2012-06 CFA L2 100 Forecast

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1

Catalog
Equity .................................................................................... 1
Case 1: Western Investments Analytics Case Scenario.............................................................1
Case 2: Fargo Durum Farms (FDF) Case Scenario...................................................................7
.............................................................................................................................15
Case 3: Bright Horizon Materials Company Case Scenario ...................................................18
Derivatives........................................................................... 26
Case 3: Robyn Lawrence Case Scenario.................................................................................26
Case 4: Ryan Parisi Case Scenario..........................................................................................34
Case 5: Meredith Whitney Case Scenario...............................................................................40
Case 6: Meredith Gale Case Scenario.....................................................................................46
.............................................................................................................................53
Economics............................................................................ 55
Case 1: Pearls of Golden Island Case Scenario.......................................................................55
Case 2: Sagara Case Scenario .................................................................................................57
Case 3: Louise Tremblay Case Scenario.................................................................................63
AlternativeInvestment......................................................... 68
Case 1: Shoshone Capital Case Scenario ................................................................................68
Case 2: Strong Family Corporation Case Scenario.................................................................76
Ethics ................................................................................... 82
Case 1: Victoria Macia Case Scenario ....................................................................................82
Case 2: Wilson Macharia Case Scenario.................................................................................88
Quantitative......................................................................... 93
Case 1: Eduardo DeMolay Case Scenario...............................................................................93
Case 2: Gary Hansen...............................................................................................................99
Case 3: Paul Charlent Case Scenario ....................................................................................106
FinancialReporting&Analysis ........................................... 116
Case 1: Bianca Puglisi Case Scenario................................................................................... 116
Case 2: Austell Industries Case Scenario..............................................................................122
Case 3: Aeolus Controls AG Case Scenario..........................................................................134
CorporateFinance.............................................................. 165
Case 1: John Earl Case Scenario...........................................................................................166
Case 2: National Plastics Case Scenario ...............................................................................171
Case 3: Hi Chu Case Scenario ..............................................................................................180
Portfolio............................................................................. 188
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Case 1: Mary Marconi Case Scenario...................................................................................188
Case 2: James Stephenson Case Scenario.............................................................................194
Case 3: Hartmut Fischer Case Scenario................................................................................202
Case 4: Jongmoo Choi Case Scenario...................................................................................210
FixedIncome...................................................................... 217
Case 1: Erik Jenkins Case Scenario ......................................................................................217
Case 2: Ellen Hurst Case Scenario........................................................................................226
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Equity
Case1:WesternInvestmentsAnalyticsCaseScenario
WesternInvestmentAnalyticsspecializesinthevaluationofthinlytradedequities.HarrietHilliard,
oneofWesternsanalysts,iscurrentlyworkingtoestablishthevalueofHattiesApparel,asmall
textileandclothingwholesalerheadquarteredinthesouthernUnitedStates.HattiesApparelisa
publicly traded company; however, in a typical week fewer than 1,000 shares trade. Triway
Textiles, Inc. is a NASDAQlisted stock that very closely resembles Hatties Apparels business
activitiesbutisfarmoreactivelytraded.
Exhibit 1 provides summary financial and economic data relating to Hatties Apparel and Triway
TextilesalongwithHilliardsestimatesoftheresponsiveness(i.e.,thebetas)ofthecompaniesto
thefactorsoftheFamaFrenchmodel[equityriskpremiumfactor(RMRF);marketcapitalization
factor (SMB); and booktomarket factor (HML)]. Exhibit 1 also includes a published estimate of
theCAPMequitybetaforTriway.SinceHattiesAppareldoesnothaveapublishedestimateofits
CAPMequitybeta,asfewanalystsfollowthestock,Hilliardcomputesit,notingthedifferencein
leveragebetweenTriwayTextilesandHattiesApparel.
Exhibit1
HattiesApparelandTriwayTextiles
SelectedFinancialInformation
HattiesApparel TriwayTextiles
Debtbeta 0.00 0.00
Debttoequityratio(marketvalues) 45% 38%
Pretaxcostofdebt 9% 8%
Marginaltaxrate 32% 32%
RMRFbeta 0.82 0.75
SMBbeta 0.75 0.00
HMLbeta 0.15 0.05
CAPMequitybeta 0.75
Assumedconstantgrowthrate(g) 3% 2.5%
Mostrecentprice(P0) $45.00 $115.48
Mostrecentdividend(D0) $2.75 8.45
Payoutratio 40% 55%
Exhibit 2 provides Hilliards estimates of market information relating to her analysis. Westerns
analysts typically use three models to estimate the required returnon equity for the companies
they evaluate: the Gordon growth dividend discount model (DDM), the capital asset pricing
model(CAPM),andtheFamaFrenchmodel(FFM).Nonetheless,inherwork,Hilliardprefersto
use the DDMbased estimate of the required return on equity when she calculates the
weightedaveragecostofcapital(WACC)forcompaniessuchasHattiesApparel.
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Exhibit2
AdditionalMarketInformation
U.S.Tbillrate 1%
Equityriskpremium 8%
Marketcapitalizationfactor 2%
Booktomarketfactor 4%
MatthewColbaugh,Hilliardssupervisor,recommendstoHilliardthatsheaddtwoapproachesto
heranalyticaltoolbag.
First,hesuggestsusingthePastorStambaughmodel(PSM)extensionoftheFFM.
Second,hesuggeststhathewouldliketoseeacomparisonofHattiesApparels
P/Etogrowthratio(PEG)toTriwayTextilesPEG.EvenifyoubasethePEGanalysison
currentprices,earnings,andestimatesofgrowthratherthantheirforwardlooking
equivalents,therelativePEGofHattiesApparelcomparedtothatofTriwayTextilesisof
interesttome,statesColbaugh.
Colbaugh also criticizes Hilliards use of the published CAPM equity beta for Triway. Lastly,
Colbaugh suggests that applying Blumes adjustment to Triways published CAPM equity beta
wouldimprovetheexantepropertiesofheranalysis.
1. UsingtheinformationreportedinExhibit1andtheapproachHilliarduses,theequitybeta
forHattiesApparelisclosestto:
A.0.71.
B.0.79.
C.0.84.
Answer=B
ReturnConcepts,JohnStowe,ThomasRobinson,JeraldPinto,andDennisMcLeavey
2012ModularLevelII,Vol.4,pp.7879
StudySession1035b,d
Calculateandinterpretanequityriskpremiumusinghistoricalandforwardlookingestimation
approaches.
Explainbetaestimationforpubliccompanies,thinlytradedpubliccompanies,andnonpublic
companies.
Biscorrect.First,calculatetheunleveredbetaofthebenchmark(TriwayTextiles):
( )
u E
D
E
1 1
= = 0.75=0.54348
1+ 1.38

ThencalculatetheequitybetaforHattiesApparelas:
( )
D'
E U E'
' = 1+ =1.45 0.54348=0.78805

2. UsingtheinformationreportedinExhibit1andExhibit2,theFamaFrenchestimateofthe
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requiredreturnonequityforHattiesApparelisclosestto:
A.8.0%.
B.8.7%.
C.9.7%.
Answer=C
StudySession1035c
Estimatetherequiredreturnonanequityinvestmentusingthecapitalassetpricingmodel
(CAPM),theFamaFrenchmodel(FFM),thePastorStambaughmodel(PSM),macroeconomic
multifactormodels,andthebuildupmethod(e.g.,bondyieldplusriskpremium).
Ciscorrect.TheFamaFrenchestimateoftherequiredreturnonequityiscalculatedas:
mkt size value
i F i i i
r R RMRF SMB HML b b b = + + +

Forthegiveninformationwehave:
r 0.01 0.82 0.08 0.75 0.02 0.15 0.04=0.09660=9.7%
i
= + ? ?
3. UsingthevaluesreportedinExhibit1andHilliardspreferredapproach,theWACCfor
HattiesApparelisclosestto:
A.6.2%.
B.7.9%.
C.8.3%.
Answer=C
DiscountedDividendValuation,JeraldPinto,ElaineHenry,ThomasRobinson,andJohnStowe
2012ModularLevelII,Vol.4,pp.9394,225
StudySession1035g,1139m
Explainandcalculatetheweightedaveragecostofcapitalforacompany.
EstimatearequiredreturnbasedonanyDDM,includingtheGordongrowthmodelandthe
Hmodel.
Ciscorrect.HilliardpreferstousetheDDMbasedestimateforreturnonequityintheWACC.
( )
r 1 Tax rate
d
MVD MVCE
WACC r
MVD MVCE MVD MVCE
= - +
+ +

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MVD
MVD MVCE +
isthemarketbasedweightofdebtforthefirmand
MVCE
MVD MVCE +
istheweightof
equity.Inthiscase,withadebttoequityratioof45%,HattiesApparelhasaweightofdebtof
0.31034(calculatedas0.45/1.45).Theweightofequityis0.68966(calculatedas10.31034).
Thepretaxcostofdebtis9%,andthetaxrateis32%.Thecostofequityiscalculatedusingthe
Gordonmodelas:
2.75 1.03
45
+0.03=0.9294.
TheWACCis:[0.310340.09(10.32)]+[0.689660.09294]=0.08309=8.3%.
4. IfHilliardadoptsColbaughsfirstrecommendationregardingtheuseofadditional
analyticalmodels,whichofthefollowingwillshemostlikelyincorporateintoheranalysis?
Anestimateofriskpertainingto:
A.liquidity.
B.timehorizon.
C.businesscycle.
Answer=A
EquityValuation:ApplicationsandProcesses,JeraldPinto,ElaineHenry,ThomasRobinson,and
JohnStowe
StudySession1034c
Estimatetherequiredreturnonanequityinvestmentusingthecapitalassetpricingmodel
(CAPM),theFamaFrenchmodel(FFM),thePastorStambaughmodel(PSM),macroeconomic
multifactormodels,andthebuildupmethod(e.g.,bondyieldplusriskpremium).
Aiscorrect.ColbaughsfirstrecommendationpertainstotheuseofthePastorStambaugh
model,whichaddsafourthfactortotheFFMcompensationforthedegreeofliquidityofan
equityinvestment.
5. IfHilliardadoptsthesecondrecommendationofColbaughregardingadditionalanalytical
models,whichofthefollowingbestdescribestheresult?Themetricsuggestedby
Colbaugh:
A.showsHattiesApparelislessattractivethanTriwayTextiles.
B.assumesthattherelationshipbetweenP/Eandgrowthisnonlinear.
C.failstocapturedifferencesinriskbetweenHattiesApparelandTriwayTextiles.
Answer=C
MarketBasedValuation:PriceandEnterpriseValueMultiples,JeraldPinto,ElaineHenry,
ThomasRobinson,andJohnStowe
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StudySession1241k
CalculateandinterprettheP/Etogrowthratio(PEG)andexplainitsuseinrelativevaluation.
Ciscorrect.ColbaughsuggestscomparingHattiesPEGtoTriwaysPEG.PEGisusefulbutmust
beusedwithcare:PEGassumesalinearrelationshipbetweenP/Eandgrowth,doesnotfactorin
differencesinrisk,anddoesnotaccountfordifferencesinthedurationofgrowth.Further,per
computationsshownbelow,HattiesApparelismoreattractivethanTriwayTextilesbasedon
PEG,notlessattractive.
Dividends Payout
Ratio
EPS Price P/E Growth PEG
Hatties
Apparel
2.75 0.40 2.75/0.40
=6.875
45 45/6.875=
6.54545
3% 6.54545/3
=2.2
Triway
Textiles
8.45 0.55 8.45/0.55
=15.36364
115.48 115.48/15.36364
=7.51645
2.5% 7.51645/2.5=
3.0
6. AccordingtothelastsuggestionmadebyColbaugh,theCAPMequitybetaforTriway
Textilesisclosestto:
A.0.83.
B.0.86.
C.0.92.
Answer=A
2012ModularLevelII,Vol.4,p.74
StudySession1035d
Explainbetaestimationforpubliccompanies,thinlytradedpubliccompanies,andnonpublic
companies.
Ascorrect.ColbaughslastsuggestionistoapplyBlumesadjustmenttothepublishedCAPM
equitybeta.
Blume'sadjustedbeta=(2/3)(Unadjustedbeta)+(1/3)(1.0)
Triway'sbetawithBlumesadjustment=(2/3)(0.75)+(1/3)(1.0)=0.8333
KeyPoints
EstimatingBetaforpubliccompany
Thechoiceofindex;
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Thelengthofdataperiodandthefrequencyofobservation:mostcommonchoiceis
5yearsofmonthlydata.
Theadjustment.
adjustedbeta=(2/3)(Unadjustedbeta)+(1/3)(1.0)
Betadriftreferstotheobservedtendencyofanestimatedbetatorevertto
avalueof1.0overtime.
EstimatingBetafortinytradedstockornonpubliccompanies:
Selectingbenchmark(comparable)
Usethepubliccompaniesinformationinthesameindustry;
Estimatethebenchmarksbeta(similarwithprevioussection);
Unleverbenchmarksbeta;
Theadjustment.
Requiredreturnonequity
Multifactormodel:FamaFrenchModelVs.PastorStambaughmodel(PSM)
mkt,j
SMB,j
HML,j
Required Return RF ( )
( )
( )
mkt
small big
HBM LBM
R RF
R R
R R
= +
+
+
FFM
) R (R HL LL
liq
i
- +
PSM
Small/large cap
High/low book-to-market
4.P/Etogrowth(PEG)ratio
OnemetricthatappearstoaddresstheimpactofearningsgrowthonP/Eratios
CalculatedasthestocksP/Edividedbytheexpectedearningsgrowthrate.Theratio
ineffectcalculatesastocksP/Eperunitofexpectedgrowth.
Stocks with lower PEGs are more attractive than stocks with higher PEGs, all else
equal.
5.ThePEGratiomustbeusedwithcareforseveralreasons:
Assumes a linear relationship between P/E ratios and growth. The model for P/E in
termsofDDMshowsthatintheorytherelationshipisnotlinear.
Doesnotfactorindifferencesinrisk,averyimportantcomponentofP/Eratios.
Doesnotaccountfordifferencesinthedurationofgrowth.
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Case2:FargoDurumFarms(FDF)CaseScenario
Minneapolis Viking Arbitrageurs, LLC (MVA), is a fledgling U.Sbased hedge fund having slightly
over $50 million under its management. MVA specializes in owning and managing smallsized
propertiesinagriculture,forestry,andmining.Itsaverageinvestmentisabout$8million.
Jim Hester, MVAs Managing Partner and Chief Investment Strategist, is examining the financial
statementsandotherpertinentinformationaboutFargoDurumFarms,Inc.(FDF),asapotential
investmentopportunity.
FDF is jointly owned by two brothers, John and Man, of the Mahoney family. With all their
children graduated from North Dakota State University and currently living in Minneapolis, the
brothers have decidedto sell the property. Hester believes that commodity prices will continue
their uptrend for extended periods and investing in a North Dakota farming operation where
farm lands are still attractively priced will produce high returns for the hedge fund. Its tangible
assetsincludingworkingcapitalcompriseapproximately1,500acresoffertileandwellirrigated
land, farm buildings, machinery, residential quarters, livestock, cattle feed, seeds, grain, and so
forth.FDFalsocarriessignificantintangibleassetsthatincludebiologicalassets,patentedhybrid
seeds,andmilkquotas.
Select data from FDFs income statement for the year ended December 2010 are presented in
Exhibit1.Exhibit2containsadditionalestimatescompiledbyHester.
Exhibit1
FDFsSelectFinancialData
fortheyearendedDecember2010
GrossRevenuesfromcrops,livestock,feed,etc. $2,500,000
Costofgoodssold 1,000,000
Selling,general,andadministrativeexpenses(SG&A) 900,000
Depreciationandamortization 200,000
Taxrate 30%
Notes:
i)FDFcarriesdebtintheamountof$750,000ataninterestrateof8%,anditcomprises30%of
totalassetsonbookvaluebasis,Debtwillbeapartoftheacquisitiontransaction.
ii)FDFholds$200,000incashandshortterminvestments,butitwillnotbeapartoftheassets
underacquisitiontransaction.

Exhibit2
AdditionaldataandHestersestimatesfornormalization
1. Thecostofgoodssoldratioshouldbehigherat45%.
2. SG&A includes $400,000 in owners compensation. According to Hesters research,
ownerscompensationexpenseforsimilarsizedfarmsis$200,000.
3. Aranchandlivingquartersarenotrequiredforthefarmscoreoperations.Atotalof
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$125,000 in expenses ($25,000 in depreciation and $100,000 in operating expenses
included in SG&A) relate to those properties. The ranch and living quarters will be
kept by the current owners and are not a part of FDFs farming operations being
consideredforpurchasebythehedgefund.
4. Forproformapurposes,depreciationandamortizationwillbe10%ofgrossrevenues
andthecurrenttaxrateof30%isconsideredreasonable.

First Hester assesses FDFs normalized operating income after tax. Next, he values FDFs equity
usingthefreecashflowtothefirm(FCFF)approachunderthefollowingadditionalassumptions.
Revenuesandfreecashflowswillgrowataconstantrateof5%peryearfortheforeseeable
future.
Onaverage,FDFsoperatingincome(EBITDA)willbe30%ofgrossrevenues.
Requiredcapitalexpenditureswillequaltheprojecteddepreciation&amortizationexpense
plus10%oftheincrementalrevenue.
Additionalworkingcapital(otherthancash)equalto15%oftheincrementalrevenueis
required.
Thecostofequityandweightedaveragecostofcapital(WACC)are14%and11.5%
respectively.
HesterpresentshisinitialassessmentandvaluationofFDFtoMVAsInvestmentCommittee,The
commentsandsuggestionsfromsomemembersontheCommitteeareasfollows:
Xavier Moreno, Commodities Analyst, suggests the use of excess earnings method (EEM) for
valuingFDFandmakesthefollowingthreestatementsinsupportofhispreference:
1. EEM involves estimating the earnings remaining before deducting amounts that reflect the
requiredreturnstothetangibleassets.
2.ItisawidelyusedmethodforpricingentireprivatebusinessessuchasFDF.
3. EEM is especially useful for valuing FDF as it allows for valuing working capital, fixed assets,
andintangiblesusingdifferentdiscountrates.
Jamal Bahrami, the External Consultant on the Committee, differs from Hester and prefers the
useoffreecashflowtoequity(FCFE)model.Further,hedevelopshisownestimatesforvaluing
FDFsequity:
Owingtothecontinuedstrengthintheglobaldemandforwheat,FDFwillexperiencea
higherannualgrowthrateof10%overthenexttwoyears,2011and2012;thereafter,itwill
growataconstantrateof6%peryear.
Nextyear(2011)FDFwillrealize$1,000,000incashflowfromoperations.
Tosupportitshighgrowthneeds,FDFwillrequire$400,000innewcapitalinvestmentnext
year.
Thecompanywouldneedadditionalborrowingintheamountof$250,000ataninterest
costof8%.
Becauseofilliquidityandsmallfirmriskpremiums,theappropriateWACCandrequired
returnonequity,respectively,willbehigherat12.9%and16%.
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Hestermadeacashofferof$9milliontotheMahoneybrothers.However,theydecidedtomake
acounterofferandapproachedJoselynOlsen,areputableagricultureindustryanalystattheRed
RiverValleyConsultants,LLP,forherassessmentofFDFsvalue.
Olsen prefers the guideline transactions method (GTM) using next years expected EBITDA to
valueFDFandsheestimatesthefollowingfromthecompanydata,marketinformation,andher
ownassessments.
FDFsexpected2011grossrevenue=$2,800,000
2011costofgoodssold=42%ofgrossrevenue
2011SG&A=25%ofgrossrevenue
ThreerecentpurchasetransactionsofsimilarfarmsinNorthDakotaindicateanaverage
MVIC(MarketValueofInvestedCapital)toEBITDAmultipleof9.0
FDFcommandsa30%controlpremium.
FDFneednotincuranyadditionalcapitalexpendituresorborrowing.
OlsenjustifiesherchoiceoftheGTMapproachinthefollowingthreestatements:
1.TheGTMapproachworkswellforvaluingFDFasit usesamultiplethatspecificallyrelatesto
sales of entire companies. SFAS No.157 presents a fair value hierarchy that gives the highest
priority to market based evidence. Further, tax courts in U.S. assessing private company
valuationshavegenerallystatedapreferenceforvaluationbasedonmarkettransactions.
2.MostappraisersreadilyacceptthevaluationfromGTMapproachbecauseofthereliabilityof
transactionsdata.
3.Themarketapproachtodeterminethevalueofequityisappropriateevenforcompanieswith
highly leveraged financial conditions or significant volatility expected in future financial
performance.
Satisfied with Olsens valuation and her methodological choice, the Mahoney brothers move
aheadwiththeircounteroffertoHester.
7. Thenormalizedoperatingincomeaftertaxesfortheyear2010forFDFusingthe
companysdataandHestersassessmentsandestimatesinExhibits1and2isclosestto:
A. $325,500.
B. $367,500.
C. $402,500.
Correctanswer:B
PrivateCompanyValuation,RaymondD.Rath,MA,CFA
StudySession1243c
Explaincashflowestimationissuesrelatedtoprivatecompaniesandadjustmentsrequiredto
estimatenormalizedearnings.
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FDFsfinancialperformancefortheyearendedDecember
2010
Asreported$ Normalized$
GrossRevenuesfromcrops,livestock,feed,etc. 2,500,000 2,500,000
Costofgoodssold:Normalizedto45%ofRevenues (1,000,000) (1,125,000)
Grossprofit 1,500,000 1,375,000
Selling,general,andadministrativeexpenses(SG&A):
reflects$200,000reductioninownerscompensationand
$100,000reductioninoperatingexpensesrelatedtothe
ranch.
(900,000) (600,000)
EBITDA 600,000 775,000
Depreciationandamortization:normalizedto10%of
revenues
(200,000) (250,000)
Earningsbeforeinterestandtaxes 400,000 525,000
Proformataxes(at30%) (120,000) (157,500)
Operatingincomeaftertaxes 280,000 367,500

8. FDFsvalueofequityasattheendof2010usingthecompanydatainExhibit1,and
Hestersapproachandassumptions,isclosestto:
A. $5,611,111.
B. $8,084,877.
C. $8,526,620.
Correctanswer:B
FreeCashFlowValuation,JeraldPinto,CFA,ElaineHenry,CFA,ThomasRobinson,CFkandJohn
Stowe,CFA2012ModularLevelI,Vol.4,pp.307312
PrivateCompanyValuation,RaymondD.Rath,ASA,CFA2012ModularLevel1,Vol.4,pp.
537540
StudySessions1240j;1243f
Estimateacompanysvalueusingtheappropriatefreecashflowmodel(s).
Demonstratethefreecashflow,capitalizedcashflow,andexcessearningsmethodsofprivate
companyvaluation.
CalculationofnextyearsFCFF,valueofthefirm,andvalueofequity $
Grossrevenues2011 2.500,000 1.05=2,625,OO0
Increment&revenueover2010 2,625.000 2,50O,O00=125,O0O
EBITDA(30%ofrevenue) 2,625,000 0.30 787,500
Depreciation(10%ofrevenue) 2,625,000 0.10=262,500
+Depreciation Taxrate 262,500 0.30 78,750
Requiredcapitalexpenditures
(depreciation+10%incrementalrevenues)
262,500+(125,00010%) (275,000)
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Increaseinworkingcapital
(15%ofincrement&workingcapital)
125,000 0.15 (187,500)
Freecashflowtothefirm(FCFF
2011
) 572,500
V
2010
=FCFF
2011
/(WACC g) 572,500/(0.115 0.05)= 8,834,877
Lessdebt (750,000)
Valueofequity(December2010) 8,084,877

9. InregardtoMorenosthreestatements,heismostaccuratewithrespecttothe
statement:
A. 1.
B. 2.
C. 3
CorrectanswerC
PrivateCompanyValuation,RaymondD.Rath,ASA,CFA
2012ModularLevel1,Vol.4,pp.548550
StudySession1243e,f
Explaincashflowestimationissuesrelatedtoprivatecompaniesandadjustmentsrequiredto
estimatenormalizedearnings.
Demonstratethefreecashflow,capitalizedcashflow,andexcessearningsmethodsofprivate
companyvaluations.
Statement3iscorrect.Theexcessearningsmethod(EEM)allowsforvaluingworkingcapital,
fixedassets,andintangibleassetsusingdifferentdiscountrates.
10. ThevalueofFDFsequityasofDecember31,2010,accordingtotheapproachpreferred
byBahramiandusingtheestimatesdevelopedbyhimisclosestto:
A. $8,554,891
B. $8,793,104
C. $12,755,292
Correctanswer:B
FreeCashFlowValuation,JeraldPinto,CFA,ElaineHenry,CFA,ThomasRobinson,CFA,and
JohnStowe,CFA2012ModularLevelI,Vol.4,pp.292297,315320
2012ModularLevelI,Vol.4,pp.546548
StudySessions1240c,j;1243g
Explaintheappropriateadjustmentstonetincome;earningsbeforeinterestandtaxes(EBIT);
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earningsbeforeinterest,taxes,depreciation,andamortization(EBITDA);andcashflowfrom
operations(CFO)tocalculateFCFFandFCFE.
Explainfactorsthatrequireadjustmentwhenestimatingthediscountrateforprivatecompanies.
Calculationofnextyears(2011)FCFFandvalueofequityattheendof2010
Cashflowfromoperations(CFO)fortheyear2011 $1,000,000
Newcapitalinvestment(FCInv) (400,000)
+ Netborrowing 250,000
Freecashflowtoequity(FCFE
2011
) 850,000
FCFE
2012
=FCFE
2011
1.10=850,0001.10 935,000
FCFE
2013
=FCFE
2013
1.06=935,0001.06 991,100
Usingatwostagemodel:
TV
2012
=991,100/(0.16 0.06)=9,911,000
V
2010
=850,000/1.16+935,000/1.162+9,911,000/1.162
=732,759+694,857+7,365,488=
8,793,104

11. ThevalueofFDFsequityasattheendof2010accordingtotheapproachandestimates
byOlsenisclosestto:
A. $10,060,800.
B. $10,260,800.
C. $10,810,800.
CorrectanswerA
MarketBasedValuation:PriceandEnterpriseMultiples,JeraldPinto,CFA.ElaineHenry,CFA,
ThomasRobinson,CFA,andJohnStowe,CFA
2012ModularLevel1,Vol.4,pp.426431
PrivateCompanyValuation,Raymond0.Rath,ASA.CFA
2012ModularLevelLVol.4,pp.550557StudySessions1241n;1243i,k
Calculateandinterpretenterprisevaluemultiples,andevaluatetheuseofEV/EBITDA.
Demonstratethemarketapproachestoprivatecompanyvaluation(forexample,guidelinepublic
companymethod,guidelinetransactionmethod,andpriortransactionmethod),anddescribe
advantagesanddisadvantagesofeach.
Explainandevaluatetheeffectsonprivatecompanyvaluationsofdiscountsandpremiumsbased
oncontrolandmarketability.
GrossRevenues2011 $2,800,000
Costofgoodssold 2,800,0000.42 (1,176,000)
SG&A 2,800,0000.25 (700,000)
EBITDA 924,000
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EBITDA multiple for FDF (including control
premium)
9.01.30 11.70
MVIC=EBITDAMultiple 924,00011.70 10,810,800
LessDebt (750,000)
Valueofequityasattheendof2010 10,060,800

12. WhichofOlsensthreestatementsjustifyingherchoiceofGTMapproachismost
accurate?
A. Statement1.
B. Statement2.
C. Statement3.
CorrectanswerA
2012ModularLevelJVol.4,pp.550555
StudySession1243i
Demonstratethemarketapproachestoprivatecompanyvaluation(forexample,guidelinepublic
companymethod,guidelinetransactionmethod,andpriortransactionmethod),anddescribe
advantagesanddisadvantagesofeach.
TheGTMapproachusesamultiplethatspecificallyrelatestosalesofentirecompanies,andSFAS
No.157alsopresentsafairvaluehierarchythatgivesthehighestprioritytomarketbased
evidence.Additionally,intheUnitedStates,taxcourtsassessingprivatecompanyvaluations
havegenerallystatedapreferenceforvaluationbasedonmarkettransactions,althoughthey
oftenacceptvaluationsbasedontheincomeapproach.
Keypoints
3issuesofthefinancialstatementadjustments
Normalizedearnings
Strategicandnonstrategicbuyers
Estimatingcashflows
Normalizedearningsarecalculatedbyadjustingfor:
Nonrecurring and unusual items.
Discretionary expenses.
Non-market levels of compensation.
Personal expenses charged to the firm.
Real estate expenses based on historical cost.
Nonmarketleaserates.
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FCFF
Thefreecashflowmethod
2stagemodel
Thecapitalizedcashflowmethod
singlestage model: a single measure of economic benefit is divided by a
capitalization rate to arrive at firm value, where the capitalization rate is
requiredrateofreturnminusagrowthrate.
1
1
=
=
FCFF
Value of firm
WACC g
FCFE
Value of equity
r g
Value of equity Value of firm MD
Marketbasedvaluation
Usingpricemultiplesanddatafrompreviouspublicandprivatetransaction
Guidelinepubliccompanymethod(GPCM)
Guidelinetransactionsmethod(GTM)
Priortransactionmethod(PTM)
MarketMultiples
Largesize:EBIT/EBITDAmultiples
Smallsize:netincomemultiples
Thethreemarketapproachmethodsareasfollows:
The guideline public company method (GPCM) uses price multiples from
traded public companies with adjustments for risk differences. The
advantage is that there are usually numerous public company transactions
available, but the public firms may not be comparable. When estimating a
control premium for a controlling interest, the transaction type, industry
conditions,typeofconsideration,andreasonablenessshouldbeconsidered.
Theguidelinetransactionsmethod(GTM)usesthepricemultiplesfromthe
sale of whole public and private companies with adjustments for risk
differences. The following issues regarding the comparable data should be
considered: transaction type, contingent consideration, type of
consideration,availabilityofdata,anddateofdata.
Thepriortransactionmethod(PTM)useshistoricalstocksalesofthesubject
company and is best when using recent, arm'slength data of the same
motivation.
Theexcessearningsmethod
EE=firmearningstheearningsrequiredtoprovidetherequiredrateofreturnon
workingcapitalandfixedasset
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4stepsofEEM
Step1Calculatetherequiredreturnforworkingcapitalandfixedassets
Step2Calculatetheexcessearnings
Step3Valuetheintangibleassets
Step4Sumtheassetvaluestoarriveatthetotalfirmvalue
Nenkovmakesthefollowingtwocomments:
(1) CCM is most often used for the valuation of large public companies, and it is less valid for
valuingprivatecompanies.
(2) The excess earnings method is preferable as it provides an estimate of the value of
intangible assets by capitalizing future earnings in excess of the estimated return requirements
associatedwithworkingcapitalandfixedassets.
13. RegardingthetwocommentsthatNenkovmade,heismostlikelycorrectwithrespectto:
A.comment 1 only.
B.comment 2 only.
C.both comments 1 and 2.
Answer=B
PrivateCompanyValuation,RaymondD.Rath
StudySession1243a,b
Comparepublicandprivatecompanyvaluation.
Describetheusesofprivatebusinessvaluation,andexplaintheapplicationsofgreatestconcern
tofinancialanalysts.
Biscorrect.Nenkovisincorrectwithrespecttohisfirststatementbecausethecapitalizedcash
flowmethodisrarelyusedforthevaluationofpubliccompanies,anditismoreappropriatefor
valuingaprivatecompany,suchasRRBL.
Nenkovssecondstatementiscorrectbecausetheexcessearningsmethodinvolvesestimating
theearningsremainingafterdeductingtheamountsthatreflecttherequiredreturnstoworking
capitalandtangibleassets.Theresidualamountofearnings(i.e.,theexcessearnings)is
capitalizedtoobtainanestimateofthevalueofintangibleassets.
Therefore,onlyNenkovssecondstatementiscorrect.
Metev recalls FDLFs willingness to purchase a noncontrolling ownership interest but at a
discount for lack of control. Nenkov responds saying that a control premium of 30% is typically
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applied for purchase transactions of small, privately owned firms similar to RRBL, and proper
adjustment for lack of control should be made if the transaction involves a noncontrolling
interest.MetevthanksNenkovforhishelpandgoesbacktohisdesktorevisehisvaluations.
14. Thediscountforlackofcontrol,giventhetypicalcontrolpremiumindicatedbyMetev,is
closestto: 2012 mock 36
A.12%.
B.23%.
C.30%.
Answer=B
PrivateCompanyValuation,RaymondD.Rath
StudySession1243k
Explainandevaluatetheeffectsonprivatecompanyvaluationsofdiscountsandpremiumsbased
oncontrolandmarketability.
Biscorrect.DLOC=1[1/(1+Controlpremium)]=1[1/(1.30)]=23.1%
2012 mock 42
Tanner discusses the merits of different valuation methods with three of his colleagues: Marcia
Stephens,DaleMathews,andKevinBaldridge.Theymakethefollowingstatements:
Stephens: Free cash flow valuation is especially appropriate for investors who want to take a
control perspective in takeovers. Also, free cash flow to equity is the cash flow available to be
distributedtoshareholderswithoutimpairingthecompanysvalue.
Mathews: Remember that the Gordon growth model is based on indefinitely extending future
dividends, and the intrinsic value derived by the model is very sensitive to small changes in the
assumedgrowthrateandrequiredrateofreturn.
Baldridge: You can use the residual income approach as well, a simpler model that does not
requirecleansurplusrelationtohold,andthevaluationisnotimpactedbybookvalueseither.
Tanner prepares a list of issues he needs to consider as he begins his analysis for writing his
report.
15. ThestatementbywhichofTannerscolleaguesregardingvaluationmethodsisleast
accurate?
A.Stephens
B.Mathews
C.Baldridge
Answer=C
DiscountedDividendValuation,JeraldPinto,ElaineHenry,ThomasRobinson,andJohnStowe
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ResidualIncomeValuation,JeraldPinto,ElaineHenry,ThomasRobinson,andJohnStowe
2012ModularLevelII,Vol.4,pp.476,484,494
StudySession1139a,h;1242b,d
Comparedividends,freecashflow,andresidualincomeasmeasuresindiscountedcashflow
models,andidentifyinvestmentsituationsforwhicheachmeasureissuitable.
DescribethestrengthsandlimitationsoftheGordongrowthmodel,andjustifyitsselectionto
valueacompanyscommonshares.
Describetheusesofresidualincomemodels.
Explainfundamentaldeterminantsofresidualincome.
Ciscorrect.Baldridgesstatementisleastaccurate.Theresidualincomeapproachusesthebook
valueofequity,anditrequiresthatthecleansurplusrelationholds.
KeyPoints
Discountoflackofcontrol
Minorityshareholdersareatadisadvantagerelativetocontrollingshareholders.
1
1 [ ]
1
=
+
DLOC
control premium

Scenario Comparable data Subject Valuation Adjustment
1 Controlling Interest Controlling Interest None
2 Controlling Interest Noncontrolling Interest DLOC
3 Noncontrolling Interest Controlling Interest Control Premium
4 Noncontrolling Interest Noncontrolling Interest None
Discountoflackofmarketability
Method1:usingpriceofrestrictedshares
Method2:thepriceofpreIPOsharesiscomparedtothatofpostIPOshares
Method 3: estimate DLOM as the price of a put option divided by the stock price,
wheretheputisatthemoney
TotalDiscount
1 [(1 )(1 )] = Total discount DLOC DLOM

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Case3:BrightHorizonMaterialsCompanyCaseScenario
BrightHorizonMaterialsCompany(BHM)
Rating:Buy
Priceon30August2008:$29.64
AnalystEllenChau,CFA
Bright Horizon Materials Company, located in the northeastern region of the United States,
specializesinpreparingscrapmetalandglassforrecycling.Thecompanybuyssurplusmetalfrom
equipment manufacturers and construction companies, and glass from a local network of
individual suppliers. The company sorts its incoming materials by type and quality. Workers use
handsorting methods to identify and recover the most valuable materials. The company then
shreds the metals and crushes the glass, both of which it packages for resale. Metals processing
provides85%ofBrightHorizonsrevenues,andglasstheremainder.
IndustryStructure
The structure of the scrap materials industry is characterized by an unusual factor metals are
expensivetotransportrelativetotheirvalueperpound.Althoughtheindustryiscapitalintensive
and large economies of scale are present the valuetoweight factor noted above predominates.
We believe that suppliers to Bright Horizon have relatively high bargaining power. Firms in the
industrymaintainanintenserivalryincompetingforscrapmetalsupply.Webelievethatbuyers
ofBrightHorizonsproductshavestrongbargainingpower
Competitionstructuremeasuresareasfollows:
10firmconcentrationratiois20%
HerfindahlIndexis0.0032
OperationalAnalysisofBrightHorizon
Following more than a decade of mediocre financial results, the firms revenue growth has
benefitedfromtherecentsharpriseinrawmaterialsprices.Moreover,thefirmhastakenstrong
preemptive steps to contain its costs of operation and seeks to be the industry cost leader The
most notable steps include fuel hedging and the acquisition of more efficient machinery, which
are improving the firms profitability. This cost strategy is likely to reduce the degree of
competitivepressurethatthefirmexperiences.
Exhibitsland2showselectedfinancialandmarketinformationforBrightHorizonanditsindustry.
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Exhibit1
BrightHorizonandIndustryAverage
SelectedFinancialInformation
FortheFiscalYearEnded30June2008
BrightHorizon IndustryAverage
Returnonassets(%) 10.6 11.0
Returnonequity(%) 18.4 16.0
Netprofitmargin(%) 4.3 4.1
Earningspershare(EPS)2008($) 2.45 n/a*
Dividendpayoutratio2008(%) 14.0 10.0
*n/a=notapplicable
Exhibit2
CurrentMarketDataforBrightHorizonandIndustryAverage
BrightHorizon IndustryAverage
Currentpricetoearnings(P/E)ratio 12.0 9.5
FranchisevalueP/Eratio 5.0 n/a*
Requiredrateofreturnonequity(%) 17.1 14.7
*n/a=notapplicable
We are placing a Buy rating on the shares of Bright Horizon, with a 12month price target of
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$35. 78. This assumes a projected EPS for 2009 of $2.84, and a P/E ratio of 12.6, Further, our
BuyratingissupportedbyBrightHorizonstwostrengthsasstatedbelow:
Statement1:BrightHorizonuseslessfinancialleveragethantheaveragefirmintheindustry.
Statement 2: Bright Horizon is more efficient in the use of assets than the average firm in the
industry.
The primary risk faced by Bright Horizon is the possibility of an economic recession, resulting in
lowerdemandforthefirmsoutputbyindustrialendusers,depressedrawmaterialsprices,lower
revenues,andasignificantreductioninprofits.
Another risk is continued increases in the costs of energy and labor, which have already risen
dramaticallyinrecentyears.Theinflationrateisexpectedtoremainatitshistoricalaverageof4%
butthefirmsinflationflowthroughratetoitsearningsis75%.
16. BasedonChausanalysisoftheindustrystructure.BrightHorizonscompetitiveadvantage
andabilitytocapturethevalueitcreatesforbuyersaremostlikelydueto:
A.barrierstoentry
B.rivalryamongcompetitors
C.bargainingpowerofsuppliers
Correctanswer:A
Equity:ConceptsandTechniques,BrunoSolnikandDennisMcLeaveyIndustryAnalysis,
JeffreyC.Hooke
Distinguishbetweencountryanalysisandindustryanalysisandcompareandevaluatekey
conceptsofindustryanalysis,suchasdemandanalysis,industrylifecycleanalysis,and
competitionstructureanalysis,aswellasriskelementsinherentinindustryanalysis.
Discussthekeycomponentsthatshouldbeincludedinanindustryanalysismodel.
Accordingtothedescription,thescrapmaterialsindustryiscapitalintensivewithhighexitcosts
andlargeeconomiesofscale,makingitlessattractivetonewentrants.Thus,thefirmsinthis
industrywillhaveacompetitiveadvantageandgreaterabilitytocapturethevaluecreatedfor
buyers.
17. Basedonthecompetitionstructuremeasurespresentedinchausreport,whichofthe
followingisthebestcharacterizationofBrightHorizonsindustry?
A.Theindustryisexperiencingmoderateconcentration.
B.Theindustryconsistsofapproximately313equivalentfirmsofthesamesize.
C.Theindustryisoligopolisticandgametheoriesaremoreimportantthanproduct
differentiation.
Correctanswer:B
Equity:ConceptsandTechniques,BrunoSolnikandDennisMcLeavey
Distinguishbetweencountryanalysisandindustryanalysisandcompareandevaluatekey
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conceptsofindustryanalysis,suchasdemandanalysis,industrylifecycleanalysis,and
competitionstructureanalysis,aswellasriskelementsinherentinindustryanalysis.
OnthebasisoftheHerfindahlIndexindicatingtheindustrycompetitionstructure,thenumberof
equivalentfirmsofthesamesizeintheindustry=1/0.0032=312.50.
18. BrightHorizonsintrinsicP/Eratioisclosestto:
A.10.9.
B.12.6.
C.14.5.
Correctanswer:A
Evaluatethecommonapproachesofequityanalysis(ratioanalysisanddiscountedcashflow
models,includingthefranchisevaluemodel)andidentifymispricedstocksusingeithermethod.
IntrinsicP/E=(1b)/(rg);(1b)=Payoutratio(given)=14%;r=Requiredrateofreturnon
equity(given)=17.1%;g=ROERetentionRatio=18.4(10.14)=15.82%;IntrinsicP/E=0.14
/(0.1710.1582)=10.9.
19. InregardtoBrightHorizonstwostrengthsidentifiedinsupportoftheBuyrating,itis
mostaccuratetostatethat:
A.Statement#1iscorrect.
B.Statement#2iscorrect.
C.neitherstatementiscorrect.
Correctanswer:C
Evaluatethecommonapproachesofequityanalysis(ratioanalysisanddiscountedcashflow
models,includingthefranchisevaluemodel)andidentifymispricedstocksusingeithermethod.
UsingthedatainExhibit1,financialleverageandassetturnovercanbecomputedasfollows:
Ratio BrightHorizon IndustryAverage
FinancialLeverage=ROE/ROA =18.4/10.6=1.7 =16.0/11.0=1.5
AssetTurnover=ROA/NPM =10.6/4.3=2.5 =11.0/4.1=2.7
Fromtheabovecomputations,itcanbeseenthatBrightHorizonuseshigherfinancialleverage
thantheaveragefirmintheindustrytherebymakingStatement#1tobeincorrect.Ontheother
hand,efficiencyintheuseofassetsasindicatedbytheassetturnoverratioissmallerforBright
HorizoncomparedtotheaveragefirmintheindustrytherebymakingStatement#2tobe
incorrect.Thus,neitherstatementiscorrect.
20. GiventhecharacterizationofBrightHorizonsprimaryrisk,theindustryinwhichBright
Horizonoperatesisbestclassifiedasa:
A.growthindustry
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B.cyclicalindustry
C.defensiveindustry
Correctanswer:B
IndustryAnalysis,JeffreyC.Hooke
Analyzetheeffectsofbusinesscyclesonindustryclassification(i.e.,growth,defensive,cyclical).
Cyclicalindustriesarethosewhoseearningstrackthebusinesscyclewithprofitsbenefitingfrom
economicupturnsbutsufferingindownturns.Therefore,thepossibilityofaneconomicrecession
isasignificantriskfactorforfirmsincyclicalindustries.TheprimaryriskfacedbyBrightHorizon
isthepossibilityofaneconomicrecession,resultinginlowerdemandforthefirmsoutputby
industrialendusers,depressedrawmaterialsprices,lowerrevenuesandasignificantreduction
inprofits.Therefore,BrightHorizonisinacyclicalindustry.
KeyPoints:
IndustryAnalysis:Porter'sFiveForces
1. Threatofnewentrants
1) Economiesofscale
2) Proprietaryproductdifferentiation
3) Capitalrequirements
4) Switchingcosts
5) Accesstodistribution
6) Absolutecostadvantages(independentofscale)
7) Governmentpolicy
8) Expectedretaliation
9) Brandidentity
2. Supplierbargainingpowerincreaseswhen:
1) Suppliersarelargeandfewinnumber
2) Suitablesubstituteproductsarenotavailable
3) Individualbuyersarenotlargecustomersofsuppliersandtherearemanyofthem
4) Suppliersgoodsarecriticaltobuyersmarketplacesuccess
5) Suppliersproductscreatehighswitchingcosts.
6) Suppliersposeathreattointegrateforwardintobuyersindustry
3. Buyerbargainingpowerincreasewhen:
1) Buyersarelargeandfewinnumber
2) Buyerspurchasealargeportionofanindustrystotaloutput
3) Buyerspurchasesareasignificantportionofasuppliersannualrevenues
4) Buyerscanswitchtoanotherproductwithoutincurringhighswitchingcosts
5) Buyersposethreattointegratebackwardintothesellersindustry
4. Thethreatofsubstituteproductsincreaseswhen:
1) Buyersfacefewswitchingcosts
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2) Thesubstituteproductspriceislower
3) Substitute products quality and performance are equal to or greater than the existing
product
Differentiatedindustryproductsthatarevaluedbycustomersreducethisthreat
5. Industryrivalryincreaseswhen:
1) Therearenumerousorequallybalancedcompetitors
2) Industrygrowthslowsordeclines
3) Therearehighfixedcostsorhighstoragecosts
4) Thereisalackofdifferentiationopportunitiesorlowswitchingcosts
5) Whenthestrategicstakesarehigh
6) Whenhighexitbarrierspreventcompetitorsfromleavingtheindustry
AntitrustlawandHHI
Los 32.g calculate the HerfindahlHirschman Index and evaluate the likelihood of an antitrust
challengeforagivenbusinesscombination;
TheHHIiscalculatedasthesumofthesquaredmarketsharesforallfirmswithinanindustry.
( )
=
=
n
1 i
2
i
100 MS HHI
MSi=marketshareoffirmi
n=numberoffirmsintheindustry
HHIconcentrationlevelandlikelihoodofantitrustaction
PostmergerHHI Concentration ChangeinHHI Governmentaction
HHI<1,000 Notconcentrated Anyamount Noaction
1,000<HHI<1,800 Moderately
concentrated
100ormore Possiblechallenge
HHI>1,800 Highlyconcentrated 50ormore Challenge
KeyPoints:
TheGordonGrowthModel
Los 39.c calculate the value of a common stock using the Gordon growth model, and explain
themodelsunderlyingassumptions;
1. Assumptions
1) Thefirmexpectstopayadividend,D,inoneyear
2) dividendswillgrowataconstantrate,g,forever.
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3) Thegrowthrate(g)islessthantherequiredrate(r)
2. Theformulaisasfollows:
g r
D
V
=
1
0

3. Limitations
1) Verysensitivetoestimatesofrandg
2) Difficultwithnondividendstocks
3) Difficultwithunpredictablegrowthpatterns(usemultistagemodel)
Los 39.e calculate and interpret the present value of growth opportunities (PVGO) and the
componentoftheleadingpricetoearningsratio(P/E)relatedtoPVGO;
4. Thevalueofafirmsequityhastwocomponents
1) ThepresentvalueofaperpetualcashflowofE
2) Thepresentvalueofitsfutureinvestmentopportunities(PVGO)
V
0
=E
0
/r+PVGO
where:E=nogrowthearningslevel r=requiredreturnonequity
5. JustifiedP/E
1) leadingP/E=P0/E1=(1b)/(rg)
2) trailingP/E=P0/E0=(1b)*(1+g)/(rg)
MultistageDividendDiscountModels
HModel:thegrowthratestartsouthigh,andthendeclineslinearlyoverthehighgrowthstage
untilitreachesthelongrunaveragegrowthrate

IntroductiontoFreeCashFlows
( ) [ ] [ ]
L
L s L
g r
g g H D g D
V
+ +
=
) ( 1
0 0
0
2
t
H =
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ForecastingFreeCashFlow
1. FCFF
FCFF=NI+NCC+Int (1t)FCInvWCInv
FCFF=CFO+Int(1t)FCInv(underUSGAAP);
FCFF=EBIT(1t)+DepFCInvWCInv;
FCFF=EBITDA(1t)+DeptFCInvWCInv;
2. FCFE
FCFE=FCFFInt(1t)+Netborrowing
FCFE=NI+NCCFCInvWCInv+Netborrowing
FCFE=CFOFCInv+Netborrowing
FCFE=NI(1DR)(FCInvDep)(1DR)WCInv
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Derivatives
Case3:RobynLawrenceCaseScenario
Robyn Lawrence is a senior quantitative analyst in the Global Derivatives Group of Ridgeview
Capital, an investment management firm based in New York City. Lawrence is conducting a
trainingsessionfortworecentlyhiredanalysts,WilmaKaplanandAnitaMehra.Atthemeeting,
KaplanandMehraareaskedquestionsabouttheBerkeleyCorporationandareprovidedwiththe
informationinExhibit1.
Exhibit1
StockandOptionsDataforBerkeleyCorporation
andRiskFreeInterestRate
CurrentCallPrice $2.30
CurrentPutPrice $4.70
ExercisePrice $130.00
DaystoExpiration* 60
CurrentStockPrice $128.55
UpMoveonStock 15%
DownMoveonStock 10%
RiskFreeInterestRate 3%
*Note:Assumea365dayyear.
Lawrencebeginsthemeetingbystating:
Statement1:
You have both been asked to use the information provided in Exhibit 1 to perform certain
calculations. One of your tasks was to calculate the synthetic values of call and put options for
BerkeleyCorporation.Canoneofyoutellmewhyitisusefultoconstructandvaluesyntheticcalls
andputs?
Kaplan responds, Deriving synthetic values enables us to determine whether it is possible to
earn arbitrage profits. For example, if we find that the current call price is greater than the
synthetic call price then we could earn an arbitrage profit by carrying out the following
transactions: selling the call, purchasing the put, and taking short positions in the stock and the
bond.
The discussion then moves on to the BlackScholesMerton option pricing model. Lawrence
states: The BlackScholesMerton option pricing model is based on a number of assumptions,
including:underlyingpricesfollowalognormalprobabilitydistribution,theriskfreerateisknown
and constant, there are no cash flows on the underlying, and the options being priced are
Europeanoptions.Whataretheotherassumptionsofthismodel?Kaplanresponds:
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Theotherassumptionsofthemodelare:
Assumption1:Therearenotaxesortransactionscosts.
Assumption2:Thevolatilityoftheunderlyingassetschangethroughtime.
Assumption3:Thepricesoftheunderlyingassetfollowalognormaldistribution.
Lawrence continues the discussion: In the BlackScholesMerton model, option prices for
European calls and puts are impacted by a number of variables, including time to expiration,
volatility,andtheriskfreerate.Canoneofyouexplaintheeffectofchangesinthesevariableson
thepricesofEuropeancallandputoptions?
Mehraresponds:Callandputpricesarehigherwhenvolatilityishigher,andcallandputprices
are lower for higher riskfree rates. However, while call options are higher for longer time to
expiration,putoptionpricescanbehigherorlowerthelongerthetimetoexpiration.
Lawrenceendsthemeetingwiththefollowingstatement:
Statement2:
AnimportantoptionGreekthatyoushouldbefamiliarwithistheoptiondelta,becausetraders
canusethistoconstructhedgestooffsettherisksoftheiroptionpositions.Youshouldnotethat
for inthemoney call and put options, delta approaches 1 as the option moves toward
expiration.
1. BasedontheinformationprovidedfortheBerkeleyCorporationinExhibit1,thepriceofa
synthetic60daycalloptionwitha$130.00strikepriceisclosestto:
A.$3.25
B.$3.88
C.$5.52
Answer=B
OptionMarketsandContracts,DonM.Chance
StudySession1756a
Calculateandinterpretthepricesofasyntheticcalloption,syntheticputoption,syntheticbond,
andsyntheticunderlyingstock,andinferwhyaninvestorwouldwanttocreatesuch
instruments.
Biscorrect.Thesyntheticcalloptionisconstructedbygoinglongtheputandthestockandshort
thebond.
Syntheticcall=
( )
0 0
+
1
T
X
p s
r
-
+
=
( )
60
365
130
4.7 128.55 =$3.88
1 0.03
+ -
+

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2. KaplansresponsetoLawrencesStatement1ismostlikely:
A.correct.
B.incorrectwithregardtopurchasingtheput.
C.incorrectwithregardtotakingashortpositioninthestock.
Answer=C
StudySession1756a
Calculateandinterpretthepricesofasyntheticcalloption,syntheticputoption,syntheticbond,
andsyntheticunderlyingstock,andinferwhyaninvestorwouldwanttocreatesuch
instruments.
Ciscorrect.Kaplaniscorrectaboutthereasonforcalculatingsyntheticoptionvalues;itallows
onetodetermineifitispossibletoearnarbitrageprofits.However,Kaplanisincorrectaboutthe
setoftransactionsthatcanbeusedtoearnanarbitrageprofitifthecurrentpriceofthecall
optionisgreaterthanthesyntheticvalue.Thecorrectstrategyistosellthecalloptionandthen
takelongpositionsintheputandthestockandashortpositioninthebond(purchasethe
syntheticcall).Heincorrectlystatesthatashortpositionshouldbetakeninthestock.
3. BasedontheinformationinExhibit1andusingaoneperiodbinomialmodel,thevalueof
a60dayBerkeleyCorporationcalloptionwithastrikeof$130.00,isclosestto:
A.$6.67.
B.$8.31.
C.$9.00.
Answer=C
StudySession1756b
Calculateandinterpretpricesofinterestrateoptionsandoptionsonassetsusingoneand
twoperiodbinomialmodels.
Ciscorrect.Thevalueofthecalloptionusingtheoneperiodbinomialmodeliscalculatedas
follows:
( )
( )
( ) ( )
( )
1 0.52 17.8325 0.48 0
$9.00
1 1.03
c c
c
r
p p
+ -
+ - ?
= = =
+
givenby:
S
+
=128.551.15=147.8325
S
=128.550.90=115.695
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c
+
=Max[0,S+X]=Max[0,147.8325130]=17.8325
c
=Max[0,SX]=Max[0,115.695130]=0
( )
( )
( )
( )
1 1 0.03 0.9
0.52
1.15 0.09
r d
u d
p
+ - + -
= = =
- -

4. KaplansresponsetoLawrenceregardingtheassumptionsoftheBlackScholesMerton
modelisleastlikelycorrectwithrespectto:
A.Assumption1.
B.Assumption2.
C.Assumption3.
Answer=B
StudySession1756c
ExplainandevaluatetheassumptionsunderlyingtheBlackScholesMertonmodel.
Biscorrect.Kaplanisincorrect.TheBlackScholesMertonmodelassumesthatthevolatilityof
theunderlyingassetisknownandisconstant.
5. MehrasresponsetoLawrenceisleastlikelycorrectwithrespecttotheimpactoncalland
putpricesof:
A.volatility.
B.theriskfreerate.
C.timetoexpiration.
Answer=B
StudySession1756d
Explainhowanoptionprice,asrepresentedbytheBlackScholesMertonmodel,isaffectedbya
changeinthevalueeachoftheinputs.
Biscorrect.Mehraincorrectlystatestherelationshipbetweentheriskfreerateandthepricesof
callandputoptions.Thepriceofacalloptionrisesastheriskfreerategoesup.Thepriceofa
putoption,however,declinesastheriskfreeraterises.
6. IsStatement2byLawrencemostlikelycorrect?
A.Yes.
B.No,sheisincorrectwithrespecttocalls.
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C.No,sheisincorrectwithrespecttoputs.
Answer=C
StudySession1756d,e
Explainhowanoptionprice,asrepresentedbytheBlackScholesMertonmodel,isaffectedbya
changeinthevalueeachoftheinputs.
Explainthedeltaofanoptionanddemonstratehowitisusedindynamichedging.
Ciscorrect.Forinthemoneyputoptions,deltaapproaches1,not1,astheoptionmoves
towardexpiration.
KeyPoints
PutcallparityforEuropeanoptions
Afiduciarycallisaportfolioconsistingof:
A long position in a European call option with an exercise price of X that
maturitiesinTyearsonastock.
AlongpositioninapurediscountrisklessbondthatpaysXinTyears.
Aprotectiveputisaportfolioconsistingof:
A long position in a European put option with an exercise price of X that
maturitiesinTyearsonastock.
Alongpositionintheunderlyingstock.
Noticethatthepayofftoafiduciarycallisthesameasthepayoffprotective
put.Arbitrageensuresthatthetwoshouldhavethesamecost,whichleads
ustoPutcallparityforEuropeanoptions:

T-t
f
X
C + =P +S
(1+R )
t t t
Therearetworeasonswhyinvestorsmightwantstocreatesyntheticpositionsinthe
securities.
Topriceoptionsbyusingcombinationsoftheotherinstrumentswithknown
prices.
To earn arbitrage profits by exploiting relative mispricing among the four
securities.Ifputcallparitydoesnthold,anarbitrageprofitisavailable.
Aribitrage:
As with all arbitrage trades, you want to buy low and sell high. if putcall
paritydoesnthold(ifthecostofafiduciarycalldoesnotequalthecostofa
protectiveput),thenyoubuy(golongin)theunderpricedpositionandsell
(goshort)intheoverpricedposition.
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Abinomialmodel
isbasedontheideathat,overthenextperiod,somevaluewillchangetooneoftwo
possible values (binomial). To construct a binomial model, we need to know the
beginningassetvalue,thesizeofthetwopossiblechanges,andtheprobabilitiesof
eachofthesechangesoccurring.
Riskneutral probability of an up move is

u
; Riskneutral probability of an down
moveis
d
=1
u
;
u
1
f
R d
u d
+
=

Westartwithacalloption.IfthestockgoesuptoS
1
+
,thecalloptionwillbeworth
C
1
+
.IfthestockgoesdowntoS
1
,thecalloptionwillbeworthC
1
.Weknowthatthe
valueofacalloptionwillbeitsintrinsicvalueonexpirationdate.Thusweget:C
1
+
=
Max(0,S
1
+
X);C
1
=Max(0,S
1
X)

1 1
1
value of an option: c
(1 )
u d T
f
C C
R

+
= +

+

DeltaHedge
delta=Changeinoptionprice/Changeinunderlyingprice
Thecalloptionsdeltaisdefinedas:
delta
call
=(C
1
C
0
)/(S
1
S
0
)=C/S
Thedeltaofaputoptionisthecalloptionsdeltaminusone:
delta
put
=(P
1
P
0
)/(S
1
S
0
)=P/S=delta
call
1
The call options delta is also equal to N(d
1
) from the BSM model, and the put
optionsdeltaequalsN(d
1
)1.
Thecalldeltaincreasesfrom0to1asstockpriceincreases.
When the call option is deep outofthemoney, the call delta is close to
zero.Theoptionpricechangesaverysmallamountforagivenchangeinthe
stockprice.
Whenthecalloptionisdeepinthemoney,thecalldeltaisclosetoone.The
optionpricechangesalmostonedollarforaonedollarchangeinthestock
price.
Theputdeltaincreasesfrom1to0asstockpriceincreases.
Whentheputoptionisdeepinthemoney,theputdeltaiscloseto1.
When the put option is deep outofthemoney, the put delta is close to
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zero.
Thebinomialinterestratetreeisasetofpossibleinterestratepathsthatweusetovalue
optionsonbondsorinterestrates.
Youdontneedtoknowhowtoconstructaninterestratetree,sinceitwillbegiven
toyouontheexam.
Youshouldknowthattheinterestratesateachnodeareoneyearforwardrates.
You also should know that riskneutral probabilities for The binomial interest rate
tree,and1,arealways0.5.
Therearethreebasicstepstovaluinganoptiononafixedincomeinstrumentusing
abinomialtree:
Step1:Pricethebondateachnodeusingtheprojectedinterestrates.
Step 2: Calculate the intrinsic value of the option at each node at the
maturityoftheoption.
Step3:BringtheterminaloptionvaluesdeterminedinStep2backtotoday.
The famous BlackScholesMerton model (BSM model) values options in continuoustime
andisderivedfromthesamenoarbitrageassumptionusedtovaluethebinominalmodel.
TheunderlyingassumptionsoftheBSMmodelare:
Thepriceoftheunderlyingassetfollowsalognormaldistribution.
The(continuous)riskfreerateisknownandconstant.
Thevolatilityoftheunderlyingassetisknownandconstant.
Themarketsarefrictionless.
Therearenocashflowsontheunderlyingasset.
TheoptionsvaluedareEuropeanoptions.
TheBSMformulasforthepricesofEuropeancallandputoptionsare:
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0 0 1 2
[ ( )] [ ( )]
c
f
R T
C S N d X e N d

=

( ) 0 0 0
c
f
R T
P C S X e

= +
OptionGreeks
The BlackScholesMerton model has five inputs: underlying asset price,
volatility,riskfreerate,timetoexpiration,andstrikeprice.Therelationship
between each input and the European option price is captured by a
sensitivityfactorcalledtheoptionGreeks.
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Case4:RyanParisiCaseScenario
RyanParisiisaManagingDirectorintheDerivativesGroupatHighRidgePartners,aninvestment
management firm. Parisi specializes in advising institutional clients on the use of forward
contractsintheirportfoliomanagementstrategies.Parisiispreparingtomeetwiththreeofthe
firms U.S. based clients: Leslie Sheroda, Kihoon Kwon, and David Ruane. Corey Curmaci. an
analystintheDerivativesGroup,hasalsobeenaskedtoattendthemeeting.Priortothemeeting,
Parisi asks Curmaci if he is clear about how the value of a forward contract is determined.
Curmaci responds, Yes, lam. In general, the value of a forward contract may be positive or
negativeattheinceptionofthecontract,duringitslife,andattheexpirationofthecontract.
LeslieSherodamanagesequityportfoliosforapensionfund.Onemonth(30days)ago,Sheroda
hadindicatedthatthepensionfundexpectedalargeinflowofcashin60days.Inordertohedge
against a potential rise in equity values over this period, Parisi advised Sheroda to enter into a
longforwardcontractontheS&P500stockindexexpiringin60days.SherodahasaskedParisito
calculatethevalueoftheforwardpositiontoday;thatis,30daysafterthecontractwasinitiated.
ParisihascollectedtheinformationinExhibit1belowtocarryoutthevaluationassignment.
Exhibit1
SelectedFinancialInformationforSherodaMeeting
Priceofa60dayS&P500ForwardContract30DaysAgo 1403.22
S&P500IndexLevelToday 1450.82
AnnualizedContinuouslyCompoundedRiskFreeRate 3.92%
AnnualizedContinuouslyCompoundedDividendYieldforS&P500 2.50%
Three months ago (90 days), Kwon purchased a bond with a 5% annual coupon rate and a
maturity of 7 years from the date of purchase. The bond has a face value of $1,000 and pays
interestevery180daysfromthedateofissue.Kwonisconcernedaboutapotentialincreasein
interestratesoverthenextyearandhasapproachedParisiforadviceonhowhecanuseforward
contractstomanagehisrisk.ParisiadvisesKwontoenterintoashortforwardcontractexpiring
in 360 days. The annualized riskfree rate now is 4% per year and the price of the bond with
accruedinterestis$1,071.33.KwonasksParisitocalculatetheappropriatepricefortheforward
contract.
KwonasksParisi,Willtherebeanycreditriskassociatedwiththisforwardposition?
Parisirespondswiththefollowingstatement:
Youwillnotbeexposedtocreditriskattheinceptionofthecontractoratexpirationafterthe
contractismarkedtomarket.Inbetweenmarktomarketdates,youfacecreditriskiftheprice
oftheforwardcontractrisesabovethepriceattheinceptionofthecontract.
ParisisnextmeetingiswithRuane,whoisthecorporatetreasurerforamanufacturingfirm.For
themeeting,ParisihascollectedtheinformationinExhibit2.
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Exhibit 2
Selected Financial Information for Ruane Meeting
Annualized 90-day LIBOR rate 3.2%
Annualized 450-day LIBOR rate 4.5%
Annualized risk-free rate in the U.S. 4.0%
Annualized risk-free rate in the euro zone. 6.0%
Spot Exchange Rate $ per 1.3900

Threemonths(90days)fromnowRuaneexpectstoborrow$5million,atLIBOR,foraperiodof
twelvemonths(360days).Heisconcernedthatinterestratesmayrisesignificantlyoverthenext
few months and wishes to hedge this risk. Parisi advises Ruane to enter into a Forward Rate
Agreement(FRA)expiringin90dayson360dayLIBOR.Ruanewantstoknowtheratehewould
receiveontheFRA.
Ruanealsoexpectsaninflowof3millionthatneedstobeconvertedto$USin270daysandis
concernedthattheeurowilldeclineinvalueoverthisperiod.RuaneisadvisedbyParisitoenter
into an agreement to sell the euro forward in 270 days. Ruane asks Parisi to determine the
appropriateforwardpriceontheeuro.
7. InhisresponsetoParisi,Curmaciisleastlikelycorrectwithrespecttothevalueofa
forwardcontract:
A. atinception.
B. atexpiration.
C. duringthelifeofthecontract.
Correctanswer:A
FuturesMarketsandContracts,DonM.Chance,CFA
2012ModularLevelII,Vol.6,pp,1826
StudySession1654a
Explainhowthevalueofaforwardcontractisdeterminedatinitiation,duringthelifeofthe
contractandatexpiration.
Aiscorrect.Atinceptionthevalueofaforwardcontractissettozero.Thatis:
0 0
(0, )
(0, ) 0
(1 )
F T
V T S
r
= =
+

8. BasedontheinformationinExhibit1andassuminga360dayyear;thevalueofSherodas
forwardcontractisclosestto:
A. $49.16.
B. $50.71.
C. $52.18.
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Correctanswer:A
ForwardMarketsandContracts,DonM.Chance,CFA
2012ModularLevelII.Vol.6,pp.2631
StudySession1654b
Calculateandinterpretthepriceandthevalueofanequityforwardcontract,assumingdividends
arepaideitherdiscretelyorcontinuously.
Aiscorrect.
0.025(30/360) 0.0392(30/360)
30
(0,60) (1450.82 ) (1403.22 ) $1,447.80 $1,398.64 $49.16 V e e

= = =
9. Basedona360dayyear,thepriceoftheforwardcontractonthebondpurchasedby
Kwonisclosestto:
A. $1,042.55.
B. $1,063.19.
C. $1,114.18.
Correctanswer:B
StudySession1654c
Calculateandinterpretthepriceandthevalueof(1)aforwardcontractonafixedincome
security,(2)aforwardrateagreement(FRA),and(3)aforwardcontractonacurrency.
Biscorrect.
PVofcoupons=
90/360 270/360
25/ (1.04) 25/ (1.04) 24.7561 24.2753 $49.03 + = + =
360/360
(0,360) (1071.33 49.03)(1.04) $1,063.19 F = =
10. InhisresponsetoKwon,Parisiisleastlikelycorrectwithrespecttocreditrisk:
A. atcontractexpiration.
B. whenthecontractisinitiated.
C. betweenmarkedtomarketdates.
Correctanswer: C
FutureMarketsandContractDonM.Chance,CFA
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StudySession1654d
Evaluatecreditriskinaforwardcontract,andexplainhowmarketvalueisameasureofthe
creditrisktoapartyinaforwardcontract.
Ciscorrect.Parisiisincorrect.Kwonhasenteredintoashortforwardcontract.Betweenmarked
tomarketdates,ifthepriceofthecontractrisesabovethepriceofthecontractatinception,itis
Kwonscounterpartythatisexposedtocreditrisk,notKwon.Kwonisexposedtocreditriskifthe
priceofthecontractfallsbelowthepriceofthecontractatinception
11. TheratethatRuanewouldgetontheFRAexpiringin90dayson360dayLIBORisclosest
to:
A. 1.26%
B. 3.83%.
C. 4.79%.
CorrectanswerC
StudySession1654c
Ciscorrect.
450
1 0.045( )
360
360
(0,90,360) 1 ( ) 0.0479
90
360
1 0.032( )
360
FRA

+

= =

+

12. TheforwardpriceatwhichRuaneshouldbeabletoselleurosisclosestto:
A. $1.3306.
B. $1.3703.
C. $1.4167.
Correctanswer:B
StudySession1654c
Biscorrect.
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270/360
270/360
1.3900
(0, ) (1.04) $1.3703
(1.06)
F T per

= =
KeyPoints
Tbill(zerocouponbond)forwards
buyaTbilltodayatthespotprice(S
0
)andshortaTmonthTbillforwardcontractat
theforwardprice(FP)

0
(1 )
T
f
FP S R = +

Forwardcontractsonadividendpayingstock
Price:

T
f
R PVD S FP ) 1 ( ) ( 0 0 + =
Value:

(1 )
long t t T t
f
FP
V S PVD
R

=
+

Forwardcontractsonanequityindex
Continuouslycompoundedriskfreerate:
R
f
c
=ln(1+R
f
)
Continuouslycompoundeddividendyield:

c
Price:

( )
0
c c
f
R T
FP S e

=
Value:

=
) ( ) ( t T R t T
t
long c
f
c
e
FP
e
S
V

Couponbonds
Similartodividendpayingstocks,butthecashflowsarecoupons
Price:

T
f
R PVC S FP ) 1 ( ) ( 0 0 + =
Value:
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( )
(1 )
t t
long
T t
f
FP
V S PVC
R

=
+

AForwardRateAgreement(FRA)isaforwardcontractonaninterestrate(LIBOR).
(1 / 360) (1 / 360) (1 ( ) / 360)
m m n
L m FR n L m n
+
+ + = + +
CurrencyForwardContracts
Price:coveredInterestRateParity(IRP)

T
T
F
D
R
R
S FP
) 1 (
) 1 (
0
+
+
=
FPandS
0
arequotedincurrencyDperunitofcurrencyF(i.e.,D/F)
Value:

t T
D
t T
F
t
long
R
FP
R
S
V

+
+
=
) 1 ( ) 1 (

Ifyouaregiventhecontinuousinterestrates

( )
0
c c
F D
R R T
FP S e

=
( ) ( )
c c
D F
t
long
R T t R T t
S FP
V
e e

=

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Case5:MeredithWhitneyCaseScenario
Structuringandimplementingswapprogramstomanagetheirriskexposures.
Forhermeetings.WhitneyplanstousethedatapresentedinExhibit1.
Exhibit1
CurrentTermStructureofRates:LIBOR.EURIBORandHIBOR
LIBORTermStructure EURIBORTermStructure HIBORTermStructure
Days Rate(%) Days Rate(%) Days Rate(%)
90 1.42 90 1.86 90 1.22
180 1.84 180 2.11 180 1.53
270 2.12 270 2.24 270 1.70
360 3.42 360 2.34 360 1.87
Note:
LIBORistheLondonInterbankOfferrate.
EURIBORisEuroInterbankOfferRate.
HIBORistheHongKongInterbankOfferrate.
Allratesshownareannualized.
Whitneys first meeting iswith Novatel, a U.S.based company thatcurrently has an outstanding
loan of $250,000,000 that carries a 5.15% fixed interest rate. Novatels managers feel that the
current interest rate on the loan is high and they also believe that interest rates are poised to
decline.WhitneyadvisesNovateltoenterintoaoneyearpayfloatingLIBORandreceiveafixed
interest rate swap with quarterly payments. The notional principal on the swap will be
$250,000,000.
Next,WhitneymeetswithGrandManufacturing.ThisclientisbasedinHongKongbutrequiresa
25,000,000 oneyear bridge loan to fund operations in Germany. Grand Manufacturing is
currently able to borrow euros at an interest rate of 3.75%, but wonders if there is a less
expensivealternative.WhitneyadvisesGrandtoborrowinHK$andenterintoaoneyearforeign
currencyswapwithquarterlypaymentstopayeurosatafixedrateof2.32%andreceiveHK$ata
fixedrateof1.84%.ThecurrentexchangerateisHK$11.42per.
ThefinalmeetingiswithKPSFinancialServices,aU.Sbasedassetmanager.KPSwantstoincrease
theequityexposuretotheU.S.marketofoneofitsportfoliosby$100,000,000.Whitneyadvises
KPStoenterintoaoneyearequityswapwithquarterlypaymentstoreceivethereturnonaU.S.
stockindexandpayafloatingLIBORinterestrate.ThecurrentvalueoftheU.S.stockindexis925.
EachclientfollowsWhitneysadviceandimmediatelyimplementstherecommendedposition.
Fortyfive days have passed since Whitneys initial meetings and in the interim a worldwide
financialcrisishascausedinterestratestorisedramatically.Whitneysclientshaveaskedtomeet
with her to review their positions. In particular, Novatel has asked Whitney to provide
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recommendationsonhowtheymightterminatetheswaptheyenteredintobasedonherearlier
recommendation.Whitneyoutlinesthreeoptions:
Option1:Acashsettlementwiththecounterparty.
Option2:Enterintoapayerswaption.
Option3:Enterintoareceiverswaption.
Toprepareforthemeeting,Whitneyhasobtainedupdatedinterestratedatathatispresentedin
Exhibit 2. In addition, she notes that the exchange rate for the Hong Kong dollar is HK$9.96 per
euroandtheU.S.stockindexisat905.
Exhibit2
TermStructureofRates45DayLater:LIBOR.EURIBORandHIBOR
LIBORTermStructure EURIBORTermStructure HIBORTermStructure
Days Rate(%) Days Rate(%) Days Rate(%)
45 2.21 45 2.94 45 1.95
135 2.62 135 3.03 135 2.45
225 3.73 225 3.08 225 2.70
315 4.92 315 4.15 315 3.85
Note:
LIBORistheLondonInterbankOfferrate.
EURIBORisEuroInterbankOfferRate.
HIBORistheHongKongInterbankOfferrate.
Allratesshownareannualized.
13. TheannualizedfixedrateoftheswaprecommendedbyWhitneyforNovatelisclosestto:
A.2.22%.
B.3.36%,
C.5.15%,
Correctanswer:B
SwapMarketsandContracts,DonM.Chance
Calculateandinterpretthefixedrateonaplainvanillainterestrateswapandthemarketvalue
oftheswapduringitslife.
Biscorrect.Theappropriatepresentvaluefactorsareprovidedbelow:
B0(90)0.9965
B0(180)0.9909
B0(270)0.9843
B0(360)0.9669
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Forexample,B0(90)iscalculatedas:
1
0.9965
90
1 0.0142
360
=

+

Otherpresentvaluefactorsarecalculatedinasimilarmanner.
Thefixedrateiscalculatedasfollows:
( )
( )
0
0
1
1.0
n
n
j
j
B h
B h
=
1.0 0.9669
0.0084
0.9964 0.9909 0.9843 0.9669
=
+ + +

Theannualizedrate=0.00844=0.0336
14. Themarketvalue($)ofNovatelsswapafter45daysisclosestto:
A.2,875,000.
B.2,250,000.
C.718,750.
Correctanswer:B
Calculateandinterpretthefixedrateonaplainvanillainterestrateswapandthemarketvalueof
theswapduringitslife.
Biscorrect.Per$1ofnotionalprincipalthepresentvalueofthefixedpayments=(0.0084)
(0.9972+0.9903+0.9772+0.9587)+(10.9587)=0.9917
Per$1thepresentvalueofthefloatingpayments=presentvalueoffirstfloatingpayment+the
presentvalueoffuturefloatingpayments=((0.014290/360)+1)(0.9972)=1.0007
Themarketvalueofthepayfloatingreceivefixedrateswap=$250,000,000(0.99171.0007)=
$2,250,000
15. Themarketvalue(HK$)ofGrandManufacturingsswapafter45daysisclosestto:
A.1,313,300.
B.35,402,000.
C.36,500,000.
Correctanswer:B
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Calculateandinterpretthefixedrate,ifapplicable,andtheforeignnotionalprincipalforagiven
domesticnotionalprincipalonacurrencyswap,anddeterminethemarketvaluesofeachofthe
differenttypesofcurrencyswapsduringtheirlives.
Biscorrect.InitiallyGrandreceives25,000,000andpaysHK$285,500,000basedonthecurrent
exchangerateofHK$11.42pereuro.WearetoldthatGrandwillpayaninterestrateof2.32%on
theeuroandreceive1.84%ontheHongKongdollar.
Fortyfivedaysintotheswap:
PerHK$1ofnotionalprincipalthepresentvalueofthefixedpaymentsreceivedontheHong
dollar=(0.0046)(0.9976+0.9909+0.9834+0.9674)+(10.9674)=0.9855
Per1ofnotionalprincipalthepresentvalueofthefixedpaymentspaidontheeuro=(0.0058)
(0.9963+0.9888+0.9811+0.9650)+(10.9650)=0.9878
NotethatbasedontheexchangerateofHK$11.42,theactualnotionalprincipal=1/11.42=
0.08757
Thepresentvalueofeurofixedpayments=0.98780.08757=0.08649
ThepresentvalueofeurofixedpaymentsinHK$=0.086499.96=0.8615
Themarketoftheswap=285,500,000(0.98550.8615)=HK$35,402,000
16. Themarketvalue($)ofKPSFinancialServicesswapafter45daysisclosestto:
A.4,372,000.
B.2,320,000.
C.2,162,000.
Correctanswer:B
Calculateandinterpretthefixedrate,ifapplicable,onanequityswapandthemarketvaluesof
thedifferenttypesofequityswapsduringtheirlives.
Biscorrect.Themarketvalueoftheswapper$notionalprincipal=valueof$1investmentin
equitypresentvalueoffloatingpayment.
Valueof$1investmentinequity=905/925=0.97838
Per$1thepresentvalueofthefloatingpayments=presentvalueoffirstfloatingpayment+the
presentvalueoffuturefloatingpayments=((0.014290/360)+1)(0.9972)=1.0007
Marketvalueofswap=(0.978381.0007)$100,000,000=$2,232,000
17. WithrespecttotherecommendationsmadebyWhitneyfortheterminationofNovatels
swapposition,themostappropriateoptionis:
A.option1.
B.option2.
C.option3.
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Correctanswer:A
Explainandinterpretthecharacteristicsandusesofswaptions,includingthedifferencebetween
payorandreceiverswaptions.
Aiscorrect.Atthispoint,45daysintotheswap,theswapcanbesettledwithacashpaymentto
thecounterpartyifthemarketvalueisnegative.Alternatively,ifthemarketvalueispositive,then
Novatelwouldreceiveacashpaymentfromthecounterparty.
18. ThecreditriskwithrespecttoKPSFinancialServicesswappositionismostlikelythe
highest:
A.attheendoftheswapslife.
B.atthebeginningoftheswapslife.
C.duringthemiddleoftheswapslife.
Correctanswer:C
Evaluateswapcreditriskforeachpartyandduringthelifeoftheswap,distinguishbetween
currentcreditriskandpotentialcreditrisk,andillustratehowswapcreditriskisreducedbyboth
nettingandmarkingtomarket.
Ciscorrect.Interestrateandequityswapsdonotinvolveanexchangeofprincipal.Therefore,
creditriskisgreaterduringthemiddleofthelifeoftheseswaps.KPSFinancialhasenteredinto
anequityswap,sothecreditriskishigherduringthemiddleofitslife.
KeyPoints:
1. Pricingaplainvanillaswap
LOS 57.c: Calculate and interpret the fixed rate on a plain vanilla interest rate swap and the
marketvalueoftheswapduringitslife.
1=CB1+CB2+CB3++CBn+1Bn
AndthenwecangettheCas:
n
n
B B B
B
C
+ + +

=
L
2 1
1
RecallthatBnisthediscountfactor,whichisthepresentvalueof$1innperiods.Itsimportant
to note that the answer C is a periodic rate, and you must annualize it to get the annual swap
rate.
Pricinganequityswap
LOS57.e:Calculateandinterpretthefixedrate,ifapplicable,onanequityswapandthemarket
valuesofthedifferenttypesofequityswapsduringtheirlives.
1.There are three types of equity swaps: (1) pay fixed rate and receive equity return; (2) pay
floating rate and receive equity return; (3) pay one equity return and receive another equity
return.Weonlyneedtopricethefirsttypeofswapsbecausetherearenofixedratesintheother
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two.
Wehavethesameformulaasfortheplainvanillaswaptogettheperiodicswaprateofanequity
swap:
Why is this the case? We can exchange a fixedrate bond with periodic coupon rate of C for a
stockoranindexwiththenotionalamountequaltotheparvalueofthebond,becausethebond
valueatinceptionisequaltopar.
Valuingaplainvanillaswap
The market value of a swap to the payfixed side is the difference between the value of a
floatingrate bond and the value of a fixedrate bond at any time during the life of the
swap.
CompanyX CompanyY
( )
fix flt swap
B B X = V
flt fix swap
B B Y V = ) (
Notes: the value of a floating rate bond will be equal to the notional amount at any of its
periodicsettlementdateswhenthenextpaymentissettothemarketrate(floating).
CreditRiskinSwaps
LOS 57.i: Evaluate swap credit risk for each party and during the life of the swap, distinguish
between current credit risk and potential credit risk, and illustrate how swap credit risk is
reducedbybothnettingandmarkingtomarket.
1. At any time during the life of a swap contract, one party with the negative value may
default.Theotherpartywithpositivevaluehascreditrisk.
2. Thecreditriskinaswapvariesduringitslifeforinterestrateswap.
Thecreditriskinaninterestrateorequityswapisgreaterduringthemiddleofitslife.
Atthebeginningofitslife,thecreditriskisusuallylowbecausenoonewillenterintoa
swapifthereisagreatdealofcreditrisk.
Attheendofitslife,thecreditriskislowbecausetherearefewmoneypaymentsleft.
3. In a currency swap where the notional principals are exchanged at the contract end, the
creditriskisconcentratedbetweenthemiddleandtheendofitslife.
n
n
B B B
B
+ + +

=
K
2 1
1
C
Paying fixed rate
Paying floating rate
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Case6:MeredithGaleCaseScenario
MeredithGale,ananalystatamoneymanagementfirm,ispreparingforameetingwithclientsto
discussusingequityoptionsandinterestrateswaptionsasinvestmentandhedgingvehicles.Gale
planstofocusonthreemajorissues:
(1)theimplicationsofputcallparityforidentifyingandexploitingarbitrageopportunities,
(2)valuingoptionsbyusingbinomialpricingmodels,
and(3)theapplicationandpricingofinterestrateswaptions.
AllisonBurke,asummerintern,ishelpingGaleprepareforthemeeting.Basedonherresearchon
putcallparityandswaptionvaluation,Burkemakesthefollowingstatements:
1. Based on putcall parity, an arbitrage opportunity is indicated when the price of the
protectiveputisgreaterthanthepriceofthefiduciarycall.
2. Using putcall parity, you can create a long position in a synthetic underlying asset by
combininglongpositionsinacalloption,ariskfreebond,andaputoption.
3.Usingputcallparity,youcanalsocreatesyntheticoptionsonforwardcontracts.Thedatain
Exhibit1canbeusedtoestablishthepriceofsuchasyntheticput.
EXHIBIT1MarketDataforOptionsonForwardContracts
Callprice $7.50
Putprice $18.00
Exerciseprice $55.00
Daystooptionexpiration 175
Daysinyear 365
Forwardprice $46.00
Annualizedriskfreerate 4.00%
Marketvalueofforwardcontract $0.00
Burkealsoexaminesthevaluationofcalloptionswithaoneperiodbinomialpricingmodel.She
uses the information in Exhibit 2, which applies to a non dividendpaying stock whose price
could rise by 12 percent or fall by 15 percent over one year. Based on a oneperiod binomial
model, she calculates the price of a call option on this stock to be $7.44 and concludes that an
arbitrageopportunityisavailable.
EXHIBIT2MarketDataforOptiononNonDividendPayingStock
Annualizedriskfreerate 4.00%
Exerciseprice $45
Currentstockmarketprice $50
Currentcalloptionmarketprice $7.75
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Note:Onecallisexercisableforoneshare.
Inaddition,Galemustaddressthefollowingsituationsoftwoclients:
Client1hasaskedGaletovaluethefollowingEuropeanstyle,interestratepayerswaption:
Thepayerswaptionwasenteredintooneyearagoandismaturingtoday.
Thepayerswaptionisonatwoyearswapthatwillmakesemiannualpayments.
Thepayerswaptionhasanexerciserateof5.10percentandanotionalprincipalof$15
million.
BasedonthedatainExhibit3,theannualizedfixedpaymentontheswapunderlyingthe
payerswaptionis6.20percent.
EXHIBIT3TermStructureofInterestRatsatExpirationofSwaptions
Days Rate DiscountFactor

180 0.0583 0.9717
360 0.0605 0.9430
540 0.0614 0.9157
720 0.0651 0.8848
Finally,GalemeetswithClient2,wholastyearpurchasedaninterestrateswapinwhichhepays
fixed and receives floating. Now, Client 2 would like to know the type of interest rate swaption
contract to buy in order to have the flexibility to remove interest rate uncertainty from his
interestrateswapposition.
19. ToexploitthearbitrageconditiondescribedinBurkesstatement#1,twooftheactions
thatarenecessary,butnotsufficient,are
A.selltheputandselltheunderlyingasset.
B.selltheputandselltheappropriateriskfreebond.
C.buythecallandbuytheunderlyingasset.
CorrectanswerA
SolutionBurkesstatement#1hasthepriceoftheprotectiveputabovethatofthefiduciarycall.
Putcallparityestablishesthatthetwoshouldbeequal.Toexploitanarbitragecondition,one
buysthe(relatively)undervaluedandsellsthe(relatively)overvalued.Thus,inthisproblem,one
wouldselltheovervaluedprotectiveput(selltheputandselltheasset)andbuytheundervalued
fiduciarycall(buythecallandbuytheappropriateriskfreebond).OnlyanswerAisacorrect
statementinexploitingthisarbitrage.
20. IsBurkesstatement#2correct?
A.Yes.
B.No,becausetheappropriatecombinationisalongpositioninacalloption,alongposition
inariskfreebond,andashortpositioninaputoption.
C.No,becausetheappropriatecombinationisalongpositioninaputoption,ashort
positioninariskfreebond,andashortpositioninacalloption.
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CorrectanswerB
SolutionInstatement#2,Burkemischaracterizesputcallparity.Putcallparityis
P
0
+S
0
=C
0
+X/(1+r)
T
Solvingfortheunderlyingasset,S
0
=C
0
+[X/(1+r)
T
)P
0

Therefore,thesyntheticlongassetsareacombinationoflongthecall,longtheriskfreebond,
andshorttheputoption.
21. Thepriceofthesyntheticputinstatement#3isclosestto
A.$15.48.
B.$16.33.
C.$18.00.
CorrectanswerB
SolutionWhendealingwithforwardcontracts,asinBurkesstatement#3,putcallparitymust
bemodified.Ratherthanshortingthestock,aforwardcontractisused.Thecurrentstockprice,
S0,dropsoutoftheformulaandisreplacedbythepresentvalueoftheforwardprice.Thatis:
P
0
=C
0
+[XF(0,T)]/(1+r)
T
SubstitutingthevaluesfromExhibit1:
P
0
=7.5+(5546)/(1.04)
(175/365)
=$16.33
22. BasedonExhibit2andBurkesvaluationofthecalloption,anappropriatesetofarbitrage
transactionsisto
A.sell1,000callsandbuy815shares.
B.sell815callsandbuy1,000shares.
C.buy1,000callsandsell815shares.
CorrectanswerA
SolutionBurkehasvaluedthecallat$7.44.Exhibit2reportsthemarketpriceofthecallis$7.75.
ThecallisovervaluedfromBurkesperspective.Toarbitragethisdifference,Burkeshouldsell
callsandbuytheunderlyingshares.Thus,theansweriseitherAorB.Next,considerthequestion
ofhowmanycallspersharetoformthearbitrage.Notethesefacts:thedeltaofacallisthe
changeinvalueofthecallforaunit($1.00)changeinthevalueofthestock.Deltasrangefrom
+1.00(verydeepinthemoney)to0.00(veryfaroutofthemoney).Ignoringverydeepinthe
moneyoptionswherethehedgeisoneunderlyingassettoonecall,inordertoforma
deltaneutralhedge,oneneedsmorecalls(onaperunitbasis)thanunderlyingassets.
Confirmationcomesfromsolvingthebinomialmodelforthegivenvalues.Theexpirationdate
valuesforthestockare$56(up12%)or$42.5(down15%).Assumeoneborrowsthepresent
valueof$42.50attimezero.Thepayoffsatexpirationfromaportfoliooflongthestockand
shortthebondarezerointhedownstate(42.5042.50)whenthestockissoldandthebond
(loan)paidoffand$13.50intheupstate(5642.50).Theterminalvaluesofthecallwitha
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strikeof$45are$11.00intheupstateand$0.00inthedownstate.Tomaketheexpiration
payoffsmatch,multiplythecallpayoffsby13.50/11.Toavoidarbitrage,foreachshareofstock
boughtoneshouldsell13.50/11callsorforeachcallsoldoneshouldbuy11/13.50stocks.For
1,000calls,thereplicatingportfoliowouldneed815sharesofstock[(11/13.5)1,000].
23. BasedonthedatainExhibit3,themarketvalueoftheEuropeanstyle,interestratepayer
swaptionatexpirationisclosestto
A.$307,000.
B.$330,000.
C.$465,000.
CorrectanswerA
SolutionThevalueoftheswaptionisthesumofthepresentvaluesoftherelatedcashflows.
Thenetcashflowsreflectthefixedrateof6.20%,adjustedforsemiannualpayments,minusthe
exerciserateof5.10%,adjustedforsemiannualpayments,timesthenotionalprincipalof$15
million.Thus,thesemiannualpaymentsare[(0.062/2)(0.051/2)]$15,000,000=$82,500.
FindthePVofthesecashflowsatthegiveninterestrates:$82,500(0.9717+0.9430+0.9157+
0.8848)=$306,504.
24. ToremoveClient2sinterestrateuncertainty,Galeismostlikelytorecommendbuyinga
A.payerswaptionthatwouldallowClient2theoptiontoenterintoaswaptopayfloating
andreceivefixed.
B.receiverswaptionthatwouldallowClient2theoptiontoenterintoaswaptoreceive
floatingandpayfixed.
C.receiverswaptionthatwouldallowClient2theoptiontoenterintoaswaptoreceive
fixedandpayfloating.
CorrectanswerC
SolutionUnderthetermsoftheswapClient2enteredintolastyear,Client2iscurrently
committedtopayingfixedandreceivingfloating.Byenteringintoareceiverswaptiontoreceive
fixedandpayfloating,theclientcanoffsetthecurrentswapcommitmentiffutureconditions
makeitattractivetodoso.
KeyPoints:
PutcallparityforEuropeanoptions
LOS 56.a: Calculate and interpret the prices of a synthetic call option, synthetic put option,
syntheticbond,andsyntheticunderlyingstock,andinferwhyaninvestorwouldwanttocreate
suchinstruments.
Notice thatthe payoff to a fiduciary call is the same as the payoff protective put.Arbitrage
ensures that the two should have the same cost, which leads us to Putcall parity for
Europeanoptions:
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Createsyntheticinstruments
Swaptioncontracts
LOS 57.f: Explain and interpret the characteristics and uses of swaptions, including the
differencebetweenpayerandreceiverswaptions.
1. Aswaptionisanoptiontoenterintoaswap.Wewillfocusontheplainvanillainterestrate
swaption. The notation for swaptions is similar to FRAs. For example, a swaption that
matures in 2 years and gives the holder the right to enter into a 3year swap at the end of
thesecondyearisa25swaption.
2. Apayerswaptionisanoptiontoenterintoaswapasthefixedratepayer.
If interest rate increases, the payer swaption value will go up. So a payer swaption is
equivalenttoaputoptiononacouponbond.
Itsalsoequivalenttoacalloptiononfloatingrate.
3. A receiver swaption is an option to enter into a swap as the fixedrate receiver (the
floatingratepayer).Ifinterestrateincreases,thereceiverswaptionvaluewillgodown.Soa
( )
t t
t T
f
S P
R
+ =
+
+

1
X
C
t
( )
t t
t T
f
t
P C
R
S =
+
=

1
X
V
t

Stock
Forward
Bond
Call
Put
S
t
( )
t T
f t
R X

+ 1 / S
( )
t T
f
R X

+ 1 /
( )
t
p
t
C
There are four synthetic instruments:
A synthetic European call option:
synthetic call = put + stock bond
A synthetic European put option:
synthetic put = call + bond stock
A synthetic pure-discount risk-less bond:
synthetic bond = put + stock call
A synthetic stock position:
synthetic stock= call + bond put
T
f
R
X
S P C
) 1 (
0 0 0
+
+ =
0 0 0
) 1 (
S
R
X
C P
T
f

+
+ =
0 0 0
) 1 (
C S P
R
X
T
f
+ =
+
0 0 0
) 1 (
P
R
X
C S
T
f

+
+ =
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receiverswaptionisequivalenttoacalloptiononacouponbond.
Whyswaptionexist
1. Therearethreeprimaryusesofswaption:
Lockinfixedrate.Ifaninvestoranticipatesafloatingrateexposureatsomefuturedate
(e.g.,hewillbeissuingbondsorgettingaloan),apayerswaptionwouldlockinafixed
rate and provide floatingrate payments for the loan. It would be exercised if the yield
curve shifted up to give the investor (effectively) a loan at the fixed rate on the
swaption.
Interest rate speculation. Swaption can be used to speculate on changes on interest
rates. The investor would buy a payer swaption if he expects rate to rise, or buy a
receiverswaptionifheexpectsratestofall.
Swap termination. Swaption can be used to terminate a swap. A fixed rate payer on
5yearsswapcouldbuya3yearreceiverswaption(atthesamefixedrateastheswap)
expiring in two years. This swaption would give the investor the right to enter into an
offsettingswapattheendoftwoyears,effectivelyterminatingthe5yearswapat the
endofthesecondyear.
Forwardcontractvalue
Valuationofaforwardcontractmeansdeterminingthevalueofthecontracttothelong(or
theshort)atsometimeduringthelifeofthecontract.
Tbill(zerocouponbond)forwards
t T
f
t long
R
FP
S V

+
=
) 1 (

EquityForwardContracts
LOS54.b:Calculateandinterpretthepriceandthevalueofanequityfowardcontract,assuming
dividendsarepaideitherdiscretelyorcontinuously.
Forwardcontractsonadividendpayingstock
Price:
T
f
R PVD S FP ) 1 ( ) ( 0 0 + =

Value:
t T
f
t t long
R
FP
PVD S V

+
=
) 1 (

Forwardcontractsonanequityindex
continuouslycompoundedriskfreerate: =ln(1+R
f
)
continuouslycompoundeddividendyield:
c
Price:
T R
c c
f
e S FP

=
) (
0

Value:
=
) ( ) ( t T R t T
t
long c
f
c
e
FP
e
S
V

ForwardContractsonCouponBonds
LOS 54.c: Calculate and interpret the price and the value of 1) a forward contract on a
fixedincome security,2) a forward rate agreement(FRA), and 3) a forward contract on a
currency.
t
t T
f
long short
S
R
FP
V V
+
= =

) 1 (
c
f
R
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Couponbondsaresimilartodividendpayingstocks,butthecashflowsarecoupons
Price:
T
f
R PVC S FP ) 1 ( ) ( 0 0 + =

Value:
( )
(1 )
t t
long
T t
f
FP
V S PVC
R

=
+

FRAPricing
TheforwardpriceinanFRAisthenoarbitrageforwardrate(FR)
Ifspotratesareknown,TheFRisjusttheunbiasedestimateoftheforwardinterestrate:
(1 / 360) (1 / 360) (1 ( ) / 360)

m m n
L m FR n L m n
+
+ + = + +

CurrencyForwardContracts
Price:coveredInterestRateParity(IRP)
T
T
F
D
R
R
S FP
) 1 (
) 1 (
0
+
+
=

FPandS
0
arequotedincurrencyDperunitofcurrencyF(i.e.,D/F)
Value:
t T
D
t T
F
t
long
R
FP
R
S
V

+
+
=
) 1 ( ) 1 (

Ifyouaregiventhecontinuousinterestrates
( )
0
c c
F D
R R T
FP S e

=

F D
( ) ( )

=

c c
t
long
R T t R T t
S FP
V
e e

L(m) FR/n
L(m+n)
F is Foreign
Currency, not
risk-free rate
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TyraMerinarCaseScenario
Genghasbeenstudyinganinvestmentstrategythatinvolvespotentialchangesincreditratingsof
individualsecurities.Gengstates,IhavebeenevaluatingbondsofOnexCorporation,whichare
currentlyratedBBB.Onexhasjustannouncedanacquisitionthatwebelievewilllikelyweakenits
credit metrics over the next two years. However, longer term, say 4 to 5 years, Onex should
generate enough cash flow to improve credit quality to preacquisition levels. We could use
forwardcontractsonacreditdefaultswap(CDS)index,suchastheCDX,totakeadvantageofthis.
ThebestwaytodothisistobuyCDXinvestmentgradeexpiringin5yearsandsellCDXhighyield
expiringin2years.
25. IsGengsstrategytotakeadvantageofhiscreditexpectationsmostlikelyappropriate?
A.Yes.
B.No,theappropriatestrategywouldbetosell2yearCDSandbuy5yearCDSforOnex
Corporation.
C.No,theappropriatestrategywouldbetobuy2yearCDSandsell5yearCDSforOnex
Corporation.
Answer=C
UsingCreditDerivativestoEnhanceReturnandManageRisk,GeorgeSpentzos
StudySession1759d
Describecreditderivativestradingstrategies,andexplainhowtheyareusedbyhedgefundsand
othermanagers.
Ciscorrect.SinceGengexpectscreditratingsforOnexCorporationbondstoweakenoverthe
neartermuptotwoyears,andthenstrengthenoverthelongerterm(fiveyears),the
appropriatestrategyistobuy2yearCDSandsell5yearCDS.The2yearCDSwouldprovidea
hedgeagainstshorttermvolatility,andthesaleofthe5yearCDSwouldpartiallyfundthe
purchaseof2yearCDS.Thisisaflattenercurvetrade.
Keypoints:
Credit derivatives are used in many strategies, the most common being the basis trade,
curvetrade,indextrade,optionstrade,capitalstructuretrade,andcorrelationtrade.
Basistrade.Inabasistrade,theCDSpremiumiscomparedtotheassetswapspread
oftheunderlyingbond.Thelatterreferstoabondsyieldaboveabenchmarkswap
rate.Thisspreadshouldreflectthecreditriskofthebond.IfitishigherthantheCDS
premium,thebasisisnegativeand,toexploitthearbitrageopportunity,theinvestor
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shouldbuythebondandbuytheCDS.
Curve trade. In a curve trade, the investor has different opinions than the market
aboutthelongtermversusshorttermprospectsforabondissuer.Thetradecanbe
flattener or a steepener. In the flattener, the investor believes that the issuer has
someshortterminstability,butthatitslongtermprospectsaresound.Inthiscase,
theinvestorsbuysashorttermCDSandsellalongtermCDS.
Index trade. Credit indices, such as the Dow Jones iTraxx Asian and Europe indices,
represent opportunities to use CDS to exploit perceived mispricing. A short index
positioncanbeusedtohedgeaportfolioofcreditsorexploitanexpectedincreasein
marketwidecreditrisk.
Options trade. In a receiver option, the option buyer has the right to sell a CDS (go
long the underlying) at some future date. An investor with a bullish outlook would
buyareceiveroptioninanticipationoftighteningcreditspreads.
Capitalstructuretrade.Inacapitalstructuretrade,theinvestorusesCDSstoexploit
different views on a firms various securities, such as, the investor believes that a
subsidiaryhaslesscreditriskthantheparent,sohesellsaCDSonthesubsidiaryand
buysCDSontheparent.
Correlationtrade.
OnetypeofCorrelationtradeisusingthedefaultcorrelationofabasketof
CDSs.
Anothertypeofcorrelationtradeutilizesadeltahedgeofdifferenttranches
ofasyntheticCDO.
For example, a position in an equity tranche could be delta hedged with a
debt tranche position, thereby earning the net difference between the
equity tranche yield and the debt tranche yield. The equity tranche could
alsobehedgedwithabasketofsingleissuerCDSs.
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Economics
Case1:PearlsofGoldenIslandCaseScenario
Golden Island is a country flourishing with tourism and it has huge deposits of precious
commodities (pearls, corals, and so forth), Its currency is called the Sona (S
n
) and its current
exchangerateisS
n
8.50/$US.TheislandisgovernedbyaGovernorGeneral,aparliamentarybody
of elected legislators, and a couple of agencies to regulate the islands major industries: pearls
and tourism. The country, however, does not have its own economic team and there is no
officially published economic data and other information. Economists regularly vacationing on
the island serve as independent consultants to the government and private firms having ties to
the island nation also provide advice to the government. The economists and the private firms
compile data, track economic performance, and publish newsletters relating to Golden Island.
Tirumala Gopal is one such economist and he publishes a monthly newsletter titled,
EcoWisdom.
Gopals EcoWisdom starts with an assessment of the countrys balance of payments. He states,
BasedonthedatainExhibit1,IconcludethatfromMarchtoJune2011,GoldenIslands:
1.currentaccounthasimproved.
2.financialaccounthasdeteriorated,
3.officialreservespositionhasimproved.

Exhibit1
SelectDatafromGoldenIslandsCurrentandCapitalAccounts
Sona(S
n
)inmillions
Quarterending
March2011
Quarterending
June2011
Exportsofgoodsandservices 150 160
Importsofgoodsandservices 130 170
Netforeigndirectinvestmentabroad 200 230
NetportfolioinvestmentinGoldenIsland 250 200
Netinterestincome 15 12
Netbankingflows (50) 15
Currenttransfers (10) 10

1. InregardtoGopalsconclusionsinEcoWisdomconcerningGoldenIslandsbalanceof
payments,heismostaccuratewithrespecttoconclusion:
A. 1.
B. 2.
C. 3.
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Correctanswer:B
ForeignExchangeParityRelations,BrunoSolnikandDennisW.McLeavey,CFA
StudySession418b,c
Explaintheroleofeachcomponentofthebalanceofpaymentsaccounts.
Explainhowcurrentaccountdeficitsorsurplusesandfinancialaccountdeficitsorsurpluses
affectaneconomy.
Ascanbeseenfromthecomputationsbelow,GoldenIslandsfinancialaccounthasdeteriorated
fromthequarterendingMarch2011tothequarterendingJune2011.
Sona(S
n
)inmillions
QuarterendingMarch2011 QuarterendingJune2011
Currentaccount
Exportsofgoodsandservices 150 160
Importsofgoodsandservices (130) (170)
Netinterestincome 15 12
Currenttransfers (10) 10
Total 25 12
FinancialAccount
Netforeigndirectinvestmentabroad (200) (230)
NetportfolioinvestmentinGoldenIsland 250 200
Netbankingflows (50) 15
Total 0 (15)
Netchangeinofficialreserves 25 (3)
KeyPoints
Balanceofpaymentsaccounts
Current Account covers all current transactions that take place in the normal
business of residents of a country, including exports and imports, services, income
(interest, dividends, and a variety of investment income from crossborder
investments)andunilateraltransfers.
Financial Account covers a countrys residents investments abroad and
nonresidents investments in the country, including direct investment made by
companies; portfolio investments in equity, bonds, and other securities; and other
investmentsandliabilitiessuchasdepositsorborrowingwithforeignbanks.
TherearetwosmallaccountsinBOP.Capitalaccounttrackscapitaltransfers(capital
gifts),andneterrorsandomissionsadjustedforstatisticaldiscrepancies.
Thesumofthesetwoaccounts,calledtheoverallbalance,shouldbezero.
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Case2:SagaraCaseScenario
Sagara is a resourceabundant West African country. Although the majority of its population is
impoverished,Sagarahasalonghistoryofadvancededucationandiscommittedtotechnological
progress. Newly elected President Benjamin Banantoumou appoints Fatima NDiarra, Ph.D., as
Economic Development Secretary, and asks her to help him develop progrowth economic
policies.
Shortly after his election, Banantoumou attends a summit of international leaders, where he
learns that a countrys government can provide incentives to its population to pursue certain
activities.Theseactivities,inturn,shouldhelpacountryexperienceconsistenteconomicgrowth.
Hecitesthefollowingactivitiesasimportantinfosteringconsistenteconomicgrowth:
Discoveryofnewtechnologiestoincreaseproductivity.
Investmentinhumancapitaltoboostliteracyandtechnicalskills;and
Increasingconsumptionthroughpopulationgrowth,includingimmigration.
NDiarra,whohasstudiedgrowthaccountingandtheNewGrowthTheory,believesthatSagaras
primary goal should be to raise its per capita GDP, which depends on increasing the countrys
growthrateofcapitalperhouroflabor.Hertworecommendations,therefore,areto:
1.providetaxincentivestostimulatesavings,and
2.investineducationtoraisethepopulationsproductivity.
Banantoumou is convinced that a significant industrial capital investment will persuade foreign
direct investors that he is serious about economic development. He announces that the Sagara
governmentwillconstructalargetirefactorytotakeadvantageofthecountrysrubberresources.
ThefactorywillincreaseSagaraspercapitainvestmentinphysicalcapitalby10%.Banantoumou
expectsthatduetothisinvestment,percapitaGDPwillriseatasimilarrate.
NDiarra is not as optimistic. She cautions Banantoumou that without improvements in
technology(andholdingallelseconstant),therubberfactoryinvestmentwillraisepercapitaGDP
atalowerrate,perhapsbyaslittleas3%,duetotheimpactofthelawofdiminishingreturnson
capitalinvestment.
NDiarra knows that according to the Classical Growth Theory, gains in per capita GDP are
temporary, as the resulting population explosion will lower per capita GDP back to subsistence
realwagelevels.SheconsidersNewGrowthTheorytobemorerealistic,however,believingthat
gainswillspurnewtechnologicaldiscoverieswhich,aspublicgoods,willraisepercapitaGDPin
the longterm. As a result, NDiarra expects that Sagaras technology related investments will
negatethelawofdiminishingreturnsandwillraiseSagarasoverallstandardoflivinginstead.
IntheyearsafterBanantoumouselection,SagarasGDPgrowsover10%annually,thepercapita
GDP increases commensurately, and the countrys literacy rate doubles. Banantoumou believes
thatthenextimportantstepistoprovideelectricitybeyondthecapitalcityintoruralregions,and
begins negotiations with a multinational utility company to be the sole provider of this
infrastructure.
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BanantoumouandNDiarradiscusstheroleofanewregulatorydepartment,whichwilloversee
theutilitycompanywiththeobjectivetocreateasystemthatprovidestheserviceatafairprice.
Banantoumousuggeststhatafairpricewouldbetorequiretheutilitytosetthepriceequaltoits
marginalcostNDiarrawarnsBanantoumouthatifamonopolyisforcedtooperatewherepriceis
setequaltomarginalcostthemonopolywillsufferaloss.Furthermore,NDiarrastatesthatwhile
regulationofmonopoliesmayappeartocontrolcosts,thetotalsocialcostofregulationincludes
numerousunobservedindirectcoststhatimpactdeliveryofelectricity.
Continuing their discussion, NDiarra notes that attempts to regulate firms behavior sometimes
result in the industry being captured by the regulators. Regulators have also been known to
sometimes adopt a sharethegains, sharethepains approach to regulation. She points out
that under the capture hypothesis, the government takes full ownership and control of the
industry(i.e..capturestheindustry)whileunderthesharethegains,sharethepainsapproach,
theindustryremainsprivatelyownedandoperatedwhileregulatorsactintheirownintereststo
keep their jobs in addition to taking into account the often conflicting concerns of legislators,
consumers,andtheindustry.
2. Whichoftheactivities,citedbyBanantoumouaftertheinternationalleaderssummitis
leastimportantforfosteringconsistentgrowth?
A.Discoveryofnewtechnologiestoincreaseproductivity
B.Investmentinhumancapitaltoboostliteracyandtechnicalskills
C.Increasingconsumptionthroughpopulationgrowth.includingimmigration
Correctanswer:C
EconomicGrowth,MichaelParkin
Definethesourcesofeconomicgrowthanddiscussthepreconditionsforeconomicgrowth.
Thethreesourcesofeconomicgrowthinclude:physicalcapitalgrowth,humancapitalgrowth,
andtechnologicaladvances.Increasingconsumptionthroughpopulationgrowthdoesnot
necessarilyleadtoeconomicgrowth.
3. AreNDiarrasrecommendationsappropriatetoachievetheprimarygoalshesetsfor
Sagara?
A.Yes
B.No,becauseinvestmentineducationissubjecttothelawofdiminishingreturns.
C.No,becauseprovidingtaxincentivestoincreasesavingsdoesnotstimulateproductivity.
Correctanswer:A
Discusshowfastereconomicgrowthcanbeachievedbyincreasingthegrowthofphysical
capital,technologicaladvance,andinvestmentinhumancapital.
Compareandcontrastclassicalgrowththeory,neoclassicalgrowththeory,andnewgrowth
theory.
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Thefollowing,accordingtogrowthaccounting,arehelpfulinincreasingthegrowthrateofan
economy:stimulatesaving,stimulateresearchanddevelopment,targethightechnology
industries,encourageinternationaltrade,andimprovethequalityofeducation.NDiarras
suggestionswouldincreaseinvestmentincapitalthroughhighersavings,andincreasing
investmentineducationmakeslaborandmachinesmoreproductive.Inaddition,thenew
growththeorystatesthatknowledgeisnotsubjecttothelawofdiminishingreturns.
4. IsNDiarracorrectincautioningBanantoumouaboutthepotentialriseinpercapitaGDP
fromthetirefactory?
A.Yes.
B.No,becausethelawofdiminishingreturnsappliesonlytolabor.
C.No,becauseGDPpercapitadoesnotdependontechnologicalchange.
Correctanswer:A
Definethesourcesofeconomicgrowthanddiscussthepreconditionsforeconomicgrowth.
DiscusshowtheOneThirdRulecanbeusedtoexplainthecontributionsoflaborand
technologicalchangetogrowthinlaborproductivity.
Theshapeoftheproductivitycurvereflectsthelawofdiminishingreturns,whichstatesthatas
thequantityofoneinputincreasesoutputincreasesbutbyeversmallerincrements.Further,
accordingtotheOneThirdRule,withnochangeintechnology,a1%increaseincapitalperhour
oflaborbringsaonethirdof1%increaseinrealGDPperhouroflabor.
5. NDiarrasunderstandingofthetwogrowththeoriesismostaccuratewithregardto:
A.NewGrowthTheoryonly.
B.ClassicalGrowthTheoryonly.
C.bothClassicalGrowthTheoryandNewGrowthTheory.
Correctanswer:C
Compareandcontrastclassicalgrowththeory,neoclassicalgrowththeory,andnewgrowth
theory.
NDiarrasunderstandingofbothClassicalGrowthTheoryandNewGrowthTheoryiscorrect,as
isherunderstandingoftheirimplications.
ClassicalGrowthTheoryholdstheviewthatthegrowthrateofrealGDPperpersonistemporary
becauseofpopulationexplosion,whereasNewGrowthTheoryholdsthatrealGDPperperson
growsbecausetechnologicalchangeinducesalevelofsavingandinvestmentthatmakescapital
perhouroflaborgrow.
6. NDiarraswarningsregardingtheimpactofregulationontheutilitycompanysprofit/loss
andtotalsocialcostsofregulationaremostlikely
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A.correctregardingboth.
B.correctonlyregardingprofit/loss.
C.correctonlyregardingtotalsocialcostsofregulation.
Correctanswer:A
RegulationandAntitrustPolicyinaGlobalizedEconomy,RogerLeRoyMiller
Explaintherationaleforgovernmentregulationintheformof(1)economicregulationofnatural
monopoliesand(2)socialregulationofnonmonopolisticindustries.
Discussthepotentialbenefitsandpossiblenegativesideeffectsofsocialregulation.
Monopolistsforcedtooperatewherepriceequalsmarginalcostwillsufferlossesandgooutof
businessratherthanfacesuchregulation.Thus,someformofaveragecostpricingmustbeused.
Also,thetotalcostofregulationincludesexpenditureofresourcestocomplywithregulations,
developingcreativeresponsestoregulations,costoflobbyingefforts,andopportunitycosts
imposedonowners,managers,andemployeesofthecompany.
7. NDiarrasdescriptionsofthecapturehypothesisandthesharethegains,sharethepains
approachtoregulationaremostaccuratewithrespectto:
A.both.
B.onlythecapturehypothesis.
C.onlythesharethegains,sharethepainsapproach.
Correctanswer:C
RegulationandAntitrustPolicyinaGlobalizedEconomy,RogerLeRoyMiller
Differentiatebetweenthecapturehypothesisandthesharethegains,sharethepainstheoryof
regulatorybehavior.
Thecapturehypothesisreflectsthefactthatregulatorsoftenendupbeingchampionsofthe
firmstheyarechargedwithregulating.Ineffect,theindustrycapturestheregulators.The
sharethegains,sharethepainstheoryholdsthatregulatorsmainobjectiveissimplytokeep
theirjobsandtotakeintoaccounttheneedsoflegislators,consumers,andindustry.
KeyPoints:
Reading14.EconomicGrowth
TheOneThirdRule:
Atagivenleveloftechnology,a1%increaseincapitalperlaborhourresultsinaonethird
of1%increaseinrealGDPperlaborhour
T
T
k
k
y

+
3
1 y
Itcanbeusedtodivideachangeinproductivitygrowthinto:
Changeincapitalperlaborhour(i.e.movementalongaproductivitycurve)
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TechnologicalChange(i.e.shiftsinaproductivitycurve)
Thecontributionsoflaborandtechnologicalchange
Productivityslowdownsresultwhentechnologyisappliedtodealwithissuesotherthan
increasingproductivity.(technologiesthatincreasefuelefficiency,technologyappliedto
improvingenvironmentalquality)
Thekeymethodsforincreasingeconomicgrowth(i.e.productivityspeedup):
Encouragesavings,
EncouragebasicR&D,
Stimulateinternationaltrade,
Improvethequalityofeducation.
Los14.dcompareandcontrastclassicalgrowththeory,neoclassicalgrowththeory,andnew
growththeory.
Classicaltheory
Thegrowth inrealGDPisnotpermanent.
Technologicaladvancesinvestmentinnewcapital laborproductivityandnew
businessstartanddemandforlaborrealwagesandemploymentpopulation
explosionrealGDP
Subsistencerealwage:minimumrealwagenecessarytosupportlife
Nomatterhowmuchtechnologyadvances,realwageswilleventuallybedrivenbacktothe
subsistencelevel,andnopermanentproductivitygrowthorimprovementinthestandardof
livingwilloccur.
Neoclassicaltheory
Technologicalchangessaving&investmentlaborproductivity
Technologicalchangesrealwagespopulationgrowth

Technologicalchangesincomesandhealthcarepopulationgrowth
Technologydriveseconomicgrowth,buttechnologicalgrowthisnotinfluencedby
economicgrowth
Targetrateofreturn:peopleuseasabenchmarkwhenmakingtheirsavingdecision
Economicgrowthstopsatthepointwheretherealinterestrateisequaltothetargetrate
ofreturn.
Newgrowththeory
Assumptions
Discoveriesaretheresultofchoices
Discoveriesleadtoprofit,butcompetitioneliminatesprofit
Discoveriesarepubliccapitalgoods
ThelawofdiminishingreturnsDOESNOTapplytoknowledgecapital.
Adecreaseinrealinterestrateswillintensifypeoplesintensivetodiscovernew
productsandmethods
Economicgrowthwillequalgrowthincapitalperlaborhour.
Thekeydifferencebetweenthenewgrowththeoryandneoclassicaltheoryisthat
neoclassicaltheorydoesnotincludethelinkbetweenlowerprofitsandtheresulting
incentivetoinnovate.
Undertheneoclassicalmodel,lowerprofitsdonotprovideanincentiveforcompanies
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toinnovateanddevelopnewtechnologies.
R15.RegulationandAntitrustPolicyinaGlobalizedEconomy
Los15.b discussthepotentialbenefitsandpossiblenegativesideeffectsofsocialregulation;
Negativeeffectsofsocialregulation
CreativeResponse(toproducer)
Firmsconformtotheletterofthelaw,butnottheintent,oftheregulation
Example:Companygrantinginterviewtomale&female,buttheofferisonlyextended
tomen.
FeedbackEffect(atypicalexampleofacreativeresponse)
Itoccurswhenconsumersbehaviorischangedasaresultofthenewregulation
Exampleifregulatorsrequiredthatautomobilesutilizefuelmoreefficiently,then
consumersinturnmaybecomelessdiligentintheirefforttoconservefuelanddrive
morebecausetheircosttodrivepermilehasdecreased.Theeffectistoundermine
theoriginalintentoftheregulation,whichwastoreducefuelconsumption
Los15.cdifferentiatebetweenthecapturehypothesisandthesharethegains,sharethepains
theoryofregulatorbehavior.
Capturehypothesis(toregulator)
Basedupontheassumptionthatregardlessofthereasonwhyaregulatoryagencywas
established,itwilleventuallybeinfluencedorcapturedbytheindustrythatisbeing
regulated.
Thesharethegains,sharethepainstheory
Basedupontheassumptionthatregulatorswillstrivetosatisfyallthreeinterested
parties:thelegislator,thecustomers,andtheregulatedfirmsthemselves.
Incontrasttothecapturehypothesis,underthistheorytheregulatorsarenot
completelycapturedbytheregulatedfirm;instead,regulatorsconsiderthe
consequencesoftheirdecisionsfromthestandpointofeachofthethreeaffected
parties.
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Case3:LouiseTremblayCaseScenario
Louise Tremblay, CFA, is a portfolio manager for a global equity fund domiciled in the United
States. She wants to add positions in foreign stocks of Canada and Brazil, two countries where
there is currently no exposure. Tremblay places a call to Hal Baroque, the firms economist, to
arrange a meeting to discuss both his outlook for these economies and some issues related to
foreignexchangerelationsandinternationalassetpricing.Duringthemeeting,Baroquepresents
theinformationhegatheredinpreparationfortheirdiscussion,asshownbelowinExhibit1.
Exhibit1
SelectedCurrencyExchangesandMarketRates
Country Currency SpotExchangeRate* OneYear

RiskfreeRate
Expected
Annual
InflationRate
U.S. USD$ NA 4.80% 2.30%
Canada CAD$ 1.21381.2259 4.10% 1.90%
Brazil Real 2.38442.4082 8.80% 6.30%
*NumberofforeigncurrencyunitsperoneU.S.dollar
Baroquebeginshisdiscussionbyreviewingsomebasicrelationsthatareusefulinunderstanding
the interplay between exchange rates, interest rates, and inflation. He remarks, Theoretically,
theinterestratedifferentialbetweentwocountriesshouldbeequaltotheexpectedinflationrate
differentialoverthetermoftheinterestrate.
TremblayprovidestwojustificationsforaddingCanadianstockstoherportfolio:
1) TherealreturnsarecurrentlyhigherinCanadathanintheUnitedStates.
2) Byherownprediction,CanadawillexperiencehighereconomicgrowththantheUnited
Statesoverthenextthreetofiveyears.SheisconvincedthatchangesinCanadasfinancial
accountbroughtaboutbythishighergrowthwilldominateanychangesinCanadascurrent
accountthatmightoccurbecauseofthishigherrelativegrowth.
BaroquesoutlookforBrazilseconomyisnotfavorable.Heexplainsthatingeneral,theeconomy
of an emerging market tends to have a strongly positive correlation with the value of both its
currency and its stock markets. Baroque thinks that Brazils economic situation will continue to
deteriorate along with the value of its currency, which he expects to depreciate by 5 percent
againsttheU.S.dollaroverthecomingyear.
8. GivenabidsidequoteonthethreemonthforwardcontractofCAD$1.1986perU.S.dollar,
thethreemonthforwardU.S.dollarisquotedatanannualized:
A.5.00%discount.
B.1.25%discount.
C.5.00%premium.
Correctanswer:A
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CurrencyExchangeRates,BrunoSolnikandDennisMcLeavey,CFA
Distinguishbetweenspotandforwardtransactions,andcalculatetheannualizedforward
premium/discountforagivencurrencyandinferwhetherthecurrencyisstrongorweak.
TheU.SdollarbuyslessCanadiandollarsinthefuture:
PremiumorDiscount=[(forwardratespotrate)/(spotrate)]x(12/#ofmonths)x100%
=(1.19861.2138)/(1.2138))x(12/3)x100%
=0.0152/1.2138x4x100%
=0.0125x4x100%=5.00%
9. Accordingtopurchasingpowerparityandbasedonthespotratebidquote,theoneyear
forwardexchangeratefortheCanadiandollarperU.S.dollarisclosestto:
A.CAD$1.2057.
B.CAD$1.2091.
C.CAD$1.2186.
Correctanswer:B
ForeignExchangeParityRelations,BrunoSolnikandDennisMcLeavey,CFA
Defineanddiscussabsolutepurchasingpowerparityandrelativepurchasingpowerparity.
Calculatetheendofperiodexchangerateimpliedbypurchasingpowerparity,giventhe
beginningofperiodexchangerateandtheinflationrates.
PurchasingpowerparitycanbewrittenasS1/S0=(1+I
DC
)/(1+I
FC
).Inthiscase,S1/1.2138=
(1.019)/(1.023)=0.9961.S1=1.2091
10. IfadealersbidsidequotefortheCanadianDollar/BrazilianRealisCAD$0.5250,
TremblaysprofitonaUSD$1,000,000initialinvestmentinthetriangulararbitrage
opportunityisclosestto:
A.USD$21,135.
B.USD$31,315.
C.USD$31,328.
Correctanswer:A
CurrencyExchangeRates,BrunoSolnikandDennisMcLeavey,CFA
Calculatetheprofitonatriangulararbitrageopportunity,giventhebidaskquotationsforthe
currenciesofthethreecountriesinvolvedinthearbitrage.
ItischeapertobuyCanadiandollarsindirectlythroughBrazilianRealsthandirectlywithU.S.
Dollars.Thiscreatesatriangulararbitrageopportunity:
USD$1,000,000x(2.3844)=2,384,400BrazilianReal
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2,384,400x(.5250)=CAD$1,251,810
CAD$1,251,810/1.2259=USD$1,021,135
USD$1,021,135USD$1,000,000=USD$21,135profit
11. ThespecificrelationreferredtoinBaroquesremarkmostaccuratelydescribesthe:
A.interestrateparityrelation
B.internationalFisherrelation
C.purchasingpowerparityrelation
Correctanswer:B
DefineanddiscusstheinternationalFisherrelation.
CalculatetheinternationalFisherrelation,anditslinearapproximationbetweeninterestrates
andexpectedinflationrates.
TheinternationalFisherrelationstatesthattheinterestratedifferentialbetweentwocountries
shouldbeequaltotheexpectedinflationratedifferentialoverthetermoftheinterestrate.
12. WhichofTremblaysjustificationsforaddingCanadianstockstotheportfolioismost
appropriate?
A.1only
B.2only
C.Both1and2
Correctanswer:C
Describethefactorsthatcauseanationscurrencytoappreciateordepreciate.
HigherrealratesandhighergrowtharebothappropriatejustificationsforinvestinginCanada.
13. BasedonthedatapresentedinExhibit1,BaroquesexpectationforBrazilscurrencyisbest
describedas:
A.interestrateparity
B.purchasingpowerparity
C.uncoveredinterestrateparity
Correctanswer:C
Defineanddiscussabsolutepurchasingpowerparityandrelativepurchasingpowerparity.
Calculatetheendofperiodexchangerateimpliedbypurchasingpowerparity,giventhe
beginningofperiodexchangerateandtheinflationrates.
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Defineanddiscussthetheoryofuncoveredinterestrateparity,andexplainthetheorys
relationshiptootherexchangerateparitytheories.
Calculatetheexpectedchangeintheexchangerate,giveninterestratesandtheassumptionthat
uncoveredinterestrateparityholds.
Uncoveredinterestrateparityisaneconomictheoryaboutexpectations.Baroqueisstatingan
expectationregardingBrazilscurrency.Interestrateparityallowsonetopriceaforward
exchangeratecontractgiventhespotexchangerateandthetwointerestrates.Baroqueisnot
pricingaforwardcontract;rather,heisexpressinganexpectation.ForthedatainExhibit1,
interestrateparityimpliesanapproximate4percentdepreciationintheRealagainsttheUSD.
Baroqueexpectsa5percentdepreciation,whichisnotconsistentwithinterestrateparity.For
thedatainExhibit1,purchasingpowerparity(PPP)impliesanexpectedspotrateof2.47763
(calculatedasS1/2.3844=1.063/1.023;solveforS1).Baroqueexpectsthecurrencyto
depreciate5%2.3844(1.05)=2.5036whichisnotconsistentwiththeS1valuecalculatedwith
PPP.
KeyPoints
R17.CurrencyExchangeRates
Los17.dcalculatetheprofitonatriangulararbitrageopportunity,giventhebidask
quotationsforthecurrenciesofthreecountriesinvolvedinthearbitrage;
TriangulararbitragemeansconvertingfromcurrencyAtocurrencyB,thenfromcurrencyBto
currencyC,thenfromcurrencyCbacktoA.IfweendupwithmoreofcurrencyAattheendthan
westartedwith,we'veearnedanarbitrageprofit.
R18.ForeignExchangeParityRelations
TheInternationalParityRelationshipsCombined
Example: AUD: USD=0.6000 - 0.6015
USD: MXN=10.7000 - 10.7200
AUD: MXN=6.3000 - 6.3025
How to arbitrage from these markets?
0.6000-0.6015USD/AUD (1)
10.700-10.720MXN/USD (2)
6.3000-6.3025MXN/AUD (3)
Step One: 1$(1) 1/0.6015AUD(3) (1/0.6015)*6.3000MXN(2)
((1/0.6015)*6.3000)/10.720USD 0.97704USD
Step Two: 1$(2) 1*10.700MXN(3) (1*10.700)/6.3025AUD(1)
((1*10.700)/6.3025)*0.6000USD 1.01864USD
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TheInternationalParityRelationshipsCombined
Los18.mdiscusstheforeignexchangeexpectationrelationbetweentheforwardexchangerate
andtheexpectedexchangerate.
Combining all parity relationships indicates that the expected return on riskfree securities
should be the same in all countries and that exchange rate risk is really just inflation risk.
Therearefivepracticalimplicationsfromthisframework:
Thereal,riskfreereturnwillbethesameinallcountries.
Investingincountrieswithhighnominalinterestrateswillnotgenerate excessreturns
because the high nominal interest rates will be accompanied by local currency
depreciation.
All investors will earn the same expected return in their own currency on any
investmentdenominatedinaforeigncurrency.
Exchange rate risk is simply inflation risk, so investors interested in real returns will
notfaceexchangeraterisk.
Foreign currency risk can be hedged without cost because there is no foreign
currencyriskpremium.
Foreign
exchange
expectations
relation
1
1
x
y
r
r
+
+
( )
1
0
E S
S

1
1
x
y
I
I
+
+
0
F
S

IRP
Fisher
R-PPP

Exchange rate
expectation /
movements
Inflation rate
differential
Forward
discount or
premium
Foreign
Exchange
Expectatio
ns Relation
Interest rate
differentials
Uncovered Interest Rate
Parity
Relative Purchasing Power Parity
International Fisher effect
Interest Rate Parity
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AlternativeInvestment
Case1:ShoshoneCapitalCaseScenario
ShoshoneCapitalisaprivateequityfirmthatstructuresfundsaslimitedpartnershipsforwhichit
serves as the general partner. The funds focus on buyouts of publicly traded companies.
Shoshone has produced a new marketing brochure that it will use to solicit capital investments.
The first section of the brochure describes the common characteristics of buyout investments,
including:
Characteristic1: Thetargetfirmsgenerallyhaveexperiencedmanagementteams.
Characteristic2:Thereisoftenpotentialforsubstantialcostreductionsintargetfirms.
Characteristic 3: The deals are generally arranged through relationships with the existing
shareholders.
Section2ofthebrochurediscusseshowShoshonealignsitsinterestswiththoseofthemanagers
ofitsportfoliocompanies.
Shoshonesbrochureprovidesanexampleofatypicalacquisition,inwhichitpurchasesLUW,Inc.
for$160million.Aftertheacquisition,LUWsnewcapitalstructureconsistsof$80millionindebt,
$65 million in preference shares, and $15 million in common equity. After six years, Shoshone
sellsLUW,Inc.toanotherprivateequityfirmfor$285million.
ThebrochurealsoprovidesanexampleofaprivateequityfundcalledTensleepFund,whichhas
committedcapitalof$150million,amanagementfeeof2%,carriedinterestof20%,andahurdle
rate of 9%. Carried interest is paid on a dealbydeal basis. In the example, the fund calls $100
million in commitments at the beginning of the first year and invests $40 million in Firm A and
$60millioninFirmB.Atthebeginningofthesecondyear,itcallstheremaining$50millionand
investsitinFirmC.Attheendofthesecondyear,theinvestmentinFirmBissoldfor$70million.
Attheendofthethirdyear,thefundsinvestmentinFirmAisworth$54million,itsinvestmentin
FirmCisworth$40million,andithas$46millionincash.
The brochure concludes with the history of a second private equity fund called Pocatello Fund.
ThefirstfiveyearsofthisfundscashflowsanddistributionsarepresentedinExhibit1.
Exhibit1
PocatelloFund
CashFlowsandDistributions(USDmillion)
Year
PaidIn
Capital
Mgmt
Fees
Operating
Results
NAVbefore
Distributions
Carried
Interest

Distributions
NAVafter
Distributions
2005 40 0.8 3 36.2 36.2
2006 55 1.1 4 54.1 54.1
2007 80 1.6 11 88.5 88.5
2008 100 2.0 27 133.5 4.2 19 110.3
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2009 125 2.0 34 167.3 6.6 38 122.7
1. Whichofthecharacteristicslistedinthebrochureregardingbuyoutinvestmentsisleast
likelycorrect?
A.Characteristic1
B.Characteristic2
C.Characteristic3
Answer=C
PrivateEquityValuation,YvesCourtoisandTimJenkinson
StudySession1346c
Distinguishbetweenthecharacteristicsofbuyoutandventurecapitalinvestments.
Ciscorrectbecauseitdescribesventurecapitalinvestments,whicharecommonlytheresultof
relationshipsbetweenventurecapitalistsandentrepreneurs(existingshareholdersorowners).
Mostbuyouttransactionsareauctions,involvingmultiplepotentialacquirers.
2. WhichoftheseclausesismostlikelytobeincludedinSection2ofShoshonesbrochure?
A.Reservedmatters
B.Liquidationpreference
C.Tagalong,dragalongrights
Answer=C
StudySession1346b
Explainhowprivateequityfirmsaligntheirinterestswiththoseofthemanagersofportfolio
companies.
Ciscorrectbecausetagalong,dragalongrightsprotecttheinterestsofmanagers,notthe
privateequityfirm.Tagalong,dragalongrightsensureanypotentialfutureacquirerofthe
companymaynotacquirecontrolwithoutextendinganacquisitionoffertoallshareholders,
includingthemanagementofthecompany.
3. WhenLUW,Inc.issoldbyShoshone,whichpartofitscapitalstructurewillmostlikelyhave
decreasedinsize?
A.Debt
B.Commonequity
C.Preferenceshares
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Answer=A
StudySession1346d
Describevaluationissuesinbuyoutandventurecapitaltransactions.
Aiscorrectbecauseacommonsourceofvaluecreationinleveragedbuyoutsisdebtreduction.
4. Comparedtotheexitroutechosen,ShoshonesleastlikelyalternateexitroutefortheLUW,
Inc.investmentisa(n):
A.liquidation.
B.managementbuyout.
C.initialpublicoffering.
Answer=A
StudySession1346e
Explainalternativeexitroutesinprivateequityandtheirimpactonvalue.
Aiscorrectbecauseliquidationistheroutechosenifthecompanyisnolongerviable.Theexit
routeusedforLUW,Inc.isasecondarymarkettransaction,atapricethatindicatesastrong
company.
5. ThecarriedinterestpaidtothegeneralpartneroftheTensleepFundattheendofthe
secondyearisclosestto:
A.$0.
B.$0.7million.
C.$2.0million.
Answer=A
StudySession1346f,i
Explainprivateequityfundstructures,terms,valuation,andduediligenceinthecontextofan
analysisofprivateequityfundreturns.
Calculatemanagementfees,carriedinterest,netassetvalue,distributedtopaidin(DPI),residual
valuetopaidin(RVPI),andtotalvaluetopaidin(TVPI)ofaprivateequityfund.
AiscorrectbecausealthoughtheinvestmentinFirmBproduceda$10millionprofitintwo
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years,thatfigurerepresentsanannualreturn(IRR)ofonly8.01%=(70million/60million)1/21,
whichisbelowthehurdlerate.Thegeneralpartnerwillnotreceiveanycarriedinterest
paymentsuntilthefundsinternalrateofreturnexceedsthehurdlerate.
6. In2009,thetotalvaluetopaidin(TVPI)ofthePocatelloFundisclosestto:
A.0.46.
B.0.98.
C.1.44.
Answer=C
StudySession1346i
valuetopaidin(RVPI),andtotalvaluetopaidin(TVPI)ofaprivateequityfund.
Ciscorrectbecausetotalvaluetopaidin(TVPI)equalsdistributedtopaidin(DPI)plusresidual
valuetopaidin(RVPI),whereDPIisthesumofdistributionsdividedbypaidincapital[(19+
38)/125]=0.46andRVPIisNAVafterdistributionsdividedbypaidincapital(122.7/125)=0.98.
TVPI=0.46+0.98=1.44.
Keypoints
Los46.cdistinguishbetweenthecharacteristicsofbuyoutandventurecapitalinvestments

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EconomictermsofaPEfund
Managementfees&Transactionfees
Management fees: These are fees paid to the GP on an annual basis as a
percentofpaidincapitalinvestedandusuallyrangefrom1.5%to2.5%.
Transaction fees: These are paid to the GP for fund investment banking
services,suchasarrangingamerger.Thesefeesareusuallysplitevenlywith
theLPsand,whenpaid,aredeductedfrommanagementfees.
Carriedinterests,Ratchet,&Hurdlerate
Carriedinterest:ThisistheGPsshareofthefundprofitsandisusually20%
aftermanagementfees.
Ratchet: This specifies the allocation of equity between stockholders and
managementoftheportfoliofirmandallowsmanagementtoincreasetheir
allocation,dependingonfirmperformance.
Hurdle rate: This is the IR that the fund must meet before the GP can
receivecarriedinterest.Itusuallyvariesfrom7%to10%andincentivizesthe
GP.
Targetfundsize,Vintage,&Termofthefund
Targetfundsize:ThestatedtotalmaximumsizeofthePEfund,specifiedas
anabsolutefigure.ItsignalstheGPsabilitytomanageandraisecapitalfor
afund.Itisanegativesignalifactualfundsultimatelyraisedaresignificantly
lowerthantargeted.
Vintage: This is the year the fund was started and facilitates performance
comparisonswithotherfunds.
Term of the fund: As discussed previously, this is the life of the firm and is
usuallytenyears.
Keymanclause&performancedisclosureandconfidentiality
Keymanclause:Ifakeynamedexecutiveleavesthefundordoesnotspend
a sufficient amount of time at the fund, the GP may be prohibited from
makingadditionalinvestmentsuntilanotherkeyexecutiveisselected.
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Performance disclosure and confidentiality: This specifies the fund
performanceinformationthatcanbedisclosed.Notethattheperformance
informationforunderlyingportfoliocompaniesistypicallynotdisclosed.
Clawback&distributionwaterfall
Clawback: If a fund is profitable early in its life, the GP receives
compensationfromtheGPscontractuallydefinedshareofprofits.Undera
clawback provision, if the fund subsequently underperforms, the GP is
requiredtopaybackaportionoftheearlyprofitstotheLPs.Theclawback
provisionisusuallysettledatterminationofthefundbutcanalsobesettled
annually(alsoknownastrueup).
Distribution waterfall: This provision specifies the method in which profits
willflowtotheLPsandwhentheGPreceivescarriedinterest.Twomethods
are commonly used. In a dealbydeal method, carried interest can be
distributedaftereachindividualdeal.Thedisadvantageofthismethodfrom
the LPs perspective is that one deal could earn $10 million and another
could lose $10 million, but the GP will receive carried interest on the first
deal,eventhoughtheLPshavenotearnedanoverallpositivereturn.
Tagalong,dragalongclause&Removeforcause
Tagalong, dragalong clauses: Anytime an acquirer acquires control of the
company, they must extend the acquisition offer to all shareholders,
includingfirmmanagement.
Removal for cause: This clause allows a GP to be fired if a supermajority
(usually75%ormore)oftheLPsagreetodoso.
Nofaultdivorce&Investmentrestrictions
Divorce for cause: This provision allows for the firing of a manager or the
termination of a fund given sufficient cause (e.g., a felony conviction of a
seniormanager).
Investmentrestrictions:Thesespecifyleveragelimits,aminimumamountof
diversification,etc.
Coinvestment
Coinvestment: This provision allows the LPs to invest in other funds of the
GP at low or no management fees. This provides the GP another source of
funds. The provision also prevents the GP from using capital from different
funds to invest in the same portfolio company. A conflict of interest would
arise if the GP takes capital from one fund to invest in a troubled company
thathadreceivedcapitalearlierfromanotherfund.
BuyoutValuationIssues
CalculatingPayoffMultiplesandIRRsforEquityInvestors
Calculatingtheexitvalue
Calculatingtheclaimantspayoffs:
Debt
Preferenceshares
PEfirms
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Management
Calculating the total investment and total payoff, using these two can get
thepayoffmultiplesforPEfirms
CalculatingtheIRRsforPEinvestorsandmanagementequity
VCValuationIssues
PreandPostMoneyValuation
Thepostmoneyvaluationofthefirmis
PRE+INV=POST
TheownershipproportionoftheVCinvestorisINV/POST
Forasinglefinancinground
Step1:PostMoneyValuation
POST=FV/(1+r)
N
Step2:PreMoneyValuation
PRE=POSTINV
Step3:OwnershipFraction
f=INV/POST
Step4:No.ofthesharestobeheldbythePEfirm
S
pe
=S
e
[f/(1f)]
Step5:Pricepershare
P=INV/S
pe
Typeofexitroutes
IPO(InitialPublicOffering)
In an IPO, a firms equity isoffered for public sale. An IPO usually results in
the highest exit value due to increased liquidity, greater access to capital,
and the potential to hire better quality managers. However, an IPO is less
flexible, more costly, and a more cumbersome process than the other
alternatives.
SecondaryMarketSale
Inasecondarymarketsale,thefirmissoldtoanotherinvestorortoanother
firminterestedinthepurchaseforstrategicreasons(e.g.,afirminthesame
industry wishes to expand its market share). Secondary market sales from
oneinvestortoanotherarequitefrequent,especiallyinthecaseofbuyouts.
VCfirmsaresometimesexitedviaabuyouttoanotherfirm,butVCfirmsare
usuallytooimmaturetosupportalargeamountofdebt.Secondarymarket
salesresultinthesecondhighestfirmvaluationsafterIPOs.
MBO(ManagementBuyout)
In an MBO, the firm is sold to management, who utilize a large amount of
leverage. Although management will have a strong interest in the
subsequent success of the firm, the resulting high leverage may limit
managementsflexibility.
Liquidation
Liquidation, the outright sale of the firms assets, is pursued when the firm
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is deemed no longer viable and usually results in a low value. There is
potentialfornegativepublicityasaresultofdisplacedemployeesandfrom
theobviousimplicationsofthefirmsfailuretoreachitsobjectives.
EvaluatingperformanceofPEfund
ThemorepopularmultiplesandthosespecifiedbyGIPSincludethefollowing:
PIC(paidincapital).ThisisthecapitalutilizedbytheGEItcanbespecified
inpercentagetermsasthepaidincapitaltodatedividedbythecommitted
capital.Alternatively,itcanbespecifiedinabsolutetermsasthecumulative
capitalutilizedorcalleddown.
DPI (distributed to paidin capital). This measures the LP's realized return
andisthecumulativedistributionspaidtotheLPsdividedbythecumulative
invested capital. It is net of management fees and carried interest. DPI is
alsoreferredtoasthecashoncashreturn.
RVPI (residual value to paidin capital). This measures the LP's unrealized
return and is the value of the LP's holdings in the fund divided by the
cumulative invested capital. It is net of management fees and carried
interest.
TVPI (total value to paidin capital). This measures the LP's realized and
unrealized return and is the sum of DPI and RVPI. It is net of management
feesandcarriedinterest.
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Case2:StrongFamilyCorporationCaseScenario
The Strong Family Corporations portfolio has two allocations to alternative investments: one to
Real Estate and one to Private Equity. The primary purpose of the Real Estate allocation is to
producehighcurrentcashflows,ratherthanlongtermcapitalgains.ThePrivateEquityallocation
isintendedtoproducecapitalgainsoverthelongterm.
Kathryn Reed, CFA. Strongs portfolio manager, is considering a number of properties to add to
theRealEstateportfolio.AftercarefulanalysisofPropertyA,shehasestimatedtheaftertaxcash
flows shown in Exhibit 1. The asking price of Property A is $6.39 million, investment in the
propertywouldbe100%equity,andStrongseffectivemarginaltaxrateis26%.
Exhibit1
PropertyAEstimatedAfterTaxCashFlows
Year AfterTaxCashFlow($millions)
1 0.26
2 0.44
3 0.74
4 0.91
5 6.11
AspartofherreviewofPropertyB,Reedisanalyzingitseventualsale.Detailsofheranalysisof
thiseventarefoundinExhibit2
Exhibit2
InformationRegardingtheSaleofPropertyBinYear10
Purchaseprice $4,570,000
Expectedsellingprice $8,300,000
Accumulateddepreciation $1,520,000
Mortgagebalanceoutstanding $1,140,000
Sellingexpenses $539,500
Taxesondepreciationrecapture 25%
Taxesofcapitalgains 20%
Reed is also analyzing Property C. The acquisition cost of this property is $2.3 million. If
purchased,55%ofthepurchasepricewillbeborrowedat9.0%throughanamortizingmortgage
with a 25year term and monthly compounding. The remaining funds will come from equity
investment and the Strong portfolios required return for equity investment in properties of this
sortis14.5%.
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On the private equity side, Reed is considering an investment in Pegasus Technology b (PTb), a
new US.based private equity fund that will acquire firms in the aerospace industry and is
currentlybeingformedbyPegasusTechnologyOptions(PTO).Whilereviewingitsprospectus,she
learns that PTb will reorganize each company it acquires so that a future acquirer cannot take
controlwithoutextendingapurchaseoffertoallshareholders,includingcurrentmanagement.In
aphoneconversationwiththegeneralpartnerhereferstothisasanofaultdivorceclause
The PTb prospectus provides some performance information for Pegasus Technology a (PTa),
PTOsfirstaerospacefund,whichhasthesamegeneralpartnerasPTb.PTascommittedcapitalis
$100 million, The funds yearly capital calls, operating results, and distributions are shown in
Exhibit3.Itsfeesconsistofa2.0%managementfeeandcarriedinterestof20%.
Exhibit3
PTasCapitalCalls,OperatingResults,andDistributions($millions)
2004 2005 2006 2007 2008
Calleddown 40 20 15 15 10
Realizedresults 0 0 10 25 35
Unrealizedresults 10 5 30 10 25
Distributions 0 0 0 25 40
7. GiventhestatedpurposeofitsRealEstateallocation,inwhichofthesepropertytypesis
theStrongportfoliomostlikelytoinvest?
A.Warehouses
B.Officebuildings
C.Hotelsandmotels
Correctanswer:A
InvestmentAnalysis,JamesD.Shilling
Illustrate,foreachtypeofrealpropertyinvestment,themainvaluedeterminants,investment
characteristics,principalrisks,andmostlikelyinvestors.
Aiscorrectbecausewarehousestypicallyprovidelittlevalueappreciationandthereforeoffer
highercashflowsrelativetothelevelofinvestmentthanotherpropertytypes.
8. TheaftertaxreturnatwhichReedwouldpurchasePropertyAfortheStrongportfoliois
closestto:
A.4.87%.
B.5.77%.
C.6.58%.
Correctanswer:C
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Evaluatearealestateinvestmentusingnetpresentvalue(NPV)andinternalrateofreturn(IRR)
fromtheperspectiveofanequityinvestor.
CiscorrectbecauseitistheIRR(internalrateofreturn)oftheaftertaxcashflowsprovided.
9. AccordingtoReedsanalysis,theaftertaxequityreversionofPropertyBwouldbeclosest
to:
A.$1,032,400.
B.$5,602.400.
C.$6,742,400.
Correctanswer:B
Calculatetheaftertaxcashflowandtheaftertaxequityreversionfromrealestateproperties.
Biscorrectbecause,followingFigure10onpage21,theaftertaxequityreversioniscalculated
asfollows:
Salesprice $8,300,000
Lesssellingexpenses 539,500
Netsalesprice 7,760,500
Lessadjustedbasis
Purchaseprice 4,570,000
Lessaccumulateddepreciation1,520,000 3,050,000
Gainonsale 4,710,500
Gainonsalelessdividendrecapture 3,190,500
Taxoncapitalgain@20% 638,100
Taxondepreciationrecapture@25% 380,000
Taxesdueonsale 1,018,100
Salesprice 8,300,000
Lesssellingexpenses 539,500
Lessoutstandingmortgagebalance 1,140,000
Lesstaxesdueonsale 1,018,100
Aftertaxequityreversion 5,602,400
10. Usingthebandofinvestmentmethod,thecapitalizationrateforPropertyCisclosestto:
A.11.48%.
B.12.06%.
C.13.68%.
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Correctanswer:B
IncomePropertyAnalysisandAppraisal,JamesD.Shilling
Determinethecapitalizationratebythemarketextractionmethod,bandofinvestmentmethod,
andbuiltupmethod,andjustifyeachmethodsuseincapitalizationratedetermination.
Biscorrectbecauseinordertocalculatethecapitalizationrateusingthebandofinvestment
method,onemustfirstdeterminethemortgageconstant,whichcanbefoundbyfirstcalculating
themonthlyannuitypaymenton$1principalforthemortgagerateandterm(300payments,$1
presentvalue,9%/12monthlyrateimpliesamonthlypaymentof0.008392)andmultiplyingby
12(120.008392)=0.1007or10.07%.Thecapitalizationrateistheweightedaverageofthe
mortgageconstantandtherequiredequityreturn,or(0.5510.07%)+(0.4514.5%)=12.06%.
11. PTbsgeneralpartnersdescriptionofaprovisionasanofaultdivorceclauseis:
A.correct.
B.incorrect,becauseitisacoinvestmentclause.
C.incorrect,becauseitisatagalong,dragalongrightsclause.
Correctanswer:C
PrivateEquityValuation,YvesCourtois,CFA,andTimJenkinson
Explainprivateequityfundstructures,terms,valuation,andduediligenceinthecontextofan
analysisofprivateequityfundreturns.
Ciscorrectbecauseatagalong,dragalongrightsclauserequiresafutureacquirertomakean
offerforallsharesbeforetakingcontrol.
12. In2006,thecarriedinterestearnedbythegeneralpartnerofPTawasclosestto:
A.$0.0million.
B.$23million.
C.$3.0million.
Correctanswer:A
PrivateEquityValuation,YvesCourtois,CFA,andTimJenkinson
valuetopaidin(RVPI),andtotalvaluetopaidin(TYPI)ofaprivateequityfund.
Aiscorrectbecausein2006theNAVbeforedistributionswas$83.5million,whichislessthan
thecommittedcapital($100million);therefore,nocarriedinterestisearned.Seebelowfora
tableshowingresults.
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Year Called
Down
Paidin
Capital
Mgmt
Fees
Operatin
gResults
NAV
before
Distributi
ons
Carried
Interest
Distrib
ution
NAV
after
Distribu
tion
2004 40 40 0.8 10 29.2 29.2
2005 20 60 1.2 5 43.0 43.0
2006 15 75 1.5 30 86.5 76.5
KeyPoints
ATCF&ATER
CalculationProcess:
Step1:determinetaxpayable
Taxes=(NOIDep.Int.)Xinvestorsmarginalincometaxrate
Step2:DetermineATCF
ATCF=NOIdebtservicetaxespayable
Step3:DetermineATER
ATER=salespricesalesexp.mortgagebalancetaxonsales
Recaptureddepreciation:
Depreciation that was taken in anticipation of a decline in the value of an asset which
ultimatelydidnotmaterialize.
Recaptureddepreciation capitalgain t1t2realizedgain
accumulated depreciation (AD) realized gaint1realized gain
AD ADgaint1t2
Example:Bandofinvestmentmethod
Apropertyisfinanced65%witha20yearmortgageand35%ofequitycapital.Theinterest
rate on the mortgage is 8% with monthly payments. The required cash on cash return on
equitycapitalis12%.Computethemarketcapitalizationrate.

Sinkingfundfactorcalculation:
N=20*12=240;I/Y=8/12;FV=1;PV=0;(CPT)PMT=0.0017
Sinkingfundfactor=PMT*12=2.04%
Mortgagecost=returnonfunds+returnofcapitaltolender=8%+2.04%=10.04%
R0(BOI)=65%*10.04%+35%*12%=10.73%
PrivateEquityFundStructure
CorporateGovernancetermsofaPEfund
Tagalong,dragalongclause&Removeforcause
Tagalong, dragalong clauses: Anytime an acquirer acquires control of the
company, they must extend the acquisition offer to all shareholders,
includingfirmmanagement.
Removal for cause: This clause allows a GP to be fired if a supermajority
(usually75%ormore)oftheLPsagreetodoso.
Nofaultdivorce&Investmentrestrictions
Divorce for cause: This provision allows for the firing of a manager or the
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termination of a fund given sufficient cause (e.g., a felony conviction of a
seniormanager).
Investmentrestrictions:Thesespecifyleveragelimits,aminimumamountof
diversification,etc.
Clawback&distributionwaterfall
Clawback:Ifafundisprofitableearlyinitslife,theGPreceivescompensation
from the GPs contractually defined share of profits. Under a clawback
provision,ifthefundsubsequentlyunderperforms,theGPisrequiredtopay
back a portion of the early profits to the LPs. The clawback provision is
usually settled at termination of the fund but can also be settled annually
(alsoknownastrueup).
Distribution waterfall: This provision specifies the method in which profits
willflowtotheLPsandwhentheGPreceivescarriedinterest.Twomethods
are commonly used. In a dealbydeal method, carried interest can be
distributedaftereachindividualdeal.Thedisadvantageofthismethodfrom
theLPsperspectiveisthatonedealcouldearn$10millionandanothercould
lose $10 million, but the GP will receive carried interest on the first deal,
eventhoughtheLPshavenotearnedanoverallpositivereturn.
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Ethics
Case1:VictoriaMaciaCaseScenario
VictoriaMacia,CFA,isaseniorpartneratRobonAssetManagementaninternationalequityfund
manager affiliated with a global bank. Robons client base includes segregated retail clients,
pension plans, and both mutual and hedge funds. Robon is a newly established firm currently
assessingsoftdollararrangementsthatwouldreduceitsdirectexpenses.
Macia is responsible for initiating all of Robons brokerdealer relationships and is currently
reviewingaproposalfromDigaSecurities.Diga,anaffiliatedcompany,wouldlikeRobontolocate
their business in Digas hedge fund hotel, a hedge fund incubator business center, and has sent
Maciathefollowingnote:
Our welllocated midtown office space provides a full array of business amenities for financial
services companies. All offices come fully wired with phones and computers for investment and
support staff, as well as a complete trading desk with widescreen televisions and Bloomberg
terminals.Sincewearebothpartofthesameglobalbank,thismovewouldalsolookgoodona
corporatelevel.Anychargesforservicesandspacecanbepaidforwitheitherhardorsoftdollars.
Whenyouexecuteatleasthalfofallofyourtradeswithus,wewillhelpyouraiseassetsforyour
hedgefundbyconnectingyouwithourclientswhoarequalifiedinvestors.
Digachargestradingcommissionsthataverage2.5centspershare,whichMaciaconsiderstobe
thebestexecutionRoboncouldachievebaseduponher20yearsofexperienceatotherfirmsin
the investment business. Diga provides proprietary research related to the market for equity
securities, such as trade analytics, and advice on execution strategies. Both of these research
toolswouldbenefitallofRobonsclients.Afterconsideringseveralotherbrokers,comparingthe
quality of services offered and their financial position, Macia decides to work out an agreement
withDiga.
In order to be competitive and build its business, Robon claims to meet the CFA Institute Soft
DollarStandards.Maciahasinstitutedthefollowingpracticestocomplywiththisclaim:
Providesoftdollardisclosureeveryotheryear;
Providesoftdollardisclosuretohedgeandmutualfundclients;and
Provideanynecessarydisclosuresinthefirmsbrochure,whenintroducingRobontonew
clients.
Several of Macias partners who manage the firms hedge funds disagree with her attempts to
haveRoboncomplywithCFAInstituteSoftDollarStandards.Thesepartnersstatetheirobjections
asfollows:
We are hedge fund managers, so why do we need to disclose our soft dollar arrangements to
ourclients?Hedgefundcustomersaremoresophisticatedthanmostandarefullyawareofthe
issuesrelatedtosoftdollars.
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Inaddition,sincetheresearchwereceiveisproprietary,wearelegallyrestrictedfromdisclosing
itsuse.
MacianextreviewsRobonsbrochureforprospectiveclients.Itincludesthefollowingstatements:
It is our policy to comply with the CFA Institute Soft Dollar Standards. All of our brokerage
accountsmaygeneratesoftdollarsthatRobonusestopurchaseequityresearch.Equityresearch
that Robon pays for with soft dollars may benefit clients other than those whose trades
generated the brokerage. For the purposes of this brochure, soft dollar brokerage refers to
transactionsconductedonanagencybasisanddoesnotincludetradesconductedonaprincipal
basis.
Robons disclosed brokerage policy is to seek best execution, commingle all trades, and average
thebrokeragecostsacrossallclientssothattheycanallbenefitfromvolumediscounts.
1. TheproposedarrangementbetweenRobonandDigaleastlikelyviolateswhichofthe
following?
A.Dutiestoclients
B.SoftDollarStandards
C.Communicationwithclients
Correctanswer:C
GuidanceforStandardsIVII,CFAInstitute
CFAInstituteSoftDollarStandards
DemonstrateathoroughknowledgeoftheCodeofEthicsandStandardsofProfessionalConduct
byapplyingtheCodeandStandardstospecificsituations.
Determinewhetheraproductorservicequalifiesaspermissibleresearchthatcanbe
purchasedwithclientbrokerage.
CiscorrectasitdoesnotappearthattherehasbeenaviolationofthisStandardsince
communicationwithclientsisnotnecessaryduringthenegotiatingprocess.
2. WithrespecttoclientreferralsbyDigaSecuritiec,Maciasmostappropriatecourseof
actionisto:
A.providefulldisclosureofthearrangementtoallclients.
B.refusetoallocateaclientsbrokeragebasedontheamountofclientreferrals.
C.determineifthebrokerprovidesbestexecutionpriortoenteringintothearrangement.
Correctanswer:B
Critiquecompanysoftdollarpracticesandpolicies
Biscorrectasaninvestmentmanagershouldnotallocateaclientsbrokeragebasedonthe
amountofclientreferralstheinvestmentmanagerreceivesfromabroker.
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3. MaciasevaluationofDigasabilitytoprovidebestexecutionalsoneedstoincludewhichof
thefollowing?
A.Thebrokersfinancialstability
B.Therangeofservicesofferedbythebroker
C.Theobligationtogenerateaspecificamountofbrokerage
Correctanswer:C
Ciscorrect.Althoughanagreementtogenerateaspecificamountofbrokerageisnotsomething
thatisrequiredtobeevaluatedinthecontextofbestexecution,itisanagreementthatshould
bedocumentedandmaintained.
4. AreRobonssoftdollarpoliciesincompliancewiththeCFAInstituteSoftDollarStandards?
A.No.
B.Yes,becausedisclosureisprovidedonatimelybasis.
C.Yes,becausetheyprovidethenecessaryinformationtoallmutualandhedgefunds.
Correctanswer:A
DefinesoftdollararrangementsandstatethegeneralprinciplesoftheSoftDollarStandards.
Aiscorrectasfullandfairdisclosureisnotprovidedannuallyasrequired,norisitprovidedtoall
clients,includingretail.
5. InordertobeincompliancewiththeCFAInstituteSoftDollarStandards,Robonsbrochure
shouldmostlikelyberevisedtodiscloseallofthefollowingexcept
A.whetheranyaffiliatedbrokerisinvolved
B.toserveasanannualsoftdollardisclosure
C.researchmayalsobeobtainedasaresultofprincipaltrades.
Correctanswer:B
Biscorrectastheannualsoftdollardisclosuremustbeprovidedatleastannuallytoallclients
anditisnotsufficienttosimplyreferclientstothefirmsbrochure.
6. DoRobonsbrokeragearrangementsmeettherequirementsoftheCFAInstituteSoftDollar
Standards?
A.No.
B.Yes,becauseallclientsaretreatedequally.
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C.Yes,becauseclienttradescanbecommingled.
Correctanswer:A
Aiscorrect.TheStandardsrequirethattheinvestmentmanagernotusebrokeragefromanother
clientaccounttopayforaproductorservicepurchasedundertheclientdirectedbrokerage
arrangement.
KeyPoints:
Contrastbetweensomesimilarstandards
1. I(C)Misrepresentation,III(D)performancePresentation,V(B)Communicationwithclients
I(C) focuses on performance presentation, so guarantee the investment performance
with volatile return, misrepresentation of service and qualification, and plagiarism
violatethisstandard.
III(D)focusesonthestatementofperformancetoclients,sothemisleadingstatement
concerningperformance,includinggiveclientsthehintthattheycanearnthehistorical
yield,violatethisstandard
V(B) focuses on disclosing the member's own changes for clients, letting clients know
theirinformation,anddifferenciatingbetweenfactandopinion
2. III(B)Fairdealing,VI(B)PriorityofTransactions
III(B)focusesonconstrainingthefairnessoftheorderoftransactionbetweenclients
VI(B)focusesontheorderoftransactionamongclients,individualsandemployers
3. IV(B)Additionalcompensationarrangement,VI(A)DisclosureofConflicts
IV(B)focusesondisclosingtheadditionalcompensationfromclientsandthethirdparty
totheemployer
VI(A) focuses on disclosing the possible interest conflict to clients and public, so that
clientscanhaverightjudgments
CFAInstituteSoftDollarStandard
I. General
Required:
Softdollarpracticesmustbenefittheclientandmustplacetheclientsinterestsbefore
theinvestmentmanagersinterests.
Allocationofclientbrokerageshouldnotbebasedontheamountofclientreferralsthe
investmentmanagerreceivesfromabroker.
Regardingmutualfunds,theinvestmentmanagersclientisthefund.Thefundsboard,
notthefundshouldsetpoliciesregardingbrokerselection.
II. RelationshipsWithClients*
Required:
Disclose to the client that the manager may engage in soft dollar arrangements
involvingtheclientsaccountpriortoengaginginsucharrangements.
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Recommended:
For agency trades: It is permissible to use a clients brokerage to obtain research that
may not directly benefit the client. But over a reasonable period of time, the client
shouldreceivethebenefitsofresearchpurchasedwithclientbrokerage.Benefitothers
onlyifmutuallybenefit.
Forprincipaltrades:
IfsubjecttoERISA,clientbrokeragemustbenefittheclientaccountonly;
IfNot,itispermissibletouseclientbrokeragetobenefitotherclientaccounts,as
longasthisisdisclosedtotheclientandpriorconsentisreceived.
III. SelectionofBrokers
Purpose:
Investmentmanagermusthavetheabilitytoaddvaluetotheclientportfolios.
Thefailuretoobtainbestexecutionwillhurtperformancefortheclient.
Required:
Mustconsiderthetradeexecutioncapabilitiesinselectingbrokers.
Recommended:
When evaluating best execution, consider the brokers financial responsibility,
responsiveness to the investment manager, commission rate or spread involved, and
rangeofservicesprovided.
IV. EvaluationofResearch (Required)*
whethertouseclientbrokeragetopayforresearch,considerfollowingcriteria:
Researchmustmeetthedefinition.
Researchmustbenefittheclient.
Thebasisforthedeterminationsmustbedocumented.
Certainfiduciaryregulationsundertheprincipaltrades(eg.ERISA)
Theinabilitytodecideanddocumentthattheresearchmeetstheabovecriteriarequiresthe
investmentmanagermustpayfortheresearch.
Inthecaseofmixeduseresearch
makeareasonable,justifiable,anddocumentableallocationofthecostoftheresearch
basedonitsexpectedusage.
Paywithclientbrokerageonlytheportionsoftheresearchthatisactuallyusedbythe
investmentmanagerintheinvestmentdecisionmakingprocess.
Reevaluatethemixeduseresearchallocationatleastannually.
V. ClientDirectedBrokerage*
Principle:
Thepracticeofclientdirectedbrokeragedoesnotviolateanyinvestmentmanagerduty
perse.(broker, bestexecution.)
Required:
Must not usebrokerage from another client to pay for products or services purchased
underanyclientdirectedbrokerageagreement.
Recommended:
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Theinvestmentmanagershoulddisclosetotheclient:
thedutytoseekbestexecution.
the arrangement may adversely affect the managers ability to obtain best execution
andreceiveadequateresearchfortheclient.
Theinvestmentmanagershouldstructurethearrangementssothattheydonotrequire
the commitment of a certain portion of client brokerage to a single broker. The
arrangement should ensure that commissions are negotiated and that there is an
emphasisonbestexecution.
RefertoAppendix3A
VI. Disclosure*
Required:
Investmentmanagersmustdiscloseinplainlanguagetheirsoftdollarpolicies.
Toclientsandpotentialclients:
Whethercanusetheresearchtobenefitotherclients;
Whetherthetradesinvolveprincipaltrades.
Toclients(shouldmakeadditionaldisclosureexcepttheabove):
thetypesofresearchreceivedthroughproprietaryorthirdpartyresearch;
theextentofuse;
whetheranaffiliatedbrokerisinvolved.
To claim compliance with Soft Dollar Standards, the client must receive a statement
that soft dollar practices conform to these standards, and the statement must be
providedatleastannually.
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Case2:WilsonMachariaCaseScenario
Wilson Macharia, CFA. a lawyer specializing in trusts and estate planning, acts as a professional
trusteeonbehalfofseveralpensionfundswhorequirelegalexpertise.Healsoprovidesinputson
theinvestmentprocessandmonitoringoftheperformanceofthefunds.Machariaoftencarries
outtrainingseminarstodiscusspertinentissuesconcerningtrustlawandtrusteeresponsibilities.
Duringarecenttrainingsessionwithtrusteesofapensionfund,heinformedthetrusteesabout
the requirements of prudence. Macharia outlined what he thought were the most important
parametersofthenewPrudentInvestorRuleasfollows:
Parameter1: Diversificationisrequiredonlyifitisappropriatetoachievethefundsobjectives.
Parameter2: Trustees must consider fees, costs, and other expenses when makinginvestment
decisions.
Parameter3: Trusteesmustnowdelegateassetmanagementtoaprofessionalfundmanager.
Macharia went on to discuss the differences between the old Prudent Man Rule and the new
PrudentInvestorRuleasshowninExhibit1.
Exhibit1
ChangesinPrudentRules
Features OldPrudentManRule NewPrudentInvestorRule
A
Each investment within a portfolio
mustmeettheprudencetest.
Prudencetestisonthewholeportfolio,not
onindividualsecuritieswithintheportfolio.
B
A trustee is required to perform
dutiespersonally.
A trustee is allowed to delegate duties to
others.
C
Investmentsinmutualfundsorindex
fundsareseenasimproper.
Investments in mutual funds or index funds
are considered passive investments and
thusnotallowed.
Machariasubsequentlyhighlightedthefollowingcasestudy:
A pension fund for a very large organization with no current exposure to the real estate market
wantedtodevelopacommercialbuildingtohouseitsadministrationdepartmentandtorentthe
remaining space to third parties. The trustees considered the likely capital gain upon sale of the
building at a time to be determined dependent upon market conditions as well as likely rental
yields.
Based on their experiences in the residential real estate market, the trustees estimated the
commercial building would make an investment return higher than what the fund had achieved
over the last ten years. The trustees also considered the much higherlevel risk associated with
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the project and the very low correlation with the remaining assets within the portfolio. One of
the new trustees, a qualified civil engineer with substantial commercial real estate experience,
suspectedcostswouldriseconsiderablyduetopoorestimatesgivenbythedeveloper.Hedidnt
mentionhisconcernsbecausethiswashisfirstappointmentasatrustee.Thetrusteesapproved
theprojectandappointedadevelopertocompletetheproject.
Attheendoftheseminar,Machariareceivedthefollowingquestionsfromtheaudience:
Question1 Im a trustee for a pension fund. Under the new Prudent Investor Rule, can we
buy a unit trust with a 6% front load despite a noload unit trust with the same
objectives and risk being available? The manager of the frontload fund just
started his business and is a friend of the trustees, so we want to support him.
Themanagersoftheotherfundshavebeeninbusinessformanyyearsandhave
atopquadrantperformancehistory,butwedontknowthem.
Question2 Iactasatrusteeforatrustwitharemainderbeneficiary.Theremaindermanis
suing the trustees in a court of law on the basis that the trust suffered a
significant loss as a result of the global financial crisis. We delegated the asset
managementtoawellestablishedassetmanagerafterathoroughduediligence
processtodetermineskillsandhistoricalperformance.Thefundmeetswiththe
objectives and risk profile of the trust considering both the interests of the
income beneficiary and the remainder man. The manager continues to
consistentlyoutperformotherfundsandatlowerfees.Astrustees,whatdefense
dowehave?
Question3 Ifthebeneficiaryofatrustisemployedinaveryhighpaidjob,whatparticular
key factors do I, as a trustee, need to consider when making investment
decisions?
7. WhichofMachariasparametersmostaccuratelyreflectstheprinciplesofthenewPrudent
InvestorRule?
A.Parameter1
B.Parameter2
C.Parameter3
Correctanswer:B
PrudenceinPerspective,JohnTrainandThomasA.Melfe
ExplainthebasicprinciplesofthenewPrudentInvestorRule.
BiscorrectbecauseunderthenewPrudentInvestorRule,atrusteehasadutytoavoidfees,
transactioncosts,andotherexpensesthatarenotjustifiedbytheobjectivesoftheinvestment
program.
8. Exhibit1leastlikelyshowsthecorrectdifferencebetweentheoldandnewPrudentRules
withregardto:
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A.FeatureA.
B.FeatureB.
C.FeatureC.
Correctanswer:C
DifferentiatebetweentheoldPrudentManRuleandthenewPrudentInvestorRule.
CiscorrectbecauseunderthenewPrudentInvestorRule,investmentsinunittrustsandmutual
fundsareallowed
9. Didallofthetrusteesofthepensionfundinthecasestudymostlikelyconformtothe
GeneralFiduciaryStandards?
A.No
B.Yes,becausetheyexercisedappropriatecareandskill.
C.Yes,becausethetrusteesconsideredpotentialtotalinvestmentreturn.
Correctanswer:A
ExplaintheGeneralFiduciaryStandardstowhichatrusteemustadhere.
Aiscorrectasthetrusteewiththerealestateexperienceandthecivilengineeringqualification
didnotutilizehisexpertiseinhelpingthetrusteestomakeaninformedinvestmentdecision.
UndertheGeneralFiduciaryStandards,ifatrusteepossessesmorethanordinaryskill,hemust
useit.
10. MachariasleastappropriateresponsetoQuestion1fromtheaudienceis:
A.Youmustactwithcare,skill,andcaution.
B.Trusteesshoulddelegateauthoritytothosetheyknow.
C.Youhaveadutytoavoidfeesnotjustifiedbytheobjectivesoftheinvestmentprogram.
Correctanswer:B
ExplainthebasicprinciplesofthenewPrudentInvestorRule.
Biscorrectbecausewhiletrusteesmaydelegateauthority,theymustalsoconsidertheirdutyto
avoidfeesthatarenotjustifiedbytheobjectivesoftheinvestmentprogramaswellasactwith
care,skill,andcaution.Thereforethedecisiontodelegatemustnotbebasedsolelyonthebasis
ofknowingthemanager.Ifthealternativenoloadfundmeetswiththesameobjectivesand
risktolerance,thetrusteesshouldgowiththatfundafterundertakingaduediligenceprocesson
thatfundmanager.
11. WithregardtoGeneralFiduciaryStandards,whatisMachariasmostappropriateanswer
toQuestion2fromtheaudience?
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A.Trusteesconsideredgrowthfortheremainderman.
B.Thedutyofcarerequirestrusteestodelegateassetmanagement.
C.Compliancewithdutiesisjudgedatthetimeaninvestmentdecisionismade.
Correctanswer:C
ExplaintheGeneralFiduciaryStandardstowhichatrusteemustadhere.
Ciscorrectbecauseatrusteescompliancewithhisdutiesi.e.,care,skill,andcautionare
judgedasofthetimeaninvestmentdecisionismade,andnotwiththebenefitofhindsightor
subsequentdevelopments,norontheoutcomeofhisinvestmentdecisions.
12. WhatistheleastappropriatestatementthatMachariacouldmakeinresponsetoQuestion
3?
A.Employersfinancialstability
B.Taxconsequencesofinvestmentdecisions
C.Needforliquidityandregularityofincome
Correctanswer:A
Explainthekeyfactorsthatatrusteeshouldconsiderwheninvestingandmanagingtrustassets.
Aiscorrectbecausetheemployersfinancialstabilityisnotaprimaryconcernwhenmaking
currentinvestmentdecisions.
KeyPoints:
PrudenceinPerspective
Prudence is a process, a trustee must act prudently in all he does for a trust and its
beneficiaries(forafund)
Administrativeprudence
Investmentprudence
FivebasicprinciplesofNewRule
Diversificationisfundamentaltoriskminimization;
Trustees must base an investments appropriateness on its risk/return profile: how it
contributestotheoverallriskoftheportfolio;
Prudent Man
Prudent Investor
Prudent Expert
Not delegate Individual investment
Risk averse
delegate
ERISA Portfolio Risk & Return
Diversification
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Avoidexcessivetrading(churning)aswellasexcessivefees,costsandotherexpenses;
BalanceofCurrentincomeandgrowth
Trustees are allowed to delegate investment authority (a duty if the trustee does not
havetherequiredlevelofexpertise)
Prudence:determinationatforesightnothindsight
Loyalty:actsolelyintheinterestsofbeneficiaries,andavoidconflictsofinterests
Imparity: resolve the divergent interests of different beneficiaries in a fair and
reasonablemanner
Care:gatherpertinentinformationandseekadviceofotherstouseintheirinvestment
decisions
Skill: without the relevant investment knowledge, the trustee has duty to delegate
investmentauthoritytoothers
Caution:bothsafetyofcapitalandsecuringareasonablereturn
TheOldRule
(man)
TheNewRule(investor)
Return
Preservethe
purchasingpower
Totalreturn:incomeandcapitalgrowth
Risk Avoidallrisks
Activeriskmanagement:
balancetheriskandreturn
Evaluation Avoidunduerisk Viewtheriskinaportfoliocontext
Restriction
Riskytoolnotto
beincluded
Nosecuritiesareofflimits
Delegation Nodelegation
Candelegate
Selecttheagent
Establishthescopeandtermsofthedelegation
Periodicallyreviewtheagentsactions
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Quantitative
Case1:EduardoDeMolayCaseScenario
Eduardo DeMolay, a research analyst at Mumbai Securities, is studying the time series behavior
of price/earnings (P/E) ratios computed with trailing 12month earnings (Etrailing). He and his
assistant, Deepa Kamini, are reviewing the results of the ordinary least squares time series
regressionshowninExhibit1
Exhibit1
ResultsofRegressionofP/EonLaggedP/E
P/E
t
=b
0
+b
1
*P/E
t1
+
t
Coefficient Std.Error t Significanceoft

Constant(b
0
) 0.143 0.153 0.935 0.176
LaggedP/E(b
1
) 0.991 0.003 292.958 0.000
RSquare Std.Errorofthe
Estimate
DurbinWatson F SignificanceofF
0.982 0.7428 1.200 85,825.180 0.000
UponreviewingtheresultsofExhibit1,DeMolaystates:Thevalueforb
0
isclosetozeroandthe
valueofb
1
isclosetoone.Thosevaluessuggestthatthetimeseriesisarandomwalk.
Kaminireplies:ImconvincedtheP/Eseriesbasedontrailingearningstrulyisarandomwalk.
KaminiandDeMolaynextexaminethebehaviorofP/Eratioscalculatedusingforward12month
earnings (E
forward
). Kamini estimates another AR(1) model, but this time using the forward P/E
values.Shedenotestheerrorsfromthissecondregressionas
t
andExhibit2showstheresultsof
testingwhethertheerrorsareARCH(1).
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Exhibit2
ResultsofRegressionofSquaredResiduals,
t
2
,
OnLaggedSquaredResidual,
t1
2
,
t
2
=c
0
+c
1
t1
2
+u
t
Coefficient Std.Error t Significanceoft

Constant(c
0
) 0.339 0.039 8.768 0.000
Lag1(c
1
) 0.273 0.024 11.405 0.000
RSquare Std.Errorofthe
Estimate
DurbinWatson F SignificanceofF
0.075 1.48978 2.094 130.066 0.000
After further discussion, DeMolay suggests that he and Kamini incorporate more variables into
theanalysis.HesuggeststheyuseavariationoftheFedModel,inwhichtheEarnings/Price(E/P)
ratioisregressedonlongterminterestrates.
DeMolay cautions Kamini, Remember that when we analyze two time series in regression
analysis,weneedtoensurethat
1. neither the dependent variable series nor the independent variable series has a unit root, or
that
2.bothserieshaveaunitrootandarenotcointegrated.
Unless condition (1) or condition (2) hold, we cannot rely on the validity of the estimated
regressioncoefficients.
13. DeMolaysstatementthatthecoefficientsdepictedinExhibit1areconsistentwitha
randomwalkismostlikely:
A.correct
B.incorrect,becauseb0shouldbeclosetoone
C.incorrect,becauseb1shouldbeclosetozero
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Correctanswer:A
TimeSeriesAnalysis,RichardA.Defusco,CFA,DennisW.McLeavey,CFA,JeraldE.Pinto,CFA,
andDavidE.Runkle
Describethecharacteristicsofrandomwalkprocessesandcontrastthemtocovariance
stationaryprocesses.
Whenmodeledusingafirstorderautoregressive(AR(1))model,asintheformulagiveninExhibit
1,randomwalkswillhaveanestimatedinterceptcoefficientnearzeroandanestimatedslope
coefficientonthefirstlagnearone.Thereforehisstatementiscorrect.
14. IfKaminiiscorrectregardingthetrailingP/Etimeseries,thebestforecastofnextperiods
trailingP/EismostLikelytobethe:
A.currentperiodstrailingP/E.
B.averageP/Eratioofthetimeseries
C.forecastderivedfromapplyingtheAR(1)modeldepictedinExhibit1tothedata.
Correctanswer:A
andDavidE.Runkle
Describethecharacteristicsofrandomwalkprocessesandcontrastthemtocovariance
stationaryprocesses.
Ifatimeseriesisarandomwalk,thebestforecastofx
t
thatcanbemadeinperiodt1isx
t1
.
SothebestforecastofthenextperiodstrailingP/EisthecurrentperiodstrailingP/E.
15. TheresultsdepictedinExhibit2arebestdescribedasconsistentwitharegressionthathas
ARCH(1)errorsbecause:
A.c0issignificantlydifferentfrom0.
B.c1issignificantlydifferentfrom0.
C.c1issignificantlydifferentfrom1.
Correctanswer:B
andDavidE.Runkle
Explainautoregressiveconditionalheteroskedasticity(ARCH)anddiscusshowARCHmodelscan
beappliedtopredictthevarianceofatimeseries.
WecantestwhetheratimeseriesisARCHbyregressingthesquaredresidualsfromapreviously
estimatedtimeseriesmodelonaconstantandonelagofthesquaredresiduals(asinExhibit2).
Iftheestimateoftheslope(c1inExhibit2)oftheregressionofthesquaredresidualsonthe
laggedoneperiodsquaredresidualsisstatisticallysignificantlydifferentfromzero,thetime
seriesisARCH(1).
16. BasedontheresultsdepictedinExhibit2,DeMolayandKaminishouldmostlikely:
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A.modeltheforwardP/EdatausinganAR(1)model.
B.modeltheforwardP/Edatausingarandomwalkmodel.
C.usegeneralizedleastsquarestomodeltheforwardP/Edata.
Correctanswer:C
andDavidE.Runkle
Explainautoregressiveconditionalheteroskedasticity(ARCH)anddiscusshowARCHmodelscan
beappliedtopredictthevarianceofatimeseries.
Selectandjustifythechoiceofaparticulartimeseriesmodelfromagroupofmodels.
First,ifARCHexists,thestandarderrorsfortheregressionparameterswillnotbecorrect.In
caseARCHexists,wewillneedtousegeneralizedleastsquares(p.440).
17. DeMolayscautiongivenincondition(1)isbestdescribedas:
A.correct
B.incorrect,becauseonlythedependentvariableseriesneedstobetestedfortheabsence
ofaunitroot
C.incorrect,becauseonlytheindependentvariableseriesneedstobetestedforthe
absenceofaunitroot
Correctanswer:A
andDavidE.Runkle
Explainhowtimeseriesvariablesshouldbeanalyzedfornonstationarityand/orcointegration
beforeuseinalinearregression.
Whenworkingwithtwotimeseriesinaregressionanalysis,bothoftheseriesmustbetestedfor
thepresenceofaunitroot.Ifneitherserieshasaunitroot,wecansafelyuselinearregression.
18. DeMolayscautiongivenincondition(2)isbestdescribedas:
A.correct
B.incorrect,becausetheregressionresultsarevalidwhethercointegrationexistsordoes
notexist
C.incorrect,becauseifbothserieshaveunitroots,theymustexhibitcointegrationforthe
resultsoftheregressiontobevalid
Correctanswer:C
andDavidE.Runkle
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Ifthetwoserieseachhaveaunitroot,regressionresultswillbeconsistentprovidedthatthetwo
seriesarecointegrated.
KeyPoints:
RandomWalks
LOS 13i. describe the characteristics of random walk processes, and contrast them to
covariancestationaryprocesses;
1. Randomwalk
AspecialAR(1)modelwithb0=0andb1=1
Simplerandomwalk:x
t
=x
t1
+
t
Thebestforecastofx
t
isx
t1
2. Randomwalkwithadrift
x
t
=b
0
+b
1
x
t1
+
t
b
0
0,b
1
=1
Thetimeseriesisexpectedtoincrease/decreasebyaconstantamount
3. Covariancestationary
Arandomwalkhasanundefinedmeanrevertinglevel
Atimeseriesmusthaveafinitemeanrevertingleveltobecovariancestationary
Arandomwalk,withorwithoutadrift,isnotcovariancestationary
Thetimeseriesissaidtohaveaunitrootifthelagcoefficientisequaltoone
DickeyandFullerTest
4. Firstdifferencing
Definey
t
asy
t
=x
t
x
t1
=
t
ThisisanAR(1)modely
t
=b
0
+b
1
y
t1
+
t
,whereb
0
=b
1
=0
Thefirstdifferencedvariabley
t
iscovariancestationary
RandomWalks
LOS13j.discusstheimplicationsofunitrootsfortimeseriesanalysis,explainwhenunitroots
are likely to occur and how to test for them, and demonstrate how a time series with a unit
rootcanbetransformedsoitcanbeanalyzedwithanARmodel;
1. Theunitroottestofnonstationarity
Thetimeseriesissaidtohaveaunitrootifthelagcoefficientisequaltoone
Acommonttestofthehypothesisthatb1=1isinvalidtotesttheunitroot
DickeyFullertest(DFtest)totesttheunitroot
StartwithanAR(1)modelx
t
=b
0
+b
1
x
t1
+
t

Subtractxt1frombothsidesx
t
x
t1
=b
0
+(b11)x
t1
+
t

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x
t
x
t1
=b
0
+gx
t1
+
t

H0:g=0 Ha:g<0
Calculateconventionaltstatisticanduserevisedttable
Ifwecanrejectthenull,thetimeseriesdoesnothaveaunitrootandisstationary
AutoregressiveConditional Heteroskedasticity(ARCH)
Los 13m. explain autoregressive conditional heteroskedasticity (ARCH), and discuss how ARCH
modelscanbeappliedtopredictthevarianceofatimeseries;
1. Heteroskedasticity refers to the situation that the variance of the error term is not constant
BPtest
2. TestwhetheratimeseriesisARCH(1)

t t
u a a + + =

2
1 1 0
2
t

Ifthecoefficienta
1
issignificantlydifferentfrom0,thetimeseriesisARCH(1)
3. Generalizedleastsquaresmustbeusedtodevelopapredictivemodel
4. UsetheARCHmodeltopredictthevarianceoftheresidualsinfollowingperiods
RegressionwithMoreThanOneTimeSeries
Los 13n. explain how timeseries variables should be analyzed for nonstationarity and/or
cointegrationbeforeuseinalinearregression;
1. Inlinearregression,ifanytimeseriescontainsaunitroot,OLSmaybeinvalid
2. UseDFtestsforeachofthetimeseriestodetectunitroot,wewillhave3possiblescenarios
Noneofthetimeserieshasaunitroot:wecanusemultipleregression
Atleastonetimeserieshasaunitrootwhileatleastonetimeseriesdoesnot:wecannot
usemultipleregression
Each time series has a unit root: we need to establish whether the time series are
cointegrated.Ifconintegrated,cansuemultipleregression
Los13o.selectandjustifythechoiceofaparticulartimeseriesmodelfromagroupofmodels.
1. Two time series are cointegrated if a longterm financial or economic relationship exists
betweenthem
2. UsetheDickeyFullerEngleGrangertest(DFEGtest)totestthecointegration
H0:nocointegration Ha:cointegration
Ifwecannotrejectthenull,wecannotusemultipleregression
Ifwecanrejectthenull,wecanusemultipleregression
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Case2:GaryHansen
Gary Hansen is a securities analyst for a mutual fund specializing in smallcapitalization growth
stocks.Thefundregularlyinvestsininitialpublicofferings(IPOs).Ifthefundsubscribestoanoffer,
it is allocated shares at the offer price. Hansen notes that IPOs frequently are underpriced, and
thepriceriseswhenopenmarkettradingbegins.TheinitialreturnforanIPOiscalculatedasthe
change in price on the first day of trading divided by the offer price. Hansen is developing a
regression model to predict the initial return for IPOs. Based on past research, he selects the
followingindependentvariablestopredictIPOinitialreturns:
Underwriterrank =110,where10ishighestrank
Preofferpriceadjustment
a
=(OfferpriceInitialfilingprice)/Initialfilingprice
Offersize($millions) =sharessold*Offerprice
Fractionretained
a
=Fractionoftotalcompanysharesretainedbyinsiders
a
Expressedasadecimal
Hansencollectsasampleof1,725recentIPOsforhisregressionmodel.Regressionresultsappear
inExhibit1,andANOVAresultsappearinExhibit2
EXHIBIT1 Hansens Regression Results Dependent Variable: IPO Initial Return (Expressed in
DecimalForm,i.e.,1%=0.01)
Variable Coefficient(
j
b ) StandardError tstatistic
Intercept 0.0477 0.0019 25.11
Underwriterrank 0.0150 0.0049 3.06
Preofferpriceadjustment 0.4350 0.0202 21.53
Offersize 0.0009 0.0011 0.82
Fractionretained 0.0500 0.0260 1.92
EXHIBIT2SelectedANOVAResultsforHansensRegression
DegreesofFreedom(df) SumofSquares(SS)
Regression 4 51.433
Residual 1,720 91.436
Total 1,724
MultipleRsquared=0.36
142.869
HansenwantstousetheregressionresultstopredicttheinitialreturnforanupcomingIPO.The
upcomingIPOhasthefollowingcharacteristics:
Underwriterrank=6
Preofferpriceadjustment=0.04
Offersize=40million
Fractionretained=0.70
Because he notes that the preoffer price adjustment appears to have an important effect on
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initial return, Hansen wants to construct a 95 percent confidence interval for the coefficient on
thisvariable.Healsobelievesthatforeach1percentincreaseinpreofferpriceadjustment,the
initial return will increase by less than 0.5 percent, holding other variables constant. Hansen
wishestotestthishypothesisatthe0.05levelofsignificance.
Before applying his model, Hansen asks a colleague, Phil Chang, to review its specification and
results.Afterexaminingthemodel,Changconcludesthatthemodelsuffersfromtwoproblems:
(1)conditionalheteroskedasticity,and(2)omittedvariablebias.Changstates:
1. Conditional heteroskedasticity will result in consistent coefficient estimates, but both the
tstatisticsandFstatisticwillbebiased,resultinginfalseinferences.
2. If an omitted variable is correlated with variables already included in the model, coefficient
estimateswillbebiasedandinconsistentandstandarderrorswillalsobeinconsistent.
SelectedvaluesforthetdistributionandFdistributionappearinExhibits3and4,respectively.
EXHIBIT3SelectedValuesforthetdistribution(df=)
AreainRightTail tValue
0.050 1.645
0.025 1.960
0.010 2.326
0.005 2.576
EXHIBIT4 Selected Values for the Fdistribution( 01 . 0 = )(df1/df2: Numerator/Denominator

DegreesofFreedom)
df1
4
4 16.00 13.50
df2 3.32 1.00
19. BasedonHansensregression,thepredictedinitialreturnfortheupcomingIPOisclosestto
A.0.0943.
B.0.1064.
C.0.1541.
CorrectanswerC
Solution
Ciscorrect.Thepredictedinitialreturn(IR)is:
( ) ( ) ( ) ( ) 0.0477 0.0150 6 0.435 0.04 0.0009 40 0.05 0.70 0.1541 IR = + + + =

20. The 95 percent confidence interval for the regression coefficient for the preoffer price
adjustmentisclosestto
A.0.156to0.714.
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B.0.395to0.475.
C.0.402to0.468.
CorrectanswerB
Solution
Biscorrect.The95%confidenceintervalis0.435(0.0202X1.96)=(0.395,0.475).
21. ThemostappropriatenullhypothesisandthemostappropriateconclusionregardingHansens
belief about the magnitude of the initial return relative to that of the preoffer price
adjustment(reflectedbythecoefficientb
j
.)are

NullHypothesis Conclusionaboutb
j
(0.05LevelofSignificance)
A.
5 . 0 :
0
=
j
b H
Reject
0
H
B.
5 . 0 :
0

j
b H
Reject
0
H
C.
5 . 0 :
0

j
b H
Reject
0
H
CorrectanswerB
Solution
Biscorrect.TotestHansensbeliefaboutthedirectionandmagnitudeoftheinitialreturn,the
testshouldbeaonetailedtest.Thealternativehypothesisis 5 . 0 :
1
<
j
b H ,andthenull
hypothesisis 5 . 0 :
0

j
b H .Thecorrectteststatisticis:t=(0.4350.50)/0.0202=3.22,and
thecriticalvalueofthetstatisticforaonetailedtestatthe0.05levelis1.645.Theteststatistic
issignificant,andthenullhypothesiscanberejectedatthe0.05levelofsignificance.
22. ThemostappropriateinterpretationofthemultipleRsquaredforHansensmodelisthat
A.unexplainedvariationinthedependentvariableis36percentoftotalvariation.
B.correlationbetweenpredictedandactualvaluesofthedependentvariableis0.36.
C.correlationbetweenpredictedandactualvaluesofthedependentvariableis0.60.
CorrectanswerC
Solution
Ciscorrect.ThemultipleRsquaredfortheregressionis0.36;thus,themodelexplains36
percentofthevariationinthedependentvariable.Thecorrelationbetweenthepredictedand
actualvaluesofthedependentvariableisthesquarerootoftheRsquaredor 6 . 0 36 . 0 =
23. IsChangsstatement#1correct?
A.Yes.
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B.No,becausethemodelsFstatisticwillnotbebiased.
C.No,becausethemodelststatisticswillnotbebiased.
CorrectanswerA
Solution
Aiscorrect.Changiscorrectbecausethepresenceofconditionalheteroskedasticityresultsin
consistentparameterestimates,butbiased(upordown)standarderrors,tstatistics,and
Fstatistics.
24. IsChangsstatement#2correct?
A.Yes.
B.No,becausethemodelscoefficientestimateswillbeunbiased.
C.No,becausethemodelscoefficientestimateswillbeconsistent.
CorrectanswerA
Solution
Aiscorrect.Changiscorrectbecauseacorrelatedomittedvariablewillresultinbiasedand
inconsistentparameterestimatesandinconsistentstandarderrors.
KeyPoints:
AnalysisofVariance(ANOVA)
1. ANOVATable
df SS MSS
Regression k RSS MSR=RSS/k
Error nk1 SSE MSE=SSE/(nk1)
Total n1 SST
2. Standarderrorofestimate
MSE
k n
SSE
SEE =

=
1

3. Coefficientofdetermination(R)
1
= =
k n
SSE
k
SSR
MSE
MSR
F

SST
SSE
SST
SSR
R = = 1
2

Adjusted
( )
=
2 2
1
1
1
1 R
k n
n
R

adjustedRR
adjustedRmaybelessthanzero
MultipleRegressionAssumptions
LOS12d.explaintheassumptionsofamultipleregressionmodel;
1
1
1 n
R adjusted 1
2 2

k n
R
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1. Theassumptionsofthemultiplelinearregression
Alinearrelationshipexistsbetweenthedependentandindependentvariables
The independent variables are not random, ORX is unrelated to error term. There is no
exactlinearrelationbetweenanytwoormoreindependentvariables
Theexpectedvalueoftheerrortermiszero(i.e.,E(
i
)=0)
Thevarianceoftheerrortermisconstant(i.e.,theerrortermsarehomoskedastic)
Theerrortermisuncorrelatedacrossobservations(i.e.,E(
i
j
)=0forallij)
Theerrortermisnormallydistributed
MultipleRegressionAssumptionViolations
LOS12i.discussthetypesofheteroskedasticityandtheeffectsofheteroskedasticityandserial
correlationonstatisticalinference;
1. Heteroskedasticity
Heteroskedasticity refers to the situation that the variance of the error term is not
constant(i.e.,theerrortermsarenothomoskedastic)
Unconditionalheteroskedasticityoccurswhentheheteroskedasticityisnotrelatedtothe
level of the independent variables, which means that it dose not systematically increase
or decrease with the change in the value of the independent variables. It usually causes
nomajorproblemswiththeregression.
Conditional heteroskedasticity is heteroskedasticity that is related to the level of the
independentvariables.Conditionalheteroskedasticitydosecreatesignificantproblemsfor
statisticalinference.
2. EffectofHeteroskedasticityonRegressionAnalysis
Thestandarderrorsareusuallyunreliableestimates.
Thecoefficientestimates(the
j
b
)areconsistent(largersample,lesserror).
If the standard errors are too small, but the coefficient estimates themselves are not
affected, the tstatistics will be too large and the null hypothesis of no statistical
significance is rejected too often (Type I error). The opposite will be true if the standard
errorsaretoolarge.(TypeIIerror)
ThettestandFtestareunreliable.
3. DetectingHeteroskedasticity
Twomethodstodetectheteroskedasticity
1. residualscatterplots(residualvs.independentvariable)
2. theBreuschPagentest
H0:Noheteroskedasticity
BP=nRresidual ,df=k onetailedtest
squredresiduals X
Decisionrule:BPteststatisticshouldbesmall (
4. Correctingheteroskedasticity
robuststandarderrors(alsocalledWhitecorrectedstandarderrors)
generalizedleastsquares(GLS)
CFA robust standard error
tstatistics
5. Serialcorrelation(autocorrelation)
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Serial correlation (autocorrelation) refers to the situation that the error terms are
correlatedwithoneanother
Serialcorrelationisoftenfoundintimeseriesdata
Positive serial correlation exists when a positive regression error in one time period
increasestheprobabilityofobservingregressionerrorforthenexttimeperiod.
Negative serial correlation occurs when a positive error in one period increases the
probabilityofobservinganegativeerrorinthenextperiod.
6. EffectofSerialcorrelationonRegressionAnalysis
1) PositiveserialcorrelationTypeIerror&Ftestunreliable
Because of the tendency of the data to cluster together from observation to
observation, positive serial correlation typically results in coefficient standard errors
thataretoosmall,whichwillcausethecomputedtstatisticstobelarger.
2) NegativeserialcorrelationTypeIIerror
Because of the tendency of the data to diverge from observation to observation,
negative serial correlation typically causes the standard errors that are too large,
whichleadstothecomputedtstatisticstoosmall.
7. DetectingSerialcorrelation
Twomethodstodetectserialcorrelation
(1)residualscatterplots
(2)theDurbinWatsontest
H0:Noserialcorrelation
DW2(1r)
Decisionrule
8. MethodstoCorrectSerialcorrelation
adjustingthecoefficientstandarderrors(e.g.,Hansenmethod):theHansenmethodalso
correctsforconditionalheteroskedaticity.
Improvethespecificationofthemodel:Thebestwaytodothisistoexplicitlyincorporate
thetimeseriesnatureofthedata(e.g.,includeaseasonalterm).
LOS12j.describemulticollinearity,anddiscussitscausesandeffectsinregressionanalysis;
1. Multicollinearity
Multicollinearityreferstothesituationthattwoormoreindependentvariablesarehighly
correlatedwitheachother
Twomethodstodetectmulticollinearity
(1) ttests indicate that none of the individual coefficients is significantly different
thanzero,whiletheFtestindicatesoverallsignificanceandtheRishigh
(2) the absolute value of the sample correlation between any two independent
variables is greater than 0.7 (i.e., r>0.7) , potentially multicollinear. Lower
0 d
1
d
U
4-d
U
4-d
t
4

Reject Ho,
conclude
positive serial
correlation
Inconclusive
Do not
reject H
0
Inconclusive
Reject H
o
,
conclude
negative serial
correlation
correlation
r=0,1,1
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correlationdoesnotmeannoproblem.
Methods to correct multicollinearity: omit one or more of the correlated independent
variables
1. Summaryofassumptionviolations
Assumptionviolation Impact Detection

Conditional
Heteroskedasticity
TypeI/IIerror Residualscatterplots
Breusch Pagentest(BP=nR)
Positiveserialcorrelation TypeIerror
Negativeserialcorrelation TypeIIerror
Residualscatterplots
Durbin Watsontest(DW2(1r))
Multicollinearity TypeIIerror t tests:failtorejectH0;
Ftest:rejectH0;Rishigh
Highcorrelationamongindependentvariables
ModelMisspecification
LOS 12k. discuss the effects of model misspecification on the results of a regression analysis,
andexplainhowtoavoidthecommonformsofmisspecification;
1. Sixcommonmisspecificationoftheregressionmodel
Omittingavariable
Variableshouldbetransformed
Incorrectlypoolingdata()
Usinglaggeddependentvariableasindependentvariable
Forecastingthepast(returnln )
Measuringindependentvariableswitherror(e.g.,expectedinflationvs.actualinflation)
2. Effectsofthemodelmisspecification:regressioncoefficientsarebiasedandinconsistent
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Case3:PaulCharlentCaseScenario
Paul Charlent works for a Londonbased merchant bank that specializes in assisting small and
mediumsizedcompaniesindevelopingmarketstoplacedebtandequityissueswithU.S.andU.K.
investors. Charlent is conducting exploratory analysis regarding possible relationships between
developing market equity returns and various U.S. and U.K macroeconomic variables. He
regresses monthly total returns of the Bangkok SET Index on onemonth LIBOR (for a U.S.
dollardenominatedcontract).TheperiodofthestudyisfromJuly2003throughDecember2010.
Toimprovethestatisticalvalidityofthevariables,forboththeSETindexandLIBOR,Charlentuses
the natural logarithms of one plus the monthly returns in the regression calculation. The results
oftheregressionareshowninExhibit1andExhibit2.

Exhibit1
RegressionofSETIndexonLIBOR
( ) ( ) + + + = + LIBOR SET 1 1 ln

SummaryOutput
RegressionStatistics
MultipleR 0.1623
R2 0.0263
AdjustedR2 0.0152
Standarderror 0.0729
Observations 89
Exhibit2
RegressionofSETIndexonLIBOR
( ) ( ) + + + = + LIBOR SET 1 1 ln

ANOVA
df SS MS F SignificanceF
Regression
1 0.0125 0.0125 2.355 0.1285
Residual
87 0.4624 0.0053
Total
88 4499.91
Coefficients
Standard
Error
tStatistic pValue
Lower
95%
Upper
95%
Intercept 0.031 0.015 1.997 0.0489 0.010 0.061
LIBOR 0.732 0.477 1.535 0.1285 1.679 0.216

Charlent suspects that his regression equation might not be well specified. In particular, he is
concernedwiththepossibilitythatoneorbothofthetimeseriesintheregressionexhibitaunit
root. Using the EngleGranger approach, he tests the residuals from the above regression and
rejectsthenullhypothesisthattheerrortermhasaunitroot.
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Charlent next regresses the natural logarithm of one plus the SET Index monthly returns on the
naturallogarithmofoneplusLIBOR,thenaturallogarithmofoneplustheeffectiveFedfundsrate,
and the USD/GBP exchange rate. The results are reported in Exhibit 3 and Exhibit 4. Charlent
recalls that the null hypothesis of no positive serial correlation is rejected if the calculated DW
statistic is less than the lower critical value and that the null hypothesis of no negative serial
correlationisrejectedifthecalculatedDWstatisticexceeds4minusthelowercriticalvalue.
Exhibit5reportsthepairwisecorrelationsofthevariablesusedinthesecondregression.
Exhibit3
RegressionofSETIndexonLIBOR,FedFunds,andUSD/GBP
( ) ( ) ( ) + + + + + + = + / $ Funds Fed 1 1 1 ln
3 2 1
LIBOR SET

( ) ( ) + + + = + LIBOR SET 1 1 ln
SummaryOutput
RegressionStatistics
MultipleR 0.5544
R
2
0.3073
AdjustedR
2
0.2829
Standarderror 0.0622
DurbinWatson(DW)statistic 1.9566
DWuppercriticalvalue 1.73
DWlowercriticalvalue 1.59
Observations 89
Exhibit4
RegressionofSETIndexonLIBOR,Fedfunds,andUSD/GBP
( ) ( ) ( ) + + + + + + = + / $ Funds Fed 1 1 1 ln
3 2 1
LIBOR SET

( ) ( ) ( ) + + + + + + = + / $ Funds Fed 1 1 1 ln
3 2 1
LIBOR SET

ANOVA
df SS MS F SignificanceF
Regression 3 0.1460 0.0486 12.572 7.03E07
Residual 85 0.3289 0.0039
Total 88 0.4749

Coefficients
Standard
Error
tStatistic pValue Lower
95%
Upper
95%
Intercept 0.152 0.077 1.977 0.0512 0.001 0.304
LIBOR 11.199 1.966 5.697 1.711E07 15.107 7.291
Fedfunds 11.070 1.920 5.765 1.284E07 7.252 14.888
USD/GBP 0.063 0.048 1.293 0.199 0.159 0.034

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Exhibit5
PairwiseCorrelations
Variable LIBOR FedFunds USD/GBP
LIBOR 1.0000
Fedfunds 0.9814 1.0000
USD/GBP 0.6872 0.6798 1.0000
Geoffrey Small, a colleague of Charlent, comments on the results of the two regressions. Small
states that the highly significant Fstatistic of the second regression along with the increased R2
of the second regression means that the addition of the Fed funds rate and the USD/GBP
exchangeratetotheanalysisprovidesmorereliableestimatesoflinearassociationsthanthefirst
regression.

25. BasedontheresultsinExhibits1and2,themostappropriateinterpretationisthat:
A.thereisasmallbutpositivecorrelationbetweentheSETIndexandLIBOR.
B.thevariationinLIBORdoesnotexplainthevariationinSETindexreturns.
C.LIBORhasastatisticallysignificantlinearrelationshipwithreturnsoftheSETIndex.
Answer=B
CorrelationandRegression,RichardA.DeFusco,DennisW.McLeavey,JeraldE.Pinto,and
DavidE.Runkle
StudySession311e,f
Explaintheassumptionsunderlyinglinearregressionandinterprettheregressioncoefficients.
Calculateandinterpretthestandarderrorestimate,thecoefficientofdetermination,anda
confidenceintervalforaregressioncoefficient.

Biscorrect.Thecoefficientofdetermination(R
2
)is0.0263.SuchalowR
2
indicatesthatthe
regressionhaslittleexplanatorypowerthatis,lessthan3%ofthevariationintheSETIndexis
explainedbythevariationinLIBOR.TheinsignificanceoftheFtestinExhibit2confirmsthislack
ofexplanatorypower.Theslopecoefficientisnotsignificant(pvalue=0.1285),againconfirming
thatthisregressionhaslittleexplanatorypower.
26. UsingExhibit2andtwotailtteststodetermineifthecoefficientsareequaltozero,atthe
0.05significancelevel,thenullhypothesesaremostlikely:
A.rejectedforboththeinterceptandtheslope.
B.acceptedfortheinterceptandrejectedfortheslope.
C.rejectedfortheinterceptandacceptedfortheslope.
Answer=C
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DavidE.Runkle
StudySession311e,f,g
Explaintheassumptionsunderlyinglinearregressionandinterprettheregressioncoefficients.
Calculateandinterpretthestandarderrorestimate,thecoefficientofdetermination,anda
confidenceintervalforaregressioncoefficient.
Formulateanullandalternativehypothesisaboutapopulationvalueofaregressioncoefficient,
selecttheappropriateteststatistic,anddeterminewhetherthenullhypothesisisrejectedata
givenlevelofsignificance.
Ciscorrect.Theinterceptcoefficientoftheregressionlineis0.031.Thepvalueindicatesthat
theprobabilityofhavingasampleresultof0.031whentheunderlyingpopulationcoefficientis
zeroisabout4.89%.Asthispvalueislessthan5%,werejectthenullhypothesisforthe
intercept.Theslopecoefficientis0.732.Thepvalueindicatesthattheprobabilityofhavinga
sampleresultof0.732whentheunderlyingpopulationcoefficientiszeroisabout12.85%.As
thepvalueexceedsthe5%levelofsignificance,wefailtorejectthenullhypothesisfortheslope
coefficient.Notethatyoucanalsoanswerthequestionbyexaminingthereportedconfidence
intervals.The95%confidenceintervalfortheinterceptdoesnotcontainzero(werejectthe
null).The95%confidenceintervalfortheslopedoescontainzero(weacceptthenull).

27. UsingtheregressionequationresultsreportedinExhibit2,ifthevalueforLIBORis3%,and
thustheln(1+0.03)is0.02956,thepointestimateoftheassociatedreturnontheSET
Indexisclosestto:
A.2.16%.
B.0.90%.
C.0.94%.
Answer=C
DavidE.Runkle
StudySession311h
Calculateapredictedvalueforthedependentvariable,givenanestimatedregressionmodeland
avaluefortheindependentvariable,andcalculateandinterpretaconfidenceintervalforthe
predictedvalueofadependentvariable.
Ciscorrect.Theregressionequationisln(1+SETIndexreturn)=0.0310.732ln(1+LIBOR).
IfLIBORis3%,thenln(1+SETIndexreturn)=
0.0310.7320.02956=0.00936.
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Continuing,exp[ln(1+SETIndexreturn)]=exp(0.00936)and,therefore,
1+SETIndexreturn=1.00941.TheestimateoftheSETIndexreturnis0.941%.
28. ThemostappropriateconclusionthatfollowsfromtheresultoftheEngleGrangertestis
thatthetwotimeseriesare:
A.cointegrated,andtestsoftheestimatesoftheinterceptandslopearethereforevalid.
B.cointegrated,andtestsoftheestimatesoftheinterceptandslopearethereforenotvalid.
C.notcointegrated,andtestsoftheestimatesoftheinterceptandslopearethereforevalid.
Answer=A
TimeSeriesAnalysis,RichardA.DeFusco,DennisW.McLeavey,JeraldE.Pinto,andDavidE.
Runkle
StudySession313n
Aiscorrect.BasedonStatement4onpage489:
Ifthe(EngleGranger)DickeyFullertestrejectsthenullhypothesisthattheerrortermhasaunit
root,asCharlentstestdid,thenweconcludethattheerrortermintheregressioniscovariance
stationary.Therefore,thetwotimeseriesarecointegrated(i.e.,thetwoseriesshareacommon
trend).Theparametersandstandarderrorsfromlinearregressionwillbeconsistentandwilllet
ustesthypothesesaboutthelongtermrelationbetweenthetwoseries.

29. BasedonExhibit3andExhibit4andthereportedDurbinWatsonstatistic,themost
appropriateconclusionis:
A.serialcorrelationisnotsignificant,andthestandarderrorsareunbiased.
B.significantserialcorrelationispresent,andthestandarderrorsarelikelytobe
overestimated.
C.significantserialcorrelationispresent,andthestandarderrorsarelikelytobe
underestimated.

Answer=A
MultipleRegressionandIssuesinRegressionAnalysis,RichardA.DeFusco,DennisW.
McLeavey,JeraldE.Pinto,andDavidE.Runkle
StudySession312i
Explainthetypesofheteroskedasticityandtheeffectsofheteroskedasticityandserial
correlationonstatisticalinference.
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Aiscorrect.ThevalueoftheDurbinWatsonstatisticexceedstheuppercriticalvalue(1.9566>
1.73).Wefailtorejectthenullhypothesisofnopositiveserialcorrelation.ThevalueoftheDW
statisticislessthanthevalue(41.59)=2.41.Thus,wealsofailtorejectthenullhypothesis
regardingnegativeserialcorrelation(seefootnote49,page381ofthereading).

30. RegardingGeoffreySmallsstatementaboutthesecondregression,whichofthefollowing
isleastaccurate?
A.TheFstatisticofthesecondregressionislikelyoverestimated.
B.Smallisincorrectbecausethesecondregressiondisplaysmulticollinearity.
C.Thesecondregressionisanimprovement,asbothLIBORandFedfundsshowsignificant
relationshipstoSET.
Answer=C
MultipleRegressionandIssuesinRegressionAnalysis,RichardA.DeFusco,DennisW.
McLeavey,JeraldE.Pinto,andDavidE.Runkle
StudySession312j
Describemulticollinearityandexplainitscausesandeffectsinregressionanalysis.
Ciscorrect.ThehighpairwisecorrelationsofExhibit5,especiallythecorrelationbetweenLIBOR
andFedfunds,suggestamulticollinearityproblem.Inthepresenceofmulticollinearity,R2values
andFstatisticsareoverstatedandestimatesofthecoefficientsbecomeextremelyimpreciseand
unreliable.
KeyPoints:
TheBasicsofSimpleLinearRegression
Theassumptionsofthelinearregression
AlinearrelationshipexistsbetweenXandY
Xisnotrandom,andtheconditionthatXisuncorrelatedwiththeerrortermcan
substitutetheconditionthatXisnotrandom.
Theexpectedvalueoftheerrortermiszero(i.e.,E(
i
)=0)
The variance of the error term is constant (i.e., the error terms are
homoskedastic)
Theerrortermisuncorrelatedacrossobservations (i.e.,E(
i
j
)=0forallij)
Theerrortermisnormallydistributed.
StandardErrorofEstimate&Coefficientof Determination(R
2
)
StandardErrorofEstimate(SEE)measuresthedegreeofvariabilityoftheactualYvalues
relativetotheestimatedYvaluesfromaregressionequation.
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SEE will be low (relative to total variability) if the relationship is very strong and high if
therelationshipisweak.
TheSEEgaugesthefitoftheregressionline.Thesmallerthestandarderror,thebetter
thefit.
TheSEEisthestandarddeviationoftheerrortermsintheregression.
The Coefficient Determination (R
2
) is defined as the percentage of the total variation in
thedependentvariableexplainedbytheindependentvariable.
Example:R
2
of0.63indicatesthatthevariationoftheindependentvariableexplains63%
ofthevariationinthedependentvariable.
Regressioncoefficientconfidenceinterval
1
1
c
b
b t s
Regressioncoefficientconfidenceinterval
If the confidence interval at the desired level of significance dose not include zero, the
nullisrejected,andthecoefficientissaidtobestatisticallydifferentfromzero.

HypothesisTestingabouttheRegressionCoefficient
Significancetestforaregressioncoefficient
H
0
:b
1
=Thehypothesizedvalue

1
1 1
b
s
b b
t

= df=n2
Decisionrule:rejectH
0
if+t
critical
<t,ort<t
critical
Rejection of the null means that the slope coefficient is different from the
hypothesizedvalueofb
PredictedValueoftheDependentVariable
Predictedvaluesarevaluesofthedependentvariablebasedontheestimatedregression
coefficientsandapredictionaboutthevalueoftheindependentvariable.
Pointestimate
'
1 0

X b b Y + =
Confidenceintervalestimate
( )
f c
s t Y

c
t =thecriticaltvaluewithdf=n2
f
s =thestandarderroroftheforecast
+ + =
+ + =
2
2 '
2
2 '
) (
) ( 1
1
) 1 (
) ( 1
1
X X
X X
n
SEE
s n
X X
n
SEE s
i X
f

AnalysisofVariance(ANOVA)
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ANOVATable
df SS MSS
Regression k RSS MSR=RSS/k
Error nk1 SSE MSE=SSE/(nk1)
Total n1 SST
Standarderrorofestimate
MSE
k n
SSE
SEE =

=
1

Coefficientofdetermination(R)

SST
SSE
SST
SS
R = = 1
R
2

2 2
1 adjusted R 1 R
n 1 n k 1

=

( )
=
2 2
1
1
1
1 R
k n
n
R adjusted

adjustedRR
adjustedRmaybelessthanzero
Heteroskedasticity
Heteroskedasticity refers to the situation that the variance of the error term is
notconstant(i.e.,theerrortermsarenothomoskedastic)
Unconditional heteroskedasticity occurs when the heteroskedasticity is not
related to the level of the independent variables, which means thatit dose not
systematically increase or decrease with the change in the value of the
independentvariables.Itusuallycausesnomajorproblemswiththeregression.
Conditional heteroskedasticity is heteroskedasticity, that is, variance of error
termis relatedtotheleveloftheindependentvariables.
Conditional heteroskedasticity dose create significant problems for
statisticalinference.
EffectofHeteroskedasticityonRegressionAnalysis
Notaffecttheconsistencyofregressionparameterestimators
Consistency: the larger the number of sample, the lower probability of
error.
Thecoefficientestimates(the
j
b )arenotaffected.
Thestandarderrorsareusuallyunreliableestimates.
If the standard errors are too small, but the coefficient estimates
themselvesarenotaffected,thetstatisticswillbetoolargeandthenull
hypothesisofnostatisticalsignificanceisrejectedtoooften().
The opposite will be true if the standard errors are too large. (
)
TheFtestisalsounreliable.
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DetectingHeteroskedasticity
Twomethodstodetectheteroskedasticity
(1)residualscatterplots(residualvs.independentvariable)
(2)theBreuschPagentest
H
0
:Noheteroskedasticity
BP=nR
residual
,df=k onetailedtest
squredresiduals X
Decisionrule:BPteststatisticshouldbesmall (
Correctingheteroskedasticity
robuststandarderrors(alsocalledWhitecorrectedstandarderrors)
generalizedleastsquares
CFA robuststandard
error tstatistics
DetectingSerialcorrelation
Twomethodstodetectserialcorrelation
(1)residualscatterplots
(2)theDurbinWatsontest
H
0
:Noserialcorrelation
DW2(1r) correlation r0,1,1
Decisionrule
DurbinWatsontest2012
H
0
:Nopositiveserialcorrelation
DW2(1r)
Decisionrule
Multicollinearity
Multicollinearityreferstothesituationthattwoormoreindependentvariables
arehighlycorrelatedwitheachother
Inpractice,multicollinearityisoftenamatterofdegreeratherthanofabsence
orpresence.
Twomethodstodetectmulticollinearity
(1)ttestsindicatethatnoneoftheindividualcoefficientsissignificantly
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differentthanzero,whiletheFtestindicatesoverallsignificanceand
theRishigh
(2)theabsolutevalueofthesamplecorrelationbetweenanytwo
independentvariablesisgreaterthan0.7(i.e., r>0.7)
Methodstocorrectmulticollinearity:omitoneormoreofthecorrelated
independentvariables
Summaryofassumptionviolations
Assumption
violation
Impact Detection
Conditional
Heteroskedasticity
TypeI/IIerror Residualscatterplots
Br euschPagentest(BP=nR)
Positiveserial
correlation
TypeIerror Residualscatterplots
Durbin Watsontest(DW2(1r))
Multicollinearity TypeIIerror
(highR
2
andlow
tstatistics)
t tests:failtorejectH
0
;
Ftest:rejectH
0
;Rishigh
Highcorrelationamong
independentvariables
RegressionwithMoreThanOneTimeSeries
Inlinearregression,ifanytimeseriescontainsaunitroot,OLSmaybeinvalid
UseDFtestsforeachofthetimeseriestodetectunitroot,wewillhave3possible
scenarios
Noneofthetimeserieshasaunitroot:wecanusemultipleregression
Atleastonetimeserieshasaunitrootwhileatleastonetimeseriesdoesnot:
wecannotusemultipleregression
Eachtimeserieshasaunitroot:weneedtoestablishwhetherthetimeseries
arecointegrated.
Ifconintegrated,canestimatethelongtermrelationbetweenthetwo
series(butmaynotbethebestmodeloftheshorttermrelationship
betweenthetwoseries).
UsetheDickeyFullerEngleGrangertest(DFEGtest)totestthecointegration
H
0
:nocointegration H
a
:cointegration
Ifwecannotrejectthenull,wecannotusemultipleregression
Ifwecanrejectthenull,wecanusemultipleregression
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FinancialReporting&Analysis
Case1:BiancaPuglisiCaseScenario
Bianca Puglisi, a telecommunications analyst, was recently hired by Goodwood Securities to
follow wireless companies. During an internal meeting to discuss the firms recommendation on
Eagle Technologies, a U.S. based manufacturer of handheld devices, Senior Portfolio Manager
NorbertFongasksPuglisitoexplainheranalysis.
Puglisi: After reviewing selected data from Eagles 2010 financial statements (Exhibit 1), I have
someconcernsaboutthecompanysoperatingperformance.
I thinka better representation of operating income before tax would be to expense all software
development costs, as is the norm in the industry, and deduct depreciation and amortization
expense.
Ihavecalculatedtheratioofcashfromoperationsbeforeinterestandtaxestooperatingincome
overthepastthreeyearsasfollows:
2010:1.17 2009:1.30 2008:1.50
I want to complete my analysis by determining the cashflowstatementbased aggregate
accruals.
These issues, as well as information gathered from the Managements Discussion and Analysis
section (Exhibit 2) of Eagles 2010 annual report makes me question the sustainability of the
companysstreamofearningsandoperatingcashflow,aswellastheirqualityofearnings.
Fong:Idontunderstandyourconcerns.TwoofthemetricsIwoulduse,Eaglesprofitabilityand
cashflowfromoperatingactivities,havebothincreasedsignificantlyoverthe20082010period,
whywouldtherebeanyconcernovercashflowsustainabilityorearningsquality?
Exhibit1
EagleTechnologiesInc.
PreparedaccordingtoU.S.GAAP
SelectedFinancialData
Fortheyearsended31December2010,2009,and2008($U.S.thousands)
2010 2009 2008
Revenues $1,127,043 $1,051,548 $965,106
Costofgoodssold 609,168 590,000 517,265
Selling,andadministrativeexpenses 411,194 379,770 375,192
Depreciationandamortization 13,196 12,714 9,324
Earningsbeforeinterestandtaxes 93,485 69,064 63,325
Interestexpense 3,510 3,510 3,510
Incometaxes 33,723 19,954 23,715
NetIncome $56,252 $45,600 $36,100

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Cashflowfromoperatingactivities $72,247 $66,437 $67,553
Cashflowfrominvestingactivities ($14,975) $(14,500) ($30,361)
Cashflowfromfinancingactivities ($81,465) ($17,403) ($20,440)
Netchangeincash ($24,193) $34,534 $16,752
Exhibit2
SelectedInformationfromEagles2010AnnualReport
MANAGEMENTSDISCUSSIONANDANALYSISOFFINANCIALCONDITIONANDRESULTSOF
OPERATIONS
ThisdiscussionsummarizesthesignificantfactorsaffectingtheCompanysconsolidated
operatingresults,liquidityandcapitalresourcesduringthethreeyearperiodended31
December2010(i.e.fiscalyears2010,2009,and2008).Thisdiscussionshouldbereadin
conjunctionwiththefinancialstatementsandfinancialstatementfootnotesincludedinthis
annualreport.
Netincomehasgrownatanannualcompoundrateof24.8%overthepasttwoyearsfrom$36.1
millionin2008,to$45.6millionin2009,to$56.3millionin2010.Asaresult,cashearningsas
reflectedbyEarningsBeforeInterest,Taxes,Depreciation,andAmortization(EBITDA)grewatan
annualcompoundrateof21.2%(from$72.6millionin2008to$81.8millionin2009,to$106.7
millionin2010).CashflowfromOperatingActivitiesgrewatannualcompoundrateof3.4%
(from$67.6millionin2008to$66.4millionin2009,to$72.2millionin2010).
Commencingin2009,theCompanycapitalizessoftwaredevelopmentcostsincurredbetween
theattainmentoftechnologicalfeasibilityandcompletionofdevelopment.Capitalizedsoftware
costsareamortizedusingthestraightlinemethodovertheestimatedeconomiclivesofthe
assetsnottoexceedfiveyears.
SoftwareCapitalization(millions)
2010 2009
Capitalizeddevelopmentcosts $9.0 $6.5
Accumulatedamortization 4.5 2.0
Capitalizedsoftware,net $4.5 $4.5
TheseamountsareincludedinComputerequipmentandsoftwareonthebalancesheet.The
Companyrecordedcapitalizedsoftwareamortizationof$2.5millionin2010.
Wecapitalizeinterestontheconstructionofanewmanufacturingplantasanadditionalcostof
theplant.Interestiscapitalizedatourweightedaverageinterestrateonlongtermdebt.Interest
capitalizationendswhenthefacilityisreadyforitsintendeduse.
InterestCosts(millions)
2010 2009 2008
Totalinterestcostsincurred $3,534 $3,540 $3,574
Lessamountscapitalized 24 30 64
Interestexpense $3,510 $3,510 $3,510
Revenueforretailpackagedproducts,productslicensedtooriginalequipmentmanufacturers
(OEMs),andperpetuallicensesisgenerallyrecognizedasproductsareshippedwithaportionof
therevenuerecordedasunearnedduetotheundeliveredelements,includingfreepostdelivery,
telephonesupportandtherighttoreceiveunspecifiedupgradesandenhancements.
DeferredRevenue(millions)
2010 2009 2008
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Deferredrevenue $210.8 $243.0 $92.4
In2008,afterlengthydiscussionswithourprimarysuppliers,theCompanywasabletonegotiate
moreadvantageouspaymentterms.Asaresult,ournumberofdaysofpayablesincreasedfrom
anaverageof22daysin2008,to34daysin2009,andto45days(themaximumtimeaccording
tothenegotiatedagreement)in2010.
31. ComparedtoreportedEBIT,Puglisisoperatingincomefor2010wouldmostlikelybe:
A.lower.
B.higher.
C.thesame.
Answer=C
LonglivedAssets:ImplicationsForFinancialStatementsandRatiosElaineHenry,CFAand
ElizabethA.Gordon
TheLessonsWeLearn,PamelaP.Peterson,CFAandFrankJ.Fabozzi,CFA
Discusstheimplicationsforfinancialstatementsandratiosofcapitalizingversusexpensingcosts
intheperiodinwhichtheyareincurred.
Distinguishamongthevariousdefinitionsofearnings(e.g.,EBITDA,operatingearnings,net
incomeetc.).
Puglisiscalculatesoperatingincomebeforetaxbyexpensingallsoftwaredevelopmentcosts,
$2.5millionin2010
1
.
Butamortizationexpensewouldbereducedbytheamountofsoftwaredevelopmentcosts
amortizedwhichisalso$2.5millionin2010
2
.
Becausethesetwoamountsarethesamein2010,therewouldbenochangeinoperating
income.
1
Theamountofsoftwarecapitalizedisthechangeincapitalizedcostsfrom2009to2010(9.0
6.5=2.5).
2
Theamountamortizedin2010isthechangeintheaccumulatedamortizationfrom2009to
2010(4.52.0=2.5),alsogivenintheMD&A
32. Eaglescashflowstatementbasedaggregateaccrualsfor2010(in$thousands)isclosest
to:
A.30,970.
B.15,995.
C.1,020.
Answer=C
EvaluatingFinancialReportingQuality,ScottRichardsonandIremTuna
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Discussearningsqualityandthemeasuresofearningsquality,andcompareandcontrastthe
earningsqualityofpeercompanies.
Thecashflowstatementbasedaggregateaccruals=NI(CFO+CFI)
=56,252(72,247+14,975)=1,020
33. In2009whichofthefollowingaccountingpoliciesmostlikelyhadthelargesteffectonthe
increaseinEaglesEBIT?
A.Interestcosts
B.Deferredrevenue
C.Softwaredevelopmentcosts
Answer=A
ElizabethA.Gordon
EvaluatingFinancialReportingQuality,ScottRichardsonandIremTuna.
Discussproblemswiththequalityoffinancialreporting,includingrevenuerecognition,expense
recognition,balancesheetissues,andcashflowstatementissuesandinterpretwarningsignsof
thesepotentialproblems.
In2009,thecapitalizationofinterestcostsincreasedEBITby$30million,whereasthe
capitalizationofsoftwaredevelopmentcostsonlyincreasedEBITby$4.5million($6.5million
capitalizedless$2.0millionamortizedintheyear).Sincedeferredrevenueincreasedin2009,it
decreasedEBIT,notincreasedit.
34. WhichofthefollowingmostlikelyincreasedbothofthemetricsthatFongreferstoover
the20082010period?
A.Deferredrevenuerecognition
B.Capitalizationofinterestcosts
C.Extensionofpaymenttermswithsuppliers
Answer=B
ElizabethA.Gordon
Illustratehowtrendsincashflowfromoperationscanbemorereliablethantrendsinearnings.
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recognition,balancesheetissues,andcashflowstatementissues,andinterpretwarningsignsof
Thecapitalizationofinterestincreasesnetincomeandbecausetheinterestcost,whenitis
capitalizedtofixedassets,isclassifiedasaninvestingactivityonthecashflowstatementinstead
ofanoperatingactivity,italsoincreasescashfromoperatingactivities.
35. In2009and2010,asaresultofthenegotiatedagreementwithsuppliers,Eaglemostlikely
reportedahigher:
A.currentratio.
B.cashflowfromfinancingactivities.
C.cashflowfromoperatingactivities.
Answer=C
FinancialRatioList
IntegrationofFinancialStatementAnalysisTechniquesJackT.Cieielski,Jr.,CFA
recognition,balancesheetissues,andcashflowstatementissuesandinterpretwarningsignsof
Predicttheimpactonfinancialstatementsandratios,givenachangeinaccountingrules,
methodsandassumptions.
Theincreaseinaccountspayableasaresultofthemorefavorablepaymenttermsnegotiated
withsupplierswouldbereportedasasourceofcashintheoperatingsectionofthecashflow
statement;hencethechangeinsuppliertermsincreasescashfromoperatingactivities.
36. TheleastaccuratereasonthatPuglisicangiveinresponsetoFongscriticismisthat:
A.growthinnetincomeexceedsgrowthinrevenues.
B.growthinnetincomeexceedsgrowthincashflowfromoperatingactivities.
C.theratioofcashfromoperationbeforeinterestandtaxestooperatingincomeis
decreasing.
Answer=A
IntegrationofFinancialStatementAnalysisTechniques,JackT.Ciesielski,Jr.,CFA
Illustratehowtrendsincashflowfromoperationscanbemorereliablethantrendsinearnings.
Evaluatethequalityofacompanysfinancialdataandrecommendappropriateadjustmentsto
improvequalityandcomparabilitywithsimilarcompanies,includingadjustmentsfordifferences
inaccountingrules,methods,andassumptions.
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Earningsqualityisconcernedwiththelevelofaccrualsinnetincomeandwhethernetincomeis
backedbycashflows.Thelargedifferencebetweenthegrowthinnetincome(24.8%giveninthe
MD&A)andcashfromoperations(3.4%)wouldbeanindicatoroflowerearningsqualityandlack
ofcashflowsustainability.Revenuegrowth(calculatedat8.06%compoundgrowthfrom2008to
2010)wouldnotbeasstronganindicatoroflowerqualityearningsasthepoorrelationship
betweennetincomegrowthandcashfromoperationsgrowth.Thedecreaseintheratioofcash
fromoperationsbeforeinterestandtaxestooperatingincomealsoindicatesthatearnings
qualityisdecreasing.
KeyPoints:
Financialreportingquality
Measureearningquality
DecompositionwithB/Sapproach
Netoperatingassets(NOA)isthedifferencebetweenoperatingassetsandoperating
liabilities:
NOA=(totalassetscash)(totalliabilitiestotaldebt)
Aggregatedaccruals(AA),underB/Sapproach,referstothechangesinNOAduringa
fiscalperiod:
AA
B/S
=NOA
t
NOA
t1

Accrualratio,(AR)
B/S
=AA
B/S
/[(NOA
t
+NOA
t1
)/2]
In order to analyze the subcomponents of accrual activity, relevant line of accrued
itemscouldbefurtheranalyzedwithdeflatedbyaverageNOA.
DecompositionwithCFapproach
AA
C/F
=NI
t
(CFO
t
+CFI
t
)
AR
C/F
=AA
C/F
/[(NOA
t
+NOA
t1
)/2]
Compareearningqualitywithpeercompanies
Compare the accrual ratio of comparable companies calculated in a consistent
approach;
Normally,thehighertheaccrualratio,thelowertheearningquality.
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Case2:AustellIndustriesCaseScenario
Gordon Rowland, a nonexecutive (independent) director of Austell Industries PLC is reviewing
information related to the companys executive compensation prior to an upcoming meeting of
the Remuneration Committee of the Board. Austell is a large public company with revenues of
approximately 8,500 million, trading on the London Stock Exchange. Austell prepares its
financialstatementsinaccordancewithInternationalFinancialReportingStandards(IFRS).
Existingremunerationhasfourcomponents:i)fixedcompensationwhichincludesbasesalary
andbenefitsii)shorttermperformancelinkedbonus,iii)longtermperformancelinked
incentives,andiv)postemploymentbenefits.Thepurposeoftheupcomingmeetingisto
approvechangestothelongtermincentiveplanandreviewthepoliciesandperformance
relatedtothepostemploymentbenefitsplans.
Thecurrentlongtermincentiveplan(LTIP)providesformanagementtoreceiveoptions,as
determinedbytheBoard,onordinary(common)shares.Theexercisepriceoftheoptionsis10%
abovemarketpriceonthedayofgrantingandtheoptionsrequireaserviceperiodof6years.
Thefirstproposedchangewouldaddtherequirementofmeetingcertainfinancialperformance
objectivestotheconditionstobemetbeforetheoptionscanbeexercised.Theproposed
performancemetricsrelatetoEarningsBeforeInterest,Tax,DepreciationandAmortization
(EBITDA)andatargetgrowthinearningspershare.
Thesecondproposedchangepertainstotheassumptionsusedintheapplicationoftheoption
pricingmodelusedtovaluethestockoptions.Theseassumptionsarereviewedeverythreeyears,
basedoneconomicfactorsandsharepricehistory.Thecompanycurrentlyusesthe
BlackScholesmodeltodeterminethefairvalueofgrantedstockoptionsandExhibit1contains
thecurrentandproposedassumptions.
Exhibit1
InputassumptionsusedbyAustellIndustriesPLC
inthevaluationofstockoptionsusingBlackScholesModel
CurrentAssumptions ProposedAssumptions
Riskfreerate 5.0% 4.5%
Volatility 20% 18%
Expectedlifeofoptions 6years 6years
Dividendyield 4% 3.5%
Rowland reviews the information in Exhibit 2 concerning the stock options granted this year
undertheLTIP.
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Exhibit2
AustellIndustriesPLC
StockOptionData2010
2010
Numberof
Options
WeightedAverage
ExercisePrice
Balancebeginningoftheyear 3,666,500 3.06
Grantedduringtheyear 872,000 3.30
Exercisedduringtheyear (278,400) 2.88
Forfeitedduringtheyear (123,700) 2.96
Balanceendofyear 4,136,400 3.13
Exercisableatendoftheyear 827,280 2.90
All options granted during 2010 were granted on 1 July 2010. The market price of the shares at
keydatesduringtheyearandthefairvalueofstockoptionsonthosedatesareinExhibit3.
Exhibit3
SharePricesandOptionValuesin2010
SharePrice OptionFairValue
1January2010 2.85 0.370
1July2010 3.00 0.390
31December2010 3.06 0.400
Averagefor2010 2.97 0.386
Rowland now turns his attention to the information provided about the company pension plan.
Increasing pension costs have been a concern for several years. The increasing pension costs
combined with the impact on pension assets from the economic downturn had resulted in a
fundingdeficitintheplanduring2010.InanattempttobettercontrolpensioncostsAustellhad
madethefollowingchangestotheplanoverthepasttwoyears:
During2009thecompanyhadchangedtheearlyretirementbenefitsformemberswhojoinedthe
planbefore2000.
During2010Austellcappedthesalaryincreasesthatwereeligibleforpensionablebenefitsto1%.
Thesechangeswerereportedasplanamendmentsintheyearmade.Thestatusoftheplanasat
31 December 2010 is shown in Exhibit 4. Rowland wanted to determine the effect of those
changes on the pension expense, operating cash flows and the plans funding position. He was
also aware that accountingpolicies allowed for some pension related costs to besmoothed and
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was concerned about whether the poor fund performance, resulting from the impact of the
economicdownturn,wasappropriatelyreflectedintheamountsrecordedfortheyear.
Exhibit4
AustellPensionPlanDisclosures
31December2010
Allfiguresinmillions 2010 2009
Totalmarketvalueofassets 3,307.5 4,038.0
Presentvalueofpensionliabilities 3,431.3 3,651.2
Netfundedpensionplan(deficit) (123.8) 386.8

PensionPlanAssets 2010 2009
Fairvalueatthebeginningoftheyear 4,038.0 4,182.0
Actualreturnonassets (749.0) (59.0)
Employercontributions 74.0 89.0
Employeecontributions 1.5 1.0
Benefitspaid (57.0) (175.0)
Fairvalueattheendoftheyear 3,307.5 4,038.0

PensionObligation 2010 2009
Presentvalueatbeginningoftheyear 3,651.2 4,408.6
Currentservicecost 60.0 85.0
Planamendments (189.0) (78.4)
Interestcost 239.4 227.0
Contributionsfromemployees 1.5 1.0
Benefitspaid (57.0) (175.0)
Actuarialgain (274.7) (817.0)
Presentvalueatendoftheyear 3,431.3 3,651.2

PensionExpense 2010 2009
Currentservicecost 60.0 85.0
Planamendments (189.0) (78.4)
lessExpectedreturnonassets (267.7) (274.2)
plusInterestonpensionobligation 239.4 227.0
Total (157.4) (40.5)
37. WhichofthefollowingstatementsregardingthefirstproposedchangefortheLTIPismost
likelytrue?Theproposedchangewill:
A.nolongerrequiretheuseofanoptionpricingmodeltovaluethecompensationexpense.
B.increasetheincentiveformanagementtointerveneintheexternalfinancialreporting
process.
C.resultintheexpensebeingrecognizedattheendoftheserviceperiodwhenthe
performancemetricsbecomeknown.
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Answer=B
EmployeeCompensation:PostEmploymentandShareBased,ElaineHenry,CFA,andElizabeth
A.Gordon
Discusstheissuesinvolvedinaccountingforsharebasedcompensation.
Discusstheopportunitiesandmotivationsformanagementtointerveneintheexternalfinancial
reportingprocessandthemechanismsthatdisciplinesuchintervention.
Thechangerequirescertainmetricstobemetbeforetheoptioncanbeexercisedandtherefore
introducesthepotentialformanagementtoselectaccountingpoliciesorestimatesthatmay
increasethemetricandhenceincreasetheircompensation.
Thechangedoesnotalterthefactthatthecompensationisbasedonoptionvaluethereby
necessitatingtheuseofanoptionpricingmodel.Inaddition,theexpenseisstilltoberecognized
overtheestimatedserviceperiod.
38. InthesecondproposedchangefortheLTIP,whichindividualchangeintheassumptions
summarizedinExhibit1willmostlikelyresultinanincreaseincompensationexpense?
A.Volatility.
B.Riskfreerate.
C.Dividendyield.
Answer=C
A.Gordon
OptionMarketsandContracts,DonM.Chance,CFA
Explaintheimpactonfinancialstatementsofaccountingforstockgrantsandstockoptions,and
theimportanceofcompaniesassumptionsinvaluingthesegrantsandoptions.
Explainhowanoptionprice,asrepresentedbytheBlackScholesMertonmodel,isaffectedby
eachoftheinputvalues(theoptionGreeks).
Discusstheeffectoftheunderlyingassetscashflowsonthepriceofanoption.
Adecreaseindividendyieldincreasestheestimatedfairvalueofanoptionwhenusingthe
BlackScholesmodelandhencewouldincreasetherelatedcompensationexpense.
39. Theportionofthecompensationexpenserelatedtothestockoptioncomponentofthe
LTIPearnedin2010isclosestto:
A.28,340.
B.56,680.
C.66,816.
Answer=A
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A.Gordon
Discusstheissuesinvolvedinaccountingforsharebasedcompensation.
Explaintheimpactonfinancialstatementsofaccountingforstockgrantsandstockoptions,and
theimportanceofcompaniesassumptionsinvaluingthesegrantsandoptions.
Theexpensefortheyear=optionsgrantedoptionpriceonthatdate6yearserviceperiod
andonlyforyear(July1Dec31).$872,0000.396=$28,340
40. Theeconomicexpense(inmillions)forAustellspensionplanin2010isclosestto:
A.436.6.
B.584.6.
C.1,024.4.
Answer=B
EmployeeCompensation:PostEmploymentandShareBased,ElaineHenry,CFAandElizabeth
A.Gordon
Calculatetheunderlyingeconomicpensionexpense(income)andotherpostemployment
expense(income)basedondisclosures.
millions calculations
Changeinbenefitobligation 219.9 3,431.3 3,651.2

Changeinplanassets 730.5 3,307.5 4,038.0
Employercontribution(2010) 74.0
804.5

Economicpensionexpense 584.6 219.9(804.5)
Alternatively:
Overfundingatstartof2010 386.8 4,038.0 3,651.2
Underfundingatendof2010 (123.8) 3,307.5 3,431.3
Changeinfundingduring2010 (510.6)
Employercontribution 74.0
Economicpensionexpense 584.6
41. Themostlikelyeffectofthepoorperformanceofthepensionplanassetsin2010isthatit:
A.hadnoeffectonthepensionexpense.
B.increasedthepensionexpenseby749.
C.increasedthepensionexpenseby1,017.
Answer=A
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A.Gordon
Describethecomponentsofacompanysdefinedbenefitpensionexpense.
Explaintheimpactofadefinedbenefitplansassumptionsonthedefinedbenefitobligationand
periodicexpense.
ExplaintheimpactonfinancialstatementsofInternationalFinancialReportingStandards(IFRS)
andU.S.GenerallyAcceptedAccountingPrinciples(U.S.GAAP)forpensionandother
postemploymentbenefitsthatpermititemstobereportedinthefootnotesratherthaninthe
financialstatements.
Theexpectedreturnonplanassetsreducespensionexpense,whiletheactualreturn(negativein
2010)hasnoeffectonpensionexpense.Consequently,thepoorperformanceofthepension
plan(reflectedinthenegativeactualROA)in2010didnotaffectpensionexpensethatyear.
42. IfAustellusestheindirectmethodinthepreparationofcashfromoperations,the
adjustmenttonetincomein2010relatedtothepensionplan,ignoringincometaxes,is
closesttoa(n):
A.decreaseof83.4.
B.increaseof157.4.
C.decreaseof231.4.
Answer=C
A.Gordon
Evaluatepensionplanfootnotedisclosuresincludingcashflowrelatedinformation.
Theeffectonoperatingcashflowsisthedifferencebetweenthepensionexpenseandthe
companyscontributions.In2010thepensionexpenseisnegative157.4.Anegativeexpense(a
benefit)wouldincreasenetincomebythatamount.Thecalculationofcashfromoperations
wouldfirstdeductthisnoncashbenefitfromnetincome,andthensubtracttheactualcash
outflowforthecompany,whichistheemployerscontributionof74.0.
Netincome157.474=Netincome231.4
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KeyPoints
OptionGreeks2
Sensitivity
Factor(Greek)
Input Calls Puts
Delta Underlying
price(S)
Positivelyrelated
(Delta>0)
Negativelyrelated
(Delta<0)
Vega Volatility() Positivelyrelated
(Vega>0)
Positivelyrelated
(Vega>0)
Rho Riskfreerate
(r)
Positivelyrelated
(Rho>0)
Negativelyrelated
(Rho<0)
Theta Timeto
expiration(T)
Value $0
Ascall maturity,
Theta<0
Valueusually $0
asput maturity,
Theta<0*
Strikeprice(X) Negativelyrelated Positivelyrelated
*ThereisanexceptiontothegeneralrulethatEuropeanputoptionthetasarenegative.Theput
valuemayincreasesastheoptionapproachesmaturityiftheoptionisdeepinthemoneyand
closetomaturity.
Theeffectoftheunderlyingassetscashflow
LOS56.g:Discusstheeffectoftheunderlyingassetscashflowsonthepriceofanoption.
Allelseequal,theexistenceofcashflowsontheunderlingassetwill:
Decreasethevalueofacalloption;
Increasethevalueofaputoption.
Valuingequityindexoptioncontracts,wesubstituteS0eTforS0intheBSMformulas,
whereisthecontinuouslycompoundeddividendyield.Cashflowswilldecreasecallvalues
andincreaseputvalues.
Example:ValuationofaEuropeancallonadividendpayingstock
Theunderlyingstockpriceis225withavolatilityof0.15.Thecontinuouslycompoundedriskfree
rateis5.25%andthecontinuouslycompoundeddividendyieldis2.7%.Considerthevalueofa
3yearEuropeancallwiththeexercisepriceof200.
PensionreportingI/S
TheitemsattributabletochangesinfundedstatusSummary
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Items Nature TreatmentinI/S
ServiceCost
IncreaseinPBOduetoserviceof
employees
FullyrecognizedonI/Sasexpenses.
InterestCost
Interestaccruedonthecurrent
benefitobligation.
FullyrecognizedonI/Sasexpenses.
Pastservicecost
IncreaseinPBOduetochanges
intermsoftheplanapplicable
toserviceinprioryears.
IFRS:Vestedemployees'portionexpensed
immediately;unvestedemployees'portion
expensed over average period until
vesting(offB/S)
US GAAP: Amortization is charged to I/S;
unamortized portion was recognized on
OCI.
Actuarialgainor
losses,
ChangesinPBOduetochanges
ofactuarialassumptions
IFRS: 1) Recognized immediately either in
I/Sor asOCI;or2)deferredandamortized
using the corridor or a faster recognition
method. If the cumulative unrecognized
amount of actuarial G/L exceeds specified
levels, a portion of the excess is
recognizedasanexpense.
US GAAP: Recognized immediately as an
expense or deferred and amortized using
thecorridororfasterrecognitionmethod.
All amounts not immediately recognized
asanexpenseareincludedinOCI.
Returnonplan
assets
Gains/lossesfromplanassets
Only the expected return isrecognized on
I/S. The treatment on difference
between actual return and expected
returnisconsideredpartofactuarial
gainsorlosses
PensiondisclosureEconomicpensioncosts
LOS23.h:calculatetheunderlyingeconomicpensionexpense(income)andother
postemploymentexpense(income)basedondisclosures
Underlyingeconomicexpenses(orincome)
Referstothechangesoffundedstatusexclusiveofemployerscontribution.
Calculationofunderlyingeconomicexpenses(orincome)
Underlyingeconomicexpenses=changesinfundedstatusemployerscontribution
Where,
Fundedstatus=PBOfairvalueofplanassets.
Changesinfundedstatus=Fundedstatusatendingfundedstatusatbeginning;
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PensiondisclosureCashflow
AdjustmentofC/F
GAP AdjustmentonCFO AdjustmentonCFF

Overcontributed Increase Decrease
Undercontributed Decrease Increase
Categorizationofinvestment:overview
LOS22.a:describetheclassification,measurement,anddisclosureundertheInternational
FinancialReportingStandards(IFRS)for1)investmentsinfinancialassets,2)investmentsin
associates,3)jointventures,4)businesscombinations,and5)specialpurposeandvariable
interestentities(SPEs,VIEs)
Financial
assets
Associates
Business
combination
Joint
Ventures
Degreeof
Influence
Nosignificant Significant Control Sharedcontrol
Typical%
Interest
<20% 20%50% >50% Varies
Termof
investee
N/A Associate Subsidiary N/A
TreatmentUS
GAAP
Equity
Method
Treatment
IFRS
CostorMarket
HTM;
TS;
AFS
DesignatedFV
Equity
Method
Acquisition
IFRS:Proportionate
consolidationpreferred
Percentageofinterestsheldbyinvestorsisnotthesolecriterionofdegreeofinfluence. Other
factorsshouldbeconsidered,suchas,involvementinpolicyanddecisionmaking.
Financialassets
Summaryofreportingmethodsforminoritypassiveinvestment
HeldtoMaturity
(HTM)
Availableforsale
(AFS)
TradingSecurities
(TS)
Carryingvalue(Balance
sheet)
Amortizedcost Marketvalue Marketvalue
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Return
(Incomestatement)
Interest;
RealizedG/L;
Interest;
Dividend;
RealizedG/L;
UnrealizedG/Lis
recognizedinequity
(notinI/S)andreleased
toI/Swhenrealize.
Interest;
Dividend;
Realizedand
unrealizedG/L;
Associate
EquityMethodMorecomplicatedissues
Iftheinterestsinanassociateisacquiredwithconsiderationinexcessofbookvalue,howto
dealwithit?
BusinesscombinationComparisonof2methods
Purchasevs.Pooling
Differences Purchase Pooling
Combination Accountedforatfairvalue Accountedforatbookvalue
Preacquisition
earnings
Notrecognized Acquireepreacquisitionearningsare
recognizedbyacquirer
Postacquisition
earnings
Includesadditionaldepreciation
andamortizationbasedonfair
value
Dosenotincludeadditionaldepreciation
andamortizationbecausebookvalueare
retained
Profitmargin Lower(becauseofgreater
depreciation,etc)
Higher(noincreaseinexpenses)
ROA Lower(lowerearningsandhigher
recordedassetbase
Higher
ROE Lower(lowerearningsandhigher
recordedequitybase)
Higher

Goodwill
Fair value
Appreciation
Book value
of net
identifiable
assets
Fair value of
net
identifiable
assets
Acquisition
cost
When making profit sharing, this
part is amortized to the investees
profit or loss over the economic
lives of the assets whose fair value
exceeded book value.
Remains except for an impairment
post to the acquisition
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IllustrationofDB
KeyTerminology
Definition Calculationbase/Assumptions
ProjectedBenefit
Obligation(PBO)
The actuarial present value of all
benefitsattributedbytheplan'sbenefit
formula to employee service rendered
priortothatdate.
Expectedfuturesalaryincreases.
Goingconcern
Employeescontinuedservice.
Accumulated
BenefitObligation
(ABO)
The actuarial present value of benefits
attributed to employee service
rendered prior to that date and based
on current and past compensation
levels.
Current compensation levels
(ignoringfutureincreases.)
Liquidationofpensionobligation.
VestedBenefit
Obligation(VBO)
The amount of ABO to which the
employeeisentitled.
ABO
Vestingschedule
TranslationofforeigncurrencyFS
Adoptionof2methods
Comparisonof2methodsapplicableFXrate(1)
B/Sitems
Rateunder
TemporalMethod
RateunderCurrentRate
Method
MonetaryAssets/Liabilities Ending Ending
Re-measurement
Temporal
Method
Translation
Current rate
Method
Reporting
Currency
Functional
Currency
Local
Currency
Integrated
Independent
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Nonmonetaryassets/Liabilities
(inventories,FA,unearned
revenue)
Historical Ending
Capital Historical Historical
R/E Balancing Balancing
Equity(asawhole)
Mixed(becausethechangein
retainedearningsismixed)
Ending
Note:Liabilityisusuallyregardedasmonetary.
Comparisonof2methodsapplicableFXrate(2)
I/Sitems
Rateunder
TemporalMethod
RateunderCurrentRateMethod
Salesandotherexpenses Average Average
COGS Historical Average
Depreciation Historical Average
Revenueandother
expenses
Average Average
TranslationG/L
RecognizedonI/S
(Affectingretainedearnings,no
CTA)
Recognizedinequity(B/S,not
throughI/S)resultinginCTA
(cumulativetranslationadjustment)
TranslationofforeigncurrencyFS
Exposuretotranslation
ThetranslationG/Lisduetotheexposureofassetsandliabilitieswhicharetranslated(or
remeasured)attheendingFXrate.
Theexposureundereachmethodissummarizedasfollows:
Temporalmethod: theexposure=monetaryassetsmonetaryliabilities
Currentratemethod:theexposure=shareholdersequity.
TheeffectofFXtranslationG/LduetothechangesinFXrateissimilarwiththatinforeign
currencytransaction(section2).
Flow effect (in $) = change in exposure (in LC) (ending rate average rate)
Holding gain/loss effect (in $) = beginning exposure (in LC) (ending rate beginning
rate)
Translation gain/loss (in $) =flow effect + Holding gain/loss effect
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Case3:AeolusControlsAGCaseScenario
KarenSpauldingisthechiefequityanalystatShearsonWoods.ShewasaskedbyJim
Tomlinson,thefirmschiefinvestmentofficer,tocarryoutananalysisofthecommonshares
ofAeolusControlsAG,acompanythatpreparesitsfinancialstatementsusingIFRS.
AeolusControlsproducesabroadrangeofheating,cooling,andrefrigerationproductsfor
globaluse.Itsthreemajoroperatingsegmentsarehomecomfortproducts,industrialand
buildingproducts,andtransportationrefrigerationunits.Selectedfinancialstatement
informationforAeolusispresentedinExhibits1and2.
Exhibit1
AeolusControls,AG
asatDecember31
(inMillions)
2010 2009
Operatingcashflow 2,449 3,229
Operatingincome 6,986 2,694
Sales 19,750 19,371
Interestexpense 152 143
Operatingleasepayments 126 113
Cashinterestpaid 81 84
Cashtaxespaid 532 496
Totalassets 20,097 19,964
Capitalexpenditures 824 835
Expendituresonintangibleassets 73 72
Currentdebt 2,271 2,599
Longtermdebt 1,347 1,614
Totalshareholdersequity 11,268 9,654
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Exhibit2
AeolusControlsAG
SelectedNotestotheFinancialStatements
OperationsandSummaryofSignificantAccountingPolicies
Note1.RevenueRecognition
Revenuefromthesaleofgoodsisrecognizedintheincomestatementatthemomentwhen
thesignificantrisksandrewardsofownershipofthegoodshavebeentransferredtothe
buyer,whichismainlyuponshipment.Inspecialcircumstances,atthecustomersrequest,
thecompanymaysellproductsonabillandholdbasisprovidedthattheproductisready
forshipment.Suchgoodsaresegregated,andtherisksofownershipandlegaltitlehave
passedtothecustomer.Thispracticeislimitedonlytocustomerswhoaregovernment
agencieswhorequestitforbudgetaryandphysicalplanningreasons.Theamountofsuch
billandholdsalesaveragesabout3%ofconsolidatedsalesannually.
Note7.Property,Plant,andEquipment
Upuntil31December2010,thecompanyamortizeditsmachineryandequipmentona
straightlinebasisovera10yearexpectedusefullife.Asof2011,thecompanysestimateof
theusefullifeofcertainmachineryandequipmentwillbereducedtoeightyears.
Note12.RestructuringCharges
In2010,thecompanyintroducedanearlyretirementprogramforthoseemployeeswho
were50yearsofageorolderwhovoluntarilyleftemployment.Alargernumberof
employeesthananticipatedacceptedtheoffer,andthecompanyrecordedanexpenseof
10.5million,ofwhich4.5millionwasclassifiedasnonrecurring.
Note18.FinancialandOperatingLeases
A.FinancialLeases
Theimplicitinterestrateonfinanceleasesfor2009and2010was6.0%.
B.OperatingLeaseCommitments(inMillions)
asof31December2010
Due1January:2011,2012,2013,and2014 130
Due1January2015 80
Totaloffutureleasepaymentsthereafter* 320
TotalCommitments 920
*After2015,allleasepaymentsareassumedtobethesameasin2015
SpauldingtellsTomlinsonthatshesuspectstherecentincreaseinprofitabilityistheresultof
earningsmanagement.Insupport,shepresentsseveralratiosinExhibit3.
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Exhibit3
AeolusControlsAG
SelectedAccrual,CashFlowandProfitRatios
asatDecember31
2010 2009
Balancesheetaccrualsratio 7.6% 3.1%
Cashflowaccrualsratio 10.5% 1.1%
OperatingcashflowOperatingincome 0.4 1.2
RevenueCashcollectedratio 99.8% 98.8%
Netprofitmargin 32.2% 11.0%
Tomlinson responds, The comparison you have made between operating cash flow and
operatingearningsisbiasedupwardwhencomparingtoaccrualbasedoperatingincome.
Spauldingsays,Althoughthecompanycouldrepayallofitsdebtandmaintainreinvestment,if
it chose do so, there are offbalancesheet issues to consider. Im in the process of capitalizing
theoperatingleasesbutsofarhaveonlycalculatedtheadjustedlongtermdebt/equityratiofor
2009.ItisshowninExhibit4.
Exhibit4
AeolusControls,AG
LongTermDebt/EquityRatios
Unadjusted AfterCapitalizationofOperatingLeases
2009 17% 23%
Finally, Spaulding said that she was worried about the companys recent capital allocation
decisions and earnings sustainability, as she suspects that the topperforming segments are
beingallocatedasmallerproportionofcapitalexpendituresthantheirproportionoftotalassets.
ShepresentsherfindingsinExhibit5.
Exhibit5
AeolusControls,AG
SegmentsData
EBITMargin SegmentAssetsasa%of
TotalAssets
SegmentCapexasa%of
TotalCapex
2010 2009 2010 2009 2010 2009
HomeComfort 13.8 13.6 7.2 7.2 29.0 35.9
Industrial&
Building
20.5 20.4 25.7 29.0 6.4 4.4
Transportation
Refrigeration
14.5 14.2 67.1 63.8 64.6 59.7

43. Whichofthefollowingaccountingpoliciesofthecompanywouldmostlikelylead
Spauldingtobeconcernedaboutlowqualityearnings?Thecompanys:
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A.revenuerecognitionpractices.
B.changeindepreciationmethods.
C.classificationoftheearlyretirementexpense.
Answer=C
StudySession726d,f
Describeearningsqualityandmeasuresofearningsquality,andcomparetheearningsqualityof
peercompanies.
Explainpotentialproblemsthataffectthequalityoffinancialreporting,includingrevenue
recognition,expenserecognition,balancesheetissues,andcashflowstatementissues,and
interpretwarningsignsofthesepotentialproblems.
Ciscorrect.Onceavailable,earlyretirementprogramsareanormalbusinessoperationandthe
entireamountshouldbeclassifiedasanoperatingexpense.Thebillandholdapproachis
appropriateheregiventhatitisattherequestofthecustomer(andtheearningsprocessis
virtuallycomplete).
44. BasedonExhibit3,whichofthefollowingstatementsismostappropriate?
A.Thecompanyexperiencedmorecashearningsthanaccountingearningsin2010.
B.Tomlinsonscommentaboutthebiasinthecashflowtooperatingincomeratioiscorrect.
C.Thecompanysearningsqualityhasimprovedin2010accordingtothecashflowbased
accrualsratio.
Answer=A
IntegrationofFinancialStatementAnalysisTechniques,JackT.Ciesielski,Jr.
StudySession726d;727c
Describeearningsqualityandmeasuresofearningsquality,andcomparetheearningsqualityof
peercompanies.
Aiscorrect.Anegativebalancesheetaccrualsratioindicatesthatcashearningsexceeded
accountingearnings.
45. Using2010data,ifthecompanywishedtopayoffallofitsdebtwhilemaintainingits
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currentreinvestmentpolicy,thenumberofyearsitwouldtaketodosoisclosestto:
A.1.5.
B.1.7.
C.2.3.
Answer=C
StudySession727c,d,e
Evaluatetheeffectonfinancialstatementsandratiosofagivenchangeinaccountingrules,
methods,orassumptions.
Analyzeandinterprettheeffectsofbalancesheetmodifications,earningsnormalization,and
cashflowstatementrelatedmodificationsonacompanysfinancialstatements,financialratios,
andoverallfinancialcondition.
Ciscorrect.
Yearstorepaydebtfromoperatingcashflow=
Total debt
Operating cash flow-reinvestment

Totaldebt=Currentdebt+Longtermdebt 2,271+
1,347
3,618
Reinvestment=Capitalexpenditures+Expenditureson
intangibles
824+73 897
OperatingcashflowReinvestment 2,449897 1,552/year
Yearstorepaydebtfromoperatingcashflow=
3, 618
2.3
1, 552
years =

46. UsingtheleaseinformationinExhibits1and2,thecompanysadjustedlongterm
debt/assetsratioasoftheendofDecember,2010isclosestto:
A.10.1%.
B.10.5%.
C.10.8%.
Answer=A
LongLivedAssets:ImplicationsforFinancialStatementsandRatios,ElaineHenryandElizabeth
A.Gordon
2012ModularLevelII,Vol.2pp.96100
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StudySession721e;727c,d,e
Explainandevaluatetheeffectsonfinancialstatementsandratiosofleasingassetsinsteadof
purchasingassets.
cashflowstatementrelatedmodificationsonacompanysfinancialstatements,financialratio,
andoverallfinancialcondition
PresentValueofOperatingLeasePayments
Theleasecommitmentsafter2015areassumedtobethesameasin2015,meaningthat
thereisestimatedtobe32080=4additionalpayments.
Thepresentvalueoftheoperatingleasepaymentscanbecalculatedasthesumofthe
presentvaluesoftwoannuitiesinadvance:afouryearannuitystartingimmediately(2011),
andafiveyearannuitystartinginfouryears(2015).
Years CashFlowAnnuityinAdvance
Factor
Discountby Present
Value

2011to2014 130PVAADV(4years,6%)=477.5 () 477.5
2015&
beyond
80PVAADV(5years,6%)=357.2 () 282.9
Total 760.4
PVAADV(4years,6%)byFinancialCalculator:N=4;I=6;PMT=1;Mode=BGN;
ComputePV

AdjustedLongTermDebt/AssetRatioCalculation
Adjustedlongtermdebt 1,347+760= 2,107
Adjustedtotalassets 20,097+760= 20,857
Adjustedlongterm
debt/assetratio
2,10720,857= 10.1%
Alternatively,theindividualcashflowscanbeseparatelydiscounted
PresentValueofOperatingLeasePayments
Year CashFlow CashflowPVFactor PV
0 130 130PV(0y,6.0%) 130.0
1 130 130PV(1y,6.0%) 122.6
2 130 130PV(2y,6.0%) 80.1
3 130 130PV(3y,6.0%) 67.2
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4 80 80PV(4y,6.0%) 39.6
Beyond4 320$80/yr=4years 80PVA(4y,6.0%)PV(4y,
6.0%)
219.6
Total 760.4
PVA(4years,6%)byFinancialCalculator:N=4;I=6;PMT=1;Mode=END;
ComputePV
47. Theinterestcoverageratiofor2009aftercapitalizingtheoperatingleasesisclosestto:
A. 14.7.
B. 15.3.
C. 19.2.

Answer=B
StudySession727c,d,e
cashflowstatementrelatedmodificationsonacompanysfinancialstatements,financialratio,
Biscorrect.
TheinterestcoverageratiowouldbeRevisedEBITRevisedinterestexpense.
Iftheoperatingleaseshadbeencapitalized,theEBITwouldexcludeleasepaymentsbut
include
depreciationexpenseonthecapitalizedleases.
Theinterestexpensewouldincludeinterestonthecapitalizedleasedebt.
Step1:Determinetheamountofleasesthatwerecapitalizedbyusingtheadjusted
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longtermdebt/equityratioinExhibit4.
Thelongtermdebt/equityratioadjustedforoperatingleasesin2009was0.23(Exhibit4).
Theadjustedamountofdebtwas:0.23=
654 . 9
Debt Adjusted

Adjusteddebt=2,220
Capitalizedoperatinglease=AdjustedlongtermdebtOriginallongtermdebt
=2,2201,614=606
Step2:DeterminetherevisedEBIT.
EBIT(OperatingIncome,2009) 2,694.0 (inmillions)
Operatingleasepayments 113.0
Estimateddepreciationonnewly
recognizedassets
(60.6) 60610years
RevisedEBIT 2,746.4
Step3:Determinetherevisedinterestexpense.
Interestexpensereported 143.0
Assumedinterestexpenseonleases 36.4 6%606(Note18Exhibit
1)
Assumedinterestexpenseonleases 179.4

Adjustedinterestcoverageratio 15.3 2,746.4179.4
48. During2010,thecompanymostlikelyallocateditscapitalexpendituresonagrowthbasis
towhichoperatingsegment?
A.HomeComfort
B.Industrial&Building
C.TransportationRefrigeration
Answer=A
StudySession727c
Aiscorrect.
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Theratioofcapitalexpenditurepercentagetototalassetpercentageshouldbecalculated
foreachsegment:Ifgreaterthan1,itindicatesthatasegmentisbeingallocatedagreater
proportionofcapitalexpendituresthanitsproportionoftotalassetsandisthusgrowingthe
segment.Asdeterminedbelow,theratioexceeds1.0foronlytheHomeComfortsegment.
SegmentAssetsasa%of
TotalAssets
SegmentCapexasa%of
TotalCapex
Ratio
HomeComfort 7.2 29.0 4.02
Industrial&Building 25.7 6.4 0.25
Transportation
Refrigeration
67.1 64.6 0.96
%of captical expenditures
Ratio=
%of total assets

KeyPoints:
Financialreportingquality
Los 26.d describe earnings quality and measures of earnings quality, and compare the earnings
qualityofpeercompanies.
Measureearningqualityoverview
Earningqualityreferstopersistenceandsustainabilityofearnings.
Earningsaredecomposedintotheaccrualcomponentandcashcomponent;thatis
Aggregatedaccruals=accrualbasedearningscashearnings
Twoapproachestodecomposition:
B/Sapproach;
CFapproach.
Measureearningquality
DecompositionwithB/Sapproach
Net operating assets (NOA) is the difference between operating assets and
operatingliabilities:
NOA=(totalassetscash)(totalliabilitiestotaldebt)
Aggregated accruals (AA), under B/S approach, refers to the changes in NOA
duringafiscalperiod:
AA
B/S
=NOA
t
NOA
t1

Accrualratio,(AR)
B/S
=AA
B/S
/[(NOA
t
+NOA
t1
)/2]
In order to analyze the subcomponents of accrual activity, relevant line of
accrueditemscouldbefurtheranalyzedwithdeflatedbyaverageNOA.
DecompositionwithCFapproach
AA
C/F
=NI
t
(CFO
t
+CFI
t
)
AR
C/F
=AA
C/F
/[(NOA
t
+NOA
t1
)/2]
Los 27. c evaluate the quality of a company's financial data and recommend appropriate
adjustments to improve quality and comparability with similar companies, including
adjustmentsfordifferencesinaccountingrules,methods,andassumptions
OffBSleveragefromoperatinglease
Purpose:
LookingforanyoffBSleverageimpact
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Collectinputdata
PVfactor
Process&Analyze/Interpretdata
Leaseexpensesanalysis;
Paymentanalysis;
PVofleasepaymentiscapitalizedtorecalculatetheratios.
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Case4:PeterLangerCaseScenario(2012MockExamMorningSession)
Peter Langer is a credit analyst with a national credit rating agency and is preparing a credit
rating for a new client, Masson Enterprises Inc (Masson). Masson operates a chain of 250 retail
stores specializing in the hardware and home renovation market. The midsized stores are
locatedinsuburbanmallsintheAmericanNorthWest.In2009,Massonbuiltalargedistribution
center near Seattle, Washington, U.S.A. that the company uses to supply the stores with its
products, many of which are made in China. In 2010, Masson made an acquisition of a small
regionalchainofstores,whichresultedinanincreaseinbothassetsanddebt.
The home renovation industry has been particularly hard hit by an economic slowdown that
startedin2010.BecauseMassonsyearendisOctober31,theslowdownonlyhadasmallimpact
on2010results,butthefulleffectwillbereflectedinthe2011results.Langersassistant,Evelyn
Aubry, has prepared projected results for 2011 for Masson based on thirdquarter results and
other information she obtained from the company. Masson prepares its financial statements
accordingtoU.S.GAAP.
WithhisconcernsabouttheeffectsoftheeconomicslowdownandtheacquisitiononMassons
financialresults,LangeristryingtodeterminetheappropriatecreditratingforMasson.Tostart
his analysis, Langer summarizes key information for the last two years along with Aubrys
projectionsfor2011,seeExhibit1.
Exhibit1
MassonEnterprisesInc.
YearsEndedOctober31
(allfigures$millionsexceptROE)
Year Sales Net
Income
Total
Assets
Total
Liabilities
Total
Equity
ROE
2011p* 4,820 160 2,410 945 1,465 10.9%
2010 4,720 170 2,482 1,177 1,305 13.0%
2009 4,605 175 2,110 975 1,135 15.4%
*projectionsincludingtheexpectedsaleofthedistributioncenter
Duringameeting,AubrybringstoLangersattentiontwotransactionsundertakenin2011:
1. A large portion of Massons centralized purchases is received at the distribution center in
December and January, so that they are available to be shipped to the stores for the home
renovation markets peak season, spring. In anticipation of an increasing volume of purchases
fromChinaandtoprotectagainsttheweakeningU.S.dollar,Massonpurchasedfuturescontracts
ontheyuan.
2. Masson has announced that at the end of the final quarter of fiscal 2011, it will sell its
distribution center to Sequoia Corporation (Sequoia), an enterprise established, but not
controlled,byMasson.
LangerandAubrydiscusshowshereflectedthesaleofthedistributioncenterinherfinancial
projectionsanditsimpactonMassonsratios.
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Aubryexplains:
Masson is selling the distribution center for $200 million and thus will record a $30 million
gain, which I reflected in my projections as an increase in net income in 2011. There will be no
taxesonthisgainduetotheavailabilityoflosscarryforwards.
The$10millioninannualrentexpenseMassonwillpaytoSequoiaforuseofthecenteristhe
sameastheannualdepreciationexpensetheyweretakingonthecenter.Becausethesaleisat
theendofthefiscalyear,Itookafullyearsdepreciationfor2011.
Masson plans to use the proceeds from the sale to pay off debts, so I reduced the total
liabilities.
Thenetbookvalueofthecenterwouldhavebeen$170millionatyearend,sobyremovingit
fromthebalancesheet,thecompanyshowsanincreaseinitsassetturnoverandthusitsROA.
Langerresponds:
I believe, based on the terms of the agreement, that Sequoia will qualify as a variable interest
entity(VIE)andMassonwillbeconsideredtheprimarybeneficiary.
Hesummarizesthetermsofsaleasfollows:
1.Massonhassigneda14yearleaseforthecenterwithSequoia.Theagreeduponfair
valueofthecenter,forthetransfer,is$200million,whichMassonintendstouseto
paydownlongtermdebt.
2.Sequoiaisfinancingthepurchaseofthecenterthroughborrowingarrangements
totaling$192millionwithagroupoffinancialinstitutions.Thelandandbuildingare
pledgedascollateralagainsttheseloans,andMassonwillprovideunconditional
guaranteesaswell.
3.Inreturnfortheguarantees,Massoniseligibletoappointthemajorityofthe
directorstoSequoiasboard.
4.MassonwillreceivethemajorityoftheprofitsofSequoiaandabsorbthemajorityof
thelosses,ifany.
Hefurthercontinues:
IfitisaVIE,Iwonderwhatrevisionswouldbenecessarytoyourprojectionsandhowtheywould
affectourratiocalculations(whichareallbasedonyearendbalances).
49. Themostappropriatewaytoaccountforthegainsorlossesonthefuturescontractthat
Massonboughtistorecordthemin:
A.othercomprehensiveincomeonapermanentbasis.
B.netincomeintheperiodinwhichthegainsandlossesoccur.
C.othercomprehensiveincome,withrecognitioninnetincomewhenthetransaction
occurs.
Answer=C
TheLessonsWeLearn,PamelaP.PetersonandFrankJ.Fabozzi
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StudySession:725c
Describetheaccountingtreatmentforderivativesbeingusedtohedge:
exposuretochangesinthevalueofassetsandliabilities,
exposuretovariablecashflow,and
foreigncurrencyexposureofinvestmentsinforeigncorporations.
Ciscorrect.Thefuturescontractisaderivativebeingusedtohedgethefuturecashflowsfroma
forecastedtransaction(thepurchasesfromChina),andhencethegainsandlossesare
recognizedinothercomprehensiveincomeuntiltheforecastedtransactionaffectsearnings
(whenthepurchasesoccur),andthentheyarereclassifiedtonetincome.
50. BasedonAubrysprojectedinformation,howwillthe2011ratioofcashflowfrom
operationstonetincomebeaffectedasaresultofthesaleofthedistributioncenter,
comparedtoifthesalehasnotoccurred?Ifthecenterissold,theratiowillmostlikelybe:
A.lower.
B.higher.
C.thesame.
Answer=A
StudySession:727e
Aiscorrect.IfAubrysprojectionsarecorrect,Massonwillreporta$30milliondollargainonthe
sale.Thisgainincreasesnetincome,butthegainisdeductedfrom(thehigher)netincomein
determiningcashfromoperations,sothereisnoneteffectonoperatingcashflow.(Thefull
proceedsfromthesaleofanassetwouldbereportedasaninvestingcashinflow.)Therefore,the
ratioCFO/NIwilldecrease:Operatingcashflowdoesnotchange,butnetincomeislarger.
(Becausethesaleoccursattheendoftheyear,thereisnodifferenceindepreciationexpensefor
theyear:Thecenterwouldhaveafullyearsdepreciationwhethersoldornot,soitdoesnot
affecteithercashflowornetincome.)
51. BasedonAubrysprojectedinformation,ifthecompanydoesnotsellthedistribution
center,Massons2011totaldebttoassetsratiowouldbeclosestto:
A.36.6%.
B.44.4%.
C.47.5%.
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Answer=B
StudySession:727d,e
Biscorrect.Aubrysprojections(assumingsaleofthedistributioncenter)includereductionin
theliabilitiesbythefullproceedsof$200millionandtheassetsbythe$170millionbookvalue;
therefore,ifthecenterhadnotbeensold,theliabilitiesandtheassetswouldbehigherbythese
amountsrespectively.
Totaldebttoassetswouldbe:D/A=44.4%
52. WhichofthetermsofthesaleofthedistributioncenteroutlinedbyLangerisleastlikelya
reasonthatSequoiawouldqualifyasavariableinterestentity(VIE)ofMasson?
A.1
B.2
C.3
Answer=A
IntercorporateInvestments,SusanPerryWilliams
StudySession:622a
Describetheclassification,measurement,anddisclosureunderInternationalFinancialReporting
Standards(IFRS)for1)investmentsinfinancialassets,2)investmentsinassociates,3)joint
ventures,4)businesscombinations,and5)specialpurposeandvariableinterestentities.
Aiscorrect.ThesaleandleasebackofanassetdoesnotautomaticallymakeSequoiaaVIE.Itis
theinabilityofSequoiatofinanceitselfwithoutfinancialsupportfromothers(Massonhas
providedunconditionalguarantees)andthefactthattheequityinvestorswillnotbeableto
makethedecisions,asMassoncontrolstheboard,thatwouldmaketheenterpriseaVIE.
53. IfLangeriscorrectinhisbeliefaboutSequoia,themostappropriateaccountingtreatment
byMassonwillbeto:
A.consolidateSequoia.
B.disclosethearrangementsinthenotestothefinancialstatementsonly.
C.usetheequitymethodtoreportMassonsproportionalinterestintheenterprise.
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Answer=A
StudySession:622a
Aiscorrect.LangerbelievesthatSequoiawillqualifyasaVIEandbeconsideredtheprimary
beneficiary.Asprimarybeneficiary,MassonmustfullyconsolidateSequoiaregardlessofthe
amountofitsequityinvestment.
54. IfLangeriscorrectinhisbeliefaboutSequoiabeingaVIE,therevisedprojectedROEfor
Massonin2011wouldbeclosestto:
A.8.9%.
B.9.1%.
C.10.9%.
Answer=B
StudySession:622a,727e
Biscorrect.IfLangeriscorrectandSequoiaisaVIE,thenonconsolidation,netincomewouldbe
reducedbythe$30milliongainandretainedearnings(andtotalequity)wouldalsodecreaseby
thesameamount.
$millions
As
Projected
Including
Consolidation
ofVIE
Adjustment
Net
income
160 130 DeductgainincludedinNI
16030=130
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Total
equity
1,465 1,435 DeductgainincludedinNI(andretained
earnings)
1,46530=1,435
ROE 130
9.06%
1, 435
=

KeyPoints:
Fifthlessonunderstandtherisk
Fairvaluehedge
referstothehedgeoffairvalueofassetsownedbycompany,suchas:
Tohedgethevalueofoilownedbythecompanywithshortpositionofoil
futures;
Tohedgethevalueofbondsheldbythecompanyduetoincreaseininterest
ratewithshortpositionofinterestratefuture;
Thechangesinfairvalueofhedginginstrumentarerecognizedasgainorlossonthe
I/Sduringtheperiod.
Cashflowhedge
referstothehedgeofamountofcashflowcommittedbycompany. Forexample,
Thecompanyborrowedaloanwithfloatingrateofinterestreferringto
LIBOR. Itexpectsthattheinterestrateprobablyincrease.
Theincreaseofinterestratewillincreasethefuturecashoutflowofthe
companyduetothefloatingrateofinterests.
Tohedgetheriskofincreaseinfuturecashoutflow,thecompanyenteredintoaSWAPpaying
dandreceivingfloating.
Thechangesinfairvalueofhedginginstrumentarerecognizedasother
comprehensiveincomeinequityratherthanNI,duringtheperiodofhedging.Andit
istransferredtoI/Suponcompletionofthehedge.
Netinvestmenthedgeofaforeignsubsidiary
referstothehedgeofamountofinvestmentinforeigncountry.Forexample,
TheUSbasedcompanyinvestedasubsidiaryinAustraliawithUSD10million.
IftheAUDdepreciateswhentheUSCompanyliquidatethesubsidiary,aloss
willincur.
Tohedgetherisk,thecompanyenteredintoaforwardcontractstosellAUD
atapredeterminedratewithUSD.
Thechangesinfairvalueofhedginginstrumentarerecognized:
Undercurrentratemethod:Gainsandlossesarerecognizedinequityasa
partofothercomprehensiveincome.
UnderTemporalmethod:GainsandlossesarerecognizedinI/Salongwith
remeasurementgainsandlosses.
SPEandVIE
SPEscanbealegitimatefinancingmechanismforacompanytosegregatecertainactivities
andtherebyreducerisk.
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UnderUSGAAP,atermofVIEisused.AVIEisanentitythathasoneorbothofthe
followingcharacteristics:
1.Atriskequitythatisinsufficienttofinancetheentitysactivitieswithout
additionalfinancialsupport.
2.Equityinvestorsthatlackanyoneofthefollowing:
Decisionmakingrights.
Theobligationtoabsorbexpectedlosses.
Therighttoreceiveexpectedresidualreturns.
TheIASBcontinuestousethetermspecialpurposeentity.Thesponsoringentitymust
consolidateifitcontrolstheSPE.Indicationsofcontrolincludeasponsoringentitythat:
BenefitsfromtheSPE'sactivities.
HasdecisionmakingrightstoreceivebenefitsfromtheSPE.
AbsorbstherisksandrewardsoftheSPE.
HasaresidualinterestintheSPE.
IfanSPEisconsideredaVIE,itmustbeconsolidatedbytheprimarybeneficiary.The
primarybeneficiaryistheentitythatabsorbsthemajorityoftherisksorreceivesthe
majorityoftherewards.
ThebasisissueinregardingwithVIEorSPEistoconsiderwhetheritshouldbe
consolidatedbythePrimaryBeneficiary;
ConsolidationofVIEorSPEwillsignificantlyaffectthefinancialpositionofthegroup.
QSPE
PriortorecentrevisionsU.S.GAAPpermittedasponsortoavoidconsolidatingasset
securitizationsbycreatingaqualifyingspecialpurposeentity(QSPE).
QSPEcouldonlyholdfinancialassets,usuallyreceivablesthatweretransferredfromthe
sponsor.
TheSPEissuesdebttopurchasethereceivablesfromthesponsorandthedebt
isrepaidasthereceivablesarecollected.
Afterthesubprimecrisisin2007andtheresultingcreditcrisisin2008,FASBeliminated
QSPE.
IFRSdidnotpermitQSPEs.
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Case5:DagmarCaseScenario(2012MockExamAfternoonSession)
DagmarAGisaEuropeanbasedmanufacturingfirmthatpreparesitsfinancialstatements
accordingtoIFRS.TwomembersofDagmarstreasurygroup,HenrikFerdinandandAdele
Christoph,arereviewingDagmarsportfolioofinvestments.Theyareparticularlyinterested
intheinvestmentincomereportedduringtheyearandifanyoftheinvestmentsshouldbe
consideredimpaired.Exhibits1and2containinformationaboutthefirsttwoinvestments
theyarereviewing.
Exhibit1
SelectedInformationonInvestments
Fortheyearended31December2011
Allfiguresin000exceptpersharedata
Companyname AlmeAG ElbeAG
(Additionalinformation
inExhibit2)
Securitydescription Bonds
maturing31December2020,
5%couponpayableannually,
6%effectivemarketratewhen
issued1January2010
Commonshares
Classificationatpurchase Heldtomaturity Associatecompany
Dateofpurchase 1January2010 28February2000
AmountownedbyDagmar Facevalue4,000 1.8millionshares
Total#ofshares
outstanding
n.a.* 6.0millionshares
Marketvalue
1January2011
3,600.60 31.92pershare
Marketvalue
31December2011
3,634.76 30.20pershare
Netearningsofinvestee
companyin2011
n.a. 12,375
Dividendspaidbyinvestee
companyin2011
n.a. 0.50pershare
*n.a.=notapplicable
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Exhibit2
AdditionalInformation
InvestmentinElbeAG
(Allfiguresin000sexceptpersharedata)
Atthedateofacquisition(28February2000)
Pricepaid 17pershare
TotalnetbookvalueofElbe 90,000
Excessoffairmarketvalueofplantandequipmentabovebookvalue 5,250
Expectedusefulliferemainingonplantandequipment 15years
Elbeusesstraightlinedepreciationforallofitstangibleassets
At31December2011
BookvalueofinvestmentonDagmarsstatementoffinancialposition 59,022
Ferdinandopensthemeetingwiththestatement:
Beforeweconsiderimpairment,letscalculatewhateachinvestmentwillcontributeto
Dagmarsnetearningsthisyear.
TurningtotheissueofimpairmentChristophsays:
IbelievethedeclineinthesharepriceofElbeisrelatedtouncertaintysurroundingthe
currentstatusofElbesdefinedbenefitpensionplan.
Atarecentboardmeeting,ElbesmanagementdisclosedtheinformationinExhibit3
concerningthecompanyspensionplan,basedonarecentactuarialrevaluation.Elbealso
announceditwasgoingtochangeitspolicyofdeferringactuarialgainsandlossesand
insteadrecognizethemastheyarise.Elbesmanagementbelievesthiswillincrease
transparencygoingforwardandthattheimproveddisclosurewillhelpthestockprice.
Exhibit3
SelectedDatafromElbesPensionPlan
Asat31December2011
(Allfiguresin000s)
PensionPlanData
beforeRevaluation
PensionPlanData
afterRevaluation
Presentvalueofdefinedbenefit
obligation
40,060 45,200
Fairvalueofplanassets 29,522 29,522
Unrecognizedactuariallosses 1,500 4,250
Unrecognizedpastservicecosts 433 433
FurtherChristophstates:
IthinkweshouldconsidertheinvestmentinElbeimpairedbecausewiththedeclineinthe
sharepricethemarketvaluehasrecentlyfallenbelowourbookvalue.
FurtherChristophstates:
IthinkweshouldconsidertheinvestmentinElbeimpairedbecausewiththedeclineinthe
sharepricethemarketvaluehasrecentlyfallenbelowourbookvalue.
1.despitethepensionplanproblems,Elbehasbeenabletomaintainitsdividendsatits
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historicalrate;and
2.theremaininggoodwillfromtheacquisitionhasnotbeenfullywrittenoff.
Christophconcludesthemeetingbyreviewingtheeventssurroundinganotherfixedincome
investmentDagmarheld.ThecompanyownsbondsofBergenfeldAGhavingafacevalueof
5millionandacouponrateof6%,payablesemiannually.Thebondshavebeenheldfor
fiveyearsandareclassifiedasheldtomaturity.
IamconcernedaboutwhethertheinvestmentinBergenfeldisimpairedforthefollowing
reasons:
InAugust2011,StandardsandPoorsloweredthecreditratingforBergenfeldfromA
toBB.
InOctober2011,thebondsofBergenfeldwerenolongerpubliclytradedduetolow
volumes.
InNovember2011,Bergenfeldaskedholdersofthebondsiftheywouldforgothe
couponpaymentdueon31December2011inexchangeforanincreaseinthecouponrate
onfuturepaymentdatesto7.5%.Thebondholdersagreedtothechange.
55. ThecontributionfromtheinvestmentinAlmetoDagmarsnetearnings(in000s)for2011
isclosestto:
A.200.
B.224.
C.234.
Answer=B
"IntercorporateInvestments,SusanPerryWilliams
StudySession622a
Biscorrect.TheinvestmentinAlmewasclassifiedasheldtomaturity;therefore,Dagmarwould
beusingamortizedcostasthemethodtoaccountfortheinvestment,andtheeffectonnet
earningswouldbetheinterestrevenueearnedfortheyearattheeffectivemarketrateatthe
timeofpurchasebyDagmar(6%).
Theinterestrevenuefor2011canbecalculatedintwoways:
1. MarketrateatissueBookvalueatthe
beginningoftheyear(seebelowforthe
bookvalue):
6.0%3,727.9=223.7
2. Interestcouponpaymentreceived+
Amortizationofthebonddiscount(see
below)
200+23.7=223.7
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SupportingCalculations:
Thebookvalueofthebondatanypointintimeisthepresentvalueoftheremainingcash
flowsdiscountedatthehistoricalmarketrate(i.e.,therateatthedateofpurchase)
Inputs Calculations Value
Bookvalueofthebond
at
1January2011
Facevalue4,000
Coupon=5%
4,000=200
Marketinterest
rate=6%
#ofyears(N)=9
Usingafinancial
calculator:
FV=4,000
PMT=200
Interestrate=6%,N=9
ComputePV
3,727.9
Bookvalueofthebond
at
31December2011(1
January2012)
Facevalue4,000
Coupon=5%
4,000=200
Marketinterest
rate=6%
#ofyears(N)=8
FV=4,000
PMT=200
Interestrate=6%,N=8
ComputePV
3,751.6
Bondamortizationfor2011
Differenceinbookvalue
3,751.6 3,727.9=
23.7
56. ThecontributiontoDagmars2011netearnings(in000s)fromitsinvestmentinElbeis
closestto:
A.3,607.5.
B.3,712.5.
C.4,507.5.
Answer=A
StudySession622a
Aiscorrect.DagmarwouldbeusingtheequitymethodtoaccountforitsinvestmentinElbe
becauseofitsclassificationasanassociatedcompany.Therefore,Dagmarwillincludeits
proportionateshareofElbesnetearnings,lesstheamortizationoftheexcesspurchaseprice
fromtheinitialacquisition.Dagmarowns30%(1.86.0millionshares)ofElbe.
Calculations in000s
%ofElbesnetincome 30% 12,375 3,712.5
Lessamortizationoftheexcessvalueoftangible 5,250 30%=1,575 (105.0)
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assetsatacquisition(fromExhibit2) 1,57515years
InvestmentincomefromElbein2011 3,607.50
57. WhichofthefollowingbestdescribestheaccountingforgoodwillintheElbeinvestment?
A.2,025,000includedintheinvestmentinElbeaccount.
B.3,600,000includedintheinvestmentinElbeaccount.
C.Thereisnogoodwillarisinginaninvestmentinanassociatedcompany.
Answer=A
StudySession622a
Aiscorrect.Undertheequitymethod,goodwilliscalculatedatthedateofacquisitionand
includedinthecarryingamountoftheinvestment.Itisnotamortized.UsingdatainExhibit2:
Acquisitioncalculation
Pricepershare 17.00
#ofshares 1,800,000
Totalpricepaidfor30% 30,600,000
30%ofNetbookvalueofElbe
(0.30 90,000,000) 27,000,000
Excesspurchasepricepaid 3,600,000
Allocatedtoplantandequipment
(0.30 5,250,000) 1,575,000
Goodwill 2,025,000
58. Aftertheactuarialrevaluationofthepensionplanandthechangeinaccountingpolicy
relatedtoactuarialgainsandlosses,thenetpensionliability(in000s)Elbewouldreport
onitsstatementoffinancialpositionwillbeclosestto:
A.11,428.
B.15,245.
C.15,678.
Answer=B
EmployeeCompensation:PostEmploymentandShareBased,ElaineHenryandElizabeth
Gordon
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StudySession623b
Explainandcalculatemeasuresofadefinedbenefitpensionobligation(i.e.,presentvalueofthe
definedbenefitobligationandprojectedbenefitobligation)andnetpensionliability(orasset).
Biscorrect.IFRSdoesnotrecognizethedeferredportionofpastservicecostsinthebalance
sheetliability.Thenetpensionliabilityreportedwhenactuarialgainsandlossesarerecognized
immediatelyiscalculatedasfollows:
Presentvalueofdefinedbenefitobligation 45,200
Lessfairvalueofplanassets (29,522)
Lessunrecognizedpastservicecosts (433)
Netpensionliability 15,245
59. WhichofthestatementsconcerningwhethertheinvestmentinElbeshouldbeconsidered
impairedasattheendof2011ismostappropriate?
A.Christophsstatementaboutmarketvalue
B.Ferdinandsstatementaboutthedividends
C.Ferdinandsstatementabouttheremaininggoodwill
Answer=B
StudySession622a
Biscorrect.UnderIFRS,theremustbeobjectiveevidenceofimpairmentasaresultofoneor
morelosseventsaftertheinitialrecognitionoftheinvestment,andthattheseeventshavean
impactontheinvestmentsfuturecashflows,whichcanbereliablyestimated.Ferdinandis
correctinherstatementthatElbehasbeenabletomaintaindividendpayments.Current
dividendsare0.50onEPSof12,3736,000=2.06,thusapayoutratioof24%,implyingthat
cashflowsdonotappeartobeimpaired.Therefore,theinvestmentshouldnotbeconsidered
impairedforthatreason.
Ifthefairmarketvalueoftheinvestmentisbelowitscarrying(book)valueandthedeclineis
deemedotherthantemporary,animpairmentlossmustberecognized.However,accordingto
Christophthemarketvaluehasjustnowfallenbelowthebookvalue,andthereisnoindication
thatthesituationoffairvaluebelowcarryingvalueisotherthantemporary.Undertheequity
method,theinvestmentisnotcarriedatmarketvalue.Goodwillisnottestedseparatelyfor
impairmentforinvestmentsusingtheequitymethod.
60. Duringwhichmonthin2011wouldithavebeenmostappropriateforDagmartoconsider
thevalueofitsinvestmentinBergenfeldtobeimpaired?
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A.August
B.October
C.November
Answer=C
"IntercorporateInvestments,SusanPerryWilliams
StudySession622a
Ciscorrect.TheearliestpointatwhichitwouldhavebeenappropriateforDagmartoconsider
theinvestmentinBergenfeldtobeimpairedisNovember.Thedowngradingofdebt(inAugust)
orthedisappearanceofanactivemarketforasecurity(October)aloneisnotevidenceofan
impairment.Buttherequestforandacceptanceofconcessionsonthecouponpaymentin
conjunctionwiththeearliereventswouldindicatethatthedebtisimpaired.

KeyPoints:
Financialassets
Summaryofreportingmethodsforminoritypassiveinvestment
HeldtoMaturity
(HTM)
Availableforsale
(AFS)
TradingSecurities
(TS)
Carryingvalue
(Balancesheet)
Amortizedcost Marketvalue Marketvalue
Return
(Incomestatement)
Interest;
RealizedG/L;
Interest;
Dividend;
RealizedG/L;
Unrealized G/L is recognized in
equity (not in I/S) and released
toI/Swhenrealize.
Interest;
Dividend;
Realizedand
unrealizedG/L;
Associate
Goodwillistheamountthatconsiderationinacquiringtheequityinterestsofinvesteein
excessoftherelatedFairvalueofequity.
GoodwillisNOTamortized;
Goodwillissubjecttoanimpairmenttestatleastannually;
GoodwillImpairmenttest
Becauseofitsinseparability,goodwillisvaluedatthereportingunitlevel.
UnderIFRS,testingforimpairmentinvolvesasinglestepapproach.If
thecarryingamountofthecashgeneratingunit(wherethegoodwillis
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assigned)>therecoverableamount,animpairmentlossisrecognized.If
GWdecreasedtozero,theexcessamountoflossesisprorataallocated
totheassetofassociateexcludingcash,tradereceivable,inventory,and
assetstobetraded.
Goodwill
GoodwillImpairmenttestunderUSGAAP
goodwillimpairmentpotentiallyinvolvestwosteps.
Inthefirststep,ifthecarryingvalueofthereportingunit(includingthe
goodwill)>thefairvalueofthereportingunit,animpairmentexists.
MaximumreductionisamountofGW
Inthesecondstep,Onceitisdeterminedthegoodwillisimpaired,the
lossismeasuredasthedifferenceinthecarryingvalueofthegoodwill
andtheimpliedfairvalueofthegoodwill.
Theimpliedfairvalueofthegoodwilliscalculatedinthesame
mannerasgoodwillattheacquisitiondate.FVofthefirmFV
oftheidentifiablenetasset.
Theimpairmentlossisrecognizedintheincomestatementasa
partofcontinuingoperations.
ReversalofFairValueofinvestment
NeitherUSGAAPnorIFRSallowsthereversalofimpairmentprovisionor
allowance.

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Case6:ReadyPower,Inc.,CaseScenario(2012MockExamAfternoonSession)
Ready Power, Inc., is a manufacturer of high quality industrial electric generators. While many
companies have been negatively impacted by the continued global economic weakness, Ready
Power has experienced strong demand for its products largely as a result of several recent
natural disasters and many occurrences of rolling brownouts and blackouts arising from
excessive strains on power grids. Although this strong demand has resulted in higher inventory
costsinrecentyears,thecompanyhasbeenabletopassthemontocustomersthroughhigher
prices. The companys generators have expected useful lives of about 25 years, and it normally
depreciatesitsassetsonastraightlinebasis.
MargoLenz,CFA,anequityanalystatLivermoreInvestmentCouncil,isreviewingReadyPowers
recentfinancialstatements,whicharepreparedaccordingtoU.S.GAAP.
Exhibits 1 and 2 contain selected portions of the companys statement of operations and
statementoffinancialposition,whileExhibit3containsselectednotesfromthecompanys2011
financialstatements.
Exhibit1
ReadyPower,Inc.
ConsolidatedResultsofOperations($U.S.millions)
FortheYearEndedDecember31 2011
Sales 24,910
Costofgoodssold 17,729
Grossprofit 7,181
Netprofit 2,122
Exhibit2
ReadyPower,Inc.
ConsolidatedFinancialPosition($U.S.millions)
December31 2011 2010
Cash 318 665
Receivables 8,983 8,381
Inventories 3,811 3,134
Othercurrentassets 744 1,441
Currentassets 13,856 13,621
Netproperty,plant,andequipment 5,311 4,794
Otherassets 11,360 9,826
Totalassets 30,527 28,241
Accountspayable 2,451 2,047
Othercurrentliabilities 9,100 9,262
Totalcurrentliabilities 11,551 11,309
Longtermliabilities 14,861 11,873
Totalliabilities 26,412 23,182
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Totalshareholdersequity 4,115 5,059
Totalliabilitiesandshareholdersequity 30,527 28,241
Exhibit3
ReadyPower,Inc.
SelectedNotestoConsolidatedFinancialStatements
Note1.OperationsandSummaryofSignificantAccountingPolicies
D.Inventories
Inventoriesarestatedatthelowerofcostormarket,withcostdeterminedusingthelastin,
firstout(LIFO)method.
$U.S.millions 2011 2010
LIFOreserve $1,442 $1,407
NoLIFOliquidationoccurredduringtheyears2009to2011.
F.Depreciationandamortization
Depreciationofplantandequipmentiscomputedusingthestraightlinedepreciation
method.
Consolidateddepreciationexpense $332 $235
J.Incometaxes
Thecompanyseffectivetaxratehasbeen29%foreachofthepast3years
Note10.Property,Plant,andEquipment
December31
Land 110 92
Plantandequipment 10,257 9,426
Totalplantandequipment 10,367 9,518
Lessaccumulateddepreciation 5,056 4,724
Netproperty,plant,andequipment 5,311 4,794
Harold Mays, one of Lenzs assistants, made the following comments about Ready Powers
inventorypolicy:
1.OneoftheadvantagesofusingLIFOisthatitsimplifiestheaccountingprocessfor
inventoriesasitgivesthesameresultsforinventoryandcostofgoodssoldwhetherthe
companyusesaperiodicorperpetualinventorysystem.
2.AnotheradvantageofusingLIFOisthatitappearstoimprovethecompanyscash
conversioncycle.
LenzmentionedtoMaysthatearlierthatday,shehadseenBillJacobs,theCEOofReadyPower,
in an exclusive interview on a cable news network specializing in financial news. Lenz was
particularly interested in the portion of the interview dealing with the companys new program
toleaseoutelectricalgenerators.Selectedexcerptsfromatranscriptoftheinterviewarefound
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inExhibit4.
Exhibit4
SelectedExcerptsfromaCableTVInterviewofHaroldJacobs
4March2012
Jacobs:Thefirmismeetingthegrowingdemandforourelectricalgeneratorsandwillbe
introducingaleasingprogramtofurtherconsolidateourleadinthisarea.Weanticipatethat
about80%oftheleaseswegrantwillhaveatermof20yearsormore,withtheremainder
havingshortertermsofaround5years.
After reading the excerpts from the cable TV interview, Mays wondered what impact the
companysnewpositionasalessoranditsclassificationofleaseswouldhaveonthecompanys
futurefinancialstatements.Finally,hecommented:
1.Foragivenleasedasset,intheinitialyearofthelease,ReadyPowersprofitsshouldbe
higherifthecompanyclassifiestheleaseasanoperatinglease.
2.Regardlessofhowthecompanyclassifiesalease,itstotalcashflowandoperatingcash
flowovertheleasetermwillbethesame.
61. IfReadyPowerhadusedtheFIFOmethodtoaccountforitsinventory,itscostofgoods
sold(inmillions)in2011wouldhavebeenclosestto:
A.$16,287.
B.$17,694.
C.$17,764.
Answer=B
Inventories:ImplicationsforFinancialStatementsandRatios,MichaelA.Broihahn
StudySession520c
ConvertacompanysreportedfinancialstatementsfromLIFOtoFIFOforpurposeofcomparison.
Biscorrect.
COGS(FIFO)= COGS(LIFO) IncreaseinLIFOreserve*

17,72935=17,694
*IncreaseinLIFOreserve=1,4421,407=35
62. IfReadyPowerhadbeenusingFIFOaccountingsinceincorporation,itsretainedearnings
attheendof2011wouldmostlikelybehigher(inmillions)by:
A.$1,024.
B.$1,442.
C.$2,927
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Answer=A
StudySession520c
ConvertacompanysreportedfinancialstatementsfromLIFOtoFIFOforpurposeofcomparison.
Aiscorrect.TheLIFOreserveattheendof2011was$1,442,indicatingthatcumulativegross
profitswouldhavebeen$1,442higherunderFIFO.Withataxrateof29%,thecumulative
additionalincometaxexpensewouldbe$1,442 0.29=$418,resultinginanincreasein
retainedearningsof$1,442$418=$1,024.
63. ThestatementinNote1.D(Exhibit3)concerningLIFOliquidationsmostlikelymeansthat
forthestatedperiod:
A.costsandpricesmusthavebeenrisingthroughout.
B.therewerenoinventorywritedownsinanyofthethreeyears.
C.unitsmanufactured(orpurchased)equaledorexceededunitsalesforeachyear.
Answer=C
StudySession520b,d
ExplainLIFOreserveandLIFOliquidationandtheireffectsonfinancialstatementsandratios.
Describeimplicationsofvaluinginventoryatnetrealizablevalueforfinancialstatementsand
ratios.
Ciscorrect.LIFOliquidationariseswhenthenumberofunitssoldexceedsthenumberofunits
purchasedormanufactured,andtherefore,aportionoftheolderinventoryissoldoffor
liquidated.
64. WithregardtoMayscommentsabouttheLIFOmethod,whichofhisstatementsismost
accurate?
A.Statement1only
B.Statement2only
C.Bothstatements1and2
Answer=B
StudySession520c,e
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ConvertacompanysreportedfinancialstatementsfromLIFOtoFIFOforpurposeof
comparison.
Analyzeandcomparefinancialstatementsandratiosofcompanies,includingthosethatuse
differentinventoryvaluationmethods.
Biscorrect.OnlyStatement2iscorrect:
Inperiodsofrisinginventoryprices,asrecentlyexperiencedbythecompany,LIFOCOGSis
higherandaverageinventoryislower,resultinginfasterinventoryturnoverand,therefore,
fewerdaysofinventoryonhand(DOH).Receivablesandpayablesarenotaffectedbythechoice
ofinventorymethod.ThelowerDOHwillappeartoshortentheoperatingandcashconversion
cycles.
Statement1isincorrect:
TheLIFOinventory(andcostofgoodssold)willusuallydifferdependingonwhetherthe
companyusesaperiodicorperpetualcountingsystem;inaddition,itmustkeeptrackofthe
valueofFIFObasedinventorysoastoreporttheLIFOreserve.
65. In2011,theestimatedremaininglife(inyears)ofthecompanysassetbaseisclosestto:
A.15.2.
B.15.7.
C.16.0.
Answer=B
LonglivedAssets:ImplicationsforFinancialStatementsandRatios,ElaineHenryandElizabeth
A.Gordon
StudySession521d
Analyzeandinterpretthefinancialstatementdisclosuresregardinglonglivedassets.
Biscorrect.
( )
Net deprecible PP&E
Estimated remaining life =
annual depreciation expense
=5,201332=15.7
Net(depreciable)PP&Eexcludesland,fromNote10:$5,311 $110=$5,201
DepreciationexpensefromNote1.F:$332
66. WhichofMaysstatementsaboutthenewleasingprogramismostlikelycorrect?
A.Statement1only
B.Statement2only
C.Neitherstatement1nor2
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Answer=C
LonglivedAssets:ImplicationsforFinancialStatementsandRatios,ElaineHenryandElizabeth
A.Gordon
StudySession521f
Explainandevaluatetheeffectsonfinancialstatementsandratiosoffinanceleasesand
operatingleasesfromtheperspectiveofboththelessorandthelessee.
Ciscorrect.
Neitherstatementiscorrect.
Statement1
isincorrect:
Lessorsgenerallyprefersalestypeleasestooperatingleasesbecauseasales
typeleaseacceleratesrevenuerecognition.Assumingthattheleasepayments
willbethesameunderbothtypesofleases(asthecasescenarioindicates),in
theinitialyearofthelease,forasalestypelease,thecompanywillreportthe
differencebetweenthepresentvalueoftheleasepaymentsandtheassets
carryingvalueasprofit,aswellastheinterestrevenueontheleasereceivable;
fortheanoperatinglease,thecompanysincomewillbetheleasepaymentless
thedepreciationexpense,whichwillbelowerthanthegrossprofitonthesale
plusinterestrevenuefromthesalestypelease.
Statement2
isincorrect:
Whiletotalcashflowoveraleasetermunderthetwodifferentmethodsof
accountingforaleasewillbethesame,theoperatingcashflowswillnotbe.
Underanoperatinglease,thenetdifferencebetweentheleasereceiptsand
depreciationexpensewillbetreatedasoperatingcashflows.Afterthefirstyear
ofthelease,onlytheinterestrevenuewillbetreatedasanoperatingcashflow
underafinancinglease(directorsalestype),withtheamountaffectingthe
principalamountoftheleasereceivablebeingtreatedasaninvestingcashflow.
KeyPoints:
FrameworkofInventories
Inventoryaccountinganditsbasicequation
InventoryCOGS
Inventory
END
=Inventory
BGN
+PurchasesCOGS
FIFO,LIFOandWAC
Theitemsfirst/lastpurchasedareregardedasCOGS;endinginventoryisthe
mostrecent/earliestitems
Impactofpriceincrease/decreaseonCOGSandendinginventory
Periodicandperpetualinventorysystem
ForLIFOandWACmethods,COGSandinventoryvaluemightdifferunder
periodicandperpetualsystem
Inventoryvaluationmethod
IFRS:Min[cost,netrealizablevalue(NRV)],whereNRV=sellingpricesellingcost
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GAAP:Min[cost,market]wheremarket=replacementcost,ifreplacementcost
isbetween[NRV,NRVnormalprofitmargin]
NowriteupallowedunderGAAP
Analyzethedisclosure
Componentsofinventory:materials,workinprocessandfinishedgoods
Summary
Assumingstableorincreasinginventoryquantities
Economic
environment
Account FIFO LIFO
Endinginventory Higher Lower
Inflationary
(Risingprice)
COGS Lower Higher
FIFO LIFO
I/S Highertaxes Lowertaxes
CFS LowerCFO(taxespaid) HigherCFO(taxespaid)
Ratios Lower inventoryturnover Higher inventoryturnover
LeasingAccountingTreatmentsoflease
Salestypevs.Directfinancinglease (lessor):
Salestypelease Directfinancinglease
At inception
I/S
Sales=PVofMLP(leasereceivable)
COGS=CostofassetsPVofsalvage
(Profit=SalesCOGS)
Noprofitisrecognized.
At inception
B/S
Netinvestmentinlease
=PVofMLP+PVofsalvagevalue
Netleasereceivable
=costofassets
PeriodicI/S Interestrevenue
= implicit interest rate * net lease
receivable at the beginning of the
period
Interestrevenue
= implicit interest rate * net
lease receivable at the
beginningoftheperiod
At inception
CashFlow
Noeffect Noeffect
Periodic
CashFlow
CFOinflow
CFIinflow
CFOinflow
CFIinflow
CorporateFinance
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Case1:JohnEarlCaseScenario
John Earl is a project analyst for kames Inc. Earl is currently reviewing the projected annual
incomestatementsforthefiveyearlifeofProject#162todeterminetheNPVoftheprojectusing
anannualdiscountrateof10%(seeExhibit1).
Exhibit1
Project#162ForecastedIncomeStatements
Year1: Year2: Year3: Year4: Year5:
Sales $300,000 $320,000 $350,000 $390,000 $440,000
CashOperatingExpenses 210,000 224,000 245,000 273,000 308,000
Depreciation 30,000 30,000 30,000 30,000 30,000
OperatingIncome 60,000 66,000 75,000 87,000 102,000
Interest 13,500 10,800 8,100 5,400 2,700
TaxableIncome 46,500 55,200 66,900 81,600 99,300
Tax(40%) 18,600 22,080 26,760 32,640 39,720
NetIncome 27,900 33,120 40,140 48,960 59,580
The project will require an increase in fixed assets of $150,000 that will be fully depreciated.
Currentassetsareexpectedtoincreaseby$80,000andcurrentliabilitiesareexpectedtoincrease
by$45,000.Thisincreaseinnetworkingcapitalwillberecoveredwhentheprojectisfinished.
Justpriortocompletingtheanalysis,Earlfindsoutthatthefixedassetscanbedepreciatedusing
anacceleratedmethod(seeExhibit2).
Exhibit2
Project#162ForecastedIncomeStatementswithAcceleratedDepreciation
Year1: Year2: Year3: Year4: Year5:
Sales $300,000 $320,000 $350,000 $390,000 $440,000
CashOperatingExpenses 210,000 224,000 245,000 273,000 308,000
Depreciation 49,995 66,675 22,215 11,115 0
OperatingIncome 60,000 66,000 75,000 87,000 102,000
Interest 13,500 10,800 8,100 5,400 2,700
TaxableIncome 26,505 18,525 74,685 100,485 129,300
Tax(40%) 10,602 7,410 29,874 40,194 51,720
NetIncome 15,903 11,115 44,811 60,291 77,580
Given the use of the accelerated depreciation method, Earl concludes that the NPV of Project
#162increasesto$146,445.
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In an initial discussion with fellow analyst David North, about Project #162 Earl tells North: I
havecorrectlypreparedtheanalysisusingnominalvaluesandanominaldiscountrate.
North responds: Even though the analysis is in nominal terms, the discount rate should be
increasedbyaninflationrateof2%basedonthehistoricalinflationrate.
Later Earl and North continue their discussion. Earl explains: In case there is an opportunity to
expand,theprojectcanchangeinscalequicklyinordertorespondtoanychangesindemandfor
theproduct.
Northreplies:Itappearsthatyourprojecthasthecapacitytoexpandquicklybecausethereisno
needforanyadditionalcapitalexpenditures.Assumingtheperunitcontributionmarginremains
unchanged,thedegreeofoperatingleveragewillincreaseuponexpansion.
67. GiventheinformationinExhibit1,theaftertaxoperatingcashflow(in$thousands)for
Year1forProject#162isclosestto:
A.36.0.
B.66.0.
C.71.4.
Correctanswer:B
CapitalBudgeting,JohnD.Stowe,CFA,andJacquesR.Gagne
Computetheyearlycashflowsofanexpansioncapitalprojectandareplacementcapitalproject
andevaluatehowthechoiceofdepreciationmethodaffectsthosecashflows.
Operatingincome(1taxrate)+depreciation=aftertaxoperatingcashflow:$60(140%)
+$30=$66
68. Theinitialinvestmentoutlay(in$thousands)forProject#162isclosestto:
A.185.
B.230.
C.275.
Correctanswer:A
Theinitialinvestmentistheincreaseinthefixedassets+additionalworkingcapital:$150+($80
$45)=$185
69. Byswitchingtoanaccelerateddepreciationmethod,theincreaseinNPV(in$)forProject
#162isclosestto:
A.4,445.
B.6,667.
C.11,112.
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Correctanswer:A
andevaluatehowthechoiceofdepreciationmethodaffectsthosecashflows.Itisnotnecessary
tocomputetheNPVinExhibit1tofindthisvalue(however,thiswillalsoleadtothecorrect
answer).Sumthediscounteddifferencesinthedepreciationcashflows(Exhibit2lessExhibit1)
multipliedbythetaxrateof40%:
Year1 Year2 Year3 Year4 Year5

Depreciation(Accelerated) 49,995 66,675 22,215 11,115 0
Depreciation(Straightline) 30,000 30,000 30,000 30,000 30,000
AcceleratedStraightline 19,995 36,675 (7,785) (18,885) (30,000)
Diff(AccelSL)*0.4 7,998 14,670 (3,114) (7,554) (12,000)
NPVofDiff@10%=$4,444.74
70. Intheirinitialdiscussion,NorthsresponsetoEarlismostlikely
A.correct
B.incorrect,becausethediscountratedoesnotneedtobeadjusted
C.incorrect,becausetheinflationrateadjustmentshouldbebasedonexpectedinflation.
Correctanswer:B
Discusstheeffectsofinflationoncapitalbudgetinganalysis.
Theresponseisincorrectbecausenominalcashflowsshouldbediscountedatnominaldiscount
rates.
71. Earlssecondstatementismostlikelyanexampleofwhichtypeofrealoption?
A.Sizing
B.Timing
C.Pricesetting
Correctanswer:A
Discussthetypesofrealoptionsandevaluateacapitalprojectusingrealoptions.
Earlssecondstatementisanexampleofasizingoption.
72. Northsstatementconcerningthedegreeofoperatingleverageismostlikely:
A.correct.
Bincorrect,becausethedegreeofoperatingleveragedecreaseswithexpansion.
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C.incorrect,becausethedegreeofoperatingleverageremainsunchangedwithexpansion.
Correctanswer:B
CapitalStructureandLeverage,RajAggarwal,CFA,CynthiaHarrington,CFA,AdamKobor,CFA,
andPamelaPeterson
Calculateandinterpretthedegreeofoperatingleverage,thedegreeoffinancialleverage,and
thedegreeoftotalleverage
Northsstatementisincorrect.Theincreasedunits(Q)multipliedbytheunchangedperunit
contributionmargin(PV)meansDOLaccordingtoequation(2)decreaseswiththeunchanged
fixedcost(F):DOL=Q(PV)/[Q(PV)F]=1/[1F/{Q(PV)}]
KeyPoints:
CashFlowProjection
Los28.acomputetheyearlycashflowsofanexpansioncapitalprojectandareplacementcapital
projectandevaluatehowthechoiceofdepreciationmethodaffectsthosecashflows;
Evaluatingprojectswithrealoptions
Los28.fdiscussthetypesofrealoptionsandevaluateacapitalprojectusingrealoptions;
Realoptionsallowmanagerstomakedecisionsinthefuturethatalterthevalueofcapital
budgetinginvestmentdecisiontoday.
Instead of making all capital budgeting decision now, managers can wait and make
additional decisions at future dates when these decisions are contingent upon future
economicinformation.
Likefinancialoptionsarecontingentonanunderlyingasset,realoptionsarecontingent
onfutureevents.
ThisflexibilityenhancestheNPVofaproject.
Typesofrealoptionsinclude:
Timingoptions:delaydecisionwithhopeofhavingbetterinfo
Abandonmentoptions: >CF
Expansionoptionslikecalloption
CAPEX
W.C.investment
Cashcollected
OperatingCF
CFfromdisposal
W.C;
FA
Basic Formula
Initial
stage
Operating
stage
Terminating
stage
Initialoutlay=
FCInv+NWCInv
Sal
0
T(Sal
0
B
0
)
CF=(SCD)(1T)+D
=(SC)(1T)+DT
TNOCF = Sal
T
+ NWCInv
T(Sal
T
- B
T
)
In operating stage, the CF is
based on incremental, i.e.,
Incremental sales;
Incremental cost;
Incremental depreciation.
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Flexibilityoptions:morechoicesonoperationalaspects
Fundamentaloptions:projectsareoptionsthemselvesbecausethepayoffsdependon
thepriceofunderlyingasset.
Alternativemeasuresofincomeandvaluationmodels
EconomicincomeVs.Accountingincome
Economicincome Accountingincome
onomicincome=aftertaxcashflow+changein
themarketvalue
Accountingincome=revenueexpense
Economicdepreciation:
hedecreaseinthemarketvalueofinvestment
Accountingdepreciation:
thedecreaseinthebookvaluebasedonthe
originalcostofinvestment
Financingcost:
Areignored
Financingcost:
Aresubtractedtoarrivedatnetincome

Evaluatingamergerbid
Los 32.K evaluate a merger bid, calculate the estimated postmerger value of an acquirer, and
calculatethegainsaccruedtothetargetshareholdersversustheacquirershareholders;
postmergervalueofthecombinedcompany(acquirerandtarget)
premergervalueofacquirer
=premergervalueoftarget
S synergiescreatedbythemerger
C cashpaidtotarget
AT A T
AT
A
T
V V V S C
V
V
V
= + +
=
=
=
= shareholders
target of ue merger val - pre

for target paid price
premium takeover
rs shareholde target to accrued gains
=
=
=
=
= =
T
T
T
T T T
V
P
TP
Gain
V P TP Gain
rs shareholde acquirer the to accrued gains

) (
=
= =
A
T T A
Gain
V P S TP S Gain

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Case2:NationalPlasticsCaseScenario
National Plastics Corp. is a leading manufacturer of highquality injectionmolded plastic
packaging materials used in various industries, primarily in the food and beverage industry. In
late November 2010, the company received approval for two important patent
applicationsone providing for improved tamper protection for plastic containers and another
foranimprovedbiodegradableplasticfilmthatallowsforbetterfoodpreservation.
On 4 January 2011, Haines Foods and Snacks, Inc. launched a hostile takeover bid for all of the
shares of National at $30 per share (which was a $5 premium in excess of the prebid price).
Haines Foods is a national supplier of deli and dairy products. If its bid is successful, it plans to
continuetooperateNationalasawhollyownedsubsidiary.
Zenith ThermoPlastics Inc. produces plastic containers and bags that are used in the food and
beverageindustry.KeithWhelan,whoisbothchiefexecutiveofficerandchieffinancialofficerof
Zenith, had been in discussions with National to either purchase or license its newly patented
technologies. As a possible alternative, in view of the Haines bid, Whelan began to consider
havingZenithmakeitsowntakeoverbidforNational.
Whelan provided Nationals most recent financial statements, as indicated in Exhibits 1 to 3, to
one of his assistants, Mike Noth, with directions to calculate Nationals free cash flow as a first
stepindeterminingthemaximumvaluethatZenithshouldbewillingtopayforNationalsshares,
usingthediscountedcashflowapproach.

Exhibit1
NationalPlasticsCorp.
($millions,exceptpershareamounts)
ForYearEnding31December 2010
Revenues $1,614
Costofgoodssold 841
Selling,general,andadministrativeexpense 436
Earningsbeforeinterest,taxes,depreciation,andamortization(EBITDA) 337
Depreciationexpense 61
Operatingincome 276
Interestexpense 47
Pretaxincome 229
Incometax(32%) 73
Netincome $156
Numberofoutstandingshares(millions) 60
2010Earningspershare $2.60
2010Dividendspaid(millions) $37
2010Dividendspershare $0.62
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Exhibit2
NationalPlasticsCorp.
ConsolidatedBalanceSheets
($millions)
At31December 2010 2009
Cashandcashequivalents $8 $5
Othercurrentassets 315 295
Totalcurrentassets 323 300
Longtermassets,net 1,203 1,130
Totalassets $1,526 $1,430
Currentliabilities $696 $670
Longtermdebt 562 611
Commonstockholdersequity 268 149
Totalliabilitiesandstockholdersequity $1,526 $1,430
Exhibit3
OtherFinancialInformationforNationalPlasticsCorp.
31December2010
Effectivetaxrate 32.0%
Costofequity 12.0%
Weightedaveragecostofcapital 9.0%
NothsoonreturnsandpointsoutthatthefreecashflowsfromNationalwilldifferinfutureyears
asaresultofitsnewpatentsjustasZenithwantedtolicensethetechnology,hesuggeststhat
other plastic firms would also be interested. Noth also suggests that since National has a lower
debttoequity ratio than the rest of the industry, it could support more debt, and he has
adjustedtheweightedaveragecostofcapitalaccordingly.Nothsprojectedcashflowsandother
estimatesareprovidedinExhibit4.
Exhibit4
EstimatesandAssumptionsofMikeNoth
UsedinValuingNationalPlasticsasofJanuary2011
(allnumbersin$millionsexceptWACC)
2011 2012 2013 2014 Thereafter
Endofyearfreecashflowtofirm 170 165 180 195 Growthat5%perannum
Weightedaveragecostofcapital 10.5%
Totaldebtimmediatelyfollowingacquisition 650
After a discussion about the appropriate cash flow estimates and discount rates to use in
determining the value of National to Zenith, Whelan decided that Zenith should make a mixed
offerforallofNationalssharesfor$35pershare,consistingof$23incashandZenithcommon
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stockwithanexchangeratioof0.24.ThedetailsoftheofferarefoundinExhibit5.
Exhibit5
DetailsofZenithsPlannedTenderOfferforAllofNationalPlasticsCommonShares
NationalPlastics ZenithThermoPlastics
Premergerprice $25/share $50/share
Sharesoutstanding 60million 100million
Tenderoffer Zenithwillpay$35pershareforNational,consistingof$23incash
andZenithcommonshareswithanexchangeratioof0.24.
Postmerger Followingthemerger,Zenithssharesareexpectedtobepricedat
$53/share.
Synergiesfrom
merger
Zenithbelievesthatmostofthesynergiesarisingfromthemerger
resultfromNationalsnewpatents.
Because National and Zenith are both based in the United States, Whelan also decided to have
Noth calculate the pre and postacquisition HerfindahlHirschman Index (HHI) for the industry.
NothsHHIcalculationswere1,910preacquisitionand2,170postacquisition.BasedontheHHI
values,Whelanconcludedthat:
theindustryiscurrentlyhighlyconcentrated,
butunderapplicableU.S.law,anincreaseintheHHIoflessthan300shouldnotgenerate
anygovernmentalchallengestoblocktheacquisitionofNational.
When Whelan presented Zeniths proposed takeover to his board the following day, one of the
directorsmadethefollowingcomments:
1.WhileIamcertainlyinfavorofthistakeover,Ithinkwewouldachievethegreatestvaluefrom
theacquisitionifweoffermorestockandlesscash.
2. Over the next few years, this merger should be good for our company, as the empirical
evidence from merger studies indicates that acquirers normally outperform their peers during
thethreeyearsfollowingamerger.
73. IfHainesFoodsissuccessfulinitsattempttoacquireNationalPlastics,thebusiness
combinationisbestclassifiedaswhichtypeofmerger?
A.Vertical,forward
B.Vertical,backward
C.Horizontal,conglomerate
Answer=B
MergersandAcquisitions,RositaP.ChangandKeithM.Moore
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StudySession932a
Classifymergerandacquisition(M&A)activitiesbasedonformsofintegrationandtypesof
mergers.
Biscorrect.IfHainesacquiresNational,itwouldbeaverticalmergerastheyarebothinthe
sameproductionchain.ItisanexampleofbackwardintegrationasHainesisclosertothe
consumerthanthepackagingmanufacturer.
74. Nationalsfreecashflowtothefirm(FCFF)(inmillions)for2010isclosestto:
A.$104.
B.$121.
C.$182.
Answer=B
FreeCashFlowValuation,JeraldPinto,ElaineHenry,ThomasRobinson,andJohnStowe
StudySession932i,1240c,d
Calculatefreecashflowsforatargetcompanyandestimatethecompanysintrinsicvaluebased
ondiscountedcashflowanalysis.
Explaintheappropriateadjustmentstonetincome;earningsbeforeinterestandtaxes(EBIT);
earningsbeforeinterest,taxes,depreciation,andamortization(EBITDA);andcashflowfrom
operations(CFO)tocalculateFCFFandFCFE.
CalculateFCFFandFCFE.
Biscorrect.
$inmillions
FCFF=NI+NCC+Int(1TaxRate)WCInvFCInv
Formula7inReading1240:
NI NetIncome 156
+Int(1Taxrate) +Netinterestaftertax 47(10.32) 32
+NCC +Noncashcharges DepreciationExpense +61
WCInv* Changesinnetworking
capital*
(315*696)(295*
670)
+6
FCInv Capitalexpenditures (1,2031,130)+61 134
FCFF Freecashflowtofirm 121
*Changeinnetworkingcapitalexcludeschangesincashandcashequivalents
75. BasedonNothsassumptionsinExhibit4,themostthatZenithshouldbewillingtopayfor
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eachshareofNationalisclosestto:
A.$40.
B.$51.
C.$60.
Answer=A
FreeCashFlowValuation,JeraldPinto,ElaineHenry,ThomasRobinson,andJohnStowe
StudySession932i,1240j
Calculatefreecashflowsforatargetcompanyandestimatethecompanysintrinsicvaluebased
ondiscountedcashflowanalysis.
Aiscorrect.
Year FreeCashFlow
($inmillions)
PVofFreeCashFlowat
10.5%
PV
($inmillions)
2010 170 170(1.105) 154
2011 165 165(1.105)2
135
2012 180 180(1.105)3
133
2013 195 195(1.105)4
131
PVofFCF 553
Terminalgrowthrate 5%
Terminalvalue,2013
[ ] ( )
( )
2013 * 1 g
-g
FCF
r
+

( )
( )
195* 1.05
0.105 0.05

=3,722.73
Terminalvalueatstartof2010
3,723
(1.105)4
2,497
Enterprisevalue 3,050
Lessdebtafteracquisition 650
Maximumvalueofequity 2,400
Maximumpricepershare(60millionshares) 2,40060=
$40
76. BasedonZenithsproposedtenderofferandinformationinExhibit5,thesynergyarising
fromthismerger(inmillions)isclosestto:
A.$643.
B.$943.
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C.$1,063.
Answer=B
StudySession932k,l
Evaluateamergerbid,calculatetheestimatedpostmergervalueofanacquirer,andcalculate
thegainsaccruedtothetargetshareholdersversustheacquirershareholders.
Explaintheeffectsofpriceandpaymentmethodonthedistributionofrisksandbenefitsina
mergertransaction.
Biscorrect.
SharesofZenithoutstandingaftermerger
OriginalfromZenith 100m
Issuedinacquisition 14.4m 0.24shAcquirer/shTarget60m
Totalshares 114.4m
Valueofsharespostmerger=$53/sh114.4m=$6,063million
Valueofsharespostmergerintermsofpreacquisitionvalues,synergies,andcashpaid
ValuepremergerofZenith $5,000 $50/sh100msh
ValuepremergerofNational 1,500 $25/sh60msh;price=$30$5=$25
+Synergies +X Currentlyunknown
Cashpaid 1,380 $23/sh60msh
Valueofallsharespostmerger 6,063 Valuefromabove
Synergies $943 SolveforX
*ValuetoNationalss/hpostmergeristheactualamountpaidforthetakeover
/shpershares/h:shareholder100m:100millionshares,etc.
77. ThemostaccurateinterpretationofWhelansconclusionsconcerningthepreand
postacquisitionHHIisthattheyare:
A.bothcorrect.
B.incorrectinregardtotheindustrybeinghighlyconcentrated.
C.incorrectinregardtotheincreaseinHHInecessarytotriggeragovernmentalchallengeto
theacquisition.
Answer=C
StudySession932g
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CalculatetheHerfindahlHirschmanIndexandevaluatethelikelihoodofanantitrustchallenge
foragivenbusinesscombination.
Ciscorrect.AnHHIgreaterthan1,800indicatesthatanindustryishighlyconcentrated.Should
theHHIinahighlyconcentratedindustrychangeby50ormore,agovernmentalchallengetoa
particularbusinesscombinationisverylikely(seeExhibit2onpage265).Inthisinstance,the
industryishighlyconcentratedandtheHHIchangesby260makingWhelanssecondconclusion
incorrect.
78. WhichofthefollowingstatementsmadebythememberoftheBoardofDirectorsismost
accurate?
A.Statement1only
B.Statement2only
C.Neitherstatement1nor2
Answer=C
StudySession932l,m
Explaintheeffectsofpriceandpaymentmethodonthedistributionofrisksandbenefitsina
mergertransaction.
Describetheempiricalevidencerelatedtothedistributionofbenefitsinamerger.
Ciscorrect.Bothstatementsareincorrect:[1]Themoreofthemergerthatispaidforbystock,
themorethattherisksandbenefitsofrealizingthesesynergies(assumingtheyreallyexist)will
bepassedontothetargetshareholdershencealowerbenefittotheacquiringcompanywill
resultifmorestockisused.
[2]Theempiricalevidenceshowsthatacquirerstendtounderperformcomparablecompanies
duringthethreeyearsfollowinganacquisition.
KeyPoints:
Categorizemergerandacquisitionactivities
los32a:classifymergerandacquisition(M&A)activitiesbasedonformsofintegrationandtypes
ofmergers
Typesofmergers
1) Inahorizontalmerger,thetwobusinessesoperateinthesameorsimilar
industries.
2) Inaverticalmerger,theacquirerbuysanothercompanyinthesameproduction
chain.Includingforwardintegrationtoultimateconsumersandbackward
integration(movingupanddownthesupplychain)
3) Inaconglomeratemerger,theacquirerbuysanothercompanyunrelatedtoits
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corebusiness.Therearefewsynergiesfromcombiningthetwocompanies.
Formsofintegration
1) Inastatutorymerger,theacquiringcompanyacquiresalloftargetsassetsand
liabilities. A+B=A
2) Inasubsidiarymerger,thetargetcompanybecomesasubsidiaryofthe
purchaser.A+B=A+B
3) Withaconsolidation,bothcompaniesceasetoexistintheirpriorform,and
theycometogethertoformacompletelynewcompany.A+B=C
Valuingatargetcompany
los32i:calculatefreecashflowsforatargetcompany,andestimatethecompany'sintrinsic
valuebasedondiscountedcashflowanalysis
Discountedcashflowanalysis:similartothefreecashflowtothefirm(FCFF)approach.
1) Determinewhichfreecashflowmodeltousefortheanalysis.
2) Developproformafinancialestimates.
3) Calculatefreecashflowsusingtheproformadata.
4) Discountfreecashflowsbacktothepresentattheappropriaterate.
(WACC
adjusted
)
5) Determinetheterminalvalueanddiscountitbacktothepresent.
6) AddthediscountedFCFvaluesforthefirststageandtheterminalvalueto
determinethevalueofthetargetfirm.
Net income
+ Net interest after tax = unleveled Net income
change in deferred taxes
= net operating profit less adjusted taxes (NOPLAT)
+ Net noncash charges
change in net working capital
- Capital expenditures (capex)
= Free cash flow (FCF)
AntitrustlawandHHI
los32g:calculatetheHerfindahlHirschmanIndex,andevaluatethelikelihoodofanantitrust
challengeforagivenbusinesscombination
TheHHIiscalculatedasthesumofthesquaredmarketsharesforallfirmswithinan
industry.
2
1
) 100 (
=
=
n
i
i
MS HHI

MS
i
=marketshareoffirmi
n=numberoffirmsintheindustry
HHIconcentrationlevelandlikelihoodofantitrustaction
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PostmergerHHI Concentration ChangeinHHI Government
action
HHI<1,000 Notconcentrated Anyamount Noaction
1,000<HHI<1,800 Moderatelyconcentrated 100ormore Possiblechallenge
HHI>1,800 Highlyconcentrated 50ormore Challenge
Evaluatingamergerbid
los32 k: evaluate a merger bid, calculate the estimated postmerger value of an acquirer, and
calculatethegainsaccruedtothetargetshareholdersversustheacquirershareholders
rs shareholde target to paid cash C
merger by the created synergies S
target of ue merger val - pre =
acquirer of ue merger val - pre
target) and (acquirer company combined the of ue merger val - post
=
=
=
=
+ + =
T
A
AT
T A AT
V
V
V
C S V V V

target of ue merger val - pre
for target paid price
premium takeover
rs shareholde target to accrued gains
=
=
=
=
= =
T
T
T
T T T
V
P
TP
Gain
V P TP Gain

rs shareholde acquirer the to accrued gains
) (
=
= =
A
T T A
Gain
V P S TP S Gain

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Case3:HiChuCaseScenario
Hi Chu is a manager of a manufacturing subdivision of Restar Corporation. Restar is a
conglomeratewithdivisionsinthecontainerindustry.Chustaskistoforecasttheprofitabilityof
a fouryear project for the manufacturing of specialty labeled aluminum cans. Restar has never
manufactured such an item before and will require new equipment for the project. Exhibit 1
displaysChusabridgedforecastedfinancialprojectionsfortheproject.
Exhibit1
SpecialtyLabeledAluminumCansProject
FinancialProjections
(Valuesareyearendtotalsin000s)
Year0 Year1 Year2 Year3 Year4
FixedCapital 100,000
WorkingCapital 0
TotalInvestment 100,000
Sales 60,000 72,000 86,400 103,680
OperatingCosts 24,000 28,800 34,560 41,472
Depreciation 25,000 25,000 25,000 25,000
EBIT 11,000 18,200 26,840 37,208
Interest 4,000 3,112 2,154 1,118
EBT 7,000 15,088 24,686 36,090
Tax(40%) 2,800 6,035 9,874 14,436
NetIncome 4,200 9,053 14,812 21,654
Dividends 1,680 3,621 5,925 8,662
AdditiontoRetainedEarnings 2,520 5,432 8,887 12,992
CapitalEmployed 100,000 75,000 50,000 25,000 0
RestarsCostofCapitalandCapitalStructure
CostofDebt 8.00%
CostofEquity 15.00%
DebtRatio(TotalDebtTotalAssets) 50.00%
InameetingwithRestarsCFO,TreyPapier,Chudiscussesthemeritsoftheproject.Chumakes
thefollowingpoints:
AllassumptionsintheprojectionsarebasedontheoveralldebtandequitymixofRestarand
onRestarscorporatepolicyinregardtodividendpayout.
However, instead of using the weighted average cost of capital (WACC), I think the project
shouldbeevaluatedwithaprojectspecificmarketdetermineddiscountrateof16%becausethe
project is not similar to any of the firms current manufacturing processes. Papier asks Chu if
other evaluation methods were considered. Chu replies that he has computed the economic
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profit instead, and using WACC as the discount rate, he found themarket valueadded (MVA)to
bemuchhigher($21.9million)thanthepreviousNPVcalculationof$6.4million.
Chu states that he is uncertain as to the appropriate cost of equity to use because two weeks
earlier, Restars management announced that the financing mix was going to change by
increasingthetargetdebtratioto60%.Asaresult,hesays,thechoicesseemtobethe:
costofequityforanunleveredfirm,
firmscurrentcostofequity,or
cost of equity based on the Modigliani and Miller tax model and the new target debt ratio,
assumingthatthecostofdebtrisesto8.75%.
Papierinterjectsthatthecurrentcostofequitywouldbebetterbecausetheimplementationof
thenewfinancingmixislikelytobedelayed.Papierstatesthatthedelayisbecausethestructure
oftheboardofdirectorsisabouttochangeinthefollowingways:
TheCEOwillnolongerbethechairmanoftheboard.
TheretiredoriginalfounderofRestarwillnowbecomethechairmanoftheboard.
TheboardwillnowhaveamajorityofmemberswhohavehadpastexperienceatRestar.
Despite these changes, Papier believes it is still important to explore the potential value of this
newproject.
Three weeks later, Chu and Papier meet again and review Chus work. After some discussion,
they think an alternative project will perform the same task as the original project. The
alternative project will cover a sixyear period. Chu has calculated its NPV based on aftertax
operating cash flows with the same discount rate of 16% used for the original project. Chu and
Papier agree that since the two projects are mutually exclusive, they can decide between them
using the equivalent annual annuity approach. The NPVs of the two projects aresummarized in
Exhibit2.
Exhibit2
ComparisonofProjectNPVs
Project ProjectLife NPV
Original 4years $6,406,450
Alternative 6years $8,141,220
79. BasedonExhibit1,theaftertaxoperatingcashflow(in$1,000)forYear1isclosestto:
A.31,600.
B.33,200.
C.46,600.
Answer=A
CapitalBudgeting,JohnD.StoweandJacquesR.Gagne
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StudySession828a
Calculatetheyearlycashflowsofanexpansioncapitalprojectandacapitalreplacementproject,
Aiscorrect.Basedonequation(7)onpage31:
( ) ( ) CF= sales-operating expenses -depreciation * 1-tax rate depreciation +

( ) $60, 000 $24, 000 $25, 000 *(1 0.40) $25, 000 $31, 600 CF = + =

80. BasedonExhibit1,theeconomicprofit(in$1,000)forYear1isclosestto:
A.8,400.
B.3,300.
C.1,100.
Answer=B
StudySession828a,i
Calculatetheyearlycashflowsofanexpansioncapitalprojectandacapitalreplacementproject,
Distinguishamong,andevaluateacapitalprojectusing,theeconomicprofit,residualincome,
andclaimsvaluationmodels.
Biscorrect.Basedonequation(12)onpage64(Notethatcapitalemployedisbasedon
beginningofyearvaluesasperthereadingandthedebtratiois50%fromExhibit1):
Economicsprofit=EP=NOPAT$WACC
( ) * 1 tax rate * EP EBIT WACC capital =

( ) ( ) ( ) 1 0.50*0.08* 1 0.40 1 0.50 *0.15 0.099
d d e e
WACC w r t w r = + = + =
( ) $11, 000* 1 0.40 $100, 000*0.099 $3, 300 EP = + =

81. ThedividendpaymentpolicyassumedbyChuinExhibit1ismostaccuratelydescribedas
a:
A.stabledividendpolicy.
B.residualdividendpayoutpolicy.
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C.constantdividendpayoutratiopolicy.
Answer=C
DividendsandShareRepurchases:Analysis,GregoryNoronhaandGeorgeH.Troughton
StudySession830f
Comparestabledividend,targetpayout,andresidualdividendpayoutpolicies,andcalculatethe
dividendundereachpolicy.
Ciscorrect.WhenviewingExhibit1,thedividendpayoutratioforeachyearis40%ofnet
income.Thisresultisconsistentwithaconstantdividendpayoutpolicy.
82. Thecostofequity(%)underthenewlyannouncedfinancingmixusingChusassumption
onthechangeinthecostofdebtandhissuggestedapproachisclosestto:
A.15.1.
B.15.6.
C.16.3.
Answer=B
CapitalStructure,RajAggarwal,PamelaPetersonDrake,AdamKobor,andGregoryNoronha
StudySession829a
ExplaintheModiglianiMillerpropositionsconcerningcapitalstructure,includingtheimpactof
leverage,taxes,financialdistress,agencycosts,andasymmetricinformationonacompanyscost
ofequity,costofcapital,andoptimalcapitalstructure.
Biscorrect.Basedonequations(9)onpage104:
( )( ) 0 0
r 1
e d
D
r r r t
E
= + - -

r0=costofequityofanallequitycompany=?
re=costofequityforthefirm=0.15(Exhibit
1)
rd=costofdebtforthefirm=0.08(Exhibit1)
Firstsolveforr0basedoncurrentdebtandequitymixgiventhefollowingoriginalinputs:
CurrentD/E=debttoequityratio=0.50(10.50)=1.0(impliedfromExhibit1)
t=taxrate=0.40(Exhibit1)
( )
( )
( )
( )
0
1
0.15 0.08 1 0.4 1.0 0.198
0.12375
1 1 0.4 1.0 1.6
1 1
e d
D
r r t
E
r
D
t
E
+ -
+ -
= = = =
+ -
+ -

Thensolveforrebasedonthenewdebtandequitymix(0.60)andthenewcostofdebt
(0.0875):
RevisedD/E=debttoequityratio=0.60(10.60)=1.5(basedondebtratioof0.60)
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( )( )
0.12375 0.12375 0.0875 1 0.4 1.5 0.156375 15.6%
e
r = + - - = =

83. Whichchangestotheboardofdirectorsismostconsistentwithbestpracticesinthe
compositionofaboard?
A.ChangeregardingtheCEO
B.Specificchoiceofthenewchairmanoftheboard
C.Changeinthecompositionoftheboardmembership
Answer=A
CorporateGovernance,RebeccaToddMcEnallyandKennethKim
StudySession931e
Explaineffectivecorporategovernancepracticeasitrelatestotheboardofdirectors,and
evaluatestrengthsandweaknessesofacompanyscorporategovernancepractice.
Aiscorrect.Basedonpage198,section5.1.2,thechairmanofaboardshouldnotbeasenior
executivefromthefirm.
84. Basedontheequivalentannualannuitymethodfortheoriginalandalternativeprojects,
themostappropriateconclusionisto:
A.accepttheoriginalproject.
B.acceptthealternativeproject.
C.beindifferentbetweenthetwoprojects.
Answer=A
StudySession828c
Evaluateandselecttheoptimalcapitalprojectinsituationsof1)mutuallyexclusiveprojectswith
unequallives,usingeithertheleastcommonmultipleoflivesapproachortheequivalentannual
annuityapproach,and2)capitalrationing.
Aiscorrect.
FindtheannuitizedvalueoftheNPVbasedon16%foreachproject:
ProjectLife Calculation Equivalentannualcash
flow
4years
originalproject
( )
4
1
$6, 406, 450*0.16*1/ 1
1 0.16

+

PV=6,406,450;N=4;I=16;CPTPMT?
=$2,289,506
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=$2,289,506
6years
alternative
project
( )
6
1
$8,141, 220*0.16*1/ 1
1 1.16

+

PV=8,141,220;N=6;I=16;CPTPMT?
=$2,209,445
=$2,209,445
Conclusion: Choosetheoriginal4yearprojectasitproducesthehighestequivalent
annualcashflow
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KeyPoints:
CAPEX
W.C.investment
Cashcollected
OperatingCF
CFfromdisposal
W.C;
FA
Basic Formula
Initial
stage
Operating
stage
Terminating
stage
Initialoutlay=
FCInv+NWCInv
Sal
0
T(Sal
0
B
0
)
CF=(SCD)(1T)+D
=(SC)(1T)+DT
TNOCF = Sal
T
+ NWCInv
T(Sal
T
- B
T
)
In operating stage, the CF is
based on incremental, i.e.,
Incremental sales;
Incremental cost;
Incremental depreciation.
Alternativemeasuresofincomeandvaluationmodels
los28 h: calculate and interpret accounting income and economic income in the context of
capitalbudgeting
Economic income is equal to the aftertax cash flow plus the change in the projects
marketvalue.
economicincome=cashfloweconomicdepreciation
=cashflow+(endingmarketvalue beginningmarketvalue)
economicdepreciation=beginningmarketvalue endingmarketvalue
Accountingincomeisequaltotherevenuesminuscostsoftheproject.
Basedontheoriginalcost(notmarketvalue)oftheinvestment.
Financing costs (e.g., interest expense) are considered as a separate line item
andsubtractedouttoarriveatnetincome.
EconomicincomeVs.Accountingincome
Economicincome Accountingincome
Economic income = aftertax cash flow +
changeinthemarketvalue
Accountingincome=revenueexpense
Economicdepreciation:
the decrease in the market value of
investment
Accountingdepreciation:
the decrease in the book value based on the
originalcostofinvestment
Financingcost:
Areignored
Financingcost:
Aresubtractedtoarrivedatnetincome
Mutuallyexclusiveprojectswithdifferentlives
los28c:evaluateandselecttheoptimalcapitalprojectinsituationsof
(1) mutuallyexclusiveprojectswithunequallives,usingeithertheleastcommonmultipleof
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livesapproachortheequivalentannualannuityapproach
(2) capitalrationing;
Theissue:
Can NOT assess directly by comparing with the NPV of 2 projects as 2 projects
arewithdifferentlives;
Assumedthatthe2projectsarerepeatedoverthetimehorizon
Two methods to compareprojects withunequal livesthat are exceptedto be repeated
indefinitely:
Leastcommonmultipleoflivesapproach
Extendsthelivesoftheprojectssothatthelivesdivideequallyintothe
chosentimehorizon.
Equivalentannualannuity(EAA)approach
Is the annuity payment each project year that has a present value
(discountedattheWACC)equaltotheNPVoftheproject.
choosetheinvestmentchainthathasthehighestEAA.
Thetwoapproachesarelogicallyequivalentandwillresultinthesamedecision.
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Portfolio
Case1:MaryMarconiCaseScenario
Mary Marconi is a senior portfolio manager for a U.Sbased investment management firm.
Marconiistrainingtwonewlyhiredassistantportfoliomanagers,YipengLiuandMichaelMensah.
Marconiindicatesthatthetrainingsessionwillfocusontheevaluationofinternationalsecurities,
the use of the international capital asset pricing model, and managing the impact of currency
risk.
Marconi presents the data in Exhibit 1 to help illustrate various concepts in international asset
pricing.
Exhibit1
SummaryDatafortheU.S.andU.K.
U.S.expectedinflationoverthenextyear 4.75%
U.K.expectedinflationoverthenextyear 1.25%
Currentexchangerate($/) 1.724
RiskfreeU.S.bondoneyearyield 6.50%
RiskfreeU.K.bondoneyearyield 2.35%
RatioofU.S.pricelevel/U.K.pricelevel 1.5:1
Liubeginsbystating,Thedomesticcapitalassetpricingmodel(CAPM)isausefultoolfor
analyzingtheriskreturnrelationshipforsecurities.IunderstandthatthedomesticCAPMcanbe
extendedtotheinternationalcontextprovidedthatwemakethefollowingadditional
assumptions:
1.Investorsworldwidehaveidenticalconsumptionsbaskets.
2Nominalpricesofconsumptiongoodsareidenticalineverycountry.
Marconiresponds:AmajorproblemwiththisextendedCAPMisthatitdoesnotaccountforreal
foreigncurrencyrisk.ItwouldbemoreappropriatetouseaninternationalCAPM.Mensahasks:
HowwillexchangeratechangesimpactthedollarreturnsofaU.S.investorsinvestmentinU.K.
securities?
RespondingtoMensah,Marconistates.Currencymovementscanhaveasignificantimpacton
returnsindollars.Forexample,ifthereis1%appreciationofthepound,evenwhenthereisno
changeinthepoundpriceofaU.K.security,therewillstillbea1%gaininU.S.dollarterms.
MarconithenposesthefollowingquestiontoMensahandLiu:Assumethatyouareevaluatinga
companybasedintheUnitedStatesthatpricesitsproductsinU.K.poundsbutincurscostsinU.S.
dollars.IftheU.S.dollarappreciatesinrealterms,howwillthecompanyssharepricebe
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impacted?
85. AretheassumptionsoftheextendeddomesticcapitalassetpricingmodellistedbyLiu
correct?
A.Yes.
B.No,assumption1isincorrect.
C.No.assumption2isincorrect.
Correctanswer:C
InternationalAssetPricing,BrunoSolnikandDennisMcLeavey
JustifytheextensionofthedomesticCAPMtoaninternationalcontext(theextendedCAPM)and
describetheassumptionsneededtomaketheextension.
Ciscorrect.Assumption2isincorrect.ExtendingthedomesticCAPMtotheinternationalcontext
requirestheassumptionthatrealpricesofconsumptiongoodsareidenticalineverycountry.
86. BasedonthedatainExhibit1.assumingthatinflationisaspredictedandthereal
exchangerateremainsconstanttheexpectednominalexchangerate(in$/)attheendof
oneyearisclosestto:
A.$1.666.
B.$1.783.
C.$1.836.
Correctanswer:B
Calculatetheexpected(1)exchangerateand(2)domesticcurrencyholdingperiodreturnona
foreignbond(security),givenexpected,predictableinflationrates,thebeginningofperiod
nominalexchangerate,andtheconstantrealexchangerate.
Biscorrect.
calculatedasfollows:
E(S)=S
0
*(1+I
US
)/(1+I
UK
)=1.724*1.0475/1.0125=1.783
87. BasedonthedatainExhibit1.assuminginflationisaspredictedandtheactualexchange
rateattheendoftheyearis$1.587perpound,theexpostdollarreturnonaoneyearU.K.
bondisclosestto:
A.4.54%.
B.5.79%.
C.9.29%.
Correctanswer:B
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Calculatetheendofperiodrealexchangerateandthedomesticcurrencyexpostreturnona
foreignbond(security),giventheendofperiodexchangerate,thebeginningofperiodreal
exchangerate,andtheinflationratesduringtheperiod.
Biscorrect.R
US
=R
UK
+s+sR
UK
=0.0235+(0.0795)+(0.0235(0.0795))=0.0579Where,s
=(1.5871.724)/1.724=0.07947
88. BasedonthedatainExhibit1,iftheexpectedexchangeattheendofoneyearis$1.820
perpound,theforeigncurrencyriskpremiumisclosestto:
A.1.42%.
B.4.15%.
C.5.57%.
Correctanswer:A
Calculateaforeigncurrencyriskpremiumandexplainaforeigncurrencyriskpremiuminterms
ofinterestratedifferentialsandforwardrates.
Aiscorrect.Theforeigncurrencyriskpremium(SRP)canbecalculatedastheexpected
movementintheexchangerateminusthedifferencebetweenthedomesticandforeignriskfree
rate.
SRP=E[(S1S0)/S0](r
US
r
UK
)=(1.8201.724)/1.724(0.0650.0235)=0.142or1.42%
89. TheexampleMarconiprovidesinresponsetoMensahsquestiononcurrencymovements
wouldbemostrealisticifthecorrelationbetweenU.K.securityreturns(inpounds)and
exchangeratemovements(inpoundsperdollar)isequalto:
A.1
B.0
C.1
Correctanswer:B
Definecurrencyexposureandexplainexposuresintermsofcorrelations.
Biscorrect.
=currencyexposureofU.S.asset(domestic)
FC=currencyexposureofU.K.asset(foreign)
=FC+1
IfthecorrelationbetweenreturnsonaU.K.assetmeasuredinpounds(localcurrencyreturn)
andexchangeratemovements(s)iszero,thatis
FC
=0,then=1.Thatisthecorrelation
betweenreturnsontheU.K.assetmeasuredindollars(domesticcurrencyreturn)andexchange
ratemovementsis1.So,whenthepoundappreciatesby1%,ifthecorrelationbetweenreturns
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onaU.K.measuredinpounds(localcurrencyreturn)andtheexchangeratemovementsiszero,
thentheU.S.investorgains1%inU.S.dollarterms.
90. ThemostappropriateresponsetothequestionposedbyMarconiisthatthecompanys
sharepricewilllikely:
A.increase.
B.decrease.
C.remainunchanged.
Correctanswer:B
Discussthelikelyexchangerateexposureofacompanybasedonadescriptionofthecompanys
activities,andexplaintheimpactofbothrealandnominalexchangeratechangesonthe
valuationofthecompany.
Biscorrect.Sharepriceswillmostlikelydecrease.RevenuesareearnedinU.K.poundsandcosts
areincurredinU.S.dollars.Asthedollarappreciates,revenuesthatareearnedinpoundsare
nowworthlesswhenconvertedtodollars.Inputcostsaredenominatedindollarssotheywill
remainunchanged.Earningswilldeclineandthereforesharepricescanalsobeexpectedto
decline.
KeyPoints:
DomesticCAPMandExtendedCAPM
ExtendedCAPM(extendedtointernationalenvironment)
1) Twoadditionalunreasonableassumptions:
Investorsthroughouttheworldhaveidenticalconsumptionbasket
Purchasingpowerparityholdsexactlyatanypointintime
1) Exactlyformula
E(R)=+(MRP)+
2) totalriskofindividualasset
2 2 2 2
i
+ =
m i

3) Totalriskofportfolio
2 2 2
m p p
=

RealExchangeRateandExpectedExchangeRate
Los62f.calculatetheexpected1)exchangerateand2)domesticcurrencyholdingperiodreturn
onaforeignbond(security);
Realexchangerate
1) Therealexchangerateactuallyisthespotexchangerate
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/

/
= =
DC FC
FC DC
nDC P P
real S S
FC P P

2) Realexchangeratemovementsaredefinedaschangesinthenominal
exchangeratethatarenotexplainedbyinflationdifferentials
DC
% % min S - (i )
FC
in real S in no al i =
ForeignCurrencyRiskPremium
Los62h.calculateaforeigncurrencyriskpremium,andexplainaforeigncurrencyriskpremium
intermsofinterestratedifferentialsandforwardrates;
Foreignriskpremium
1) Theforeigncurrencyriskpremium:theexpectedreturnonaninvestment
minusthedomesticcurrencyriskfree
2) ORequaltotheexpectedmovementintheexchangerateminusthe
interestratedifferential
Explanation
1) Foreigncurrencyriskpremium=0
hedgeddomesticcurrencyexpectedreturnonaninvestment
denominatedintheforeigncurrency=unhedgedexpectedreturn
noriskpremiumforremainingunhedged
2) Foreigncurrencyriskpremium>0
theexpectedunhedgedreturnisgreaterthantheexpected
hedgedreturn
thepositiveriskpremiumforremainingunhedged
3) Foreigncurrencyriskpremium<0
resultsfromthenetforeigninvestmentandtherelativerisk
aversionoftheinvestorsinthetwocountries
Determinewhethertherealexchangeratehaschangedinaperiod
Domesticandforeigncurrencyreturn
1) Foreigninvestorsmeasurethelocalinvestmentintheinvestorsdomesticcurrency:
S V
FC DC
= V

2) Foreigninvestorscurrencyreturnintheirdomesticcurrency
0 ,
0 , 1 ,
DC
DC DC
DC
V
V V
R

=

3) Unhedgedreturnontheforeignshare:
Unhedged S R R
FC DC
% + =
Where:
0 ,
0 , 1 ,
R
FC
FC FC
FC
V
V V
=
and
0
0 1
%
S
S S
S

=

4)hedgedreturntotheinternationalinvestors
Hedged
0
0
S
S F
R R
FC DC

+
and
0
0
S
S F
=theforwardpremiumordiscount
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CurrencyExposure
Los62m.definecurrencyexposure,andexplainexposuresintermsofcorrelations;
Thecurrencyexposure(
gama
)ofaforeigninvestmentisthesensitivityofthestockprice
(measured in the investors domestic currency) to a change in the value of the foreign
currency
Formula ( ) 1 LC = +
Where: =domesticcurrencysensitivity

( ) LC
=localcurrencysensitivity
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Case2:JamesStephensonCaseScenario
JamesStephenson,age55andsingle,isasurgeonwhohasaccumulatedasubstantialinvestment
portfolio without a clear longterm strategy in mind. Two of his patients who work in financial
marketscommentasfollows:
JamesHrdina:Myinvestmentfirm,basedonitsexperiencewithinvestors,hasstandard
investmentpolicystatementsinfivecategories.Youwouldbebetterservedtoadoptoneof
thesestandardpolicystatementsinsteadofspendingtimedevelopingapolicybasedon
yourindividualcircumstances.
CharlesGionta:Developingalongtermpolicycanbeunwisegiventhefluctuationsofthe
market.Youwantyourinvestmentadvisortoreactcontinuouslytochangingconditionsand
notbelimitedbyasetpolicy.
Stephensonhiresafinancialadvisor,CarolineCoppa.Attheirinitialmeeting,Coppacompilesthe
followingnotes:
Stephenson currently has a $2.0 million portfolio that has a large concentration in
smallcapitalizationU.S.equities.Overthepastfiveyears,theportfoliohasaveraged20percent
annual total return on investment. Stephenson hopes that, over thelong term, his portfolio will
continue to earn 20 percent annually. When asked about his risk tolerance, he described it as
average. He was surprised when informed that U.S. small cap portfolios have experienced
extremelyhighvolatility.
Hedoesnotexpecttoretirebeforeage70.Hiscurrentincomeismorethansufficienttomeethis
expenses. Upon retirement, he plans to sell his surgical practice and use the proceeds to
purchaseanannuitytocoverhispostretirementcashflowneeds.
Both his income and realized capital gains are taxed at a 30 percent rate. No pertinent legal or
regulatory issues apply. He has no pension or retirement plan but does have sufficient health
insuranceforpostretirementneeds.
91. ThecommentsaboutinvestmentpolicystatementsmadebyStephensonspatientsare
bestcharacterizedas
Hrdina Gionta
A. Correct Correct
B. Incorrect Correct
C. Incorrect Incorrect
CorrectanswerC

SolutionThecommentsaboutinvestmentpolicystatementsmadebyStephensonspatientsare
incorrect.TheIPSshouldidentifypertinentinvestmentobjectivesandconstraintsforaparticular
investor.Clearlyidentifiedobjectivesandconstraintsensurethatthepolicystatementis
accurateandrelevanttotheinvestorsspecificsituationanddesires.Theresultshouldbean
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optimalbalancebetweenreturnandriskforthatinvestor.TheIPSprovidesalongtermplanfor
aninvestorandabasisformakingdisciplinedinvestmentdecisionsovertime.Theabsenceofan
investmentpolicystatementreducesdecisionmakingtoanindividualevent
92. InformulatingthereturnobjectiveforStephensonsinvestmentpolicystatement,themost
appropriatedeterminingfactorforCoppatofocusonis:
A.returndesires.
B.abilitytotakerisk.
C.returnrequirement.
CorrectanswerB

SolutionAninvestorsabilitytotakeriskputsanupperlimitonareasonablereturnobjective.
93. Stephensonswillingnessandabilitytoacceptriskcanbebestcharacterizedas
Willingnesstoacceptrisk Abilitytoacceptrisk
A. Belowaverage Aboveaverage
B. Aboveaverage Belowaverage
C. Aboveaverage Aboveaverage
CorrectanswerC

SolutionEventhoughStephensondescribeshisrisktoleranceasaverage,hispresent
investmentportfolioandhisdesireforlargereturnsindicateanaboveaveragewillingnessto
takerisk.Hisfinancialsituation(largeassetbase,ampleincometocoverexpenses,lackofneed
forliquidity,andlongtimehorizon)indicatesanaboveaverageabilitytoacceptrisk.
94. Stephensonstaxandliquidityconstraintscanbebestcharacterizedas
Taxconstraint Liquidityconstraint
A. Significant Significant
B. Significant Insignificant
C. Insignificant Insignificant
CorrectanswerB

SolutionStephensonhasadequateincometocoverhislivingexpensesandhasnomajoroutlays
forwhichheneedscash,sohisliquidityneedsareminimal.Heisnotataxexemptinvestor(both
incomeandcapitalgainsaretaxedat30%),sotaxesshouldplayaconsiderableroleinhis
investmentdecisions.
95. Stephensonstimehorizonisbestcharacterizedas
A.shorttermandsinglestage
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B.longtermandsinglestage
C.longtermandmultistage
CorrectanswerC

SolutionStephensonstimehorizonislongheiscurrentlyonly55yearsold.Thetimehorizon
consistsoftwostages:thefirststageextendstohisretirementin15years;thesecondstagemay
lastfor20yearsormoreandextendsfromretirementuntilhisdeath.
96. Stephensonsreturnobjectiveandrisktolerancearemostappropriatelydescribedas
ReturnObjective RiskTolerance
A.Belowaverage Aboveaverage
B.Aboveaverage Belowaverage
C.Aboveaverage Aboveaverage
CorrectanswerC

Solution
RiskStephensonhasanaboveaveragerisktolerancebasedonbothhisabilityandwillingnessto
assumerisk.Hislargeassetbase,longtimehorizon,ampleincometocoverexpenses,andlackof
needforliquidityorcashflowindicateanaboveaverageabilitytoassumerisk.Hisconcentration
inU.S.smallcapitalizationstocksandhisdesireforhighreturnsindicatesubstantialwillingness
toassumerisk.
Return:Stephensonsfinancialcircumstances(longtimehorizon,sizableassetbase,ample
income,andlowliquidityneeds)andhisrisktolerancewarrantanaboveaveragetotalreturn
objective.Hisexpresseddesireforacontinuedreturnof20percent,however,isunrealistic.
CoppashouldcounselStephensononwhatlevelofreturnstoreasonablyexpectfromthe
financialmarketsoverlongperiodsoftimeandtodefineanachievablereturnobjective.
KeyPoints:
IPS
LOS 64d. discuss the role of the investment policy statement in the portfolio management
process,andexplaintheelementsofaninvestmentpolicystatement;
Definition
awrittenplanningdocumentthatgovernsallinvestmentdecisionsforthe
client
Mainroles
Bereadilyimplementedbycurrentorfutureinvestmentadvisers.
Promotelongtermdisciplineforportfoliodecisions.
Help protect against shortterm shifts in strategy when either market environments or
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portfolioperformancecausepanicoroverconfidence.
InvestmentObjectivesandInvestmentConstrains
LOS 64c. define investment objectives and constraints, and explain and distinguish among the
typesofinvestmentobjectivesandconstraints;
Investmentobjectives
1) Investmentobjectivesrelatetowhattheinvestorwantstoaccomplishwiththeportfolio
2) Objectivesaremainlyconcernedwithriskandreturnconsiderations
Riskobjective
RiskTolerance:
AbilityTakeRisk Willingnessto
TakeRisk
BelowAverage AboveAverage
BelowAverage Belowaveragerisktolerance Resolutionneeded
AboveAverage Resolutionneeded Aboveaveragerisk
tolerance
RiskmeasurementValueatrisk(VAR)
Somespecificfactorsthataffecttheabilitytoacceptrisk
Required spending needsHow much variation in portfolio value can the investor
tolerancebeforesheisinconveniencedintheshortterm?
Longterm wealth target: How much variation in portfolio value can the investor
tolerancebeforeitjeopardizesmeetinglongtermwealthgoals?
Financial strengths: Can the investor increase savings if the portfolio is insufficient to
meethisspendingneeds?
Liabilities:Istheinvestorlegallyobligatedtomakefuturepaymentstobeneficiaries,or
doestheinvestorhavecertainspendingrequirement?
Returnobjective
Returnmeasurement
such as: total Return; absolute Return; return relative to the benchmarks; return
nominal returns; real returns inflationadjusted returns; pretax returns; posttax
returns
Returndesireandrequirement
desiredreturnisthatlevelofreturnstatedbytheclient,includinghow
muchtheinvestorwishestoreceivefromtheportfolio
requiredreturnrepresentssomelevelofreturnthatmustbeachieved
bytheportfolio,atleastonanaveragebasistomeetthetargetfinancialobligations
Investmentconstrains
1) Investment constrains are those factors restricting or limiting the universe of available
investmentchoices
2) Types
Liquidityrequirement:aneedforcashofnewcontributionsor
savingsataspecifiedpointintime
Timehorizon:thetimeperiodassociatedwithaninvestmentobjective
(shortterm,longterm,oracombinationofthetwo).
Taxconcerns:taxpaymentsreducetheamountofthetotalreturn
Legalandregulatoryfactors:externalfactorsimposedbygovernmental,
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regulatory,oroversightauthoritiestoconstrain
investmentdecisionmaking.
Uniquecircumstances:internalfactors,anindividualinvestorsportfolio
choicesmaybeconstrainedbycircumstances
focusingonhealthneeds,supportofdependents,
andothercircumstancesuniquetotheparticular
individual.
MeanvarianceAnalysis
Los 60b. explain the minimumvariance and efficient frontiers, and discuss the steps to solve
fortheminimumvariancefrontier;
1) Formula
( ) ( )
=
=
n
i
i i p
R E w r
1
E

foratwoassetportfolio
( ) ( ) ( )
2 2 1 1
R E w R E w r E
p
+ =

( )
= =
=
n n
j
j i j i
R R w w
1 i 1
2
, cov

Forathreeassetportfolio
3 2 3 , 2 3 2 3 1 3 , 1 2 1
2
3
2
3
2
2
2
2
2
1
2
1
2
2 2 w w w w w w w + + + + =
SML
Los 60f. discuss the security market line (SML), the beta coefficient, the market risk premium,
andtheSharperatio,andcalculatethevalueofoneofthesevariablesgiventhevaluesofthe
remainingvariables;
SML:thegraphofCAPM
MaindifferencesbetweentheSMLandtheCML
SML CML
Measureof
risk
Usessystematicrisk
(nondiversifiablerisk)
Usesstandarddeviation(totalrisk)
Application Toolusedtodeterminethe
appropriateexpectedreturnsfor
securities
Toolusedtoeterminetheappropriate
assetallocation(percentagesallocated
totheriskfreeassetandtothe
marketportfolio)fortheinvestor
Definition GraphoftheCAPM Graphoftheefficientfrontier
Slope Marketriskpremium MarketportfolioSharperatio
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MacroeconomicFactor,FundamentalFactor,andStatisticalFactormodels
Los 60j. discuss and compare macroeconomic factor models, fundamental factor models and
statisticalfactormodels;
MacroeconomicFactor
1) assumption: the factors are surprises in macroeconomic variables that
significantlyexplainequityreturns
2) exactlyformulaforreturnofasseti
1 1 2 2
( ) ...
i i i i ik k i
R E R b F b F b F = + + + + +
Where:
i
R =returnforasseti
( )
i
R E =expectedreturnforasseti

1
F =surpriseintheGDPrate

2
F =surpriseinthecreditqualityspread

i1
b =GDPsurprisesensitivityofasseti

2
b
i
=creditqualityspreadsurprisesensitivityofasseti

i
=firmspecificsurprise
Los 60k. calculate the expected return on a portfolio of two stocks, given the estimated
macroeconomicfactormodelforeachstock;

Asset pricing model

b
i1
,b
i2
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Fundamentalfactormodels
1)Thefactorsareattributesofstocksorcompaniesthatareimportantin
explainingcrosssectionaldifferencesinstockprices
1) Exactlyformula
i SIZE i E P il i i
F b F b a R + + + =
2 /

3)assetreturncanbeexplainedbythepriceearningsratio,market
Capitalization.
( )
E P
i
E P E P
/
1
1
/ /
b
ArbitragePricingTheory(APT)
TherelationbetweenAPTandmultifactormodels
APT Multifactormodels
Characteristics Crosssectionalequilibrium
pricingmodelthatexplains
thevariationacrossassets
expectedreturns
Timeseriesregressionthatexplains
thevariationovertimeinreturnsfor
oneasset
Assumptions Equilibriumpricingmodel
thatassumesnoarbitrage
opportunities
Adhoc(i.e.,ratherthanbeingderived
directlyfromanequilibriumtheory,
thefactorsareidentifiedempirically
bylookingformacroeconomic
variablesthatbestfitthedata)
Interception Riskfreerate Expectedreturnderivedfromthe
APTequationinmacroeconomic
factormodel
Los 60n. compare and contrast the conclusions and the underlying assumptions of the CAPM
andtheAPTmodels,andexplainwhyaninvestorcanpossiblyearnasubstantialpremiumfor
exposuretodimensionsofriskunrelatedtomarketmovements.
5.ComparisonCAPMandAPT
CAPM APT
Assumptions Allinvestorsshouldholdsome
combinationofthemarket
portfolioandtheriskfree
asset.Tocontrolrisk,lessrisk
averseinvestorssimplyhold
moreofthemarketportfolio
andlessoftheriskfreeasst.
APTgivesnospecialroletothe
marketportfolio,andisfar
moreflexiblethanCAPM.Asset
returnsfollowamultifactor
process,allowinginvestorsto
manageseveralriskfactors,
ratherthanjustone.
Rb
i1
,b
i2
F
P/E
,F
SIZE
e.g. the return
difference between
low and high P/E
stocks
Market average: all standardized
sensitivities equal zero
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Conclusions Theriskoftheinvestors
portfolioisdeterminedsolely
bytheresultingportfoliobeta.
Investorsunique
circumstancesmaydrivethe
investortoholdportfolios
titledawayfromthemarket
portfolioinordertohedgeor
speculateonmultiplerisk
factors.
TenorBlackCalculations
1. Stockalphas =
i
forecastreturnforstocki{ ( ) [ ]
F M i F
R R E R + }
2. weightswithintheactivelymanagedportfolioA:
( )
( ) ( )
2
2
2
1
2
1
1
2
1
1

+
= w
,
1 2
1 w w =
3. PortfolioAAlpha:
A
=forecastreturnforportfolioA{ ( ) [ ]
F M i F
R R E R + },or,
2 2 1 1
w w
A
+ =
PortfolioAstandarddeviationforecast ( ) [ ]
2 / 1
2 2 2
A M A A
+ =
4. PortfolioAexpectedreturn:
( ) ( ) ( )
2 2 1 1
E R E w R E w R
A
+ = ,or, ( ) ( ) [ ]
F M A F A A
R R E R R E + + =
5. CovarianceofactiveportfolioAwithpassivemarketindexM:
2
M M A AM
Cov =

AnalystsAccuracyInForecastingAlphas
Los 63c. describe how an analysts accuracy in forecasting alphas can be measured and how
estimatesofforecastingcanbeincorporatedintotheTreynorBlackapproach.
1. Reason
1) Ananalystsforecastsarenotalwaysright
2) To account for the inaccuracy of analysts forecasts ,we can impose imprecision
penaltyordiscountontheanalystsforecastalpha
2 R
2

1) purpose:toadjusttheforecastalphastoaccountforthelackofperfect
forecastingabilityoftheanalyst
2) FortheTreynorblackalphaforecast
R
2
=thepercentageofthechangesintherealizedalphathatareexplainedbychanges
intheforecastalpha
Thespecificstepsthatimposeimprecisionpenaltyonforecastalpha:
collecttheanalyst'shistoryalphaforecastsdata
computethecorrelationrbetweenalphaforecastsandrealized
calculateparameterR
2
=r
2
,
discountontheanalystsforecastalphabymultiplyingitbytheanalystsR
2

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Case3:HartmutFischerCaseScenario

Hartmut Fischer, age 30, is the founder and 100% owner of startup firm High Vision Social
Network(HVSN),basedinStuttgart,Germany.HeissellingHVSNtoglobalmediaandconsumer
goodsgiantPSMGAG(PSMG)forcashandstock.GermantaxrulesallowsFischertosellthefirm
withoutanytaxobligationforcapitalgains.

ExecutiveWealthManagementAssociates(EWMA),anationalinvestmentandfinancialplanning
firm, is advising Fischer in his wealth planning and in the negotiations with PSMG. Although
HVSNs internationally held stock is publicly traded largecap equity, Fischer is restricted from
sellinghisstockforatleastfiveyearsandwillremainasdirectoroftheGermandivision.

As the transaction is being finalized, Fischer meets with Silvia Schilz, a portfolio manager at
EWMA,todiscusshisinvestmentneeds.Hesharesthefollowinginformationwithher:

MyincomeasdirectoratPSMGwillbemorethanenoughtocoverallofmylivingexpensesand
save at least 100,000 annually, so I do not plan to withdraw funds from my portfolio. I would
have preferred selling HVSN for cash, but by accepting the restricted stock, the total sales
proceeds were almost twice as much as in a cash sale. This is the first time Ive ever had any
amount of wealth, and I want to be sure that it lasts a long time. The portfolio will fund our
retirement. I want my portfolio to show steady growth, averaging 7% to 9% annually, with
moderatevolatility.AlistofmyassetsisshowninExhibit1:

Exhibit1
FischerFamilyAssets
Assets Value
Personalhome 1,450,000
PSMGrestrictedstockfromHVSNsale 14,000,000
CashfromHVSNsale 6,250,000
SchilzarrangesafuturemeetingwithFischertopresentspecificrecommendationsanddraftsan
investmentpolicystatement(IPS)withthefollowingelements:

1)A7%to9%returnobjective
2)A9%standarddeviationriskobjective
3)Anappropriatetimehorizonthatrecognizeshisobjectivesandconstraints
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4)Noanticipatedliquidityneeds
EWMA uses proprietary diversified funds of funds (FOF) for each asset class. The funds can only
be liquidated monthly. Individual stocks are typically only held pursuant to a clients direction.
Shenarrows herchoiceoffundstothethreefunds,whicharepresentedinExhibit2alongwith
EWMAscapitalmarketassumptions:
Exhibit2
CapitalMarketAssumptions
Expected
Return
Standard
Deviation
Beta Sharpe
Ratio
Correlation
withPSMG
PSMGstock 12% 20% 1.2 0.50 1.00
LargeCapEquityIndex
Fund
12% 15% 1.0 0.67 0.90
EWMAAggressiveFOF 15% 13% 0.9 1.00 0.75
EWMAAlternativeFOF 12% 15% 0.1 0.67 0.00
EWMAShortAssetsFOF 9% 12% 0.4 0.58 0.75
Riskfreerate 2%
FinallyFischerasksSchilz,IwouldalsobeveryinterestedinlearningyouropinionofPSMGasan
investment,sinceitissuchalargepartofmyportfolio.Schilzresponds,Accordingtoourcapital
market assumptions and the capital asset pricing model (CAPM), I find that PSMG stock is
undervalued.

97. ThemostappropriatetimehorizonthatSchilzshouldincludeintheinvestmentpolicy
statementis:
A.Fiveyears.
B.Amultistageperiod.
C.Asingle35yearperiod.
Answer=B

ThePortfolioManagementProcessandtheInvestmentPolicyStatement,JohnL.Maginn,
DonaldL.Tuttle,JeraldE.Pinto,andDennisW.McLeavey
StudySession1864f
Contrastthetypesofinvestmenttimehorizons,determinethetimehorizonforaparticular
investor,andevaluatetheeffectsofthistimehorizononportfoliochoice.

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Biscorrect.FischermustfirstconsiderhisconcentratedrestrictedPSMGthatreduces
diversificationduringthefirstfiveyearswhilestilladdressinghislongtermobjectivestofundhis
retirement.

98. BasedontheIPSandExhibit2,whichofthefollowingelementsofFischersinvestment
policyisleastlikelytobesatisfied?
A.Risktolerance
B.Liquidityneeds
C.Returnobjective
Answer=A

ThePortfolioManagementProcessandtheInvestmentPolicyStatement,JohnL.Maginn,
DonaldL.Tuttle,JeraldE.Pinto,andDennisW.McLeavey
StudySession1864c
Defineinvestmentobjectivesandconstraints,andexplainanddistinguishamongthetypesof
investmentobjectivesandconstraints.

Aiscorrect.Noneoftheinvestmentalternativesoffersastandarddeviationlessthan12%;which
ismorethanSchilzsrecommendationofa9%standarddeviationriskobjective.

99. BasedonthedatainExhibit2,whichofthefollowingwouldSchilzleastlikelyincludein
herinitialassetallocationrecommendation?
A.EWMAAggressiveFOF
B.EWMAAlternativeFOF
C.LargeCapEquityIndexFund
Answer=C

PortfolioConcepts,RichardA.DeFusco,DennisW.McLeavey,JeraldE.Pinto,andDavidE.
Runkle
StudySession1860c
Explainthebenefitsofdiversificationandhowthecorrelationinatwoassetportfolioandthe
numberofassetsinamultiassetportfolioaffectthediversificationbenefits.
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CiscorrectbecausePSMGstockhasahighcorrelationwiththelargecapindexandwouldoffer
littlediversificationbenefit.

100. BasedontheSharperatio,whichsingleEWMAFOFshouldbeaddedtothePSMGstock
holdinginordertoachievethegreatestmeanvarianceimprovementfortheresulting
twoassetportfolio?
A.Aggressive
B.Alternative
C.ShortAssets
Answer=C

Runkle
StudySession1860c
Explainthebenefitsofdiversificationandhowthecorrelationinatwoassetportfolioandthe
numberofassetsinamultiassetportfolioaffectthediversificationbenefits.

Ciscorrect,becausetheadditionofanewassettoaportfolioisoptimaliftheSharperatioofthe
newinvestmentislargerthantheproductoftheSharperatiooftheexistingportfolioandthe
correlationofthenewinvestmentsreturnswiththereturnsofthecurrentportfolio.
( )
( )
( )
p new
p
F p
new
F new
R R Corr
R R E
R R

>

E

TheproductoftheSharperatioofPSMGandthecorrelationbetweenPSMGandShortAssets
FOFis0.375.ThedifferencebetweenthisandtheSharperatiooftheShortAssetsFOFis
greatestat0.958.

101. 23.IfFischerinvestshisavailablecashof6,250,000intheEWMAShortAssetsFOF,the
standarddeviationofthetwoassetportfolioisclosestto:
A.11.3%.
B.14.3%.
C.17.5%.
Answer=A

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Runkle
StudySession1860a
Explainmeanvarianceanalysisanditsassumptions,andcalculatetheexpectedreturnandthe
standarddeviationofreturnforaportfoliooftwoorthreeassets.

Aiscorrect.Thestandarddeviationoftheportfoliobyusinghisavailablefundsfromcashto
purchase6,250,000oftheEWMShortAssetsFundisapproximately11.3%.Usingtheformula
tocalculatestandarddeviationofacombinationoftwoassets,

2 1 2 1 2 1
2
2
2
2
2
1
2
1
2
2
+
+ + = w w w w
p

where:
theweightingoftheFOFis0.309
theweightingofPSMGis0.691
(0.309
2
0.12
2
)+(0.691
2
0.2
2
)+(20.3090.6910.750.20.12)=0.113
102. 24.AccordingtotheCAPM,isSchilzsassessmentofPSMGsvaluationmostlikelycorrect?
A.Yes.
B.No,becausePSMGisovervalued.
C.No,becausePSMGisfairlyvalued.
Answer=C

PortfolioConcepts,byRichardA.DeFusco,DennisW.McLeavey,JeraldE.Pinto,andDavidE.
Runkle
StudySession1860f
Explainthesecuritymarketline(SML),thebetacoefficient,themarketriskpremium,andthe
Sharperatio,andcalculatethevalueofoneofthesevariablesgivenvaluesoftheremaining
variables.

Ciscorrect.Exhibit2containstheinputsoftheCAPM,andtheexpectedreturnforPSMGisthe
sameasindicatedbythemodel:
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( ) ( ) [ ]
F m i F i
R R E R R + = E

where
E(Ri)=theexpectedreturnonasseti(PSMG)
p 1 1 2 2 3 3
( ) ( ) ( ) ( ) E r w E R w E R w E R = + +
RF=theriskfreerateofreturn(2%)
E(RM)=theexpectedreturnonthemarketportfolio(globallargecapequities,12%)
i=betaofasseti,1.1
AccordingtotheCAPM,theexpectedreturnofPSMG=2%+1.2(12%2%),or12%.Becausethe
expectedreturnisalso12%,thestockisfairlyvalued.
KeyPoints:
InvestmentObjectivesandInvestmentConstrains
Investmentobjectives
Investment objectives relate to what the investor wants to accomplish withthe
portfolio
Objectivesaremainlyconcernedwithriskandreturnconsiderations
Riskobjective
RiskmeasurementValueatrisk(VAR)
Somespecificfactorsthataffecttheabilitytoacceptrisk
Required spending needsHow much variation in portfolio value can the
investortolerancebeforesheisinconveniencedintheshortterm?
Longtermwealthtarget:Howmuchvariationinportfoliovaluecantheinvestor
tolerancebeforeitjeopardizesmeetinglongtermwealthgoals?
Financial strengths: Can the investor increase savings if the portfolio is
insufficienttomeethisspendingneeds?
Liabilities: Is the investor legally obligated to make future payments to
beneficiaries,ordoestheinvestorhavecertainspendingrequirement?
Returnobjective
Returnmeasurement
such as: total Return; absolute Return; return relative to the
benchmarks; return nominal returns; real returns inflationadjusted
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returns; pretaxreturns; posttaxreturns
Returndesireandrequirement
desiredreturnisthatlevelofreturnstatedbytheclient,includinghow
muchtheinvestorwishestoreceivefromtheportfolio
required return represents some level of return that must be achieved
bytheportfolio,atleastonanaveragebasistomeetthetargetfinancial
obligations
Investmentconstrains
Investment constrains are those factors restricting or limiting the universe of
availableinvestmentchoices
Types
Liquidity requirement: a need for cash of new contributions or savings at a specified
pointintime
Time horizon: the time period associated with an investment objective (short term,
longterm,oracombinationofthetwo).
Taxconcerns:taxpaymentsreducetheamountofthetotalreturn
MeanvarianceAnalysis
Definition: it refers to the use of expected returns, variances, and covariances of
individual investments to analyze the riskreturn tradeoff of combinations (i.e.,
portfolios)oftheseassets.
Mainassumptions
All investors are risk averse; they prefer less risk to more for the same level of
expectedreturn;
Expectedreturnsforallassetsareknown;
Thevariancesandcovariancesofallassetreturnsareknown;
Investors need only know the expected returns, variances, and covariance of
returnstodetermineoptimalportfolios.Theycanignoreskewness,kurtosisand
otherattributesofadistribution;
Therearenotaxesortransactioncosts.
Formula
p
1
( ) ( )
n
i i
i
E r w E R
=
=

2
1 1
cov( , )
n n
p i j i j
i j
ww R R
= =
=

Foratwoassetportfolio
p 1 1 2 2
( ) ( ) ( ) E r w E R w E R = +
2 2 2 2 2
p 1 1 2 2 1 2 1,2 1 2
w w 2w w = + +
Forathreeassetportfolio
2 2 2 2 2
p 1 1 2 2 1 2 1,2 1 2
w w 2w w = + +
2 2 2 2 2 2 2
p 1 1 2 2 3 3 1 2 1,2 1 2 1 3 1,3 1 3 2 3 2,3 2 3
w w w 2w w 2w w 2w w = + + + + +
MinimumVarianceandEfficientFrontiers
The minimumvariance frontier is a graph of the expected return/variance combinations for all
minimumvarianceportfolios.
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Stepstosolvefortheminimumvariancefrontier
Estimation step: Estimate the expected return and variance for each individual
assetandthecorrelationofeachpairofassets.
Optimization step: Solve for the weights that minimize the portfolio variance
subjecttothefollowingconstraints:
Theportfolioexpectedreturnequalsaprespecifiedtargetreturn
Theportfolioweightssumto100%
Repeat Optimization Step for many different values of prespecified target
return
Calculation step: Calculate the expected returns and variances for all the
minimumvarianceportfoliosdeterminedinOptimizationStep.
Characteristicsaboutminimumvariancefrontiersanddiversification
Theendpointsforallofthefrontiersarethesame
Correlationinthetwoassetportfolio
Correlation = +1 the minimumvariance frontier is an upwardsloping straight line
diversificationhasnopotentialbenefits.
Correlationfrom+1to0.5theminimumvariancefrontierbowsouttotheleft,inthe
directionofsmallerstandarddeviation
Correlation of 0.5, 0 and 1 we can get more expected return with less risk. As we
lower correlation, holding all other values constant, there are increasingly larger
potentialbenefitstodiversification.
Correlation=1theminimumvariancefrontierhastwolinearsegments.Portfoliorisk
canbereducedtozero,ifdesired.
SML
SML:thegraphofCAPM
MaindifferencesbetweentheSMLandtheCML
SML CML
Measureofrisk Usessystematicrisk
(nondiversifiablerisk)
Usesstandarddeviation
(totalrisk,systematicrisk)
Application Toolusedtodeterminethe
appropriateexpected returns for
securities
Toolusedtodeterminetheappropriate
assetallocation(percentagesallocatedto
theriskfreeassetandtothemarket
portfolio)fortheinvestor
Definition GraphoftheCAPM Graphoftheefficientfrontier
Slope Marketriskpremium MarketportfolioSharperatio
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Case4:JongmooChoiCaseScenario
Jongmoo Choi is a portfolio manager at Silver Oak Capital Management based in Omaha,
Nebraska. Silver Oak provides customized portfolio management and investment consulting
services to institutional clients. Choi is meeting with a new assistant, Raul Fernandez, to review
the firms portfolio management models and techniques. Choi begins the meeting with the
followingstatement:

Statement 1: We use multifactor models to estimate the expected return and risk of securities
weareevaluating.Dependingonthesituation,weuseoneofthreetypesofmultifactormodels:
a macroeconomic factor model, a fundamental factor model, or a statistical factor model. For
macroeconomic factor models, the factors are the value or level of selected macroeconomic
variables. For fundamental factor models, the factors are company share attributes, such as
priceearnings ratio and market capitalization. Finally, when using statistical factor models, we
apply statistical techniques, such as factor analysis or principal component analysis, to historical
returnstoidentifyfactorsthatbestexplainhistoricalvariancesandcovariances.

FernandezasksChoi:Howisarbitragepricingtheory(APT)relatedtothesemultifactormodels?

Choiresponds,APThelpsusdeterminetheappropriatenumberoffactorstouseinamultifactor
model,theidentityofthosefactors,andtheexpectedreturnoftheinvestmentbeingevaluated.

Choicontinueswiththediscussionofmultifactormodelsbystating:

Statement2:Multifactormodelsareparticularlyusefulinanalyzingtheactiveriskofaportfolio.
Specifically, we carry out our analysis using active risk squared, which can be decomposed into
twocomponents:activefactorriskandactivespecificrisk.Activefactorriskistheriskthatisdue
to variation between factor exposures in the portfolio and the benchmark. Active specific risk
identifiestheresidualriskexposureoftheportfolio.

The discussion turns to international investing. Choi says one must take into account exchange
rates, inflation, and interest rates in order to properly evaluate international investments. He
presentstheinformationinExhibit1toillustratehispoint.

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Exhibit1
SelectedEconomicandFinancialData
CurrentValuesandExpectedValuesinOneYear
CurrentValue ExpectedValue
Currentexchangerate(USD/EUR) 1.33 1.38
RiskfreeU.S.bondoneyearyield 1.20%
RiskfreeGermanbondoneyearyield 1.64%
GermanConsumerPriceIndex 144.7 146.3
U.S.ConsumerPriceIndex 211.7 218.3
OneyearreturnU.S.stockindex1 9.40%
OneyearreturnGermanstockindex1 6.75%
1Stockindexreturnsaremeasuredinlocalcurrencyterms.
Choimakesthefollowingstatement:

Statement 3: In order to evaluate an investment in the German stock market index, we use an
international asset pricing model (ICAPM) to estimate the return on the German stock index in
dollartermsasafunctionof:

theGermanriskfreerate,plus
theworldmarketriskpremiumtimestheGermanmarketsbetawiththeworldmarket
index,plus
theforeigncurrencyriskpremiumtimestheGermanindexscurrencyexposures.
103. InStatement1,Choiisleastlikelycorrectwithrespectto:
A.statisticalfactormodels.
B.fundamentalfactormodels.
C.macroeconomicfactorsmodels.
Answer=C

Runkle
StudySession1860j
Describeandcomparemacroeconomicfactormodels,fundamentalfactormodels,andstatistical
factormodels.
Ciscorrect.Inmacroeconomicmodels,thefactorsaresurprisesinmacroeconomicvariables,
notthelevelorvalueofmacroeconomicvariables.
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104. ChoisresponsetoFernandezismostlikelycorrectwithregardtothe:
A.expectedreturn.
B.numberoffactors.
C.identityofthefactors.
Answer=A

Runkle
StudySession1860l
Describethearbitragepricingtheory(APT),includingitsunderlyingassumptionsanditsrelation
tothemultifactormodels;calculatetheexpectedreturnonanassetgivenan
assetsfactorsensitivitiesandthefactorriskpremiums;anddeterminewhetheranarbitrage
opportunityexists,includinghowtoexploittheopportunity.

Aiscorrect.TheAPTmodeltellsuswhattheinterceptterm(expectedreturn)inamultifactor
modelshouldbe.

105. InStatement2,doesChoicorrectlyexplainactivefactorriskandactivespecificrisk?
ActiveFactorRisk ActiveSpecificRisk
A. Yes Yes
B. Yes No
C. No Yes
Answer=A

Runkle
StudySession1860m
Explainsourcesofactiverisk;interprettrackingerror,trackingrisk,andtheinformationratio;
andexplainfactorportfolioandtrackingportfolio.
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Aiscorrect.Choicorrectlyexplainsactivefactorriskandactivespecificrisk.Activefactorrisk
measuresthefactorexposuresoftheportfoliorelativetoitsbenchmark.Activespecificriskis
thecontributiontoactiverisksquaredduetoeachassetsactiveweight(actualweightinthe
portfoliominusweightinthebenchmark)timesitsresidualrisk(thevarianceoftheassets
returnsleftunexplainedbythefactors)thatis,itmeasurestheresidualrisktakenonbythe
portfolio.

106. BasedonthedatainExhibit1,assumingactualpricelevels,exchangerate,andstockindex
valuesattheendoftheyearareasexpected,theoneyeardollarreturnontheGerman
stockindexisclosestto:
A. 3.13%.
B.10.76%.
C.12.76%.
Answer=B

StudySession1862g
Calculatetheendofperiodrealexchangerateandthedomesticcurrencyexpostreturnona
foreignbond(security).

Biscorrect.RUS=RGER+s+(sRGER)=0.0675+0.0376+(0.03760.0675)=0.1076,
where,s=(1.381.33)1.33=0.0376.

107. BasedonthedatainExhibit1,theforeigncurrencyriskpremiumisclosestto:
A.3.32%.
B.3.76%.
C.4.20%.
Answer=C

StudySession1862h
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Calculateaforeigncurrencyriskpremium,andexplainaforeigncurrencyriskpremiuminterms
ofinterestratedifferentialsandforwardrates.

Ciscorrect.Theforeigncurrencyriskpremium(SRP)canbecalculatedastheexpected
movementintheexchangerateminusthedifferencebetweenthedomesticandforeignriskfree
rate.
SRP=E[(S1S0)/S0](rUSrGER)=(1.381.33)1.33(0.0120.0164)=0.042or4.2%.

108. InStatement3,doesChoiaccuratelydescribethemodelusedtoestimatereturnsonthe
Germanstockindex?
A.Yes.
B.No,theU.S.riskfreeratemustbeused.
C.No,Germanstockindexreturnsmustbemeasuredinlocalcurrencyterms.
Answer=B
StudySession1862i
Statetheriskpricingrelationandtheformulafortheinternationalcapitalassetpricingmodel
(ICAPM),andcalculatetheexpectedreturnonastockusingthemodel.

Biscorrect.SincethehomecountryistheUnitedStates,theU.S.riskfreeratemustbeusedin
theICAPM.
KeyPoints:
Statisticalfactormodels
uses multivariate statistics (factor analysis or principal components) to identify
multiplestatisticalfactorsthatexplainthecovarianceamongassetreturns
major weakness: the statistical factors do not lend themselves well to
economicinterpretation
ArbitragePricingTheory(APT)
APT
assetpricingmodeldevelopedbythearbitragepricingtheory
Assumptions
Afactormodeldescribesassetreturns
There are many assets, so investors can form welldiversified portfolios that
eliminateassetspecificrisk
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Noarbitrageopportunitiesexistamongwelldiversifiedportfolios
Exactlyformula
,1 1 ,2 2 ,
( ) ( ) ( ) ... ( )
P F P P P k k
E R R = + + + +
ActiveRisk andInformationRisk
Activerisk
Activityreturn(trackerror)
Definition: the differences in returns between a managed portfolio and its
benchmark
Exactlyformula
P B
active return R R =
Activityrisk
Definition:thestandarddeviationofactivereturns
Exactlyformula

2
( )
( )

1

= =
P B
Pt Bt
R R
R R
active risk s
n

FactorPortfolioandTrackingPortfolio
Factor portfolio: a portfolio that has been constructed to have sensitivity equal
to1toonlyoneriskfactor(e.g.GDPgrowthrate),andsensitivitiesof 0tothe
remainingfactors
Tracking portfolio: a portfolio with factor sensitivities that match those of
benchmarkportfolioorotherportfolio
Domesticandforeigncurrencyreturn
Foreign investors measure the local investment in the investors domestic
currency:
=
DC FC
V V S
Foreigninvestorscurrencyreturnintheirdomesticcurrency

,1 ,0
,0
=
DC DC
DC
DC
V V
R
V

Unhedgedreturnontheforeignshare:
unhedgedR
DC
=R
FC
+%S
where:
,1 ,0
,0
=
FC FC
FC
FC
V V
R
V
and 1 0
0
%

=
S S
S
S

hedgedreturntotheinternationalinvestors

0
0

+
DC FC
F S
hedged R R
S
and 0
0
F S
S
=theforwardpremiumordiscount
Realexchangerate
Therealexchangerateactuallyisthespotexchangerate
/

1 /
DC FC
FC DC
SDC P P
real S S
FC P P
= =

Realexchangeratemovementsaredefinedaschangesinthenominalexchange
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ratethatarenotexplainedbyinflationdifferentials
DC
% % min S - (i ) =
FC
in real S in no al i
Expectedexchangerate
AccordingtoIRPformula
DC
0 FC
1 r F
, S and F in DC/ FC
S 1 r
+
=
+

So,theexpectedexchangerate
0
1
1
+
=
+
DC
FC
r
F S
r

Domesticcurrencyexpostreturn
0
0

+
DC FC
F S
hedged R R
S
and 0
0
F S
S
=theforwardpremiumordiscountofFC
ForeignCurrencyRiskPremium
Foreignriskpremium
The foreign currency risk premium: the expected return on an investment
minusthedomesticcurrencyriskfree
( ) =
f
FCRP E R R

OR equal to the expected movement in the exchange rate minus the interest
ratedifferential 1 0
0
( )
( )
=
DC FC
E S S
FCRP r r
S

Explanation
Foreigncurrencyriskpremium=0
hedgeddomesticcurrencyexpectedreturnonaninvestment
denominatedintheforeigncurrency=unhedgedexpectedreturn
noriskpremiumforremainingunhedged

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FixedIncome
Case1:ErikJenkinsCaseScenario
ErikJenkins,CFA,isDirectorofFixedIncomeResearchatAlphaAdvisors.Eachmorninghemeets
with the firms key strategists to discuss market conditions and trading strategies. A packet of
exhibits is provided at the meeting to facilitate the discussion. Jenkins asks Jim Jones, the firms
economist,toprovidehislatestviewonthedirectionofinterestrates.
Jonesrespondsthathehastwoscenariosforthedirectionofinterestrates.Inthefirstscenario,
he expects interest rates to rise materially over the next six months. In addition, he does not
expectthemovetobeevenacrosstheyieldcurvebutratherexpectsapositivebutterflytwistHe
notes that under this scenario, some portfolios managed by Alpha may underperform based on
their currentpositioning along the yield curve. The key rate duration profiles of these portfolios
arepresentedinExhibit1.
Exhibit1
KeyRateDurationProfileforThreeTreasuryBondPortfolios
KeyRate PortfolioA PortfolioB PortfolioC
3months 0.3 0.2 0.9
2years 0.4 0.2 0.9
5years 0.4 2.3 1.1
l0years 3.6 0.3 0.9
20years 0.5 0.3 1.0
30years 0.4 2.3 0.8
In the second scenario, Jones expects higher volatility and uncertainty to cause a steepening of
the yield curve. Under this scenario investors will charge a higher premium for longer maturity
issues.
Next,JoePeters,CFA,aSeniorCreditAnalyst,providesanupdateonthecorporatebondmarket
Heisevaluatingthreecompaniesthatmanufactureautopartsforpotentialinclusioninthefirms
portfolios.Petersexplainsthathiscreditanalysisusesonlysolvency,capitalization,andcoverage
ratios to determine each firms ability to repay debt Financial data for the three potential
investmentsareprovidedinExhibit2.
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Exhibit2
SelectedFinancialData(inUSS)
CompanyA CompanyB CompanyC
CurrentAssets 20,900,000 60,280,000 25,700,000
CurrentLiabilities 9,500,000 27,400,000 14,250,000
EBITDA 5,250,000 10,560,000 4,727,000
OperatingIncome 4,200,000 8,550,000 3,300,000
InterestExpense 645,000 1,980,000 1,040,000
LongTermDebt 9,200,000 26,400,000 13,000,000
ShareholdersEquity 23,000,000 45.000,000 16,500,000
PetersfurtherpointsoutthatCompanyBhasabankagreementthatrequiresittoadheretothe
followingcovenants:
Covenant1: The borrower cannot incur additional debt, if its fixedcharge coverage ratio is
lessthan2.0X,adjustedforthenewdebt.
Covenant2: Theborrowerwillnotpaydividendsinexcessof$5millioninanycalendaryear.
Covenant3: Theborrowershallmaintainallpropertiesownedingoodcondition.
Finally, Ann Gibbons, CFA, Head of Trading, discusses valuations in the corporate bond market.
SheobservesthatcertaincallablebondsmaybeattractivegivenJonesforecastforinterestrates.
In particular, she will calculate the fair value of a bond issued by Telemoviles being offered by a
dealer,basedonthedataprovidedinExhibit3.Thebondiscallableat$101.00everyyearstarting
oneyearfromtoday.
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Exhibit3
BinomialInterestRateTree(10%volatilityassumed)
forValuinga3YearCallableBondwitha6.00%Coupon
GibbonsisalsoevaluatingaconvertiblebondissuedbyAutopartCorp.thatiscurrentlytradingat
$1,125.00andconvertsinto26.75commonshares.Thecommonstockcurrentlytradesat$31.75.
Sheestimatesthatthestraightvalueofthebondis$992.00.
109. WhichoftheportfoliosinExhibit1ismostlikelytounderperformbasedonJonesinterest
rateforecast?
A.PortfolioA
B.PortfolioB
A.PortfolioC
Correctanswer:B
TermStructureandVolatilityofInterestRates,FrankJ.Fabozzi,CFA
Illustrateandexplainparallelandnonparallelshiftsintheyieldcurve,ayieldcurvetwist,anda
changeinthecurvatureoftheyieldcurve(i.e.,abutterflyshift).
Computeandinterprettheyieldcurveriskofasecurityoraportfolio,usingkeyrateduration.
Biscorrectbecauseinascenariowhereinterestratesriseinapositivebutterflytwist,shortand
longratesrisebymorethanintermediaterates.PortfolioBisabarbellportfolioandisexpected
tounderperformbecauseitslargerweightinginshortandlongmaturitieswillunderperform
intermediatematurities.
110. ThetheorythatbestexplainsthetermstructureofinterestratesdescribedinJonessecond
scenarioisthe:
A.preferredhabitattheory.
3.25%
6.90%
5.60%
4.75%
5.00%
4.30%
9.00%
7.40%
6.10%
4.90%
Year 1 Year 2 Year 3 Year 4
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B.pureexpectationstheory.
C.liquiditypreferencetheory.
Correctanswer:C
TermStructureandVolatilityofInterestRates,FrankJ.Fabozzi,CFA
Illustratethevarioustheoriesofthetermstructureofinterestrates(i.e.,pureexpectations,
liquidity,andpreferredhabitat)andtheimplicationsofeachtheoryfortheshapeoftheyield
curve.
Ciscorrectbecausetheliquiditypreferencetheorystatesthatinvestorswillholdlongerterm
maturitiesonlyiftheyareofferedariskpremiumandthereforeforwardratesshouldreflect
bothinterestrateexpectationsandaliquidityriskpremium.
111. BasedonPeterscriteria,whichcompanyinExhibit1ismostlikelytomeetitsdebt
obligations?
A.CompanyA
B.CompanyB
C.CompanyC
Correctanswer:A
GeneralPrinciplesofCreditAnalysis,FrankJ.Fabozzi,CFA
Calculateandinterpretthekeyfinancialratiosusedbycreditanalysts.
Evaluatethecreditqualityofanissuerofacorporatebond,givensuchdataaskeyfinancial
ratiosfortheissuerandtheindustry.
Aiscorrectbasedonthecurrentratioasameasureofsolvency,aswellasthelongtermdebtto
capitalizationandEBITDAinterestcoverageratios,whichareallstrongestforCompanyA.Results
fortheratiosareprovidedinthetablebelow.
Ratio CompanyA CompanyB CompanyC
CurrentRatio 2.20 2.20 1.80
DebttoCapitalization 28.6% 37.0% 44.1%
CoverageRatio 8.1 5.3 4.5
CalculationsforCompanyA=
CurrentRatio=20,900/9,500=2.20
Debt/Capitalization=9,200/(9,200+23,000)=28.6%
CoverageRatio=5,250/645=8.1X
Note:Evenifcurrentliabilitiesareusedinatotaldebt/capitalizationratio,CompanyAstillranks
first.
112. WhichofthecovenantsinCompanyBsbankagreementisanaffirmativecovenant?
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A.Covenant1
B.Covenant2
C.Covenant3
Correctanswer:C
GeneralPrinciplesofCreditAnalysis,FrankJ.Fabozzi,CFA
Explain,andanalyze,thekeycomponentsofcreditanalysis.
Ciscorrectbecausethecovenantcallsupontheborrowertodoacertainthing,inthiscaseto
maintainallpropertiesownedingoodcondition.
113. Thecurrentprice($)oftheTelemovilescallablebondisclosestto:
A.100.82.
B.103.50.
C.104.17.
Correctanswer:B
ValuingBondsWithEmbeddedOptions,FrankJ.Fabozzi,CFA
Computethevalueofacallablebondfromaninterestratetree.
Biscorrect.Thepricesarecalculatedfromthetreebutreplacinganyresultingpriceabove101
by101beforecalculatingthenextnode.Theresultingcalculationisprovidedinthetreebelow.
99.158(a)
100.732(d)
103.502(f) 100.379(b)
101.000(e)
101.000(c)
Thecalculationsareasfollows:
(a) 106.00/1.069=99.158
(b) 106.00/1.056=100.379
(c) 106.00/1.0475=101.19=101
(d)
99.158 6.00 100.379 6.00
201.46
1.05 1.05
100.73
2 2
+ +
+
= =

(e)
100.379 6.00 101.193 6.00
204.76
1.043 1.043
102.38 101
2 2
+ +
+
= = =

(f)
100.732 6.00 101.000 6.00
207.00
1.0325 1.0325
103.502
2 2
+ +
+
= =

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114. ThemarketconversionpremiumratioforAutopartCorpisclosestto:
A.13.4%.
B.24.5%.
C.32.4%.
Correctanswer:C
ValuingBondsWithEmbeddedOptions,FrankJ.Fabozzi,CFA
Describeandevaluateaconvertiblebondanditsvariouscomponentvalues.
Ciscorrect,asshowninthefollowingthreestepcalculation:
1)Marketconversionprice=$1,125.00/26.75=$42.05
2)Marketconversionpremiumpershare=$42.05$31.75=$10.30
3)Marketconversionpremiumratio=$10.30/31.75=32.4%
KeyPoints:
TermStructureandVolatilityofInterestRates
Keyrateduration
Example:
Bond
(zero
coupon)
Weight D1 D2 D3 D4 KeyRateDuration
2year 10 2 0.2
10year 20 10 2.0
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20year 40 20 8.0
25year 30 25 7.5
Portfolio 100 17.7
Example:nonparallelshift
Bond
(zerocoupon)
Weight D1 D2 D3 D4 KeyRate
Duration
Changes
(%)
2year 10 2 0.2 0.2
10year 20 10 2.0 3.0
20year 40 20 8.0 6.4
25year 30 25 7.5 7.5
Portfolio 100 17.7 2.1
Shifts(bp) 100 150 80 100
LOS49f.computeandinterprettheyieldcurveriskofasecurityoraportfoliobyusingkeyrate
duration;
Barbellportfolios:containarelativelylargepercentageoflongandshortmaturity
bonds
Ladderportfolios:containbondsthatareevenlydistributedthroughoutthematurity
spectrum
Bulletportfolios:typicallyhavearelativelyhighconcentrationofbondsatsome
intermediatematurity
Keyratematurity Bullet Ladder Barbell

3month 0.07 0.05 0.05
1year 0.09 0.06 0.06
2year 1.10 1.04 0.11
3year 0.83 1.04 2.25
5year 0.42 1.07 0.65
7year 0.73 1.07 1.05
10year 1.20 1.07 1.03
15year 4.22 1.08 1.12
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20year 0.70 1.06 1.08
25year 0.20 1.05 2.15
27year 0.07 1.04 0.08
Effectiveportfolioduration 9.63 9.63 9.63
Whatistheimpactofa75basispointincreaseinthe15yearspotrate
whileallotherkeyratematurityratesremainstable?
Theoriesofthetermstructureofinterestrates
Los49e.illustratethetheoriesofthetermstructureofinterestrates(i.e.,pureexpectations,
liquidity,andpreferredhabitat),anddiscusstheimplicationsofeachfortheshapeoftheyield
curve;
Description Shapes Limitations
Broadest
interpretation
Pureexpectations
theory
Forwardrates
=f(expectedfuture
spotrates)
Local
expectation
Upward
slope:rise
Downward
Slope:fall
Flatyield:
remain
Pricerisk(sold
priorto
maturity)
Reinvestment
risk
Biased
expectation
theory
Liquidity
theory
Forward
rates=expectation
offuturerates
+liquiditypremium
Upward
slope:
eitherrising
expected
futurerates
orrates
remainbut
liquidity
premium
added
Downward
slope:fall
Preferred
habitat
Theory
Forward
rates=expectation
offuturerates+
premiumfor
movingoutofthe
preferredhabitats
Premiumsare
relatedto
supplyand
demandfor
funds;not
necessarily
relatedto
maturity
Explain
almostany
yieldcurve
shape
Convertiblebond(Basic)
Describeandevaluateaconvertiblebondanditsvariouscomponentvalues;
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M
straight value price of straight bond
min value=max
conversion value = stock P conversion ratio
premium payback period
market conversion price per share = market conversion price - stock price
=
fav
=
the
M
coupon
orable income difference per share =
conversion ratio
P of bond
conversion ratio
=
coupon interest
- dividnd per share
conversion ratio

stock
dividend
P
1. Example:BSCconvertiblebondhasa7%couponthatiscurrentlysellingat985witha
conversionratioof25andastraightvalueof950.AssumethevalueofBSCscommonstock
iscurrently35pershareandthatpays1pershareindividendsannually.
2. Couponinterest=0.07*1,000=$70
Conversionratio*dividendspershare=25*1=$25
Favorableincomedifferencepershareis(7025)/25=$1.8
Marketconversionpriceis985/25=$39.4
Marketconversionpremiumis39.435=$4.4
Premiumpaybackperiodis4.4/1.8=2.44years

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Case2:EllenHurstCaseScenario
EllenHurst,afixedincomeportfoliomanagerataprivatefoundation,isconsideringthepurchase
of a mortgagebacked security for the foundations portfolio. The mortgage market has shown
recentsignsofturmoilduetoaspikeinmortgageratesandadeclineinnewandexistinghome
salesandHurstbelievesthatyieldsonMBSareatattractivelevels.
Hurst is considering the two securities described in Exhibits 1 and 2. Both are specifiedpool,
seasonedissues.SecurityAisanonconformingprivateissuemortgagepassthroughandSecurity
BisaconventionalFannieMaepassthrough.BothareratedAAA.
EXHIBIT_MBSDescriptions
ParValue Passthrough
Rate
PoolFactor Average
Life(years)
WAC WAM
SecurityA $1,175,000 5.60% 0.72 10.44

SecurityB $1,225,000 5.50% 0.85 11.50
6.10% 136
months
EXHIBIT2CollateralDescriptionMortgagePoolSecurityA
Loan Outstanding
Mortgage
Balance
WeightinPool MortgageRate Months
Remaining
1 $152,000 17.88% 5.80% 156

2 $86,000 10.12% 6.32% 169
3 $92,000 10.82% 6.15% 150
4 $128,000 15.06% 6.20% 175
5 $185,000 21.77% 6.00% 187
6 $101,00 11.88% 5.75% 162
7 $106,000 12.47% 6.25% 157
Total $850,000 100.00%
115. Intheprevailingeconomicenvironment,whichofthefollowingbestdescribestherisk
encounteredbyinvestorsinmortgagepassthroughsecurities?
A.Extensionrisk,becauseprepaymentsaremostlikelytoincrease.
B.Extensionrisk,becauseprepaymentsaremostlikelytodecrease.
C.Cyclerisk,becauseprepaymentsaremostlikelytoincrease.
CorrectanswerB

SolutionExtensionriskdescribestheriskthatmortgageprepaymentswillslowdownmorethan
the investor anticipates. Slow prepayments are associated with a rise in interest rates, declining
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housingturnover,orchangingcharacteristicsofunderlyingresidentialmortgageloans.
116. TheWACandWAMforSecurityAareclosestto:
WAC WAM
A.6.04% 167months
B.6.07% 165months
C.6.07% 167months
CorrectanswerA

SolutionTheWACistheweightedaverageofthecouponratesforeachmortgageinthepool
andtheWAMistheweightedaverageremaining
monthstomaturityforeachmortgageinthepool.
WAC=0.1788(5.80%)+0.1012(6.32%)+0.1082(6.15%)+0.1506(6.20%)+0.2177(6.00%)+
0.1188(5.75%)+0.1247(6.25%)=6.04%
WAM=0.1788(156)+0.1012(169)+0.1082(150)+0.1506(175)+0.2177(187)+0.1188(162)+
0.1247(157)=167.11 167months
117. Whichofthesecuritiesismostlikelysubjecttohigherinterestraterisk?
A.SecurityA,becauseithasalongermaturity.
B.SecurityB,becauseithasahighercoupon.
C.SecurityB,becauseithasalongeraveragelife.
CorrectanswerC

SolutionSecurityBhasthelongeraveragelifeandisconsideredtohavethegreaterinterestrate
risk.Inthebondmarket,foragivencoupon,thegreaterthematurity,thegreatertheinterest
raterisk.Formortgagebackedsecurities,thelegalmaturity(thetimeuntilthelastscheduled
principalpayment)doesnotgiveinvestorsmuchinformationregardingthecharacteristicsofthe
securityasrelatedtointerestraterisk.Prepaymentsmustbeaccountedforaswellasscheduled
payments.Therefore,formortgagebackedsecurities,marketparticipantsgenerallyusethe
weightedaveragelife(orsimplyaveragelife)astheconventionbasedaveragetimetoreceiptof
principalpaymentsorastheappropriatemeasureofmaturityinevaluatinginterestraterisk.
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118. Given150PSA,theCPR(conditionalprepaymentrate)andSMM(singlemonthlymortality
rate)forSecurityBformonth140areclosestto:
CPR SMM
A.6.0% 0.5143%
B.6.0% 0.7828%
C.9.0% 0.7828%
CorrectanswerC
SolutionBecausethepoolisseasonedmorethan30months,weuse6%astheCPRofthe100
PSAprepaymentbenchmark.TheCPRofamortgagepoolisequaltotheCPRofthePSA
benchmark(PSAofmortgagepool/100).
CPRofSecurityB=6%(150/100)=9.0%.Thisisanannualrate.
TheSMMisamonthlyrate.SMM=1(10.09)
1/12
=1(0.91)
0.08333
=0.007828=0.7828%.
119. ThemonthlymortgageservicingfeeforSecurityBisclosestto:
A.0.05%.
B.0.50%.
C.0.60%.
CorrectanswerA
SolutionThemonthlymortgageservicingfeeisthedifferencebetweenthemortgagerateand
thepassthroughratedividedby12.
Servicingfee=(6.10%5.50%)/12=0.05%
120. Whichofthetwosecuritiesismostlikelytohavethelowercreditrisk?
A.SecurityAbecauseithastheshortestaveragelife.
B.SecurityBbecauseithasanagencyguarantee.
C.SecurityBbecauseithasconventionalmortgages.
CorrectanswerB
SolutionSecurityBhaslesscreditrisksinceitisguaranteedbyFannieMae,acorporate
instrumentalityoftheU.S.government.Generally,nonagencysecuritiesareconsideredtobe
exposedtocreditrisk.ThefactthatSecurityAhasnonconformingmortgagesdoesnot
necessarilymeanithaslowercreditquality
KeyPoints:
WAM&WAC
LOS 51b. illustrate the investment characteristics, payment characteristics, and risks of
mortgagepassthroughsecurities;
1. Weighted average maturity (WAM): the weighted average of all the mortgages in the pool,
eachweightedbytherelativeoutstandingmortgagebalancetothevalueoftheentirepool.
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2. Weighted average coupon (WAC): weight the mortgage rate of each mortgage loan in the
pool by the percentage of the mortgage outstanding relative to the outstanding amount of
allthemortgagesinthepool.
3. Example:
Loan Outstanding
MortgageBalance
WeightinPool MortgageRate Months
Remaining
1
2
3
4
5
$125,000
$85,000
$175,000
$110,000
$70,000
22.12%
15.04%
30.97%
19.47%
12.39%
7.50%
7.20%
7.00%
7.80%
6.90%
275
260
290
285
270
Total $565,000 100.00% 7.28% 279
4. WAC=22.12%*7.50%+15.04%*7.20%+30.97%*7.00%+19.47%*7.80%+12.39%*
6.90%=7.28%
5. WAM=22.12%*275+15.04%*260+30.97%*290+19.47%*285+12.39%*270=279
Quantifyprepaymentrisk
LOS 51d. compare and contrast the conditional prepayment rate (CPR) with the Public
SecuritiesAssociation(PSA)prepaymentbenchmark;
1
12

6% 1 (1 )
30
( )
x x
m begin at m
x
CPR CPR mPSA m CPR SMM CPR
PRE SMM Mort Scheduled principal pay for m
= = = =
=

1. Example:
2. ComputetheCPRandSMMforthe25thand35thmonths,assuming100PSA.
Solution:
CPR(month25)=6%*(25/30)=5%
SMM=1(10.05)1/12=0.004265
CPR(month35)=6%
SMM=1(10.06)1/12=0.0051
3. Assume that you have invested in a mortgage pool with a $100,000 principal balance
outstanding at the beginning of the 25th month. The scheduled monthly principal payment
formonth25is$28.61.Computetheprepaymentforthe25thmonth.
Solution: Prepayment25=0.004265*($100,000$28.61)=$426.38
OverviewofMBS
Los 51a. describe a mortgage loan, and illustrate the cash flow characteristics of a fixed rate,
levelpayment,andfullyamortizedmortgageloan;
1. Netinterest/coupon:mortgagerateservicingfee
2. The dollar amount of the servicing fee is based on the outstanding loan balance and it
declinesasthemortgageisamortized.
3. Thereductioninprincipalassociatedwitheachpaymentisbasedonthemortgagerateand
unaffectedbytheservicingfee.
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insurance
securitize
MBS sold
buy MBS
fund
1 1
Ginnie
1 2 2
Freddie
3 2 3
Fannie
4 4
loan sell
B I
B I
bank
B I
B I

qualitative 3 factors
Public Securities Association (PSA)
quantitative Conditional Prepayment Rate (CPR)
Single Monthly Mortality rate (SMM)
-
Avg.life
maturity
-
contraction
exte
1
2
3
4
B
B R
B C
B

( )
pass
CMO
PO/IO nsion
- -
pay back service
1
Ginnie
2
Freddie
8% 6% 3
Fannie
4
I
I
I
I

Contrast
LOS48j.contrastthecreditanalysisrequiredforcorporatebondstothatrequiredfor
1)assetbackedsecurities,2)municipalsecurities,and3)sovereigndebt.
CorporateBond ABS Municipalbond Sovereignbond
Capacitytopay
Qualityofcollateral;
diversification
Flowoffunds Economicrisk(ability)
Character
(Governance
structure)
QualityofServicer
Politicalrisk
(willingness)
Covenants
Collateral CFStress RateCovemant
LegalStructure Priorityofrevenueclaims
Yieldspreads
Los50b.evaluatetheimportanceofbenchmarkinterestratesininterpretingspreadmeasures;
Description Character
The two GSEs face little or no market
disciplinefromtheirdebtholdersbecause
ofabelieftheU.S.governmentwillback
these institutions under almost any
circumstances.
ThetwoGSEsfacelittleornomarketdisciplinefromtheirdebt
holdersbecauseofabelieftheU.S.government"willback
theseinstitutionsunderalmostanycircumstances."
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Nominal
spread
=Bondyieldtomaturityyieldona
comparablematuritygovernmenttreasurysecurity
( ) ( )
K +
+ +
+
+ +
=
2
2
1
1
1 1
P
N R
CF
N R
CF
market

Useasingleinterest
ratetodiscount
eachcashflow
Zspread
( ) ( )
K +
+ +
+
+ +
=
2
1
2
1
1
1
1 1
P
Z R
CF
Z R
CF
market

Assumetheinterest
ratevolatilityiszero
OAS
( ) ( )
K +
+ +
+
+ +
=
2
"
2
2
1
"
1
1
1 1
P
OAS R
CF
OAS R
CF
market
Optioncost=ZspreadOAS
Benchmarkinterestrates:
1.UStreasurysecurities
2.Aspecificsectorofthebondmarketwithacertaincreditratinghigherthantheissue
valued
3.Aspecificissuer
Judgeundervaluedorovervalued,givenanappropriatebenchmark
LOS 50a. evaluate, using relative value analysis, whether a security is undervalued or
overvalued;
TreasuryBenchmark BondSector
Benchmark
Issuerspecific
Benchmark
Creditrisk Creditrisk
Liquidityrisk Liquidityrisk Liquidityrisk
Nominal
Spread
Zspread
Optionrisk Optionrisk Optionrisk
Creditrisk Creditrisk OAS
Liquidityrisk Liquidityrisk Liquidityrisk
OAS>0 Overifactual
OAS<requiredOAS;
Udervaluedif
OAS>requiredOAS
Overifactual
OAS<requiredOAS;
Undervaluedif
OAS>OAS
Undervalued
OAS=0 Over Over Fairlypriced
OAS<0 Over Over Over
Effectivedurationandeffectiveconvexitycalculatedusingthebinomialmodel
Los 50h. illustrate how effective duration and effective convexity are calculated using the
binomialmodel;
0
2
0
(2 )
2
y y
BV BV BV
EC
BV y
+
+
=

0
2
y y
BV BV
ED
BV y
+
=

EXAMPLE:
V is originally 102.218; Yield changes 25bps; when yield increases, V equals to 101.621; when
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yielddecreases,Vequalsto102.765.
ComputetheEDandEC.
Accruedtranche,theplannedamortizationclasstrancheandthesupporttranche
Tranche Contractionrisk Extensionrisk
A
B
C
D
Z (zerocoupon) int. accrued and paid as
principle to senior tranches (no reinvestment
risk)
HIGH
LOW
LOW
HIGH
Tranche Prepaymentrisk
A
B
C
D
E
F
Support(brokenorbustedPAC)
LOW
HIGH
StrippedPO/IO
Los51j.explaintheinvestmentcharacteristicsofstrippedmortgagebackedsecurities;
PO IO
Sellatadiscount Shorterlife
Smalltobig Bigtosmall
Prepaymentrise:good Prepaymentfall:good
Interestratefall:good Interestraterise:good
Greatervolatilitythanpassthrough Greatervolatilitythanpassthrough
Sequential pay CMO
PAC tranches
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1. POpriceincreasewheninterestratesfall.
2. Theyalsoexhibitsomenegativeconvexityatlowrates.
Homeequityloans
Los 52e. describe the cash flow and prepayment characteristics for securities backed by home
equity loans, manufactured housing loans, automobile loans, student loans, SBA loans, and
creditcardreceivables;
HEL MBS
Credit:notmeetagencyrequirements Credit:meetagency
requirements
Closedend Fullyamortized
Openend
Similar
CPR CPR PPC(prospectus
prepayment
curve)
IssuerSpecific
PSA
Generic
HELfloaters(6&1month)Couponratecaps None
NAS(non
accelerating
senior)
Noprepaymentinearlyyears(reduce
contractionrisk/extensionrisk?);
higherpercentageofpaymentsinthe
latteryears(reduceextension/
contractionrisk?)
Support
PAC Similar PAC Similar
Whichspreadshouldbeusedtoevaluateaspecificfixedincomesecurityametaphor
LOS 53i. determine whether the nominal spread, zerovolatility spread, or optionadjusted
spreadshouldbeusedtoevaluateaspecificfixedincomesecurity.
MeredithWhitneyisaseniorconsultantintheSwapsAdvisoryGroupofDCMCapital,an
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Auto loan ABS
With
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Plain vanilla corporate
path rate int. refinance rate prepay CF

2012-06 CFA L2 100 Forecast

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Riskneutral probability of an up move is

Days Rate DiscountFactor

(1 / 360) (1 / 360) (1 ( ) / 360)

Country Currency SpotExchangeRate* OneYear

Coefficient Std.Error t Significanceoft

Coefficient Std.Error t Significanceoft

EXHIBIT4 Selected Values for the Fdistribution( 01 . 0 = )(df1/df2: Numerator/Denominator

Assumptionviolation Impact Detection

Regression 3 0.1460 0.0486 12.572 7.03E07

Residual 85 0.3289 0.0039

GAP AdjustmentonCFO AdjustmentonCFF

COGS(FIFO)= COGS(LIFO) IncreaseinLIFOreserve*

Year1 Year2 Year3 Year4 Year5

target of ue merger val - pre

rs shareholde acquirer the to accrued gains

Asset pricing model

Keyratematurity Bullet Ladder Barbell

SecurityA $1,175,000 5.60% 0.72 10.44

1 $152,000 17.88% 5.80% 156

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