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CFALEVEL2NOTES

peterding10@gmail.com

ETHICS
CodeofEthics(SeparatefromCodeofStandards)
Actwithintegritycompetencediligenceandrespectinanethicalmannerwitheveryone
Placeintegrityofinvestmentprofessionandinterestofclientsabovepersonalinterest
Usereasonablecareandindependentprofessionaljudgmentwrtinvestmentanalysis,action,recommendation
Practiceandencourageotherstobeprofessional,ethical,whichreflectscreditonthemselvesandprofession
Promotetheintegrityandviabilityofglobalcapitalmarketsforultimatebenefitofsociety
Maintainandimproveprofessionalcompetenceforyourselfandothers

StandardsofProfessionalConduct(CodeofStandards)

OktocompeteagainstemployerforadditionalcompensationwhenworkingforthemifyouhavewrittenCONSENT
Notifyemployerofservicesrendered,durationofservicesandcompensationforservices

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Cantsolicitcurrentclientstojoinnewfirmifyoustillworkatoldfirm.Youcanpreparetogointocompetitivebusinessbeforeleaving
workaslongasitdoesntbreachemployeesdutyofloyalty
Youcansolicitcurrentclientsofoldfirmafteryouveleft(unlesstheresanoncompeteclause)
CanttakeoldworkfromoldemployertonewemployerwithoutwrittenCONSENTofpreviousemployer
Analystnotpreventedfromwritingresearchreportbecauseofrelationshipbetweenemployerandtargetcompany,DISCLOSURE
Doesntmatterthatbrokeragefirmprovidesresearchthatisnotusedbyaccountgeneratingcommissionifaccountisntpayingforit
Bestthingtodoistopayforaccommodations,acceptingnotnecessarilyaviolationifitdoesntimpedeobjectivity
RewardforstrongpastrealizedreturnfromclientsokifotherclientsaretreatedthesameDISCLOSURE
Rewardsbasedonfutureperformance:mustreceivewrittenpermissionfromemployer
Oktoownsameinvestmentsasclients.Responsibilitytoclients,thenemployer,thenyourself.
Employeesshoulddisseminatepublicmaterialinformationifitdoesntbreachduty
Youmustattempttomakeeveryone(notjustdirectreports)adheretolaws,rulesandregulations
Responsibilityofsupervisors:areheldaccountablefortheiremployeesactions.
Supervisorydutiesmaybedelegatedbutthatdoesntrelievesupervisorsfromresponsibility
Ifblocktradesoccuratdifferentpricestheymustbeallocatedprorataacrossallaccountswithnopreferentialtreatment.
Acceptabletobasearecommendation,inpart,onanexpectationoffutureevents,evenifisuncertain
EX:apoliticianisfightingforsubsidiestoanindustryandbelievesthatsaidsubsidywillpass
CandidatescantsaytheyreceivedhighestscoreonCFAexamsb/cscoresarebrokeninto<50,5070,70<scoresections.Youdont
knowyouractualscore,justifyoupassed/failed.
CFAlogocantbeincorporatedintocompanynameorlogo.CFAlogousedonlytoidentifycharterholdersnotcandidates
AllocateIPOstosuitableclientsproratadirectly,notoktoallocatetomanagerswhothenhavediscretiontoallocatetotheirclients
Oversubscribedissues:forgosalestoyourselfandimmediatefamily(unlesstheyreregularaccts),prorateremainingamongstclients
Presentoutcomesfrommodelsorstatisticalestimatesasopinionsnotfactandwithqualifyingstatementsandcaveats
Plagiarismincludes:usingexpertseitherverbatimorwithslightchangesinwordingw/oacknowledgement,specificquotationsto
vaguesources(leadinganalysts,Investmentexperts),usingcharts/graphswithoutcitingsources,copyingspreadsheetsoralgos
withoutseekingcooperationorauthorizationofcreators.
Youcanusepreviousresearchdonebyanotheranalysteveniftheyhaveleftthefirm.Youcannotreissuepreviouslyreleasedreport
solelyunderyourname.Firmcanissueresearchifanalystisgonetoo.
Citingdirectsourceorintermediarysource:bestobtaincompletestudyfromoriginalauthorandciteauthorpreferred,oruseboth
intermediaryandsourceandcitebothsources.
Aninfluentialanalystwiththeabilitytomovemarketsisconsideredmaterial.Butsincethisanalystisnotacompanyinsiderareport
writtenbythemisnotconsideredMNPIanddonthavetobepubliclydisseminated.Ifyouwantaccessyoucanpaythem.
If10largestshareholdersaretoldsomethingatameeting.Analystcannotusethisinformationbecauseitisnotpublic,ithasnotbeen
widelypubliclydisseminated
Investmentdecisionsmadeincontextofthewholeportfolio,considertheinvestmentsplaceintheoverallportfolio
Afamilymembersaccountisaregularfeepayingaccountcomparabletoallclients.Dontdisadvantagethemoranyotherspecific
clientbecauseofovercorrectingnotionoffairnessduetothisspecialrelationship
Disseminationshouldbefair(equaldisseminationatsametimeforeveryonetoohard),cantdiscriminatewithselectivedissemination
Higherfeepayingclientsgetmoreserviceandattentionbutnottodetrimenttoothers
UsingQuantModels:donthavetoknoweverytechnicalaspectbutyoushouldunderstandassumptionsandlimitations
Developingquantmodels:understandtechnicalaspects.Thoroughtestingofmodelandresultinganalysisshouldbecompleted
CFAinstituterecommendsmaintainingrecordsforatleast7years
Ifyouissuearecommendationgiveampletimeforclientstoreceivemessageandforthemtoactbeforeyouoryourfirmtradesinan
efforttopreventfrontrunning
Noneedtodissociateyourselffromreportifyoudisagreewithconsensusgroupopinionifyoubelieveopinionhasreasonablebasis.
IfmarketmakersareinpossessionofMNPI,theyshouldbepassivemarketparticipants.Outrightprohibitionofmarketmakingmight
beconstruedasatiptooutsiders
Exemptfrombestexecutionbrokerageifclientexpresslyprohibitsbestexecutionandisawareoftheimpactontheiraccount
MNPIviolatedifyouactorcauseothertoactonMNPIreceivedamereoutlook(promising,negative)doesnotviolatethis
Diligenceandreasonablebasisnotviolatedifnoformalrecommendationismade
Allclientsparticipatinginablocktradeshouldbegivensameexecutionpriceandpaysamecommission

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Receivetradeallocationrequest(whatclientswouldliketoown)notificationfromclientsbeforereceivingstockfromIPO
Whistleblowerstatusgrantedifyoudonthaveanythingtogainpersonally
Ifclientistryingtosetupinvestmenttrustforkids,thenthekidsaretheactualclients(trustbeneficiaries),considerkidsrisksand
investmentobjectives
Suitabilityisntanissuewhenrecommendingtogeneralclients.Suitabilitymaybeissueifrecommendinginvestmentforspecificclient
Cantsaydateortimeframeofreceivingcharter.Say:CFAcharterreceivedwhenIvecompletedrequiredworkexperienceafter
passing3levels
IfinfluentialanalysttellsyouaboutrecommendationbeforegoingonTVitisconsideredMNPIifyouactonit.

ResearchObjectivity:

AllcommunicationbtwnIBDandresearchshouldtakeplacethroughcomplianceorlegal.Draftshouldbesubmittedbeforehand.
Communicationshouldbeonlytoverifyfactualinfoorconflictsofinterest.
NocommunicationbtwnIBDandbrokerage
ResearchcantshareanypartofrecommendationwithIBDorCorpFin
Researchcantparticipateinmarketingactivities,iftheyaretheyshouldbedisclosed.
CantlinkresearchanalystcompensationtospecificIBDproject.Although,compensationcanbelinkedtooverallIBDdepartment
performance.
Canttradeagainstfirmrecommendationunlesstheresextremefinancialhardship(differentfromStandardPriorityof
transactionswherefirmshouldbenotifiedofopposingtradeandaslongastradedoesntdisadvantageclients)
Ratingrecommendedtohave:1)recommendationorratingcategory2)timehorizoncategories3)riskcategories
Recommendedrestrictedtradingperiodsofatleast30daysbeforeand5daysafterrecommendationtopreventclientfrontrunning
Recommendedquietperiod:30daysbeforeIPO,10daysbeforesecondaryoffering
Researchreportsshouldbeupdatedideallyquarterly.Alsoshouldbeupdatedwhentheresamajorevent
Finalresearchreportshouldbeissuedifcoverageisbeingdiscontinued.Thisreportshouldexplainreasonsfordiscontinuingcoverage

QUANTITATIVEMETHODS
EstimatedSlopecoefficient=
ttestforsignificance:,REJECTiftstat>tcrit.Conclude:coefficientissignificantinandisnotequalto0
Pvalueisthesmallestlevelofsignificancewherethenullcanberejected.
IfPvalue<Significancelvl,thenullhypothesiscanbeREJECTedandthevariableisconsideredsignificant
CONFIDENCEINTERVALS

+RSS(explained)isvariationofyexplainedbyx
+SSE(unexplained)isvariationofyNOTexplainedbyx
=SST(total).istotalvariationofdependentvariable(y)
CorrelationCoefficient==rCov1,2=Corr1,212r=Corr1,2=1,2=Cov1,2/12
testforsignificanceofCorr(r):

moreindependentvariablestendtooverestimateR2.AdjR2revisesthenumberdownward
FStatistic(Calculatingindependentvariablesasagroupexplainsdependentvariablemovement)

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IfFstat>Fcritthenreject.Groupofindependentvariablevariationdescribesdependentvariation
ModelMisspecification:omittingavariable,variableshouldbetransformed,incorrectlypoolingdata,usinglaggeddependent
variableasindependentvariable,forecastingthepast,measuringindependentvariableswitherror.
Effectsofmisspecification:Regressioncoefficientsarebiasedandinconsistent,lackofconfidenceinhypothesistestsofthe
coefficientsorinthemodelpredictions.
MultipleRegressionIssue
Heteroskedasticity:residualvarianceisnot
constant

Serialcorrelation/Autocorrelation:residuals
correlated,futuredataaffectedbypastdata,
laggedcorrelationpresent

Detection
BreuschPagan:regressthesquareofresiduals
onoriginalindependentvariablesandcreate
newChisquaredtest.REJECT:nR2>2HS
exists
(R2correspondsto2ndregression:Regressing2
(residualssquared)onindependentvariable.
DurbinWatson:DWstat=2(1r),whereris
samplecorrelationbetweensquaredresiduals
fromoneperiodandpreviousperiod.
+SCinconclusivenoneinconclusiveSC

Correcting
WhitecorrectedSE(robuststandarderrors),
Generalizedleastsquares(gls),HSconsistent
standarderrors(SE)

Hansenmethod,whitecorrected.
Adjust/modifycoefficientstandarderrors.

0dLdu~24du4dL
4
Positiveserialcorrelation:SEunderestimated,tstatlarger
Negativeserialcorrelation:SEoverestimated,tstatsmaller

MultiCollinarity:highcorrelationbetween2or
moreindependentvariables.

Yt=ebo+b1tln(yt)=b0+b1X

Highpairwisecorrelation
HighR2,highstandarderrors(lowtstats),
indepcoefficienttstatsarenotsignificant

Stepwiseregression:omitoneormoreof
collinearvariables

Regressnaturallogofdependentvariablesonindependentvariables

AutoregressivemodelsAR(p):xt=b0+b1xt1+b2xt2++bpxtp+t
ARValidif:
Notheteroskedastistic
Notseriallycorrelated(seebelowhowtofix)
COVARIANCESTATIONARYif:
E(timeseries)constant,finiteandmeanrevertinglevel,ifb1=1ARisUnitRoot=noncovstationary
Var(observations)constant,finite
Cov(Timesseries)constant,finite
NOunitroot(seriestrendsupordown).Correctwithfirstdifferencing(describedinARCHsectionbelow)
Testwithdickeyfuller.Unitrootexistsifb11=0(itisnonstationary)

ARtestforresidualcorrelationfortimeseriesmodels(iftimesserieshasautocorrelationitisnotcovariancestationary):
Detect:ttestforautocorrelationinresiduals:
rejectnull,CONCLUDE:serial/autocorrelationssignificantlydifferentfrom0.

Fix:IncludeadditionallagsforAR(p)model(pincreasing)sotheresnoautocorrelation(tstatdeclinesto0)

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TestingforARCHandnonstationarityforARmodels**Remember:ifnonstationarythenARisinvalid**

Ifb1=1,thentheprocesshasaunitrootandisnoncovariancestationaryfromxt=b0+b1xt1+et
RandomWalkisNONcovariancestationary(nofinitemeanrevertinglevel)
Iffirstdifferencedb0=0andb1=0andtheresnotautocorrelationbetweenresidualsthenARisNOTrandomwalk
andIScovariancestationary
DICKEYFULLERTEST(firstdifferencingmethod)
(xtxt1)=b0+(b11)xt1+et
whereg1=b11
H0:g1=0Timeserieshasunitrootandg1willequal0(b1=1):acceptnullnonstationary
H1:g1<0Timeseriesdoesnthaveunitrootandiscovariancestationary
FIXnonstationarityFirstdifferencing:modelchangeinvalueofdependentvariablext,ratherthanthevariableitselfxt
EX:runregressiononln(salest)=ln(salest)ln(salet1)
Timeseriesautocorrelationssignificantlydifferentfrom0atalllags.reestimatemodelusinggeneralizedleastsquares.

TestforARCHisbasedonaregressionofthesquaredresidualsontheirlaggedvalues:
1) Squareresidualsfromautoregressivemodel
2) Regresssquaredresidualsagainstsquaredresidualsfrompreviousperiod
3) Ifcoefficient1(usingttest)from
modelexhibitsARCH(1)
4) FIXARCHerror:usegeneralizedleastsquares

Seasonality
DetectingSeasonality:
lnxt=b0+b1(lnxt1)+et
ifresiduallag4
FixingSeasonality:
lnxt+b0+b1(lnxt1)+b2(lnxt4)+et
Addlagged4thterm

Then4thautocorrelationisseasonal

AfterEngleGrangerARCHtestingforcointegration
Cointegration:2timeseriesareeconomicallylinked
Xt=0+1tyt=0+1t+
yt=0+1t

isstatisticallysignificant(differentfrom0)concluderegression

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Indep&DependentVariablesare:
Regressionresults:
Neitherhasunitroot(covariancestationary) Valid
1hasunitroot. Notvalid
2haveunitroot&cointegrated..Valid(goodforLTregressionestimatesforSTestimatesusecorrectionmodels)
2haveunitroot&notcointegrated.Notvalid
ifEngleGrangercriticalvaluesrejectsnullhypothesisunitroot.CONCLUDE:covariancestationary,2seriesarecointegrated
ECONOMICS
Converting:
upthebid&multiplydowntheask&divide
Crossratesw/bidaskspreadsswitchbid&offerinterchangeably
TriangularArbitrage
Market:
Bid
Ask
USD/EUR 1.271 1.272
EUR/GBP 1.249 1.250
USD/GBP 1.6 1.601

USDEURGBPUSD

Setalltobidoraskwithinvertingdependingonstrategy

Becomes:

ArbProfit=$1.006289$1

Buy@DealerAsk,SellatDealerBidtocompletearb

Calculateforwardpremium(discount)=
Carrytradeforarbitrageopportunities:borrowinloweryieldingcurrencyandinvest(lend)inhigheryieldingone.Thennet
anyprofitafterborrowingcostsandexchangeratemovements.
(rdrf)<(ForwardSpot)/Spot
BorrowDomestic
InvestForeign
(rdrf)>(ForwardSpot)/Spot
BorrowForeign
InvestDomestic
EX:BorrowinUSD,translatetoEuros,LendEuros,translatetoUSD,RepayinUSD

Valueofcurrencyforward:

*FPt,Randdaysareintermsofthenumberofdaysremainingincontract
EX:originally90dayforward,60dayshavepassed(30daysremain).FPt,Randdaysuse30dayinputs
RelativePPP:statesthatexchangerateswillchange
toreflectdifferencesinactualinflationbetweencountries
ExantePPP:similartorelativePPP,butinsteadofactualinflation
itsaysexpectedinflationchangesexpectedchangesinspotrates

AbsolutePPP:Givenabasketofgoodsshouldcostthesameindifferentcountriesaftertakingintoconsiderationexchange
rates.Goodsandservicescanbetransportedatnocost,allcountriesusesamemethodtomeasurepricelevels

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InterestRateParity:exchangerateschangesothatriskadjustedreturnsoninvestmentsinanycurrencywillbeequal.
Investorsareriskneutral
1) Coveredinterestrateparity:investorsearnsameprofit,derivesnoarbforwardrate

Derivesnoarbitrageforwardrate.Interestratesandexchangerateswilladjustsotheriskadjustedreturnonassetsbetween
any2countriesandtheirassociatedcurrencieswillbethesame(premiumsanddiscountswilloffset).Realinterestrate
differentialswouldresultincapitalflowstothehigherrealinterestratecountry,equalizingratesovertime.
2) UncoveredInterestRateParity:Forwardisunbiasedpredictorofexpectedfuturespotrates.Expectedspotpriceisnot
markettradedandthusUIRPdoesnotholdbyarbitrage.Expectedappreciation/depreciationoffsetbyintrtdifferential

FisherRelation:Countrysnominalinterestratesshouldbesimilartoexpectedinflationdifferences
Rnominal=Rreal+E(inflation)RnomARnomB=E(InflationA)E(InflationB)
1+Rnominal=(1+Rreal)[E(inflation)]
TaylorRule:1)controlinflation2)maximizeemployment
R=rn++(*)+(yy*)
Centralbankpolicy=Neutralrealpolicyintrate+inflation+diffintargetandactualinflation+diffbtwnoutputandtargetoutput

RealFXrateF/D =equilibriumrealexchangerateF/D
+(realinterestrateDrealinterestrateF)
+[(DD*)(FF*)]
(ifinflationgapofdomesticisgreaterrelativetoforeignFXF/Dwillrise,Dappreciates)
+[(YDYD*)(YFYF*)]
(ifoutputgapofdomesticisgreaterrelativetoforeignFXF/Dwillrise,Dappreciates)
(riskpremiumDriskpremiumF)
(ifgreaterriskpremiumrequiredtoholddomesticFXF/Dwilldecrease,Ddepreciates)
AssessinglongrunfairvalueofFX:
MacroeconomicBalanceApproach:estimateshowmuchcurrentexchangeratesmustadjusttoequalizeacountrys
expectedcurrentaccountimbalanceandsustainablecurrentaccountimbalance
Externalsustainabilityapproach:estimateshowmuchcurrentexchangeratesmustadjusttoforceacountrys
externaldebt(asset)relativetoGDPtowardsitssustainablelevel
Reducedformeconometricmodelapproach:findsequilibriumpathofFXmovementsbasedonpatternsinseveral
macroeconomicvariables,suchastradebalance,netforeignasset/liabilityandrelativeproductivity
MundellFlemingModel:monetaryandfiscalpolicyimpactoninterestratesandexchangerates
ExpansionaryMonetary:pumpmoneyintoeconomyintrtslowercapitalmovesout(domesticdepreciates)
ExpansionaryFiscal:lowertaxes/higherspendingmoregovborrowingintrtshighercapitalmovesin

MonetaryModels:
PureMonetaryModels:PPPholds,outputisconstant
Expansionarymonetary/fiscal:prices,valueofcurrency
Restrictivemonetary/fiscal:prices,valueofcurrency
DornbushOvershootModel:pricesareinflexibleanddontreflectchangesinpolicyimmediately*thinkofoversteeringacaronice
EX:expansionarymonetary:prices,realinterestratesdepreciationofdomesticcurrencyduetocapitaloutflow
InShortterm:depreciationofcurrency>depreciationimpliedbyPPP.Depreciationishigherthanitshouldbe.
Inlongterm:FXrtsgraduallyincrease(appreciate)towardtheirnormallongrunPPPimpliedvalues.
GrowthEconomics:

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Classical:GrowthinrealGDPistemporaryandislimitedbyasubsistencelevel,newtechnologiesresultinlargerbutnotricherpopulation
Neoclassical:Tech(TFP)improvementlaborproductivityresultinginupwardshiftofproductionfunctioncurve.
inK(capitaldeepening)andLdoesntchangegrowthinoutputperworkerpermonlyamtofproduction(movementonproductioncurve)
Sustainablegrowthcomesfrompopulationgrowth.Laborsshareofincomeincreasesfromtechnologicaladvancement(treatedas
exogenousvariable).aftertradeopensupandsavingsreallocatedeconomiesconvergeatsamegrowthrateasthereisnopermanent
increaseingrowthrate.Diminishingmarginalproductivityofcapitalbutconstantmarginalproductofcapital.Savingsandinvestmenthave
temporaryimpactongrowth
Insteadystate,marginalproductofcapital(MPK)isequaltorentalpriceofcapital:
MPK=Y/K=(capital'sshareoftotaloutputas%xoutput)/totalcapital=capital'sshareoftotaloutput/totalcapital.
GDPgrowthrate=(growthrateintotalfactorproductivity/(1)labor'sshareoftotalfactorcost)+growthinlaborforce
Endogenous:Technologyleadstobetterlaborproductivity,capitaldeepening,knowledgecapitalandR&Dleadstosocialandother
technologicalbenefitsandexternalitiesforeveryone.Savingandinvestmentcangenerateselfsustaininggrowthatapermanently
higherrateasthepositiveexternalitiesassociatedwithR&Dpreventdiminishingmarginalreturnstocapitalfromsettingin.Differsfrom
neoclassicalbecauseendogenoussayscapitalinvestmenthasconstantreturnswhileneoclassicalsaysKinvestmentisdiminishing.
GDPgrowth=TFP(tech)growth+(LTgrowthrateofcapital)+(1)(LTlaborgrowth)
TFP(tech)growth=GrowthinlaborproductivityCapitaldeepening
Stockmarketgrowth=GDPGrowth+Capitalgrowth+P/Emultiplegrowthrates
*InLRstockgrowthdependsonlyonGDPgrowth
StockMarket=GDP*(E/GDP)*(P/E)=GDP*corporateshareofearningsinGDP*marketP/Eratio
Regulationsnecessaryb/cofinformationfrictions(informationasymmetry,moralhazard,adverseselection)&externalities
RegulatoryArbitrage:companiesexploitdifferencebetweeneconomicsubstanceandinterpretationofaregulation.
RegulatoryCapture:regulatorybodygetsinfluencedbyregulatedindustryandadvanceinterestofregulated(eg.banks)
RegulatoryCompetition:regulatorscompetetoprovidebestenvironment
CoaseTheorem:Whenpropertyrightsareinvolved,peoplewillmakeefficientdecisionsthataremutuallybeneficial

FRA:INVENTORIESANDLONGLIVEDASSETS

Inventories

LR=LIFORESERVE(lifotofifo)

FIFOinventory =LIFOinventory+LIFOreserve(writedowncharges)
FIFOCOGS
=LIFOCOGS(LREndLRBegining)+(writedowncharges)

LIFOtoFIFOConversionchangeamount:
NetIncome.=+(LREndLRBeg)x(1taxrate)
CurrentAssets =+(LIFOreserve)(1taxrate)
Inventory.. =+(LIFOreserve)
Cash.. =(LIFOreserve)x(taxrate)
Liab(d.taxes)=+(LIFOreserve)x(taxrate)
Equity(RE).=+(LIFOreserve)x(1taxrate)
LIFOresultsinhighercashflowsbecausewithlowerreportedincome,incometaxwillbelower
LIFOLiquidation:COGS>Purchased,goodsheldinBeginningInventoryareincludedinCOGS
Firmallowsinventorytodecrease.LowerCOGS.Leadstounsustainabletemporaryincreaseinnetincome.
InventoryWriteDowns:
IFRS:min(cost,NRV=salespriceselling&completioncosts)
(maybewrittenbackuptootoextentofloss)
GAAP:min(cost,marketreplacementcost)
NRVNormalprofit<market<NRV

(cantbewrittenbackup.Exception:agriculture,mining,forestrywithactivemarketcanbereflectedinISasG/L)
Writedownprocess:COGS,resultsin:NetIncome

LongLivedAssets
Capitalizeasassetonbalancesheet:
1)Initially:noncurrentasset,CFI(similartoinvestinginasset)
2)Future:noncurrentasset,NI,RE,Equity(allbecauseof

COMPARISON
NI1styr
NI(future)[b/c

depex)

T.Assets
Equity
CFO
CFI
IncomeVariability
D/ERatio

Expensecostinincomestatement
Initially:NIby(cost)(1tax),OCFnofuturecosts

Intangiblecapitalize/expensetreatment:
IFRS:R&Dresearchexpensed
Development(tobringtomarket)capitalized

Capitalizing
Higher
Lower

Expensing
Lower
Higher

Higher
Higher
Higher
Lower
Lower
Lower

Lower
Lower
Lower
Higher
Higher
Higher

depex]

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GAAP:R&Dresearchexpensed
Softwaredevelopment:establishingfeasibilitycostviewedasR&Dcostsexpensed
Whenfeasibilityisestablished:costscapitalizedasinventory
Internallydevelopedsoftwareisexpensed.Thencapitalizedwhensoftwareusedasintended.
Patent&copyrightdev:capitalizedwhenpurchasedfromoutside
Expensedwhendevelopedinternally
ReverseCapitalizingofexpenses:(adjustedEBT)=EBTCapitalizedinterest+AmortizationofCapitalizedinterest
AssetImpairment(downward):fairvalue
valueinuse
IFRS: ifCV>recoverableamt=Max[(FVsellingcosts),PV(E(CFs)].
1.Writedowntorecoverableamount
GAAP: ifCV>undiscountedCFs.WritedowntorecoverableFVorDCFamt.
2.LossisinI/S
CFsameb/cimpairmentisNCC
AssetRevaluation(Upwards):
IFRS 1)Revaluationmethod::CV=FairValueSubsequentAccumulatedDepreciation&Impairment
2)Costmethod::CV=HistoricalCostAccumulatedDepreciation

*RevaluationrecordedinI/SanyrevaluationexceedingoriginalcostisrecordedasrevaluationsurplusasOCIequity

GAAP 1)Costmethodonly.Valuecanneverexceedhistoricalcost
AcctTreatmentofRevaluation:
IFRS:G/LinISanyexcessgainsaboveoriginalcostisrecognizedinOCI(equity)asrevaluationsurplus
GAAP:notallowedexceptforlonglivedassetsheldforsale.
Onlythecostmodelmaybeusedasvaluecanneverexceedhistoricalcosts.

Leasesfromlesseesperspective
OperatingLease

@inception
Nochanges

Finance(Capital)Lease
BS(LongLivedAsset&noncurrent
Liab):
Higherassets/liab/leverage/
Min(PVleasepymts,FairValue)
OCF/EBIT
OCFhigherbecauseintexp
paidinOCF,onlyprincipalpaid
inCFF

Duringlife
IS:lease/rentexpenseeveryyear
CF:leaseexpenseisCFOoutflow
BS:Assetbydepreciation
Liabbyprincipalpayment
=leasepymtinterestexpense
(discrtxliabbeginning)
IS:intexp,depex(opexpaffectsEBIT)

CF:TotalLeasePayment=
IntExpisCFOoutflow
PrincipalPymtisCFFoutflow

FRA:INTERCORPORATE,POSTEMPLOYMENTANDSHAREBASEDCOMPENSATION,ANDMULTINATIONALOPERATIONS
INTERCORPORATEINVESTMENTS:
Ownership
Amtofcontrol
GAAP
IFRS
Lessthan20%:finassets
None
HFT,AFS,HTM
same
Investmentinfinancialassetsdetaillevel(amountonparentsfinancialstatementsproportionatetoownership%[020%]):
FV=marketvalueifavailableUnrealizedgain=FVInvestmentBeginningamtdiscount
FVthroughprofitorloss
HFT(designatedatFV)

AFS

HTM

B/S:GAAP&IFRS
MarketFV(fairvalue)

I/S:GAAP
Interest,Divd
Realized/unrealizedG/L
Interest,Divd
RealizedG/L

FV:
IFRS:unrealizedG/LinOCI
GAAP:ALLunrealizedG/LinOCI ReversedoutofOCIinReclassificationadj
Initiallyrecorded@FV
Interestincluding
Subsequentlyreportedatamortizedcostusing
amort.

I/S:IFRSdifference
none
UnrealizedFOREXG/L
recognizedinIS
Realized
none

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effectiveinterestmethod
Costofdebt+discountpremiumthatsbeen
amortized

RealizedG/L

FV=par,n=timeremaining,I/Y=rate/period,PMT=coupon/period,PVFVinBS
EffectiveInterestMethod:(anydiffbetweenpar&FVisamortizedoverterm)
Par>FV(effectiveinterestrate>statedcoupon)securitiestradeatadiscount

Par<FV(effectiveinterestrate<statedcoupon)securitiestradeatapremium

CarryingValue1=CarryingValue0+FairValue(mktintrt)Par(Coupon)
*UsemarketforFVifavailable

Amortizationofthediscount/premiumresultsinthecarryingvalueofsecuritiesasitconvergestowardsparastimepasses

Comprehensiveincome(CI=NI+OCI):Changeinequity,netassetsfromnonownersources.
Othercomprehensiveincome(OCI):SE,unrealizedG/Lb/cthoseitemshaveNOTbeensettled

Ownership
Amtofcontrol
GAAP
IFRS
2050%:associates
Significantinfluence
Equity
same
50%(mayvary):jointventure Sharedcontrol
Equity
EquityorProportionatecons
Morethan50%:bizcombo Control
Acquisition(akaconsolidation) same
EquityMethod:
ONELINECONSOLIDATIONofproportionateshareofnetassetsandnetincomeinB/SandI/Srespectively.Investmentis
listedatcost.Totalvalueoftheinvestment=Carryingvalueofinvestment+(earningsdividends)
GoodwillTreatment:
proportionofnetassetsowned
goodwillabsorptionbyPPEdiff
Goodwill=Investmentamount(ownershipshare%)x[(BVcurrentassets+BVPPELiab)+(FVPPEBVPPE)]
IfFVofnetassets>investmentamount
Excess(negativegoodwill)excludedfromCVandincludedasincome
ProportionateConsolidation(IFRSjointventureonlyiftheresastrongerimpliedrelationshipthanequitymethod):
AllproportionallyownedpartsofB/SandI/Sareincludedintheparentsfinancialstatementlinebyline.
AcquisitionMethod(bizcombo):
BS:assets&liabconsolidatedonB/S@FV,minorityinterestiscreatedforportionthatparentdoesntowntobalanceaccteqn
IS:rev&expensesareadded,minorityinterestisportionthatfirmdoesntown
GoodwillTreatmentinBizCombos:
IFRS(optional):Fullgoodwill=FVsubsidiaryFVidentifiableassets
Partialgoodwill=purchasepriceFVparentsproportionateshareofsubsidiarysidentifiablenetassets
GAAP(required):Fullgoodwill=FVsubsidiaryFVidentifiableassets
GOODWILLIMPAIRMENT:recognizedseparatelyaslineitemonconsolidatedIS
IFRS:CV>recoverableamt(goodwillabsorbs1sthitofimpairment,thennoncashassets,thencashunits)
GAAP:CV>FV(writtendowntoFVifimpaired)
Notesonthe3methods(assumingtheyallhave50%(same)ownership):
1. All3havesamenetincome
2. Equityandproportionateconsolidationreportsameequity,ACQUISITIONequityishigher
3. Assets,liabilities,salesandexpenses:highestinACQUISTIONPCisinthemiddle,lowestunderequity

Reclassificationoffinancialassets
Fro
To
UnrealizedG/L
m
HFT
Any I/S(toextentnotrecognized)
AFS
HT
AmortizedoutofOCI
M
AFS
HFT TransferoutofOCI
HTM HFT I/S
HTM AFS OCI

ItsaVIEIF:insufficientatriskequityinvestment,shareholderslackdecision
makingrights,dontabsorblosses,dontreceiveresidualbenefits
VIE:HaslowercostofcapitalbecauseassetsandliabilitiesofVIEare
isolated;VIEscanbeintheformofacorporation,partnership,jointventure
ortrust.NotnecessaryforVIEtohaveseparatemanagementand
employees.

Page11of36

PENSIONACCOUNTING
*FundedstatusshowsupinBS
differentcurriculumsdenotepositivefundedstatusas
Eithernetpensionliabilityorasset

=(PBObeg)x(DiscRt)

AffectsactuarialG/L
*ACTUARIALG/LISPLUGGainsdecrease
PBO,lossesincreasePBO
*Ifcontributions>periodicpensionexpense,remaindercanbeviewedasareductioninPBO
PeriodicpensionCOST:totalcostlistedineitherISorOCIforGAAP/IFRS
Periodicpensionexpense:periodicpensioncostsrecognizedONLYinIS/P&L(notOCI)
PeriodicPensionCostTreatment
Component
Item
IFRSRecognition
+ServiceCost
+CurrentServiceCost
ActualEvents
+PriorServiceCost
IS(P&L)
+AmortizationofUnrecognizedPrior
ServiceCosts
+NetInterestExpense +(FundedStatus)x(DiscRate)
(income)
+(PBOBeginPVAssetsBegin)x(DiscRt)
(PVAssetsBeginPBOBegin)x(DiscRt)
NetActual/Expected
(ActualReturn)+(PlanAssets)x(DiscRt) Remeasurement
PlanAssetReturns
Recognizedin
OCI,not
Amortizationof
Gains
subsequently
Deferred
+Losses
amortizedinto
ActuarialAssumptions Gains(decreaseobligationpymt)
P&L
onPBO
+Losses(increaseobligationpymt)
=PeriodicPensionCost

GAAPRecognition
ServiceCostIS
PastServiceCostOCI
SubsequentlyRecognizedinIS
IS

2Ways:
1)ImmediatelyinIS
2)unamortizedamtinOCIthen
amortizedtoISusingcorridor
method

Corridormethod:amortizationifactuarialG/Loutsideof10%beginning
PBOorplanassets.AmortizationGreducespensionexpense.
AmortizationofactuarialLincreasespensionexpense.

=PBOendPBObeg

TotalPeriodicPensionCost(TPPC)(I/Sexpense)
+benefitspaidactualreturnonplanassets

=contributions

statusend
funded
status
beginning)

contributionsfundedstatus
Pensionobligationreduction(similartoprincipalreduction)
=contributionspensionexpense

(funded

Page12of36

MultinationalOperations
PresentationCRFunctionalCurrencyTLocalCurrency
UseCRwhensubsidiaryisindependent
UseTifsubsidiaryishighlyintegratedwithparent
MonetaryA/L
NonmonetaryA/L
Commonstock,Divd
(capitalstock)
Equity
Revenues,Expenses
COGS
Depreciation
NetIncome
Exposure
ExchangertG/L

TemporalMethod
(akaremeasurement)
CurrentRate
HistoricalRate
HistoricalRate

CurrentRateMethod
(akatranslation)
CurrentRate
CurrentRate
HistoricalRate

Mixed*REPLUG
Averagerate
HistoricalRate
HistoricalRate
Mixed**=RevExp
Netmonetaryassets
IncomeStatement

CurrentRate***fromI/S
AverageRate
AverageRate

AverageRate
AverageRate=RE+divd
Shareholdersequity(netasset)
Equity*PLUGA=L+(E+CTA)

*REfromIScanbeplugsothattheBScanbalance
**FXG/LshownonIS
***Ifnotgiven,equitytranslated@currentrate,thenfindplugto
makeA=L+(E+CTA)
Inhighlyinflationaryenvironment
IFRS:restateforinflation,usecurrentrate
GAAP:temporal,nonmonetaryA/LNOTrestatedforinflation

G/LrecordedinIS.
Exposureexample(frompovDomestic):iftheresaNETASSETand
theforeigncurrencyisappreciating,theresatranslationexposure
GAIN

iftheresaNETLIABILITYandtheforeigncurrencyisappreciating,theresatranslationexposureLOSS

Speculativehedges
Purpose
FVhedge(changesinA/L)
CFhedge(offsetvariableCFs)
Netinvestmenthedgeinforeignsubsidiary

I/S
G/LonIS
G/LinequityOCI
G/LinISonceanticipatedtransactionaffectsearnings
G/Lw/translationG/LinSHequity/OCI

B/S
FV
FV

FRA:EARNINGSQUALITYISSUESANDFINANCIALRATIOANALYSIS
ConsolidatingQSPEandSPEonBSresultsinassetsandliabilitiesincreasingbythesameamount
Cashcollectedfromcustomers=salesnetinA/R+netindeferredrevenue.
Whenearningsarerelativelyfreefromaccruals,meanreversionwilloccurataslowerrate.
*NOA=AL(excludecashequivalentandmarketablesecuritiesanddebt)
Lowertheratiothehigherqualitytheearnings

=EBT

NEERTaTe.NSAE.
TIEAF
Beneishmodel:if(M>1.78)indicateshigherthanacceptableprobabilityofearningsmanipulation

CORPORATEFINANCE

NPV
WACCreflectsinflation&financingcharges,CFsshouldbeadjustedtoreflectinflationotherwiseNPVwillbebiased
Depreciationisaddedb/citisanoncashchargethatexpenses,income.D(1t)+D=tDwhichistheDEPEXtaxshield
NWC=NWCInv=noncashcurrentassetsnondebtcurrentliabilities
*NWCInviscumulativeNWCduringproject

Ifanassetisnotbeingreplaced:
Initialinvestment(outlay)=FCInv+NWCInv(outflow,forinflow)
CF=(SCD)(1t)+D
=(SC)(1t)+tD
TNOCF=SalT+NWCInvt(SalTBT)

S=salesorrevenue
C=operatingcosts
D=depreciation
t=taxrate
Sal0=saleofoldasset
SalT=saleofnewasset
t(SalTBT)=taxchargeforgainonassetsale
BT=investmentaccum.Depreciation
FCInv=costofmachine+installationcost

Page13of36

Ifanassetisbeingreplaced(replacementproject):
Initialinvestment=FCInv+NWCInvSal0+T(Sal0B0)
CF=(SCD)(1t)+D
=(SC)(1t)+tD
aftertaxnetproceedsfromsale
TNOCF=(SalTSal0)+NWCInvT[(SalTBT)(Sal0B0)]

EAA(equivalentannualannuity):
InputNPVofprojectintoPV,N,IofcalculatorandsolveforPMToncalculator,whicheverishighestisthebestproject
LeastCommonMultipleLives(replacementchainapproach):linearlylineupsameprojectoneafteranotherterminallinesup
withlastCF,thenfindNPV
2yrprojectx3=6years
3yrprojectx2=6years

MarketValueAdded:
EconomicProfit=NOPAT$WACC
*Returnstodebtandequitycapitalholders
=EBIT(1Tax)WACCxTotalCapital(MVdebtandequity)
,
Accountingincome:accountingdepreciationbasedonoriginalcostofinvestment
NIfromproject=Accountingincomeinterestexpense
Economicincome:EconDepbasedonchangesinmarketvalue
Interestexpenseisimplicitintherequiredrateofreturnusedtocalculateassetsmarketvalue
Economicincome=aftertaxcashfloweconomicdepreciation
EIT=
ATCFT(MVT1MVT)
EIT=
ATCFT+IncreaseinMarketValue
EIT=
ATCFT+(MVTMVT1)
Note:theseareheretoconfuseyou,theyrethesame:
CORPFIN:EconomicProfit=NOPLAT$WACC
EQUITY:EconomicValueAdded(EVA)=NOPAT$WACC

M&MPropositions:
MMProposition
1(changesinvalue)
Notax,transactioncosts,
bankruptcy
2
(changesinWACC)

VL=EBIT(1t)/WACC
VU=EBT(1t)/WACC

NOTax(capstructuredoesntmatter)
CapitalStructureDoesntMatter
VL=VUvaluebasedonOCF

WithTax(100%debtisbest)
Debthastaxshieldadvantages
VL=VU+tDebt

Costofcapitalnotdeterminedby
structurebutratherbybusinessrisk.
Increasinguseofrelativelycheaper
debtwillincreaseriskandcostequity.
Sothetwooffseteachother

Costofequityincreaseswithmoredebt
butnotenoughtoperfectlyoffsetcheaper
debt.WACCminimized@100%debt

Page14of36
StaticTradeoff:VL=VU+tDPV(costsoffinancialdistress)*theresasweetspotformaximizingfirmvalue
SystematicRisk:

Debt
Usage

Institutionalframework
Efficien Commo
Lowerinfo
tLegal nLaw> asymmetr
System Civillaw y
Lower
Lower
Lower
Longer
Longer
Longer

D/Eratio
Maturity
Dividends
Doubletaxation:
EffectiveTax=CorpTax+(1CorpTax)(DivdTax)
=1(1CorpTax)(1DivdTax)

Favorabl
etaxes
onequity
Lower
N/A

FinancialandBankingSystem
Activebond Bankbased Large
institutional
andstock
financial
investors
market
system
N/A
Higher
Lower
Longer
N/A
Longer

MacroEnvironment
High
HighGDP
inflation growth
Lower
Shorter

Lower
Longer

Imputationtaxsystem:taxespaidoutatcorporatelevel,butattributedtoshareholder:alltaxesareeffectivelypaidatshareholderrate.

If(MarginalTax)<(CorpTaxpaid)Investorgetstaxcredit=frankingcredit
If(MarginalTax)>(CorpTaxpaid)Investorpaysforgap
Splitratetaxsystem:REtaxedathigherratethanprofitsitpaysoutatdividends,encouragescompaniestohavealower
retentionratio,andpayhigherdividends,dividendstaxedagain@shareholderlevelasordinaryincome
Expecteddividend=(previousdividend)+[(expectedincreaseinEPS)(targetpayoutratio)(adjustmentfactor)]
adjustmentfactor=1/#yrsthatadjustmenttakesplace

Pricechange=PwdivdPw/odivd=(1TD)/(1TCG)xDivd
FCF=NI+Netinterestaftertaxchangeindeferredtaxes+netNCCnetWCCAPEX
Unleverednetincome
NetOperatingprofitlessadjustedtaxes(NOPLAT)
Netinterestaftertax=(interestexpenseinterestincome)(1marginaltaxrate)
NetWorkingCapital+currentassetscurrentliabilities(excludingcashandequivalentsandSTdebt)

FCFEcoverage=FCFE/(divd+sharerepurchases)
FCFE=CFOFCInv+netborrowing
DividendCoverageRatio=NI/Dividends
Dividendpayoutratio=1/Dividendcoverageratio=Dividend/NI

PrivateEquity
Bootstrapping:highP/EfirmpurchaseslowP/Efirm
CurrentEPSishigherattheexpenseoflowergrowthprospectsandlowerfutureEPS
Equitycarveout:subsidiarycreatedandIPOdparentstillretainscontrol.Saleofequityofnewcotooutsiders
Spinoffsharesofnewfirmaredistributedtoparentsexistingshareholdersonproratabasis
Splitoff:parentandsubsidiaryexchange(surrender)stock.Parentwishestodrawdistinctionwithsubsidiary.
M&A
GainTarget=Takeoverpremium=PTVTHHI=Sum([Salescompany/T.SalesIndustryx100]2)
GainAcquirer=STP=S(PTVT)
VAT=VA+VT+SC(cashpaidtotargetshareholders)
M&ADCFFCFFusingNOPLAT:
IncometoallinvestorsTaxsavingsfromhigherdepreciation
FCFF=NI+NetInterestAfterTax+Changesindeferredtaxes+NCCINC_NWCFCInv
NOPLAT(netoperatingprofitlessadjustedtaxes)
UnleveredIncome

BusinessEthicsPhilosophy:

Page15of36
Friedmandoctrine:socialresponsibilitiesofbusinessistoincreaseprofitswithinrulesofthegamefaircompetitionw/o
deceptionorfraud
Utilitarianism:maximizepositive,minimizenegativeoutcomes.Bad:difficulttomeasureutility,whatmaybegoodforlarger
groupmaycomeatexpenseofminority(eg:notprovidinghealthcareforfewAIDSpatients)
Kantian:Peoplearedifferentthanfactorsofproduction,theymustbetreatedwithdignityandrespect
Rightstheories:everyonehasrightsandprivileges,greatestgoodutilitarinismcannotviolatetherightsofothers
Justicetheories(Rawls):rulesarefairifyoudontknowyourownparticularcharacteristics.Differencingprinciple:unequal
divisionmustbenefitleastadvantagedmembersofsociety.Everyonedecidesifsweatshopislawfulifyoudontknowifyou
fallunderthecategoryofworkinginone.
CorporateGovernance
Makesureassetsusedproductively,mitigateconflictsofinterest,ensurefairnessbtwnBOD,managers,shareholders
Risks:assetrisk,liabilityrisk,financialdisclosurerisk,strategicpolicyrisk

EQUITY
Returnconcepts:Estimaterequiredreturn:
MRP
ERP
ExpandedCAPM:Req=RFR+(E(Rmkt)RFR)+SmallCo.Premium+Co.SpecificRiskPremium
FamaFrench:marketriskpremium,smallcapriskpremium,valueriskpremium.
RmarketRFRRsmallRbig
RhighbooktovalueRlowbooktovalue
PastorStambaughmodel:addsliquidityfactortoFFmodel
ChenIbbottson:ERP=(1+i)(1+REg)(1+PEg)1+YRFR
Termsinorder:inflationforecast,growthinrealearnings,growthinmarketPEratio,yieldonindex
Yieldonindex=dividendandreinvestmentincome

grealearnings=GDPinflation

E(Inflation)forecast=(1+YTM20yrtbond)/(1+YTM20TIPS)1
BIRR(Burrmeister,Roll,Ross)model(factorxSensitivitytothatfactor):
RFR+ 1)ConfidenceRisk:unexpectedchangeindifferencebetweenreturnofriskycorporateandgovbond
2)Timehorizonrisk:unexpectedchangeindiffbtwnreturnofLTgovbondsandSTgovbonds
3)inflationrisk:unexpectedchangeinlvlofinflation
4)Businesscyclerisk:unexpectedchangeinlevelofrealbusinessactivity
5)Markettimingrisk:equitymarketreturnnotexplainedbyother4factors
Buildupmethod(betasarehardtofind,alsoconsiderpremiumsanddiscountsforcontrol,marketability):
Return=RFR+ERP+SizePremium+Companyspecificpremium+IndustryPremium
Smallercompanieshavelargersizepremiums
BondYieldPlusRiskPremium(BYPRP)=YTMLTdebt+RiskPremium(associatedwithowningequityinvestmentoverdebt)
YTMincludes:realintrt,inflation,defaultriskpremium
GordonGrowthEquityRiskPremium=(divdyield)+earningsgrowthRFR=D/P+gearningsRFR
Adjusted(Blumemethod)adj=(1/3)+(2/3)=0+1
BetaLeveraging:1+[(1TaxRate)x(Debt/Equity)]OR(1+D/E)
Porters5forces:threatofentry,powerofsuppliers,powerofbuyers,threatofsubstitutes,rivalryamongexisting
competitors.
Shorttermfleetingfactors:industrygrowthrate,technology,innovation,government
PickingCorporateStrategy:
LessPredictable
MorePredictable
LessMalleable
Adaptivequickandefficienttochange
ClassicalPlanforbestmarketposition
MoreMalleable
Sharinginfluenceindustrytofurtherinterests,networkof Visionaryhighrisk,disruptive
buyers/suppliersdefinenewmarket,goods/services,lobby
ReturnonInvestedCapital(ROIC)=NOPLAT/InvestedCapital
InvestedCapital=Op.AssetsOp.Liabilities

ReturnonCapitalEmployed(ROCE)=EBIT/CapitalEmployed

Page16of36
CapitalEmployed=DebtCapital+EquityCapital

DIVIDEND(minoritynoncontrollingperspective)
Inflectionpoint:fundamentalchangeineconomicswhereprevioustrendsarentlikelytocontinueintofuture
Twostagedividenddiscountmodel:
Excessshorttermgrowth
TheHModel:
r
n=lengthofsupernormalgrowth
gs=Shorttermsupernormalgrowthrate
gL=Longtermsustainablegrowthrate
H=HalfLife=0.5timesthelengthoftheshortterm/highgrowthperiod
SUSTAINABLEGROWTHRATE
ROE=ROAxequitymultiplier(E/A)
g=RetentionRatio(b)xROE

b=(earningsdividends)/earnings

financial

Stockprice=(nogrowthearningsforecast/requiredreturn)+PVGO
PVGO=Stockprice(earnings/requiredreturn)
FreeCashFlow
FCFFirm(FCFF)=
NI+NCC+Int(1taxRT)FCInvWCInv
EBIT(1taxRT)+DepFCInvWCInv
EBITDA(1TaxRT)+Dep(taxRT)FCInv
WCInv
CFO+Int(1taxRT)FCInv

FCFEquity(FCFE)=
FCFFInt(1taxRT)+NetBorrowing
NI+NCCFCInvWCInv+NetBorrowing
EBIT(1taxRT)Int(1taxRT)+DepFCInvWCInv+NetBorrowing
EBITDA(1TaxRate)Int(1TaxRate)+Dep(TaxRate)FCInvWCInv+NetBorrowing

CFOFCInv+NetBorrowing
NI(1Debt/Assets)x(FCInvDepex)[(1Debt/Assets)xWCInv]*forecasting
*easiertoremember

Addback:preferreddividendstoFCFF

Addback:netissuanceofpreferredstocktoFCFE

NCC=Depreciation+Amortization+Impairment+Reversalofincomefromrestructuring

Netborrowing=debtissues(raisingcapital)Principalpayments
CFO=NI+D&Againonsaleofequipment

Page17of36
Adj.toNItogetFCF
Dep&Amort
Restructuringexp
Restructuringincome
(reversal)
Lossesfromsale
Gainsfromsale
AmortLTbonddiscount
AmortLTbondpremium
Deferredtax

Addback
Addback
Subtract
Addedback
Subtracted
Addedback
Subtracted
Addedback

FCInv=CapExProceedsfromsale*excludesdepreciationinFCFcalcualtion
WCInv=CA(excl.cash)CL(excl.STdebt)
Preferredstocklikedebtexceptpreferreddividendsnottaxdeductiblelike
interestpayments
CFTreatment
IFRS
GAAP
InterestReceived
CFOorCFI
CFO
InterestPaid
CFOorCFF
CFO
DividendReceived
CFOorCFI
CFO
DividendPaid
CFOorCFF
CFF

(onlyiftaxexpcanbedeferred
indefiniately,nocashisleaving)

EBITDAnotgoodproxyforFCFFandFCFE.EBITDAislookingatdebtrepayment
strength,doesntconsiderWCInv,FCInv.LookatrelationshipsinFCFandEBITDAderivationtoseespecifics.

MarketComparables
EV=MVeq+MVDebt+minorityinterest+preferredsharescash&STinvestments
(#preferredshares)x(CommonSharePrice)

Enterprisevalueratiodenominators:

MarketRatios
b=retentionratio=(EPSDivPerShare)/EPS

*(1+g)multipliedb/citnegatesnextperiodsearningtocurrent

B0=bookvalueofequity=(assetsliability)preferredstock
**P/CFandD/Parethesamebutflipped

=BVPS=CommonStock+AdditionalpaidinCapital+RetainedEarnings()TreasuryStock+Accum.OCI
FedModelP/E=1/(10yrtbondyield)
YardenimodelP/E=1/(Aratedcorporateyield5yrearningsgrowthforecast)

TotalInvestedCapital
=NetWorkingCapital+NetFixedAssets
=BVLTDebt+BVEquity

Page18of36
RESIDUALINCOMEMODEL
RITOEQUITYHOLDERS
ResidualIncome=NIEquitycharge
Equitycharge=ReqXBVequity
RITOALLCAPITALHOLDERS
EVA
=[EBIT(1TaxRate)](WACC%XTotalinvestedcapital)
=NOPAT$WACC
Residualincome=AfterTaxOperatingProfitCapitalCharge
=(ROICWACC)xTotalCapital(Assets)
CapitalCharge =EquityCharge+DebtCharge
=ReqxBVequity+RdebtxDebtCapitalx(1tax)
BVt=BVt1+earningst1Divdt1

MVA =MarketvalueofthecompanyBookValueofInvestedCapital
=([sharesxstockprice]+[%ofpardebt])(BVeq+BVdebt)
RIValueofthefirm:

RI:residualincomeE:earningsr:reqrtB:bookValue/share
ifROE>requiredreturnvalue>stockprice&P/Bjustified>P/B
Tobinsq=Marketvalueofdebtandequity/Replacementcostoftotalassets
MultiStateResidualIncomeModel
V0=B0+(PVoffutureRIovertheshortterm)+(PVofcontinuingRIearnings/re;perpetuity)
PTistheterminalstockprice
BTisthebookvaluepershare
Persistencefactor:
Strongpersistencefactor:lowdividendpayout(firmisretainingmoneytogrowcompany),RIpersistsforever
Weakpersistencefactor:highROE(nonrecurringitems,highaccountingaccrualsmaketheserelativelyhighreturnsunsustainable)
Terminalvalue

PV(continuingresidualincomeinyrT1)
ROEdeclinestocostofequityovertimeduetocompetitivemarket,soRIgoestozero
RIappropriatewhenterminalvalueisuncertainandwhencleansurplusrelationshipholds
Cleansurplusrelationship:
EndingBV=BeginningBV+netincomedividends
Violatedwhencurrencytranslationg/lskipsI/Sgostraighttoequity
Totalinvestedcapital(TIC)=MVdebt&equity(incl.cash&STinvestments)
UnexpectedEarningsSurprise=ActualEPSE(EPS)
Standardizedunexpectedearnings(SUE)=Earningssurprise(returnpredicted)/earningssurprise
earningssurpriseisthescalebymeasureofthesizeofthehistoricalerrorsorsurprises

wisweight,xisratio(P/E,P/B)
PrivateFirmValuation:
CapitalizedCFmethod:Valueofinvestedcapital=FCFF1/(WACCg)+MVdebtCapital
PrivateCompanyComps:
GuidelinePublicCompanyMethod(GPCM)

Page19of36
Publiccompanyratiosadjustedforrisk&growth,&co.specific
Guidelinetransactionsmethod(GTM)
Multiplesfromacquisitionsofentirefirms,includescontrolpremiums
PriorTransactionsMethod(PTM)
Saleofstockinsubjectprivatecompany(usuallyfornoncontrollingstakes)
Excessearningsmethod:
RIintangibles=Normalizedearnings(rWC)x(WC)(rfixedassets)x(fixedassets)
Vintangibles=RIintangibles/(rintangibles)
MVinvestedcapital=WorkingCapital+FixedCapital+Intangibles
DLOC=1(1/(1+controlpremium))
Totaldiscount=1[(1DLOC)(1DLOM)]
OR
Transactionvalue=proratacontrolvaluex(1DLOC)(1DLOM)
DLOMestimatedusingrestrictedsharevspubliclytradedshareprices,preIPOvspostIPOpricesandputprices.The
advantageofusingputpricesoftheother2DLOMestimationmethodsisthattheestimatedriskofthefirmcanbe
factoredintotheoptionprice.
ALTERNATIVEINVESTMENTS

RealEstate:
(insurance,utilities,maintenance**interestandtaxareNOTincluded)
NOI=RentalIncome+OtherIncomeVacancy&CollectionLossOperatingExpenses
PotentialGrossIncomeEffectivegrossincome

NOIforecast=trailingNOInoncashrents+adjforfullimpactofacquisitions+growthinNOI
Allrisksyield=rent1/Value0allrisksyieldisusedwhentenantsarerequiredtopayallexpenses(NNN)andwhengrowthinrentsandvalueareexpectedfromproperty
CapRate=DiscountrateGrowthRate
Yearspurchase=(CapRate)1=yearsofcurrentincometoequaloriginalpurchaseprice
DirectCapValue=NOI0/CapRate
CPT:I/YLeveredIRR
TerminalValue=NOIterminal/Caprateterminal
PMT=Dividend=NOIIntPymts
Grossincomemultiplier=Salesprice/grossincome
PV=equityinvestment=[1LTV]*(valueofbuilding)
EquityDividendRate=(CF1styr=NOIIntExp)/Equity
FV=SalesPriceOutstandingLoan

N=#yrs
CostapproachforRE:
+Land
+Replacementcostofbuilding=(replacementcost+developersprofit)xSqFt
AdjtomakeComplikeSubjectProperty
+Currentcosttoconstructbuilding(tocurrentstandards)
SalesComp(inverse):
Physicaldeterioration=(effectiveage/economiclife)
Adjratioforundesirabletargettraits
CurableDeterioration
Adjratiofordesirabletargettraits
Incurablephysicaldeterioration(depreciationcharge)
=(replacementcostcurabledeterioration)x(Effectiveage/t.economiclife)
t.depreciation
Functionalobsolescence(notintendedforcurrentuse)=newcost/caprt
Externalobsolescence(locational,economical)
FFO=AccountingNetEarnings+Dep+DeferredTaxCharges+()losses(gains)fromsalesofpropertyanddebtrestructuring
*Continuingoperatingincome

AFFO=FFOnoncashrentmaintenanceCAPEX&leasingcosts
*betterrepresentationofeconomicincome

NAV=NOI1/CapRt+AssetsLiabilities(*nogoodwill,nodeferredtaxes)
AdjNOI=NOInoncashrents+adjforimpactofacquisitions+growth(1+g)
NAVPS=(NOI/CapRt+MVotherassetsMVLiabilities)
ROEChasmoreflexibilitytoinvestandretainincome
REIThashighestincomeyieldsandpayoutratios,lowercorporatetaxes,distributionsaredividedby:taxableincome,capital
gain,returnofcapital(morefavorable)

Page20of36

VentureCapital
FuturevalueofVCinvestment=(Initialinvestment)x(1+IRRrate)Years

Exitvalue=Investmentcost+earningsgrowth+incpricemultiples+reductionindebt

...basedoffthisratiotocalculateVCsharesandVC%...
Price=Initialinvestment/#sharesrequiredforfractionalownership
Adjdiscountrate=(1+r)/(1q)
POST2=FV/(1+r)N
POST2(Compound)PRE3
whereqisthe%failurerate
POST2=PRE2+INV2POST2(Disctount)PRE3
PrivateEquity:
Committedcapital:amtfrominvestorspropmisedtoGP
Paidincapital..=investedcapital,receivedfrominvestorstoGP
PIC. =capitalcalleddown
DistributedtoPIC(DPI)=distributions/PIC(LPcapitalcalleddown)*cashoncashreturn
Residualvaluetopaidin(RVPI) =NAVafterdistribution/PIC(LPcapitalcalleddown)*unrealizedreturn
TVPI=DPI+RVPI
=(distributions+NAVafterdistribution)/PIC(LPcapitalcalleddown)
NAVbeforedistributiont =NAVafterdistributiont1+Capitalcalleddowntmgmtfeest+operatingresultst
NAVafterdistributiont =NAVbeforedistributiontcarriedinteresttdistributionst
Carriedinterest. =(NAVbeforedisttcommittedcapital)x(carriedinterest%)
Tagalongdragalong:mgmt.maybuy/sellstakeifPEfirmsells
Ratchet:mgmtorLPcanincreaseitsequityallocationdependingonperformance
Carriedinterest:GPprofitsfromperformance
DistributionWaterfall:diffinvestorsgetpaidoutbasedonhierarchypriority
HedgeFunds:AddinghedgefundswillcauseSTDtoincrease,Sharpetodecrease,negativeskewnessandpositivekurtosis

Commodities:

F0=S0e(RFRc+UY)T*continuouslycompounded
F0=S0(1+RFR)tFV(Benefits)+FV(Costs)*discrete
U=Storagecosts,Y=convenienceyieldbenefitofholdingasset
Backwardation:futures<spot
NormalBackwardation:futures<E(futurespotrate)
T.CommodityReturn=
Spotreturn
cheapertoreplace
+RollReturn(Replacematuringwithnewcontracts.Backwardation:+rollreturn,Contango:rollreturn)
+CollateralReturn(Postedcollateralreturnsinvestedintbills)
+RebalancingReturn(portfoliorebalancingadjustmentbykeepingsameproportionofassetsinportfolio)
Insuranceperspective:longcommoditieswillearn+returnsforsupportingshorthedgers
HedgingPressureHypothesis:riskpremiumearnedonothersideofheavylong/short
Theoryofstorage:difficulttostorecommodities.Positiveconvenienceyield

Page21of36
ConvenienceYield:monetarybenefitofholdingassetvsholdingfuturescontract
Convenienceyieldishigh:spot,futures&inventoryislow

FIXEDINCOME
Structuralmodelsofcorporatecreditrisk:looksatBSandoptionofA=L+E.Defaultriskisconstant.Doesntchangefor
businesscyclesorchangingeconomicvariables.Assumptions:B/Sissimplewithonlyoneclassofzerocouponbond,assetis
activelytradedonfrictionlessmarket,RFRisconstant.
Reducedforms:imposeassumptionsonoutputofstructuralmodels.Performbetterthanstructuralmodelsbecausethey
imposeassumptionsonstructuralmodelsAssumptions:Theresa0couponliabilitytradedonthemarket,RFRisstochastic
(random,notconstant),defaultriskdependsontheeconomicconditionswhichdependonnonconstantvariablesvaries
w/businesscycle.
Maxamtbondholderwantstopayforinsurancetoremovecreditrisk=EL=ParDebt[1eLGDx(defaultintensity)x(timetomaturity)]
ExpectedLoss=ParDebtxN(e2)AssetxeE(returnonassets)xtimetomaturityN(e1)
PV(ExpectedLoss)=ParDebtxeRFRxtimetomaturityN(d2)AssetxN(d1)
IfPV(EL)>ELthenriskpremiumdominatestimevaluediscount
Segmentedmktstheory:yieldsoncurverepresentsupplyanddemand.Soyieldsdontreflectspotratesorliquiditypremiums.
Preferredhabitat:preferredmaturitiesofinvestors,ifpremiumsforothermaturitiesarelargeenoughtheywillinvest
KeyRateCalculations
Foragivenchangeintheyieldcurve,eachrateismultipliedbytheassociatedkeyrateduration.Thesumofthoseproducts
givesthechangeinthevalueoftheportfolio.Ifonlythe5yearinterestratechanges,thentheeffectontheportfoliowillbe
theproductofthatchangetimesthe5yearkeyrateduration.*rememberwhenratesgoup,Bondvaluegoesdown
ZSpread:ZerovolatilityspreadisaddedtoeverytreasuryspotratetomakeDCFofABS,MBSequaltoitsmarketprice.There
aremultipletreasuryspots,only1zspread.Zspreadconsidersonly1pathofinterestrates:thecurrentUStreasuryterm
structure.Notsuitableforbondswithembeddedoptionsb/czerointerestratevolatilityoptionsaremeaningless
OAS:isaddedtoeach&everypathinaninterestratetree.OASisbestusedforembeddedoptionsthataresensitiveto
changesininterestratevolatility(likeMBS).OAScapturescreditandliquidityrisk,removesoptionrisk.YouwantbiggerOAS
relativetoeffectivedurationbecauseitimplieslowerprice.OAS&EDshouldhavepositivelinearrelationship(eg.LowerOAS
(return)forlowerduration(lowerpricesensitivitytointerestrates)isacceptabletradeoff).

TreasuryBenchmark
SectorBenchmark
OAS>0
RichifactualOAS<requiredOAS
RichifactualOAS<requiredOAS
CheapifactualOAS>requiredOAS
CheapifactualOAS>requiredOAS
OAS=0
Rich
Rich
OAS<0
Rich
Rich
*Cheapmeansthebondisundervalued,richmeansthebondisovervalued
Spreadsrepresenttheseriskswhencomparedtovariousbenchmarks

Alloftheseincludemodelrisks(parameterassumptions)
TreasuryBenchmark
BondSectorBenchmark
Nominalspread Creditriskrelativetotreasuries
Creditriskrelativetosector
Liquidityriskrelativetotreasuries Liquidityriskrelativetosector
Optionrisk
Optionrisk
ZSpread
Creditriskrelativetotreasuries
Creditriskrelativetosector
Liquidityriskrelativetotreasuries Liquidityriskrelativetosector
Optionrisk
Optionrisk
OAS
CreditRiskrelativetotreasuries
CreditRiskrelativetosector
Liquidityriskrelativetotreasuries Liquidityriskrelativetosector

IssuerSpecific
Cheap
FairlyPriced
Rich

IssuerBenchmark
Liquidityrisktoother
issuerssecurities
Optionrisk
Liquidityrisktoother
issuerssecurities
Optionrisk
Liquidityrisktoother
issuerssecurities

Page22of36
*Whencomparingzspreadandnominalspreadwillnotreflectcreditriskbecausecreditriskoftheissueandtheissuer
benchmarkisthesame.

Findvalueofportfoliowhentheresaparallelshift
1. Calculateeffectivedurationforeachbond
a. Addupeachdurationforeachbond
b. Multiplyeachdurationbyitscorrespondingbondsweight
c. Sumthemtogetportfolioeffectiveduration
2. Valueofnewportfolio=(valueofoldportfolio)(%change)x(effectiveduration)
FCF=CFOCAPEXDIVD

%Returnimpact=(DurationSpread)+(1/2)(Convexity)(Spread)2
EffectiveDuration=(VV+)/(2V0(y))
EffectiveConvexity=(V+V+2V0)/(2V0(y)2)

ModifiedrelatestooptionfreebondsastheyassumeCFs
frombondcannotchange.
Effectiveisusedtovaluebondswithandwithoutoptions
asCFsmaychange.CFschangeifbondiscalled.

Effectiveconvexitycomputedusingbinomialmodel:theyieldcurveisshiftedupwardanddownwardinparallelmannerand
binomialtreecalculatedeachtime.Resultingbondvaluesareusedtocomputeeffectiveconvexity.
Ispread:Riskybondyieldswaprateforthesamematurity
representscreditandliquidityrisk
TEDspread:indicatescommercialbanklendingrisk,perceivedcreditriskineconomy
LIBORtreasuryrate
LIBOROIS:Liquidityinmoneymarketsecurities
LIBOR(creditrisk)OIS(overnightindexswapfederalfundsrate.Verylittlecreditandcounterpartyrisk)
Low:highmarketliquidity
High:unwillingtolendbecauseofconcernsovercreditandliquidity
Swaprate:liquid,flexibleandefficientforhedging
Swapratedetermination:EXfindswapfixedrateforathreeyearinterestrateswap
1)Spot1,Spot2Spot3aregiven
2)FindCouponRt3thisistheswapratefor3yrIRS

TermStructureModels:
Equilibriumtermstructuremodels:looksatfactorsthatdrivetermstructures,haveadriftterm
CoxIngersollRoss(CIR)Model:usesSTintrttodeterminetheentiretermstructureofinterestrates.Intrtscantbeneg
HasDeterministic(drifttomeanrevertinglevel)andstochastic(randominterestratevolatility)components
VasicekModel:SimilartoCIRbutassumesthatinterestrtvolatilityisconstant.Possibleforintrtstobeneg
Arbfreemodel:takesmarketpricesthenworksbacktoderiveyieldcurveincludingrandomdriftterm
HoLee:Usesbinomiallattice,timedependentdriftinferredfrommarketprices,usesrelativevaluationofBSMmodel

Page23of36
ConvertibleBonds
CBlimitdownsideriskduetopricefloorsetbystraightbondvalueandreducedupsidepotentialduetoconversionpremium
ofstock.*differentiatebetweenparandmarketprice,conversionratiostaysthesameregardless
MinimummarketpriceofConvertiblebond=Max(PVstraightbond,Stockxconversionratio)

Conversion Stock Conversion

=
x
Value Price
Ratio
MarketConversion
MarketConversion CurrentMarket
=
x
PremiumPerShare
Price
Price

Market
MarketPriceof
Conversion = Convertiblebond
Price
ConversionRatio

PremiumPayback
MarketConversionPremiumPershare
=
Period Favorableincomedifferentialpershare
MarketConversion Marketconversionpremiumpershare
=
PremiumRatio
Marketpriceofcommonstock
FavorableIncome
=
Differentialpershare

Coupon(ConversionRatio)x(Divdpershare)
ConversionRatio

CallableConvertible Straight Callon Puton Callon

=

+
+
BondValue
Bond
Bond
Bond
Stock
FIXEDINCOME:STRUCTUREDPRODUCTS
+Scheduledprincipalpayment=balanceprepayment/SMM
+prepayment
+netinterest=balancebegxpassthroughrt/12

=PaymenttoSecurityHolders
PSA(publicsecuritiesassociation)prepaymentmode

SMM=1(1CPR)1/12
MonthlyPrepaymentamount=SMMx(MortgageBEGMonthlyprincipalpymt)
Monthlyprincipalpymt=interestpymtmortgagebegx(coupon/12)
Interestpymt:::PMT..PV=initialprincipal,FV=0,I/Y=coupon/12,n=#monthsremaining
CPR=yrly,SMM=monthly.Theyareprepaymentsas%availablefromlastmonth
Monthlyservicingfee=(WACpassthroughrate)/12
ForABSautoloans:
,WHERE:ABS=absoluteprepaymentspeed(*confusing),m=#monthssinceorigination
CDOtypes
ArbitragedrivenCDO:takeadvantageofspreadbetweenthereturnoncollateralandfundingcosts
CashflowCDO:principalandinterestpaymentscanpaytranches
Marketvalue/BalanceSheetCDOisactivelymanagedtogeneratesufficientcashflows
Termstructure:
Pureexpectations:forwardratesareunbiasedpredictoroffutureexpectedrates
Yieldvolatility:

Page24of36
Withwhatspreadtouse
NominalSpread

Typeofbondtoanalyze

OAS:binomial

OAS:montecarlo

Bondswithputorcalloptions,
prepaymentoptions(notinterestrate
dependent)
HomeequityABS,MBS

ZSpread

ABSwithnoprepayment

None:simpleCFmodel

ABScreditcards

Reasoning
Doesntcaptureprepaymentrisk,itcaptures
inflationandinterestraterisk
Bondscaneitherbeputorcallsotheres2waysa
pricecango
Interestratepathdependentbecause
prepaymentoptionaffectsprice(wheninterest
ratesgolower,thebondismoreandmorelikely
tobecalled)
Onlyoneinterestratepath,noprepayment
option.ValueisPVofCFsdiscounted@spotrates
+zspread
ABScreditcardsarentamortizingbecausethe
poolconstantlychanges

ValuingMBSandABS:
CFyieldcomparisontoYTM:Bondequivalentyield=2[(1+monthlyCFyield)61]
Method
Description
Drawbacks,notes
CashFlowYield
RateofreturnthatmakesCFs=Marketprice
Reinvestmentrisk,priceriskassecuritymightbe
soldpriortoactualmaturity,prepaymentrisk
Nominalspread
CFyieldTreasuryYTM.Partofthisspread
Wedontknowhowmuchofspreadrepresents
representscompensationfortakingon
prepaymentrisk.Assumesprepaymentrateisthe
prepaymentriskofMBS
samewhichisunrealistic
Zerovolatilityspread
1spreadaddedtoeachandeverytreasury
Onlyconsidersonepathofinterestrates
(zspread)
spotrate.TomakeDCFforMBSorABSequal (treasuryspotratecurve).Assumessecuritywill
toprice
beheldtilmaturitywhichisunrealistic.
OAS=zspreadoptioncost OASaddedtotreasuryspotratealongeach
Highervolatility,lowertheOAS
andeverypathinaninterestratetree.Thisis OAStakesintoconsiderationthechangeinCFs
usedforbondswithembeddedoptionsthat
fromembeddedoption.Zspreaddoesnot.
aresensitivetochangesininterestrate
volatility(MBSprepayment).
MonteCarlo
1) SimulateinterestratepathsandCFsfrom MontecarlogoodforvaluingMBSb/citcan
Simulation
assumptionsaboutbenchmarkrates,rate modelmultipleinterestratepathswhichaffect
volatility,refinancingspreadsand
prepaymentrisks.
prepaymentrates
Pathdependency:
2) CalculatePVof1000interestratepaths
1. Prepaymentburnout.Ifyouvealready
3) MBSprice=averageofallprices
refinancedyourelesslikelytodoagain
4) CalcOASthatmakestheoretical=MV
2. Prepaymentamountdependsonprincipal,
5) Option=zspreadOAS
historyandinterestratepaths
BinomialModel
Backwardinduction.CFthatisdiscounted=
Usesonly1interestrateateverynode
min(callprice,theoreticalvalue)
ValueofCFsisindependentofthepathof
interestratesfolloweduptothatpointmakingit
goodforvaluingcallablebondsastheyonlyhave
onepath
Zspreadandnominalspreadconvergeasavglifedecreases.Differencebetweenzspreadandnominalspreadincreaseas
slopeofyieldcurveincreases.

DERIVATIVEINVESTMENTS:FORWARDSANDFUTURES

Page25of36
Whichdaycounttouse:
360(simpleinterest):LIBOR(caps,floors,swaptions),FRA,Swaps,TBills365(compound&continuousinterest):Equities,bonds,currencies,options

Forwards:
Forwardpriceisdeterminedatcontractinitiation.Itisthepricethatmakesthecontractvaluezeroanddependson
currentinterestratesthroughthecostofcarrycalculation
Forwardpriceisfixedforthelifeofthecontractsothecontractmayaccumulateeitherapositiveornegativevalueto
longorshortastheforwardpricefornewcontractschangesoverthelifeofthecontract

ForwardContract
ForwardPrice=Spot0(1+r)T
Valueoflong=Spott[Forward/(1+r)tr]
Valueofshort=[Forward/(1+r)tr]Spott
**Valueofshortissimplyvalueoflongtermsswitched
EquityForwardContracts
ForwardPrice=[Spot0PV(Divd)](1+r)T
=Spot0(1+r)TFV(Divd)

CurrencyForward(noarb)(foreignintermsofdomestic)

Ex:$forEuro
CurrencyForward(priortomaturity)

***dividendsaresubtractedbecausederivativeholderforgoes
dividendsinlieuofholdingactualsecurity

ValueofLong=[SpottPV(Divd)][Forward/(1+r)tr]
EquityForward(contcompoundDivdonequityindices)
CurrencyForward(ContinuouslyCompounded)
ContinuousForwardPrice=Spot0xe(rcc)T
ContinuousForwardPrice=Spot0xe(rcDCrcFC)T
ValueofLong=
FixedIncomeForwardContracts
ForwardPrice=[Spot0PV(coupons)](1+r)T
=(Spot0)(1+r)TFV(coupons)
ValueofLong=[SpottPV(coupons)]Forward/(1+r)tr
@expiration:spot=futuresprice
WhereTistotaltimefrominceptiontomaturity,tristimeREMAININGuntilmaturity,trepresentstimethathaspassed
RCandcarecontinuouslycompoundedRFRanddividendyieldConverttocontinuouslycompounded:Rc,c=ln(r)

Ifyouthinkassetpricewillenterintoaforwardcontracttobuyasset(atlowerprice)
Ifyouthinkassetpricewillenterintoaforwardcontracttosellasset(athigherprice)
DividendandCoupontreatmentExample
Time(days)0=InceptionDay30,Divd1=$1.2Day100,Divd2=$1.4Day150Maturity

Wheregis
the#ofdays
afterinitiation

FRA:
h=expirationin90days

3x9FRA:6(m)monthliborrate,3(h)monthsfromnow
h+mm=9mo3mo=180DayLIBOR

Page26of36
0(Today)g=daysthathavepassedh=expirationh+m
BuyFRAeffectivelylongloancontractprice
IFFloatingrate>contractrate
Longborrows@belowmarketrt&getspaid

SellFRAeffectivelyshortloancontractprice
IFContractrate>floatingrate
Shortloans@belowmarketrt&getspaid

FRA@Initiation:
FRAondayg:

*Valuetoshortisjustthe
negativeofthevaluetolong

FRAlongpayoff@Expiration *intrt=spotrate@expiry
FRAlongpayoffbeforeexpiration
*SwitchorangeparttofindpayofftoSHORT

Futures:
Thevalueofafuturescontractiszerowhentheaccountismarkedtomarketandthereisnomargincall.Thepriceofthe
contractisadjustedtothenewnoarbitragevalue,whichistheoreticallythesameasthesettlepriceattheendoftrading,as
longaspricechangelimitshavenotbeenreached

Futurespriceswillbeunbiasedpredictorsoffuturespotrates
FuturesContract=Spot(1+RFR)T+FV(Costsofholding)FV(benefitsfromholding)
*FVvaluesarestraight,notdiscounted
Costsincreasethepriceofafuturescontractb/cbuyerskipsoutonthosecostsbybuyingafuturescontractinsteadof
theunderlyingasset.Whichinclude:storagecosts
Benefitsdecreasethepriceofafuturescontractb/cthebuyerskipsoutonthosebenefitsbybuyingafuturescontract
insteadoftheunderlyingasset.Whichinclude:dividends,cashflows,convenienceyield
Contango:Ifcostsofcarryaregreaterthanbenefitsthenfuturespricearegreaterthanthespotprice
Backwardation:Ifcostsofcarryarelessthanbenefitsthenfuturepriceislessthanspotprice
Normalcontango:Futuresprice>ExpectedFuturespotrate
Normalbackwardation:FuturesPrice<ExpectedFuturespotrate
Traderswantnormalbackwardationbecausetheycanenterintocontracttobuyinfuture@lowerprice

ConvenienceYield:
Ifconvenienceyield>borrowingrate,futurespriceisbelowspotpriceandmarketisinbackwardation.Itmeansthat
thevalueoftheconvenienceofholdingtheassetisworthmorethanthecostoffundstopurchaseit.Thenoarbitrage
costofcarrymodelwillnotapply.Thisappliestononfinancialfuturescontracts.
Futuresvsforwards
Futuresaremarkedtomarketforwardsarenot.Futurescontractstradeonexchanges,nocounterpartyrisk(margin
requirementsbyclearinghouse).Ifmarktomarketispreferredthenfuturesprice>forwardprice.

Differencesbetweentheoretical(noarb)pricesofforwardsandfutures:
Ifassetpricesand
Preferencesbased
interestratescorrelation
is:
Positive
Preferlonginfuturescontracttohavemarkettomarketfeatures.Futuresprice>forward
price.Whenassetincreasesandmarktomarketcontractgeneratescash,reinvestmentopportunitiestendtobe

Page27of36
betterduetopositivecorrelationofassetvaluesandhigherinterestrates.Gainsfromadjustmentscanbeinvested
athigherlevel,whilelossescanbefinancedatlowercosts.

Zero
Negative

Nopreference
Preferlonginforwardscontracttoavoidmarktomarket.Gainsfromadjustmentsareinvested
inlowerlevel,whilelossesmustbefinancedatahighercost
Valueoffuturescontract=currentfuturespricepricewhenpreviouslymarkedtomarket
Contractsmarkedtomarket,contract=0@endoftradingday,contractonlyhasvalueduringtradingday.

DERIVATIVEINVESTMENTS:OPTIONS,SWAPS,INTERESTRATEANDCREDITDERIVATIVES
Call+X/(1+r)T=Put+Stock
PUT_CALLPARITYCall+[XForward]/(1+r)T=P
FiduciaryCall=Protectiveput
Sensitivityofoptionpriceto

Greek

CallOptions

PutOptions

UnderlyingPrice

Delta

PositiveDelta:higherunderlying
valuehighercallvalue
Higherexerciseprice,lowercallvalue

RFR

Rho

TimeDecay

Theta

Vega

PositiveRho:higherRFRslightly
highercallvalue
NegativeTheta:callvaluedecreases
withpassageoftime
PositiveVega:whenvolatility
increasescallvalueincreases

NegativeDelta:higherunderlying
valuelowerputvalue
Higherexerciseprice,higherput
value
NegativeRho:higherRFR
slightlylowerputvalue
NegativeTheta:putvalue
decreaseswithpassageoftime
PositiveVega:whenvolatility
increasesputvalueincreases

ExercisePrice

PriceVolatility

BinomialOptionPricingModel
CallOptions:
u=S+/S
Stockup=S+
Callvalueup=C+=Max[0,S+x]

Stockdown=S d=S /S
Callvaluedown=C=Max[0,Sx]
RiskNeutralProbabilityupmove
RiskNeutralProbabilitydownmove=
ValueofCall=
PutOptions:
Everythingisthesameasaboveexceptcallsreplacedwithputsfor:
Putvalueup=P+=Max[0,xS+]
Putvaluedown=P=Max[0,xS]

DeltaHedging:*dynamichedgeb/citmustconstantlyberebalanced
Deltaischangeinpriceofanoptionforaoneunitchangeinthepriceofanunderlyingsecurity
Calloptionhedging
Putoptionhedging
Deltacalculation
,willbepositive
,willbenegativeDeltaPut=DeltaCall1
DeltaCall=DeltaPut+1

#optionstohedge

Page28of36
Optionisoverpriced

Calloptionmarket>calloptionintrinsic
Selloptions,buyshares
Calloptionmarket<calloptionintrinsic
Buyoptions,sellshares
=[#shares]*[Stock0][#calls]*[callval0]
=(ns)(S0)(nc)(C0)

Putoptionmarket>Putoptionintrinsic
Selloptions,sellshares
Putoptionmarket<Putoptionintrinsic
Buyoptions,buyshares
=[#shares]*[Stock0][#puts]*[putval0]
=(ns)(S0)(nP)(P0)

Portfoliovalue

Portfoliovalueinupmove:

Portfoliovalueinupmove:

*upanddownmoveportfolio
valuewillbethesame

[#shares]*[Stockup][#Calls]*[Callvalup]
=(ns)(S+)(nc)(C+)

[#shares]*[Stockup][#puts]*[putvalup]
=(ns)(S+)(nP)(P+)

Portfoliovalueindownmove:

Portfoliovalueindownmove:

[#shares]*[Stockdown][#Calls]*[Callvaldown]
=(ns)(S)(nc)(C)

[#shares]*[Stockdown][#puts]*[putvaldown]
=(ns)(S)(nP)(P)

Optionisunderpriced
PortfolioCost
(buyisoutflow,sellis
inflowofcash)

Profit
HedgeRatio=H=nSC
Effectonoptionvalueif
stockpricechanges

PortfolioValuePortfolioCost
PortfolioHedgedif:H=H+whichmeans: nS+C+=nS+C
Calldelta=N(d1)>0CallpriceN(d1)xS
Putdelta=[N(d1)1]<0Value,asstock
Value,asstock
Putprice[N(d1)1]xS

ValueofAmericanstylecalloption=Eurostyle.Ifunderlyingdoesnt
paydividend,itisneveroptimaltoexercisetheAmerican
optionearly.

DELTASIZEIS:
tmaturity.Effects
Option
Range
Faroutthemoney
FarInthemoney
Call
0to1
Closeto0
Closeto1
Put
1to0
Closeto0
Closeto1
*thecloserthedeltaisto0themoreoptionsarerequiredtohedge

Aspriceincreases
CallIncreasefrom0to1
PutIncreasefrom1to0

Gamma:measuressensitivityofdeltatochangesinthepriceofunderlyingGamma=delta/priceofunderlying
Large(bad)whenoptionisatmoneyandclosetoexpiration(moresensitive).Optionvaluemoresensitivetochangesin
stockleadtolargechangesindeltaandhavefrequentrebalancingofdynamichedges.
Small(good)whenoptionisdeepinoroutthemoney(notsensitive)b/cchangesinstockdontaffect.Dynamichedge
willperformwell

BlackScholesMerton:
Assumptions:pricehaslognormaldistribution,RFR&Volatilityisconstantknown,notaxes/transactioncosts,noCFsfrom
underlyingasset,optionsareEuropean.
Computingimpliedvolatilityrequirements:RFR,assetprice,timetoexpiry,strikeprice,marketpriceofoption

Page29of36

INTERESTRATEDERIVATIVES
Capisseriesofcaplets.Floorsareseriesoffloorlets.(multipleinterestrateoptionsthatcanbeexercisedperiodically)
InterestRateCap
InterestRateFloor
Summary
Sellerpaysbuyerwhenbenchmarkinterestrate(eg:
Sellerpaysthebuyerwhenbenchmarkinterest
LIBOR)exceedsstrikerate.Buyerwantstolimit
rate(eg:LIBOR)fallsbelowthestrikerate.
interestexpenseonfloatingbenchmarkrate.
Buyer
Rate>Strike(caprate).IntRate,BondValue
Rate<Strike(floorrt).Intrt,bondvalue
receives
payment
Seller
Rate<Strike(caprate).IntRate,BondValue
Rate>Strike(floorrt).Intrt,bondvalue
receives
payment
Equivalence Capbuyer(long)buyscallonLIBOR.
Floorbuyer(long)buysPutonLIBOR
forLong
Capbuyer(long)buyslongputonbondwhich
Floorbuyer(long)buyscallonbondwhichwill
increaseinvaluewheninterestrateandbondvalue invaluewheninterestrategoes(bondprice
.
goesup).
Periodic
Payment
CapletValue

FloorletValue

2yearcap=2yearcaplet+1yearcaplet
Value2yearcaplet.Valueright3endnodes(red)withcapletvalue.Value2
middlenodes(blue)byusingbinomialmethoddividingsumof250%weighted
nodesfromrightthendividingbycorrespondingintrt
Valuechangesfor:
ShortCap
LongCap
ShortFloor
LongFloor

Option
ValueofcallonLIBOR
Valueofcallonbondprice
ValueofputonLIBOR
Valueofputonbondprice

Wheninterestrates
Decrease
Increase
Increase
Decrease

Wheninterestrates
Increase
Decrease
Decrease
Increase

Ifrtsandbondprice
Increases
Decreases
Decreases
Increases

Ifrtsandbondprice
Decreases
Increases
Increases
Decreases

Interestratestraddles:
Buycapandfloor:receivepaymentswhenratesriseandfall
Sellcapandfloor:receivepaymentswhenratesstaywithinrange:capletsandfloorletswouldbeexercisedagainst
sellerifinterestrateschange
Interestratecollars:Buycap,sellfloor
Protectagainstrisinginterestrates,whilegivingupbenefitfromlowerinterestrates

Page30of36
PurchaseofCapprotectsagainstrisingrateswhilethesaleoffloorgeneratesoptionpremiumincome.Hedgea
floatingrateliability.
Collarcreatesbandwithinwhichthebuyereffectiveinterestratefluctuates
Reversecollars:sellcap,buyfloor.
Swaps:priceisfixedandisquotedasfixedrateintheswap.Volatilityisconstant
EX:forquarterlypymts(every90days)
Useoriginaltermstructureatinitiation

Fixedrate
PresentValueFactors
Pricerate=C/Principalamount

annualizedfixedrate=Cx(360/periodlength)*inexaboveitwouldbe90

FixedRateReceiver

Profit
MktRts

Loses
MktRts

FloatingRateReceiver

MktRts

MktRts

Equivalence
LongInterestRatePuts
Shortinterestratecalls
ShortInterestRatePuts
LongInterestRateCalls

SwapValue
Fixedpaymentamount=(fixedratefromabove)x(360/periodlength)x(notional)
PV(fixedrate)=Z1(daysuntilpymt1)x(fixedpymt)+Z2(daysuntilpymt2)[fixedpymt+notional]
*Usesnewtermstructure
EX:originallypymtsmadeannually,now180dayshavepassed

PV(floating)usesonly1stfloatingpaymentandnotionalforcalculation
=Z1(daysuntilpymt1)x[(Ratepymt1)*(periodlength/360)*(notional)+notional]
Useinitiationoriginaloldtermstructureforfloatingpymt
UsenewtermstructureforPVfactor
EquitySwaps:
Payfixed,receivefloat:(1+ROE)xNPPV(remainingfixedrtpayments)
Payfloat,receivefixed:(1+ROE)xNPPV(coupon+par)
Swaption:
Payerswaptiongivesholderrighttoenterintoaswapinthefutureasafixedratepayer
Ifswapfixedratesincrease(asinterestratesincrease),therighttoenterthepayfixedsideoftheswap(a
payerswaption)becomesmorevaluable,wheninterestratesincreasebondpricesfallandputoptionsonthe
bondbecomesmorevaluable.
ReceiverSwaptiongivesholdertherighttopayfloatingandreceivefixed.

CDS:
Payoutamount=(payoutratio)x(notional)
Payoutratio=1recoveryrate
Bondspread=yieldinvestorscostoffundingcomparew/CDSspread
CDSassetswapspread=couponinterestrateonswapfixed
CDSspread<assetswapspread
CDSspreadsarenegativelyrelatedtoprobabilityofsurvivalandrecoveryrate,andpositivelyrelatedtoprobabilityofdefault
andloss.
Cheapesttodeliversameseniority(paripassu):
singlenamepayoff=protectionnotional(par%)x(notional)
indexpayoff=proportionalweightednotional(%ofparafterdefault)x(weightednotional)
newnotional=totalnotionaldefaultpayoff
physicalsettlement
Cashsettlement
Discounted/defaultedreferenceobligation
Parmarketvalueincash

Page31of36
Parvalue
CDSprice(per$100notional)=100upfrontpremium
Valueprotectionleg =creditrisk,contingentpaymentthatmaybemadefromCDSsellertoCDSbuyerincaseofdefault
=valueofRFRbondE(payoffriskybond)
Upfrontpayment=PV(protectionleg)pv(premiumleg)
Ifthisispositiveitmeansprotectionbuyermustmakepaymenttobuyerb/cpremiumsareartificiallylow
Upfrontpremium=[CDSspreadCDScoupon]xduration
(paidbybuyer)
Creditspread=upfrontpremium/duration+fixedcoupon
ValuationafterinceptionofCDS:
Profitforprotectionbuyer(chanceinspread%)x(duration)
CDSspreadmaydifferfromfixedcoupononCDS,sodifferenceispaidPV(couponspread),Sellerpaysbuyerif+
Hazardrate=P(default|givenithasntalreadyoccured)

(hazardrt )

Probabilityofsurvival=

PORTFOLIOMANAGEMENT
Variancefor2assetportfolio
MinimumVariancePortfolio:
Correlation==Cov(1,2)/12

EquallyWeightedPortfolioVariance:
PortfolioSTDofreturn

Maximizeriskreduction:

When#ofassets,Varavgcovariance
Whennthen

CapitalAssetAllocationLine(CAL):
CombinesRFassetandriskyportfoliotomaximizerewardtoriskratio.
Tangencypointistangencyonefficientfrontier
InterceptandslopeofCALdependonvariedinvestorexpectationsforfuture.
CALEQN=

Coefficient=SharpeRatio=Rewardtoriskratio

BasedonGraph
BorrowmoneyatRFRandinvestinriskyassets.MoveonlineAfrombottomtotop(samerisk,morereturn)
LendmoneyatRFR,earnsamereturnbutlessrisk.MoveonlineBfromrighttoleft(samereturn,lessrisk)

CapitalMarketLine(CML):
CALwhereinvestorsagreeonE(returns),standarddeviationsandcorrelationsofallassets.
ThiswillmaketheoptimalinvestmentportfoliobyallocatingbetweentheRFRandriskymarketportfolio.

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Slope=marketpriceofrisk/reward
WeightingforRiskymarketportfolio
combo=Wmarketmarket
*marketportfolioisconsideredrisky
WRFR=1WMarket
*RFRportfolioisconsideredriskfree
CAPM/SecurityMarketLineSML:

CMLVSCAPM:
Ifmarketsareinequilibriumrisk&returnwilllieonSML,notCML.Risk&returncombosforindividualsecuritieswilllie
belowCMLb/ctheirincludeunsystematicriskwhichcanbediversifiedaway
SML
CML
Measureofrisk
Uses(systematic,market,nondiversifiable)
Uses=standalonerisk=systematic+unsystematic
Application
Determinebenchmarkappropriatereturns
AssetallocationbtwnRFassetandriskyportfolio
Definition
GraphCAPM
Graphefficientfrontier
Slope
Marketriskpremium
Marketportfoliosharperatio
Assetssystematicrisk:
wherei=stock,M=market
MarketModel:estimatebeta
Ri=i+iRM+i
MarketModel:
1. E(Ri)=i+i(RM)
2. i2=i22Mi+2
3. Covij=ijM2
4.

MarketModel:3assumptions:
1) E(error)=0
2) error,market=0
3) Firmspecificsurprisesareuncorrelated

ADJUSTEDBETAforstability,asit
tendstogravitatetowards1
Adji=0+ii ORadj1=1/3+2/3i
ishistorical.Notnecessarilygood@
predictingfuture.Calledinstability

Addingnewassettoportfolioisoptimalifthefollowingconditionissatisfied:
Thesearejustsharperatios:
Sharpenewasset>sharpecurrentXCorrcurrent,newasset
Macroeconomicmodel:thesemodelsusesurprisestoexplainequityreturn
Fundamentalfactormodel:microeconomic,sharerelated,macrodatathatdrivecompanygrowth
Factorsensitivitiesarestandardized
ArbitragePricingTheorymodel:E(RP)=RFR+11+22++
*=RiskPremiumFactors
LessrestrictivethanCAPM,APTisequilibriumpricingmodel.Factorsareriskpremiumsanalogoustothemarketriskpremium
inSML.APTconsidersmultiplesourcesofrisk.Noarbitrageopportunitiesexistforinvestorsbecausecapitalmarketare
competitive.Diversificationeliminatesnonsystematicrisk.
Arbitrageprofitssetweightedfactorsensitivitiessumto0.Longandshortcorrespondingsensitivitiesandfind
weightedexpectedreturnforportfolioandprofit

MarkowitzDecisionRule:whencomparing2portfolioschoosehigherE(return)lower(R)ceterusparibus
Tofullyhedgefactorrisksetcombinedweightingsto0andsolveforw.

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TotalactiveReturn=[(portfoliosensitivitybenchmarksensitivity)xfactorreturn]+Assetselectionreturns

=Factortilts(AKAsumabsolutecontributiontoactivereturn)+individualsecurityreturn

*pisportfolio,bisbenchmark

(Activerisk)2=ActiveFactorRisk+ActiveSpecificRisk
Activefactore.g.:riskindexesfundamentalaspectsofcompanies(leverage,yield),industrialcategoriesexposureto
certainindustries(binary)
Activefactorrisk:differencesinfactorsensitivitiesbtwnportfolioandbenchmark
Activespecificrisk:attributedtodifferencesintheweightsofindividualassetsbetweenportfolioandbenchmark

Factorsmarginalcontributiontoactiverisksquared(FMCAR):
**WhereAEF=Active
ExposureFactor**

IR=InformationRatio(meanactivereturnperunitofrisk)

indicatespurestockselectionabilityandmanagerperformance,independentofaggressiveness(aggressivenessincluded
inresidualrisk)
addstockswithhighestIR

ResidualRisk:
tradeoffbetweenactivereturn&activerisk

t=tstatsiticofintheregressionmodel
n=#ofyears
budgetconstraint==IRxbcinordertoincreasereturnuneedtoincreaseresidualrisk
FundamentalLawofActiveManagement:

InformationCoefficient(IC):forecastingskill,correlationbetweenforecastandresults
Breadth=#independentforecastsofexceptionalreturn

ValueAddedVA=(x2)=IRx(x2),=riskaversion
Expost=realized
ExAnte=forecastofresidualreturns
InformationCoefficientcombining2sources:

TimeFactors:
Annualquarterly
IRannual/sqrt(4)
Annualmonthly
IRannual/sqrt(12)

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IRA&B2=(IRportA)2+(IRportb)2=(ICportA2+BRportA)+(ICportB2+BRportB)
R=correlationbtwn2sourcesofinvestmentinformation
Notimpressiveifmanageruses1pieceofinformationtopick2differentinvestments

InvestorPolicyStatement:
Willingnesstotakeriskisbasedonsubjectivepsychologicalfactors
Abilitytotakerisk:liquidity/spendingneeds,timehorizon,portfoliosize,tax/legal/uniquecircumstances
Objectives:concernedmainlywithriskandreturn