FINANCE 1331Core MBA Class

Can you do this? (2016)

This is a non-exhaustive list of concepts you should be familiar with for the final exam. Use it
in conjunction with reviewing course notes, homeworks, etc. to check that you have a solid
grasp of the main ideas we covered in the course.

1. You should be able to find the present value for any future cash flow stream that is any
number of periods away given any discount rate assumption and any reasonable
compounding assumption (annual, semi-annual, continuous). You should know how to
use that information to compute NPV, the price a bond, stock, or other asset by adding
together the PVs of the constituent CFs.

BONDS

2. You should understand the basic equation for finding the Price of a bond, given its Yield
OR find Yield, given its Price, and know how and when AI (accrued interest) fits into the
equation.

3. You should understand the basic principle of bid/ask spreads and that if you purchase an
asset, and immediately turn around and sell it, it will cost you a transaction cost
approximately equivalent to the bid/asked spread.

4. You should be able to price a risk-free bond using the risk-free term structure of spot
rates if it is given to you (as in the coupon stripping example). You should also
understand that this IS the proper way to price a bond (get its true price or theoretically
correct price) because all bonds in the (risk-free, government bond) economy can be
priced off of this one set of spot rates (zero-coupon rates). You should also understand
that this term structure changes over time, and so, as it does, the prices of all risk-free
government coupon bond will be recalculated.

This course help note was written by Professors Craig Doidge, Mike Simutin, and Kent L. Womack.
Finance 1331 in 2016Can You Do This?

5. You should be able to determine whether there are arbitrage opportunities and what
strategy should be employed to exploit them. That is, if a bond is expensive or cheap
relative to its theoretically correct price from the term structure of spot rates or Treasury
strips, you should know to buy the cheap asset and sell short the expensive asset, locking
in a profit.

6. You should understand the calculation and meaning of the durations (Macaulay and
modified) of a bond. You should then be able to articulate how to use that number in
comparing the price volatility (sensitivity to yield changes) of bonds when the interest
rate changes.

7. You should, therefore, be able to articulate which characteristics (bigger coupon, longer
maturity, etc.) of bonds are associated with higher or lower duration.

8. You should be able to calculate forward rates using spot rates (and vice versa) using
either annual or semi-annual compounding. See the Bloomberg forward rate pages in our
slides for examples.

9. You should understand the key idea behind the expectations and liquidity premium
hypotheses. How are they reflected in the forward rates?

10. You should understand what the term structure of interest rates is and what it means if
the term structure is rising, falling, or flat.

11. You should understand what yield to maturity of a bond is. You should know how it
relates to the spot rates.

STOCKS

12. You should be able to map out the future Cash Flows (CFs) of any stock with equal-
length future periods, from inputs (usually a few years of given CFs and a growing or
non-growing perpetuity assumption).

13. You should be able to find the present value for any future cash flow any number of
periods away and given any discount rate assumption. You should know how to use that
information to price a stock by adding together the PVs of the stocks constituent CFs.

14. You should be able to build and calculate a dividend discount model or free cash flow
model from any given assumptions about dividend/CF growth rates (for growth rates
both constant and changing over time) in a stock.

15. You should understand why some valuation models estimate CFs of individual years for
several years and then estimate a terminal value rather than estimating CF growth in
perpetuity starting from Year 1.

16. You should understand the linkage between a given discount rate and/or an assumed
terminal growth rate and the stock price inferred from them (see Data Table in HW 6).

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17. You should understand the difference between a dividend discount model (DDM) and a
free cash flow (FCF) model and the pros and cons of each.

18. You should be able to distinguish between an expected return and a historical realized
return.

19. You should understand a simple utility function consisting of expected return and
standard deviation of return inputs.

20. You should understand the mean-variance framework, how an investor trades off return
and risk and why he/she would want to be on the highest indifference curve he/she can
be on.

21. You should understand the difficulty in forecasting expected rates of return, and
variances, and covariances (correlations) and the limitations and risks of using historical
realizations for forecasts.

22. You should be able to derive the mean and standard deviation of a portfolio of two risky
assets. You should know what inputs are necessary to make those calculations.

23. You should be able to articulate what the efficient frontier is and conceptually how one
would derive it.

24. You should be able to infer whether a stock or a given portfolio that you start with can be
dominated by a combination using other assets.

25. You should be able to articulate where the benefits of diversification come from and why
some ostensibly unattractive securities might actually improve the efficient frontier.

26. You should be able to explain which portfolios all investors will choose from under the
assumptions of the mean-variance framework.

27. You should be able to remember the most important assumptions behind the CAPM (risk
free rate, identical expectations, etc.) and what additional results or conclusions are
attainable from those assumptions.

28. You should know the CAPM and what to do with it. What number does it give you and
why is that number valuable?

29. You should understand that the use of CAPM gets you re and is applicable to an equity
valuation of the company. For a firm valuation, one needs to calculate WACC, which
incorporates the after-tax cost of debt as well.

30. You should understand the difference between firm and equity value.
31. You should understand what weighted average cost of capital (WACC) is, and what
inputs go into its calculation.

32. You should understand what the market (equity) risk premium is.
33. You should understand the main ideas of different valuation approaches such as DCF
and comparable multiples analysis.

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34. You should be able to compute the equity value or firm value of a company (the
standard model) using DCF if you have the appropriate inputs. Inputs include EBITDA
projections for several (e.g. five) years, tax, working capital adjustments and CAPEX
expenditure adjustments, possibly FCF projections too, a terminal (perpetual) growth
rate, and data necessary to determine the cost of equity and/or cost of debt.

35. You should understand the difference between free cash flows, EBITDA, and EPS, and
articulate why FCFs are more appropriate to use when valuing a company than either of
the other two measures.

36. You should understand what Capital Allocation Line and Security Market Line are, and
explain the difference between the two.

37. You should know the important facts about Beta such as: the beta of the market is 1.0;
the beta of a portfolio is the weighted average of the individual stocks in the portfolio;
etc.

38. You should understand that the total risk of a stock is made up of market
(systematic/undiversifiable) risk and firm-specific (idiosyncratic/diversifiable) risk, and
that only market risk is priced in the CAPM. You should understand investors do not,
in theory, pay for diversifiable risk. It essentially vanishes in a well-diversified portfolio.

39. You should understand what the advantages and disadvantages are of a multi-factor
model relative to the CAPM. How are the simple CAPM and more complex multi-factor
models different?

40. You should be able to compute expected returns from a multi-factor model such as the
Fama-French three-factor model when given betas and expected returns on the factors.

41. You should be able to interpret the coefficients from a single factor model like the
CAPM and be able to make conclusions about the (historical) alpha.

42. You should be able to interpret the coefficients (SMB, HML, etc.) from a multi-factor
model like the Fama-French model, and be able to make conclusions about the
(historical) alpha.

43. You should be able to evaluate the performance of an investment (such as a mutual fund)
on a risk-adjusted basis and how to choose an appropriate benchmark portfolio. That is,
you should realize that alpha (measure of risk-adjusted performance) is the difference
between actual realized return and expected return computed from a model such as the
CAPM or a multi-factor model. You should also be able to assess the extent to which a
fund deviates from its style and to which it is active (deviates from its benchmark
portfolios).

44. You should understand the three forms of market efficiency and be able interpret
whether some given piece of empirical evidence violates any of the three forms.

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FUTURES and OPTIONS

45. You should be able to explain arbitrage, the law of one price, and understand how these
concepts are used to price derivative securities. You should be able to determine whether
there are arbitrage opportunities and what strategy should be employed to exploit them.

46. You should be able to explain the differences between forward contracts and futures
contracts and discuss the advantages and disadvantages of each.

47. You should be able to understand and calculate the fair forward/futures price of a stock
or bond or portfolio using parity conditions (the cash-and-carry model).

48. You should be able to calculate contract value for bond or equity futures if given a
printout from Bloomberg.

49. You should understand what futures-contract open interest is and what it proxies for.
50. You should know the practical problems an investor can encounter when hedging.
51. You should know where to find the risk (approximate duration) and price of the futures
contract you need when hedging a bond portfolio. You should also know how to make a
judgment of which futures contract is most efficient to use for hedging (has least basis
risk).

52. You should know what basis risk is (the imperfection of the correlation of the asset or
liability being hedged versus the hedging futures contract).

53. You should be able to choose the right futures contract for futures hedging. Know
whether you should buy or sell. Be able to determine the right number of futures
contracts needed.

54. You should know what covered interest rate parity is and be able to apply it to calculate
forward exchange rates. You should know how to pull relevant information for the
calculation from Bloomberg pages.

55. You should know the basic definition option pricing definitions: call option, put option,
moneyness, spot price, strike (exercise) price, underlying asset, intrinsic value, time
value, long (buy), short (sell).

56. You should understand the basics of continuous compounding.

57. You should know what put-call parity is and be able to apply it.
58. You should be able to solve a simple one-period binomial model to find the price of a
call or a put option. You should understand the framework of a binomial as a replicating
portfolio for the option that includes amounts of bond and stock that we can easily value.

59. More generally, you should understand that many assets can be priced by forming a
replicating portfolio.

60. You should understand the intuition behind the Black-Scholes Option Pricing Model.

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61. You should understand what delta means and how it changes for a put and a call when
stock price changes.

62. You should understand key drivers of call and put option prices: volatility, strike price,
spot price, risk-free rate, asset yield, time to expiration.

63. You should understand what implied volatility is and how it is calculated from an option
pricing model such as Black-Scholes.

64. You should be able to explain in general terms the costs and benefits of hedging with
futures versus with options.

65. You should understand one-to-one hedging with put options. You should be able to
calculate the number of put options you would need to hedge, given a certain floor
strategy. You should be able to calculate the cost of insurance, and the cost-benefit to
the hedger if the hedged asset (stock) appreciated or depreciates.

66. You should understand the basic ideas of mergers and acquisitions.