assets working together and by human capital applied to managing
Value Definition and

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those assets makes estimated goingconcern value greater than liquidation value
Valuation Applications Going-Concern Value and Liquidation Value

Orderly liquidation value

Liquidation value

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Different time frame for liquidating causes different assets value of a company

is the price at which an asset (or liability) would change hands between a willing buyer and a willing seller
when the former is not under any compulsion to buy and the latter is not under any compulsion to sell

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Fair market value includes an assumption that both buyer and seller are informed of all material aspects of the underlying investment
Fair Market Value and Investment Value often used in valuation related to assessing taxes

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The concept of value to a specific buyer taking account of potential
Investment value synergies and based on the investors requirements and expectations

Selecting stocks Primary use

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evaluate the reasonableness of the expectations
Inferring (extracting ) market expectations
as a benchmark or comparison value of the same characteristic for another company
es

A merger the general term for the combination of two companies

a combination of two companies, with one of the companies

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identified as the acquirer, the other the acquired

An acquisition the acquiring companys own common stock
is often used as currency for the purchase
29. Equity Valuation:
affects a companys future cash flows -> equity
Applications and Processes
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Evaluating corporate events A divestiture a company sells some major component of its business

- Part 1
the company separates one of its component businesses and transfers
A spin-off the ownership of the separated business to its shareholders
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Valuation Applications
an acquisition involving significant leverage [i.e., debt], which is
A leveraged buyout often collateralized by the assets of the company being acquired.)
to

The parties to a merger may be required to seek a fairness opinion on

Rendering fairness opinions the terms of the merger from a third party, such as an investment bank
ay

Companies concerned with maximizing shareholder value

evaluate the effect of alternative strategies on share value
Evaluating business strategies and models

Communicating with analysts and shareholders

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E.g acquisitions or buy-sell agreements for the transfer of equity

for transactional purposes interests among owners when one of them dies or retires, IPO,...
Appraising private businesses
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Sharebased payment (compensation)

the basis for computing the target

When a research report states a
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information on the uncertainty of reaching the target

target price for a stock, it should
clarify a time frame for reaching the target

An update on the companys

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financial and operating results

Sell-side analysts report: The key assumptions and A description of relevant aspects of the
investment recommendation expectations underlying that current macroeconomic and industry context
Kind of infor. intended readers seek to gain
Persuasive supporting The intrinsic value estimated intrinsic value An analysis and forecast for
arguments of the security the industry and company
Detailed historical descriptive statistics
about the industry and company

May be accompanied by an explanation of the underlying rationale

Specific forecasts
Contents of a Research Report
A description of the valuation model
Key valuation inputs
Usual contents
A discussion of qualitative factors and other considerations that affect valuation
Objectively address the uncertainty associated with investing in the security,
and/or the valuation inputs involving the greatest amount of uncertainty

Contains timely information

is written in clear, incisive language
is objective and well researched, with key assumptions clearly identified The requirements are more specific in some situations. For e.g,
distinguishes clearly between facts and opinions regulations governing disclosures of conflicts and potential conflicts
An effective research report of interest vary across countries, investment recommendations are
contains analysis, forecasts, valuation, and a recommendation that are internally consistent affected by policies of the firm employing an analyst
Communicating Valuation Results presents sufficient information to allow a reader to critique the valuation
states the key risk factors involved in an investment in the company
discloses any potential conflicts of interests faced by the analyst

Format of a Research Report

All analysts have an obligation to provide substantive and Analysts who are CFA Institute members, however, have an additional and overriding responsibility to adhere to
meaningful content in a clear and comprehensive report format the Code of Ethics and the Standards of Professional Conduct in all activities pertaining to their research reports

Research Reporting Responsibilities

The analyst must hold himself accountable to both standards of competence and standards of conduct

29. Equity Valuation. Applications and Processes - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
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 Sell-side analyst: Analysts Valuation judgments to distribute to current and
who work at brokerage firms prospective retail and institutional brokerage clients

Investment discipline (security is to understand the basic characteristics of the markets served by a company and the economics of the company
selection) and quantitative Valuation judgments to a portfolio manager or to an
give appropriate attention to to organize thoughts about an industry and to better understand a companys
investment disciplines investment committee as input to an investment decision
Buy-side analysts the most important economic prospects for success in competition with other companies in that industry
The purposes and the intended drivers of a business
consumer of the valuation to highlight the greatest challenges and opportunities need more sensitivity analysis ?
Both corporate analysts and investment bank analysts may also Applying the Valuation Conclusion: Usefulness
identify and value companies that could become acquisition targets The Analysts Role and Responsibilities
Analysts at independent vendors of financial information usually offer How attractive are the industries in which
Try to understand the industry structure
valuation information and opinions in publicly distributed research reports the company operates, in terms of offering
prospects for sustained profitability Porter 5 forces
Help their clients achieve their investment objectives Stay current on facts and news concerning all the industries
Contribute to the efficient functioning of capital markets Investment analysts play a critical role in collecting, organizing, analyzing,
and communicating corporate information, and in some contexts, What is the companys The level and trend of the companys market share indicate
Benefit the suppliers of capital, including shareholders, when
recommending appropriate investment actions based on sound analysis Industry and Use various relative competitive position its relative competitive position within an industry The term business model refers
they are effective monitors of managements performance
Competitive Analysis frameworks within its industry, and what Cost leadership generally to how a company makes
is its competitive strategy money
How is a useful Corporate strategies Differentiation
E.g when assess how a change in assumptions about a companys
future growth or analyze how different competitive responses framework? Focus Focus
to determine how changes in an assumed on these questions
would affect the forecasted financials and the estimated valuation input would affect the outcome Sensitivity analysis
Analyzing the companys financial
report to evaluate the company's Looking annual reports
Historical analysis to have
the value of a stock investment strategic objectives' performances for 10, 5, 2 years prior
control premiums its insights through time
and develop expectations to it
How well has the company

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the value of nonpublicly traded stocks Converting Forecasts executed its strategy and what are
lack of marketability discounts importance of qualitative (non-numeric factors)
Two important aspects to a Valuation its prospects for future execution

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2 caveats merit mention avoid simply extrapolating past operating
the prices of shares with less depth to their markets
Situational adjustments results when forecasting future performance
an investor wishes to sell an amount of stock that is large relative to that stocks
trading volume (assuming it is not large enough to constitute a controlling ownership) most relevant for evaluating a companys Financial ratio analysis is useful for established companies
illiquidity discounts
success in implementing strategic choices

s.
The price that would be lower than the Individual drivers of profitability for merchandising and manufacturing companies
market price for a smaller amount of stock Analysis of Financial Reports can be evaluated against the companys stated strategic objectives
blockage factor

Analysts can compare the information provided directly

by companies to their own independent research

es
used to produce an estimate of value that can
be compared with the assets market price Regulatory requirements concerning disclosures and filings vary internationally
Def. a model that specifies an assets intrinsic value Sources of Information
Be aware when regulations (e.g., Regulation FD in the United States) prohibit companies from disclosing
material nonpublic information to analysts without also disseminating that information to the public
The value of an asset to an investor must be related to the
returns that investor expects to receive from holding that asset.

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The scrutiny of all financial statements, including the balance sheet, Also require careful scrutiny of
Defines cash flow net of to evaluate both the sustainability of the companies performance accounting statements, footnotes,
Free cash flow
payments to providers of debt and how accurately the reported information reflects economic reality and other relevant disclosure
to equity model

Analysts frequently Equity analysts: develop better insights into a company and improve forecast accuracy

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Free cash flow
Defines cash flows before those payments to the firm define cash flows at Quality of earnings analysis Sustainability of performance: identify aspects of reported nonrecurring performance
the company level The fundamental
approach to comparison of a companys net
Based on accrual accounting Identify reporting decisions that may result in a level
For common equity valuation income with its operating cash flow
earnings in excess of the opportunity of reported earnings that are unlikely to continue
stock: Dividend

cost of generating those earnings Residual income model
its CFs and discount rate
Need sensitivity
need to address other issues, such as
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discount models
Present value models Poor quality of accounting disclosures, such as segment information, acquisitions,
Absolute Valuation Models Understanding the business accounting policies and assumptions, and a lack of discussion of negative factors.
(discounted CF models)
Existence of relatedparty transactions
Greater uncertainty than
Existence of excessive officer, employee, or director loans

analysis
the value of corporate control or the
value of unused assets
A stream of cash payments specified in
a legal contract (the bond indenture)
an
the case with bonds due to
29. Equity Valuation: High management or director turnover
Excessive pressure on company personnel to make revenue or earnings targets,
Applications and Processes - particularly when combined with a dominant, aggressive management team or individual
Part 2: The Valuation Process A working selection of risk factors (AICPA 2002) (in case growth in Material non-audit services performed by audit firm

in
an asset account at a much faster rate than the growth rate of sales
Not as uncertain as common stock Applied to bond valuation Reported (through regulatory filings) disputes with and/or changes in auditors
A discount rate can usually be based on
market interest rates and bond ratings Management and/or directors compensation tied to profitability or stock price
(through ownership or compensation plans). Although such arrangements are
usually desirable, they can be a risk factor for aggressive financial reporting.
Values a company on the basis of the market

of
Can provide an independent estimate of value Economic, industry, or companyspecific pressures on profitability,
value of the assets or resources it controls such as loss of market share or declining margins
Asset- based valuation
Management pressure to meet debt covenants or earnings expectations
Underlying idea: similar assets should sell at similar prices Def. estimate an assets value relative to that of another asset A history of securities law violations, reporting violations, or persistent late filings

t
Undervalue ratios of stock price to a fundamental
P/E

ay
Relatively undervalue such as cash flow per share Considerations in Using
using price multiples Accounting Information
How?
ratios of the total value of common stock and debt net of cash and shortterm investments
to certain of a companys operating assets to a fundamental such as operating earnings enterprise multiples
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Selecting the Appropriate Valuation Model
The more conservative investing strategies involve overweighting (underweighting)
relatively undervalued (overvalued) assets, with reference to benchmark weights Relative Valuation Models

Pairs trading: buying the relatively undervalued Relative value investing (or relative spread
:/

stock and selling short the relatively overvalued stock The more aggressive strategies allow short
investing, if using implied discount factors)
selling of perceived overvalued assets

does not specify intrinsic value without making the further

assumption that the comparison asset is fairly valued The method of comparables is characterized by
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a wide range of possible implementation choices Frequently involve a group

being simple, related to market prices, and
of comparison assets
grounded in a sound economic principle

Breakup value or Sums the estimated values of each of the

The value derived using a
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private market value companys businesses as if each business

sum-of-the-parts valuation
were an independent going concern

Value a company with segments in different industries

that have different valuation characteristics
evaluate the value that might be unlocked in a restructuring through When to use
a spinoff, splitoff, tracking stock, or equity (IPO) carveout

The market applies a discount to the stock of a company Sum-of-the-parts

operating in multiple, unrelated businesses compared to valuation Valuation of the Total Entity
the stock of companies with narrower focuses and Its Components
inefficiency of internal capital markets
Conglomerate discount
endogenous factors Alternative explanation
research measurement errors
Approach moves from international and national macroeconomic forecasts
A breakup value in excess of a companys unadjusted goingconcern to industry forecasts and then to individual company and asset forecasts
value may prompt strategic actions such as a divestiture or spin-off Top-down forecasting
The economic environment
Forecasting Company Performance Bottom-up forecasting Approach aggregates forecasts at a micro level to larger scale forecasts, under specific assumptions
understanding the nature of its assets and having a good understanding Two perspectives
how it uses those assets to create value consistent with the characteristics
of the business
of the company being valued Consider qualitative as well as quantitative factors
Criteria for model selection are The companys own operating and financial characteristics
that the valuation model be
appropriate given the availability and quality of data
Issues in Model Selection
consistent with the purpose of valuation, including the analysts perspective and Interpretation
Professionals frequently use multiple valuation
models or factors in common stock selection

29. Equity Valuation. Applications and Processes - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
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 om
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To be continued

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For MORE CFA Mind Maps, please go to

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http://waytofinancesuccess.com
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Wanna get Full Mind Maps for FREE ???
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INTRODUCTION
PRIVATE MARKET REAL ESTATE DEBT

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REAL ESTATE INVESTMENT: BASIC FORMS
INDICES

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REAL ESTATE: CHARACTERISTICS AND CLASSIFICATIONS

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VALUATION IN AN INTERNATIONAL CONTEXT
39. Private Real

an
Estate Investments:

in
DUE DILIGENCE An Overview PRIVATE MARKET REAL ESTATE EQUITY INVESTMENTS

t of
RECONCILIATION ay THE COST AND SALES COMPARISON APPROACHES TO VALUATION
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OVERVIEW OF THE VALUATION

THE INCOME APPROACH TO VALUATION
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OF COMMERCIAL REAL ESTATE

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39. Private Real Estate Investments - Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
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 often included in the portfolios of investors with long-term investment
horizons and with the ability to tolerate relatively lower liquidity
Private equity investment: sometimes
INTRODUCTION referred to as direct ownership

suitable for investors with short investment horizons and higher liquidity needs
Publicly traded debt investment:
sometimes referred to as indirect lending

The first dimension: whether the investment

is made in the private or public market
Investment in real estate has been defined from a capital market perspective The second dimension: whether the investment
in the context of quadrants which are a result of two dimensions of investment is made in the private or public market

REAL ESTATE INVESTMENT:

BASIC FORMS

Four quadrants
Private real estate investment, compared with publicly traded real estate investment, typically
involves larger investments because of the indivisibility of real estate property and is more illiquid
Publicly traded real estate investment allows the real estate property to
remain undivided but the ownership or claim on the property to be divided
Equity investors generally expect a higher rate of return than lenders (debt investors) because they take on more risk
Debt investors in real estate, whether through private or public markets, expect to receive their return from
promised cash flows and typically do not participate in any appreciation in value of the underlying real estate

Heterogeneity and fixed location

High unit value
Management intensive
High transaction costs
Characteristics Depreciation
Need for debt capital
Illiquidity :
Price determination

Single-family properties may be

REAL ESTATE: CHARACTERISTICS
AND CLASSIFICATIONS Residential properties: single-family houses
and multi-family properties, properties that
provide housing for individuals or families
owner-occupied or rental properties
Multi-family properties are rental properties even if
the owner or manager occupies one of the units
Multifamily housing is usually differentiated
by location and shape of structure
Properties purchased with the
Commercial real estate properties intent to let, lease, or rent

Classifications
Office
Industrial and warehouse
Non-residential properties include commercial properties
other than multifamily properties, farmland, and timberland Retail

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Hospitality
Other types

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Current income
Price appreciation (capital appreciation)

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Inflation hedge
Motivations
Diversification
Tax Benefits

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Business conditions
Long lead time for new development
Cost and availability of capital
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Unexpected inflation
Demographics
Characteristic sources of risk or risk
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factors of real estate investment Lack of liquidity

Risk Factors Environmental
Availability of information
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Management
Leverage
39. Private Real Estate Other risk factors
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Investments - Part 1
PRIVATE MARKET REAL ESTATE
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Risk and return of equity real estate investments is affected by the characteristics of
real estate and the risk factors, structure of leases between the owner and tenants
Real Estate Risk and Return

EQUITY INVESTMENTS Relative to Stocks and Bonds

The demand for office depends heavily on employment growth

The average length of an office building lease varies globally
to

net lease requires the tenant to be

An important consideration in office leases is whether the responsible for paying operating expenses
Office
owner or tenant incurs the risk of operating expenses gross lease requires the owner
ay

to pay the operating expenses

Not all office leases are structured as net or gross leases
There are differences in how leases are structured over time and in different countries
/w

The demand for industrial and warehouse space is heavily dependent on the overall strength
Industrial and Warehouse of the economy and economic growth and on import and export activity in the economy
Commercial Real Estate
:/

The demand depends heavily on trends in consumer spending. Consumer spending, in turn,
depends on the health of the economy, job growth, population growth, and savings rates
Percentage lease: the requirement that the tenants pay additional rent once their sales reach a certain level
Retail
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The lease will typically specify a minimum rent that must be paid regar dless of the tenants sales
and the basis for calculating percentage rent once the tenants sales reach a certain level or breakpoint

The demand for multi-family population growth, especially for the age segment most likely to rent apartments
ht

space depends on how the cost of renting compares with the cost of
Multi-Family owning-that is, the ratio of home prices to rents

The cost approach involves estimating the value of the building(s) based on adjusted replacement cost
The replacement cost is adjusted for different types of depreciation (loss in value) to arrive at a depreciated replacement cost
curable: fixing the problem will add value that
Physical deterioration related to the age is at least as great as the cost of the cure
of the property because components of the
property wear out over time. Two types incurable: Fixing a structural problem with the foundation
of the building may cost more to cure than the amount
that it would increase the value of the property if cured
The Cost Approach
Functional obsolescence: a loss in value due to a design that is different from that of a
Types of depreciation new building constructed with an appropriate design for the intended use of the property

External obsolescence: due to either the location of Locational obsolescence results when
the property or economic conditions, results when the location is not optimal for the property
the location is not optimal for the property Economic obsolescence results when new construction
is not feasible under current economic conditions

The sales comparison approach implicitly assumes that the value of a property
THE COST AND SALES COMPARISON
depends on what other comparable properties are selling for in the current market
APPROACHES TO VALUATION The Sales Comparison Approach

Advantages and Disadvantages of the

Cost and Sales Comparison Approaches

Appraisals (estimates of value) are critical for such infrequently traded and unique assets as real estate properties
Market value: can be thought of as the most probable sale price. It is what a typical investor is willing to pay for the property
Investment value: the value to a particular investor, could be higher or lower than market
Appraisals Value value depending on the particular investors motivations and how well the property fits into the
There are other definitions of value investors portfolio, the investors risk tolerance, the investors tax circumstances, and so on.
that differ from market value
Value in use: the value to a particular user
OVERVIEW OF THE VALUATION The income approach considers what price an investor would pay based on an
OF COMMERCIAL REAL ESTATE expected rate of return that is commensurate with the risk of the investment
The cost approach considers what it would cost to buy the land and construct a new property on the site that
Three different approaches has the same utility or functionality as the property being appraised (referred to as the subject property )
Introduction to
The sales comparison approach considers what similar or comparable
Valuation Approaches
properties (comparables) transacted for in the current market

Highest and Best Use Highest and best use: the use that would result in the highest value for the land

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 capitalizes the current NOI using a growth implicit capitalization rate

the direct capitalization method When the capitalization rate is applied to the forecasted first-year
NOI for the property, the implicit assumption is that the first-year NOI
There are two income approaches is representative of first-year NOI would be for similar properties

applies an explicit growth rate to construct an NOI

the DCF method stream from which a present value can be derived

Income can be projected either for the entire economic life of the property or for a typical
General Approach and
holding period with the assumption that the property will be sold at the end of the holding period
Net Operating Income
Rental income at full occupancy
+ Other income (such as parking)
= Potential gross income (PGI)
Vacancy and collection loss
= Effective gross income (EGI)
Operating expenses (OE)
Calculating NOI = Net operating income (NOI)

The cap rate is like a current yield for the property whereas
the discount rate is applied to current and future NOI
The Capitalization Rate and the Discount Rate
Cap rate = Discount rate - Growth rate

going-in cap rate is used to clarify that it is based on the first

year of ownership when the investor is going into the deal
Cap rate = NOI/Value terminal cap rate is based on expected income for
the year after the anticipated sale of the property

Defining the Capitalization Rate observing what other similar or comparable

Value = NOI/Cap rate properties are selling for to know the cap rate

The Direct Capitalization Method Cap rate = NOI/Sale price of comparable

Market value = Rent/ARY ARY: all risks yield

If NOI is not representative of the NOI of similar properties because

Stabilized NOI of a temporary issue, the subject property's NOI should be stabilized

Gross income multiplier: the ratio of the sale price to the gross
income expected from the property in the first year after sale
Other Forms of the Income Approach The problem of gross income multipler: not explicitly
consider vacancy rates and operating expenses

If the growth rate is constant V = NOI/(r g)

The Relationship between
Discount Rate and Cap Rate If NOI is not expected to grow at a constant rate, then NOIs are projected into
THE INCOME APPROACH the future and each periods NOI is discounted to arrive at a value of the property
TO VALUATION
The cap rate used to estimate the resale price or terminal value
is referred to as a terminal cap rate or residual cap rate
It is a cap rate that is selected at the time of valuation to be applied to the NOI
earned in the first year after the property is expected to be sold to a new buyer
If interest rates are expected to be higher in the
The Terminal Capitalization Rate future => terminal cap rates might be higher
The terminal cap rate could be the same, higher, or
The Discounted Cash lower than the goingin cap rate depending on expected The growth rate is often assumed to be a little
Flow (DCF) Method discount and growth rates at the time of sale lower => a slightly higher terminal cap rate

om
Uncertainty about what the NOI will be in the future
may also result in selecting a higher terminal cap rate

Lease structures vary across locales and can have an effect

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Adapting to Different Lease Structures on the way value is typically estimated in a specific locale

The equivalent yield is a single discount rate that could be applied

The Equivalent Yield mathematically to both income streams that would result in the same value

ss
Project income from existing leases
Assumptions also have to be made about what will happen when a lease

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Make assumptions
about lease renewals comes up for renewaloften referred to as market leasing assumptions

Make assumptions about Operating expenses involve items that must be paid by the owner, such as
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operating expenses property taxes, insurance, maintenance, management, marketing, and utilities
The general s teps to a DCF
analysis are as follows
Make assumptions about
capital expenditures such as a new heating and air conditioning system or replacing a roof, etc.,
es

Make assumptions about absorption of any vacant space

Estimate resale value (reversion) how long the property will be held by the initial investor
nc

Advanced DCF:
Lease-by- Lease Analysis Select discount rate to find PV of cash flows

39. Private Real Estate Advantages and Disadvantages Advantage: it captures the cash flows that investors actually care about
na

of the Income Approach

Investments - Part 2 Disadvantage is the amount of detailed information that is needed and the need to forecast what will happen in
the future even if it is just forecasting a growth rate for the NOI and not doing a detailed lease-by-lease analysis

The discount rate does not reflect the risk

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Income growth is greater than expense growth

Common Errors The terminal cap rate is not logical compared with the implied going-in cap rate
The terminal cap rate is applied to an income that is not typical
to

The cyclical nature of real estate markets is not recognized

ay

Three different approaches to valuation: the income, cost, and sales comparison approaches may produce the different answers due to imperfections in the data and inefficiencies in the market
The appraiser needs to reconcile the differences and arrive at a final conclusion about the value
RECONCILIATION The purpose of reconciliation is to decide which approach or approaches you have the most confidence in and come up with a final estimate of value
/w

In an active market: sales comparison approach is preferred

When there are fewer transactions: income approach is preferred
:/

To verify other facts and conditions that might affect the value of the property and that might not have been identified by the appraiser
Review the leases for the major tenants and review the history of rental payments and any defaults or late payments.
Get copies of bills for operating expenses, such as utility expenses.
tp

Look at cash flow statements of the previous owner for operating expenses and revenues.
Have an environmental inspection to be sure there are no issues, such as a contaminant material on the site.
Have a physical/engineering inspection to be sure there are no structural issues with the property
ht

and to check the condition of the building systems, structures, foundation, and adequacy of utilities.
DUE DILIGENCE
E.g Have an attorney or appropriate party review the ownership history to be sure there are no issues related
to the sellers ability to transfer free and clear title that is not subject to any previously unidentified liens.
Review service and maintenance agreements to determine whether there are recurring problems.
Have a property survey to determine whether the physical improvements are in the boundary
lines of the site and to find out if there are any easements that would affect the value.
Verify that the property is compliant with zoning, environmental regulations, parking ratios, and so on.
Verify that property taxes, insurance, special assessments, and so on, have been paid

VALUATION IN AN
INTERNATIONAL CONTEXT

Return = {NOI Capital expenditures + (Ending market value Beginning market value )}/Beginning market value
May not capture the price increase until a quarter or more after it was reflected in transactions
Appraisal lag
Appraisal-Based Indices Disadvantages Tend to smooth the index, have lower correlation with others => allocation to real estate would likely overestimated
How to adjust: unsmooth the appraisalbased or use a transactionbased index when comparing real estate with other asset classes
INDICES In recent years, indices have been created that are based on actual transactions rather than appraised values
A repeat sales index relies on repeat sales of the same property
Two main ways
Transaction-Based Indices A hedonic index which requires only one sale

Disadvantages Include random elements in the observations => may be upward or downward movements from quarter to quarter that are somewhat random

The maximum amount of debt that an investor can obtain on commercial real estate is usually limited by either the ratio
of the loan to the appraised value of the property (loan to value or LTV) or the debt service coverage ratio (DSCR)
PRIVATE MARKET REAL ESTATE DEBT
DSCR = NOI/Debt service
The debt service coverage ratio is the ratio of the firstyear NOI to the loan payment

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 m
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PRICING EURODOLLAR FUTURES, TREASURY BOND

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FUTURES, STOCK INDEX AND CURRENCY FUTURES FUTURE CONTRACTS

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THE RELATION BETWEEN FUTURES
PRICES AND EXPECTED SPOT PRICES
48. Futures Markets and FUTURES PRICE & THE VALUE
OF A FUTURES CONTRACT

an
Contracts: An Overview

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t of
MONETARY & NONMONETARY BENEFITS AND COSTS
ay WHY FORWARD AND
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ASSOCIATED WITH HOLDING THE UNDERLYING FUTURES PRICES DIFFER
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ASSET AND THEIR EFFECTS TO FUTURES PRICE

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48. Futures Markets and Contracts - Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
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 Deliverable contracts obligate the long to buy and the short to sell a certain quantity of an asset for a certain price on a specified future date
Similar to forward Cash settlement contracts are settled by paying the contract value in cash on the expiration date
contracts in
Both forwards and futures are priced to have zero value at the time the investor enters into the contract

Futures are marked to market at the end of every trading day. Forward contracts are not marked to market
FUTURE CONTRACTS
Futures contracts trade on organized exchanges. Forwards are private contracts and do not trade on organized exchanges
Different from Futures contracts are highly standardized. Forwards are customized contracts satisfying the needs of the parties involved
forward contracts Forwards are contracts with the originating counterparty; a specialized entity called a clearinghouse is the counterparty to all futures contracts
Forward contracts are usually not regulated. The government having legal jurisdiction regulates futures markets

At expiration, the spot price must equal the futures price because the futures price Arbitrage will force the prices to
has become the price today for delivery today, which is the same as the spot. be the same at contract expiration

Futures price must converge
to the spot price at expiration
The clearinghouse guarantees that traders in the futures market will honor their
obligations by splitting each trade once it is made and acting as the opposite
side of each position => To safeguard the clearinghouse, both sides of the trade
Futures margin is a
Future margins and are required to post margin and settle their accounts on a daily basis
performance guarantee
marking to market
Marking to market is the process of adjusting the margin balance in a futures account each day for

m
FUTURES PRICE & THE VALUE the change in the value of the contract from the previous trading day, based on the settlement price

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OF A FUTURES CONTRACT
Has no value at contract initiation
Does not accumulate value changes over the term of the contract.

s.
The value after the margin deposit has been adjusted for the day's gains and losses in contract value is always zero
The futures price at any point in time is the price that makes the value of a new contract equal to zero

es
Value of a
futures contract The value of a futures contract strays from zero only during the trading periods between the times at which the account is marked to market

cc
Value of futures contract = current futures price - previous mark-to-market price
If the futures price increases, the value of the long position increases

su
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FP = futures price should be the same as that of a forward contract
The no-arbitrage price of a futures contract So = spot price at inception of the contract ( t = 0)

an
R f = annual risk-free rate
48. Futures Markets T = futures contract term in years
and Contracts - Part 1

in
If investors prefer the mark-to-market feature of futures, futures prices will be higher than forward prices
Cases that causes futures and If investors would rather hold a forward contract to avoid the marking to market
forward prices to be different of a futures contract, the forward price would be higher than the futures price

t of
ay
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:/
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WHY FORWARD AND

FUTURES PRICES DIFFER
ht

A cash-and-carry arbitrage consists of buying the asset, storing/holding the

asset, and selling the asset at the futures price when the contract expires
Borrow money for the term of the contract at market interest rates
At the initiation of the contract Buy the underlying asset at the spot price

Steps Sell (go short) a futures contract at the current futures price
Cash-and-carry arbitrage
Deliver the asset and receive the futures contract price
At contract expiration
Repay the loan plus interest
If the futures contract is overpriced => generate a riskless profit
Future arbitrage The futures contract is overpriced if the actual market price is greater than the no-arbitrage price

When the futures price is too low (which presents a profitable arbitrage opportunity)
Sell the asset short
At the initiation of the contract Lend the short sale proceeds at market interest rates
Reverse cash-and-carry arbitrage
Steps Buy (go long) the futures contract at the market price

Collect the loan proceeds

At contract expiration
Take delivery of the asset for the futures price and cover the short sale commitment

48. Futures Markets and Contracts - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
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 Any positive costs associated with storing or holding the asset in a cash and carry arbitrage will increase the no-arbitrage futures price
E.g., Financial assets: no storage costs other than the opportunity cost of the funds
A monetary benefit from holding the asset
will decrease the no-arbitrage futures price
Convenience yield: The return from non-monetary benefits which come from holding an asset in short supply
MONETARY AND NONMONETARY
BENEFITS AND COSTS ASSOCIATED WITH
HOLDING THE UNDERLYING ASSET AND net costs (NC) = storage costs - convenience yield
The no-arbitrage futures price counting net costs
THEIR EFFECTS TO FUTURES PRICE FV (NC)= future value, at contract expiration, of the net costs of holding the asset

NB = yield on the asset + convenience yield

The no-arbitrage futures price counting net benefits
FV (NB) = future value, at contract expiration, of the net benefits of holding the asset

refers to a situation where the futures price is below the spot price

Backwardation to occur, there must be a significant benefit to holding E.g., benefits to holding the asset that offset the opportunity cost of
the asset, either monetary or non-monetary holding the asset (the risk-free rate) and additional net holding costs

Backwardation and contago

refers to a situation where the futures price is above the spot price
Contango
happens when there is no benefits to holding the asset, the futures price will be

m
The futures price might be temporarily above or below expected future
spot prices, but it would be an unbiased predictor of future spot rates

co
If both parties to a futures transaction are hedging existing risk,
the futures price may be equal to expected future spot prices

happens when the futures price is lower than the expected price in the future to compensate the future buyer for accepting asset price risk

s.
Normal backwardation

happens when the futures price is greater than the expected spot price

es
Normal contango
The most likely situation in financial markets is normal backwardation
similar to a forward rate agreement to lend US$1,000,000 for three months beginning on the contract settlement date

cc
THE RELATION BETWEEN
FUTURES PRICES AND based on 90-day LIBOR, which is an add-on yield
EXPECTED SPOT PRICES Eurodollar
the price quotes are calculated as (100 - annualized LIBOR in percent)

su
the minimum price change is one "tick," which is a price change of 0.0001 = 0.01 %

traded for T-bonds with a maturity of 15 years or more

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the contract is deliverable with a face value of $100,000
Treasury Bonds
Eurodollar, Treasury Bonds, Stock T-bond futures are quoted as a percent and fractions of 1 % (measured in 1/32nds) of face value

an
48. Futures Markets Index, and Currency Futures
each bond is given a conversion factor (multiplier) that is used to adjust the long's payment at delivery
and Contracts - Part 2 based on the level of an equity index

in
Stock index futures most popular stock index future is the S&P 500
settlement is in cash and is based on a multiplier of 250

of
Currency Futures In the United States, currency contracts trade on the euro, Mexican peso, and yen, among others

t
Treasury bill (T-bill) futures contracts are based on a $1 million face value 90-day (13-week) T-bill, and they settle in cash

ay
Treasury Bill Futures Pricing
The price quotes are 100 minus the annualized discount in percent on the T-bills
T-bill futures are priced using the no-arbitrage principle
/w
Eurodollar futures are priced as a discount yield, and LIBOR-based deposits are priced as an add-on yield
=> The result is that the deposit value is not perfectly hedged by the Eurodollar contract
:/

=> Eurodollar futures can't be priced using the standard no-arbitrage framework
Eurodollar futures
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The no-arbitrage futures price for a T-bond contract

FVC: the future value of the coupon payments
ht

The futures price that insures a cash-and-carry arbitrage would provide no profit is lower than
Treasury Bond Futures without the cash flows Because the cost to hold the asset is reduced by the asset cash flows

T-bond futures prices must be adjusted to conform to the price for

the bond that is cheapest to deliver, using its conversion factor (CF)

The no-arbitrage futures price adjusted for the future value of

the dividends (FVD) or present value of the dividends (PVD)
PRICING EURODOLLAR FUTURES,
Stock futures
TREASURY BOND FUTURES, STOCK
INDEX AND CURRENCY FUTURES

The no-arbitrage futures price

Equity Index Futures

The price of currency futures DC = domestic currency

Currency Futures FC = foreign currency

In continuous time it is

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 m
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AMERICAN/EUROPEAN OPTIONS ON FUTURES AND FORWARDS PUT-CALL PARITY FOR EUROPEAN OPTIONS

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AND APPROPRIATE PRICING MODEL FOR EUROPEAN OPTIONS

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SYNTHETIC CALL/PUT OPTION, BOND AND UNDERLYING STOCK
PUT-CALL PARITY FOR FORWARD/FUTURES OPTIONS

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ONE- AND TWO-PERIOD BINOMIAL MODELS TO
THE HISTORICAL AND IMPLIED 49. Option Markets and CALCULATE AND INTERPRET PRICES OF INTEREST

an
VOLATILITIES OF AN UNDERLYING ASSET RATE OPTIONS AND OPTIONS ON ASSETS
Contracts: An Overview

in
of
EFFECT OF THE UNDERLYING ASSET'S CASH ASSUMPTIONS UNDERLYING THE

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FLOWS ON THE PRICE OF AN OPTION BLACK-SCHOLES-MERTION MODEL
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THE DELTA OF AN OPTION AND A CHANGE IN THE VALUE OF EACH INPUT AFFECTS THE OPTION
:/

ITS USE IN DYNAMIC HEDGING PRICE (UNDER THE BLACK-SCHOLES-MERTION MODEL)

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49. Option Markets and Contracts - Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
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 A long position in a European call option with an exercise price of X that matures in T years on a stock (with a price at time t of S t)

A long position in a pure-discount riskless bond that pays X in T years

A fiduciary call

PUT-CALL PARITY FOR EUROPEAN OPTIONS

A long position in a European put option with an exercise price of X that matures in T years
A long position in the underlying stock

A protective put

That the cost of a fiduciary call must be equal to the cost of a protective up

Put-call parity for European options

+: long position
- : short position

Buying a European put option on the same stock with the same exercise price (X) and the same maturity (T)
A synthetic European Buying the stock
call option is formed by Shorting (i.e., borrowing) the present value of X worth of a pure-discount riskless bond

Buying a European call option

A synthetic European Shorting the stock
put option is formed by
SYNTHETIC CALL/PUT OPTION, Buying (i.e., investing in) the discount bond
BOND AND UNDERLYING STOCK
Buying a European call option
A synthetic stock Shorting (i.e., writing) a European put option
position is formed by Buying (i.e., investing in) the discount bond

Buying a European put option

A synthetic pure-discount Buying the stock
riskless bond is created by
Shorting (i.e., writing) a European call option

To price options by using combinations of other instruments with known prices

Two reasons to create synthetic
positions in the securities To earn arbitrage profits by exploiting relative mispricing among the four securities

If put-call parity doesn't hold (if the cost of a fiduciary call does not equal the cost of a protective
put), buy (go long in) the underpriced position and sell (go short) in the overpriced position

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Using put-call parity for arbitrage

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D =risk-neutral probability of an down-move = 1 - U

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R f = risk-free rate
U = size of an up-move
D = size of a down-move

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Calculating the payoff of the option at maturity
in both the up-move and down-move states
Calculate the value of
One-Period Binomial Model Calculating the expected value of the option in one year as
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an option on the stock
the probability-weighted average of the payoffs in each state
Discounting the expected value back to today at the risk-free rate
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provides the information required to calculate a hedge ratio

Arbitrage with one-period (the fractional share of stock in the arbitrage trade)
binomial model
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Calculate the stock values at the end of two periods (there are three possible outcomes
49. Option Markets because an up-then-down move gets you to the same place as a down-then-up move)
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and Contracts - Part 1 Calculate three possible option payoffs at the end of two periods
Calculate the expected option values at the end of two
periods (t = 2) using the up-and down-move probabilities
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Steps to value
ONE- AND TWO-PERIOD BINOMIAL Discount the expected option values (t = 2) back one period at the risk-free
MODELS TO CALCULATE AND an option
Two-Period Binomial Model rate to find the option values at the end of the first period (t = 1)
INTERPRET PRICES OF INTEREST RATE
OPTIONS AND OPTIONS ON ASSETS Calculate the expected option value at the end of one
to

period (t = 1) using up-and down-move probabilities

Discount the expected option value at the end of one period (t = 1)
back one period at the risk-free rate to find the option value today
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is the set of possible interest rate paths that are used to value bonds with a binomial model
the values for on-the-run issues
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Binomial interest generated using an interest rate tree the interest rate tree must maintain the interest
rate trees the underlying rule governing the should prohibit arbitrage opportunities rate volatility assumption of the underlying model
construction of an interest rate tree
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price the bond at each node using projected interest rates

There are three basic steps to valuing an option
on a fixed-income instrument using a binomial tree calculate the intrinsic value of the option at each node at maturity of the option, and
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Options on Fixed calculate the value of the option today

Income Securities

The value of an interest rate cap or floor is the sum of the values of the individual caplets or floorlets
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Options on Interest Rates: Expiration value of caplet

Caps and Floors

Expiration value of floorlet

As the period covered by a binomial model is divided into arbitrarily small, discrete time periods, the model results converge to those of the continuous-time model

The Black-Scholes-Merton (BSM) model values options in continuous time and is derived from the same no-arbitrage assumption used to value options with the binomial model
To derive the BSM model, an "instantaneously" riskless portfolio is used to solve for the option price based on the same logic
The price of the underlying asset follows a lognormal distribution
The (continuous) risk-free
rate is constant and known Limitation: The BSM model is not useful for pricing options on bond prices and interest rates

The volatility of the underlying In practice, the volatility is not known and must be estimated. The bigger problem is that
asset is constant and known volatility is often not constant over time and the BSM model is not useful in these situations

Assumptions and Limitations Markets are "frictionless" Model is less realistic and less useful

The BSM model can be easily altered if we relax the

The underlying asset generates no cash flows assumption of no cash flows on the underlying asset

The model does not correctly price American options. Binomial option
The options are European pricing models are more appropriate for pricing American options

ASSUMPTIONS UNDERLYING THE

BLACK-SCHOLES-MERTION MODEL

The formula for the BSM model

Use put-call parity to calculate the put value

49. Option Markets and Contracts - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
WAY TO FINANCE SUCCESS - Website: http://waytofinancesuccess.com
 A Greek is a sensitivity factor that captures the relationship between each input (asset
price, asset price volatility, time to expiration, and the risk-free rate) the option price

Delta describes the relationship between asset price and option price

Vega measures the sensitivity of the option price to changes

in the volatility of returns on the underlying asset

A CHANGE IN THE VALUE OF

EACH INPUT AFFECTS THE
OPTION PRICE (UNDER THE
BLACK-SCHOLES-MERTION

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MODEL)

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Rho measures the sensitivity of the option price to changes in the risk-free rate
There is a benefit to early exercise of options on futures when they are deep in the money theta is less than zero: as time passes and the option
Exercising the option (either a put or call) early will generate cash from the mark to market => cash can earn approaches the maturity date, its value decreases
American options on futures are more valuable
interest, while the futures position will gain or lose from movements in the futures price => these price than comparable European options because

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movements between early exercise and option expiration will mirror those of the deep in the money option

There is no mark to market on forwards, early exercise does not accelerate the payment of any gains
With no reason for early exercise, the value of American
and European options on forwards are the same
Theta measures the sensitivity of the option price to the passage of time

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AMERICAN/EUROPEAN OPTIONS
ON FUTURES AND FORWARDS
AND APPROPRIATE PRICING
MODEL FOR EUROPEAN OPTIONS

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The Black model can be used to price European options on forwards and futures

su
= standard deviation of returns on the futures contract
F T = futures price

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PUT-CALL PARITY FOR
Put-call parity for options on forwards and futures is as follows FORWARD/FUTURES OPTIONS

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American options on futures are more valuable than European options because early exercise provides mark to market funds on the futures, which can earn interest
49. Option Markets
Americans and European options on forward contracts are equivalent because there is no mark to market
and Contracts - Part 2

in
Step 1: Convert a time series of N prices to returns

of
Step 2: Convert the returns to Delta is the change in the price of an option for a one-unit change in the price of the underlying security C = change in the price of the call over a short time interval
continuously compounded returns S = change in the price of the underlying stock over a short time interval
The steps in computing historical volatility for use as an THE HISTORICAL AND C N(d1) x S
input in the BSM continuous-time options pricing model are IMPLIED VOLATILITIES OF

t
P (change in put price) [N(d1) - 1] x S
AN UNDERLYING ASSET Use BSM model to estimate the change in the value of the call
given the change in the value of the stock and the option's delta

Step 3: Calculate the variance and standard

deviation of the continuously compounded returns

when used in the Black-Scholes formula, it produces the current market price of the option
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Implied volatility is the value for standard deviation of continuously compounded
rates of return that is "implied" by the market price of the option

Decrease the value of a call option

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Increase the value of a put option
All else equal, the existence of cash flows on the underlying asset will
EFFECT OF THE UNDERLYING
ASSET'S CASH FLOWS ON
THE PRICE OF AN OPTION
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Put-call parity for options on underlying assets with cash flows by adjusting S for the present value of the cash flows (PVCF) Out-of-the-money (stock price is less than exercise price), the call delta moves
A call option delta is between closer to 0 as time passes, assuming the underlying stock price doesn't change
0 and 1. If the call option is In-the-money (stock price is greater than exercise price), the call delta moves
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closer to 1 as time passes, assuming the underlying stock price doesn't change
Interpreting Delta
Out-of-the-money (stock price is greater than exercise price), the put delta moves
A put option delta is between closer to O as time passes, assuming the underlying stock price doesn't change

THE DELTA OF AN OPTION AND -1 and 0. If the put option is In-the-money (stock price is less than exercise price), the put delta moves
ITS USE IN DYNAMIC HEDGING closer to -1 as time passes, assuming the underlying stock price doesn't change

The goal of a delta-neutral portfolio (or delta-neutral hedge) is to combine a long position in a stock with a short
position in a call option so that the value of the portfolio does not change when the value of the stock changes
Number of call options needed to delta hedge = number of shares hedged/delta of call option
Number of put options needed to delta hedge = number of shares/delta of the put option
Dynamic Hedging
The delta-neutral position only holds for very small changes in the value of the underlying stock
costly in terms of transaction costs
=> must be continually rebalanced to maintain the hedge (a dynamic hedge)

can be viewed as a measure of how poorly a dynamic hedge will perform

Gamma measures the rate of change in delta as the underlying stock price changes when it is not rebalanced in response to a change in the asset price

Call and put options on the same underlying asset with the same exercise price and time to maturity will have equal gammas
Long positions in calls and puts have positive gammas
Gamma is largest when a call or put option is at-the-money and close to expiration

Gama effect

49. Option Markets and Contracts - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
WAY TO FINANCE SUCCESS - Website: http://waytofinancesuccess.com
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To be continued

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