Quicksheet 2011 - _ LEVEL1 ETHICAEAND PRQFESSIONAL...

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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—of-time period. * Perpetaities: annuities with infinite lives. PVPHPMW = PMT)r (discount rate). Required Rate of Return Components: 1. Real risk-free 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 _i-tar er Roy s safigr-first 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 Z-Scores Z-seore: “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 Bis-nmiair 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 olfin-as't-hesamplgosiit'e becomes large. Standard Error Standard error ofn’ire sample mean is the standard deviation-of distribution ofthe sample means, . . . . . _. .i , _ I 0' known population-variance: 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 {II-1,3: concluded if there is sufficient evidence to reject the null hypothesis. Difference Between One- and Two-Tailed Tests One-taiieci test: tests whether value is greater than or less than a given number. Tron-taiieti test: tests whether value is equal to a given number. ' One-tailed test: I—Ifl: p. :5: 0 versus 1—1,: ii 3-.- i}. ' Two-tailed 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'rice-tintseaI 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 ever-decreasing 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 rein-nae product (MRP). Profit-maximizing 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: ' Common-site 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 debt-to-eqmry rang, : —.. total equity total debt total-debt-ratio : 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_ Long-Lived Assets Capitalizing vs. Expensing Capitalizing: lowers income variability and increases near-term profits. increase assets, equity. Exp-easing.- 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 lFl-ES: 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. Aooileolefin-sale: 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 woman-an: a: -.-v--- 's' S! i z ‘. EGRPORflTi iENAMEE teetinued... Pure-Play 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' l-tT 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‘. u-1._____.. ib-fl-h---" 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 ESE-En. 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. .‘r-vstt-ntatit {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 Qnote-tiriven 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. ' Semi-strongfosvn. 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! (main-stage) 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. * Zero-coupon hands. No-interest 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 floating-rate 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 zero-coupon 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 non-callable 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 price-yield 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 short-term 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 longer-term 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, exchange-traded 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 risk-free 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 Exchange-traded 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. Put-Call Parity Put-call parity holds that portfolios with identical payoffs must sell for the same price to prevent arbitrage. The put-call 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 ISBN-l 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 Exchange-Traded 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 low-cap 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'sectttity-as agreed-on 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 T-bills 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.

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Quicksheet 2011 - _ LEVEL1 ETHICAEAND PRQFESSIONAL...

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