2016 Free Mind Maps CFA Level 2

All CFA Institute members and candidates are required to comply with the Code and Standards Basic structure for enforcing the Code and Standards

The CFA Institute Bylaws Based on two primary principles

Rules of Procedure

Fair process to member and candidate Confidentiality of proceedings

Maintains oversight and responsibility The CFA Institute Board of Governors

Structure of the CFA Institute Professional Conduct Program

Professional Conduct program (PCP) The CFA Designated Officer

Is responsible for the enforcement of the Code and Standards

Through the Disciplinary Review Committee (DRC)

Directs professional conduct staff

Conducts professional conduct inquiries

Selfdisclosure An inquiry can be prompted by several circumstances

Written complaints Evidence of misconduct Report by a CFA exam proctor Analysis of exam materials and monitoring of social media by CFA Insitute

a.

The Professional Conduct staff conducts an investigation that may include

Requesting a written explanation from the member or candidate The member or candidate Interviewing

Complaining parties Third parties

Collecting documents and records in support of its investigation

1. Code Of Ethics And Standards Of Professional Conduct

Conclude the inquiry with no disciplinary sanction

Process for the enforcement of the Code and Standards

When an inquiry is initiated

Issue a cautionary letter If finding that a violation of the Code and Standards occurred, the Designated Officer proposes a disciplinary sanction

Upon reviewing the material obtained during the investigation, the Designated Officer may Continue proceedings to discipline the member or candidate

Rejected by member

Integrity of investment profession & interest of clients above personal interest

Six components of the Code of Ethics

Care & judgment Practice ethics & encourage others to practice Integrity & viability of the global capital markets Professional competence

b,c.

Professionalism Integrity of Capital markets Duties of Clients

Seven Standards of Professional Conduct

Duties to Employers Investment analysis, Recommendations & Actions Conflict of interest Responsibilities as a CFA Institute member or CFA Candidate

1. Code Of Ethics And Standards Of Professional Conduct - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

The matter is referred to a hearing by a panel of CFA Institute members

condemnation by the member's peers If sanction is imposed

Act with integrity, competence, diligence, respect and in an ethical manner

Accepted by member

suspension of candidate's continued participant in the CFA program

Understand and comply with applicable laws and regulations Code and Standards vs. Local law

Follow stricter law and regulation

Responsible for violations in which they knowingly participate or assist Dissociate from illegal, unethical activities

Guidance

Leave employers (in extreme case) Attempt to stop the behavior by bringing it to the attention of employer through a supervisor or compliance department

Participation or association with violations by others

May consider directly confronting the involved individuals

Intermediate steps

If not successful,--> step away and dissociate from the activity by

Removing their name from written reports Asking for a different assignment

Inaction with continued association may be construed as knowing participation

A. Knowledge of the law

Not required reporting violations to government, CFAI, but advisable in some cases or required by laws in others Stay informed Review procedures Members and candidates

Maintain current files When in doubt, seek advice of compliance personnel or legal counsel When dissociating from violations, --> Document any violations and urge firms to stop them

Recommended procedures for compliance (RPC)

Develop and/or adopt a code of ethics Firms

Make available to employees info that highlights applicable laws and regulations Establish written procedures for reporting suspected violation of laws, regulations or company policies

Application Maintain independence and objectivity in professional activities

External pressures

By benefits

Gifts, Invitations to lavish functions, Tickets, Favors, Job referrals, Allocation of shares in oversubscribed IPOs...

May try to pressure sellside analysts

From Buyside clients From their own firms Internal pressures How to cope with external and internal pressures

To issue favorable reports

From public companies

e.g. to issue favorable research reports/ recommendations for certain companies to issue favorable research on current or prospective investmentbanking clients

Investmentbanking relationships

Conflicts of interest

Modest gifts and entertainment are acceptable but special care must be taken

must disclose to employers

Best practice: reject any offer of gifts, threatening independence and objectivity

Guidance

convey true opinions -->

Recommendations must

B. Independence and objectivity

free of bias from pressures be stated in clear and unambiguous language

Portfolio managers must respect and foster honesty of sellside research Is fraught with conflicts

2.1 Standard I PROFESSIONALISM

Must engage in thorough, independent, and unbiased analysis Must fully disclose potential conflicts, including the nature of compensation Issuerpaid research

Must strictly limit the type of compensation they accept for conducting research

Analysts

Accept only flat fee for their work prior to writing the report Best practice

Without regard to conclusions or recommendations

Protect integrity of opinions Create a restricted list Restrict special cost arrangements Limit gifts

RPC

Equity IPOs

Restrict employee investments

Private placements

Review procedures Written policies on independence and objectivity of research Definition of "Misrepresentation"

any untrue statement or omission of a fact or any false or misleading statement

Must not knowingly make misrepresentation or give false impression in

oral representations, advertising electronic communications written materials qualifications or credentials, services performance record

Guidance

Must not misrepresent any aspect of practice, including

Without regard to conclusions or recommendations characteristics of an investment any misrepresentation relating to member's professional activities

C. Misrepresentation

Must not guarantee clients specific return on investments that are inherently volatile Standard I(C) prohibits plagiarism in preparation of material for distribution to employers, associates, clients, prospects, general publish Written list of available services, description of firm's qualification Designate employees to speak on behalf of firm

RPC

Prepare summary of qualifications and experience, list of services capable of performing Maintain copies To avoid plagiarism

Attribute quotations Attribute summaries

Address conduct related to professional life Any act involving lying, cheating, stealing, other dishonest conduct that reflects adversely on member's professional activities would be violation

Guidance

D. Misconduct

Violations

Conduct damaging trustworthiness or competence (include behaviour may not be illegal but negatively affect a member to perform responsibility such as abusing alcohol during lunch hours) Abuse of the CFA Institute Professional Conduct Program Involved in personal bankruptcy is not automatically assumed to be in violation but bankruptcy involve fraudulent or deceitful business conduct may be a violation

Develop and/or adopt a code of ethics

RPC

Disseminate to all employee a list of potential violations Check references of potential employees

2.1 Standard I PROFESSIONALISM - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

its significant impact to the price of security if it is disclosed

Definition of "Material nonpublic information"

The reliability of the information Non-public until

Guidance

Reasonable investors would like to know for making decision

Material information

disseminated to the market place and effficient time for investors to react

Must be particularly aware of info selectively disclosed by corporations Analysis of Public info + nonmaterial nonpublic info --> Investment conclusion Mosaic Theory

Analysts are free to act on this collection of info without risking violation Analysts should save and document all their research

A. Material non-public information (MNI)

Make reasonable efforts to achieve public dissemination of material info Must communicate the info only to the designated supervisory and compliance personnel within the firm

If public dissemination is not possible,

Must not take investment action on the basis of the info

Must not knowingly engage in conduct inducing insiders to privately disclose MNI

2.2 Standard II INTEGRITY OF CAPITAL MARKETS

adopt compliance procedures preventing misuse of MNI

RPC Encourage firms to

develop & follow disclosure policies to ensure proper dissemination use "firewall"

Prohibition of all proprietary trading while firm is in possession of MNI may be inappropriate

Definition

Distort prices or artificially inflate trading volume with the intent to mislead market participants

transactions that deceive market participants

B. Market manipulation

can be related to dissemination of false or misleading info

Transactions that artificially distort prices or volume Securing a controlling, dominant position in a financial instrument to exploit and manipulate price of a related derivative/or underlying asset including spreading false rumors to induce trading by others

prohibit legitimate trading strategies

Standard II(B) not meant to

prohibit transactions done for tax purposes

The intent of action is critical to determining whether it is a violation of this Standard 2.2 Standard II INTEGRITY OF CAPITAL MARKETS - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

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Describe limitations of regression analysis

A sample covariance, a sample correlation coefficient and a scatter plot Describe the use of analysis of variance (ANOVA) in regression analysis, interpret ANOVA results, and calculate and interpret the F-statistic

Limitation to correlation analysis

Calculate and interpret a confidence interval for the predicted value of the dependent variable

Calculate the predicted value for the dependent variable, given an estimated regression model and a value for the independent variable

Formulate a null and alternative hypothesis about a population value of a regression coefficient and determine the appropriate test statistic and whether the null hypothesis is rejected at a given level of significance

Calculate and interpret the standard error of estimate, the coefficient of determination, and a confidence interval for a regression coefficient

9. Correlation and Regression - An Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

Uses of correlation Analysis

9. Correlation and Regression - An Overview

Formulate a test of the hypothesis that the population correlation coefficient equals zero and determine whether the hypothesis is rejected at a given level of significance

Distinguish between the dependent and independent variables in a linear regression

Describe the assumptions underlying linear regression and interpret regression coefficient

A graph that shows the relationship between the observations for two data series in two dimensions

Scatter Plots

Each observation in the scatter plot is represented as a point, and the points are not connected The scatter shows only the actual observation of both data series plotted as pairs Correlation analysis expresses the same relationship (between two data series) using a single number The correlation coefficient measures the direction and extent of linear association between two variables A correlation coefficient less than 0 indicates a negative linear association

A sample covariance, a sample correlation coefficient and a scatter plot

Correlation Analysis

A correlation coefficient can have a maximum value of 1 and a minimum value of -1

A correlation coefficient greater than 0 indicates a positive linear association A scatter plot of two variables with a correlation of 0; they have no linear relation -> the value of A tells us nothing about the value of B

The sample covariance of X and Y, for a sample of size n

Calculate the Correlation Coefficient

The expression for the sample variance of X, is

The sample correlation coefficient

9. Correlation and Regression - Part 1

Correlation may be an unreliable measure when

Two variables can have a strong nonlinear relation and still have a very low correlation

Limitation to correlation analysis

Outliers are present in one or both of the series. Outliers are small numbers of observations at either extreme (small or large) of a sample correlation between two variables that reflects chance relationship in a particular data set correlation induced by a calculation that mixes each of two variables with a third

Spurious correlation

correlation between two variables arising not from a direct relation between them but from their relation to a third variable

In investment decision-making (for example: inflation forecast)

Uses of correlation Analysis

Correlation of stock market tells us how successfully the assets can be combined to diversify risk Used in a financial statement setting H0: the correlation in the population is 0 (p = 0) Ha : the correlation in the population is different from 0 (p # 0)

Formulate a test of the hypothesis that the population correlation coefficient equals zero and determine whether the hypothesis is rejected at a given level of significance

The formula for the t-test

This test statistic has a t-distribution with n-2 degrees of freedom if the null hypothesis is true

Sampling from the same population, a false null hypothesis H0: is more likely to be rejected as we increase sample size. The result whether H0 is rejected also depends on significance level

Distinguish between the dependent and independent variables in a linear regression

9. Correlation and Regression - Part 1.mmap - 4/28/2016 - Mindjet

Linear regression with one independent variable (or simple linear regression) models the relationship between two variables as a straight line Linear regression provides a simple model for forecasting the value of one variable, known as the dependent variable, given the value of the second variable, known as the independent variable

b0, b1 are the regression coefficients

Y: dependent variable X: independent variable b0: the intercept b1: a slope coefficient

Slope coefficient

The estimated slope coefficient is interpreted as the change in the dependent variable for a 1-unit change in the independent variable

The regression equation

The intercept term

The intercept is an estimate of the dependent variable when the independent variable takes on a value of zero

error term (represents the portion of the dependent variable that cannot be explained by the independent variable The X is and The

Describe the assumptions underlying linear regression and interpret regression coefficient

relationship between the dependent variable, Y, and the independent variable, linear in the parameter b0 and b1. b0 and b1 are raised to the first power only that neither b0 nor b1 is multiplied or divided by another (for example, b0/b1). requirement does not exclude X from being raised to a power other than 1

Critical for a valid linear regression. If the relationship between the independent and dependent variables is nonlinear in the parameters, then estimating that relation with a linear regression model will produce invalid results

The independent variable, X, is not random Ensure that linear regression produces the correct estimates

The expected value of the error term is 0 Six classic normal linear regression model assumptions

The variance of the error term is the same for all observations:

The error term is uncorrelated across observations. Consequently, E(ei,j) = 0 for all i not equal to j.

use the linear regression model to determine the distribution of the estimated parameters and and thus test whether those coefficients have a particular value

The error term is normally distributed

Calculate and interpret the standard error of estimate, the coefficient of determination, and a confidence interval for a regression coefficient

The formula for the standard error of estimate (SEE) for a linear regression model with one independent variable is

The different between the actual and predicted values of the dependent variable is the regression residual

defined as the percentage of the total variation in the dependent variable explained by the independent variable The coefficient of determination (R^2)

R^2 = r^2 for a regression with one independent variable Confidence interval spans the range

Regression coefficient confidence interval A confidence interval is an interval of values that we believe includes the true parameter value, , with a given degree of confidence

the estimated parameter value A hypothesis test using the confidence interval approach if we know

9. Correlation and Regression - Part 2

Formulate a null and alternative hypothesis about a population value of a regression coefficient and determine the appropriate test statistic and whether the null hypothesis is rejected at a given level of significance

the hypothesized value b0 or b1 a confidence interval around the estimated parameter

In practice, the most common way to test a hypothesis using a regression model is with a t-test of significance. To test the hypothesis, we can compute the statistic

This test statistic has a t-distribution with n-2 degrees of freedom. Reject H0 if t> +tcritical or t the issue of parameter instability Public knowledge of regression relationships may negate their future usefulness If the regression assumptions are violated, hypothesis tests and predictions based on linear regression will not be valid

9. Correlation and Regression - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

Introduction

29. Equity Valuation: Applications and Processes An Overview

Value Definition and Valuation Applications

Communicating Valuation Results

The Valuation Process

29. Equity Valuation. Applications and Processes - Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

Valuation

The estimation of an asset’s value based on variables perceived to be related to future investment returns, on comparisons with similar assets, or on estimates of immediate liquidation proceeds What is value?

Introduction

Who uses equity valuations? Basic questions

What is the importance of industry knowledge? How can the analyst effectively communicate his analysis? The value of the asset given a hypothetically complete understanding of the asset’s investment characteristics Reflects investor's view of the “true” or “real” value of an asset Market price and intrinsic value are identical Grossman-Stiglitz paradox

Investors will not rationally incur the expenses of gathering information unless they expect to be rewarded by higher gross returns compared with the free alternative of accepting the market price

Rational efficient markets formulation Common stock Trading costs exist

Difficult to determine especially

Further room exists for price to diverge from value

Seek to identify mispricing

Analysts often view market prices both with respect and with skepticism

A difference between the estimated intrinsic value and the market price of an asset

Rely on price eventually converging to intrinsic value Recognize distinctions among the levels of market efficiency or tiers of markets

Intrinsic Value

Uncertainty is constantly present

Valuation is an inherent part to attempt positive excess risk adjusted returns (abnormal return or alpha)

Revaluate by looking for the presence of a particular market or corporate event ( catalyst)

The error in the estimate of the intrinsic value

(V E -V): the difference between the valuation estimate and the true but unobservable intrinsic value

VE = estimated value V E - P = (V - P) + ( V E - V)

P = market price V = intrinsic value

Definition

Contribute to the abnormal return

(V-P): the true mispricing, the difference between the true but unobservable intrinsic value V and the observed market price P

Combine accurate forecasts and appropriate valuation model

A useful estimate of intrinsic value

Active security selection

Manager’s expectations must differ from consensus expectations and be correct

Expectational inputs used in valuation models

The assumption that the company will continue its business activities into the foreseeable future

accessing its optimal sources of financing not appropriate for a company in financial distress

Going-concern assumption Value Definition and Valuation Applications

value maximizing using assets

The value added by assets working together and by human capital applied to managing those assets makes estimated goingconcern value greater than liquidation value

Going-Concern Value and Liquidation Value

Orderly liquidation value Liquidation value Different time frame for liquidating causes different assets value of a company is the price at which an asset (or liability) would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell includes an assumption that both buyer and seller are informed of all material aspects of the underlying investment

Fair market value

often used in valuation related to assessing taxes

Fair Market Value and Investment Value

The concept of value to a specific buyer taking account of potential synergies and based on the investor’s requirements and expectations

Investment value Selecting stocks

Primary use evaluate the reasonableness of the expectations

Inferring (extracting ) market expectations

A merger

as a benchmark or comparison value of the same characteristic for another company the general term for the combination of two companies a combination of two companies, with one of the companies identified as the acquirer, the other the acquired

An acquisition

29. Equity Valuation: Applications and Processes - Part 1

Evaluating corporate events

the company separates one of its component businesses and transfers the ownership of the separated business to its shareholders

A leveraged buyout

Rendering fairness opinions

affects a company’s future cash flows -> equity

a company sells some major component of its business

A divestiture

A spin-off

Valuation Applications

the acquiring company’s own common stock is often used as currency for the purchase

an acquisition involving significant leverage [i.e., debt], which is often collateralized by the assets of the company being acquired.)

The parties to a merger may be required to seek a fairness opinion on the terms of the merger from a third party, such as an investment bank

Evaluating business strategies and models

Companies concerned with maximizing shareholder value evaluate the effect of alternative strategies on share value

Communicating with analysts and shareholders Appraising private businesses

for transactional purposes

E.g acquisitions or buy-sell agreements for the transfer of equity interests among owners when one of them dies or retires, IPO,...

Sharebased payment (compensation) the basis for computing the target When a research report states a target price for a stock, it should clarify

information on the uncertainty of reaching the target a time frame for reaching the target An update on the company’s financial and operating results

Kind of infor. intended readers seek to gain

Sell-side analyst’s report: investment recommendation

Persuasive supporting arguments

The intrinsic value of the security

The key assumptions and expectations underlying that estimated intrinsic value

A description of relevant aspects of the current macroeconomic and industry context An analysis and forecast for the industry and company Detailed historical descriptive statistics about the industry and company

May be accompanied by an explanation of the underlying rationale Specific forecasts Contents of a Research Report

A description of the valuation model Usual contents

Key valuation inputs A discussion of qualitative factors and other considerations that affect valuation Objectively address the uncertainty associated with investing in the security, and/or the valuation inputs involving the greatest amount of uncertainty Contains timely information is written in clear, incisive language is objective and well researched, with key assumptions clearly identified

An effective research report

Communicating Valuation Results

distinguishes clearly between facts and opinions contains analysis, forecasts, valuation, and a recommendation that are internally consistent

The requirements are more specific in some situations. For e.g, regulations governing disclosures of conflicts and potential conflicts of interest vary across countries, investment recommendations are affected by policies of the firm employing an analyst

presents sufficient information to allow a reader to critique the valuation states the key risk factors involved in an investment in the company discloses any potential conflicts of interests faced by the analyst

Format of a Research Report All analysts have an obligation to provide substantive and meaningful content in a clear and comprehensive report format

Analysts who are CFA Institute members, however, have an additional and overriding responsibility to adhere to the Code of Ethics and the Standards of Professional Conduct in all activities pertaining to their research reports

Research Reporting Responsibilities The analyst must hold himself accountable to both standards of competence and standards of conduct

29. Equity Valuation. Applications and Processes - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

Sell-side analyst: Analysts who work at brokerage firms Investment discipline (security selection) and quantitative investment disciplines

Valuation judgments to distribute to current and prospective retail and institutional brokerage clients is to understand the basic characteristics of the markets served by a company and the economics of the company

Valuation judgments to a portfolio manager or to an investment committee as input to an investment decision

Buy-side analysts

The purposes and the intended consumer of the valuation

Both corporate analysts and investment bank analysts may also identify and value companies that could become acquisition targets

give appropriate attention to the most important economic drivers of a business Usefulness

Applying the Valuation Conclusion: The Analyst’s Role and Responsibilities

to organize thoughts about an industry and to better understand a company’s prospects for success in competition with other companies in that industry to highlight the greatest challenges and opportunities

How attractive are the industries in which the company operates, in terms of offering prospects for sustained profitability

Analysts at independent vendors of financial information usually offer valuation information and opinions in publicly distributed research reports Help their clients achieve their investment objectives Investment analysts play a critical role in collecting, organizing, analyzing, and communicating corporate information, and in some contexts, recommending appropriate investment actions based on sound analysis

Benefit the suppliers of capital, including shareholders, when they are effective monitors of management’s performance E.g when assess how a change in assumptions about a company’s future growth or analyze how different competitive responses would affect the forecasted financials and the estimated valuation

to determine how changes in an assumed input would affect the outcome

the value of a stock investment the value of nonpublicly traded stocks

Industry and Competitive Analysis

How is a useful framework? Focus on these questions

Sensitivity analysis

lack of marketability discounts

Two important aspects

Converting Forecasts to a Valuation

Need sensitivity analysis

Analysis of Financial Reports

Sources of Information

Historical analysis to have its insights through time

Looking annual reports for 10, 5, 2 years prior

importance of qualitative (non-numeric factors) avoid simply extrapolating past operating results when forecasting future performance

Financial ratio analysis is useful for established companies Individual drivers of profitability for merchandising and manufacturing companies can be evaluated against the company’s stated strategic objectives

Be aware when regulations (e.g., Regulation FD in the United States) prohibit companies from disclosing material nonpublic information to analysts without also disseminating that information to the public The scrutiny of all financial statements, including the balance sheet, to evaluate both the sustainability of the companies’ performance and how accurately the reported information reflects economic reality

Also require careful scrutiny of accounting statements, footnotes, and other relevant disclosure

Equity analysts: develop better insights into a company and improve forecast accuracy Quality of earnings analysis

The fundamental approach to equity valuation

Sustainability of performance: identify aspects of reported nonrecurring performance Identify reporting decisions that may result in a level of reported earnings that are unlikely to continue

Present value models (discounted CF models)

comparison of a company’s net income with its operating cash flow

Poor quality of accounting disclosures, such as segment information, acquisitions, accounting policies and assumptions, and a lack of discussion of negative factors.

Understanding the business

Absolute Valuation Models

Existence of relatedparty transactions

Greater uncertainty than the case with bonds due to

Existence of excessive officer, employee, or director loans

29. Equity Valuation: Applications and Processes Part 2: The Valuation Process

A stream of cash payments specified in a legal contract (the bond indenture) Not as uncertain as common stock

High management or director turnover Excessive pressure on company personnel to make revenue or earnings targets, particularly when combined with a dominant, aggressive management team or individual

A working selection of risk factors (AICPA 2002) (in case growth in an asset account at a much faster rate than the growth rate of sales

Applied to bond valuation

Material non-audit services performed by audit firm Reported (through regulatory filings) disputes with and/or changes in auditors Management and/or directors’ compensation tied to profitability or stock price (through ownership or compensation plans). Although such arrangements are usually desirable, they can be a risk factor for aggressive financial reporting.

Values a company on the basis of the market value of the assets or resources it controls

Can provide an independent estimate of value

Analyzing the company’s financial report to evaluate the company's strategic objectives' performances and develop expectations to it

Regulatory requirements concerning disclosures and filings vary internationally

Def. a model that specifies an asset’s intrinsic value

For common stock: Dividend discount models

A discount rate can usually be based on market interest rates and bond ratings

The term “business model” refers generally to how a company makes money

Analysts can compare the information provided directly by companies to their own independent research

Analysts frequently define cash flows at the company level

Residual income model

need to address other issues, such as the value of corporate control or the value of unused assets

Differentiation Focus

most relevant for evaluating a company’s success in implementing strategic choices

illiquidity discounts

Free cash flow to equity model

its CFs and discount rate

Cost leadership Corporate strategies

2 caveats merit mention

The value of an asset to an investor must be related to the returns that investor expects to receive from holding that asset.

Based on accrual accounting earnings in excess of the opportunity cost of generating those earnings

The level and trend of the company’s market share indicate its relative competitive position within an industry

How well has the company executed its strategy and what are its prospects for future execution

blockage factor

used to produce an estimate of value that can be compared with the asset’s market price

Free cash flow to the firm

Porter 5 forces

Situational adjustments

an investor wishes to sell an amount of stock that is large relative to that stock’s trading volume (assuming it is not large enough to constitute a controlling ownership)

Defines cash flows before those payments

Use various frameworks

What is the company’s relative competitive position within its industry, and what is its competitive strategy

control premiums

the prices of shares with less depth to their markets

Defines cash flow net of payments to providers of debt

Try to understand the industry structure Stay current on facts and news concerning all the industries

Contribute to the efficient functioning of capital markets

The price that would be lower than the market price for a smaller amount of stock

need more sensitivity analysis ?

Economic, industry, or companyspecific pressures on profitability, such as loss of market share or declining margins

Asset- based valuation

Management pressure to meet debt covenants or earnings expectations

Underlying idea: similar assets should sell at similar prices Undervalue

P/E

Relatively undervalue

A history of securities law violations, reporting violations, or persistent late filings

Def. estimate an asset’s value relative to that of another asset

ratios of stock price to a fundamental such as cash flow per share

Considerations in Using Accounting Information

using price multiples How?

ratios of the total value of common stock and debt net of cash and shortterm investments to certain of a company’s operating assets to a fundamental such as operating earnings

enterprise multiples

The more conservative investing strategies involve overweighting (underweighting) relatively undervalued (overvalued) assets, with reference to benchmark weights Pairs trading: buying the relatively undervalued stock and selling short the relatively overvalued stock

Relative value investing (or relative spread investing, if using implied discount factors)

does not specify intrinsic value without making the further assumption that the comparison asset is fairly valued

being simple, related to market prices, and grounded in a sound economic principle Breakup value or private market value

The more aggressive strategies allow short selling of perceived overvalued assets

The method of comparables is characterized by a wide range of possible implementation choices

The value derived using a sum-of-the-parts valuation

Selecting the Appropriate Valuation Model Relative Valuation Models

Frequently involve a group of comparison assets

Sums the estimated values of each of the company’s businesses as if each business were an independent going concern

Value a company with segments in different industries that have different valuation characteristics evaluate the value that might be unlocked in a restructuring through a spinoff, splitoff, tracking stock, or equity (IPO) carveout

When to use Sum-of-the-parts valuation

The market applies a discount to the stock of a company operating in multiple, unrelated businesses compared to the stock of companies with narrower focuses

inefficiency of internal capital markets endogenous factors

Alternative explanation

Valuation of the Total Entity and Its Components

Conglomerate discount

research measurement errors A breakup value in excess of a company’s unadjusted goingconcern value may prompt strategic actions such as a divestiture or spin-off understanding the nature of its assets and how it uses those assets to create value

having a good understanding of the business

Forecasting Company Performance consistent with the characteristics of the company being valued

appropriate given the availability and quality of data

Approach moves from international and national macroeconomic forecasts to industry forecasts and then to individual company and asset forecasts

Two perspectives

Bottom-up forecasting

Approach aggregates forecasts at a micro level to larger scale forecasts, under specific assumptions

The company’s own operating and financial characteristics

Criteria for model selection are that the valuation model be

consistent with the purpose of valuation, including the analyst’s perspective

Top-down forecasting The economic environment

Issues in Model Selection and Interpretation

Professionals frequently use multiple valuation models or factors in common stock selection

29. Equity Valuation. Applications and Processes - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

Consider qualitative as well as quantitative factors

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INTRODUCTION

PRIVATE MARKET REAL ESTATE DEBT

REAL ESTATE INVESTMENT: BASIC FORMS

INDICES

VALUATION IN AN INTERNATIONAL CONTEXT

DUE DILIGENCE

39. Private Real Estate Investments: An Overview

RECONCILIATION

THE INCOME APPROACH TO VALUATION

39. Private Real Estate Investments - Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

REAL ESTATE: CHARACTERISTICS AND CLASSIFICATIONS

PRIVATE MARKET REAL ESTATE EQUITY INVESTMENTS

THE COST AND SALES COMPARISON APPROACHES TO VALUATION

OVERVIEW OF THE VALUATION OF COMMERCIAL REAL ESTATE

INTRODUCTION

often included in the portfolios of investors with long-term investment horizons and with the ability to tolerate relatively lower liquidity

Private equity investment: sometimes referred to as direct ownership

suitable for investors with short investment horizons and higher liquidity needs

Publicly traded debt investment: sometimes referred to as indirect lending

The first dimension: whether the investment is made in the private or public market Investment in real estate has been defined from a capital market perspective in the context of quadrants which are a result of two dimensions of investment

The second dimension: whether the investment is made in the private or public market

REAL ESTATE INVESTMENT: BASIC FORMS Four quadrants Private real estate investment, compared with publicly traded real estate investment, typically involves larger investments because of the indivisibility of real estate property and is more illiquid Publicly traded real estate investment allows the real estate property to remain undivided but the ownership or claim on the property to be divided Equity investors generally expect a higher rate of return than lenders (debt investors) because they take on more risk Debt investors in real estate, whether through private or public markets, expect to receive their return from promised cash flows and typically do not participate in any appreciation in value of the underlying real estate Heterogeneity and fixed location High unit value Management intensive High transaction costs Characteristics

Depreciation Need for debt capital Illiquidity : Price determination Single-family properties may be owner-occupied or rental properties

REAL ESTATE: CHARACTERISTICS AND CLASSIFICATIONS

Residential properties: single-family houses and multi-family properties, properties that provide housing for individuals or families

Multi-family properties are rental properties even if the owner or manager occupies one of the units Multifamily housing is usually differentiated by location and shape of structure Commercial real estate properties

Classifications

Properties purchased with the intent to let, lease, or rent

Office

Non-residential properties include commercial properties other than multifamily properties, farmland, and timberland

Industrial and warehouse Retail Hospitality Other types

Current income Price appreciation (capital appreciation) Motivations

Inflation hedge Diversification Tax Benefits Business conditions Long lead time for new development Cost and availability of capital Unexpected inflation Characteristic sources of risk or risk factors of real estate investment

Demographics Lack of liquidity Environmental

Risk Factors

Availability of information Management Leverage

39. Private Real Estate Investments - Part 1

Other risk factors

PRIVATE MARKET REAL ESTATE EQUITY INVESTMENTS

Risk and return of equity real estate investments is affected by the characteristics of real estate and the risk factors, structure of leases between the owner and tenants

Real Estate Risk and Return Relative to Stocks and Bonds

The demand for office depends heavily on employment growth The average length of an office building lease varies globally

Office

An important consideration in office leases is whether the owner or tenant incurs the risk of operating expenses

“net lease” requires the tenant to be responsible for paying operating expenses “gross lease” requires the owner to pay the operating expenses

Not all office leases are structured as net or gross leases There are differences in how leases are structured over time and in different countries

Commercial Real Estate

Industrial and Warehouse

The demand for industrial and warehouse space is heavily dependent on the overall strength of the economy and economic growth and on import and export activity in the economy

The demand depends heavily on trends in consumer spending. Consumer spending, in turn, depends on the health of the economy, job growth, population growth, and savings rates Retail

“Percentage lease”: the requirement that the tenants pay additional rent once their sales reach a certain level The lease will typically specify a “minimum rent” that must be paid regar dless of the tenant’s sales and the basis for calculating percentage rent once the tenant’s sales reach a certain level or breakpoint The demand for multi-family space depends on

Multi-Family

population growth, especially for the age segment most likely to rent apartments how the cost of renting compares with the cost of owning-that is, the ratio of home prices to rents

The cost approach involves estimating the value of the building(s) based on adjusted replacement cost The replacement cost is adjusted for different types of depreciation (loss in value) to arrive at a Physical deterioration related to the age of the property because components of the property wear out over time. Two types The Cost Approach

incurable: Fixing a structural problem with the foundation of the building may cost more to cure than the amount that it would increase the value of the property if cured

Functional obsolescence: a loss in value due to a design that is different from that of a new building constructed with an appropriate design for the intended use of the property

Types of depreciation

External obsolescence: due to either the location of the property or economic conditions, results when the location is not optimal for the property

THE COST AND SALES COMPARISON APPROACHES TO VALUATION

The Sales Comparison Approach

depreciated replacement cost

curable: fixing the problem will add value that is at least as great as the cost of the cure

Locational obsolescence results when the location is not optimal for the property Economic obsolescence results when new construction is not feasible under current economic conditions

The sales comparison approach implicitly assumes that the value of a property depends on what other comparable properties are selling for in the current market

Advantages and Disadvantages of the Cost and Sales Comparison Approaches

Appraisals (estimates of value) are critical for such infrequently traded and unique assets as real estate properties Market value: can be thought of as the most probable sale price. It is what a Appraisals

Value

There are other definitions of value that differ from market value

OVERVIEW OF THE VALUATION OF COMMERCIAL REAL ESTATE

typical investor is willing to pay for the property

Investment value: the value to a particular investor, could be higher or lower than market value depending on the particular investor’s motivations and how well the property fits into the investor’s portfolio, the investor’s risk tolerance, the investor’s tax circumstances, and so on. Value in use: the value to a particular user

The income approach considers what price an investor would pay based on an expected rate of return that is commensurate with the risk of the investment Three different approaches Introduction to Valuation Approaches

The cost approach considers what it would cost to buy the land and construct a new property on the site that has the same utility or functionality as the property being appraised (referred to as the subject property ) The sales comparison approach considers what similar or comparable properties (comparables) transacted for in the current market

Highest and Best Use

Highest and best use: the use that would result in the highest value for the land

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capitalizes the current NOI using a growth implicit capitalization rate When the capitalization rate is applied to the forecasted first-year NOI for the property, the implicit assumption is that the first-year NOI is representative of first-year NOI would be for similar properties

the direct capitalization method There are two income approaches

applies an explicit growth rate to construct an NOI stream from which a present value can be derived

the DCF method

Income can be projected either for the entire economic life of the property or for a typical holding period with the assumption that the property will be sold at the end of the holding period

General Approach and Net Operating Income

Calculating NOI

Rental income at full occupancy + Other income (such as parking) = Potential gross income (PGI) – Vacancy and collection loss = Effective gross income (EGI) – Operating expenses (OE) = Net operating income (NOI) The cap rate is like a current yield for the property whereas the discount rate is applied to current and future NOI

The Capitalization Rate and the Discount Rate

Cap rate = Discount rate - Growth rate going-in cap rate is used to clarify that it is based on the first year of ownership when the investor is going into the deal

Cap rate = NOI/Value

Defining the Capitalization Rate Value = NOI/Cap rate The Direct Capitalization Method

terminal cap rate is based on expected income for the year after the anticipated sale of the property observing what other similar or comparable properties are selling for to know the cap rate

Cap rate = NOI/Sale price of comparable ARY: all risks yield

Market value = Rent/ARY

Stabilized NOI

If NOI is not representative of the NOI of similar properties because of a temporary issue, the subject property's NOI should be stabilized Gross income multiplier: the ratio of the sale price to the gross income expected from the property in the first year after sale

Other Forms of the Income Approach

The Relationship between Discount Rate and Cap Rate THE INCOME APPROACH TO VALUATION

The problem of gross income multipler: not explicitly consider vacancy rates and operating expenses

If the growth rate is constant

V = NOI/(r – g)

If NOI is not expected to grow at a constant rate, then NOIs are projected into the future and each period’s NOI is discounted to arrive at a value of the property The cap rate used to estimate the resale price or terminal value is referred to as a terminal cap rate or residual cap rate It is a cap rate that is selected at the time of valuation to be applied to the NOI earned in the first year after the property is expected to be sold to a new buyer

The Terminal Capitalization Rate

The terminal cap rate could be the same, higher, or lower than the goingin cap rate depending on expected discount and growth rates at the time of sale

The Discounted Cash Flow (DCF) Method

If interest rates are expected to be higher in the future => terminal cap rates might be higher The growth rate is often assumed to be a little lower => a slightly higher terminal cap rate Uncertainty about what the NOI will be in the future may also result in selecting a higher terminal cap rate

Lease structures vary across locales and can have an effect on the way value is typically estimated in a specific locale

Adapting to Different Lease Structures

The “equivalent yield” is a single discount rate that could be applied mathematically to both income streams that would result in the same value

The Equivalent Yield

Project income from existing leases Make assumptions about lease renewals

The general s teps to a DCF analysis are as follows

Assumptions also have to be made about what will happen when a lease comes up for renewal—often referred to as market leasing assumptions

Make assumptions about operating expenses

Operating expenses involve items that must be paid by the owner, such as property taxes, insurance, maintenance, management, marketing, and utilities

Make assumptions about capital expenditures

such as a new heating and air conditioning system or replacing a roof, etc.,

Make assumptions about absorption of any vacant space Estimate resale value (reversion) Advanced DCF: Lease-by- Lease Analysis

39. Private Real Estate Investments - Part 2

how long the property will be held by the initial investor

Select discount rate to find PV of cash flows Advantages and Disadvantages of the Income Approach

Advantage: it captures the cash flows that investors actually care about Disadvantage is the amount of detailed information that is needed and the need to forecast what will happen in the future even if it is just forecasting a growth rate for the NOI and not doing a detailed lease-by-lease analysis

The discount rate does not reflect the risk Income growth is greater than expense growth Common Errors

The terminal cap rate is not logical compared with the implied going-in cap rate The terminal cap rate is applied to an income that is not typical The cyclical nature of real estate markets is not recognized

Three different approaches to valuation: the income, cost, and sales comparison approaches may produce the different answers due to imperfections in the data and inefficiencies in the market The appraiser needs to reconcile the differences and arrive at a final conclusion about the value RECONCILIATION

The purpose of reconciliation is to decide which approach or approaches you have the most confidence in and come up with a final estimate of value In an active market: sales comparison approach is preferred When there are fewer transactions: income approach is preferred To verify other facts and conditions that might affect the value of the property and that might not have been identified by the appraiser Review the leases for the major tenants and review the history of rental payments and any defaults or late payments. Get copies of bills for operating expenses, such as utility expenses. Look at cash flow statements of the previous owner for operating expenses and revenues. Have an environmental inspection to be sure there are no issues, such as a contaminant material on the site. Have a physical/engineering inspection to be sure there are no structural issues with the property and to check the condition of the building systems, structures, foundation, and adequacy of utilities.

DUE DILIGENCE E.g

Have an attorney or appropriate party review the ownership history to be sure there are no issues related to the seller’s ability to transfer free and clear title that is not subject to any previously unidentified liens. Review service and maintenance agreements to determine whether there are recurring problems. Have a property survey to determine whether the physical improvements are in the boundary lines of the site and to find out if there are any easements that would affect the value. Verify that the property is compliant with zoning, environmental regulations, parking ratios, and so on. Verify that property taxes, insurance, special assessments, and so on, have been paid

VALUATION IN AN INTERNATIONAL CONTEXT

Return = {NOI

Appraisal-Based Indices

Disadvantages

Capital expenditures + (Ending market value

Appraisal lag

Beginning market value )}/Beginning market value

May not capture the price increase until a quarter or more after it was reflected in transactions Tend to smooth the index, have lower correlation with others => allocation to real estate would likely overestimated

How to adjust: unsmooth” the appraisalbased or use a transactionbased index when comparing real estate with other asset classes

INDICES

In recent years, indices have been created that are based on actual transactions rather than appraised values Two main ways Transaction-Based Indices Disadvantages

PRIVATE MARKET REAL ESTATE DEBT

A repeat sales index relies on repeat sales of the same property A hedonic index which requires only one sale Include random elements in the observations => may be upward or downward movements from quarter to quarter that are somewhat random

The maximum amount of debt that an investor can obtain on commercial real estate is usually limited by either the ratio of the loan to the appraised value of the property (loan to value or LTV) or the debt service coverage ratio (DSCR) The debt service coverage ratio is the ratio of the firstyear NOI to the loan payment

39. Private Real Estate Investments - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

DSCR = NOI/Debt service

PRICING EURODOLLAR FUTURES, TREASURY BOND FUTURES, STOCK INDEX AND CURRENCY FUTURES

THE RELATION BETWEEN FUTURES PRICES AND EXPECTED SPOT PRICES

MONETARY & NONMONETARY BENEFITS AND COSTS ASSOCIATED WITH HOLDING THE UNDERLYING ASSET AND THEIR EFFECTS TO FUTURES PRICE

48. Futures Markets and Contracts - Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

FUTURE CONTRACTS

48. Futures Markets and Contracts: An Overview

FUTURES PRICE & THE VALUE OF A FUTURES CONTRACT

WHY FORWARD AND FUTURES PRICES DIFFER

Deliverable contracts obligate the long to buy and the short to sell a certain quantity of an asset for a certain price on a specified future date Cash settlement contracts are settled by paying the contract value in cash on the expiration date

Similar to forward contracts in

Both forwards and futures are priced to have zero value at the time the investor enters into the contract Futures are marked to market at the end of every trading day. Forward contracts are not marked to market

FUTURE CONTRACTS

Futures contracts trade on organized exchanges. Forwards are private contracts and do not trade on organized exchanges Different from forward contracts

Futures contracts are highly standardized. Forwards are customized contracts satisfying the needs of the parties involved Forwards are contracts with the originating counterparty; a specialized entity called a clearinghouse is the counterparty to all futures contracts Forward contracts are usually not regulated. The government having legal jurisdiction regulates futures markets

At expiration, the spot price must equal the futures price because the futures price has become the price today for delivery today, which is the same as the spot.

Futures price must converge to the spot price at expiration

Futures margin is a performance guarantee

Future margins and marking to market

Arbitrage will force the prices to be the same at contract expiration

The clearinghouse guarantees that traders in the futures market will honor their obligations by splitting each trade once it is made and acting as the opposite side of each position => To safeguard the clearinghouse, both sides of the trade are required to post margin and settle their accounts on a daily basis

Marking to market is the process of adjusting the margin balance in a futures account each day for the change in the value of the contract from the previous trading day, based on the settlement price

FUTURES PRICE & THE VALUE OF A FUTURES CONTRACT

Has no value at contract initiation Does not accumulate value changes over the term of the contract. The value after the margin deposit has been adjusted for the day's gains and losses in contract value is always zero Value of a futures contract

The futures price at any point in time is the price that makes the value of a new contract equal to zero The value of a futures contract strays from zero only during the trading periods between the times at which the account is marked to market Value of futures contract = current futures price - previous mark-to-market price If the futures price increases, the value of the long position increases

The no-arbitrage price of a futures contract

48. Futures Markets and Contracts - Part 1

FP = futures price So = spot price at inception of the contract ( t = 0) R f = annual risk-free rate T = futures contract term in years

should be the same as that of a forward contract

If investors prefer the mark-to-market feature of futures, futures prices will be higher than forward prices Cases that causes futures and forward prices to be different

If investors would rather hold a forward contract to avoid the marking to market of a futures contract, the forward price would be higher than the futures price

WHY FORWARD AND FUTURES PRICES DIFFER

A cash-and-carry arbitrage consists of buying the asset, storing/holding the asset, and selling the asset at the futures price when the contract expires Borrow money for the term of the contract at market interest rates At the initiation of the contract Cash-and-carry arbitrage

Buy the underlying asset at the spot price Sell (go short) a futures contract at the current futures price

Steps At contract expiration

Deliver the asset and receive the futures contract price Repay the loan plus interest

If the futures contract is overpriced => generate a riskless profit Future arbitrage

The futures contract is overpriced if the actual market price is greater than the no-arbitrage price When the futures price is too low (which presents a profitable arbitrage opportunity) Sell the asset short Reverse cash-and-carry arbitrage

At the initiation of the contract

Buy (go long) the futures contract at the market price

Steps At contract expiration

48. Futures Markets and Contracts - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

Lend the short sale proceeds at market interest rates

Collect the loan proceeds Take delivery of the asset for the futures price and cover the short sale commitment

Any positive costs associated with storing or holding the asset in a cash and carry arbitrage will increase the no-arbitrage futures price E.g., Financial assets: no storage costs other than the opportunity cost of the funds

A monetary benefit from holding the asset will decrease the no-arbitrage futures price

Convenience yield: The return from non-monetary benefits which come from holding an asset in short supply MONETARY AND NONMONETARY BENEFITS AND COSTS ASSOCIATED WITH HOLDING THE UNDERLYING ASSET AND THEIR EFFECTS TO FUTURES PRICE

net costs (NC) = storage costs - convenience yield

The no-arbitrage futures price counting net costs

FV (NC)= future value, at contract expiration, of the net costs of holding the asset

The no-arbitrage futures price counting net benefits

NB = yield on the asset + convenience yield FV (NB) = future value, at contract expiration, of the net benefits of holding the asset

refers to a situation where the futures price is below the spot price Backwardation Backwardation and contago

to occur, there must be a significant benefit to holding the asset, either monetary or non-monetary

refers to a situation where the futures price is above the spot price Contango

happens when there is no benefits to holding the asset, the futures price will be

The futures price might be temporarily above or below expected future spot prices, but it would be an unbiased predictor of future spot rates

If both parties to a futures transaction are hedging existing risk, the futures price may be equal to expected future spot prices Normal backwardation Normal contango

E.g., benefits to holding the asset that offset the opportunity cost of holding the asset (the risk-free rate) and additional net holding costs

happens when the futures price is lower than the expected price in the future to compensate the future buyer for accepting asset price risk

happens when the futures price is greater than the expected spot price

The most likely situation in financial markets is normal backwardation similar to a forward rate agreement to lend US$1,000,000 for three months beginning on the contract settlement date

THE RELATION BETWEEN FUTURES PRICES AND EXPECTED SPOT PRICES

Eurodollar

based on 90-day LIBOR, which is an add-on yield the price quotes are calculated as (100 - annualized LIBOR in percent) the minimum price change is one "tick," which is a price change of 0.0001 = 0.01 % traded for T-bonds with a maturity of 15 years or more

48. Futures Markets and Contracts - Part 2

Eurodollar, Treasury Bonds, Stock Index, and Currency Futures

Treasury Bonds

the contract is deliverable with a face value of $100,000 T-bond futures are quoted as a percent and fractions of 1 % (measured in 1/32nds) of face value each bond is given a conversion factor (multiplier) that is used to adjust the long's payment at delivery based on the level of an equity index

Stock index futures

most popular stock index future is the S&P 500 settlement is in cash and is based on a multiplier of 250

Currency Futures

In the United States, currency contracts trade on the euro, Mexican peso, and yen, among others

Treasury bill (T-bill) futures contracts are based on a $1 million face value 90-day (13-week) T-bill, and they settle in cash The price quotes are 100 minus the annualized discount in percent on the T-bills

Treasury Bill Futures Pricing

Eurodollar futures

T-bill futures are priced using the no-arbitrage principle Eurodollar futures are priced as a discount yield, and LIBOR-based deposits are priced as an add-on yield => The result is that the deposit value is not perfectly hedged by the Eurodollar contract => Eurodollar futures can't be priced using the standard no-arbitrage framework

The no-arbitrage futures price for a T-bond contract

Treasury Bond Futures

FVC: the future value of the coupon payments

The futures price that insures a cash-and-carry arbitrage would provide no profit is lower than without the cash flows Because the cost to hold the asset is reduced by the asset cash flows T-bond futures prices must be adjusted to conform to the price for the bond that is cheapest to deliver, using its conversion factor (CF)

PRICING EURODOLLAR FUTURES, TREASURY BOND FUTURES, STOCK INDEX AND CURRENCY FUTURES

The no-arbitrage futures price adjusted for the future value of the dividends (FVD) or present value of the dividends (PVD) Stock futures

Equity Index Futures

The no-arbitrage futures price

The price of currency futures Currency Futures

In continuous time it is

48. Futures Markets and Contracts - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

DC = domestic currency FC = foreign currency

AMERICAN/EUROPEAN OPTIONS ON FUTURES AND FORWARDS AND APPROPRIATE PRICING MODEL FOR EUROPEAN OPTIONS

PUT-CALL PARITY FOR EUROPEAN OPTIONS

SYNTHETIC CALL/PUT OPTION, BOND AND UNDERLYING STOCK

PUT-CALL PARITY FOR FORWARD/FUTURES OPTIONS

THE HISTORICAL AND IMPLIED VOLATILITIES OF AN UNDERLYING ASSET

EFFECT OF THE UNDERLYING ASSET'S CASH FLOWS ON THE PRICE OF AN OPTION

THE DELTA OF AN OPTION AND ITS USE IN DYNAMIC HEDGING

49. Option Markets and Contracts - Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

49. Option Markets and Contracts: An Overview

ONE- AND TWO-PERIOD BINOMIAL MODELS TO CALCULATE AND INTERPRET PRICES OF INTEREST RATE OPTIONS AND OPTIONS ON ASSETS

ASSUMPTIONS UNDERLYING THE BLACK-SCHOLES-MERTION MODEL

A CHANGE IN THE VALUE OF EACH INPUT AFFECTS THE OPTION PRICE (UNDER THE BLACK-SCHOLES-MERTION MODEL)

A long position in a European call option with an exercise price of X that matures in T years on a stock (with a price at time t of S

t)

A long position in a pure-discount riskless bond that pays X in T years

A fiduciary call

PUT-CALL PARITY FOR EUROPEAN OPTIONS

A long position in a European put option with an exercise price of X that matures in T years A long position in the underlying stock

A protective put

That the cost of a fiduciary call must be equal to the cost of a protective up

Put-call parity for European options

+: long position - : short position Buying a European put option on the same stock with the same exercise price (X) and the same maturity (T) Buying the stock

A synthetic European call option is formed by

Shorting (i.e., borrowing) the present value of X worth of a pure-discount riskless bond Buying a European call option

SYNTHETIC CALL/PUT OPTION, BOND AND UNDERLYING STOCK

Shorting the stock

A synthetic European put option is formed by

Buying (i.e., investing in) the discount bond Buying a European call option

A synthetic stock position is formed by

Shorting (i.e., writing) a European put option Buying (i.e., investing in) the discount bond Buying a European put option

A synthetic pure-discount riskless bond is created by

Buying the stock Shorting (i.e., writing) a European call option

Two reasons to create synthetic positions in the securities

Using put-call parity for arbitrage

To price options by using combinations of other instruments with known prices To earn arbitrage profits by exploiting relative mispricing among the four securities If put-call parity doesn't hold (if the cost of a fiduciary call does not equal the cost of a protective put), buy (go long in) the underpriced position and sell (go short) in the overpriced position

D =risk-neutral probability of an down-move = 1 -

U

R f = risk-free rate U = size of an up-move D = size of a down-move Calculating the payoff of the option at maturity in both the up-move and down-move states

One-Period Binomial Model

Calculate the value of an option on the stock

Calculating the expected value of the option in one year as the probability-weighted average of the payoffs in each state Discounting the expected value back to today at the risk-free rate

provides the information required to calculate a hedge ratio (the fractional share of stock in the arbitrage trade)

Arbitrage with one-period binomial model

Calculate the stock values at the end of two periods (there are three possible outcomes because an up-then-down move gets you to the same place as a down-then-up move)

49. Option Markets and Contracts - Part 1

Calculate three possible option payoffs at the end of two periods

ONE- AND TWO-PERIOD BINOMIAL MODELS TO CALCULATE AND INTERPRET PRICES OF INTEREST RATE OPTIONS AND OPTIONS ON ASSETS

Calculate the expected option values at the end of two periods (t = 2) using the up-and down-move probabilities

Steps to value an option

Discount the expected option values (t = 2) back one period at the risk-free rate to find the option values at the end of the first period (t = 1)

Two-Period Binomial Model

Calculate the expected option value at the end of one period (t = 1) using up-and down-move probabilities Discount the expected option value at the end of one period (t = 1) back one period at the risk-free rate to find the option value today is the set of possible interest rate paths that are used to value bonds with a binomial model Binomial interest rate trees

the underlying rule governing the construction of an interest rate tree

the values for on-the-run issues generated using an interest rate tree should prohibit arbitrage opportunities

There are three basic steps to valuing an option on a fixed-income instrument using a binomial tree Options on Fixed Income Securities

the interest rate tree must maintain the interest rate volatility assumption of the underlying model

price the bond at each node using projected interest rates calculate the intrinsic value of the option at each node at maturity of the option, and calculate the value of the option today

The value of an interest rate cap or floor is the sum of the values of the individual caplets or floorlets

Options on Interest Rates: Caps and Floors

Expiration value of caplet

Expiration value of floorlet As the period covered by a binomial model is divided into arbitrarily small, discrete time periods, the model results converge to those of the continuous-time model The Black-Scholes-Merton (BSM) model values options in continuous time and is derived from the same no-arbitrage assumption used to value options with the binomial model To derive the BSM model, an "instantaneously" riskless portfolio is used to solve for the option price based on the same logic The price of the underlying asset follows a lognormal distribution The (continuous) risk-free rate is constant and known

Limitation: The BSM model is not useful for pricing options on bond prices and interest rates

The volatility of the underlying asset is constant and known Assumptions and Limitations

Markets are "frictionless"

In practice, the volatility is not known and must be estimated. The bigger problem is that volatility is often not constant over time and the BSM model is not useful in these situations

Model is less realistic and less useful

The underlying asset generates no cash flows

The options are European

ASSUMPTIONS UNDERLYING THE BLACK-SCHOLES-MERTION MODEL

The formula for the BSM model

Use put-call parity to calculate the put value

49. Option Markets and Contracts - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

The BSM model can be easily altered if we relax the assumption of no cash flows on the underlying asset

The model does not correctly price American options. Binomial option pricing models are more appropriate for pricing American options

A Greek is a sensitivity factor that captures the relationship between each input (asset price, asset price volatility, time to expiration, and the risk-free rate) the option price

Delta describes the relationship between asset price and option price

Vega measures the sensitivity of the option price to changes in the volatility of returns on the underlying asset

A CHANGE IN THE VALUE OF EACH INPUT AFFECTS THE OPTION PRICE (UNDER THE BLACK-SCHOLES-MERTION MODEL)

Rho measures the sensitivity of the option price to changes in the risk-free rate

There is a benefit to early exercise of options on futures when they are deep in the money Exercising the option (either a put or call) early will generate cash from the mark to market => cash can earn interest, while the futures position will gain or lose from movements in the futures price => these price movements between early exercise and option expiration will mirror those of the deep in the money option There is no mark to market on forwards, early exercise does not accelerate the payment of any gains

theta is less than zero: as time passes and the option approaches the maturity date, its value decreases

American options on futures are more valuable than comparable European options because

With no reason for early exercise, the value of American and European options on forwards are the same

Theta measures the sensitivity of the option price to the passage of time

AMERICAN/EUROPEAN OPTIONS ON FUTURES AND FORWARDS AND APPROPRIATE PRICING MODEL FOR EUROPEAN OPTIONS

The Black model can be used to price European options on forwards and futures

= standard deviation of returns on the futures contract F T = futures price

Put-call parity for options on forwards and futures is as follows

PUT-CALL PARITY FOR FORWARD/FUTURES OPTIONS

American options on futures are more valuable than European options because early exercise provides mark to market funds on the futures, which can earn interest

49. Option Markets and Contracts - Part 2

Americans and European options on forward contracts are equivalent because there is no mark to market

Step 1: Convert a time series of N prices to returns Step 2: Convert the returns to continuously compounded returns

C = change in the price of the call over a short time interval S = change in the price of the underlying stock over a short time interval

Delta is the change in the price of an option for a one-unit change in the price of the underlying security

The steps in computing historical volatility for use as an input in the BSM continuous-time options pricing model are

THE HISTORICAL AND IMPLIED VOLATILITIES OF AN UNDERLYING ASSET

Use BSM model to estimate the change in the value of the call given the change in the value of the stock and the option's delta

C N(d1) x S P (change in put price)

[N(d1) - 1] x

S

Step 3: Calculate the variance and standard deviation of the continuously compounded returns

when used in the Black-Scholes formula, it produces the current market price of the option

Implied volatility is the value for standard deviation of continuously compounded rates of return that is "implied" by the market price of the option

Decrease the value of a call option Increase the value of a put option

All else equal, the existence of cash flows on the underlying asset will

EFFECT OF THE UNDERLYING ASSET'S CASH FLOWS ON THE PRICE OF AN OPTION

Put-call parity for options on underlying assets with cash flows by adjusting S for the present value of the cash flows (PVCF) A call option delta is between 0 and 1. If the call option is Interpreting Delta

A put option delta is between -1 and 0. If the put option is

THE DELTA OF AN OPTION AND ITS USE IN DYNAMIC HEDGING

Out-of-the-money (stock price is less than exercise price), the call delta moves closer to 0 as time passes, assuming the underlying stock price doesn't change In-the-money (stock price is greater than exercise price), the call delta moves closer to 1 as time passes, assuming the underlying stock price doesn't change Out-of-the-money (stock price is greater than exercise price), the put delta moves closer to O as time passes, assuming the underlying stock price doesn't change In-the-money (stock price is less than exercise price), the put delta moves closer to -1 as time passes, assuming the underlying stock price doesn't change

The goal of a delta-neutral portfolio (or delta-neutral hedge) is to combine a long position in a stock with a short position in a call option so that the value of the portfolio does not change when the value of the stock changes Number of call options needed to delta hedge = number of shares hedged/delta of call option Dynamic Hedging

Number of put options needed to delta hedge = number of shares/delta of the put option The delta-neutral position only holds for very small changes in the value of the underlying stock => must be continually rebalanced to maintain the hedge (a dynamic hedge)

Gamma measures the rate of change in delta as the underlying stock price changes

costly in terms of transaction costs

can be viewed as a measure of how poorly a dynamic hedge will perform when it is not rebalanced in response to a change in the asset price

Call and put options on the same underlying asset with the same exercise price and time to maturity will have equal gammas Long positions in calls and puts have positive gammas Gamma is largest when a call or put option is at-the-money and close to expiration

Gama effect

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