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Unformatted text preview: _ LEVEL1 ETHICAEAND PRQFESSIONAL STANDARDS 3 . I Professionalism
I (A) Knowledge of the Law.
I (B) Independence and Objectivity.
I (C) Misrepresentation.
I (D) Misconduct.
II Integrity of Capital Markets
ll (A) Material Nonpublic Information.
ll (3) Market Manipulation.
III Duties to Clients
iii (A) Loyalty, Prudence, and Care.
III (B) Fair Dealing.
III (C) Suitability.
III (B) Performance Presentation.
III (E) Preservation of Conﬁdentiality.
IV Duties to Employers
IV (A) Loyalty.
IV (E) Additional Compensation Arrangements.
IV (C) Responsibilities of Supervisors.
V Investment Analysis, Recommendations,
and Aetion
V (A) Diligence and Reasonable Basis.
V (B) Communication with Clients and
Prospective Clients.
V (C) Record Retention.
VI Conﬂicts of Interest
VI (A) Disclosure of Conflicts.
VI (B) Priority of Transactions. VI (C) Referral Fees.
VII Responsibilities as a CFA Institute Member or CPA Candidate VII (A) Conduct as Members and Candidates in
the CPA Program. VII (B) Reference to CFA Institute, the CPA designation, and the CPA Program. Global Investment Performance Standards
(GIPSG) ' Compliance statement: “[Insert name of ﬁrm} has
prepared and presented this report in compliance
with the Global Investment Performance
Standards (GIPS).” Compliance must be applied
on a ﬁrmawide basis. * Nine sessions: fundamentals of compliance,
input data, calculation methodology, composite
construction, disclosures, presentation and
reporting, real estate, private equity, and wrap
feeiseparately managed account portfolios. QUANTITATIVE METHODS Time Value of Money Basics ' Future trains (FV): amount to which investment
grows aﬂer one or more compounding periods. ' Fatare oalae: PV 2 PVU + NY)“. * ﬁesent value(PW: current value of some future
cash flow PV = FVMI + NY)”. ' Annuities: series of equal cash ﬂows that occur at
evenly spaced intervals over time. * Ordinary annnity: cash flow at end—of—time period. ' Annain due: cash flow at deginning—oftime period. * Perpetaities: annuities with inﬁnite lives. PVPHPMW = PMT)r (discount rate).
Required Rate of Return
Components: 1. Real riskfree rate (RFR).
2. Expected inflation rate premium (IP). 3. Risk premium.
E(R) = (1+ RPRmi)“ —— IP)(I + RP) #1 I l E ER, . . CRITICAL CONCPTS FOR THE 2011 C Approximation formula for nominal required rate: E(R) E RFR + IP+RP Means Arithmetic mean: sum of all observation values in sample! population, divided by it of observations.
Geometric mean: used when calculating investment
returns over multiple periods or to measure
compound growth rates. Geometric mean return: RC: [(1+R,)x...x(1+RNj]i’* —1
N harmonic mean = N
l 1 I 2 i=1 Xi Variance and Standard Deviation
Varianee: average of squared deviations from mean.
N Za—M 2 i=1
N population variance = ct = . 2 '=
sample variance =s = l 1 1
“— Stamiarti deviation: square root of variance.
Holding Period Return (HPR) _ P, _P,_, +13, Pr +o, _
‘ _ P P t—l t—l R 1 DI Coefﬁcient of Variation
Coeﬁfsient ofoariation (CV): expresses how much
dispersion exists relative to mean of a distribution;
allows for direct comparison of dispersion across
different data sets. CV is calculated by dividing
standard deviation of a distribution by the mean or
expected value of the distribution: :4; X Sharpe Ratio Sharpe ratio: measures excess return per unit of rislt. IP——q GP Sharpe ratio = i . r _itar er
Roy s saﬁgrﬁrst ratio : A
o P For both ratios, larger is better.
Expected Return! Standard Deviation Expected return: ECK) = ZPfxi) xn
E(X) = P(xl )x] +P(x2)x2 +... + P(xn)xn Prooaoiiistie oarianse:
e a): Deli — tot
= Plxillxi — Elxllz + Plxallxz 4(1)]:
+. . . + P(xﬂ )[xﬂ ~—E(X)]2 Standard deoiation: take square root of variance. Correlation and Covariance
Correlation: covariance divided by product of the
two standard deviations. cov(a,.a,) Corf(Ri=Rl): 1w Ex” AM Expected return. oarianee of2rstoee porp‘isiio: E(RP) = w,E(R,) + meaB) var(Rp) = win2 (RA) + wéct2 (RB)
+2WawsﬁlRa )5 (RalplaarRBl Normal Distributions Nornmi distridation is completely described by its
mean and variance. 63% of observations fall within s: lo. 90% fall within 1 1.65m 95% fall within i 1.9613. 99% fall within a 2.58m Computing ZScores Zseore: “standardizes” observation from normal
distribution, represents it of standard deviations a
given observation is from population mean. observation — population mean x —r it
3::——F——————H—————————————::
standard deviation o' Binomial Models Bisnmiair damnation: assumes a variable can take
one of two values (successi failure) or, in the case of
a stock, movements (upi down). A binomial model
can describe changes in the value of an asset or
portfolio; it can be used to compute its expected
value over several periods. Sampling Distribution Sampling diminution: probability distribution of
all possible sample statistics computed from a set of
equalrsize samples randomly drawn from the same
population. The sampling siistriimtion ofrfae mean is
the distribution of estimates of the mean. Central Limit Theorem Central limit tbserem: when selecting simple
random samples of size n from popaiation with
mean u and ﬁnite variance oi, the sampling
distribution sample mean approaches normal
probability"distiributi'onattithimeau u and variance
equal to olﬁnas'thesamplgosiit'e becomes large.
Standard Error Standard error ofn’ire sample mean is the standard
deviationof distribution ofthe sample means, . . . . . _. .i , _ I 0'
known populationvariance: erg : n . . s
unknown population variance: sE 2 —~— J;
Conﬁdence Intervals Conﬁdence internal gives range of values the mean
value will be between, with a given probability (say 90% or 95%). With known variance, formula for a
conﬁdence interval is: or
E i r. — (iii (—11
am,2 = 1.645 for 90% conﬁdence intervals (signiﬁcance level 10%, 5% in each tail)
arm = 1.960 for 95% conﬁdence intervals (significance level 5%, 2.5% in each tail)
aw: 2.5?5 for 99% confidence intervals
(signiﬁcance level 1%, 0.5% in each tail) continued on next page... QUANTITATIVE METHODS continued... Null and Alternative Hypotheses Nnii hypothesis {II—In}: hypothesis the researcher
wants to reject; the hypothesis that is actually
tested; the basis for selection of the test statistics.
Afternatioe hypothesis {II1,3: concluded if there is sufﬁcient evidence to reject the null hypothesis. Difference Between One and TwoTailed Tests Onetaiieci test: tests whether value is greater than or
less than a given number. Trontaiieti test: tests whether value is equal to a
given number. ' Onetailed test: I—Iﬂ: p. :5: 0 versus 1—1,: ii 3. i}. ' Twotailed test: I—Iu: p. = 0 versus H,: ii. a I}. Type I and Type II Errors ' ijipe i error: rejection of null hypothesis when it is
actually true. * ijrpe ii error: failure to reject null hypothesis when
it is actually false. Technical Analysis
Reorrsaipo’tterns: head and shoulders, inverse HSCS, doubleitriple top or bottom. Continnation patterns: triangles, rectangles,
pennants, ﬂags. ii'ricetintseaI indicators: moving averages, Boilinger
bands, momentum oscillators [rate of change, RSI,
stochastic, hrIACD). Sentiment indicators: opinion polls, puti call ratio, VIX, margin debt, short interest ratio.
Fioto ofﬂian indicators: THIN, margin debt, mutual fund cash position, new equity issuance,
secondary onerings. MACROECONOMICS Inﬂation inﬂation rate: rate of change in Consumer Price
Index over given period of time: . current CPI — last period CPI
1 : ————————
last period CPI Unemployment ' Frictionai: economic changes prevent matching
qualiﬁed workers with job openings. " Stractarai* unemployed workers do not have the skills to match newly created jobs.
' Cyciicai: recession phase of business cycle, economy producing at less than capacity. Labor Demand and Supply A ﬁrm’s demand for labor is increased by: ' Increase in price of the ﬁrm’s output. ' Increase in price of a productive input that is a
substitute for labor. " Decrease in price of a productive input that is a
complement to labor. The supply of labor is inﬂuenced by: ' Substitution effect: increase in wage rate causes
workers to substitute labor hours for leisure hours. ' Income effect: increases in income increase
worlters3 demand for leisure. Schools of Macroeconomic Thought ' Ciassicai: shifts in AD and AS driven by
technology changes; money wages adjust rapidly
to restore equilibrium. ' Keynesian: shifts in AD caused by changes in
expectations; wages are “downward sticky”, use
fiscal and monetary policy to increase AD and
restore equilibrium. ' Monetarist: monetary policy is the main factor
leading to business cycles; central bani; should increase money supply at predictable rate. Timing of Fiscal Policy Time Logs: {1} Recognition. (2) Administrative. (3} Impact.
Automatic staiiiiiaers: {1} induced taxes. [2) Needs—tested spending. Monetary Policy Central banks control money supply three ways:
* Reserve requirements. ' Open market operations—most used.
' Discount rate. MICROECONOMICS Elasticity of Demand price elasticity of demand : x ,
‘l’oﬁ price If absolute value 1: I, demand is elastic; if absolute value c l, demand is inelastic; if absolute value = I, demand is unit elastic. Price elasticity has two main determinants: ' Availabilim of substitutes. ' Share of budget spent on product. Elasticity of demand and supply is greater in the long run. On a straightaline demand curve, demand is more elastic at high pricesilow quantities, and less elastic at low pricesihigh quantities. ' Elastic range: price increase will decrease total
revenues. ' Inelastic range: price increase will increase total
revenues. Accounting Costs vs. Economic Costs
Accounting costs include ﬁrm’s expiicit costs; economic
costs include both expiicitiimpiicit costs I opportunity
cost of equity capital). Snort ran to. iongr ran: in short rem, site of pianor
equipment cannot be changed. In iongr run, all resources {costs} are variable.
into oftiiminishing returns: as more resources are devoted to production process, they increase output
but at everdecreasing rate. Competitive 'Models Price taker accepts market price to sell product. Price
searcherseelts price that maximizes profit. Pare competition:  Large number of independent ﬁrms. ' All ﬁrms produce a homogeneous product. * Each seller is small, relative to the market. " No barriers to entry. Monopoiistic competition: * Large number of independent ﬁrms. ' Each ﬁrm produces a tiﬁrentiateti product. ' Lotti barriers to entry. ' Demand is highly elastic. Monopoiy is a market where one firm sells a well
deﬁned product that has no good substitutes and
high entry barriers. Oligopoiy is a similar structure
but has a small number of ﬁrms. Any ﬁrm will maximize proﬁts by expanding output
until marginal revenue = marginal cost. Marginal Revenue Product [fa ﬁrm uses an additional unit of an input, increase
in onmat is marginaiprodact (MP) of last unit of resource employed. increase in reoentte from
producing/selling marginal product is the marginai
reinnae product (MRP). Proﬁtmaximizing ﬁrms will
increase use of each resource until leRP = price of
the resource. Wait quantity demanded FINANCIAL REPORTING AND ANALYSIS Revenue Recognition
Two requirements: (I) completion ofearnings
process and (2) reasonable assurance of payment. Revenue Recognition Methods  Percentageaofacompletion method.
' Completed contract method. ' Installment sales. ' Cost recovery method. Unusual or Infrequent Items * Gainsi losses From disposal of a business segment. ' Gainsilosses From sale of assets or investments in
subsidiaries. ' Provisions For environmental remediation. * Impairments, writerofis, write—downs, and
restructuring costs. ' Integration expenses associated with businesses
recently acquired. Extraordinary Items (US. GAAP only) Boris unusual and infrequent (e.g., losses from
expropriation of assets). IFRS does not allow extraordinary items. Discontinued Operations To be accounted for as a discontinued operation, a
business—assets, operations, investing, ﬁnancing
activities—“must be physicallyi operationally distinct
from rest of ﬁrm. Incomeilosses are reported net of
tax after net income from continuing operations. Compute Cash Flows From Operations (CFO)
Direct metiaoa’: start with cash collections {cash
equivalent of sales); cash inputs (cash equivalent of
cost of goods sold); cash operating expenses; cash
interest expense; cash taxes. indirect method: start with net income, subtracting
back gains and adding back losses resulting from
ﬁnancing or investment cash ﬂows, adding back all
noncash charges, and adding and subtracting asset
and liability accounts that result from operations. Free Cash Flow
Free cash1 ﬂora (PCP) measures cash available for discretionary purposes. It is equal to operating cash flow less net capital expenditures. Critical Ratios Commonesizeﬁnanciai statement analysis: ' Commonsite deﬁance sneer expresses all balance
sheet accounts as a percentage of total assets. " Commomsite income statement expresses ali
income statement items as a percentage of sales. ' Commonasite cash ﬂow statement expresses each
line item as a percentage of total cash inﬂows
(outﬂows), or as a percentage of net revenue. Horizontai common—sizeﬁnanciai statement anahrsis: expresses each line item relative to its value in a common base period. Lignitiity ratios: . CLIICICEHI HSSEES
CUH‘EIIII {REID : current liabilities . . cash + marketable securities + receivables
qUicic ratio = current liabilities . cash —i— marketable securities
cash ratio = — current liabilities . . cash I— mkt. sec. —— receivables
defensive interval : — daily cash expenditures ..:._‘..__ ._:......,... _ _.
~:="~E “3.11:; ‘55; ~’+‘'"Eo’t'=':'.!"~ .=E '.‘=' .i ='5 ' '1'\ "'='s'i‘:" =' ' "
:Eht‘tsauﬁe” '.c.E ."::.:'=$'...'".:::3.} s'arE"" 1.1.4.1 .'~.«':..;.£a.'.':.'... Reeeioaivles, inoentoijr, payaliles turnover, anal elays’
snpply ratios—all oftonieb are used in tire oasis
eonoersion gale: , annual sales
receivables turnover = average receivables . cost of goods sold
inventory turnover 2 —~——— average invento ry . urchases
payables turnover ratio 2 p average trade payables _ 3(
days oFsales outstanding = _ 15
IECEIVﬂblES EurﬂﬂVﬁf
6
days oFinventory on hand 2 _ 3 5
inventory turnover
365 number of days of payables 2 days of inventory
on hand cash conversion cycle = [ number of days + days of sales _
of payables outstanding iotal asset, ﬁreaiasset, and morning capital turnover
ratios: revenue
total asset turnover = average tﬁtﬁl HEY 3536125 revenue
fixed asset turnover : average net ﬁxed assets . . revenue
working capital turnover 2 average working capital
Gross, operating, anal net proﬁt margins: . gross profit
gross proﬁt margin 2 —
revenue operating profit _ EBIT operating proﬁt margin 2 ——~—— _ revenue net sales _ net income net profit margin 2 —
IEVEHHE Return on assets [return on total capital (ROTCﬂ: return on assets : EBIT
(mull Capital) average total capital Dent to equity ratio anal total dent ratio: . . total debt
debttoeqmry rang, : —..
total equity
total debt totaldebtratio :
total assets Interest eooerage anclﬂxeel eoarge eooerage: EBIT interest coverage 2 _
interest fixed charge coverage = W interest l lease payments Grototla rate g = R x ROE
dividends declared retention rate : 1 — ﬂ
operating income after taxes Liania'ity ratios indicate company’s ability to pay its
short—term liabilities. Operating performance ratios indicate how well
management operates the business. payables turnover ratio DuPont Analysis Faditional DuPont equation: ESSEIS equir}r return on equity 2 net income“ sales I sales 333E125 You may also see it presented as: . net profitl
return on equity : E
l margin asset equity ] turnover multiplier . .n" Extended DuPont equation further decomposes net
proﬁt margin: I BET
EBIT [avg total assets]
X ..—.—.—..—......—— EBIT net income
revenue EBT revenue
X ROE = X X avg. total assets avg. equity You may also see it presented as: ROE = tax burden x interest burden x
EBIT margin x asset turnover x leverage Inventon Accounting
In periods of rising prices and stable or increasing
inventory quantities: LIFO restslts in." FIFO results in:
Higher COGS Lower COGS
Lower gross profit Higher gross proﬁt
Lower inventory Higher inventon
balances balances Basic and Diluted EPS Basie 5P3 calculation does not consider effects of any dilutive Securities in computation of EPS:
net income — preferred dividends basic BPS I wtd. avg. no. of common shs. outstanding adj. income avail. for common shares diluted EPS = common shares outstanding Therefore. diluted EPS is: ~ convertible convertible
net pfd, _ : . a— . :+ referred  debt (1—1:) income div, . . ~ ‘ tvrdends _ interest
wtd shares From I shisﬁ‘om I' l shares
avg ‘i— conversion of we conversion  issuable from
sh’s conv.pid.sl1‘s_ [comndebt 1stocl~2options_ LongLived Assets Capitalizing vs. Expensing
Capitalizing: lowers income variability and
increases nearterm proﬁts. increase assets, equity. Expeasing. opposite eilect.
Depreciation
cost — residual value useful life
Double deelining oalonee: 2
useful life Units ofproolnen'on: Stratgbt—line: (cost — accum. depreciation) cost — salvage value _
—— is: output units useful life in units Revaluation of LongrLived Assets
lFlES: revaluation gain recognized in net income
only to the extent it reverses previously recognized impairment loss; further gains recognized in equity
as revaluation surplus. U5. GM: revaluation is not permitted.
Deferred Taxes ' Created when taxable income {on tax return) i
pretax income (on financial statements) due to
temporary differences. wtd. avg. common shares plus potential ' Deﬁned tat lialiilities are created when taxable
income at pretax income. Treat DTL as equity if
not expected to reverse. ' Deﬁrreol tax assets are created when taxable income
a» pretax income. Must recognize oalnation
allowance if more likely than not that UTA will
not be realized. Lonngerm Liabilities * Premisesn lzona': coupon rate :a market rate at
issuance. * Diseonnt oonrl: coupon rate c market rate at
issuance. ' lnterest expense equals book value at the beginning
of the year multiplied by the market rate of
interest at the time the bonds were issued. Leases Financial statementlratio irnpaet of lease accounting from the lessee perspective: capital leases result in: ' Htglser: assets, liabilities, CPO, debtl equity. ' Lower: net income {early years), CFF, current
ratio. working capital, asset turnover, RDA, ROE. " Same: total cash flow. Pensions Deﬁned eontrilaation: employer contribution
expensed in period incurred. Deﬁned oeneﬁt: overﬁtnded plan recognized as asset, underfunded plan recognized as liability. Balance
sheet value equals ﬁmded status of plan under U.S. (3MP but not under IFRS. Marketable Security Classiﬁcations
Heldj‘oren'atling‘ fair value on balance sheet;
dividends, interest, realized and unrealized GlL
recognized on income statement.
Aooileoleﬁnsale: fair value on balance sheet;
dividends, interest, realized Gl L recognized on income statement; unrealized GlL is other
comprehensive income. Helaltovrnatssrige amortized cost on balance sheet; interest, realized Gil. recognized on income
statement. Intercorporate Investments c 20% ownership: no signiﬁcant inﬂuence; use
accounting methods for passive investments. 20% to 50% otonersntp: signiﬁcant inﬂuence; use
equity method. foint control: proportionate consolidation permitted
under IFRS only, equity method usually required
under US. GAAP. a 50% owrtersntp. control of the investee', use
consolidation method. CORPORATE FINANCE Weighted Average Cost of Capital
WACC = (wd ) [lid (1  t]] + {wPSXkPS} —l— (we: Hits) Cost of Preferred Stock
D
Cost of Equity Capital
is. = E + s
Po
Cost of equity using CAPM:
ltE : RFR + lii(Rmh — RFR)
Capital Budgeting
CF CF2 CF Nevzcs, —+——‘1+—2 +—”
{1+k) (Ht) (1+k)“ IRE: discount rate that makes NPV equal to zero. continued on next page... +... s':.IV.'/:M':v.::v'.Wz'.'I womanan: a: .v 's'
S!
i
z
‘. EGRPORﬂTi iENAMEE teetinued...
PurePlay Method Project Beta Deievered asset beta for comparable company: Combining Preferences with the Optimal Set of Portfolios Markowita efﬁcient frontier is the set of portfolios Risk—Adjusted Returns Sharpe ratio and M—sqnareti measure excess return
per unit of total risfe. i31ng g ‘quiw K “1— that have highest return for given level of risk. Freynor measure and jensens ante measure excess
‘ ' 1 +[(1_ E)D] F n return per unit of systematic: rat.
, thirty
. _ R' ltT I‘mnt 1:. It EIR‘
Relevered project beta for subject ﬁrm: I: ,{i L .. — r: ' J
I D m estor I...  slope = Treynot measure
r __  , 3 for Portfolio I]
ijruiect_ liasscr X 1—:— — \
E Efﬁcient Frontier SIViI.
Measures of Leverage
Totai leverage: percent change in net income RP l
From a given percent change in sales. R
M v    —   Operating ieverage: percent change in EBIT from
a given percent change in sales. Financiaf leverage: percent change in net income lama” alpha Security Market Line (SML) Investors should oniy be compensated for risk 1
relative to market. Ungrsteinatie risi.a is diversiﬁed Rf
away; investors are compensated for tyrtematir an. The equation of the SML is the CAPit‘i, which is a teturnfsystematic risk equilibrium relationship. from a given percent change in EBI'I‘. u1._____..
ibﬂh" breakeven quantity of sales = fixed operating & financing costs 7:7}
“Ci
hurl price — variable costs per unit total risk = systematic + unsystematic risk SECURITIES MARKETS operating brealteven quantity of sales 2
fixed operating costs 8: EQUITY INVESTMENTS price — variable costs per unit :
I Lia“ital Market line ' Well—Functioning Security Markets * Operational efﬁciency (lowest possible
transactions costs}. ' Informational efﬁciency {prices rapidly adjust to
new information). Dividends and Share Repurchases Cash dividend and share repurchase have same
eiiect on shareholder wealth. Share repurchase with borrowed funds will
increase EPS if cost of debt «at earnings yield.
decrease BPS iii cost of debt .3 earnings yield. Share repurchase will increase book value per
share if stock price «c BVPS, decrease book value Rig: per share ifstock price } BVPS. Eiiicient Frontier i—u—i‘tlsrket Portfolio Purchases For margin transactions:
' Leverage factor = 1i margin percentage. ' Levered return = I—IPR >< leverage factor.
Margin Call Price Pﬂ(1— initial margin We) Working Capital Management __ a
Primary sources ofiiqnia'int: cash balances. (33PM : ElR } : RFR + Rmkl l — shortrterm funding, cash ﬂow management of 1—— maintenance margin iii: collections and payment. I _ ‘ Secondary sonrees ofiiania’igx: liquidating assets; 3 ESEEn. if grim 1_ .m. compuung Index PINES negotiating debt agreements. bankruptcy ' I Pricﬂweighted Index : Estock prices
protection. adjusted divisor Cost of trade credit: Valuerweighted Index 565
1 [it’s count days past discount
+ —._
1—% discount Zlcurrent prices)(# shares)
El base year prices} year shares) _1 Britain} — a _ _ _ _ _ _ at base value Pro Forma Financial Statements
* Estimate the relations between changes in sales and changes in income statement and balance
sheet items. ' Estimate ﬁrture tax rate, interest rates on debt,
lease payments, etc. ' Forecast sales. ' Estimate ﬁxed operating and ﬁnancial costs. ' Integrate these estimates into pro forma
ﬁnancial statements. are l
L_L_.—__ coir:2}: mil: = Types of Orders Exeention instrnen’ons: how'to trade; e.g., market
orders, limit ctrders. .‘rvsttntatit {or Vaiia’ig: instructions: whento execute; e.g.., stop.
orders, dayorders, ﬁilroréliill orders: Clearing imtraetioas: how to clear and settle: for“sell
orders, specify short sale or long sale. The SM and Equilibrium Identifying mispriced stocks: Consider three stocks (A. B. C} and SML.
Estimated stock returns should plot on SML.
' A return plot over the line is trnrierpriced.
' A return plot under the line is overpriced. Market Structures Qnotetiriven markets: investors trade with dealers. Cmpﬂ rate G {W e In a n C e Orderrdriven mariners: buyers and sellers matched Favor snarenoz'rier interests: independent board. EiRI l3? “115$ I
strong code of ethics Cﬂﬂﬁdﬁntial timing Broieereoi maraets: brokers ﬁnd counterparttes.
Harm snarenot’rier interests: managementraligned Forms gf EMH board, voting restrictions. takeover defenses. PORTFOLIO MANAGEMENT Investment Policy Statement
Investment objectives: ' Return objectives. ' Risk tolerance. Constraints: ' Liquidity needs. * Time horizon. ' Tax concerns. ' Legal and regulatory factors. ' Unique needs and preferences. ' Wiraeﬁirm. Current stock prices ﬁdiy reﬂeet
avaiiaoie security marteet info. Volume
information;I past price do not relate to ﬁtture
direction of security prices. Investor eatinot
achieve excess returns using tech analysis. ' Semistrongfosvn. Security prices instantly adjust
to new pantie information. Investor eannot achieve
excess returns using Fundamental analysis. ' Strongﬁrm. Stock prices ﬁritfy reﬂect a3!
inﬁrmationﬁom pantie aneiprivate sonrees.
Assnmes Pftﬁt‘f markets in which all information
is cost free and available to everyone at the same
time. Even with inside info, investor cannot
achieve excess returns. W Basic Bond Pricing Industry Life Cycle Stages Ensirryonie: slow growth, high prices, large
investment needed, high risk of failure.
Growth: rapid growth, falling prices, limited
competition, increasing proﬁtability.
Snakeoat: slower growth, intense competition, declining proﬁtability, cost cutting, weaker ﬁrms
fail or merge. Mature: slow growth, consolidation, stable prices,
high barriers to entry. Decline: negative growth, declining prices,
consolidation. Five Competitive Forces
1. Rivalry among existing competitors.
2. Threat ofnew entrants. 3. Threat of substitute products.
4. Bargaining power of buyers.
5. Bargaining power ofsuppliers. OnevPeriod Valuation Model
Di Pi
_'_
(1+ kg} (1! kg} Be sure to use expected dividend Dl in calculation. Inﬁnite Period Dividend Discount Models
Supernorsnai growth anode! (mainstage) DDM' Vi}: VG: + .... ..+ “ nsL—"li1
(1+k.) (1+k] (1+ke)
D4.
where: PH: nil
(head Constant growth model
H Dufii—gcl m D1
kc _ g: kc _ gt Critical relationship between let and g: * As difference between lee and g: widens, value of
stockﬁtlis. * ills diEerence narrows, value of stock rises.  Small changes in difference between lag and 3;
cause large changes in stock’s value. Critical assumptions ofinﬁnite period DDM: ' Stock pays dividends; constant growth rate.
' Constant growth rate, gt, never changes. Va ' is: must be greater than 3": (or math will not work). Earnings Multiplier Model
pg
£39— “ y’El m payout ratio
E k—s k—s
Price Multiples price per share leading PIE : forecast EPS next 12 mo. price per share trailing PIE = —_——
EPS previous 12 mo. price per share PiB =
book value per share
Pig m price per share
L sales per share
WCF _ price per share cash flow per share Basic Features of Bond Structures * indentare. Agreement containing the terms under
which money is borrowed. ' learns to maturity. Length of time until loan
contract or agreement expires. * Par oaine. Amount borrower promises to pay on
or before snatarisj; date of the issue. ' Cosspon rate. When multiplied by par value, gives
amount of interest to be paid per period. * Zerocoupon hands. Nointerest bonds; are sold at
a deep discount from their par values. RepaymentiPrepayanent Provisions ' Ballet fronds. Lump sum at maturity pays entire
pﬂndpd. ' Serial oonds. Pay off principal through series of
paytnents over time. ' Amortiaing securities. Periodic principal and interest
payments. ' Siniiingﬁndprooisions. Provide for bond
retirement through predeﬁned principal payments
over life of the issue. ' Caliprooisions. issuer has right {but not
obligation} to retire all or part ryfissaeprior to
waiting». Issuer owns option to call the bonds
away from investor. 1' Reﬁna'ingprooisions. Nonrefundable bonds
prohibit premature retirement of an issue from
proceeds of a lower coupon bond. Bonds that carry these provisions can be freely callable but
nonreﬁindable. Basics of Floating Rate Bonds
' These securities pay variable rate of interest.
' Common procedure for setting coupon rates on floatingrate bonds starts with reference rate; then
adds! subtracts a stated margin. Interest Rate Risk Key point: there is an inoerse relationship hetween
interest rates antsr oondpriees. How bond’s features affect interest rate risk: ' Longer maturity bonds. Higher interest rate risk
{all else same). " Smaller coupon bonds. Higher interest rate risk
(all else same).  if market interest rates are high, price volatility
will be lower than if market interest rates are low. Floating rate securities have very low levels of price volatility in relation to interest rate changes. + If coupon rate : required market yield :> bond
price : par value: premium dorsal.  If coupon rate e required market yield za'bond
price «a par value: a’iseoant hand. I If coupon rate = required market yield =t» bond
price = par value: par frond. Reinvestment Risk If interest rates decline, investors are forced to
reinvest at lower yields. Bonds with high coupons have greater risk.
Greatest risk is with callable bonds, where all;fr part of principal can be repaid in low interest
rate environment. Credit Risk ' Lie/shalt ass. Issuer might not make payments. ' Credit spread rise. Difference in bonds yield from
yield on riskrfree security. All else equal, the
riskier the bond, the higher the spread. ' Downgrade rat. Bond may be reclassiﬁed as riskier
security by a major rating agency iii oaitse a serni~annaaipay hood using a ﬁnancial
calculator: coupon
2 N = (#yearsXZ), liY = W = par, PMT = yield
2 There are two equivalent ways to price a bond: ' Discount at constant rate applied to all cash flows
{WM} to find all future cash flows’ P‘s". * Treat each cash ﬂow as a single zerocoupon bond
and ﬁnd PV of each “zero” using appropriate spot
rates for each cash flow. Prices must he the same to prevent arbitrage. Accrued Interest and Clean Prices Bond price without accrued interest is cleanpriee.
Fniiprice includes accrued interest. full price = clean price + accrued interest Yield Calculations . annual cou on a ent
current yield 2 Am— bond price Annual Equivalent Yield Converting a bondeequivalent yield (HEY) to an
equivalent annual yield (BAY) or vice versa: BEY of an annual pay bond
: 2 + YTMannual pay bond )1”: _ Y 2
annual equivalent yield : [1+ —1 Spot Rates To derive a bond’s value using spot rates, discount
the individual cash flows at appropriate rate for
each How’s time horizon; sum PV of the cash ﬂows to get bond’s current value. This value is the
arbitragerfree value. Duration and Convexity * Dannion is the slope of a bond’s pricewyield
function. It is steeper at low interest rates, flatter
at high interest rates. So, duration (interest rate sensitivity) is high at low rates and low at higher
rates. This holds for noncallable bonds. ' Connexity is a measure of degree of curvature
or convexity in the'priceiyield relationship.
Convexity accounts for amount of error in
estimated price (based on duration). A callable bond is likely to be called as yields fall, so no one will pay a price higher than the call price. The price won’t rise signiﬁcantly as yield
falls and you’ll see negative convexity at work—as yields fall, prices rise at a decreasing rate. For a positively convex bond, as yields fall, prices rise at
an increasing rate. 2V0 (5*?) V — V
effective duration (D) :_ + Convexity measures curvature of the priceyield
function. Iilliﬁprice = l‘duration (Ay) l— convexity (rhyji l r: 1 00
Note: thy is in decimal form. continued on next page... DEBT [NUESTHENTS continued... Term Structure Theories  Erpeetoiionr hypothesis. Yield curve shape reflects
investor expectations about future behavior of
shortterm interest rates. Forward rates computed
using today’s spot rates are best guess of future
interest rates. ' Liquidigipreﬁrence theory. Investors prefer greater
liquidity; will demand premium (higher yields to
invest in longerterm issues]. ' Marilee.“ regenentotion theory. Market for debt
securities is segmented on basis of investor
maturity preferences. Each segments interest rate
level is determined by supplyir demand. Futures vs. Forwards I Forward contract: one party agrees to buy,
(counterpatty sells) a physical asset! security at
speciﬁc price on speciﬁc ﬁtters date. If asset’s
future price increases, buyer (at the older, lower
price) has a gain and seller has a loss. " Futures contract: standardized, exchangetraded
forward contract. Different from forwards in
that futures trade in active secondary market, are
regulated, backed by clearinghouse, and require
daily settlement of gainsilosses. Arbitrage ' Lore of one price: two assets with identical cash
flows in the future, regardless of future events,
should have the same price. If A and B have identical future payoffs, and A is priced lower than B, buy A and sell B.
" Second type ofnroitrrrge: two assets with uncertain
returns can be combined in a portfolio that will have a certain payoff. Ifa portfolio Offs and B
has a certain payoff, the portfolio should yield the riskfree rate. Forward Contracts ' Long must pay a certain amount at speciﬁc future
date to short, who will deliver the underlying
asset. ' A cash settlement forward contract does not
require actual delivery of the_underlying asset, but
a cash payment to the party disadvantaged by the
difference between market price of the asset and
contract price at Settlement date. ' Early termination can be achieved by entering
into a new forward contract with the opposite
position, .at the thenecurrent expected future price. This will ﬁx the amount of payment to be
madeireceived at settlement date. Forward Rate Agreements (FRA) Can be viewed as a forward contract to borrow:F lend money at a certain rate at some future date.
Formula for payment to the long at settlement is: . (floating rate — forward rate)[diiii]
[notional K #—360
. . l
Princha 1+ (Ewing m6} din]
360 Futures vs. Forwards Fortoercir Futures
Private contracrs Exchangetraded Unique contracts Standardized contracts Default risk Little or no regulation Guaranteed by clearinghouse Regulated American vs. European ICl’rptions Ameriron options let the owner exercise the option
any time before or at expiration. European options
can be exercised only at expiration. Value of the
American option will equaliexceed value of the
European option. Lower and Upper Bounds for Options r 
European CI 3. Macias: _
call {c} l L
{Hasn‘t} X I .l.
li—eRFRiL c, :3 ninjas, — European put {p} Note: t = tirne to expiration. PutCall Parity
Putcall parity holds that portfolios with identical
payoffs must sell for the same price to prevent arbitrage. The putcall parity relationship: J______DE_____;:;S.T.P l1+RPRli Each security in the putrcall parity relationship can
he expressed as: S: ‘4;_P C=5_P___X—
{more}t (1+RER1F rec—:L—s g—X—m—csw—c
{1+RERJE rr+RtRf1i ' Buyer ofa call option—long position. ' Winter {seller} ofa call option—short position. " Buyer ofa put option—long position. ' Writer (seller) ofa put option—short position.
intrinsic value ofa call option = Max[0, S — X]
intrinsic value ofa put option 2 Main, X — 5] PPM: 3213130098
ISBNl 3: 9?8142??2?381
iSBN—l II}: 142????384 9 Y8142? T2?38’l U.S. $29.00 it) 2010 llapian, Int. All Rights Reserved. ALTERNATIVE INVESTMENTS ExchangeTraded Funds (ETFs) Special type of fund that invests in a portfolio of
stocks or bonds; designed to mimic performance of
a speciﬁed index. Advantages of ETFs * Efﬁcient method of diversiﬁcation. ' Trade similar to traditional equity investments. ' Some ETFs patterned after indexes with active
futures!r option market: better risk management. ' Exact composition is known at all times. * Typically, very efflcient operating expense ratios;
no loads to purchase or redeem shares. 1' Decreased capital gains tax liability.
Disadvantages of ETFs * Some countries have fewer indexes than the U.S.
for FTP s to track (results in mid: or lowcap stocks not being well represented}. * Ability to trade intraday may not be signiﬁcant to
investors with longer time horizons. * ETFs with low trading volume may have large
bid—ask spreads. ' Larger investors may choose to directly invest in
an index portfolio, resulting in lower expenses;f
lower tax consequences. Valuation of Real Estate Investments ' l’lrirrrrtion methods: cost method, sales comparison
method, and income method. ' income method uses a discounted cash flow
model similar to that for a perpetuity: NOI value = ——
market cap rate 1' Net operating income (NOD equals gross operating
income less estimated vacancy, collections, and
other operating expenses, (including property
taxes, but excluding income taxes}. NOI does not
include depreciation or ﬁnancing costs. Hedge Funds—Risks * fifiqnidigr ' Potentioiﬁr ntirpricing. investments in esoteric,
infrequently traded securities may lead to
difﬁculty determining true value. ' Counterparth credit ririr. _ ' Settlement errors. Risk of counterparty failure to deliver'sectttityas agreedon settlement day. ' Short conning. Risk that managers who short sell
as a strategy will have to cover their shorts and
repurchase securities at price higher than where
they originally sold. ' Margin coils. Can result in forced selling of assets,
possibly at a loss, on an already highly leveraged
positron. Investing in Commodities Contnngo: futures price 2: spot price. Beetreerdetion: futures price e spot price. Sources of investment return: ' Coiktereiyieiri' return on Tbills posted as margin. ' Price return: due to change in futures price. * Roiiyieiti: positive for backwardation, negative for
contango. ...
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This note was uploaded on 12/06/2011 for the course SMO Chartered taught by Professor Peterpellat during the Fall '08 term at University of Alberta.
 Fall '08
 PeterPellat

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