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CFA LEVEL 2 NOTES

peterding10@gmail.com

ETHICS
Code of Ethics (Separate from Code of Standards)
Act with integrity competence diligence and respect in an ethical manner with everyone
Place integrity of investment profession and interest of clients above personal interest
Use reasonable care and independent professional judgment wrt investment analysis, action, recommendation

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Practice and encourage others to be professional, ethical, which reflects credit on themselves and profession
Promote the integrity and viability of global capital markets for ultimate benefit of society
Maintain and improve professional competence for yourself and others

Standards of Professional Conduct (Code of Standards)

Ok to compete against employer for additional compensation when working for them if you have written
CONSENT

Notify employer of services rendered, duration of services and compensation for services
Cant solicit current clients to join new firm if you still work at old firm. You can prepare to go into
competitive business before leaving work as long as it doesnt breach employees duty of loyalty

You can solicit current clients of old firm after youve left (unless theres a non-compete clause)
Cant take old work from old employer to new employer without written CONSENT of previous employer
Analyst not prevented from writing research report because of relationship between employer and target
company, DISCLOSURE
Doesnt matter that brokerage firm provides research that is not used by account generating commission if
account isnt paying for it
Best thing to do is to pay for accommodations, accepting not necessarily a violation if it doesnt impede
objectivity
Reward for strong past realized return from clients ok if other clients are treated the same DISCLOSURE

Rewards based on future performance: must receive written permission from employer
Ok to own same investments as clients. Responsibility to clients, then employer, then yourself.
Employees should disseminate public material information if it doesnt breach duty
You must attempt to make everyone (not just direct reports) adhere to laws, rules and regulations
Responsibility of supervisors: are held accountable for their employees actions.

Supervisory duties may be delegated but that doesnt relieve supervisors from responsibility
If block trades occur at different prices they must be allocated pro rata across all accounts with no
preferential treatment.
Acceptable to base a recommendation, in part, on an expectation of future events, even if is uncertain

EX: a politician is fighting for subsidies to an industry and believes that said subsidy will pass
Candidates cant say they received highest score on CFA exams b/c scores are broken in to <50, 50-70,
70< score sections. You dont know your actual score, just if you passed/failed.
CFA logo cant be incorporated into company name or logo. CFA logo used only to identify charterholders not
candidates
Allocate IPOs to suitable clients pro rata directly, not ok to allocate to managers who then have discretion to
allocate to their clients
Oversubscribed issues: forgo sales to yourself and immediate family(unless theyre regular accts), prorate
remaining amongst clients
Present outcomes from models or statistical estimates as opinions not fact and with qualifying statements
and caveats
Plagiarism includes: using experts either verbatim or with slight changes in wording w/o acknowledgement,
specific quotations to vague sources (leading analysts, Investment experts), using charts/graphs without
citing sources, copying spreadsheets or algos without seeking cooperation or authorization of creators.
You can use previous research done by another analyst even if they have left the firm. You cannot reissue
previously released report solely under your name. Firm can issue research if analyst is gone too.
Citing direct source or intermediary source: best obtain complete study from original author and cite author
preferred, or use both intermediary and source and cite both sources.
An influential analyst with the ability to move markets is considered material. But since this analyst is not a
company insider a report written by them is not considered MNPI and dont have to be publicly
disseminated. If you want access you can pay them.
If 10 largest shareholders are told something at a meeting. Analyst cannot use this information because it is
not public, it has not been widely publicly disseminated
Investment decisions made in context of the whole portfolio, consider the investments place in the overall
portfolio

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A family members account is a regular fee paying account comparable to all clients. Dont disadvantage
them or any other specific client because of overcorrecting notion of fairness due to this special
relationship
Dissemination should be fair(equal dissemination at same time for everyone too hard), cant discriminate
with selective dissemination

Higher fee paying clients get more service and attention but not to detriment to others
Using Quant Models: dont have to know every technical aspect but you should understand assumptions and
limitations
Developing quant models: understand technical aspects. Thorough testing of model and resulting analysis
should be completed
CFA institute recommends maintaining records for at least 7 years
If you issue a recommendation give ample time for clients to receive message and for them to act before
you or your firm trades in an effort to prevent front running
No need to dissociate yourself from report if you disagree with consensus group opinion if you believe
opinion has reasonable basis.
If market makers are in possession of MNPI, they should be passive market participants. Outright prohibition
of market making might be construed as a tip to outsiders
Exempt from best execution brokerage if client expressly prohibits best execution and is aware of the impact
on their account
MNPI violated if you act or cause other to act on MNPI received a mere outlook (promising,negative)
does not violate this
Diligence and reasonable basis not violated if no formal recommendation is made
All clients participating in a block trade should be given same execution price and pay same commission
Receive trade allocation request (what clients would like to own) notification from clients before receiving
stock from IPO
Whistleblower status granted if you dont have anything to gain personally
If client is trying to set up investment trust for kids, then the kids are the actual clients (trust beneficiaries),
consider kids risks and investment objectives
Suitability isnt an issue when recommending to general clients. Suitability may be issue if recommending
investment for specific client
Cant say date or time frame of receiving charter. Say: CFA charter received when Ive completed required
work experience after passing 3 levels
If influential analyst tells you about recommendation before going on TV it is considered MNPI if you act on
it.

Research Objectivity:

All communication btwn IBD and research should take place through compliance or legal. Draft should be
submitted beforehand. Communication should be only to verify factual info or conflicts of interest.

No communication btwn IBD and brokerage

Research cant share any part of recommendation with IBD or CorpFin

Research cant participate in marketing activities, if they are they should be disclosed.
Cant link research analyst compensation to specific IBD project. Although, compensation can be linked to
overall IBD department performance.
Cant trade against firm recommendation unless theres extreme financial hardship (different from
Standard Priority of transactions where firm should be notified of opposing trade and as long as trade
doesnt disadvantage clients)
Rating recommended to have: 1) recommendation or rating category 2) time horizon categories 3) risk
categories
Recommended restricted trading periods of at least 30 days before and 5 days after recommendation to
prevent client front running
Recommended quiet period: 30 days before IPO, 10 days before secondary offering
Research reports should be updated ideally quarterly. Also should be updated when theres a major event
Final research report should be issued if coverage is being discontinued. This report should explain reasons
for discontinuing coverage

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QUANTITATIVE METHODS

Cov
(x x )( y y )/ ( n1 ) = Cov (x , y ) b = y b^ x plug y x
b^ 1= 2 xy =
1
Var ( x) 0
X
( xx )2 /( n1 )

Estimated Slope coefficient =

t-test for significance:

t stat =

b^ 1b 0
sb

, REJECT if tstat > tcrit. Conclude: coefficient is significant in

and is not equal to 0

P-value is the smallest level of significance where the null can be rejected.
If P-value < Significance lvl, the null hypothesis can be REJECTed and the variable is considered
significant
CONFIDENCE INTERVALS

2
1 (xx )
^y t c s f where : s f = s2 1+ +
n ( n1)s x 2

s =SEE standard error of estimate measures varianceof residuals

SSE
SEE= MSE=
( n k1 )
2
'
sx isthe independent variabl e s variance

where ^y =b^ 0+ b^ 1 x

Coefficient of
determination

( ( x x )2 (x ^x )2 ) (SST SSE) RSS

( x^ x )2

R =
=
=
=
SST
SST ( x^ x )2+ ( x x^ )2
(x x )2
2

+ RSS (explained)
is variation of y explained by x
+ SSE (unexplained)is variation of y NOT explained by x
= SST (total) .is total variation of dependent variable (y)
Correlation Coefficient =

R2

test for significance of Corr (r) :

= r Cov1,2 = Corr1,2 1 2 r = Corr1,2 = 1,2 = Cov1,2/ 1 2

t stat =

r ( n 2)

(1 r )
2

Adjusted R =1

n1
2
(1r )
nk 1

more independent variables tend to overestimate R2. Adj-R2 revises the

number downward

F-Statistic (Calculating independent variables as a group explains dependent variable movement)

Fstat =

df numerator =k= independent variables

MSR
RSS/ k
=
MSE SSE / ( nk 1 )
df denominator =nk1

If Fstat > Fcrit then reject. Group of independent variable variation describes dependent variation
Model Misspecification: omitting a variable, variable should be transformed, incorrectly pooling
data, using lagged dependent variable as independent variable, forecasting the past, measuring
independent variables with error.

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Effects of misspecification: Regression coefficients are biased and inconsistent, lack of confidence
in hypothesis tests of the coefficients or in the model predictions.
Multiple Regression Issue
Heteroskedasticity: residual variance
is not constant

Serial correlation/ Auto correlation:

residuals correlated, future data
affected by past data, lagged
correlation present

Detection
Breusch-Pagan: regress the square of
residuals on original independent
variables and create new Chi-squared
test. REJECT: nR2 > 2 HS exists
(R2 corresponds to 2nd regression:
Regressing 2 (residuals-squared) on
independent variable.
Durbin Watson: DWstat = 2(1-r), where r
is sample correlation between squared
residuals from one period and previous
period.
+ SC
inconclusive
none
inconclusive
- SC
0
4- dL

dL
4

du ~2

Correcting
White corrected SE (robust standard
errors), Generalized least squares (gls),
HS-consistent standard errors (SE)

Hansen method, white corrected.

Adjust/modify coefficient standard
errors.

4- du

Positive serial correlation: SE underestimated, tstat larger

Negative serial correlation: SE overestimated, tstat smaller

Multi-Collinarity: high correlation

between 2 or more independent
variables.

High pairwise correlation

High R2, high standard errors (low tstats), indep coefficient t-stats are not
significant

Stepwise regression: omit one or more

of collinear variables

Yt = ebo + b1t ln(yt) = b0 + b1X Regress natural log of dependent variables on independent variables

Autoregressive models AR(p): xt = b0 + b1 xt-1 + b2 xt-2 + + bp xt-p + t

AR Valid if:
Not heteroskedastistic
Not serially correlated (see below how to fix)
COVARIANCE STATIONARY if:

E(time series) constant, finite and mean reverting level

b0
1b1 1

, if b1=1 AR is Unit

Root=non-cov stationary
Var(observations) constant, finite
Cov(Times series) constant, finite
NO unit root (series trends up or down). Correct with first differencing (described in ARCH
section below)

Test with dickey fuller. Unit root exists if b 1 1=0 (it is non-stationary)

AR test for residual correlation for time series models (if times series has
autocorrelation it is not covariance stationary) :
Detect: t-test for auto correlation in residuals:

autocorrelation( btwn error terror tkth laggedterm )

>t crit
1
standard error=
of observations

reject null, CONCLUDE: serial/autocorrelations significantly

different from 0.

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Fix: Include additional lags for AR(p) model (p increasing) so theres no auto correlation
(t-stat declines to 0)

Testing for ARCH and non-stationarity for AR models

**Remember: if non-stationary then AR is

invalid**

If b1 = 1, then the process has a unit root and is non-covariance-stationary from x t = b0 + b1 xt-1 + et

Random Walk is NON covariance stationary (no finite mean-reverting level)

If first differenced b0 = 0 and b1 =0 and theres not auto correlation between residuals
then AR is NOT random walk and IS covariance stationary
DICKEY FULLER TEST (first differencing method)
(xt - xt-1)= b0 + (b1 -1) xt-1 + et
where g1 = b1 - 1
H0: g1 = 0 Time series has unit root and g1 will equal 0 (b1 = 1): accept null non-stationary
H1: g1 < 0 Time series doesnt have unit root and is covariance stationary
FIX non-stationarity First differencing: model change in value of dependent variable x t ,rather
than the variable itself xt

EX: run regression on ln(salest) = ln(salest) ln(salet-1)

Time series auto correlations significantly different from 0 at all lags. re-estimate model using
generalized least squares.

Test for ARCH is based on a regression of the squared residuals on their lagged values:
1) Square residuals from autoregressive model
2) Regress squared residuals against squared residuals from previous period
3) If coefficient 1 (using t-test) from
conclude regression model exhibits ARCH(1)
4) FIX ARCH error: use generalized least squares

is statistically significant (different from 0)

Seasonality
Detecting Seasonality:

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lnxt = b0 + b1 (lnxt-1) + et
if residual lag 4
Fixing Seasonality:
lnxt + b0 + b1 (lnxt-1) + b2 (lnxt-4) + et
Add lagged 4th term

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tstat =

autocorrelationbetween lagged error terms

> t crit
1
SE=
obs

Then 4th autocorrelation is seasonal

After Engle-Granger ARCH testing for cointegration
Cointegration: 2 time series are economically linked
Xt = 0 + 1t
y t = 0 + 1 t +
yt = 0 + 1t
Indep & Dependent Variables are:
Regression results:
Neither has unit root (covariance stationary)
Valid
1 has unit root.
Not valid
2 have unit root & cointegrated.. Valid (good for LT regression estimates for ST estimates use
correction models)

2 have unit root & not cointegrated.Not valid

if Engle-Granger critical values rejects null hypothesis unit root. CONCLUDE: covariance stationary, 2
series are co-integrated

ECONOMICS

Price Currency USD

buy @ bid , sell@ ask
=
, rule for investors PRICE:
BASE: buy @ ask ,sell @ bid
Base Currency AUD

Converting:

PriceCurrency
Base Currency

up the bid & multiply

PriceCurrency
Base Currency

down the ask & divide

Cross rates w/bid-ask spreads- switch bid & offer interchangeably

( CA ) =( AB ) x ( CB ) ( CB )
bid

bid

bid

bid

1
C
B

( )

Offer

Triangular Arbitrage
Market:
USD EUR GBP USD
Bid
Ask
strategy
USD/EUR 1.271 1.272
USD 1 EUR
EUR/GBP 1.249 1.250
USD x
x
USD/GBP 1.6 - 1.601
EUR ask GBP

) (

Set all to bid or ask with inverting depending on

1

) x ( USD
GBP )
ask

bid

Becomes:

USD x

GBP
USD
x(
x(
( EUR
)
)
USD
EUR
GBP )
bid

$1 x

bid

bid

1
1
( 1.272
) x ( 1.250
) x ( 1.61 )
bid

bid

bid

=$ 1.006289> $ 1

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Calculate forward premium (discount) =

Forward f spot f =spot f

d

actual
360
actual
1+i d
360

( i f id )

Carry trade for arbitrage opportunities: borrow in lower yielding currency and invest (lend) in
higher yielding one. Then net any profit after borrowing costs and exchange rate movements.
(rd rf) < (Forward Spot) / Borrow Domestic Invest Foreign
Spot
(rd rf) > (Forward Spot) / Borrow Foreign Invest Domestic
Spot
EX: Borrow in USD, translate to Euros, Lend Euros, translate to USD, Repay in USD

Gross Return=( USD Notional ) x

Euro
( USD
)

Current

x ( LIBOR Euro ) x

( USD
Euro )

Future

LIBOR USD (return funding cost )

Value of currency forward:

inputs

*FPt, R and days are in terms of the number of days remaining in contract
EX: originally 90-day forward, 60 days have passed (30 days remain). FPt, R and days use 30 day

Relative PPP: states that exchange rates will change

1+ Actual inflation A
S t =S 0
1+ Actual inflation B

Spot f = Actual Inflationf Actual Inflationd

d

to reflect differences in actual inflation between countries

Ex ante PPP: similar to relative PPP, but instead of actual inflation

1+ E(inflation A )
S t =S 0
1+ E(inflation B)

Spot
Inflation
Inflation
E( d)
f
E( )=E ( f )
d

it says expected inflation changes expected changes in spot rates

Absolute PPP: Given a basket of goods should cost the same in different countries after taking
into consideration exchange rates. Goods and services can be transported at no cost, all
countries use same method to measure price levels

Spot f =
d

Price level f
Price Leveld

Interest Rate Parity: exchange rates change so that risk-adjusted returns on investments in
any currency will be equal. Investors are risk neutral

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days
)
360
Forward(F / D)t =
Spot(F / D )t
days
1+r D (
)
360
1+r F (

1) Covered interest rate parity:

investors earn same profit,

derives no-arb forward rate

Forward f spot f
Forward premium ( discount ) as =

spot f

R f R d

Derives no
arbitrage forward rate. Interest rates and exchange rates will
adjust so the
risk adjusted return on assets between any 2 countries and
their
associated currencies will be the same (premiums and
discounts will offset). Real interest rate differentials would result in capital flows to the higher real
interest rate country, equalizing rates over time.
2) Uncovered Interest Rate Parity: Forward is unbiased predictor of expected future spot rates.
Expected spot price is not market traded and thus UIRP does not hold by arbitrage. Expected
appreciation/depreciation offset by int rt differential

Spot

days
)
360
E( (F / D) t)=
Spot ( F / D)t
days
1+r D (
)
360

1+r F (

E(Spot f )spot f
Expected change spot FX rate=

spot f

Rf Rd

Fisher Relation: Countrys nominal interest rates should be similar to expected inflation differences
Rnominal = R real + E(inflation)
R nomA-RnomB = E(InflationA) - E(InflationB)
1+ Rnominal = (1+ R real )[E(inflation)]
Taylor Rule: 1) control inflation 2) maximize employment
R = rn + + ( *) + (y y*)
Central bank policy = Neutral real policy int rate + inflation + diff in target and actual inflation + diff btwn
output and target output

Real FX rateF/D
= equilibrium real exchange rateF/D
+ (real interest rateD - real interest rateF)
+ [(D D*) (F F*)]
(if inflation gap of domestic is greater relative to foreign FX F/D
will rise, D appreciates)

+ [(YD YD*) (YF YF*)]

(if output gap of domestic is greater relative to foreign FX F/D

(risk premium D risk premiumF)

(if greater risk premium required to hold domestic FXF/D will

will rise, D appreciates)

decrease, D depreciates)

Assessing long run fair value of FX:

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Macroeconomic Balance Approach: estimates how much current exchange rates must adjust to
equalize a countrys expected current account imbalance and sustainable current account
imbalance
External sustainability approach: estimates how much current exchange rates must adjust to
force a countrys
external debt (asset) relative to GDP towards its sustainable level
Reduced form econometric model approach: finds equilibrium path of FX movements based on
patterns in several macroeconomic variables, such as trade balance, net foreign asset/liability
and relative productivity
Mundell Fleming Model: monetary and fiscal policy impact on interest rates and exchange rates
Expansionary Monetary: pump money into economy int rts lower capital moves out
(domestic depreciates)

Expansionary Fiscal: lower taxes/ higher spending more gov borrowing int rts higher
capital moves in

Monetary Models:
Pure Monetary Models: PPP holds, output is constant
- Expansionary monetary/fiscal: prices, value of currency
- Restrictive
monetary/fiscal: prices, value of currency
Dornbush Overshoot Model: prices are inflexible and dont reflect changes in policy immediately *think of
oversteering a car on ice

EX: expansionary monetary: prices, real interest rates depreciation of domestic currency due
to capital outflow
In Short term: depreciation of currency > depreciation implied by PPP. Depreciation is higher than it
should be.
In long term: FX rts gradually increase (appreciate) toward their normal long run PPP implied values.
Growth Economics:
Classical: Growth in real GDP is temporary and is limited by a subsistence level, new technologies result in
larger but not richer population
Neoclassical: Tech (TFP) improvement labor productivity resulting in upward shift of production function
curve.
in K (capital deepening) and L doesnt change growth in output per worker perm only amt of production
(movement on production curve)
Sustainable growth comes from population growth. Labors share of income increases from technological
advancement (treated as exogenous variable). after trade opens up and savings reallocated economies
converge at same growth rate as there is no permanent increase in growth rate. Diminishing marginal
productivity of capital but constant marginal product of capital. Savings and investment have temporary impact
on growth
In steady state, marginal product of capital (MPK) is equal to rental price of capital:
MPK =Y/ K = (capital's share of total output as % x output)/total capital = capital's share of total
output/total capital.
GDP growth rate = (growth rate in total factor productivity / (1-) labor's share of total factor cost) + growth in labor force
Endogenous: Technology leads to better labor productivity, capital deepening, knowledge capital and R&D
leads to social and other technological benefits and externalities for everyone. Saving and investment can
generate selfsustaining growth at a permanently higher rate as the positive externalities associated with R&D
prevent diminishing marginal returns to capital from setting in. Differs from neoclassical because endogenous
says capital investment has constant returns while neoclassical says K investment is diminishing.
GDP growth = TFP(tech) growth + (LT growth rate of capital) + (1- )(LT labor growth)
TFP(tech) growth = Growth in labor productivity Capital deepening
Stock market growth = GDP Growth + Capital growth + P/E multiple growth rates
*In LR stock growth depends only on GDP growth
Stock Market = GDP *(E/GDP)*(P/E) = GDP * corporate share of earnings in GDP * market P/E ratio
Regulations necessary b/c of information frictions (information asymmetry, moral hazard, adverse selection) &
externalities

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Regulatory Arbitrage: companies exploit difference between economic substance and interpretation of a
regulation.
Regulatory Capture: regulatory body gets influenced by regulated industry and advance interest of regulated
(eg. banks)
Regulatory Competition: regulators compete to provide best environment
Coase Theorem: When property rights are involved, people will make efficient decisions that are mutually
beneficial

FRA: INVENTORIES
Inventories

AND

LONG-LIVED ASSETS

LR= LIFO RESERVE (lifo to fifo)

FIFO inventory
= LIFO inventory + LIFO reserve (writedown charges)
FIFO COGS = LIFO COGS (LREnd - LRBegining) + (writedown charges)

Inventory Turnover Ratio=

COGS
Avg Inventory

LIFO to FIFO Conversion change amount:

Net Income. = + (LREnd - LRBeg) x (1- tax rate)
Current Assets = + (LIFO reserve)(1-tax rate)
Inventory..
= + (LIFO reserve)
Cash.. = (LIFO reserve) x (tax rate)
Liab (d. taxes) = + (LIFO reserve) x (tax rate)
Equity (RE). = + (LIFO reserve) x (1 tax rate)
LIFO results in higher cash flows because with lower reported income, income tax will be lower
LIFO Liquidation: COGS > Purchased, goods held in Beginning Inventory are included in COGS
Firm allows inventory to decrease. Lower COGS. Leads to unsustainable temporary increase in
net income.
Inventory Write Downs:
IFRS: min(cost, NRV = sales price selling & completion costs)
(may be written back up too to extent of loss)
GAAP: min(cost, market replacement cost) NRV Normal profit < market < NRV
(cant be written back up. Exception: agriculture, mining, forestry with active market can be reflected in IS as G/L )
Write down process: COGS, results in: Net Income

Long-Lived Assets
Capitalize as asset on balance sheet:
1) Initially: noncurrent asset , CFI (similar to investing in asset)
2) Future: noncurrent asset , NI , RE , Equity (all because of
depex)

Expense cost in income statement

Initially: NI by (cost)(1-tax), OCF no future costs

COMPARISON
NI 1st yr
NI (future) [b/c depex]
T. Assets
Equity
CFO
CFI
Income Variability
D/E Ratio

Capitalizing
Higher
Lower
Higher
Higher
Higher
Lower
Lower
Lower

Expensing
Lower
Higher
Lower
Lower
Lower
Higher
Higher
Higher

Intangible capitalize/expense treatment:

IFRS: R&D research expensed
Development (to bring to market) capitalized
GAAP: R&D research - expensed
Software development: establishing feasibility cost viewed as R&D costs expensed
When feasibility is established: costs capitalized as inventory
Internally developed software is expensed. Then capitalized when software
used as intended.
Patent & copyright dev: capitalized when purchased from outside
Expensed when developed internally
Reverse Capitalizing of expenses: (adjusted EBT) = EBT Capitalized interest + Amortization of
Capitalized interest
Asset Impairment (downward):
fair value
value in use
IFRS: if CV > recoverable amt = Max[(FV-selling costs), PV(E(CFs)].
1. Write down to
recoverable amount
GAAP:
if CV > undiscounted CFs. Write down to recoverable FV or DCF amt.
2. Loss is in I/S

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CF same b/c impairment is NCC
Asset Revaluation (Upwards):
IFRS 1) Revaluation method:: CV=FairValue Subsequent Accumulated Depreciation & Impairment
2) Cost method
:: CV=HistoricalCost Accumulated Depreciation
*Revaluation recorded in I/S any revaluation exceeding original cost is recorded as revaluation surplus
as OCI equity

GAAP 1) Cost method only. Value can never exceed historical cost
Acct Treatment of Revaluation:
IFRS: G/L in IS any excess gains above original cost is recognized in OCI (equity) as
revaluation surplus
GAAP: not allowed except for long lived assets held for sale.
-Only the cost model may be used as value can never exceed historical costs.

Leases from lessees

perspective
Operating Lease

@ inception

During life

No changes

Finance (Capital) Lease

Higher assets/ liab/
leverage/ OCF/ EBIT
OCF higher because int
exp paid in OCF, only
principal paid in CFF

BS (Long Lived Asset & non-

IS: lease/rent expense every year

CF: lease expense is CFO outflow
BS: Asset by depreciation
Liab by principal payment
=lease pymt interest
expense

current Liab):

Min(PV lease pymts,

FairValue)

FRA: INTERCORPORATE, POST-EMPLOYMENT

AND MULTINATIONAL OPERATIONS
INTERCORPORATE INVESTMENTS:
Ownership
Amt of control
GAAP
IFRS
Less than 20%: fin assets
None
HFT, AFS, HTM
same

(disc rt x
liabbeginning)

IS: int exp , depex (op exp affects EBIT)

CF: Total Lease Payment =
Int Exp is CFO outflow
Principal Pymt is CFF outflow

AND

SHARE-BASED COMPENSATION,

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Investment in financial assets detail level (amount on parents financial statements proportionate to
FV through profit or loss
- HFT(designated at
FV)

AFS
HTM

B/S: GAAP & IFRS

Market FV (fair value)

I/S: GAAP
I/S: IFRS difference
Interest, Divd
none
Realized/unrealized
G/L
FV:
Interest, Divd
Unrealized FOREX
IFRS: unrealized G/L in OCI
Realized G/L
G/L recognized in IS
GAAP: ALL unrealized G/L in OCI
Realized
Reversed out of OCI in
Reclassification
adj
-Initially recorded @ FV
Interest
including
none
-Subsequently reported at amortized
amort.
cost using effective interest method
Realized G/L
Cost of debt + discount premium
thats been amortized

ownership % [0-20%]):
FV = market value if available
discount

Unrealized gain= FV Investment Beginning amt

FV=par, n=time remaining, I/Y=rate/period, PMT=coupon/period, PVFV in BS

Effective Interest Method: (any diff between par & FV is amortized over term)

Par > FV (effective interest rate > stated coupon) securities trade at a discount

Par < FV (effective interest rate < stated coupon) securities trade at a premium
CarryingValue1 = CarryingValue0 + FairValue(mkt int rt) Par(Coupon)
*Use market for FV if available

Amortization of the discount/premium results in the carrying value of securities as it converges towards par as time
passes

Comprehensive income (CI=NI +OCI): Change in equity, net assets from non-owner sources.
Other comprehensive income (OCI) : SE, unrealized G/L b/c those items have NOT been settled

Ownership
Amt of control
GAAP
IFRS
20-50%: associates
Significant influence
Equity
same
50% (may vary): joint venture
Shared control
Equity
Equity or Proportionate cons
More than 50%: biz combo
Control
Acquisition (aka consolidation)
same
Equity Method:
ONE-LINE CONSOLIDATION of proportionate share of net assets and net income in B/S and I/S
respectively. Investment is listed at cost. Total value of the investment = Carrying value of investment
+ (earnings - dividends)
Goodwill Treatment:
proportion of net assets owned

goodwill

absorption by PPE diff

Goodwill= Investment amount (ownership share%) x [(BV current assets + BV PPE Liab) +
(FV PPE BV PPE)]
If FV of net assets > investment amount
-Excess (negative goodwill) excluded from CV and included as income
Proportionate Consolidation (IFRS joint venture only if theres a stronger implied relationship than
equity method):

Page 15 of 44
All proportionally owned parts of B/S and I/S are included in the parents financial statement line by
line.
Acquisition Method (biz combo):
BS: assets & liab consolidated on B/S @FV, minority interest is created for portion that parent doesnt
own to balance acct eqn
IS: rev & expenses are added, minority interest is portion that firm doesnt own
Goodwill Treatment in Biz Combos:
IFRS (optional): Full goodwill = FV subsidiary FV identifiable assets
Partial goodwill = purchase price FV parents proportionate share of subsidiarys
identifiable net assets
GAAP (required): Full goodwill = FV subsidiary FV identifiable assets
GOODWILL IMPAIRMENT: recognized separately as line item on consolidated IS
IFRS: CV > recoverable amt (goodwill absorbs 1st hit of impairment, then non-cash assets, then cash units)
GAAP: CV > FV (written down to FV if impaired)
Notes on the 3 methods (assuming they all have 50% (same) ownership) :
1. All 3 have same net income
2. Equity and proportionate consolidation report same equity, ACQUISITION equity is higher
3. Assets, liabilities, sales and expenses: highest in ACQUISTION; PC is in the middle, lowest under equity

Reclassification of financial assets

From
To
Unrealized
G/L
HFT
Any
I/S (to
extent not
recognized
)
AFS
HTM
Amortized
out of OCI
AFS HFT Transfer out of OCI
HT
HFT I/S
M
HT
AFS OCI
M

Its a VIE IF: insufficient at risk equity investment,

shareholders lack decision making rights, dont absorb
losses, dont receive residual benefits
VIE: Has lower cost of capital because assets and liabilities of
VIE are isolated; VIEs can be in the form of a corporation,
partnership, joint venture or trust. Not necessary for VIE to
have separate management and employees.

PENSION ACCOUNTING
*Funded status shows up in BS
different curriculums denote positive funded status= (PBObeg) x

as
Either net pension liability or asset

(Disc Rt)

Affects actuarial
*A
AL G/L IS PLUG Gains decrease PBO, losses
*If contributions > periodic pension expense,
be viewed as a reduction in PBO
Periodic pension COST: total cost listed in either IS or OCI for GAAP/ IFRS
Periodic pension expense: periodic pension costs
recognized ONLY in IS/P&L (not OCI)
Periodic Pension Cost Treatment
Component
Item
IFRS
Recognition
+ Service Cost
+ Current Service Cost
Actual Events
+ Prior Service Cost
IS (P&L)
+ Amortization of Unrecognized
Prior
Service Costs

CTUARI
increase PBO
remainder can

GAAP Recognition
Service Cost IS
Past Service Cost OCI
Subsequently
Recognized in IS

Page 16 of 44
+ Net Interest
Expense (income)

- Net
Actual/Expected
Plan Asset Returns
Amortization of
Deferred
Actuarial
Assumptions on
PBO

+ ( Funded Status) x (Disc Rate)

+ (PBOBegin PV AssetsBegin) x (Disc
Rt)
(PV Assets Begin - PBOBegin) x (Disc
Rt)
(Actual Return) + (Plan Assets) x
(Disc Rt)
Gains
+ Losses
Gains (decrease obligation
pymt)
+ Losses (increase obligation
pymt)
= Periodic Pension Cost

IS

Remeasureme
nt
Recognized
in OCI, not
subsequently
amortized into
P&L

2 Ways:
1) Immediately in IS
2) unamortized amt in OCI
then amortized to IS using
corridor method

Corridor method: amortization if actuarial G/L outside of

10% beginning PBO or plan assets. Amortization G reduces
pension expense. Amortization of actuarial L increases
pension expense.

Total Periodic Pension Cost

expense)
= PBOend PBObeg +

(TPPC) (I/S
benefits paid

actual return on plan assets

= contributions (funded statusend funded status beginning)

= contributions funded status
Pension obligation reduction (similar to principal reduction)
= contributions pension expense

Multinational Operations

Presentation CR Functional Currency T Local Currency

Use CR when subsidiary is independent
Use T if subsidiary is highly integrated with parent

Monetary A/L
Non monetary A/L
Common stock, Divd

Temporal Method
(aka
remeasurement)
Current Rate
Historical Rate
Historical Rate

Current Rate Method

(aka translation)

Mixed * RE PLUG
Average rate
Historical Rate
Historical Rate
Mixed** = Rev Exp
Net monetary
assets
Income Statement

Current Rate*** from I/S

Average Rate
Average Rate

Average Rate
Average Rate = RE +divd

Current Rate
Current Rate
Historical Rate

(capital stock)

Equity
Revenues, Expenses
COGS
Depreciation
Net Income

*RE from IS can be plug so that the BS can balance

**FX G/L shown on IS
***If not given, equity translated @ current rate, then
find plug to make A=L+(E+CTA)

In highly inflationary environment

IFRS: restate for inflation, use current rate
GAAP: temporal, nonmonetary A/L NOT restated for
inflation

G/L recorded in IS.

Exposure example (from pov Domestic): if

theres a NET ASSET and the foreign currency
Exposure
Shareholders equity
is appreciating, theres a translation exposure
(net
asset)
Exchange rt G/L

GAIN
Equity *PLUG
A = L + (E +
CTA
)
if theres a NET
LIABILITY and the foreign currency is appreciating, theres a translation exposure LOSS

Speculative hedges
Purpose
FV hedge (changes in A/L)
CF hedge (offset variable CFs)
Net investment hedge in foreign
subsidiary

I/S
G/L on IS
G/L in equity OCI
G/L in IS once anticipated transaction affects
earnings
G/L w/ translation G/L in SH equity/OCI

FRA: EARNINGS QUALITY ISSUES

B/S
FV
FV

AND FINANCIAL RATIO ANALYSIS

Consolidating QSPE and SPE on BS results in assets and liabilities increasing by the same amount
Cash collected from customers = sales net in A/R + net in deferred revenue.

Page 17 of 44
When earnings are relatively free from accruals, mean reversion will occur at a slower rate.
* NOA = A- L (exclude cash equivalent and marketable
securities and debt)

Lower the ratio the higher quality the earnings

Core operating margin=

SalesCOGSSG A expenses
Sales
=EBT

N E E R Ta Te.

Tax x Interest x Operating x Asset x Fin . Leverage

( Burden
) ( Burden ) ( Margin ) ( Turnover) ( Ratio )

N S A E.

TIEAF

Beneish model: if (M > -1.78) indicates higher than acceptable probability of earnings manipulation

CORPORATE FINANCE
NPV
WACC reflects inflation & financing charges, CFs should be adjusted to reflect inflation otherwise
NPV will be biased
Depreciation is added b/c it is a non-cash charge that expenses, income. D(1-t)+D = tD which is
the DEPEX tax shield
NWC = NWCInv = non cash current assets nondebt current liabilities
*NWCInv is cumulative NWC during project

If an asset is not being replaced:

Initial investment (outlay) = FCInv + NWCInv (outflow, - for inflow)
CF = (S-C-D)(1-t)+D
= (S-C)(1-t)+tD
TNOCF = SalT + NWCInv t(SalT - BT)

NPV =outlay+

CF
TNOCF
+
t
T
(1+ r) ( 1+ r)

If an asset is being replaced (replacement project):

S= sales or revenue
C= operating costs
D= depreciation
t=tax rate
Sal0= sale of old asset
SalT= sale of new asset
t(SalT - BT)= tax charge for gain on
asset sale
BT = investment accum.
Depreciation
FCInv = cost of machine
+installation cost
=ending fixed asset - beg fixed

Initial investment = FCInv + NWCInv Sal0 + T(Sal0 B0)

CF = (S-C-D)(1-t)+ D
= (S-C)(1-t)+tD
after-tax net proceeds from sale
TNOCF = (SalT Sal0) + NWCInv T[(SalT - BT) - (Sal0 B0)]

Profitability Index=

NPV (future CF)

+1
Initial Investment

EAA (equivalent annual annuity):

Input NPV of project into PV,N,I of calculator and solve for PMT on calculator, whichever is highest is
the best project
Least Common Multiple Lives (replacement chain approach): linearly line up same project one
after another terminal lines up with last CF, then find NPV
2 yr project x 3 = 6 years
3 yr project x 2 = 6 years

Page 18 of 44

Market Value Added:

Economic Profit = NOPAT - $WACC
*Returns to debt and equity capital holders
= EBIT(1-Tax) WACC x Total Capital (MV debt and equity)

Market Value Added=

Economic Profit
,also=(MV equity+ MV < Debt ) (BV equity + BV < debt)
,
( 1+WACC )t

Accounting income: accounting depreciation based on original cost of investment

NI from project = Accounting income interest expense
Economic income: Econ Dep based on changes in market value
Interest expense is implicit in the required rate of return used to calculate assets market value
Economic income = after-tax cashflow economic depreciation

Economic rate of return=

EIT =

ATCFT

(MVT-1 MVT)

EIT =
EIT =

ATCFT
ATCFT

+ Increase in Market Value

+ (MVT MVT-1)

Economic Income
MV Beginning

Note: these are here to confuse you, theyre the

same:
CORP FIN: Economic Profit = NOPLAT - $WACC
EQUITY: Economic Value Added (EVA) = NOPAT $WACC

M&M Propositions:
MM Proposition

NO Tax (cap structure doesnt

With Tax (100% debt is best)

matter)

1 (changes in value)
No tax, transaction costs,
bankruptcy
2
(changes in WACC)

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

Capital Structure Doesnt

Matter
VL = VU value based on OCF
Cost of capital not determined
by structure but rather by
business risk. Increasing use of
relatively cheaper debt will
increase risk and cost equity. So
the two offset each other

R E=Rall eqco +( Rall eqco R D )

V=

Systematic Risk:

Assets=

Cost of equity increases with more

debt but not enough to perfectly
offset cheaper debt. WACC
minimized @ 100% debt

R E=Rall eqco +( Rall eqco R D )(1t )

D
E

Interest EBIT Interest

+
rD
rE

Static Trade off: VL = VU +tD PV(costs of financial distress)

Debt has tax shield advantages

VL = VU + tDebt

+ ( EBIT Interest )(1t )

rD

rE
V =

* theres a sweet spot for maximizing firm value

Debt
Equity
Debt
Debt +
Equity Equity = Assets + ( Assets Debt )
Debt + Equity
Debt + Equity
Equity

Institutional framework

D
E

Financial and Banking

Macro

Page 19 of 44
Debt
Usage

Efficie
nt
Legal
Syste
m
Lower

Comm
on Law
> Civil
law

Lower
info
asymme
try

Favorab
le taxes
on
equity

D/E
Lower
Lower
Lower
ratio
Maturit Longe Longer Longer
N/A
y
r
Dividends
Double taxation:
Effective Tax = CorpTax + (1- CorpTax)(DivdTax)
= 1-(1-CorpTax)(1-DivdTax)

System
Active
bond and
stock
market

Environment
High
High
inflatio GDP
n
growth

Bank
based
financial
system

Large
institution
al
investors

N/A

Higher

Lower

Lower

Lower

Longer

N/A

Longer

Shorte
r

Longer

Imputation tax system: taxes paid out at corporate level, but attributed to shareholder: all taxes are effectively
paid at shareholder rate.

If (Marginal Tax) < (Corp Tax-paid) Investor gets tax credit = franking credit
If (Marginal Tax) > (Corp Tax-paid) Investor pays for gap
Split rate tax system: RE taxed at higher rate than profits it pays out at dividends, encourages
companies to have a lower retention ratio, and pay higher dividends, dividends taxed again @
shareholder level as ordinary income
Expected dividend = (previous dividend) + [(expected increase in EPS) (target payout ratio)
(adjustment factor)]
adjustment factor = 1 / # yrs that adjustment takes place

Price change = Pw divd Pw/o divd = (1-TD)/(1-TCG) x Divd

FCF = NI + Net interest after tax change in deferred taxes + net NCC net WC CAPEX
Unlevered net income
Net Operating profit less adjusted taxes (NOPLAT)
Net interest after tax = (interest expense interest income)(1 marginal tax rate)
Net Working Capital + current assets current liabilities (excluding cash and equivalents and ST debt)

FCFE coverage = FCFE / (divd+share repurchases)

FCFE = CFO FCInv + net borrowing
Dividend Coverage Ratio = NI / Dividends
Dividend payout ratio = 1/Dividend coverage ratio = Dividend/NI

Private Equity
Bootstrapping: high P/E firm purchases low P/E firm
Current EPS is higher at the expense of lower growth prospects and lower future EPS
Equity carve out: subsidiary created and IPOd parent still retains control. Sale of equity of new co to
outsiders
Spin-off shares of new firm are distributed to parents existing shareholders on pro-rata basis
Split-off: parent and subsidiary exchange (surrender) stock. Parent wishes to draw distinction with
subsidiary.
M&A
GainTarget = Takeover premium = PT - VT
HHI = Sum([Sales company/ T. SalesIndustry x 100]2)
GainAcquirer = S TP = S (PT - VT)
VAT = VA + VT + S C (cash paid to target shareholders)
M&A DCF FCFF using NOPLAT:
Income to all investors

Tax savings from higher depreciation

FCFF = NI + Net Interest After Tax + Changes in deferred taxes + NCC INC_NWC FCInv
Unlevered Income

Business Ethics Philosophy:

NOPLAT (net operating profit less adjusted taxes)

Page 20 of 44
Friedman doctrine: social responsibilities of business is to increase profits within rules of the game
fair competition w/o deception or fraud
Utilitarianism: maximize positive, minimize negative outcomes. Bad: difficult to measure utility, what
may be good for larger group may come at expense of minority (eg: not providing healthcare for few
AIDS patients)
Kantian: People are different than factors of production, they must be treated with dignity and respect
Rights theories: everyone has rights and privileges, greatest good utilitarinism cannot violate the
rights of others
Justice theories (Rawls): rules are fair if you dont know your own particular characteristics.
Differencing principle: unequal division must benefit least advantaged members of society. Everyone
decides if sweatshop is lawful if you dont know if you fall under the category of working in one.
Corporate Governance
- Make sure assets used productively, mitigate conflicts of interest, ensure fairness btwn BOD,
managers, shareholders
- Risks: asset risk, liability risk, financial disclosure risk, strategic policy risk

EQUITY
Return concepts: Estimate required return:
MRP
ERP

Expanded CAPM: Req = RFR + (E(Rmkt) RFR) + Small Co. Premium + Co. Specific Risk
Premium
Fama French: market risk premium, small cap risk premium, value risk premium.
Rmarket RFR
Rsmall - Rbig
Rhigh book to value R low book to value
Pastor-Stambaugh model: adds liquidity factor to FF model
Chen-Ibbottson: ERP = (1+i)(1+REg)(1+PEg)-1+Y-RFR
Terms in order: inflation forecast, growth in real earnings, growth in market PE ratio, yield
on index
Yield on index=dividend and reinvestment income

g real earnings=GDP-inflation

E(Inflation) forecast = (1+ YTM 20 yr t bond)/(1 + YTM 20 TIPS) -1

BIRR (Burrmeister, Roll, Ross) model (factor x Sensitivity to that factor):
RFR + 1) Confidence Risk: unexpected change in difference between return of risky corporate
and gov bond
2) Time horizon risk: unexpected change in diff btwn return of LT gov bonds and ST gov
bonds
3) inflation risk: unexpected change in lvl of inflation
4) Business cycle risk: unexpected change in level of real business activity
5) Market timing risk: equity market return not explained by other 4 factors
Build up method (betas are hard to find, also consider premiums and discounts for
control, marketability):
Return= RFR + ERP +Size Premium + Company specific premium + Industry Premium
Smaller companies have larger size premiums
Bond Yield Plus Risk Premium (BYPRP) = YTM LT debt + RiskPremium (associated with owning equity
investment over debt)

YTM includes: real int rt, inflation, default risk premium

Gordon Growth Equity Risk Premium = (divd yield) + earnings growth RFR = D/P + g earnings - RFR
Adjusted (Blume method) adj = (1/3)+(2/3) = 0 + 1
Beta Leveraging: 1 + [(1 Tax Rate) x (Debt/Equity)] OR (1+D/E)
Porters 5 forces: threat of entry, power of suppliers, power of buyers, threat of substitutes, rivalry
among existing competitors.
Short term fleeting factors: industry growth rate, technology, innovation, government
Picking Corporate Strategy:

Page 21 of 44
Less Malleable

Less Predictable
Adaptive quick and efficient to change

More Malleable

Sharing influence industry to further interests,

network of buyers/suppliers define new market,
goods/services, lobby
Return on Invested Capital (ROIC) = NOPLAT / Invested Capital

More Predictable
Classical- Plan for best market
position
Visionary- high risk, disruptive

Invested Capital = Op. Assets Op. Liabilities

Return on Capital Employed (ROCE) = EBIT/Capital Employed

Capital Employed = Debt Capital + Equity Capital

DIVIDEND (minority non controlling perspective)

Inflection point: fundamental change in economics where previous trends arent likely to continue into
future
Two-stage dividend discount model:

V 0=

D0 (1+ g s)t
(1+r )t

D0 ( 1+ g s )n (1+ g L )

( 1+r )n (r g L )

Excess short term growth

The H-Model:

V 0=

D0 (1+ g L ) D0 H (g sg L ) D 0 ( 1+ g L ) + D 0 H (g sg L )
+
=
Growth rate declines linearly
(r g L )
(rg L )
(r g L )

D0

( 1+ g L ) + H ( gs g L ) ] + g L
r
P0 [

( )

n = length of supernormal growth

gs = Short term supernormal growth rate
gL = Long term sustainable growth rate
H = Half-Life = 0.5 times the length of the short term/ high growth period
SUSTAINABLE GROWTH RATE
ROE = ROA x equity multiplier(E/A)
g = Retention Ratio (b) x ROE
b = (earnings dividends) / earnings

g=PRA T =ProfitMargin x Retention x AssetTurnover x L everage

EPSDPS
Rev
Assets
g= x
x
x
Rev
EPS
Assets Equity

Stock price = (no-growth earnings

forecast

/ required return) + PVGO

financial

Page 22 of 44
PVGO = Stock price (earnings/required return)
Free Cash Flow
FCF Firm (FCFF) =

FCF Equity (FCFE) =

FCFF Int(1-taxRT) + Net Borrowing
NI + NCC FCInv WCInv + Net Borrowing

NI + NCC + Int(1-taxRT) FCInv WCInv

EBIT(1- taxRT) + Dep FCInv - WCInv

EBIT(1-taxRT) Int(1-taxRT) + Dep FCInv WCInv + Net

Borrowing

EBITDA(1-TaxRT) + Dep(taxRT)
FCInv - WCInv
CFO + Int(1-taxRT) - FCInv

EBITDA(1-TaxRate) Int(1-TaxRate) + Dep(TaxRate) FCInv WCInv + Net

Borrowing

CFO - FCInv + Net Borrowing

NI (1 Debt/Assets) x (FCInv Depex) [(1 Debt/Assets) x WCInv]
*forecasting

1
Add back: preferred dividends to FCFF

Debt
[ FCinv + NWCinvdep ]
Assets

*easier to remember

Add back: net issuance of preferred stock to FCFE

NCC = Depreciation + Amortization + Impairment + Reversal of income from restructuring

Adj. to NI to get FCF
IFRS
GAAP
Dep & Amort
Add back
Restructuring exp
Add back
Restructuring income Subtract
(reversal)
Losses from sale
Added
back
Gains from sale
Subtracte
d
Amort LT bond
Added
discount
back
Amort LT bond
Subtracte
premium
d
Deferred tax
Added
(only if tax exp can be
back

Net borrowing = debt issues (raising capital) Principal

payments
CFO = NI + D&A gain on sale of equipment
FCInv = CapEx Proceeds from sale * excludes depreciation in
FCF calcualtion

WCInv = CA(excl. cash) CL(excl. ST debt)

Preferred stock like debt except preferred dividends not tax
deductible like interest payments

deferred indefiniately, no
cash is leaving)

CF
Treatme
nt
Interest
Received
Interest Paid
Dividend
Received
Dividend
Paid

CFO
CFI
CFO
CFF
CFO
CFI
CFO
CFF

or

CFO

or

CFO

or

CFO

or

CFF

EBITDA not good proxy for FCFF and FCFE. EBITDA is looking at debt repayment strength, doesnt
consider WCInv, FCInv. Look at relationships in FCF and EBITDA derivation to see specifics.

Page 23 of 44
Market Comparables
EV = MV eq + MV Debt +minority interest + preferred shares cash & ST investments
(# preferred shares) x (Common Share Price)

Enterprise value ratio denominators:

Market Ratios

b = retention ratio = (EPS - DivPerShare)/EPS

Leading

P 0 P0 1
D1 1 D1 / E1 (1b)
=
=
=
=
E1 1 E1 r g E 1 rg
r g

Trailing

P0 D 0 (1+g) / E 0 (1b)(1+ g)
=
=
E0
rg
r g

( )

* (1+g) multiplied b/c it negates next periods earning to current

P0 (E 0 /S 0)(1b)(1+ g) Profit Margin x Payout Ratio(1+ g)

p
=
=
=net profit argin x justified trailing
S0
rg
r g
e
P0 ROEg
=
B0
rg
P (1+ g)
=
CF (rg)

B0 = book value of equity = (assets - liability) preferred stock

** P/CF and D/P are the same but flipped

D 0 r g
=
P0 1+ g
P
Price
=
BV Book Valueof Equity

= BVPS = Common Stock + Additional paid-in Capital + Retained Earnings ()

Treasury Stock + Accum. OCI

Fed Model P/E = 1/(10 yr t-bond yield)

Yardeni model P/E= 1/(A rated corporate yield 5 yr earnings growth forecast)

RESIDUAL INCOME MODEL

Total Invested Capital

= Net Working Capital + Net Fixed Assets
= BV LT Debt + BV Equity
Where NWC = CA (excl. Cash&STinv) % CL
(excl. ST debt)

Page 24 of 44
RI TO EQUITY HOLDERS
Residual Income = NI Equity charge
Equity charge = Req X BVequity
RI TO ALL CAPITAL HOLDERS
EVA
= [EBIT(1-TaxRate)] (WACC% X Total invested capital)
= NOPAT - $WACC
Residual income = After Tax Operating Profit Capital Charge
= (ROIC - WACC) x Total Capital(Assets)
Capital Charge
= Equity Charge + Debt Charge
= Req x BVequity + Rdebt x Debt Capital x (1-tax)
BVt = BVt-1 + earningst-1 Divdt-1

MVA

= Market value of the company Book Value of Invested Capital

=([shares x stock price] + [% of par debt]) (BV eq + BVdebt)

V 0=B0 +

RI Value of the firm:

Single Stage RI ,V 0 =B 0+

g=r

B 0 x (ROEr )
V 0B0

RI t
E r B t1
( ROEt r )Bt 1
=B0 + t
=B 0+
t
t
(1+r )
(1+r )
(1+ r)t

(ROEr)
B0 RI: residual income
r g

E:earnings

r:req rt

B:bookValue/share

if ROE > required return value > stock price & P/B justified > P/B

Tobins q = Market value of debt and equity / Replacement cost of total assets
Multi-State Residual Income Model
V0 = B0 + (PV of future RI over the short-term) + (PV of continuing RI earnings / re ; perpetuity)

(ROE tr) B t PT BT
V 0=B0 +
+
(1+ r)t
(1+r )T

PT is the terminal stock

price

Persistence factor () :
Strong persistence factor
persists forever
Weak persistence factor

=1 : low dividend payout (firm is retaining money to grow company), RI

=0 : high ROE

(nonrecurring items, high accounting accruals make these relatively

high returns unsustainable)

Terminal value
T 1

V 0=B0 +

T =1

Et r Bt1
t

(1+r )

E T r BT 1
(1+ r)(1+ r)T 1

PV ( continuing residualincome year T 1 )=

PV(continuing residual income in yr T-1)

RI t
1+r

ROE declines to cost of equity over time due to competitive market, so RI goes to zero
RI appropriate when terminal value is uncertain and when clean surplus relationship holds

Page 25 of 44
Clean surplus relationship:
Ending BV = Beginning BV + net income dividends
Violated when currency translation g/l skips I/S go straight to equity
Total invested capital (TIC) = MV debt & equity (incl. cash & ST investments)
Unexpected Earnings Surprise = Actual EPS E(EPS)
Standardized unexpected earnings (SUE) = Earnings surprise (return-predicted)/ earnings surprise
earnings surprise is the scale by measure of the size of the historical errors or surprises

Simple harmonic mean=

n
1/x i

Weighted harmonic mean=

1
wi /x i

w is weight, x is ratio (P/E, P/B )

Private Firm Valuation:

Capitalized CF method: Value of invested capital = FCFF1 /(WACC g) + MV debt Capital
Private Company Comps:
Guideline Public Company Method (GPCM)
- Public company ratios adjusted for risk & growth, & co. specific
Guideline transactions method (GTM)
- Multiples from acquisitions of entire firms, includes control premiums
Prior Transactions Method (PTM)
- Sale of stock in subject private company (usually for non controlling stakes)
Excess earnings method:
RIintangibles = Normalized earnings (rWC) x (WC) (rfixed assets) x (fixed assets)
Vintangibles = RIintangibles/ (rintangibles)
MV invested capital = Working Capital + Fixed Capital + Intangibles
DLOC = 1 (1/(1+ control premium))
Total discount = 1 [(1 - DLOC)(1-DLOM)]
OR
Transaction value = pro rata control value x (1- DLOC)(1-DLOM)
DLOM estimated using restricted share vs publicly traded share prices, pre-IPO vs post-IPO prices and
put prices. The advantage of using put prices of the other 2 DLOM estimation methods is that
the estimated risk of the firm can be factored into the option price.
ALTERNATIVE INVESTMENTS
Real Estate:

(insurance, utilities, maintenance **interest and tax are NOT

included)

NOI = Rental Income + Other Income Vacancy&Collection Loss Operating Expenses

Potential Gross Income

Effective gross income

NOIforecast = trailing NOI non-cash rents + adj for full impact of acquisitions + growth in NOI
All risks yield = rent1/Value0 all risks yield is used when tenants are required to pay all expenses (NNN) and when growth in rents and value are
expected from property

Cap Rate = Discount rate Growth Rate

Years purchase = (Cap Rate)-1 = years of current income to equal original purchase price
Direct Cap Value = NOI0/CapRate
CPT: I/Y Levered IRR
Terminal Value = NOIterminal / Cap rateterminal
PMT = Dividend = NOI Int Pymts
Gross income multiplier = Sales price / gross income
Equity Dividend Rate = (CF1st yr = NOI Int Exp)/Equity PV = -equity investment = -[1-LTV]*(value

( 1+ g )
0 ( 1+ g ST )
r g
Dividend Method=
+
t
( 1+r )
( 1+ r )T
t

of building)
FV = Sales Price Outstanding Loan
N = #yrs

Page 26 of 44
Cost approach for RE:
+ Land
+ Replacement cost of building = (replacement cost + developers profit)
x SqFtComp like Subject
Adj to make
+ Current cost to construct building (to current standards)
Property
- Physical deterioration = (effective age / economic life)
Sales Comp (inverse):
Curable Deterioration
Adj ratio for undesirable target
Incurable physical deterioration (depreciation charge) traits
t.depreciation
= (replacement cost curable deterioration) x (Effective age/t. economic life)
- Functional obsolescence (not intended for current use) = new cost/cap rt
- External obsolescence (locational, economical)
FFO = Accounting Net Earnings + Dep + Deferred Tax Charges + (-) losses (gains) from sales of
property and debt restructuring
*Continuing operating income

AFFO = FFO non-cash rent maintenance CAPEX & leasing costs

*better representation of economic income

NOI
+ MV other assetsMV Liabilities
( A)FFO
Price
Price NAV
Cap Rt
x
multiple =
=
=NAVPS=
Share
Share Share
Shares
( A) FFO
NAV = NOI1/CapRt + Assets Liabilities (*no goodwill, no deferred taxes)
Adj NOI = NOInoncash rents+adj for impact of acquisitions + growth(1+g)
NAVPS = (NOI/CapRt + MV other assets MV Liabilities)
ROEC has more flexibility to invest and retain income
REIT has highest income yields and payout ratios, lower corporate taxes, distributions are divided by:
taxable income, capital gain, return of capital(more favorable)

Venture Capital
Future value of VC investment = (Initial investment) x (1 + IRR rate)Years

VC ownership =

FV (VC investment )investment amount

exit value

Exit value = Investment cost + earnings growth + inc price multiples + reduction in debt

shares required for fractional ownership= shares by founder

VC Ownership
( 1%VC
Ownership )
VC shares

...based off this ratio to calculate VC shares and VC %... VC Owned

foudners shares
founders owned

Price = Initial investment / # shares required for fractional ownership

Adj
discount rate =
POST2 = FV / (1 + r)N
POST2 (Compound) PRE
3
(1+r)/(1-q)
where q is
POST2 =PRE2 + INV2
POST 2 (Disctount) PRE3
the
%
failure
rate
Private Equity:
Committed capital: amt from investors propmised to GP
Paid in capital..
= invested capital , received from investors to GP

Page 27 of 44
PIC.
= capital called down
Distributed to PIC (DPI) = distributions / PIC ( LP capital called down) *cash-on-cash return
Residual value to paid in (RVPI) = NAV after distribution / PIC ( LP capital called down) *unrealized
return

TVPI = DPI + RVPI

=( distributions + NAV after distribution) / PIC ( LP capital called down)
NAV before distributiont = NAV after distributiont-1 + Capital called downt mgmt feest +
operating resultst
NAV after distributiont = NAV before distributiont carried interestt distributionst
Carried interest . = (NAV before distt committed capital) x (carried interest %)
Tag along drag along: mgmt. may buy/sell stake if PE firm sells
Ratchet: mgmt or LP can increase its equity allocation depending on performance
Carried interest: GP profits from performance
Distribution Waterfall: diff investors get paid out based on hierarchy priority
Hedge Funds: Adding hedge funds will cause STD to increase, Sharpe to decrease, negative skewness and positive kurtosis

Commodities:

F0 = S0 e(RFRc + U - Y )T
t

*continuously compounded

F0 = S0 (1 + RFR) - FV(Benefits) + FV(Costs)

*discrete

U = Storage costs, Y=convenience yield benefit of holding asset

Backwardation: futures< spot
Normal Backwardation: futures < E(future spot rate)
T. Commodity Return =
Spot return
cheaper to replace
+ Roll Return (Replace maturing with new contracts. Backwardation: + roll return, Contango: roll return)
+ Collateral Return (Posted collateral returns invested in t-bills)
+ Rebalancing Return (portfolio rebalancing adjustment by keeping same proportion of assets
in portfolio)
Insurance perspective: long commodities will earn + returns for supporting short hedgers
Hedging Pressure Hypothesis: risk premium earned on other side of heavy long/short
Theory of storage: difficult to store commodities. Positive convenience yield
Convenience Yield: monetary benefit of holding asset vs holding futures contract
Convenience yield is high: spot , futures & inventory is low

FIXED INCOME
Structural models of corporate credit risk: looks at BS and option of A=L+E. Default risk is constant.
Doesnt change for business cycles or changing economic variables. Assumptions: B/S is simple with
only one class of zero-coupon bond, asset is actively traded on frictionless market, RFR is constant.
Reduced forms: impose assumptions on output of structural models. Perform better than structural
models because they impose assumptions on structural models Assumptions: Theres a 0 coupon
liability traded on the market, RFR is stochastic (random, not constant), default risk depends on the
economic conditions which depend on non-constant variables varies w/ business cycle.
Max amt bond holder wants to pay for insurance to remove credit risk = EL = ParDebt[1-e -LGD x (default
intensity) x (time to maturity)
]
Expected Loss = ParDebt x N(-e2) Asset x eE(return on assets) x time to maturity N(-e1)
PV(Expected Loss) = ParDebt x e- RFR x time to maturity N(-d2) Asset x N(-d1)
If PV(EL) > EL then risk premium dominates time value discount
Segmented mkts theory: yields on curve represent supply and demand. So yields dont reflect spot
rates or liquidity premiums.

Page 28 of 44
Preferred habitat: preferred maturities of investors, if premiums for other maturities are large enough
they will invest
Key Rate Calculations
For a given change in the yield curve, each rate is multiplied by the associated key rate duration. The
sum of those products gives the change in the value of the portfolio. If only the 5-year interest rate
changes, then the effect on the portfolio will be the product of that change times the 5-year key rate
duration. *remember when rates go up, Bond value goes down
Z-Spread: Zero volatility-spread is added to every treasury spot rate to make DCF of ABS, MBS equal
to its market price. There are multiple treasury spots, only 1 z-spread. Z-spread considers only 1 path
of interest rates: the current US treasury term structure. Not suitable for bonds with embedded
options b/c zero interest rate volatility options are meaningless
OAS: is added to each & every path in an interest rate tree. OAS is best used for embedded options
that are sensitive to changes in interest rate volatility (like MBS). OAS captures credit and liquidity
risk, removes option risk. You want bigger OAS relative to effective duration because it implies lower
price. OAS & ED should have positive linear relationship (eg. Lower OAS (return) for lower duration
(lower price sensitivity to interest rates) is acceptable trade off).

OAS > 0
OAS = 0
OAS < 0
*Cheap

Treasury Benchmark
Sector Benchmark
Rich if actual OAS < required OAS
Rich if actual OAS < required OAS
Cheap if actual OAS > required OAS
Cheap if actual OAS > required OAS
Rich
Rich
Rich
Rich
means the bond is undervalued, rich means the bond is over valued

Issuer-Specific
Cheap
Fairly Priced
Rich

Spreads represent these risks when compared to various benchmarks

All of these include model risks (parameter assumptions)
Treasury Benchmark
Bond Sector Benchmark
Issuer Benchmark
Nominal
Credit risk relative to
Credit risk relative to sector
Liquidity risk to other
spread
treasuries
Liquidity risk relative to sector issuers securities
Liquidity risk relative to
Option risk
Option risk
treasuries
Option risk
Z-Spread
Credit risk relative to
Credit risk relative to sector
Liquidity risk to other
treasuries
Liquidity risk relative to sector issuers securities
Liquidity risk relative to
Option risk
Option risk
treasuries
Option risk
OAS
Credit Risk relative to
Credit Risk relative to sector
Liquidity risk to other
treasuries
Liquidity risk relative to sector issuers securities
Liquidity risk relative to
treasuries
*When comparing z-spread and nominal spread will not reflect credit risk because credit risk of the
issue and the issuer benchmark is the same.
Find value of portfolio when theres a parallel shift
1. Calculate effective duration for each bond
a. Add up each duration for each bond
b. Multiply each duration by its corresponding bonds weight
c. Sum them to get portfolio effective duration
2. Value of new portfolio = (value of old portfolio) (% change) x (effective duration)
FCF = CFO CAPEX DIVD
2
% Return impact = (Duration Spread) + (1/2) (Convexity) Modified
(Spread)
relates to option-free bonds as they
assume CFs from bond cannot change.
Effective is used to value bonds with and
without options as CFs may change. CFs

Page 29 of 44
Effective Duration = (V- V+) / (2V0(y))
Effective Convexity = (V- + V+ 2V0) / (2V0(y)2)

Effective convexity computed using binomial model: the yield curve is shifted upward and downward
in parallel manner and binomial tree calculated each time. Resulting bond values are used to compute
effective convexity.
I spread: Risky bond yield swap rate for the same maturity
-represents credit and liquidity risk
TED spread: indicates commercial bank lending risk, perceived credit risk in economy
LIBOR treasury rate
LIBOR-OIS: Liquidity in money market securities
LIBOR(credit risk) OIS (overnight index swapfederal funds rate. Very little credit and
counterparty risk)
Low: high market liquidity
High: unwilling to lend because of concerns over credit and liquidity
Swap rate: liquid, flexible and efficient for hedging
Swap rate determination: EX find swap fixed rate for a three year interest rate swap
1) Spot1, Spot2 Spot3 are given
2) Find CouponRt3 this is the swap rate for 3 yr IRS

CouponRt 3 CouponRt 3 CouponRt 3

1
+
+
+
=1
1
2
3
3
(1+ Spot 1 ) (1+ Spot 2 ) (1+ Spot3 ) ( 1+ Spot 3)

Term Structure Models:

Equilibrium term structure models: looks at factors that drive term structures, have a drift term
Cox Ingersoll Ross (CIR) Model: uses ST int rt to determine the entire term structure of interest rates. Int rts
cant be neg
Has Deterministic (drift to mean reverting level) and stochastic (random interest rate volatility)
components
Vasicek Model: Similar to CIR but assumes that interest rt volatility is constant. Possible for int rts to be neg
Arb free model: takes market prices then works back to derive yield curve including random drift term
Ho-Lee: Uses binomial lattice, time dependent drift inferred from market prices, uses relative valuation of BSM
model

Convertible Bonds
CB limit downside risk due to price floor set by straight bond value and reduced upside potential due
to conversion premium of stock. *differentiate between par and market price, conversion ratio stays
the same regardless
Minimum market price of Convertible bond = Max (PV straight bond, Stock x conversion ratio)

FIXED INCOME: STRUCTURED PRODUCTS

+Scheduled principal payment = balance prepayment/SMM
+prepayment
+net interest = balancebeg x pass through rt/12
=Payment to Security Holders
PSA (public securities association) prepayment mode

CPR=6 x

seasoning PSA
( months
) 100
30 months

SMM = 1 (1 CPR)1/12

Monthly Prepayment amount = SMM x (MortgageBEG Monthly principal pymt)

Monthly principal pymt = interest pymt mortgage beg x(coupon/12)
Interest pymt::: PMT..PV=initial principal, FV=0, I/Y=coupon/12, n=#months remaining

CPR = yrly, SMM = monthly. They are prepayments as % available from last month
Monthly servicing fee = (WAC passthrough rate)/ 12
For ABS auto loans:
||

1 [|x|(m1) ]
, WHERE: ABS = absolute prepayment speed (*confusing), m = # months since
SMM Autoloans =
origination
CDO types
Arbitrage driven CDO: take advantage of spread between the return on collateral and funding costs
Cash flow CDO: principal and interest payments can pay tranches
Market value/Balance Sheet CDO is actively managed to generate sufficient cash flows
Term structure:
Pure expectations: forward rates are unbiased predictor of future expected rates
Yield volatility:

Annualized std= days= daily , daily = Var

2

Variance=

( x t x )
N 1

, xt =100 ln

yt
, y t = yield
y t 1

( )

With what spread to

use
Nominal Spread

Type of bond to analyze

OAS: binomial

OAS: monte carlo

Bonds with put or call options,

prepayment options (not
interest rate dependent)
Home equity ABS, MBS

Z-Spread

ABS with no prepayment

None: simple CF
model

ABS credit cards

Valuing MBS and ABS:

Reasoning
Doesnt capture prepayment risk, it
captures inflation and interest rate risk
Bonds can either be put or call so
theres 2 ways a price can go
Interest rate path dependent because
prepayment option affects price (when
interest rates go lower, the bond is more
and more likely to be called)
Only one interest rate path, no
prepayment option. Value is PV of CFs
discounted @ spot rates + z-spread
ABS credit cards arent amortizing
because the pool constantly changes

CF yield comparison to YTM:

Bond equivalent yield = 2[(1 + monthly CF yield)6 -1]
Method
Description
Drawbacks, notes
Cash Flow Yield
Rate of return that makes CFs =
Reinvestment risk, price risk as security
Market price
might be sold prior to actual maturity,
prepayment risk
Nominal spread
CF yield Treasury YTM. Part of this
We dont know how much of spread
spread represents compensation for
represents prepayment risk. Assumes
taking on prepayment risk of MBS
prepayment rate is the same which is
unrealistic
Zero-volatility
1 spread added to each and every
Only considers one path of interest rates
spread
treasury spot rate. To make DCF for
(treasury spot rate curve). Assumes
(z-spread)
MBS or ABS equal to price
security will be held til maturity which is
unrealistic.
OAS = z-spread
OAS added to treasury spot rate along Higher volatility, lower the OAS
option cost
each and every path in an interest
OAS takes into consideration the change
rate tree. This is used for bonds with
in CFs from embedded option. Z-spread
embedded options that are sensitive
does not.
to changes in interest rate volatility
(MBS- prepayment).
Monte Carlo
1) Simulate interest rate paths and
Monte carlo good for valuing MBS b/c it
Simulation
CFs from assumptions about
can model multiple interest rate paths
benchmark rates, rate volatility,
which affect prepayment risks.
refinancing spreads and
Path dependency:
prepayment rates
1. Prepayment burnout. If youve
2) Calculate PV of 1000 interest rate
already refinanced youre less likely
paths
to do again

3) MBS price = average of all prices

4) Calc OAS that makes theoretical =
MV
5) Option = z-spread - OAS
Backward induction. CF that is
discounted = min(call price,
theoretical value)

Binomial Model

2. Prepayment amount depends on

principal, history and interest rate
paths

Uses only 1 interest rate at every node

Value of CFs is independent of the path
of interest rates followed up to that point
making it good for valuing callable bonds
as they only have one path
Z-spread and nominal spread converge as avg life decreases. Difference between z-spread and
nominal spread increase as slope of yield curve increases.

DERIVATIVE INVESTMENTS: FORWARDS AND FUTURES

Which day count to use:
360 (simple interest): LIBOR (caps, floors, swaptions), FRA, Swaps, T-Bills
bonds, currencies, options

365 (compound & continuous interest): Equities,

Forwards:
Forward price is determined at contract initiation. It is the price that makes the contract value
zero and depends on current interest rates through the cost-of-carry calculation
Forward price is fixed for the life of the contract so the contract may accumulate either a positive or negative value to
long or short as the forward price for new contracts changes over the life of the contract

Forward Contract

Currency Forward (no arb) (foreign in terms of

domestic)

Forward Price = Spot0 (1+r)T

Value of long = Spott [Forward / (1+r)tr]
Value of short = [Forward / (1+r)tr] Spott
** Value of short is simply value of long terms
switched
Equity Forward Contracts
Forward Price = [Spot0 PV(Divd)](1+r)T
= Spot0(1+r)T FV(Divd)
***dividends are subtracted because derivative
holder forgoes dividends in lieu of holding actual
security

Value of Long = [Spott PV(Divd)] [Forward /

(1+r)tr]
Equity Forward (cont compound Divd on
equity indices)
Continuous Forward Price = Spot0 x e(rc - c)T
Value of Long =

St

( )(
e

c ( tr )

Forward
e rc (tr )

(1+ R Dom )T
Forward Price=Spot 0
(1+ R For )T
T

Ex: $ for Euro

, Spot

(1+ R USD)
T
(1+R EURO)

Currency Forward (prior to maturity)

Value of Long=

Spot t
tr

(1+ R For )

][

Forward
(1+ R Dom )tr

Currency Forward (Continuously Compounded)

Continuous Forward Price = Spot0 x e(rcDC - rcFC)T

Fixed Income Forward Contracts

Forward Price = [Spot0 PV(coupons)](1+r)T
Spot
Forward
Value of Long= ( rcFC )ttr ( rcDC )tr
= (Spot 0)(1+r)T FV(coupons)
e
e
Value of Long = [Spott PV(coupons)]
tr
Forward/(1+r)
@expiration: spot = futures price
Where T is total time from inception to maturity, tr is time REMAINING until maturity, t represents
time that has passed

][

RC and c are continuously compounded RFR and dividend yield

compounded: Rc, c = ln(r)

Convert to continuously

If you think asset price will enter into a forward contract to buy asset (at lower price)
If you think asset price will enter into a forward contract to sell asset (at higher price)
Dividend and Coupon treatment Example
Time (days)
0 = Inception
Day 30, Divd1= $1.2
Maturity

Day 100, Divd2= $1.4

Day 150

Where g is
the # of
days after
initiation

$ 1.2
$ 1.4
PV =
+
(30g)/ 365
(1+r )
(1+ r)(100 g)/365

FV =$ 1.2(1+ r)(15030g )/ 365 + $ 1.4(1+ r)(150100g)/365

FRA:
3 x 9 FRA: 6 (m) month libor rate, 3 (h) months from now
h = expiration in 90 days h+m m =9mo 3 mo = 180-Day LIBOR
0 (Today)

g= days that have passed

h=expiration

h+m

Buy FRA effectively long loan contract price Sell FRA effectively short loan contract price
IF Floating rate > contract rate
IF Contract rate > floating rate
Long borrows @ below market rt & gets paid Short loans @ below market rt & gets paid

FRA @ Initiation:

FRA=

( h+m
360 )
360
1 (
m )
h
1+ L ( h ) (
360 )

1+ L0 ( h+m )
0

FRA on day g:

Value of long=

1
hg
1+ L g ( hg )
360

( )

][

1+ Forward 0

1+ Lg ( h+mg )

( 360m )

mg
( h+360
)

*Value to short is just the

negative of the value to
long

FRA long payoff @ Expiration

days loan term

360

( Current Market LIBOR rateOld FRA rate )

1+[ rt ( of daystheloan term/360)]
NP

*int rt = spot rate @

expiry

FRA long payoff before expiration

( Current Forward RateOld FRA rate )

days loan term

360

1+[ Libor(date total ) ( of days until FRA expiration+ daysloan term /36
NP

*Switch orange part to find payoff to SHORT

Futures:
The value of a futures contract is zero when the account is marked-to-market and there is no margin call. The price of the
contract is adjusted to the new no-arbitrage value, which is theoretically the same as the settle price at the end of trading, as
long as price change limits have not been reached

Futures prices will be unbiased predictors of future spot rates

Futures Contract = Spot (1+RFR)T + FV(Costs of holding) FV(benefits from holding) *FV values are
straight , not discounted

Costs increase the price of a futures contract b/c buyer skips out on those costs by buying a
futures contract instead of the underlying asset. Which include: storage costs
Benefits decrease the price of a futures contract b/c the buyer skips out on those benefits by
buying a futures contract instead of the underlying asset. Which include: dividends, cash flows,
convenience yield
Contango: If costs of carry are greater than benefits then futures price are greater than the spot price
Backwardation: If costs of carry are less than benefits then future price is less than spot price
Normal contango: Futures price > Expected Future spot rate
Normal backwardation: Futures Price < Expected Future spot rate
Traders want normal backwardation because they can enter into contract to buy in future @ lower price

Convenience Yield:
If convenience yield> borrowing rate, futures price is below spot price and market is in
backwardation. It means that the value of the convenience of holding the asset is worth more
than the cost of funds to purchase it. The no-arbitrage cost-of-carry model will not apply. This
applies to non-financial futures contracts.
Futures vs forwards
Futures are marked-to-market forwards are not. Futures contracts trade on exchanges, no
counter party risk (margin requirements by clearing house). If mark to market is preferred then
futures price > forward price.

Differences between theoretical (no-arb) prices of forwards and futures:

If asset prices and
Preferences based
interest rates
correlation is:
Positive
Prefer long in futures contract to have market to market features.
Futures price > forward price. When asset increases and mark to market contract
generates cash, reinvestment opportunities tend to be better due to positive correlation of asset
values and higher interest rates. Gains from adjustments can be invested at higher level, while
losses can be financed at lower costs.

Zero
Negative

No preference
Prefer long in forwards contract to avoid mark to market. Gains from
adjustments are invested in lower level, while losses must be financed at a
higher cost
Value of futures contract = current futures price price when previously marked to market
Contracts marked-to-market, contract=0 @ end of trading day, contract only has value during
trading day.

DERIVATIVE INVESTMENTS: OPTIONS, SWAPS, INTEREST RATE

DERIVATIVES
Call + X/(1+r)T = Put + Stock
PUT_CALL PARITY
Fiduciary Call = Protective put
Sensitivity of option
price to
Underlying Price

Greek

AND

CREDIT

Call + [X Forward]/(1+r)T = P

Call Options

Put Options

Delta

Positive Delta: higher

Negative Delta: higher
underlying value higher call underlying value lower
value
put value
Exercise Price
Higher exercise price, lower
Higher exercise price, higher
call value
put value
RFR
Rho Positive Rho: higher RFR
Negative Rho: higher RFR
slightly higher call value
slightly lower put value
Time Decay
Theta Negative Theta: call value
Negative Theta: put value

decreases with passage of

decreases with passage of
time
time
Price Volatility
Vega
Positive Vega: when volatility
Positive Vega: when
increases call value
volatility increases put
increases
value increases
Binomial Option Pricing Model
Call Options:
Stock up = S+ u= S+/S
Call value up = C+ = Max[0, S+-x]
Stock down = S
d= S-/S
Call value down = C- = Max[0, S--x]

( 1+r )d

Risk Neutral Probability up-move up= ud

Risk Neutral Probability down-move =

C
(1+r )
up C
c=

++ down
Value of Call =

down=1 up

2
( down)( up )C C

(1+ r)2
+++( up)( down )C
( up)2 C
Value of 2 period call=

Put Options:
Everything is the same as above except calls replaced with puts for:
Put value up = P+ = Max[0, x- S+]
Put value down = P- = Max[0, x- S-]

Delta Hedging: *dynamic hedge b/c it must constantly be rebalanced

Delta is change in price of an option for a one-unit change in the price of an underlying security
Call option hedging
Put option hedging
Delta calculation
C
P

+S=

+S=

S
C
+
C
delta call=

, will be positive

DeltaPut= DeltaCall-1

DeltaCall = DeltaPut+1

# options to hedge

shares underlying
Hedged Calls= be hedged

S
S
P
, will be negative
+
P
delta put =

deltacall

shares underlying
Hedged Puts= be hedged

deltaPuts

Option is
overpriced

Call optionmarket > call option

Sell options, buy shares

Option is
underpriced
Portfolio Cost

Call optionmarket < call option intrinsic

Buy options, sell shares
= [# shares]*[Stock0]-[# calls]*[call
val0]
= (ns)(S0) (nc)(C0)
Portfolio value in up move:

Put optionmarket < Put option intrinsic

Buy options, buy shares
= [# shares]*[Stock0]-[# puts]*[put
val0]
= (ns)(S0) (nP)(P0)
Portfolio value in up move:

Portfolio value in down move:

Portfolio value in down move:

(buy is outflow, sell is

inflow of cash)

Portfolio value

*up and down move

portfolio value will be
the same

intrinsic

[# shares]*[Stockup]-[# Calls]*[Call valup]

= (ns)(S+) (nc)(C+)

[# shares]*[Stockdown]-[# Calls]*[Call valdown]

= (ns)(S-) (nc)(C-)

Profit
Hedge Ratio = H =
nS-C
Effect on option

Portfolio Value Portfolio Cost

Portfolio Hedged if: H-=H+
which means:
Call delta = N(d1) > 0 Call price

Put optionmarket > Put option

Sell options, sell shares

intrinsic

[# shares]*[Stockup]-[# puts]*[put valup]

= (ns)(S+) (nP)(P+)

[# shares]*[Stockdown]-[# puts]*[put valdown]

= (ns)(S-) (nP)(P-)

nS+-C+ = nS+-CPut delta = [N(d1)-1] < 0 Value ,

value if stock price

changes

N(d1) x S
Value , as stock

as stock
Put price [N(d1) -1] x S

Value of American style call option = Euro style. If

underlying doesnt pay dividend, it is never
optimal to exercise the American option early.
DELTA
SIZE IS:
Option

t maturity. Effects
Range

Far out the money

Call
0 to 1
Close to 0
Put
-1 to 0
Close to 0
*the closer the delta is to 0 the more options are
required to hedge

Far In the
money
Close to 1
Close to -1

As price increases
Call Increase from 0 to 1
Put Increase from -1 to 0

Gamma: measures sensitivity of delta to changes in the price of underlying Gamma = delta/price
of underlying
Large (bad) when option is at money and close to expiration (more sensitive). Option value more
sensitive to changes in stock lead to large changes in delta and have frequent rebalancing of
dynamic hedges.
Small (good) when option is deep in or out the money (not sensitive) b/c changes in stock dont
affect . Dynamic hedge will perform well

Black Scholes Merton:

Assumptions: price has lognormal distribution, RFR & Volatility is constant known, no
taxes/transaction costs, no CFs from underlying asset, options are European.
Computing implied volatility requirements: RFR, asset price, time to expiry, strike price, market price
of option

INTEREST RATE DERIVATIVES

Cap is series of caplets. Floors are series of floorlets. (multiple interest rate options that can be
exercised periodically)
Interest Rate Cap
Interest Rate Floor
Summary
Seller pays buyer when benchmark interest
Seller pays the buyer when benchmark
rate (eg: LIBOR) exceeds strike rate. Buyer
interest rate (eg: LIBOR) falls below the
wants to limit interest expense on floating
strike rate.
benchmark rate.
Buyer
Rate > Strike (cap rate). Int Rate , Bond
Rate < Strike (floor rt). Int rt , bond
receives
Value
value
payment
Seller
Rate < Strike (cap rate). Int Rate , Bond
Rate > Strike (floor rt). Int rt , bond
receives
Value
value
payment
Equivalen
Cap buyer (long) buys call on LIBOR.
Floor buyer (long) buys Put on LIBOR
ce for
Cap buyer (long) buys long put on bond
Floor buyer (long) buys call on bond

Long

which increase in value when interest rate

and bond value .

Periodic
Payment

cap
market
rate strike .

days until pymt

notional
]
x ( principal x
360
0,

max

floor index
strike
rate.

days until pymt

notional
]
x ( principal x
360
0,

max

Caplet Value

which will in value when interest r ate

goes (bond price goes up).

Floorlet Value

Max [0, ( market ratecap rate ) x notional ]

1+market rate

Max [0, ( floor ratemkt rate ) x notional ]

1+market rate

2 year cap = 2-year caplet + 1-year caplet

Value 2-year caplet. Value right 3 end nodes (red) with caplet
value. Value 2 middle nodes (blue) by using binomial method
dividing sum of 2 50% weighted nodes from right then dividing by
corresponding int rt
Value changes for:
Short Cap
Long Cap
Short Floor
Long Floor
Option
Value
Value
price
Value
Value
price

When interest
rates
Decrease
Increase
Increase
Decrease

When interest rates

Increase
Decrease
Decrease
Increase

of call on LIBOR
of call on bond

If rts and bond price

Increases
Decreases

If rts and bond

price
Decreases
Increases

of put on LIBOR
of put on bond

Decreases
Increases

Increases
Decreases

Interest rate straddles:

Buy cap and floor: receive payments when rates rise and fall
Sell cap and floor: receive payments when rates stay within range: caplets and floorlets would
be exercised against seller if interest rates change
Interest rate collars: Buy cap, sell floor
Protect against rising interest rates, while giving up benefit from lower interest rates
Purchase of Cap protects against rising rates while the sale of floor generates option premium
income. Hedge a floating rate liability.
Collar creates band within which the buyer effective interest rate fluctuates
Reverse collars: sell cap, buy floor.
Swaps: price is fixed and is quoted as fixed rate in the swap. Volatility is constant
EX: for quarterly pymts (every 90 days)
Use original term structure at initiation

1
Fixed rate

c=

1Z n
=
Z 1 + Z2 + Z n

1
1+ R1

1
1+ R 4

[ ])
360
360

[ ] ) ( [ ] ) ( [ ]) ( [ ] )
+

90
360

1+ R2

180
360

1+ R3

270
360

1+ R 4

360
360

90 x period

1
z (n)=
1+ raten ( 360 )

Present Value Factors

Price rate= C/Principal amount

above it would be 90

annualized fixed rate = C x (360/period length) * in ex

Fixed Rate
Receiver

Profit
Mkt Rts

Loses
Mkt Rts

Floating Rate
Receiver

Mkt Rts

Mkt Rts

Equivalence
Long Interest Rate
Puts
Short interest rate
calls
Short Interest Rate
Puts
Long Interest Rate
Calls

Swap Value

Fixed payment amount = (fixed rate from above) x (360/period length) x (notional)
PV(fixed rate) = Z1(days until pymt 1) x (fixed pymt) + Z2(days until pymt 2)[fixed pymt +
notional]
*Uses new term structure
EX: originally pymts made annually, now 180 days have passed

PV ( rate ) =

1+ R180

180
360

( )

x [ payment ] +

1
1+ R1 80

540
360

( )

x [ payment +notional ]

PV(floating) uses only 1st floating payment and notional for calculation
= Z1(days until pymt 1) x [(Rate pymt 1)*(period length/360)*(notional) + notional]
Use new term structure for PV factor Use initiation original old term structure for floating pymt
EX : PV ( floating rate )=

1
1+ R 180

( 180
360 )

) [(

R0 ( 360 ) x

x notional )+notional
( 360
]
360 )

Equity Swaps:
Pay fixed, receive float: (1+ROE) x NP PV(remaining fixed rt payments)
Pay float, receive fixed: (1+ROE) x NP PV(coupon + par)
Swaption:
Payer swaption gives holder right to enter into a swap in the future as a fixed-rate payer
If swap fixed rates increase (as interest rates increase), the right to enter the pay-fixed
side of the swap (a payer swaption) becomes more valuable, when interest rates
increase bond prices fall and put options on the bond becomes more valuable.
Receiver Swaption gives holder the right to pay floating and receive fixed.

CDS:
Payout amount = (payout ratio) x (notional)
Payout ratio = 1 recovery rate
Bond spread = yield investors cost of fundingcompare w/ CDS spread
CDS asset swap spread = coupon interest rate on swap fixed
CDS spread < asset swap spread
CDS spreads are negatively related to probability of survival and recovery rate, and positively related
to probability of default and loss.
Cheapest to deliver same seniority (pari passu):
single name payoff = protection notional (par %) x (notional)
index payoff = proportional weighted notional (% of par after default) x (weighted notional)
new notional = total notional default payoff
physical settlement
Cash settlement
- Discounted/defaulted reference obligation
- Par-market value in cash
- Par value
CDS price (per $100 notional) = 100 upfront premium
Value protection leg
= credit risk, contingent payment that may be made from CDS seller to CDS
buyer in case of default
= value of RFR bond E(payoff risky bond)
Upfront payment = PV(protection leg) pv(premium leg)
If this is positive it means protection buyer must make payment to buyer b/c premiums are
artificially low
Upfront premium = [CDS spread CDS coupon] x duration
(paid by buyer)
Credit spread= upfront premium/duration + fixed coupon
Valuation after inception of CDS:
Profit for protection buyer (chance in spread %) x (duration)
CDS spread may differ from fixed coupon on CDS, so difference is paid PV(coupon-spread), Seller pays
buyer if +
Hazard rate = P(default|given it hasnt already occured)
Probability of survival =

(hazard rtt)

PORTFOLIO MANAGEMENT
Variance for 2 asset portfolio
Minimum
Variance Portfolio:
Correlation = = Cov(1,2)/1 2
Equally Weighted Portfolio Variance:
Portfolio STD of return

Maximize risk reduction:

Minimize portfolio variance> 2p 2i

1
+
n

When # of assets , Var avg

covariance
When n then

2p =Cov

Capital Asset Allocation Line (CAL):

Combines RF asset and risky portfolio to maximize reward-to-risk ratio.
Tangency point is tangency on efficient frontier

Intercept and slope of CAL depend on varied investor expectations for future.
CAL EQN

Coefficient = Sharpe Ratio=Reward to risk

ratio

Based on Graph
Borrow money at RFR and invest in risky
assets. Move on line A from bottom to top
(same risk, more return)
Lend money at RFR, earn same return but less
risk. Move on line B from right to left (same
return, less risk)

Capital Market Line (CML):

CAL where investors agree on E(returns), standard deviations and correlations of all assets.
This will make the optimal investment portfolio by allocating between the RFR and risky market
portfolio.

Similar
CML EQN ( CAL ) : E ( R A )=RFR +

E ( R M )RFR
A
M
Slope = market price of risk/reward

Weighting for Risky market portfolio

combo = Wmarket market
*market portfolio is considered risky
WRFR = 1- WMarket
*RFR portfolio is considered risk free
CAPM/Security Market Line SML:

CML VS CAPM:
If markets are in equilibrium risk & return will lie on SML, not CML. Risk & return combos for
individual securities will lie below CML b/c their include unsystematic risk which can be diversified
away
SML
CML
Measure of
Uses (systematic, market, nonUses =stand alone risk = systematic +
risk
diversifiable)
unsystematic
Application
Determine benchmark appropriate
Asset allocation btwn RF asset and risky
returns
portfolio
Definition
Graph CAPM
Graph efficient frontier
ADJUSTED
Slope
Market risk premium
Market portfolio
sharpe BETA
ratio for stability, as
it tends to gravitate towards 1
Assets systematic risk:
Adj i= 0+ ii
OR adj 1=
1/3
+
2/3

i
where i = stock, M = market

is
historical.
Not necessarily
Market Model: estimate beta
good @ predicting future.
Called instability

Ri=i+iRM+i
Market Model:
1. E(Ri)= i+i(RM)
2. i2 = i 22Mi + 2
3. Covij= i j M2
4.

Cov ij
i j

Market Model: 3 assumptions:

1) E(error) = 0
2) error, market = 0
3) Firm specific surprises are
uncorrelated

Adding new asset to portfolio is optimal if the following condition is satisfied:

These are just sharpe ratios:

E ( R new )RFR E ( R P )RFR

>
Corr ( R new , R P)
new
p

Sharpe new asset > sharpecurrent X Corrcurrent, new asset

Macroeconomic model: these models use surprises to explain equity return
Fundamental factor model: microeconomic, share-related, macro data that drive company growth
Factor sensitivities are standardized

bij =

Asset i ' s attribute valueaverage attribute value

( Attribute values)

Arbitrage Pricing Theory model:

E(RP) = RFR + 11 + 22 + +
* = Risk
Premium Factors
Less restrictive than CAPM, APT is equilibrium pricing model. Factors are risk premiums analogous to
the market risk premium in SML. APT considers multiple sources of risk. No arbitrage opportunities
exist for investors because capital market are competitive. Diversification eliminates non-systematic
risk.
Arbitrage profits set weighted factor sensitivities sum to 0. Long and short corresponding
sensitivities and find weighted expected return for portfolio and profit
Markowitz Decision Rule: when comparing 2 portfolios choose higher E(return) lower (R) ceterus
paribus
To fully hedge factor risk set combined weightings to 0 and solve for w.
Total active Return = [(portfolio sensitivity benchmark sensitivity) x factor return] + Asset
selection returns
= Factor tilts (AKA sum absolute contribution to active return)
+ individual
security return

Active risk=S ( R R )=Tracking Error= (active returns R pR b)=

P

*p is portfolio, b is benchmark

( RP RB )2
n1

(Active risk)2 = Active Factor Risk + Active Specific Risk

Active factor e.g.: risk indexes-fundamental aspects of companies (leverage, yield), industrial
categories-exposure to certain industries (binary)
Active factor risk: differences in factor sensitivities btwn portfolio and benchmark
Active specific risk: attributed to differences in the weights of individual assets between
portfolio and bench mark

Active Weight
( pb)(Residual risk asseti )2
Active Specific Risk=
Factors marginal contribution to active risk squared (FMCAR):
k

b j b i COV (F j , F i)
FMCAR j=

Active risk squared

AEF A [ AEF Acov ( A , A ) + AEF Bcov ( A , B ) ]

Active factor risk
Ex : FMCAR A =
Active risk squared
Active Risk Squared= Active factorspecific risk
**Where AEF = Active

Exposure Factor**

IR = Information Ratio (mean active return per unit of risk)

R pR b
Active return
=
active risk
s(R p Rb )

indicates pure stock selection ability and manager performance, independent of aggressiveness
(aggressiveness included in residual risk)
add stocks with highest IR

Residual Risk:

Information ratio=

Residual return
(vs benchmark ) trade off between active return & active risk
residual risk

E x post information ratio=t / n

t = t-statsitic of in the regression model
Time Factors:
n = # of years
Annual
budget constraint = = IR x bc in order to increase return u need to increasequarterly
residual risk
Fundamental Law of Active Management:
IR annual / sqrt(4)
Information ratio( IR)=IC x Breadth
Annual monthly
IR annual /
Information Coefficient (IC): forecasting skill, correlation between forecast and results
Breadth = # independent forecasts of exceptional return

Information Coefficient ( IC )=2 ( picks that are correct )1=2

IR IC x Breadth
Optimal amount of residual risk= =
=
2
2

Nc
picks correct
1=2
1
N
total picks

( )

Residual return
(vs benchmark)
residualrisk
Risk Aversion Aversion

Information ratio=

Highest Achievable Valueadded =VA

IR IR IC x breadth
=
=
2
4
4

Value Added VA = ( x 2) = IR x ( x 2) ,=risk aversion

Ex-post = realized
Ex-Ante = forecast of residual returns
Information Coefficient combining 2 sources:

IC Combined =IC

2
(1+r =correlation)

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

R= correlation btwn 2 sources of investment information
Not impressive if manager uses 1 piece of information to pick 2 different investments

Investor Policy Statement:

Willingness to take risk is based on subjective psychological factors
Ability to take risk: liquidity/spending needs, time horizon, portfolio size, tax/legal/unique
circumstances
Objectives: concerned mainly with risk and return