2018

CFA® EXAM REVIEW

CRITICAL
CONCEPTS
FOR THE
CFA EXAM

CFA LEVEL II ®

SMARTSHEET
FUNDAMENTALS FOR CFA® EXAM SUCCESS
WCID184
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ETHICAL AND • Standard error of the estimate (smaller SEE indicates

better fit of regression model)
heteroskedasticity)
• Multicollinearity: two or more independent variables
PROFESSIONAL STANDARDS  n
1/2 1/2
(or combinations of independent variables) are highly
correlated
2  n 2
 ∑ (Yi − b0 − b1 X i )   ∑ (εˆ i ) 
ˆ ˆ
STANDARDS OF PROFESSIONAL CONDUCT SEE =  i =1  =  i =1  • Makes regression coefficients inaccurate and t-test
 n−2   n−2  for the significance of each regression coefficient
   
I. Professionalism     unreliable.
A. Knowledge of the Law • Difficult to isolate the impact of each independent
B. Independence and Objectivity • Prediction interval around the predicted value of the variable on the dependent variable.
dependent variable
C. Misrepresentation • Model specification errors
D. Misconduct  1 ( X − X)2  • Misspecified functional form (omitting important
s 2f = s 2 1 + + 2 
II. Integrity of Capital Markets  n (n − 1)sx  variables; variables may need to be transformed;
pooling data incorrectly).
A. Material Nonpublic Information
• Time-series misspecification (including lagged
B. Market Manipulation Yˆ ± tc s f
dependent variables as independent variables in
III. Duties to Clients regressions when there is serial correlation of errors;
A. Loyalty, Prudence and Care including an independent variable that is a function
MULTIPLE REGRESSION (2 OR MORE of the dependent variable; measuring independent
B. Fair Dealing
INDEPENDENT VARIABLES) variables with error; nonstationarity).
C. Suitability
D. Performance Presentation • Confidence interval for regression coefficients: use n – TIME SERIES ANALYSIS
E. Preservation of Confidentiality (k+1) degrees of freedom
IV. Duties to Employers • Linear trend model: predicts that the dependent variable
bˆ j ± (tc × sbˆ ) grows by a constant amount in each period
A. Loyalty
j

estimated regression coefficientt ± ((critical

cr
critical t -value)(coefficient standard
tanda error)
tandard
B. Additional Compensation Arrangements yt = b0 + b1t + εt , t = 1, 2, . . . , T

C. Responsibilities of Supervisors
V. Investment Analysis, Recommendations and Actions
A. Diligence and Reasonable Basis
B. Communication with Clients and Prospective
Clients
C. Record Retention
VI. Conflicts of Interests
A. Disclosure of Conflicts
• Hypothesis test on each regression coefficient: use n – • Log-linear trend model: predicts that the dependent
(k+1) degrees of freedom variable exhibits exponential growth
Estimated regression coefficientt − Hypothesized value of regression coefficient ln yt = b0 + b1t + εt , t = 11,2
1,2,
,2,, . . . , T
t-stat =
Standard error of regression coefficient
• Autoregressive (AR) time series model: uses past values
• p-value: lowest level of significance at which we can of the dependent variable to predict its current value
reject the null hypothesis that the population value of • First-order AR model
the regression coefficient is zero in a two-tailed test (the
smaller the p-value, the weaker the case for the null
xt = b0 + b1 xt −1 + εt

B. Priority of Transactions hypothesis)

C. Referral Fees • AR model must be covariance stationary and specified
• ANOVA table for testing whether all the slope coefficients such that the error terms do not exhibit serial
VII. Responsibilities as a CFA Institute Member or CFA are simultaneously equal to zero (use a one-tailed F-test
correlation and heteroskedasticity in order to be used
Candidate and reject null hypothesis if F-statistic > Fcrit)
for statistical inference.
A. Conduct as Participants in CFA Institute Programs Source of degrees of Sum of Mean Sum
• t-test for serial (auto) correlation of the error
Variation Freedom Squares of Squares F Significance
B. Reference to CFA Institute, the CFA Designation, terms (model is correctly specified if all the error
Regression k RSS MSR = RSS / k MSR/MSE p‐value
and the CFA Program autocorrelations are not significantly different from 0)
Residual n − (k + 1) SSE MSE = SSE /n − (k + 1)
RESEARCH OBJECTIVITY STANDARDS t
total n−1 SSt t-stat =
Residual autocorrelationn ffor lag
dard error of residual
da
dard
Standa esidual autocorrelation
esidua
1.0 Research Objectivity Policy
F -stat =
MSR
=
RSS / k
• Mean-reverting level of AR(1) model
2.0 Public Appearances MSE SSE /[n − ( k + 1)]
3.0 Reasonable and Adequate Basis
• Standard error of the estimate (SEE) = √MSE using MSE ver g level = xt =
b0
4.0 Investment Banking Mean revertin
vertin
from the ANOVA table 1 − b1
5.0 Research Analyst Compensation
• Coefficient of determination (higher R2 indicates a higher
6.0 Relationships with Subject Companies proportion of the total variation in dependent variable • Random walk is a special of the AR(1) model that is not
7.0 Personal Investments and Trading explained by the independent variables) covariance stationary (undefined mean reverting level)
8.0 Timeliness of Research Reports and xt = xt −1 + εt , E(εt ) = 0, E(εt2 ) = σ 2 , E(εt ε s ) = 0 if t ≠ s
Total variatio
ar
ariation − Unexplained variatio
ar
ariation SST − SSE RSS
Recommendations R2 = = =
9.0 Compliance and Enforcement
Total vari
variation
va SST SST • First difference of a random walk in order to make it
covariance stationary (mean reverting level of 0)
10.0 Disclosure
• Adjusted R2 yt = xt − xt −1 = xt −1 + εt − xt −1 = εt , E(εt ) = 0, E(εt2 ) = σ 2 , E(εt ε s ) = 0 for t ≠ s
11.0 Rating System
n −1 
Ad
Adjusted R 2 = R 2 = 1 −  (1 − R 2 ) • AR(1) model has a unit root if the slope coefficient
 n − k − 1
QUANTITATIVE METHODS equals 1, e.g. a random walk.
• Dickey-Fuller test indicates that a time series has a unit
CORRELATION AND REGRESSION VIOLATIONS OF REGRESSION root if the null hypothesis is not rejected.
(1 INDEPENDENT VARIABLE) ASSUMPTIONS • Seasonality in AR models: the seasonal autocorrelation
of the error term will be significantly different from
• Sample correlation coefficient • Heteroskedascity: variance of error term is not constant 0 (can be solved by introducing a seasonal lag in the
• Unconditional: heteroskedasticity is not related to model).
Cov(X,Y) the independent variables (does not affect statistical • ARCH models: used to determine whether the variance
Sample correlation coefficient = r = of the error in one period depends on the variance
s X sY inference).
• Conditional: heteroskedasticity is correlated with of the error in previous periods (if ARCH errors are
• Testing the significance of the correlation coefficient the independent variables (causes F-test for overall found, use generalized least squares to correct for
significance of the regression and t-test for the heteroskedasticity)
r n−2 significance of each regression coefficient to become • Regression with two time series: use the Dickey-Fuller
Test-stat = t =
1− r2 unreliable). test to determine whether the independent variable and
n = Number of observations • Serial correlation: regression errors are correlated the dependent variable have a unit root
r = Sample correlation across observations (could be positive or negative and • If neither of the time series has a unit root, linear
n – 2 = Degrees of freedom regression can be used to test the relationships
has same effect on statistical inference as conditional

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between the two time series. • Fisher and international Fisher effects: if there is real • Endogenous growth model
• If either of them has a unit root, linear regression interest rate parity, the foreign-domestic nominal yield • Capital is broadened to include human and knowledge
cannot be used as results may be spurious. spread will be determined by the foreign-domestic capital and R&D.
expected inflation rate differential
• If both of them have unit roots and if they are • R&D results in increasing returns to scale across the
cointegrated, the regression coefficients and standard Fischer Effect: i = r + πe entire economy.
errors will be consistent and they can be used to • Saving and investment can generate self-sustaining
International Fisher effect: (iFC − iDC) = (πeFC − πeDC)
conduct hypothesis tests. growth at a permanently higher rate as the positive
externalities associated with R&D prevent diminishing
RISK TYPES AND PROBABILISTIC • FX carry trade: taking long positions in high-yield marginal returns to capital.
APPROACHES currencies and short positions in low-yield currencies
• Convergence
(return distribution is peaked around the mean with
Discrete/ Correlated/ Sequential/ negative skew and fat tails) • Absolute: regardless of their particular characteristics,
output per capita in developing countries will
Continuous
Discrete
Independent
Independent
Concurrent
Sequential
Risk Approach
Decision tree %
• Mundell-Fleming model with high capital mobility eventually converge to the level of developed
Discrete Correlated Concurrent Scenario analysis • A restrictive (expansionary) monetary policy under countries.
Continuous Either Either Simulations
floating exchange rates will result in appreciation
• Conditional: convergence in output per capita is
(depreciation) of the domestic currency.
dependent upon countries having the same savings
• A restrictive (expansionary) fiscal policy under
ECONOMICS floating exchange rates will result in depreciation
rates, population growth rates and production
functions.
(appreciation) of the domestic currency.
• Convergence should occur more quickly for an open
CURRENCY EXCHANGE RATES • If monetary and fiscal policies are both restrictive or economy.
both expansionary, the overall impact on the exchange
• Exchange rates are expressed using the convention rate will be unclear. ECONOMICS OF REGULATION
a/b, i.e. number of units of currency a (price currency)
• Mundell-Fleming model with low capital mobility (trade
required to purchase one unit of currency b (base • Economic rationale for regulatory intervention:
flows dominate)
currency). USD/GBP = 1.5125 means that it will take informational frictions (resulting in adverse selection
1.5125 USD to purchase 1 GBP • A restrictive (expansionary) monetary policy will lower
(increase) aggregate demand, resulting in an increase and moral hazard) and externalities (free-rider problem)
• Exchange rates with bid and ask prices (decrease) in net exports. This will cause the domestic • Regulatory interdependencies: regulatory capture,
• For exchange rate a/b, the bid price is the price at currency to appreciate (depreciate). regulatory competition, regulatory arbitrage
which the client can sell currency b (base currency) to •
• A restrictive (expansionary) fiscal policy will lower Regulatory tools: price mechanisms (taxes and
the dealer. The ask price is the price at which the client subsidies), regulatory mandates/restrictions on
(increase) aggregate demand, resulting in an increase
can buy currency b from the dealer. behaviors, provision of public goods/financing for private
(decrease) in net exports. This will cause the domestic
• The b/a ask price is the reciprocal of the a/b bid price. currency to appreciate (depreciate). projects
• The b/a bid price is the reciprocal of the a/b ask price. • If monetary and fiscal stances are not the same, the • Costs of regulation: regulatory burden and net regulatory
• Cross-rates with bid and ask prices overall impact on the exchange rate will be unclear. burden (private costs – private benefits)
• Bring the bid‒ask quotes for the exchange rates into • Monetary models of exchange rate determination • Sunset provisions: regulators must conduct a new cost-
a format such that the common (or third) currency (assumes output is fixed) benefit analysis before regulation is renewed
cancels out if we multiply the exchange rates • Monetary approach: higher inflation due to a relative
JPY
=
JPY USD
×
increase in domestic money supply will lead to
depreciation of the domestic currency. FINANCIAL REPORTING
EUR USD EUR
• Dornbusch overshooting model: in the short run, an
increase in domestic money supply will lead to higher
AND ANALYSIS
• Multiply bid prices to obtain the cross-rate bid price. inflation and the domestic currency will decline to INTERCORPORATE INVESTMENTS
• Multiply ask prices to obtain the cross-rate ask price. a level lower than its PPP value; in the long run, as
domestic interest rates rise, the nominal exchange rate • Investments in financial assets (usually < 20% interest)
• Triangular arbitrage is possible if the dealer’s cross-rate
will recover and approach its PPP value. under IAS 39
bid (ask) price is above (below) the interbank market’s
implied cross-rate ask (bid) price.
ECONOMIC GROWTH • Held-to-maturity (debt securities): reported at
• Marking to market a position on a currency forward amortized cost using the effective interest method;
• Growth accounting equation (based on Cobb-Douglas interest income and realized gains/losses are
• Create an equal offsetting forward position to the
production function) recognized in income statement.
initial forward position.
• Determine the all-in forward rate for the offsetting • Fair value through profit or loss (held for trading
∆Y/Y = ∆A/A + α∆K/K + (1 − α ) ∆
A/A ∆L/L
L/
L/L and investments designated at fair value): initially
forward contract.
recognized at fair value, then remeasured at fair value
• Calculate the profit/loss on the net position as of the with unrealized and realized gains/losses, interest
settlement date. • Labor productivity growth accounting equation income and dividend income reported in income
• Calculate the PV of the profit/loss. statement.
Growth rate in potential GDP = Long-term growth rate of labor force
• Covered interest rate parity: currency with the higher + Long-term growth rate in labor productivity • Available-for-sale (AFS): initially recognized at fair
risk-free rate will trade at a forward discount value, then remeasured at fair value with unrealized
gains/losses recognized in equity (other comp. income)
• Classical growth model (Malthusian model) while realized gains/losses, interest income and
1 + (iPC × Actual
Actual
360)
FPC/BC = SPC/BC × • Growth in real GDP per capita is temporary: once dividend income are recognized in income statement.
1 + (iBC × Actual 360)
it rises above the subsistence level, it falls due to a • Difference between IFRS and US GAAP: unrealized
population explosion. gains/losses on AFS debt securities arising from
• In the long run, new technologies result in a larger (but exchange rate movements are recognized in income
FPC/BC − SPC/BC
Forward premium (discount) as a % = not richer) population. statement under IFRS (other comp income under US
SPC/BC
• Neoclassical growth model (Solow’s model) GAAP).
• Uncovered interest rate parity: expected appreciation/ • Both labor and capital are variable factors of • Investments in financial assets under IFRS 9
depreciation of the currency offsets the yield differential production and suffer from diminishing marginal • All financial assets are initially measured at fair value.
productivity. • Debt instruments are subsequently measured at
(1 + iFC ) amortized cost, fair value through other comp income
SeFC/DC = SFC/DC×
FC/DC
FC/DC
(1 + iDC )
• In the steady state, both capital per worker and output
per worker are growing at the same rate, θ/(1 – α), (FVOCI) or fair value through profit or loss (FVPL).
where θ is the growth rate of total factor productivity • Equity investments held for trading must be measured
• Relative purchasing power parity: high inflation leads to and α is the elasticity of output with respect to capital. at FVPL; other equity investments can be measured at
currency depreciation • Marginal product of capital is constant and equal to the FVPL or FVOCI.
real interest rate. • Investments in associates (20-50% interest, significant
 1 + π FC 
T • Capital deepening has no effect on the growth rate of influence): use equity method
Relative PPP: E(STFC/DC ) = S0FC/DC  output in the steady state, which is growing at a rate of • Investment is initially recognized on the investor’s
 1 + π DC 
θ/(1 – α) + n, where n is the labor supply growth rate. balance sheet at cost (within a single line item);

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investor’s proportionate share of investee earnings • Positive funded status = plan is overfunded = net • Hyperinflationary economies
(less dividends) increases carrying amount of pension asset. • US GAAP: use temporal method.
investment.
• IFRS: (1) restate subsidiary’s foreign currency accounts
• Investor’s proportionate share of investee earnings is Funded statuss = Fair value of plan assets – Pension obligation
for inflation; (2) translate using current exchange rate;
reported within a single item in income statement. (3) gain/loss in purchasing power recorded on income
• Excess of purchase price over book value (if any) is first • Periodic pension cost calculation (same for IFRS and US statement.
allocated to specific assets whose fair value exceeds GAAP)
book value: excess related to inventory is expensed EVALUATING QUALITY OF FINANCIAL
Periodic Ending net Beginning
while excess related to PP&E is depreciated over an
pension = pension – net pension +
Employer REPORTS
appropriate period of time (investor adjusts carrying contributions
amount of investment on its balance sheet by reducing cost liability liability
• Beneish model: the higher the M-score (i.e. the less
its share of investee profits in the income statement) negative the number) the higher the probability of
and any remaining amount is treated as goodwill (not Periodic pension cost = Curre
Current
Current service
serv
nt servic ts + Inteerrest costs + Past service costs
ccosts
icee cos
osts
earnings manipulation
+ Actuaria
ar l losses − Actua gains − A
amortized but subject to annual impairment test). aria Actuari
ctuarial gains Actual return
eturn on plan assets
etur
• Altman bankruptcy protection model: higher z-score is
• Fair value option: unrealized gains/losses arising from • Periodic pension cost reported in P&L (also known as better
changes in fair value as well as interest and dividends periodic pension expense)
received are included in the investor’s income.
• IFRS: current service costs, past service costs and INTEGRATED FINANCIAL STATEMENT
• Joint ventures (shared control): use equity method net interest expense/income recognized in P&L ANALYSIS
• Business combinations (controlling interest): use (remeasurement refers to items in OCI).
acquisition method • US GAAP: current service costs, interest expense, • ROE decomposition (extended DuPont analysis)
• All assets (at fair value), liabilities (at fair value), expected return on plan assets, amortization of past
revenues and expenses of acquiree are combined with service costs and amortization of actuarial gains E = Tax
ROE Tax Burden × Interest burden
rden
Burden
Bu n × EBI
BIT
T mar
EBIT
E n×T
margin
margi
gin urnover × F
Totaall assett ttur
urnove Financial leverage

those of parent/acquirer. and losses recognized in P&L (past service costs and ROE =
NI
×
EBT
×
EBIT
×
Revenue
×
Average Asset

• Transactions between acquirer and acquiree are actuarial gains/losses are usually recognized in OCI EBT EBIT Revenue Average Asset Average Equity

eliminated. before subsequent amortization to P&L).

• Acquiree’s equity accounts are ignored. • Impact of key assumptions on net pension liability and
• If acquirer owns less than 100% equity interest in periodic pension cost CORPORATE FINANCE
acquiree, it must create a non-controlling interest
CAPITAL BUDGETING
Impact of Assumption on Impact of Assumption on Periodic
account on consolidated balance sheet and income Assumption Net Pension Liability (Asset) Pension Cost and Pension Expense

statement to reflect proportionate share in acquiree’s Higher discount rate Lower obligation Pension cost and pension expense will

net assets and net income that belongs to minority

both typically be lower because of lower
opening obligation and lower service
• Initial investment outlay
shareholders. costs. • New investment
• Full goodwill method: goodwill equals the excess Higher rate of Higher obligation Higher service and interest costs will
compensation increase periodic pension cost and Initial investment for a new investment = FCInv + NWCInv
of total fair value of acquiree over fair value of its increase pension expense.
identifiable net assets. • Replacement project
Higher expected No effect, because fair value Not applicable for IFRS.
• Partial goodwill method: goodwill equals the excess return on plan of plan assets are used on No effect on periodic pension cost under
assets balance sheet U.S. GAAP.
of purchase price over fair value of the acquirer’s Lower periodic pension expense under
Initial investment for a replacement project
ro
roject = FCInnvv + NWCInv − Sall 0 + t(
NWCInv
NWCInv Sal 0 − B
t(Sal BV
V0 )
proportionate share of acquiree’s identifiable net U.S. GAAP.

assets. • Annual after-tax operating cash flows (CF)

• Goodwill is not amortized but subject to annual MULTINATIONAL OPERATIONS CF = (S − C − D) (l − tt)  +  D or
D) (l CF = (S − C) (l − t) + tD
impairment test.
• Difference between IFRS and US GAAP: IFRS permits full • For independent subsidiary • Terminal year after-tax non-operating cash flows (TNOCF)
and partial goodwill methods (US GAAP requires use of • Local currency (LC) = functional currency (FC) ≠ F = Sal
TNOCF Sal T + NWCInv − t (Sal
NWCInv
NWCInv Sal T − BT )
full goodwill method). parent’s presentation currency (PC).
• Impact of different accounting methods on financial • Use current rate method to translate accounts from • Inflation reduces the value of depreciation tax savings: if
ratios LC to PC. inflation is higher (lower) than expected, the profitability
of the project will be lower (higher) than expected
• Income statement at average rate.
Equity Method Acquisition Method
• Mutually exclusive projects with unequal lives
• Assets and liabilities at current rate.
Leverage Better (lower) as liabilities are Worse (higher) as liabilities are
• Least common multiple of lives approach: choose
lower and equity is the same higher and equity is the same • Capital stock at historical rate. project with higher NPV.
Net Profit Better (higher) as sales are lower Worse (lower) as sales are higher • Dividends at rate when declared. • Equivalent annual annuity (EAA) approach: choose
Margin and net income is the same and net income is the same
• Translation gain/loss included in equity under project with higher EAA (annuity payment over the
ROE Better (higher) as equity is lower Worse (lower) as equity is higher cumulative translation adjustment (CTA). project’s life with same NPV as project’s NPV).
and net income is the same and net income is the same
• Exposure = net assets. • Capital rationing: if budget is fixed, use NPV or
ROA Better (higher) as net income is Worse (lower) as net income is • For well-integrated subsidiary profitability index (PI) to rank projects
the same and assets are lower the same and assets are higher
• LC ≠ FC = PC. • Project discount rate using CAPM
• Use temporal method to translate accounts from LC
ACCOUNTING FOR DEFINED BENEFIT to PC.
R i = R F + β i [E(R
[E(R M ) − R F ]

PENSION PLANS • Monetary assets and liabilities at current rate. • Real options: timing, sizing (abandonment and
• Nonmonetary assets and liabilities at historical rate. expansion), flexibility, fundamental
• Pension obligation components • Economic income
• Capital stock at historical rate.
Pension obligation at the beginning of the period
+ Current service costs • Revenues and expenses at average rate, except for Economic income = After‐tax operating cash flow + Change in market value
Economic income = After‐tax operating cash flow + (Ending market value − Beginning
+ Interest costs expenses related to nonmonetary assets (e.g. COGS, market value)
+ Past service costs
+ Actuarial losses
depreciation) which are translated at historical rates. OR
− Actuarial gains • Dividends at rate when declared. Economic income = After‐tax operating cash flow − (Beginning market value − Ending
− Benefits paid
Pension obligation at the end of the period • Translation gain/loss reported in income statement. market value)

• Exposure = net monetary asset or liability. Economic income = After‐tax cash flows − Economic depreciation
• Fair value of plan assets • Economic profit
• Net asset (liability) exposure and appreciating foreign
Fair value of plan assets at the beginning of the period currency = translation gain (loss)
+ Actual return on plan assets
• Ratios (originally in LC versus current rate method) Economic profit = [EBIT (1 - Tax rate)] - $WACC
+ Contributions made by the employer to the plan
− Benefits paid to employees
Fair value of plan assets at the end of the period
• Pure income statement and balance sheet ratios Economic profit = NOPAT - $WACC
unaffected.
• Balance sheet liability (or asset) equals funded status • If foreign currency is appreciating (depreciating), • Claims valuation
• Negative funded status = plan is underfunded = net mixed ratios (based on year-end b/sheet values) will be • Separate cash flows available to debt and equity
smaller (larger) after translation. holders.
pension liability.

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• Discount them at their respective required rates of • All else being equal, impact of share repurchase Post‐Merger HHI Concentration Change in HHI Government Action
return (debt cash flows discounted at cost of debt, on shareholder wealth is the same as that of cash Less than 1,000 Not concentrated Any amount No action
equity cash flows discounted at cost of equity). dividends. Between l,000 and 1,800 Moderately concentrated 100 or more Possible challenge
More than 1,800 Highly concentrated 50 or more Challenge
• Add PVs of the two cash flow streams to calculate total • Reasons to prefer share repurchase: potential tax
company/asset value. advantages, share price support, managerial flexibility,
offset dilution from employee stock options, higher • Target company valuation
CAPITAL STRUCTURE financial leverage. • DCF analysis based on FCFF.
• Effect of share repurchase on EPS • Comparable company analysis: relative valuation
• MM Prop I without taxes: given MM assumptions and measures used to estimate market value of target, then
no taxes, changes in capital structure do not affect • If funds used for share repurchase are generated
internally, EPS will increase if the funds would not have add takeover premium.
company value
earned the cost of capital if retained. • Comparable transaction analysis: recent merger
• MM Prop II without taxes: higher financial leverage raises transactions used to estimate fair acquisition price for
the cost of equity but no change in WACC • If borrowing used to finance share repurchase, EPS will
fall (rise) if after-tax cost of borrowing is higher (lower) target (takeover premium built into transaction prices).
D than earnings yield. • Merger bid evaluation
rE = r0 + (r0 − rD )
E • Affect of share repurchase on book value per share • Post-merger value of the combined company
(BVPS): when market price is higher (lower) than BVPS,
• MM Prop I with taxes: debt results in tax savings, so BVPS will decrease (increase) after repurchase VA* = VA + VT + S – C
company value would be maximized with 100% debt (no
costs of financial distress) • Dividend safety measure VA* = Post‐merger value of the combined company
VA = Pre‐merger value of the acquirer
• MM Prop II with taxes: higher financial leverage raises the FCFE coverage ratio = FCFE / [Dividends + Share repurchases] VT = Pre‐merger value of the target company
cost of equity and lowers WACC (WACC is minimized at S = Synergies created by the business combination
100% debt) C = Cash paid to target shareholders
BUSINESS ETHICS
D E
rWACC =   rD (1 t ) +   rE
(1 − t) • Takeover premium and acquirer’s gain
 V  V • Friedman doctrine: only social responsibility is to
increase profits as long as the company stays “within the
rules of the game” Target shareholders’ gain = Takeover premium = PT − VT
D
rE = r0 + (r0 − rD ) (1 − t)  
 E • Utilitarian ethics: best decisions are those that produce Acquirer’s gain = Synergies − Premium
the greatest good for the greatest number of people = S − (PT − VT)

• Kantian ethics: people should be treated as ends and

• Agency costs: using more debt reduces net agency costs never purely as means to the ends of others
S = Synergies created by the merger transaction
of equity
• Rights theories: people have certain fundamental rights
• Pecking order theory (information asymmetry): that take precedence over a collective good
• Acquirer prefers cash offer if confident of synergies
managers prefer internal financing and debt over equity and/or target’s value.
• Justice theories: just distribution of economic goods and
• Static trade-off theory (optimal capital structure): services (veil of ignorance and differencing principle)
increase debt up to the point where further increases in
value from tax savings are offset by additional costs of
CORPORATE GOVERNANCE EQUITY INVESTMENTS
financial distress
• Objectives: reduce conflicts of interest (manager- EQUITY VALUATION MODELS
DIVIDENDS AND SHARE REPURCHASES shareholder and director-shareholder conflicts) and
• Absolute valuation: estimate asset’s intrinsic value, e.g.
ensure company’s assets are used in the best interests of
• Dividend policy investors and stakeholders
dividend discount model
• MM: with perfect capital markets, dividend policy • Relative valuation: estimate asset’s value relative to that
• Desirable characteristics of an effective board of of another asset, e.g. price multiples
does not matter because shareholders can create
directors:
homemade dividends.
• 75% of the board independent. RETURN CONCEPTS
• Bird-in-hand argument: even with perfect capital
markets, shareholders prefer current dividends over • CEO and Chairman roles separate.
future capital gains. • Annual re-election of whole board or staggered board. • Holding period return
• Tax argument: if higher tax on dividends vs capital • Self-evaluation and meeting without management at PH − P0 + DH
gains, investors prefer earnings reinvestment and least annually. Holding perio
erio etur =
er d return
eturn
P0
share repurchases over cash dividends. • Independent audit, nominations and compensation
• Signaling effect: dividend initiations or increases usually committees.
taken as positive signals (unless overvalued company) • Required return
• Access to independent or expert legal counsel.
• Agency costs: shareholders prefer cash dividends to • Minimum level of return on an asset required by an
• Statement of governance policies. investor.
prevent managers investing in negative NPV projects;
bondholders often restrict dividends through covenants MERGERS AND ACQUISITIONS • If expected return is higher (lower) than required
• Factors affecting dividend policy: investment return, the asset is undervalued (overvalued).
opportunities, expected volatility of earnings, • Mergers and industry lifecycle • Equity risk premium (ERP)
financial flexibility, tax considerations, flotation costs, • Pioneering development: conglomerate and • Additional return required by investors to invest in
contractual/legal restrictions horizontal. equities rather than risk-free asset.
• Effective tax rate (ETR) when given corporate tax rate for • Rapid accelerating growth: conglomerate and • Gordon growth model estimate of ERP
earnings distributed as dividends (CTRD) and investor’s horizontal.
marginal tax rate on dividends (MTRD) • Mature growth: horizontal and vertical. D1
ERPGGM = + ge − YLTGB
• Double taxation and split-rate • Stabilization and market maturity: horizontal. P0

ETR = CTR
CTR D + [(l − CTR
CTR D ) × M
MTR
TR D ] • Deceleration of growth and decline: horizontal, vertical
and conglomerate. • Supply-side estimate (Ibbotson-Chen) of ERP
• Imputation: ETR = MTRD • Pre-offer takeover defense mechanisms: poison pills, Equity risk premium = {[(1 + EINFL) (1 + EGREPS) (1 + EGPE) − 1] + EINC} − Expected RF
• Payout policy poison puts, incorporation in a state with restrictive laws,
• Stable dividend policy staggered board of directors, restricted voting rights, • Estimating the required return on equity to discount cash
supermajority voting provisions, fair price amendments, flows to equity
Expected increase in dividends = (Expected earnings × Target payout ratio golden parachutes
– Previous dividend) × Adjustment factor • CAPM
• Post-offer takeover defense mechanisms: litigation,
greenmail, share repurchase, leveraged recapitalization, ri = r f + βi , M (rM − r f )
• Constant dividend payout ratio policy: payout is a
constant % of net income. “just say no,” “crown jewel,” “Pac‒man,” white knight
and white squire defenses
• Residual dividend policy: payout only if there is • Fama-French model
sufficient cash after investment in positive NPV • Herfindahl-Hirschman Index (HHI)
mktt
mk size value
ri = RF + βi MRF + βi
RMRF
RMR SMB + βi HML
projects. 2
n  Sales or output off ffir
irm
irmi 
• Share repurchases ∑  Total sales or output of mark
ma et
× 100 
 • Pastor-Stambaugh model: adds a liquidity factor to the
i

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Fama-French model. • Two-stage DDM: high growth rate in the short run (first E1 (1 − b)
P0 D1 //E
• Macroeconomic multifactor models: use economic stage), lower growth rate in long run (second stage) Justifie P/E =
tif d leadingg P
tifie = =
E1 r−g r−g
variables as factors.
• Build-up method for private business
n
D0 (1 + gS ) t D0 (1 + gS )n (1 + gL )
V0 = ∑ + E 0 D 0 (1 + g) / E 0 (1 − b)(1 + g)
P0 D1 //E
(1 + r ) t (1 + r )n (r − gL ) Justifie P/E =
tif d ttrailingg P
tifie = = =
t=1 E0 r−g r−g r−g
ri = Risk‐free rate + Equity risk premium + Size premium + Specific‐company premium

• Bond yield plus risk premium (BYPRP) approach with • H-model: growth rate declines linearly from a short-run • P/E-to-growth (PEG) ratio: investors prefer stocks with
high rate to long-run constant growth rate (H = half the lower PEGs
publicly-traded debt
length of the high growth period) • PEG ratio assumes linear relationship between P/E and
BYPRP cost of equity = YTM on the company’s long‐term debt + Risk premium
growth.
D0 (1 + gL ) D0 H(gs − gL )
• Adjusting beta for beta drift
V0 =
r − gL
+
r − gL • Does not account for different risk and duration of
growth.
Adjusted beta = (2/3) (Unadjusted beta) + (1/3) (1.0) • Price to book value (P/B) ratio
• Sustainable growth rate
• Estimating beta for non-public company using the pure- • Book value usually positive and more stable than
play method g = b × ROE earnings.
b = Earnings retention rate, calculated as 1 − Dividend payout ratio • Useful for financial sector companies with liquid
 
 1  assets.
ß ASSET = ßEQUITY  
D
1 +    ROE =
Net income Sales
× ×
Assets • Misleading when there are non-tangible factors and
  E  Sales Assets Shareholders
eholde ’ equity
eholders size differences.
= Prof
ofit
it margin × Assett ttur
marg urnover × Financial leverage
urnove
 D
• Affected by accounting choices.
ßPROJECT = ß ASSET
ASSET 1 +
 E  • Inflation/technology may cause big differences
FREE CASH FLOW between BV and MV.
• Weighted average cost of capital (WACC) to discount cash • Justified P/B
flows to the firm • Use free cash flow for valuation when:
P0 ROEE−g
MVD MVCE
• Company does not pay dividends or pays dividends =
B0 r−g
WACC = rd (1 − Tax ate) +
Tax rat
rate r that deviate significantly from FCFE.
D+M
MVD MVCE D+M
MVD MVCE
• Free cash flow is related to profitability.
• Investor takes a control perspective. • Price to sales (P/S) ratio
INDUSTRY AND COMPANY ANALYSIS • Free cash flow to the firm (FCFF) • Sales less affected by accounting choices than earnings
and book value.
• Projecting future sales growth FCFF = NI + NCC
C + Int
Int(1 − Tax Ratee) − F
Tax Rat nv − WCInv
FCInv
FCI
CInv • Sales positive even when earnings are negative and
• Growth relative to GDP growth approach more stable than earnings.
FCFF = EBIT
EBIT(1 − Tax ratee) + D
Tax rat ep − FCInvv − W
Dep WCInv
gS = β S ,GDP × gGDP
• Useful for mature, cyclical and loss-making companies.
• Free cash flow to equity (FCFE) • Sales ≠ profits and does not reflect cost structure.
• Sales may be distorted due to revenue recognition
• Market growth and market share approach choices.
FCFE = FCFF
FCFF − Intt(1 − T
Tax rate) + Net borrowing
ax rate

gS = (1 + gM )(1
1 + gMS ) − 1 • Justified P/S
FCFE = NI + NCC
C − FCInv − WCInvv + N
FCInv
FCInv Net Borrowing
/S0 )(1 − b)(1 + g)
P0 (E 0 /S
=
• Return measure FCFE = EBIT
EBIT(1 − Tax ate) − IInt
Tax rat
rate nt(1 − Tax ratee) + D
Tax rat ep − FCInv − WCIn
Dep WCInv
WC v+N
Inv Net borrowing S0 r−g
• Return on invested capital (ROIC): better measure of
profitability than ROE because unaffected by financial • FCFE is simpler to use when capital structure is stable
• Price to cash flow (P/CF) ratio
leverage • FCFF is preferred if it reflects company fundamentals
better or if FCFE is negative • Cash flow less affected by accounting choices than
ROIC = NOPLAT / Invested capital earnings.
• Single-stage FCFF/FCFE valuation model
• Cash flow more stable than earnings.
• Return on capital employed (ROCE): pretax measure
useful for comparisons across different countries/tax Value off tthe firm =
FCFF
FF1 • Many definitions of cash flow.
structures WACC − g • Enterprise value to EBITDA multiple
• Useful for comparing companies with different
ROCE = Operating profit / Capital employed FCFE1 leverage.
Value of equity =
r−g
• Useful for valuing capital-intensive firms.
• Analysing competitive position with Porter’s five forces • EBITDA is often positive when earnings are negative.
• Threat of substitutes. • Two-stage FCFF/FCFE valuation model • EBITDA is affected by revenue recognition choices.
• Rivalry (intensity of competition). n
FCFF
FFt FCFF
FFn+1 1 • Enterprise value = MV of common equity + MV of
Firm value =∑ +
• Bargaining power of suppliers. WACC)t (WACC
t =1 (1 + C − g) (1 + WACC)n preferred stock + MV of debt – Value of cash and short-
• Bargaining power of customers. term investments.
Firm value = PV of FCFF in Stage 1 + Terminal value × Discount Factor
• Threat of new entrants. • Weighted harmonic mean for portfolio P/E

DISCOUNTED DIVIDEND VALUATION Weighted harmonic mean = XWH =

1
∑ i=1 (wi / Xi )
n

• Use dividends as a measure of cash flow when:

• Company has dividend history. RESIDUAL INCOME
PRICE AND ENTERPRISE VALUE MULTIPLES
• Dividend policy is related to earnings.
• Non-control perspective. • Price to earnings (P/E) ratio • Use residual income (RI) for valuation when:
• Gordon growth model: constant dividend growth to • Earnings are a key driver of stock value but could be • Company does not pay dividends.
infinity negative. • Free cash flow expected to be negative.
• May be difficult to identify recurring earnings. • Accounting disclosures are good.
D0 (1 + g ) • RI model is not appropriate when:
V0 = , orr V0 =
D1 • Affected by accounting choices.
( r − g) ( r − g)
• Normalizing earnings for a cyclical company • Clean surplus relation is violated.
• Historical average EPS (does not account for changes • Book value and ROE are difficult to predict.
• Present value of growth opportunities (PVGO)
in company size). • RI calculation
V0 =
E1
+ PVGO
• Average ROE (accounts for changes in company size).
r
• Justified P/E RI t = E t − (r
(r × Bt −1 )

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RI t = (ROE
(ROE t – r)Bt −1
discounted at relevant spot rates plus the z-spread) (underpriced).
equals its market price • For a given bond price, the lower the interest rate
• Single-stage RI model • TED spread = LIBOR – Yield on a T-bill with same maturity volatility, the higher the OAS for a callable bond.
• LIBOR-OIS spread = LIBOR – overnight indexed swap rate • Effective duration
E−r
ROE
V0 = B0 +
r−g
B0 • Traditional theories of term structure (PVV− ) − (PV
V+ )
Effectiv
ff
ffective Duration =
• Unbiased (pure) expectations theory. 2 × ( ∆ Curve) × PV0
• Multi-stage RI model • Local expectations theory.
V0 = B0 + (PV of future RI over the short‐term) + (PV of continuing RI)
• Liquidity preference theory. Type of Bond Effective Duration
Cash 0
• Segmented markets theory. Zero‐coupon bond ≈ Maturity
T
(ROE t − r)B
r) Bt-1 PT − BT • Preferred habitat theory. Fixed‐rate bond < Maturity
V0 = B0 + ∑ +
t=1 (1 + r) t (1 + r)T • Modern term structure models Callable bond ≤ Duration of straight bond
• Cox-Ingersoll-Ross: short-term rate determines Putable bond ≤ Duration of straight bond
T-1 the entire term structure, interest rates are mean- Floater (Libor flat) ≈ Time (in years) to next reset
(E t − rBt −1 ) E T − rrB
BT-1
V0 = B0 + ∑ +
(1 + r) t )(1 + r)T−1
(1 + r − ω )(1 reverting, volatility proportional to short-term rate, no
t=1
negative interest rates. • Effective convexity
• Vasicek: short-term rate determines the entire term • Callable bond: when interest rates fall and the
• Economic Value Added (EVA) embedded call option is at the money, effective
structure, interest rates are mean-reverting, volatility
EVA = [EBIT (1 − Tax rate)] − (C% × TC) constant, negative interest rates possible. convexity turns negative because the bond’s price is
capped at the call price.
• Ho-Lee: arbitrage-free model, drift term is inferred
EVA = NOPAT − $WACC from market prices so that the model can accurately • Putable bond: when interest rates rise and the
generate the current term structure, volatility can be embedded put option is at the money, effective
modeled as a function of time, negative interest rates convexity remains positive but the downside is limited
PRIVATE COMPANY VALUATION possible. by the put price.
• Yield curve risk can be managed using: • Floaters
• Income approach (suitable for companies experiencing
high growth) • Key rate duration. Value of capped floater = Value of uncapped floater – Value of embedded cap

• Free cash flow method. • A measure based on a factor model which explains Value of floored floater = Value of non‐floored floater + Value of embedded floor
changes in the yield curve through level, steepness and
• Capitalized cash flow method (capitalization rate is curvature movements. • Convertible bonds
discount rate minus growth rate).
• Term structure of interest rate volatilities
• Excess earnings method (calculates firm value by Conversion value = Market
Market pric
price of
of commo
ccommon stock × Conversion ratio
ommonn stock
adding value of intangible assets to working capital • Measure of yield curve risk.
and fixed assets). • Short-term rates usually more volatile than long-term Market pric
pr e of convertible
onver
onvertible security
ecur
ecurity
• Market approach (use for stable, mature companies) rates. pr e =
Market conversion pric
Conversion ratio
• Guideline public company method (based on minority ARBITRAGE-FREE VALUATION
interest). Market conversion premium per sharee = M
Marke
Mar
arket conve
arke cconversion
onvers
rsio
ionn pri ce − Current mark
pprice
rice ma et pric
pr e

• Guideline transaction method (based on control • Use binomial interest rate tree and backward induction
perspective). for option-free bonds and bonds with embedded options Market conversion premium per share
ha
hare
• Prior transaction method (usually based on minority (except where bond’s cash flows are interest rate path- Market conversion premium ratio =
Market pric
pr e of common stock
interest). dependent)
• Asset-based approach (use for start-ups, firms with • Use Monte Carlo method to simulate a large number of
Market pric
pr e of convertible
onver
onvertible bond
minimal profits, banks, REITs, natural resources) potential interest rate paths in order to value a bond Premium over straight value= −1
Straight value
whose cash flows are interest rate path-dependent
• Discount for lack of control (DLOC)
 1  BONDS WITH EMBEDDED OPTIONS Minimum value = greater of conversion value or straight value
DLOC = 1-  
1 + C
Contro
ont l premium 
ontro
• Callable bond
Conver
Convertible callableand putable bond valuee = Straight value
• Total discount with DLOC and discount for lack of Value of callable bond = Value of straight bond – Value of embedded call option + Value off tthe call option on the stock
marketability (DLOM) − Value off tthe call option onn the
t bond
• Putable bond + Value off the
t put option on the bond

Total discount = 1 – [(1 – DLOC)(1 – DLOM)]
FIXED INCOME
TERM STRUCTURE
• Forward pricing model
P ( T * +T ) = P ( T *) F ( T *, T )
• Forward rate model
[1 + r (T * +T )]T *+ T = [1 + r (T *)]T * [1 + f (T *, T )]T
{ [1 + f (T *, T )]T }
1
r ( T * +T ) = [1 + r ( T *)]
T*
• Riding the yield curve: if yield curve is upward‒sloping
and if a trader is confident that the yield curve will not
change its level and shape over her investment horizon,
she would buy bonds with a maturity greater than her
investment horizon (instead of bonds with maturities
that exactly match her investment horizon) to enhance
her total return
• Swap spread = Swap fixed rate – Yield on government
security with equivalent maturity
• z-spread = constant spread that is added to implied spot
curve such that the PV of a bond’s cash flows (when
Value of putable bond = Value of straight bond + Value of embedded put option
• Effect of interest rate volatility
• Higher interest rate vol. increases value of embedded
call option and decreases value of callable bond.
• Higher interest rate vol. increases value of embedded
put option and increases value putable bond.
• Effect of yield curve change: value of embedded call (put)
option increases (decreases) as yield curve goes from
upward sloping to flat to downward sloping
• Valuation of callable and putable bonds with binomial
interest rate tree
• Callable bond: at each node during the call period,
the value of the bond must equal the lower of (1) the
( T *+ T )
−1
value if the bond is not called (using the backward
induction), and (2) the call price.
• Putable bond: at each node we use the higher of (1) the
value determined through backward induction, and (2)
the put price.
• Option-adjusted spread (OAS)
• Constant spread that, when added to all one-year
forward rates in interest rate tree, makes arbitrage-free
value of bond equal to its current market price.
• If the OAS for a bond is lower (higher) than that for a
bond with similar characteristics and credit quality,
it suggests that the bond is relatively overpriced
CREDIT ANALYSIS
• Loss given default = % of overall position lost if default
occurs
• Recovery rate = % of overall position recovered if default
occurs
• Expected loss = Probability of default × loss given default
• PV of expected loss = Difference between value of risky
bond and value of equivalent riskless bond
• Structural models (option analogy)
• Equity holders: comparable to holding a European call
option on company assets.
• Debt holders: comparable to holding a riskless bond
and selling a European put option on company assets.
• Model assumes that company assets trade in
frictionless markets.
• Structure of the balance sheet used to derive the
model is unrealistic.
• Only implicit estimation can be used to estimate
measures of credit risk because company asset value is
an unobservable parameter.
• Credit risk measures do not explicitly consider changes
in the business cycle.
• Reduced form models
• Model assumes that only some of company’s debt is
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traded. • Discount these interest savings for a period equal to • American options
• Model inputs are observable, allowing the use of the number of days remaining until FRA expiration • American call options on a non-dividend-paying stock
historical estimation for credit risk measures. plus the number of days in the term of the underlying will never be exercised early.
hypothetical loan (using appropriate LIBOR rate).
• Credit risk measures consider changes in the business • Early exercise of American call options on a dividend-
cycle. • Price of a bond futures contract when accrued interest is paying stock and American put options on both
not included in the bond price quote (convert this price to dividend-paying and non-dividend-paying stocks may
• Model does not impose any assumptions on balance
the quoted futures price using bond’s conversion factor) be optimal in some cases.
sheet structure but needs to be properly formulated
and backtested, e.g. hazard rate estimation. F0 (T)
(T) = [B VCI 0 ,T ] × (1 + r))T − A
[ B0 ((T + Y) + AII 0 − PVC
PVCI
PVCI AI T • Black-Scholes-Merton model for European options on
• Credit analysis of ABS non-dividend-paying stock
• Structural or reduced form model can be used. • Price of a currency forward
c = SN(d1) – e–rTXN(d2)
• ABS do not default, so probability of default replaced (1 + rPC )T
F0,PC/BC = S0,PC/BC × p = e–rTXN(–d2) – SN(–d1)
(1 + rBC )T
by probability of loss.

CREDIT DEFAULT SWAPS (CDS) F0,PC/BC = S0,PC/BC × e(r PC − rBC ) × T

• Swaptions: holder of a payer (receiver) swaption hopes
that market swap fixed rate increases (decreases) before
• Protection seller earns CDS spread and compensates • Value of a currency forward (long position) expiration of swaption
protection buyer for credit losses if a credit event occurs • Calculating the optimal number of hedging units for
Vt(T) = (Ft,PC/BC – F0,PC/BC) / (1 + rPC)T–t
• Types of CDS: single-name CDS, index CDS, tranches CDS delta hedging
• Credit events: bankruptcy, failure to pay, restructuring Portfolio delta
• Settlement protocols: physical or cash SWAPS NH = −
Delta H
• Upfront payment/premium
• Price of a plain vanilla interest rate swap (swap
Upfront payment = Present value of protection leg – Present value of premium leg fixed rate) • Estimating the value of an option using delta and gamma
 1 − B0 ( N ) 
Upfront premium % ≅ (Credit spread – Fixed coupon) × Duration of CDS Swap fixed rate =   × 100
 B0 (1) + B0 ( 2 ) + B0 ( 3) + ... + B0 ( N )  For calls: c − c ≈ Delta c (S − S) +
Gamma c 
(S − S)2
2
• Price of CDS • Value of a plain vanilla interest rate swap Gamma p
For puts: p − p ≈ Delta p (S − S) + (S − S)2
Price of CDS per 100 par =100 – Upfront premium % V = NA * (PSFR0 – PSFRt) * Sum of PV factors of remaining coupon 2
payments as of t = t
• Change in CDS price for a given change in credit spread
where PSFR is the periodic swap fixed rate.
% Change in CDS price = Change in spread in bps × Duration
• Value of an equity swap DERIVATIVE STRATEGIES
• Long/short trade: sell protection (long CDS) on entity • Pay-fixed, receive-return-on-equity swap • Managing portfolio duration
whose credit quality is expected to improve and buy
protection (short CDS) on entity whose credit quality is
[(1 + Return on equity) * Notional amount] – PV of the remaining fixed-rate payments • Increase duration: enter into receive fixed interest rate
swap or buy bond futures contracts.
expected to worsen
• Pay-floating, receive-return-on-equity swap • Reduce duration: enter into pay fixed interest rate
• Curve trade with upward-sloping credit curve: if credit
swap or sell bond futures contracts.
curve is expected to steepen, buy protection (short CDS) [(1 + Return on equity) * Notional amount] – PV (Next coupon payment + Par value)
on a long-term CDS and sell protection (long CDS) on a • Managing equity exposure
short-term CDS of the same entity • Pay-return on one equity instrument, receive-return on • Increase exposure: enter into receive-total-return-
another equity instrument swap on-equity-index, pay-LIBOR swap or buy stock index
• Basis trade: profit from temporary difference between
(1) credit spread on a bond, and (2) credit spread on a [(1 + Return on Index 2) * Notional amount] – [(1 + Return on Index 1) * Notional amount]
futures contracts.
CDS on same reference obligation with the same term • Reduce exposure: enter into pay-total-return-on-
to maturity equity-index, receive-LIBOR swap or sell equity futures
OPTIONS contracts.
• Covered call = long stock + short call on stock
DERIVATIVES • One-period binomial model for European stock options
• Protective put = long stock + long put on stock
• No-arbitrage approach and expectations approach give
FORWARDS AND FUTURES same answer. • Collar = long stock + long put on stock + short call on
stock
• Hedge ratio for call and put options
• Forward price assuming no carry costs or benefits • Bull spread = long call (or put) + short call (or put) with
c+ − c− p+ − p− higher exercise price. Profit if expected increase in stock
F0(T) = S0 (1 + r)T h= > 0, h = + <0
S+ − S− S − S− price materialises.
• Value of a forward contract during its life assuming no • Bear spread = long call (or put) + short call (or put) with
• Value of call and put options using the no-arbitrage lower exercise price. Profit if expected decrease in stock
carry costs or benefits (long position) approach price materialises.
Vt(T) = St – [F0(T) / (1 + r)T–t] c = hS + PV(–hS– + c–) or c = hS + PV(–hS+ + c+) • Long straddle = long call + long put with same strike price
and expiration. Profit if expected increase in volatility
• Forward price when underlying has discrete cash flows p = hS + PV(–hS– + p–) or p = hS + PV(–hS+ + p+) materialises.
F0(T) = (S0 – γ0 + θ0) (1 + r)T
F0(T) = S0(1 + r)T – (γγ0 – θ0)(1 + r)T • Value of call option with expectations approach (where
π = risk-neutral probability of UP move) ALTERNATIVE INVESTMENTS
• Forward price when underlying has cash flows
(continuous compounding) c=
+
πc + (1
(1 − π))cc −
PRIVATE REAL ESTATE INVESTMENTS
(1 + r)
F0(T) = S0e(rc+θc–γγc)T
where: • Net operating income
• Value of a forward contract during its life when (1 + r − d
d) Rental income at full occupancy
π=
underlying has cash flows (long position) (u − d) + Other income (such as parking)
= Potential gross income (PGI)
− Vacancy and collection loss
Vt(T) = PV of differences in forward prices = PVt,T [Ft(T) – F0(T)] • Use process to value a put option using the = Effective gross income (EGI)
• Price of a FRA: forward rate starting at FRA expiration, expectations approach. − Operating expenses (OE)
= Net operating income (NOI)
given two LIBOR rates • Two-period binomial model for European stock options
• Value of a FRA prior to expiration • Use backward induction with the expectations • Direct capitalization method
• Calculate new implied forward rate based on current approach.
• Capitalization rate from comparable property
LIBOR rates. • Value of call and put options
Cap ratee = Discoun
Ca Discount
D atee − G
iscountt rat
rrate Growth rate
• Calculate interest savings based on this new forward c = PV[π2c++ + 2 π (1 – π)c+– + (1 – π)2c– –]
rate vs FRA rate. p = PV[π2p++ + 2 π (1 – π)p+– + (1 – π)2p– –]
• Value of property
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Value =
NOI1
Ca rate
Cap
PRIVATE EQUITY PORTFOLIO MANAGEMENT
• Sources of value creation: reorganizing investee PORTFOLIO MANAGEMENT PROCESS
• Gross income multiplier method company, raising higher levels of debt, aligning interests
of management with PE firm • Planning
Selling price
Gross income multiplier =
Gross income
• LBO transactions • Identify risk and return objectives.
• Significant debt used to finance purchase. • Identify investment constraints: liquidity, time horizon,
Value of subject property = Gross income multiplier × Gross income of subject property • Exit value = Initial cost + Value creation from earnings tax concerns, legal/regulatory factors and unique
growth + Value creation from multiple expansion + circumstances.
• DCF method Value creation from debt reduction. • Create investment policy statement.
• If NOI is expected to grow at a constant rate • Venture capital transactions • Form capital market expectations.
• Pre-money valuation (PRE) = agreed value of company • Create strategic asset allocation.
NOI1 prior to a round of financing.
Value = • Execution
(r − g) • Post-money valuation (POST) = value of company after
the round of financing (I). • Feedback: monitoring/rebalancing and performance
evaluation
• If property is expected to generate income for a specific • POST = PRE + I.
holding period before being sold at the end of the
holding period, value property as the sum of the PV of
• Proportionate ownership of VC investor = I ÷ POST. MULTIFACTOR MODELS
income stream and sale price (use direct cap method • Exit routes: IPO (highest valuation), secondary market
sale, management buyout, liquidation (lowest valuation) • Arbitrage pricing theory
to estimate sale price or terminal value)
• Private equity fund performance R P ) = R F + λ1β p,1 + … + λ K β p,,K
E(R
NOI for the first year of ownership
p ffor the next investor
Terminal value =
Terminal cap rate
• Gross IRR: based on cash flows between fund and
portfolio companies. • Carhart four-factor model
• Cost approach • Net IRR: based on cash flows between fund and limited Rp) = RF + βp,1RMRF + βp,2SMB + βp,3HML + βp,4WML
E(R

• Appraised value = Land value + Building value. partners (return to investors).

• PIC (Paid-in capital): ratio of invested capital to • Active return
• Building value = Replacement cost + Developer’s profit
– Total depreciation. committed capital. Active return = Rp − RB
• Sales comparison approach: calculate average adjusted • DPI (Distributed to paid-in): ratio of cumulative
price per square foot from comparable properties and distributions paid to LPs to cumulative invested Active return = Return from factor tilts + Return from asset selection
use this to value property capital.
• Real estate indices • RVPI (Residual value to paid-in): ratio of LPs’ holdings • Active risk is the standard deviation of the active return
held with the fund to cumulative invested capital.
• Appraisal-based indices: appraisal values lag Active risk squared = S2(Rp − RB)
transaction prices when market shifts suddenly. • TVPI (Total value to paid-in): sum of DPI and RVPI.
• Transaction-based indices: repeat sales and hedonic • Basic venture capital method (in terms of NPV) Active risk squared = Active factor risk + Active specific risk
indices. • Step 1: Post-money value (POST)
• Loan to value ratio
Post-money value =
Exit value MARKET RISK
Loan amount etur Number of years to exit
(1 + Required rate of return)
eturn)
LTV ratio =
Appraised value • VaR: minimum loss over a particular time period with a
specified probability
• Debt service coverage ratio • Step 2: Pre-money value (PRE): PRE = POST –
Investment. • Parametric method
NOI • Step 3: Ownership proportion of VC investor = • VaR estimate based on return and standard deviation,
DSCR =
Debt service Investment ÷ POST. typically from normal distribution

• Equity dividend ratio (cash-on-cash return) • Step 4: Shares to be issued to VC investor n

R P ) = ∑ wi R i
E(R
i =1
First year cash
h fflow por n of venture capitalist investment × Shares held by
Proportio
portio
Equity dividend rate = companyy ffounders
Equity investment Shares to be issued =
Proportio
opor n of investment of companyy ffounders
oportio σ P = w i2 σ 2i + w 2j σ 2j + 2w i σ i w jσ jρi, j

REITS • Step 5: Price per share

Unannualized σP = Annual σP / No. of days0.5

• Historical simulation: returns are ranked lowest to

• Net asset value (NAV) approach Amount of venture
ventur capital investment highest, VaR is determined for required confidence
Price per share =
• Estimate value of operating real estate by capitalizing Number of shares issued to venture
ventur capital investment interval
NOI (exclude non-cash rents). • Monte Carlo simulation: employs user -developed
• Total NAV = Value of operating real estate + Value of assumptions to generate a distribution of random
other tangible assets – Value of liabilities. COMMODITIES outcomes
• NAV per share = Total NAV ÷ Number of shares • Spot and futures pricing • Conditional VaR: average loss expected outside
outstanding. confidence limits
• Contango: futures price > spot price.
• Price to funds from operations ratio • Incremental VaR: change in VaR if a position within the
• Backwardation: spot price > futures price.
portfolio changes
Accounting net earnings • Insurance theory (theory of normal backwardation):
Add: Depreciation charges on real estate futures market will be in backwardation normally • Marginal VaR: change in VaR for a marginal change in
Add: Deferred tax charges
because producers sell futures to lock in prices so that portfolio positions
Add (Less): Losses (gains) from sales of property and debt restructuring
Funds from operations revenues are more predictable • First- and second-order yield effects on bond price
• Hedging pressure hypothesis: if consumers (producers)
∆B ∆y 1 ( ∆yy)2
• Price to adjusted funds from operations ratio have greater demand for hedging, the futures market will = −D + C
B 1 + y 2 (1 + y)2
be in contango (backwardation)
Funds from operations • Theory of storage
Less: Non‐cash rent
• Futures price = Spot price + Storage costs – • Impact of delta and gamma on call option price
Less: Maintenance‐type capital expenditures and leasing costs
Adjusted funds from operations Convenience yield. 1
c + ∆c ≈ c + ∆ c ∆S + Γ c ( ∆S)2
• Convenience yield is inversely related to inventory size 2
• EV to EBITDA ratio: EBITDA can be computed as NOI and general availability of commodity.
minus G&A expenses • Components of futures returns: price return, roll return, • Sensitivity risk measures can complement VaR because
collateral return (1) they address shortcomings of position size measures,
• DCF valuation approach: use dividend discount model as and (2) they do not rely on history
REITs pay dividends • Commodity swaps: excess return swap, total return
swap, basis swap, variance swap, volatility swap • Scenario risk measures can complement VaR because

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 efficientlearning.com/cfa

(1) they can overcome any assumption of normal • Break-even inflation rate: difference between yield on a E(RRA )
distributions, and (2) a portfolio’s most concentrated zero-coupon default-free nominal bond and the yield on = Info
Information
In form
rmatio
ationn ratio (IR) = TC * IC * BR
ratio (IR)
σ (R A )
positions can be stress tested a zero-coupon default-free real bond (includes expected
inflation and risk premium for uncertainty over future • Independence of investment decisions
ECONOMICS AND INVESTMENT MARKETS inflation)
• BR does not equal N when (1) active returns between
• Inter-temporal rate of substitution (ITRS) ACTIVE PORTFOLIO MANAGEMENT individual assets are correlated, or (2) forecasts are not
independent from period to period
• Ratio of the marginal utility of consumption in the
future to the marginal utility of consumption today. • Sharpe ratio
N
BR =
• ITRS is inversely related to real GDP growth. SRP =
RP − R f 1 + (N
( N − 1)ρ
• ITRS is inversely related to the one-period real risk-free D ( RP )
STD
ST
rate.
• Covariance between ITRS and expected future price of a • Information ratio ALGORITHMIC TRADING
risky asset is negative, resulting in a positive risk premium. Active return
etur
eturn RA RP − RB • Execution algorithms: break down large trades into
Information ratio (IR) = = =
• The larger the negative covariance, the higher the risk Activee rrisk σ ( RA ) σ (R
( RP − RB ) smaller sizes to minimize trading impact, e.g. VWAP,
premium. market participation, implementation shortfall
• Real default-free interest rates are: • Optimal portfolio construction
• High-frequency trading algorithms: find and execute
• Positively related to GDP growth rate. • Sharpe ratio of combination opportunistic, profitable trades, e.g. event-driven
• Positively related to expected volatility of GDP growth. SR2P = SR2B + IR2 algorithms, statistical arbitrage algorithms
• Taylor rule for short-term interest rates • Market fragmentation (same instrument traded in
• Optimal level of active risk for unconstrained portfolios multiple markets): liquidity aggregation creates a “super
prt = ιt + π t + 0.5(π t − π*t ) + 0.5((Yt − Yt* )
0.5
.5 book” of quote and depth across many markets while
IR
σ* ( RA ) = σ ( RB ) smart order routing introduces orders in markets offering
Where SR B
prt = policy rate at time t
best prices and favorable market impact
ιt = real short-
or term interest rates that balance saving and borrowing
ort- • Full fundamental law
π t = inflation
*
π t = the inflatio
nf
nflation target
R A ) = TC IC BR σ A
E(R
and Yt* = logarithmi
Yt and ogar c levels of actual and potential real GDP, respectively

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