CFA mindmap

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CFA LEVEL 1    STUDY SESSION 01   

ETHICAL & PROFESSIONAL STANDARDS

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All CFA Institute members and candidates are required to comply with the Code and Standards The CFA Institute Bylaws

Basic structure for enforcing the Code and Standards

Rules of Procedure

Fair process to member and candidate

Based on two primary principles

Confidentiality of proceedings

Maintains oversight and responsibility Structure of the CFA Institute Professional Conduct Program

Professional Conduct program (PCP)

The CFA Institute Board of Governors

The CFA Designated Officer

Through the Disciplinary Review Committee (DRC)

Directs Professional Conduct Staff

Is responsible for the enforcement of the Code and Standards

Conducts professional conduct inquiries

Self-disclosure An inquiry can be prompted by several circumstances

a.

Written complaints Evidence of misconduct Report by a CFA exam proctor

Requesting a written explanation from the member or candidate

1. Code Of Ethics And Standards Of Professional Conduct

Process for the enforcement of the Code and Standards

The Professional Conduct staff conducts an investigation that may include

The member or candidate Interviewing

Complaining parties Third parties

Collecting documents and records in support of its investigation When an inquiry is initiated

Conclude the inquiry with no disciplinary sanction Issue a cautionary letter Upon reviewing the material obtained during the investigation, the Designated Officer may

Continue proceedings to discipline the member or candidate

Act with integrity, competence, diligence, respect and in an ethical manner Six components of the Code of Ethics

Integrity of investment profession & interest of clients above personal interest Care & judgment Practice ethics & encourage others to practice Integrity & rules of capital markets Professional competence

b,c.

Professionalism Integrity of Capital markets Seven Standards of Professional Conduct

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

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

Accepted by member Rejected by member

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

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Understand and comply with applicable laws and regulations Follow stricter law and regulation

Code and Standards vs. Local law

Responsible for violations in which they

knowingly participate or assist ->Leave employers (in extreme cases)

Dissociate from illegal, unethical activities Guidance

Participation or association with violations by others

a

Attempt to stop the behavior by bringing it to the attention of employer through a supervisor or compliance department Intermediate steps

May consider directly confronting the involved individuals If not successful,-> step away and dissociate from the activity by

A. Knowledge of the law

Removing their name from written reports Asking for a different assignment

Inaction with continued association may be construed as knowing participation Not require reporting violations to government, CFAI, but... Stay informed Review procedures Recommended procedures for compliance (RPC)

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

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,...

Application

Maintain independence and objectivity in professional activities Gifts, Invitations to lavish functions, Tickets, Favors, Job referrals, Allocation of shares in oversubscribed IPOs...

By benefits External pressures

To issue favorable reports

From public companies From Buy-side clients

May try to pressure sell-side analysts

e.g. to issue favorable research reports/recommendations for certain companies How to cope with external and internal pressures

From their own firms

Internal pressures

Guidance

Investment-banking relationships

to issue favorable research on current or prospective investment-banking clients 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 gift,..threatening independence and objectivity 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 sell-side research

2.1 Standard I PROFESSIONALISM

Is fraught with conflicts Must engage in thorough, independent, and unbiased analysis Must fully disclose potential conflicts, including the nature of compensation

Issuer-paid research

-->Analysts

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

Accept only flat fee for their work prior to writing the report Without regard to conclusions or recommendations

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

Limit gifts Restrict employee investments

Equity IPOs Private placements

Review procedures Written policies on independence and objectivity of research

any untrue statement or omission of a fact

Definition of "Misrepresentation"

or any fasle or misleading statement oral representations, advertising

Must not knowingly make misrepresentation or give false impression in Guidance

electronic communications written materials qualifications or credentials, services

Must not misrepresent any aspect of practice, including

performance record 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 publich 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 Violations

Conduct damaging trustworthiness or competence Abuse of the CFA Institute Professional Conduct Program

D. Misconduct

Develop and/or adopt a code of ethics RPC

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

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Definition of "Material nonpublic information" Must be particularly aware of info selectively disclosed by corporations Guidance 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

Make reasonable efforts to achieve public dissemination of material info

A. Material nonpublic information (MNI)

Must communicate the info only to the designated supervisory and compliance personnel within the firm

If public dissemination is not possible,

RPC

Must not take investment action on the basis of the info

Must not knowingly engage in conduct inducing insiders to privately disclose MNI adopt compliance procedures preventing misuse of MNI Encourage firms to

2.2 Standard II INTEGRITY OF CAPITAL MARKETS

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 transactions that deceive market participants

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

can be related to dissemination of false or misleading info

B. Market manipulation

Standard II(B) not meant to

including spreading false rumors to induce trading by others

prohibit legitimate trading strategies prohibit transactions done for tax purposes

The intent of action is critical to determining whether it is a violation of this Standard

Page 5 duty to exercise reasonable care

Prudence require cautions and discretion

act with care, skill, and diligence follow the investment parameters set forth by clients & balancing risk & return

Determine identity of "client" Must be aware of whether they have "custody" or effective control of client assets Manage pool of assets in accordance with terms of governing documents Put their obligation to client first in all dealings Avoid all real or potential conflicts of interest Forgo using opportunities for their own benefit at the expense of client Follow any guidelines set out by client for the management of assets Judge investment decisions in context of total portfolio Vote proxies in an informed & responsible manner Understand & adhere to fiduciary duties

Responsibility to a client includes

Guidance A. Loyalty, prudence, and care

duty of loyalty

"Soft dollars" Submit to clients at least quarterly itemized statements Separate assets Review investments periodically Establish policies & procedures with respect to proxy voting and the use of client brokerage Encourage firms to address some topics (p. )

RPC

Do not discriminate against any clients "Fairly" vs "equally Standard III(B) addresses the manner of disseminating investment recommendations or changes in prior recommendations to clients Ensure fair opportunity to act on Encourage firms to design equitable system to prevent selective, discriminatory disclosure Investment recommendations particularly clients may have acted on Material changes should be communicated to all current clients or been affected by earlier advise

Guidance B. Fair dealing

Clients who don't know changes and therefore place orders contrary to a current recommendation

Investment actions

2.3 Standard III DUTIES TO CLIENTS

should be advised of the changed recommendation before the order is accepted

Treat all clients fairly in light of their investment objectives & circumstances duty of fairness and loyalty to clients can Disclose to clients & never be overridden by client consent to prospects written patently unfair allocation procedures allocation procedures Should not take advantage of their position in the industry to the detriment of clients

RPC (p.

Guidance

)

In investment advisory relationships

Be sure to gather client info in the form of an IPS and make suitability analysis prior to making recommendation/taking investment action Inquiry should be repeated at least annually/prior to material changes -->suitability analysis must be If clients withhold info done based on info provided Risk analysis Fund managers

C. Suitability

In case of unsolicited trade requests unsuitable for client

Be sure investments are consistent with the stated mandate

-->refrain from making trade or seek affirmative statement from client that suitability is not a consideration

Written IPS Investors' objectives and constraints should be maintained and reviewed periodically to reflect any changes in clients' circumstances

RPC

Guidance D. Performance presentation

Standard III(D) prohibits misrepresentations of past performance or reasonably expected performance --> Provide credible performance info -->Should not state or imply that clients will obtain or benefit from rate of return generated in the past --> ensure that their claims are Research analysts promoting the success fair, accurate, and complete of accuracy of their recommendations If the presentation is brief, must make available to clients and prospects the detailed info upon request

RPC

GIPS on the basis of their special ability to conduct a portion of clients' business or personal affairs arising from or is relevant to that portion of clients' business that is the subject of special or confidential relationship Comply with applicable laws When in doubt -->consult with compliance department/ outside counsel before disclosing Standard III(E) is applicable when members receive info

Guidance E. Preservation of confidentiality

Standard III(E) does not prevent cooperating with an investigation by CFAI PCP RPC

a

Pagemust 6 In matters related to their employment, members and candidates not engage in conduct that harms the interests of the employer -->Comply with policies and procedures established by employers that govern employer-employee relationship

Employer-employee relationship

Standard IV(A) does not require to place employer interests ahead of personal interests in all matters The relationship imposes duties and responsibilities on both parties

Independent practice

Abstain from independent competitive activity that could conflict with employer's interests Provide notification to employer, obtain consent from employer in advance

Guidance

A. Loyalty Planning to leave, must continue to act in employer's best interest Must

Leaving an employer

Firm records or work performed on behalf of firm stored on a home computer should be erased or returned to employer engage in activities conflicting with duty until resignation effective

Must not

contact existing clients/potential clients prior to leaving for soliciting take records of files to a new employer without written permission

Free to make arrangements/preparations provided that not breaching duty of loyalty Applicable non-compete agreement Whistle blowing Nature of employment

2.4 Standard IV DUTIES TO EMPLOYERS

Obtain written consent from employer before accepting compensation or other benefits from third parties...

Guidance

B. Additional compensation arrangements

RPC

Should make an immediate written report to their employers

Must have in-depth knowledge of the Code & Standards Apply knowledge in discharging supervisory responsibilities Delegation of supervisory duties does not relieve members of supervisory responsibility

-->Instruct subordinates methods to prevent and detect violations

Make reasonable efforts to detect violation of laws, rules, regulations, and Code & Standards Must understand what constitutes an adequate compliance system Make reasonable efforts to see that appropriate compliance procedures are established, documented, communicated to covered personnel and followed

Guidance -->Establish and implementing Compliance procedures

C. Responsibilities of supervisors

Bring an inadequate compliance system to senior managers's attention & recommend corrective action If clearly cannot discharge responsibilities 'cos of absence of compliance system, In case of employee's violation,

-->decline in writing to accept responsibilities

promptly initiate investigation take steps to ensure no repetition

Recommend employer to adopt a code of ethics Respond promptly RPC

If there is a violation

Conduct a thorough investigation Increase supervision or place appropriate limitations on the wrongdoer pending the outcome of the investigation

investment philosophy followed The application of Standard V(A) depends on

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role of member in the investment decision-making process support and resources provided by employer

Must make reasonable efforts to cover all pertinent issues when arriving at recommendation Provide or offer to provide supporting info to clients when making recommendations/changing recommendations Guidance -->must make reasonable &diligent efforts to determine whether 2nd/3rd party research is sound

Using secondary or third-party research

A. Diligence and reasonable basis

If member does not agree with the independent and objective view of the group

Group research and decision making

-->Not necessarily have to decline to be identified if believing consensus opinion has reasonable & adequate basis -->Should document member's difference of opinion with group

RPC (p. )

Standard V(B) addresses conduct with respect to communicating with clients Communication is not confined to written form but via any means of communication Developing and maintaining clear, frequent, and thorough communication practices is critical

2.5 Standard V INVESTMENT ANALYSIS, RECOMMENDATIONS & ACTIONS

distinguish clearly between facts & opinions present basic characteristics of the analyzed security in preparing research report Must

adequately illustrate to clients & prospective clients the manner of conducting investment decision-making process keep them informed with respect to changes to the chosen investment process

Guidance

B. Communication with clients and prospective clients

-->must be supported by background report or data on request

Brief communications

-->should notify clients that additional info and analyses are available from the producer of the report

Capsule form recommendations

Investment advice based on quantitative research and analysis

-->must be supported by readily available reference material -->in a manner consistent with previously applied methodology or with changes highlighted

Should outline known limitations, consider principal risks in investment analysis, report RPC

In hard copy or electric form

Guidance

C. Record retention

Fulfilling regulatory requirements may satisfy the requirements of this Standard

Absence of regulatory guidance RPC

Must explicitly determine whether it does

CFAI recommends maintaining records for at least 7 yrs

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is a critical part of working in investment industry Managing conflicts

Best practice is to avoid conflicts of interest when possible

can take many forms

If not, disclosure is necessary

prominent Disclosures must be

made in plain language in a manner to effectively communicate the info to clients between member or their firm and issuer Relationships

investment banking underwriting and financial relationships

Broker/dealer market-making activities Material beneficial ownership of stock between duties to clients and to shareholders of the company

All matters may impair objectivity Investment personnel also serves as a director

Disclosure to clients

Guidance

poses conflicts of interest

may receive option to purchase securities of the company as compensation MNI

-->members providing investment services also serving as directors should be isolated from those making investment decisions

A. Disclosure of conflicts -->Sell-side members

should disclose material beneficial ownership interest in securities/investment recommended

-->Buy-side members

should disclose procedures for reporting requirements for personal transactions

What? Disclosure of conflicts to employers

How?

by firewalls

Same circumstances with clients Any potential conflict situation Enough info Must comply with employer's restrictions regarding conflict of interest

2.6 Standard VI CONFLICTS OF INTEREST

Other requirements

Must take reasonable steps to avoid conflicts If conflicts occur inadvertently, must report them promptly

Should disclose special compensation arrangements with employer that might conflict with client interest RPC

Document request & may consider dissociating from the activity if firm does not permit disclosure of special compensation arrangements Disclose to clients info that fee based on a share of capital gains Disclose as a footnote to research report published if members have outstanding agent options to buy stocks as a part of compensation package

Clients & employers' transactions have priority -->personal investment positions or transactions should never adversely affect client investments

Co-investment

may occur client is not disadvantaged by the trade Conflicts of interests Guidance

-->make sure

investment professional does not benefit personally from trades undertaken for clients investment professional complies with applicable regulatory requirements

B. Priority of transactions

Having knowledge of pending transactions, assess to info during normal preparation of research recommendations

-->Must not convey such info

May undertake personal transactions after clients & employers have had adequate opportunity to act on recommendation Family accounts (that are client accounts)

should be treated like other accounts if member has beneficial ownership

RPC (p. )

employer whom

client prospective client compensation

Inform

C. Referral fees

what

consideration benefit received from, or paid to, others

how

before entry into any formal agreement nature of the consideration or benefit

-->may still be subject to pre clearance or reporting requirements

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Cheating on CFA exam or any exam

A. Conduct as members and candidates in the CFA program

Prohibiting any conduct that undermines the integrity of the CFA charter (p. )

Not following rules and policies of the CFA program Giving confidential info on the CFA Program to candidates or the public .....

Not precluded from expressing opinion regarding the CFA Program or CFAI

a

Preventing promotional efforts that make promises or guarantees tied to the CFA designation

2.7 Standard VII RESPONSIBILITIES AS CFA MEMBER / CANDIDATE

B. Reference to CFA Institute, the CFA Designation and the CFA program

Over-promise the competence of an individual Over-promise future investment results

Applies to any form of communication

To maintain CFAI membership

Remit annually to CFAI a completed Professional Conduct Statement Pay applicable CFAI membership dues on an annual basis

Using the CFA designation (p. Curriculum)

Referencing candidacy in the CFA program (p. Curriculum)

Proper using of the CFA marks (p. Curriculum)

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a1. Why were the GIPS Standards created?

3. Introduction to Global Investment Performance Standards (GIPS)

a2. Who can claim compliance? a3. Who benefit from Compliance? b. Construction & purpose of Composites c. Verification The Structure of the GIPS Standards

GIPS Objectives

4a. Key characteristics of the GIPS standards & fundamentals of compliance

Key characteristics Fundamentals of compliance

Requirements Recommendations

3+4 GIPS Investment firm definition

b. The scope of the GIPS

Historical performance record

c1. How are GIPS standards implemented in countries with existing standards for performance reporting

c2. Appropriate response when the GIPS standards & local regulations conflict

d. Major sections of GIPS standards

a

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CFA LEVEL 1    STUDY SESSION 02&03   

QUANTITATIVE ANALYSIS

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Required rate of return

a. Interest rate, considered as

Discount rate Opportunity cost

=

b. Interest rate

c,d. EAR

FV=

PV=

Annuity

e. CF calculations

Ordinary Annuity Annuity Due

PV of a Perpetuity

5. TIME VALUE OF MONEY

Uneven CF

f1. Time index

Find PMT

f2. Loan payment and Amortization

Find N Find I/Y Amortization table

Rate of compound growth

f3. Other applications

Number of periods for specific growth Funding a future obligation

f4. Connection between PV, FV & series of CF

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NPV

a,b. Calculate, Interpret, Decision rule

Problems IRR

Conflict with NPV due to

# Initial costs # timing

c. HPR

Money Weighted

d. Portfolio rate of return Time weighted

6. DISCOUNTED CASH FLOW APPLICATIONS

IRR More appropriate if manager has complete control over cash in/out

Compound growth Geometric mean Not affected by cash in/out Preferred method

Bank discount yield

Holding period yield

e. Yields of T-bills

Effective annual yield

Money market yield

f1. Convert among these yields

f2. Bond equivalent yield

Page 14 Statistical methods

Descriptive statistics Inferential statistics

Population vs. Sample Nominal scales

Types of measurement scales

a.

Ordinal scales Interval scales Ratio scales

Parameter vs. Sample statistic Definition

Frequency distribution

b.

Construction of a frequency distribution

7 steps

Absolute frequency Relative frequency

c.

Cumulative absolute frequency Cumulative relative frequency Histogram

d.

Frequency polygon Population mean vs. Sample mean Arithmetic mean Weighted mean (portfolio return) Mean

Geometric mean (compound growth)

m. Use of arithmetic or geometric mean when determining investment returns

e. Measures of central tendency

Harmonic mean (cost of shares) Harmonic < geometric < arithmetic Median

Odd number of observations Even number of observations No mode

Mode

Unimodal, bimodal, trimodal Model interval

Quartiles (4) Quintile (5) Decile (10)

f. Quantile

Percentile (100)

Ly =(n+1)*y/100

Range MAD

g. Dispersion (measure of risk)

Variance & Standard deviation

Population Sample (use n-1)

1-1/(k^2)

h. Chebyshev's inequality

CV (Coefficient of Variation) = StdDev / Average

i. Relative dispersion

Sharpe Ratio / Reward-to-Variability ratio

Symmetrical

=Excess return/ StdDev

mean=median=mode Calculate: Sample skewness =

j,k. Shape of distribution

Nonsymmetrical (Skewness) (b/c of outliers)

Calculate

l. Kurtosis

Positively skewed (Sk>0) Types

mode more risk Platykurtic: less peaked (excess kurtosis < 0) Mesokurtic: identical (excess kurtosis = 0)

mean=30

e. Central limit theorem

f. Standard error of the sample mean

Point estimation

h. Estimate a population parameter

Confidence interval estimation

Unbiased

10. SAMPLING & ESTIMATION

g. Desirable properties of an estimator

Efficient Consistent

Small samples (nMinimize cost

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PERFECT COMPETITION

a

MONOPOLISTIC COMPETITION

a.b.c.d.e

OLIGOPOLY

16. The Firm And Market Structures

MONOPOLY

Use

f. Concentration measures Limitations

g. Identify type of market structure

Expenditure approach

a. Calculate GDP using

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Income approach

Sum-of-value-added method

b. Compare Value-of-final-output method

a GDP

Nominal GDP

Compare

Real GDP

c. GDP deflator

GDP National income

d. Compare Personal income Personal disposable income

Saving Investment

e. Fundamental relationship among

Fiscal balance

17. Aggregate Output, Price, And Economic Growth

Trade balance

IS curve

f.

LM curve Aggregate demand curve

Aggregate Demand and Supply

SR

g. Aggregate supply curve in LR

h. Shifts and movements along D & S curves

i. Fluctuations in aggregate D & S --> SR changes in econ & biz cycle Sources

j.

Measurement Sustainability

Economic growth

k. Production function approach

Input growth

l. Components of economic growth

Growth of total factor productivity

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Biz Cycle

a. Describe Phases of Biz Cycle

Business cycle

b. Economy moving through biz Cycle -->

Inventory levels Labor Physical capital utilization levels

c. Theories of Biz Cycle Types

d. Unemployment

Measures

Inflation

e. Explain

18. Understanding Business Cycles

Disinflation Deflation

f. Indices used to measure inflation Inflation Uses

g. Inflation measures

Limitations

h. Factors --> affect price levels

i. Describe economic indicators

Cost push inflation Demand-pull inflation

Uses Limitations

Economic indicators Past biz cycle

j. Identify

Current biz cycle Expected future biz cycle

a

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Monetary policy

a. Compare Fiscal policy

Definition, qualities and functions of money

b

Money creation process

Demand for money

c. Theories of Supply of money

d. Fisher effect Roles

e. Central banks

Objectives

f. Implementation of monetary policy Monetary policy

g. Qualities of effective central banks economic growth

h. Relationships between monetary policy and

inflation interest exchange rate

Expansionary monetary policy

19. Monetary And Fiscal Policy

i. Contractionary monetary policy

j. Limitations of monetary policy Roles

k. Describe Objectives

l. Tools of fiscal policy

Fiscal policy

Spending tools Revenue tools

m. Being concerned with Size of a fiscal debt

implementation of fiscal policy

n. Explain difficulties of implementation

Expansionary fiscal policy

o. Contractionary fiscal policy

p. Interaction of monetary and fiscal policy

Arguments for Arguments against

a

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Warm-Up: International Trade a Benefits

a. International trade

Costs

Comparative advantage

b. Distinguish Absolute advantage

Ricardian

c. Models of trade

Heckscher-Ohlin

Trade restrictions

d. Restrictions Capital restrictions

Trading blocs

20. International Trade And Capital Flows

e. Motivations for and Advantages of

Common markets

Economic unions

Description

f.

Current account Components

Capital account Financial account

Balance of payments Consumers

g. Influenced by

Firms

Govt

World Bank

h. Functions and objectives of international organizations

IMF

WTO

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Define an exchange rate Nominal exchange rates

a.

Real exchange rates

Distinguish

Spot exchange rates

a

Forward exchange rates

Functions

b. FOREX market

Participants

d. % change in a currency relative to another currency

21. Currency Exchange Rates

e. Currency cross-rates

Forward quotations Forward discount or premium

f.g. h. Calculate and interpret Forward rate consistent with

Countries that do not have their own currency

i. Exchange rate regimes

Countries that have their own currency

International trade

j. Impact of exchange rates on countries'

Capital flows

spot rate and interest rate

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CFA LEVEL 1    STUDY SESSION 7,8,9,10   

FRA

Page 34

Fin position

Role of FiR

of an entity that is useful to a wide range of users in making economic decisions

Fin performance

Provide info about

Changes in fin position

a. Roles of FR and FSA

Use info in a company's Fin Statements Use other relevant info To evaluate past, current, and prospective performance and fin position Invest in securities

Roles of FSA

a

Recommend to investors

To make economic decisions. E.g.:

Whether to extend trade, bank credit Analysts: form opinions about company's ability to earn profits and generate CF

Income Statement (financial performance)

Revenues Expenses Gains and Losses Assets

Balance Sheet (financial position) (A=L+OE)

b. Role of key FS

Liabilities Owners' equity

Operating CF CF statement

Investing CF

Financing CF Statement of changes in Owners' equity

accounting methods, assumptions, estimates

FS notes (footnotes)

Additional items:

acquisitions or disposals legal actions employee benefit plans contingencies and commitments significant customers sales to related parties segments of firm

are audited Supplementary schedules

c. Importance of

not audited operating income or sales by region or business segments reserves for an oil and gas company info about hedging activities and financial instruments

assessment of financial performance and condition of a company from the perspective of its management

22. FSA Introduction

Results from operations, with trends in sales and expenses Publicly held companies in US

Capital resources and liquidity, with trends in CF General business overview

MD&A

discuss accounting policies that require significant judgements by management discuss significant effects of trends, events, uncertainties liquidity and capital resource issues, transactions or events with liquidity implications Discontinued operations, extraordinary items, unusual or infrequent events Extensive disclosures in interim financial statements disclosure of a segment's need for CF or its contribution to revenues or profit

= independent review of an entity's FS objective: auditor's opinion on fairness and reliability of FS, "no material errors" Independent review though FS prepared by mgmt and are its responsibility 3 parts

d. Audits of FS

Standard auditor's opinion

Reasonable assurance of no material errors (follow generally accepted auditing standards) FS prepared in accordance with accepted accounting principles, reasonable accounting principles and estimates, consistency

Explanatory paragraph: when a material loss is probable but amount cannot be reasonably estimated. Uncertainties may relate to the going concern assumption --> signal serious problems and need close examination by analyst (under US GAAP): Opinion on internal controls Unqualified opinion: auditor believes statements are free from material omissions and errors 3 types of Opinions

Qualified opinion: if statements make any exceptions to accounting principles --> explain these exceptions Adverse opinion: if statements are not presented fairly or are materially nonconforming with accounting standards

Interim reports SEC filings

e. Other info sources than annual FS and supplementary info

Quarterly or Semiannual reports (update FS and footnotes, but not audited) from EDGAR to shareholders when there are matters that require a shareholder vote

Proxy statements

Filed with SEC

About election of board members, compensation, management and qualifications and issuance of stock options Corporate reports and press releases Viewed as PR or sales materials

State the objective and context Gather data

f. Steps in FSA framework

Process data Analyze and interpret data Report the conclusions or recommendations Update the analysis

Page 35

Assets Liabilities

a. Fin Statement elements and accounts

5 Elements

a

Owners' equity Revenue Expenses

Basic form

b. Accounting equation

A=L+OW

Extended forms

A=L+CC+Ending Retained Earnings A=L+CC+Beginning RE+R-X-D

Double entry accounting

c. Recording process

Unearned revenue

23. Financial Reporting Mechanics

Accruals

Accrued revenue Prepaid expenses

d. Accruals and other adjustments

Accrued expenses

Other adjustments

Historical vs Current costs --> Valuation adjustments --> income statement or in "other comprehensive income

e. Relationship among IS, BS, CF, OE (p.23)

General Journal (Journal entries) General ledger (sort entries by account)

f. Flow of Info in Accounting system

Initial trial balance-->adjusted trial balance FSs

g. Use of results of accounting process in security analysis

Page 36

Objective of Fin statements

a.

Importance of reporting standards in security analysis and valuation Of standard-setting bodies (establishing standards)

IASB (International Accounting Standards Board) US FASB (Financial Accounting Standards Board)

Of regulatory authorities (enforcing standards)

b. Role

IOSCO (International Organization of Securities Commissions) UK FSA- Financial Services Authority US SEC- Securities and Exchange Commission

Status of global convergence of accounting standards

c.

a

Barriers to developing one universally accepted set of financial reporting standards

standard setting bodies

disagree

regulatory authorities

political pressures from business groups and others Objective of financial statements Understandability consistent among firms and time periods

Comparability Qualitative characteristics

info timely and sufficiently detailed -> influence decision

Relevance

faithful representation substance over form neutrality prudence and conservatism in estimates completeness

Reliability

d. IFRS framework

Required reporting elements

assets, liabilities, equity, income, expenses Historical cost: amount originally paid for the asset Current cost: would have to pay today for the same asset Realizable value: amount for which firm could sell the asset Present value: discounted future cash flows Fair value: 2 parties in an arm's length transaction would exchange the asset

Measurement bases

reliability and relevance (timely) cost Intangible and non-quantifiable info

Constraints

Accrual basis

Assumptions

Going concern Required financial statements

BS, IS, CFS, OE, Explanatory notes (incl. accounting policies)

Fair presentation Principles for PREPARING

Going concern basis Accrual basis Consistency

24. Financial Reporting Standards

e. General requirements for Financial Statements

Materiality Aggregation Principles for PRESENTING

No offsetting Classified balance sheet Minimum information is required Comparative information

IASB requires mgmt to consider the framework if no explicit standard exists

Purpose of framework

IASB same objective

Objectives of financial statements

FASB different objectives for biz and non-biz Assumptions

IASB emphasizes going concern

Qualitative characteristics

FASB: relevance, reliability

Primary characteristics

IASB: comparability, understandability also

IASB: income+expenses

f. IFRS (by IASB) # US GAAP (by FASB)

Performance Financial statement elements

FASB: Revenues, Expenses, Gains, Losses, comprehensive income IASB: resource from which future economic benefit is expected

Asset definition

FASB: future economic benefit IASB: define criteria for recognition

"Probable"

FASB: define assets and liabilities IASB: allow

Values of assets to be adjusted upward

FASB: not allow

Reconciliation statement Characteristics of a coherent financial reporting framework

Transparency Comprehensiveness Consistency Valuation

g.

Barriers to creating a coherent financial reporting framework

Principles-based Standard setting

Rules-based

IFRS relies on broad framework FASB in the past specific guidance how to classify trx FASB moving now

Objectives oriented

blend the other two

Measurement update

h. Importance of monitoring developments in financial reporting standards

www.iasb.org www.fasb.org

In the footnotes & in MD&A (management judgment)

i. Evaluate company disclosures of significant accounting policies & estimates

new accounting standards --> 3 statements

standard does not apply will not affect the FS materially are still evaluating the effects of the new standards

Page 37

Revenues Components

a. IS

a

Expenses Gross profit

Presentation formats

unearned revenue

Accrual accounting

IASB FASB

General principles of

evidence of arrangement btw buyer and seller

Revenue recognition SEC

product delivered or service rendered price is determined or determinable seller reasonably sure of collecting money

Percentage-of-completion method

Long term contracts

b,c. Revenue recognition

Completed-contract method Certain collectibility -> normal method

Installment sales

Not reasonably estimated collectibility -> installment method Highly uncertain collectibility -> cost recovery method

Applications

Round trip transactions

Barter transactions

Gross revenue reporting (vs. net revenue reporting)

primary obligator bear inventory & credit risk ability to choose supplier reasonable latitude to establish prices

Implications for Financial Analysis

Inventories Matching principle

Depreciation Long-lived assets

Depletion Amortization

d. Expense recognition

Bad debt, warranty expenses estimation Period costs

25. Understanding The Income Statement

Admin

Implications for Financial Analysis

Discontinued operations Nonrecurring items

Unusual or infrequent items Extraordinary items

e. Financial reporting treatment and analysis of

Changes in accounting standards

Change in accounting principle Change in accounting estimate Prior-period adjustment

Operating components

f. Distinguish

Nonoperating components

Simple

Capital structure

Complex Basic EPS

Formula: Effect of: Stock dividends and Stock splits

g. EPS Diluted EPS

h.

Dilutive securities Antidilutive securities

Formula: Treasury stock method

i,j. Common size IS & financial ratios FX translation gains and losses Adjustments for minimum pension liability

l. Items excluded from IS but affect OE- other comprehensive income

Unrealized gains and losses from

CF hedging derivatives Available-for-sale securities

k. Comprehensive income: e.g.. on page __

Page 38

Assets Liabilities

a. Elements

Equity

b1. Uses of BS in financial analysis

b2. Limitations of BS in financial analysis Account format

2 common formats

Report format

c. Formats of BS

Classified BS

Current assets Current liabilities

Current vs.non current

Non current assets Non current liabilities

d. Classifying Liquidity-based presentation

Reporting noncontrolling/ minority interest

Historical cost Bases

Fair value Replacement cost PV of future CF Cash and cash equivalent Account receivable

Current assets

lower of cost or net realizable value Inventories

standard costing retail method

26. Understanding The Balance Sheet

Marketable securities Prepaid expenses and others Accounts payable

e. Measurement bases Current liabilities

Note payables Current portion of long term debt Tax payables Accrued liabilities Unearned revenue/income Tangible assets

Non-current assets

Used in operations Not used in operation -> investment assets Identifiable (finite period) -> amortized

Intangible assets

Unidentifiable (infinite) -> not amortized, but tested for impairment at least annually Internally produced -> not recorded, except legal costs

Contributed capital Minority (noncontrolling) interest Retained earnings

f. Components of OE

Treasury stock Accumulated other comprehensive income

BS

g. Analyse

Statement of changes in OE

h. Common-size balance sheet

i. Liquidity & solvency ratios

Goodwill

Page 39

The CF statement

a CFO CFI

a. CFF

affect Net Income affect Long term assets and certain investments affect capital structure

Not reported

b. Noncash investing, financing activities

Disclosed in footnote or supplemental schedule to CF statement

US GAAP: CFF

dividends paid

IFRS: CFF or CFO US GAAP: CFO

interest paid

IFRS: CFO or CFF interest and dividend received

c. IFRS vs. US GAAP

US GAAP: CFO IFRS: CFO or CFI US GAAP: CFO

taxes paid

IFRS: CFO or CFF or CFI

Direct

27. Understanding The CF Statement

d,e, f,g. CF methods

Total currency amounts

Indirect

Major sources and uses of cash CFO CFI CFF

h. Analyse and interpret

Common-size CF statement, divided by

Free cash flow

Revenue Total cash inflow (for inflows) and Total cash outflow (for outflows)

to Firm: FCFF=NI+NCC+Int*(1-t)-FCInv-WCInv=CFO+Int*(1-t)-FCInv

available to

to Equity: FCFE=CFO-FCInv+NetBorrowing CF to revenue

Performance ratios

=CFO/net revenue

Cash return-on-asset

=CFO/average total assets

Cash return-on-equity

=CFO/average total equity

=CFO/Operating income

Cash-to-income Cash flow per share

i. CF ratios

Debt coverage Interest coverage Coverage ratios

=(CFO-preferred dividends)/ Weighted average number of common shares)

=CFO/Total debt =(CFO+Interest paid+taxes paid)/interest paid

Reinvestment ratio

=CFO/cash paid for long term assets

Debt payment ratio

=CFO/cash long term debt repayment

Dividend payment Investing and financing ratio

=CFO/dividends paid =CFO/cash outflows from investing and financing activities

Stockholders Debt holders

Page 40

EXAMPLE: CASH FLOW STATEMENT

Page 41

Page 42

Ratio analysis Common size

a. Analyses

Balance sheet

Vertical

Income statement

Horizontal Charts: stacked column graph, line graph

Receivables management

Receivables T.O = annual sales/average receivables Days of sales outstanding or average collection period = 365/ receivables T.O Inventory T.O = COGS/average inventory

Inventory management

Activity

Days of inventory on hand = 365/inventory T.O Payables T.O = purchases/average trade payables

Trade credit management

Number of days of payables = 365/payables T.O

Total assets management

Total asset T.O = revenue/average total assets

Fixed assets management

Fixed asset T.O = revenue/average net fixed assets

Working capital management

Working capital T.O = revenue/average working capital

Current ratio = current assets/current liabilities Quick ratio = (cash + marketable securities + receivables)/current liabilities

Liquidity

Cash ratio= (cash + marketable securities)/ current liabilities Defensive interval= (cash + marketable securities + receivables)/ average daily expenditures Cash conversion cycle = days sales outstanding + days of inventory on hand - number of days of payables Debt-to-equity = D/E

b,c. Classes of ratios

Debt-to-capital = D/(D+E) Use of debt financing Debt-to-assets = D/A

Solvency

Financial leverage = A/E Interest coverage = EBIT/Interest payments

Ability to repay debt obligations

Fixed charge coverage= (EBIT + lease payments) / (interest payments+lease payments)

Net profit margin= Net income/ Revenue

28. Financial Analysis Techniques

Gross profit margin= (Net sales - COGS)/ Revenue Operating profitability

Operating profit margin = EBIT/ Revenue Pretax margin= EBT/ Revenue

Profitability

ROA Profitability relative to funds

Ratio analysis

Formula 1: ROA= Net income/ Average total assets Formula 2: ROA= (Net income + int exp (1- tax rate))/ Average total assets

Operating ROA = EBIT / Average total assets ROTC (Return on Total Capital) = EBIT/ Average total capital ROE = Net income/ Average total equity Return on common equity = (Net income - preferred dividends)/ Average common equity

Valuation

Sales per share, EPS, P/CF ... (in Equity study section)

Original approach

d. DuPont analysis Extended (5-way) DuPont

Valuation ratios Dividends and Retention Rate Net income per employee and Sales per employee Industry-specific ratios

for service and consulting firms

Growth in same-store sales Sales per square foot

for restaurants and retail industries

for retail industry

Revenue

Equity analysis Business risk

Coefficients of variation of

Operating income Net income

e. Ratios used in Capital adequacy VaR For Banks, Insurance companies, financial firms

Reserve requirements Liquid asset requirement Net interest margin

Credit analysis

Ratios: interest coverage ratios, return on capital, debt-to-assets, CF to total debt ... Altman Z-score Business segment

Segment analysis Geographic segment

f. Model and forecast earnings

Using ratio analysis Using techniques: sensitivity analysis, scenario analysis, simulation

a

Page 43

28. Financial analysis techniques INCOME STATEMENT

VND 3,650

Sales: 1 laptop per day, P=10m Cost of goods sold: Cost=5m SG&A EBIT

(1,825)

-50.0%

(210)

-5.8%

1,615

Interest expense

(15)

EBT

1,600

Income tax

25%

Net income

400 1,200

Dividends

100%

Increase/Decrease in Retained earnings

1,200 -

BALANCE SHEET Cash

105

Account receivable

7 days on credit

70

Inventory

5 days in store

25

Total current assets

200

Net PPE

300

Total assets

500

Account payable

10 days

50

Short-term debt

150

Long-term debt

-

Equity

300

Total liabilities+equity

500

2.9%

8.2%

1.4%

Page 44

Inventory cost flow methods Inventory valuation methods

Inventory accounting

IFRS-> Lower of cost or NRV US GAAP -> LCM=lower of cost or market

ending = beginning + purchases - COGS

a product cost --> capitalized

a. IFRS & GAAP rules for determining Inventory cost

period cost --> expensed

Specification Indication FIFO

b,c. Computing ending inventory and COGS

LIFO Weighted average cost

Periodic

d. Inventory systems

Perpetual

29. Inventories

COGS

e. Effects of different inventory accounting methods on

IFRS

f. Inventory reporting

GAAP

Inventory balances Other FS items: taxes , net income

, working capital , cash flows

Lower of cost or NRV Lower of cost or market No write-up

Exception

Commodity-like products

g. FR presentation & disclosures of inventories

Profitability

h. Effects of different inventory accounting methods on

Liquidity Activity Solvency

a

Page 45

Capitalize a1. Accounting standards

Expense

NI Shareholders' equity

CF

CFO CFI

a2. Effects of capitalizing vs expensing on Financial ratios

Profitability Interest coverage ratio

Implications for analysis

30.1. Long-lived Assets- Part1Capitalization a3. Capitalized interest

Interest incurred during construction --> capitalize

required by both US GAAP & IFRS

i/r on debt related to construction

What interest rate to use?

if no construction debt outstanding-> based on existing unrelated borrowings

Interest costs in excess of project construction -> expensed

reported in FSs

Unidentifiable: Goodwill

GW=Purchase price -Fair value Not amortized but impairment test

IFRS: R&D anything

b. Intangible assets

R: Expense D: Capitalise

Created internally --> EXPENSED except for Identifiable

US GAAP: R&D software

Software for sale --> similar to IFRS Software for use

Purchased externally --> CAPITALIZED (asset at cost) USGAAP --> expense Obtained in business acquisition IFRS --> not expense

Before technical feasibility: expense After technical feasibility: capitalize Capitalize all

Page 46 Carrying Value (or Book value)

c1. Concepts

Historical cost Economic depreciation

SL (Straight Line) depr=2/n* book value Accelerated depreciation

d. Depreciation methods

DDB (Double Declining Balance)

or final year: depr=book value - salvage

Units-of-production

c2. Effect on net income

c3. Useful lives and Salvage Values

Component depreciation

e,f. Amortization of intangible assets

Cost model

30.2. Long-lived Assets- Part2 Depreciation And Impairment

g. IFRS

Revaluation model (land, buildings...)

Reversal of previous loss --> gain in IS Above historical cost --> revaluation surplus in equity

IFRS

Recoverable amount = max (value in use, fair value - selling cost) If carrying value > recoverable amount --> impair

Step 1: Recoverability test US GAAP

Tangible assets Step 2: Loss measurement

h. Impairment

Intangible assets

Reversing an impairment loss

Asset for sale Asset held for use

Sales --> Gains/ Losses

i. Derecognition of PPE & intangible assets

j. FS presentation & disclosures of PPE & intangible assets

k. Financial reporting of investment property

Abandoned --> no proceeds, loss=carrying value Exchange --> equivalent to sell and buy another

IFRS US GAAP

Value in use = PV of future CF stream

Page 47

Taxable income

TAX RETURN

Taxes payable

current tax expense

Income tax paid

actual cash flow =past or current loss --> create DTA

Tax loss carryforward

Tax base = net amount of asset/liability used for tax reporting purposes Income before tax

Accounting profit

Earnings before tax

Income tax expense

a. Terminology FINANCIAL REPORTING

=Taxes payable + change in DTL - change in DTA

= Income tax expense - Taxes payable

DTL

Cause: depreciation =Taxes payable - income tax expense

DTA

Causes: Warranty expenses, Tax-loss carry forwards

Valuation allowance: contra account to DTA Carrying value = net balance sheet value of asset/liability Permanent difference vs. Temporary difference DTL

Income tax exp. > Current tax exp.

Revenues/Gains recognized in IS before in tax return Expenses/Losses tax deductible before recognized in IS (depreciation) Revenues/Gains taxable before recognized in IS

b.

DTA

Income tax exp. < Current tax exp.

Expenses/Losses recognized in IS before tax deductible (warranty expenses, post-employment benefits) Tax loss carryforwards

Treatment for analytical purpose: DTL not expected to reverse --> equity Definition Assets

31. Income Taxes

Examples

c. Tax base of

Depreciable equipment R&D AR

Definition Liabilities

Examples

Customer advance Warranty liability Note payable

d. Calculation Adjustment to FS

e. Income tax rate changes

=Taxes payable + change in DTL - change in DTA

Impact on FS and ratios Temporary differences

between tax base and carrying value will reverse result in DTA or DTL

f. Differences

Permanent differences

between taxable income and pretax income not reverse makes effective tax rate different from statutory tax rate

effective tax rate = income tax expense / pretax income

>50% probability

g. Valuation allowance for DTA Depreciation --> DTL (if reverse, if not --> equity) Impairments --> DTA Restructuring --> DTA

h. Deferred tax items

LIFO, FIFO Post-employment benefits and deferred compensation --> DTA Unrealized gains/losses on available-for-sale marketable securities

Analyze disclosures relating to

i

deferred tax items effective tax rate reconciliation

How disclosures affect FS and ratios

j. IFRS vs. US GAAP (see table in Schweser)

a

Page 48

Bond terminology a

BS

IS

Par bond a,b. Recognition & measurement

Premium bond

Discount bond (incl. zero-coupon debt)

32.1. Long-term LiabilitiesPart1Financing Liabilities

Amortization methods

IFRS: effective interest rate method US GAAP

b.

Issuance costs

prefers: effective interest rate method allows: straight line depreciation

IFRS: increase liability --> increase effective i/r US GAAP: capitalize as an asset (prepaid exp.)

Fair value reporting option

c. Derecognition of debt

d. Debt covenants

e. Presentation and disclosures

CF

Page 49 Less costly financing Reduced risk of obsolescence

f. Motivations for leasing vs. purchasing

Less restrictive provisions OBS financing Tax reporting advantages

Operating lease Transfer of title US GAAP: If meets one of the criteria

Lessee

Bargain purchase option Lease period >=75% economic life PV(lease pmts)>=90% fair value

g. Types of lease

Finance lease (capital lease)

IFRS: similar to US GAAP but less specific, with 1 additional criterion: leased asset is specialized

US GAAP: like lessee with added conditions:

Lessor

collectability of lease payments is reasonably certain lessor has substantially completed performance

IFRS: like lessee with added condition: substantially all rights & risks of ownership are transferred to lessee

Operating lease

Finance lease

32.2. Long-term LiabilitiesPart2- Leases & Pension Plans

h1. Reporting by Lessee

FS & ratio effects of finance lease compared to operating lease

Balance sheet Income statement Cash flow

Finance lease

Salestype lease Direct financing lease

h2. Reporting by Lessor's Operating lease

i. Disclosures of lease Defined contribution Service cost j. Two types

Interest cost Defined benefit

Pension Plans

Expected return on plan assets Actuarial G/L Prior service costs

k. Presentation & disclosure

l. Leverage & coverage ratios

Page 50

a

Meet earnings expectations overreport earnings

Lending covenants Incentive compensation Trade relief (quotas, tariffs)

underreport earnings

Negotiable favorable terms from creditors

a. Incentives to

Negotiable favorable terms from labor contracts More solvent Manage the BS

Less solvent Enhance performance ratios

Select acceptable accounting --> misrepresent economics of transactions

b. Activities--> Low quality of earnings

Structuring transactions --> achieve desired outcomes Aggressive unrealistic assumptions, estimates Exploit intent of an accounting principle: apply narrow rule to broad range of transactions

=motives Threats to financial stability or profitability Incentives or pressure risk factors

Excessive third-party pressures Personal net worth of mgmt or BOD is threatened Excessive pressure to meet internal financial goals

=weakness in internal control Nature of the firm's industry or operations Opportunity

33. Financial Reporting Quality: Red Flags And Accounting Warning Signs

risk factors

Ineffective mgmt monitoring Complex or unstable organizational structure Deficient internal control

=mindset that fraudulent behavior is justified

c. "Fraud triangle"

Inappropriate ethical standards Excessive participation by nonfinancial mgmt in the selection of accounting standards Known history of violations by mgmt or board members

Attitudes or rationalization

Obsession with increasing firm's stock price or earnings trend risk factors

Commitments to third parties Failing to correct known reportable conditions Inappropriately minimizing earnings for tax purposes Use of materiality as a basis to justify inappropriate or questionable accounting methods Strained relationship between mgmt & auditor

Aggressive revenue recognition CFO growth rate # Earnings growth rate Abnormal sales growth as compared to economy, industry or peers Abnormal inventory growth as compared to sales growth Boosting revenue with nonoperating income and nonrecurring gains Delaying expense recognition

d. Common accounting warning signs & detecting methods

Abnormal use of operating leases by lessees Hiding expenses by classifying them as extraordinary or nonrecurring LIFO liquidations Abnormal gross margin & operating margin as compared to industry peers Extending the useful lives of LT assets Aggressive pension assumptions Year-end surprises Equity method investments & OBS special purpose entities Other OBS financing arrangements including debt guarantees

Page 51

Stretching Accounts Payables

Financing Accounts Payables

Ways to manipulate CFS

Securitizing Accounts Receivables

34. Accounting Shenanigans On The Cash Flow Statement

Repurchasing stock to offset dilution

Page 52

a. Past financial performance of a company

Evaluating

a

Reflecting company's strategy

b. Basic projection of future net income and CF

Character Three C's

Collateral Capacity

35. FSA: Applications

c. FSA in assessing credit quality for DEBT investment

Credit rating agencies use formulas that include

Scale and diversification Operational efficiency Margin stability Leverage

d. FSA in screening for EQUITY investments

e. Adjustments for comparing different companies

Page 53

CFA LEVEL 1    STUDY SESSION 11   

CORPORATE FINANCE

Capital budgeting process

Page 54

Step 1: Idea generation Step 2: Analyzing project proposal Step 3: Create firm-wide capital budget Step 4: Monitoring decisions and conducting a post audit To maintain business

Replacement

a.

Project Categories

For cost reduction

Expansion New product/market development Mandatory pet project

Other

high risk (R&D)

Base on incremental CF

# accounting income sunk cost --> exclude ! Cannibalization --> include !

externalities

b. Basic principles

Opportunity cost --> include ! Timing of CF is important After tax basis Financing costs

Exclude ! because Reflected in required rate of return

Independent vs. Mutually exclusive projects Project sequencing

c. Interactions

36. Capital Budgeting

Unlimited funds vs. Capital Rationing

NPV

IRR

d. Methods

Payback period

Discounted payback period

PI

NPV profile Advantage of NPV Advantage of IRR

e. Conflicting project rankings Problems with IRR

Multiple IRR and No IRR problems

Location

Europe: PP more than IRR and NPV

Company Size

f. Which methods are popular?

Public vs Private

Larger: NPV, IRR Private: PP Public: NPV, IRR

Management education

g. Relationship between NPV, company value and stock price

More educated -> NPV, IRR

a

Page 55

a,b. Formula & tax effects:

c. Weights = Target capital structure (Market values)

If lack information -->

use Current capital structure + Trend or use Industry average

a

Yield to maturity approach

f. Cost of fixed rate debt Debt rating approach

g. Cost of preferred stocks (noncallable, non convertible) WACC Formula: i. Pure-play method to calculate beta of a project CAPM

h. Cost of equity capital --> 3 approaches

37. Cost Of Capital

j. Country equity risk premium CRP =

Dividend Discount Model

pure play Relationship between asset beta & equity beta

Sovereign yield spread x (stddev equity/stddev bond)

g=retention rate * ROE

Bond yield plus risk premium approach

e. Role of MCC in NPV

MCC

k. MCC schedule

Discount rate

=WACC if project same risk level

Assumption: same capital structure over the life of project

Upward sloping with additional capital Breakpoints

d. Optimal capital budget

Incorrect

l. Treatment of Flotation cost

Correct

MCC & Investment opportunity schedule

adjust cost of equity adjust initial project cost

Page 56

Leverage or Gearing

Business risk

a. Define

Sales risk Operating risk A --> surplus

Reconcile IS and BS increase A

CAPEX

L+E < A --> deficit

a

Page 60

41. CONSTRUCTING PRO-FORMA FINANCIAL STATEMENTS ($ millions)

Yr 2011

Yr 2012 (1st trial) Yr 2012 (2nd trial) Proportional to sales

INCOME STATEMENT Sales

100% sales projected to increase 100%

500

1,000

Cost of goods sold

(200)

-40.0%

(400)

SG&A

(100)

-20.0%

(200)

Interest expense

10%

(50)

(50)

Nonoperating income

-

Earnings before tax

150

350

-

-

150

350

-

-

150

350

Income tax

0%

Net income Dividends Increase/Decrease in Retained earnings

0%

0.0%

-

BALANCE SHEET Current assets

100

20.0%

Net PPE

900

180.0%

Total assets

1,000

200 (assume full capacity)

1,800 2,000

Current liabilities

100

Long-term debt

500

500

Common stock

100

100

Retained earnings

300

650

1,000

1,450

Total liabilities+equity

20.0%

200

Yr 2012 (final)

Page 61

internal controls Definition

processes procedures

a. Corporate governance

Describe good CG (p.113)

Majority of BOD is independent Meets regularly outside the presence of management otherwise, independent board members should have a primary or leading board member

Chairman of BOD should not be CEO or former CEO

Board members should not be closely aligned with supplier, customer, share-option plan, pension adviser Able to hire external consultants without management approval

b. Independence

firm & subsidiaries, former employees, executives & their families Individuals or groups with a controlling interest no material relationship with

c. Define "independence"

Executive management & their families Firm's advisers, auditors & their families

Effective BOD

Entity with a cross directorship with the firm b. Frequency of Board Elections

annual, not 2-3 years, not staggered (classified)

Skills, experience, qualifications Care & competence d. Experience

Ethical stances Other board experience Regularly attend meetings If served on the board for more than 10 years --> not very independent

c. Resources

Financial information to shareholders

Audit Committee

set executive compensation, commensurate with responsibilities and performance

Remuneration / Compensation Committee

42. Corporate Governance

make sure independence

e. Board committees

link compensation to firm performance and profitability

Nominations Committee

recruit new independent board members

Other Board Committees

f1. Provisions of a strong corporate code of ethics Consultancy contracts Finder's fees for identifying M&A targets

f2. Related party transactions and personal use of company assets --> should discourage:

Other compensation Related party transactions Personal use of company's assets

Confidential voting Voting Rules

Cumulative voting Voting for other corporate changes

Shareowner-sponsored proposals

Shareowner-sponsored board nominations

proxy statement

Shareowner-sponsored resolutions

g. Evaluate policies

Advisory or Binding Shareowner proposals

Common stock classes

dual classes of common stock

Shareowner Legal Rights Golden parachutes Takeover defenses

Poison pills Greenmail

a

Page 62

CFA LEVEL 1    STUDY SESSION 12   

PORTFOLIO MANAGEMENT

Page 63

a. Portfolio approach to investing Individual investors

DC pension plans DB pension plans Endowment Foundation

Institutional investors

b. Types of investors

Bank Insurance companies Investment companies/ Mutual funds Sovereign wealth funds

Planning step

c. Steps in PM process

Investment Policy Statement (IPS)

Execution step Feedback step

What is it? 2 categories

43. PM- An Overview

No-load funds

Open-end funds

Load funds

Closed-end funds

d1. Mutual funds

Money market funds Types

Bond mutual funds Stock mutual funds

Index funds Actively managed funds

ETF Separately managed account Long/Short funds Equity market-neutral funds Long bias, Short bias

d2. Other forms of pooled investments

Hedge funds

Strategies

Event-driven funds Fixed income arbitrage funds Convertible bond arbitrage funds Global macro funds

Buyout funds (Private equity funds) Venture capital funds

Page 64

HPR Arithmetic mean return

Geometric mean return Average returns

a. Major return measures

Money weighted rate of return

Gross return Pretax nominal return Other return measures

After tax nominal return Real return Leveraged return

Asset classes with greatest average return also have highest standard deviation Real return much more stable than nominal returns

b. Characteristics of major asset classes considered in Mean-Variance portfolio theory:

44. Portfolio Risk & ReturnPart 1

Returns distributions

are negatively skewed greater kurtosis (fatter tails than normal distribution)

Liquidity is a major concern in emerging markets & thinly-traded securities

Mean Variance

c. Calculate

Covariance Correlation

Risk averse investor

d. Risk aversion

Risk- seeking (risk-loving) Risk neutral

e. Portfolio standard deviation

f. If rho Effect on portfolio's risk: Minimum variance frontier of risky assets

g. Interpret

Efficient frontier of risky assets Global minimum variance portfolio

Investor's utility

h. Selection of an optimal portfolio

Capital allocation line (CAL)

Page 65

Return =

a. Risk free asset + Portfolio of risky assets -->

Standard deviation =

CAL (Capital Allocation Line)

b. CML (Capital Market Line)

Systematic

c. Risks Nonsystematic

Macroeconomic Types of Factors

45. Portfolio Risk & ReturnPart 2

Fundamental Statistical

Multifactor models

d. Return generating models

Formula

with k factors Factor sensitivity of Factor loading

Fama & French three-factor model

Firm size, Firm B/P, Rm-Rf

Carhart suggest 4th factor: prior period returns --> to measure price momentum Market model

= covar / variance of market portfolio

e. Calculate Beta

Slope of regression of returns on market index

Equation: Sharpe ratio

f,g,h. CAPM & SML

M-square Treynor measure Jensen's alpha

Page 66

a. Reasons for a written IPS

Description of Client

Circumstances & Situation Investment objectives

Statement of the purpose of the IPS Statement of duties & responsibilities of

Investment manager Custodian of assets Client

Procedures to update IPS & to respond to various possible situations Absolute

Forms

c. Investment objectives

Relative

Risk objectives

(derived from communications with the client)

d. Risk tolerance

Ability Willingness

Return objective

Liquidity

b. Major components of an IPS

e. Investment constraints

Time horizon Tax situation Legal & regulatory Unique circumstances

Investment guidelines (how the policy will be executed, asset types permitted, leverage)

46. Basics Of Portfolio Planning & Construction

Evaluation of performance (e.g..: benchmark)

Definition & Specification

Appendices

Strategic (baseline) asset allocation

Correlations within a class should be very high Correlations between classes should be low Equities

f. Asset classes

Bonds Cash Categories

Real estate Alternative

Hedge funds, PE funds, commodity funds, artwork, intellectual property rights

Tactical asset allocation (deviate from strategic asset allocation) Rebalancing: how & when

Identify investable asset classes Strategic asset allocation Principles of portfolio construction

Risk, Return, Correlation Efficient frontier Identify portfolio which best meets risk & requirement of investor (based on IPS) to take advantage of perceived short term opportunities

Tactical asset allocation

success depends on

g. Security selection Risk budgeting Role of asset allocation

success depends on

manager's ability to identify short term opportunities the existence of such short term opportunities manager's skill opportunities (mispricing or inefficiencies)

Page 67

CFA LEVEL 1 STUDY SESSION 13 & 14

EQUITY

Page 68

Saving Borrowing

a

Issuing equity

Allow entities to

Risk management

a. Main functions of financial system

Exchanging assets Utilizing information Supply & demand determine returns (i/r)

Equilibrium interest rate

Allocate capital to most efficient uses

Financial vs. Real assets Public vs. Private securities Debt vs. Equity vs. Derivative Common stock Equity

Preferred stock Warrants

Fixed income Convertible debt

Securities

b1. Classification of assets

Mutual funds Pooled investment vehicles

c. Asset classes

ETFs and ETNs (depositories) ABS Hedge funds

Currencies Forward, Futures, Swap, Option Contracts

Insurance

Credit default swap

Commodities Real assets

Spot vs. Derivative markets IPO vs. Secondary issues (or seasoned offerings)

47.1. Market Organization & Structure (part 1)

Primary market

i. Primary vs. Secondary markets

Public offerings vs Private placements & other transactions

Secondary market--> importance:

Securities trade after initial offerings provide liquidity

Money vs. Capital markets Traditional investment market (debt, equity) vs. Alternative market (hedge funds, commodities, real estate...) Trades occur at specific times All trades, bids, asks are declared, and then one negotiated price is set to clear the market for the stock

b2. Classification of markets

Call market

Traders/investors indicate their bids and asks NOT a dealer or quote-driven market in smaller markets

j1. Distinguish used

to set opening prices and prices after trading halts on major exchanges Trade occur any time the market is open

Continuous market

Price is set by

auction process dealer bid-ask quote

Quote-driven markets (dealer markets, price-driven markets, OTC markets)

j2. Distinguish

Order-driven markets (rules are used to match buyers & sellers) Brokered markets Pre-trade transparent

j3. Market information

Post-trade transparent

Brokers Brokers, Dealers & Exchanges

Block brokers Investment banks Exchanges Alternative trading systems (ATS) Dealers

d. Financial intermediaries

Securitizers Depository institutions Insurance companies Arbitrageurs Clearinghouses and Custodians

Clearinghouses Custodians

Order matching rules Trade pricing rules

Page 69

Long position

e. Positions

Short position

a

Leveraged position

The investor pays for the stock with some cash and borrow the rest through the broker The broker keeps the stock as collateral Leverage ratio Margin lending rate

f. Margin transaction

The proportion of total transaction value that must be paid in cash

Margin requirement

Initial margin (IM) Maintenance margin (MM)

-->margin call

Margin call price = Po * (1 - IM) / (1 - MM)

Bid-ask Market order Limit order Execution instructions

All-or-nothing order Hidden order Iceberg order Stop order

g,h.

Stop loss orders

To prevent losses or To protect profits

Stop-buy & Stop-sell orders day order Validity instructions

good-till-cancelled immediate or cancel order (fill or kill order) market-on-close order

good-on-close order

47.2. Market Organization & Structure (part 2)

good-on-open order Clearing instructions

Commissions Operationally efficient

low trading costs

Bid-ask spreads Price impact

Informationally efficient

k. Characteristics of well- functioning financial system

Prices that rapidly adjust to new info The prevailing price is fair since it reflects all available info regarding the asset

Allocationally efficient Allowing entities to achieve their purposes

Investors can save at fair rates of return Creditworthy borrowers can obtain funds Hedgers can manage risks Traders can obtain assets they need

Having financial intermediaries that

Without regulation --> Problems

Fraud & theft Insider trading Costly information Defaults

l. Objectives of market regulation

Consequences

liquidity declines, firms shun risky projects, new ideas go unfunded, economic growth slows

Regulation can be provided by

Governments Industry groups Protect unsophisticated investors --> preserve trust

Market regulation should

Require minimum standards of competency and make it easier for investors to evaluate performance Prevent insiders from exploiting other investors Financial reporting requirements Require minimum levels of capital

Page 70

a. Describe a security market index

Value

b. Calculate for an index

Price return Total return

Which target market Which securities

c. Index construction & management

Weighting Rebalancing frequency Re-examining selection & weighting

48.1. Security Market Indices (part 1)

arithmetic average

Price weighted index

=sum of stock prices / number of stocks adjusted for splits -->Index movements are influenced by the differential prices of the components

A percentage change in a high-priced stock will have a relatively greater effect on the index 30 stocks arithmetic 2 major indexes

limited number of stock

DJIA criticisms

downward bias

Nikkei Dow Jones Stock Average

large growing firms --> splits --> lose weights

225 stocks

arithmetic average return of the index stocks

d,e. Weighting methods

Equal weighted index

equivalent to a portfolio that has equal dollar amounts invested in each stock in the index The Value Line (VL) Composite average

1695 stock returns

Examples Financial Times Ordinary Share Index Market- cap weighted index (or value weighted index)

= Criticism: large company has greater impact Float-adjusted market cap- weighted index

Fundamental weighting (earnings, dividends, cash flow) Example

30 stocks on LSE

Page 71

f. Rebalancing & reconstitution

Reflection of market sentiment Benchmark of manager performance

g. Uses of security market indices

Measure of market return and risk Measure of beta and risk-adjusted return Model portfolio for index funds

Broad market index Multi-market index

h. Types of equity indices

Multi-market index with fundamental weighting Sector index

48.2. Security Market Indices (part 2)

Style index

Characteristics

Large universe of securities Dealer markets and infrequent trading

i. Types of fixed income indices

Sectors, geographic regions, levels of country economic development, type of issuers or collateral, coupon, maturity, default risk, inflation protection Broad market indexes, sector indexes, style indexes & other specialized indexes

Commodity indexes

j. Indices representing alternative investments

Real estate indexes Hedge fund indexes

k. Compare & contrast types of security market indices

Page 72

a. Concepts a

Market value

b. Distinguish

Intrinsic value

Number of market participants Availability of information

c. Factors affecting a market's efficiency

Impediments to trading Transaction and information costs

Weak form

d. Forms of EMH

Semi-strong form Strong-form

Fundamental analysis

e. Implications of each form of EMH for

Technical analysis Choosing between active and passive portfolio management

January effect (or turn-of-the-year effect) Turn-of-the-month effect Anomalies in Time-series data

Calendar anomalies

Day-of-the-week effect Weekend effect Holiday effect

49. Market Efficiency

Overreaction and momentum anomalies

f. Market pricing anomalies

Anomalies in cross-sectional data

Size effect Value effect

Other anomalies

Closed-end investment funds Earnings announcements IPO Economic fundamentals

Implications for investors

Loss aversion Investor overconfidence Representativeness Gambler's fallacy

g. Behavioral finance

Conservatism Disposition effect Narrow framing Information cascades Herding behavior

Page 73 Common shares Callable common shares

a Putable common shares

a. Characteristics of

Preference shares Cumulative preference shares Convertible preference shares

b. Equity classes

Public equity securities Characteristics

c. Distinguish

Private equity securities

Venture capital 3 main types

Leveraged buyouts (LBO) Private investment in public equity (PIPE)

Direct investing

50. Overview Of Equity Securities

Depository receipts (DRs)

d. Methods for investing in non-domestic equity securities

Global depository receipts (GDRs) American depository receipts (ADRs) Global registered shares (GRS) Basket of listed depository receipts (BLDR)

e. Risk and Return characteristics of various types of equity securities

f. Role of equity securities in financing company's assets & creating company value

Market value of equity securities

g. Distinguish

Book value of equity securities

Company's accounting ROE = Company's cost of equity

rate of return required by investors

h. Contrast Investors' required rates of return

depends on estimates of firm's future CF & risk

Page 74

a. Industry analysis

Grouping companies by

Products & services Sensitivity to business cycles Statistical methods (cluster)

different sectors Cyclical Non-cyclical firms with highly correlated returns --> same group Limitations GICS Systems

RGS Industry Classification Benchmark by DJ & FTSE Basic material and processing firms

b. Industry classification

Commercial classifications

Industry classification systems

Consumer discretionary Consumer staples Classification

Energy Financial services Industrial and producer durables Technology Telecommunications

United Nations Government classifications

European Community Australia & New Zealand North America (US, Canada, Mexico)

51.1. Introduction To Industry And Company Analysis (part 1) Firms

Cyclical firms Non-cyclical firms

c. Sensitivity to business cycle

Cyclical sectors Sectors Non-cyclical sectors

d. Peer group

e. Elements of an industry analysis

Macroeconomic factors

f. External influences on industry growth, profitability and risk

Technology Demographic factors Governments Social influence

Defensive (stable) Growth

Page 75

Slow growth Embryonic stage

High prices Large investment required High risk of failure Rapid growth Limited competitive pressures

Growth stage

Falling prices Increasing profitability Growth has slowed Intense competition

g. Product & industry life cycle

Shakeout stage

Increasing industry overcapacity Declining profitability Increased cost cutting Increased failures Slow growth Consolidation

Mature stage

High barriers to entry Stable pricing Superior firms gain market share Negative growth

Decline stage

Declining prices Consolidation

Industry concentration

51.2. Introduction To Industry And Company Analysis (part 2)

h. Effects on return on invested capital and pricing power of

Ease of entry Capacity Market share stability

Rivalry among existing competitors Threat of new entrants

i. Principles of strategic industry analysis- Michael Porter's five forces

Threat of substitute products Bargaining power of buyers Bargaining power of suppliers

j. Example of the candy/confections industry

Financial condition Analyze

k. Elements of a company analysis

Products and services Competitive strategy

Should include

ROE (DuPont)

Defensive vs. Offensive Cost leadership vs. Product differentiation

Firm overview, Industry characteristics, Product demand, Product costs, Pricing environment, Financial ratios, Projected financial statements and firm valuation

Page 76

Size of differences between market price and intrinsic value

a. Factors to consider when exploiting mispricing

Confidence about valuation model Confidence about the inputs Why stock is mispriced If market price will move toward intrinsic value

a

c. Rationale

d. Preferred stock

Dividend discount models

e. Common stock

Types of models

Discounted cash flow models

f. Appropriate for companies that are

Stable & mature Non-cyclical Dividend-paying

Free cash flow to equity models

52. Equity Valuation: Concepts And Basic Tools

Advantages

k. Disadvantages

b. Equity valuation models g. Rationale

h. Stock price / fundamentals Types of models

Multiplier models (or market multiple models)

e. Enterprise value / EBITDA or revenue

Advantages

k. Disadvantages

Explain

j. Assetbased models

Advantages

k. Disadvantages

Page 77

CFA LEVEL 1 STUDY SESSION 15 & 16

FIXED INCOME

Page 78

Rights and obligations Covenants

a. Bond's indenture

a

Negative Affirmative

Basic features of a bond Zero coupon Coupon rate structures

Step-up notes Deferred coupon bonds

b.

Coupon formula Floating-rate securities

Inverse floater Inflation-indexed bonds Caps and floors

Full (dirty) price = Clean Price + Accrued interest

c. Bond trades between coupon dates

Cum coupon vs. Ex-coupon Trading flat

Nonamortizing/ Bullet bond/ Bullet maturity

Amortizing securities

Prepayment options

53. Features Of Debt Securities

Call provisions

d. Provisions for redemption and retirement of bonds

Nonrefundable bonds

Sinking fund provisions

Cash payment Delivery of securities

Accelerated sinking fund provision

Redemption price

Regular Special

Security owner (bondholders) options

Conversion option Put provision Floors

e. Embedded options

Security issuer (borrowers) options

Call provision Prepayment options Accelerated sinking fund provisions Caps

Margin buying

f. Methods to finance the purchase of a security

Repo

Page 79

Interest rate risk Yield curve risk Call risk Prepayment risk Coupon Reinvestment risk

Call feature

i. Factors affecting reinvestment risk

Amortizing Prepayment option

Default risk Credit risk

a,i,j,k,l,m,n,o. Risks

j. Forms

Credit spread risk Downgrade risk

j. Meaning and role of credit rating

Liquidity risk

k. why important even hold to maturity

l. Exchange-rate risk m. Inflation risk n. Volatility risk Disaster o. Event risk

Corporate restructuring Regulatory issues

Sovereign risk

54. Risks Associated With Investing In Bonds

Coupon rate Market yield

b. Relations among

Bond's price relative to par value

Discount Premium Equal to par

Maturity Coupon Embedded options

c. Effect on interest rate risk of

Call Put

Yield

value of option-free bond Value =

minus value of embedded call

d,h. Callable bond

h. Disadvantages of a callable or prepayable security to investors

Less certain CF- call risk/prepayment risk Reinvestment risk Potential price appreciation < option free securities

Interest rate risk

e. Floating rate security

Reasons Price # Par

Cap risk Margin

Duration = Dollar duration =

f,g. Duration g. Duration and Yield curve risk for a portfolio of bonds

a

Page 80

Features

a Credit risk characteristics

a. Government securities (sovereign debt)

Regular cycle auction- single price Distribution methods

Regular cycle auction- multiple price Ad hoc auction system Tap system

T-bills

TREASURIES Instruments

T- notes T- bonds TIPS

b,c. Treasury securities (Treasuries)

Two categories (vintage)

On-the-run Off-the-run

c. Stripped Treasury securities

Coupon strips Principal strips STRIPS

55.1 Overview Of Bond Sectors And Instruments

Federally related institutions (owned by US Gov.)

Ginnie Mae (Government National Mortgage Association) TVA (Tennessee Valley Authority)

d. Types of US Fed agencies

GSEs (Government Sponsored Enterprises) (privately owned, publicly chartered) (commonly issue debentures)

Federal Farm Credit System Federal home Loan Bank System Federal National Mortgage Association (Fannie Mae) Federal Home Loan Bank Corporation (Freddie Mac) Student Loan Marketing Association (Sallie Mae)

Debentures (unsecured, not backed by collateral) Characteristics Periodic interest CF

AGENCY BONDS

Scheduled repayments of principal Principal repayments in excess of scheduled principal payments

Instruments

Mortgage passthrough security

e,f. MBS (Mortgagebacked securities)

Tranche I 3 tranches Types

CMOs (Collateralized mortgage obligations)

Tranche II Tranche III

f. Motivation for creating CMO Stripped mortgage-backed securities

Tax

Page 81

Tax exempt Taxable

Limited tax GO debt

g. MUNIS (Municipal securities)

Tax- backed bonds or GO (General Obligation) bonds

Unlimited tax GO debt Double-barreled bonds Appropriation-backed obligations (or Moral obligation bonds)

Instruments Revenue bonds Insured bonds Prerefunded bonds

Rating agencies and Credit ratings

Secured vs. Unsecured Debt

Credit enhancements

Shelf registration (sold over time)

Medium term notes

55.2 Overview Of Bond Sectors And Instruments (cont.)

Maturity ranges Best effort underwriting

= typical bond + derivative Purpose: get around restrictions Step-up notes Inverse floaters

Structured notes

Structured medium term notes

Deleveraged floaters Dual-indexed floaters Range notes Index amortizing notes

h,i,j,k. CORPORATE ISSUES

Instruments

Commercial paper

Directly placed Dealer placed

Negotiable CDs Bankers Acceptances Role of a SPV i. Asset-backed securities

Motivation External credit enhancements

Corporate guarantees LC Bond insurance

j. CDO (Collateralized debt obligation)

k. Bonds

Primary market Secondary market

Mechanism for placing bonds

a

Page 82 Discount rate OMO

Banks borrow reserves from Fed

Buy/Sell Treasuries by Fed Most commonly used

a. Interest rate policy tools

Bank reserve requirement

% of deposits banks must retain

Persuading banks to tighten/loosen credit policies

Normal / Upward Inverted / Downward

b. Yield curve / Term structure of interest rate

Flat Humped

Pure expectation

c. Basic theories of term structure of interest rate

Liquidity preference Market segmentation theory

d. Define a spot rate

56. Understanding Yield Spread

Absolute yield spread =

e. Measures

Relative yield spread = Yield ratio =

= yield difference b/c of credit rating

f. Credit (quality) spread

Relation with the well-being of the economy

Yield spread g. Effect of embedded options

Issue size

h. Liquidity spread

Maturity spread

After tax yield of a taxable security

i. Tax

j. LIBOR

Tax equivalent yield of a tax-exempt security

a

Page 83

1. Estimate CFs

a. Steps in bond valuation process

Coupons Principal

2. Determine appropriate discount rate 3. Calculate present value

Defaults and potential credit problems Embedded options -> uncertain principal repayment

b. Difficulties in estimating CFs

Floating rate securities -> uncertain coupons Convertible or Exchangeable bonds

57. Introduction To The Valuation Of Debt Securities

Compute value of bonds

c.

Value of zero coupon bonds

d. Time and value of bond

Price-yield profile

e. Yield and value of bond

f. Arbitrage free valuation approach

a

Page 84

Coupons

a. Sources of return from investing in bond

Principal + Capital gain/loss

a

Reinvestment income

Current yield

d. Calculate BEY and EAY Assumptions

CF will be reinvested at YTM Bond will be held till maturity Reinvestment income

YTM Limitations

b,c,d. Traditional yield measures

58. Yield Measures, Spot Rates And Forward Rates

c. Reinvestment

Reinvestment risk increases with

Realized yield can be different from YTM

BEY

Yield to call

Yield to worst

Yield to refunding

YTP

CFY

e. Theoretical Treasury spot rate curveBOOTSTRAPPING Nominal spread

Zero-volatility spread (Z-spread)

f. Spreads Option-adjusted spread (OAS)

g. Spot rates, Forward rates, Value of bonds

OAS = Z spread - Option cost

Higher coupons Longer maturities

Page 85

Full valuation approach (scenario analysis)

a. Measuring interest rate

Duration/ convexity approach

a

Option-free bonds

Callable bonds

b. Price volatility characteristics for

Prepayable bonds

Putable bonds

d,e. Effective duration d,e. Types of duration

Macaulay duration

Modified duration

59. Introduction To The Measurement Of Interest Rate Risk

Duration

f. Interpreting duration =

g. Portfolio duration Limitations

=

j. PVBP Relationship to duration

What is it?

Can be

Positive Negative

c,h,i. Convexity

Relation to bond price and yield h. Calculation

i. Types

Modified convexity Effective convexity

k. Impact of yield volatility on i/r risk of bonds

Page 86

CFA LEVEL 1    STUDY SESSION 17   

DERIVATIVES

Page 87

Derivative

a.

a

Exchange- traded vs. OTC

Forward contracts Forward commitment

Futures contracts Swaps

b. Calls Contingent claim

Options Puts Convertible, callable bonds

60. Derivatives Markets And Instruments

Criticisms

-

c. Derivative markets

Purposes

-

Law of one price

2 securities/portfolios with identical cash flows

d. Arbitrage 2 securities with uncertain returns combined in a portfolio

a

Page 88 Long position

a. Positions Short position

a

Deliverable forward contracts

Settling

Cash settlement

b. Settling Terminating a position prior to expiration

Basics

with same party (offsetting) with other party

Banks/Financial institutions

Dealer

Bid-ask prices

c. Parties Corporations End user

Gov. units Non-profit

Single stocks

1. Equity forward (LOS d)

Portfolio of stocks Stock index With or without dividends

Settled before bonds mature Quote: annualized % discount from FACE

Zero-coupon bonds (T-bills)

61. Forward

2. Bond Forward (LOS d)

Quote: yield to maturity

Types Coupon bonds

Exclusive of accrued interest Include provisions for default, embedded options Can be on individual or portfolio of bonds

Large banks outside of US Denominated in U$ Published daily by British Banker's Association Eurodollar time deposit

Compiled from quotes from large banks E.g..: LIBOR

e. Rates

Annualized 360-day/year Add-on rate (# T-bill) = reference/benchmark rate

Euribor

3. Loan forward (FRA)

Euro lending rate, established in Frankfurt, published by ECB

Settle in cash

f. Features

No actual loan Long=borrower

Formula:

g. Payoff of an FRA

Term of FRA # Term of loan Quote

4. Currency Forward (LOS h)

E.g.: 2x5 FRA Off-the-run FRA

Page 89

Deliverable or cash settlement

Similar to forward

Zero value at beginning Differ from forward

Futures : exchange- traded >< Forwards are private, do NOT trade Futures are highly standardized >< Forwards are customized Futures: clearinghouse as counterparty --> reduce credit risk

a,b. Characteristics of futures (vs. Forward)

Futures market regulated by government Quality, Quantity, Delivery time, manner, minimum price fluctuation

Standardization

Uniformity promotes market liquidity Long vs. Short Hedger vs. Speculator

# margins in securities markets Initial margin Types of margins

c. Margins

Maintenance margin Variation margin

Settlement price How a futures trade takes place

Price limits

Limit move

Limit up Limit down

Locked limit

62. Futures d. Marking to market

adjust margin balance on daily basis (or more frequent in chaotic situations)

Delivery 4 ways

Cash settlement Reverse/ Offsetting/ Closing out

e. Terminate a futures

Ex-pit transactions

Delivery options in futures contracts

For short position What (T-bonds), where (gold, corn), when to deliver

T-bill futures

Eurodollar futures

f.

T-bond futures

Stock Index futures

Currency futures

a

Page 90

Definition Call vs. Put

a. Options characteristics

Long vs. Short Option premium

a

b. American vs. European options

In-the-money

c. Moneyness

Out-of-the-money At-the-money

d. Exchange-traded vs. OTC options

63.1. Option (part 1) Equity Financial options

Stock indices

Bond Interest rate

e. Underlying instruments

Currencies Options on futures Commodity options

interest rate options f. Compare

FRAs

Cap

g. Interest rate ...

Floor Collar

contract multiplier

Page 91

a for a stock option

h. Option payoffs

for interest rate options

Intrinsic value

i. Option value =

+ Time value

European call European put

j,k. Rules for minimum values and lower bounds

American call American put

63.2. Option (part 2)

Exercise price Time to expiration

l,o. Option price affected by

Interest rate Volatility

m. Put- Call parity

Put-Call parity

n. CF on the underlying asset affect

Lower bounds

Page 92

Characteristics

a Mutual termination

a.

How swaps are terminated

Offsetting contract Resale Swaption

64. Swap Currency swaps

b.

Plain vanilla interest rate swaps

Equity swaps

a

Page 93

a Value at expiration Profit Maximum profit/loss

a. Simple Call & Put

Breakeven underlying price General shape of the graph Market outlook of investors

b1. Covered call

b2. Protective put

a

Page 94

CFA LEVEL 1    STUDY SESSION 18   

ALTERNATIVE INVESTMENTS

Page 95

Open- end vs. Closed- end NAV

a. Managed investment companies (mutual funds)

Investment company fees

one-time fees ongoing annual fees

Style Sector

b. Strategies

Index Global Stable Value

Definition

mimic an index

In-kind process

Advantages

price tax

Diversification

66.1. Alternative InvestmentsPart 1

Exchange traded Better risk management Advantages

Composition is known Operating expense ratio No trading at a discount or premium Tax Dividend

b,c,d. ETF

Few indices Disadvantages

Intraday trade Inefficient markets Larger investors

Market risk Asset class/ sector risk Risks

Trading prices # NAV (depth and liquidity) Tracking errors Derivative risks --> credit risk Currency and country risks

a

Page 96

Outright ownership

a Types

Leveraged equity position Mortgages Aggregation vehicles

Characteristics

e,f,g. Real Estate Investment

Cost method

f,g. Approaches to the valuation of real estate

Sales comparison method

Income method

Discounted after tax cash flow model

Seed stage

66.2. Alternative InvestmentsPart 2

R&D

Start-up financing

Formative stage

Initial marketing

Early stage

Stages

First stage financing

Balanced stage

Later stage

Expansion stage financing

Second stage investing

Third stage financing

Mezzanine (bridge financing)

h,i. Venture capital investing Illiquidity Long term horizon

Difficulty in valuation Limited data Characteristics

Entrepreneurial / Management mismatches Fund Manager incentive mistakes Timing in the business cycle Requirement for extensive operations analysis

i. NPV of a venture capital project

IPO

Commercial production

Producing and selling products Not yet generating income

Major expansion

Page 97

Absolute return

a

Limited partnership Forms

Limited liability corporation Offshore corporation Long/short funds

Classifications

Market-neutral funds Global macro funds Event- driven funds

Leverage Illiquidity Potential for mispricing

j. Hedge fund

l.

Counterparty credit risk

Unique risks

Settlement errors Short covering Margin calls

Performance Self-selection bias Backfilling bias

m.

Biases

Survivorship bias Smoothed pricing Option-like strategies Fee structures and gaming

Effect of survivorship bias

66.3. Alternative InvestmentsPart 3

Fund to invest in hedge funds

k. Fund of funds investing

Benefits Drawbacks

n. How legal issues affect valuation

n,o. Closely held companies

o. Valuation methods

Cost approach Comparable approach Income approach

describe

p. Distressed securities investing

compare with VC

Commodities Motivation for investing in

Commodities derivatives Commodity-linked securities

q,r Commodities

Sources of return on Collateralized commodity futures position

Page 98

a. Relationship between spot prices and expected future prices

67. Investing In Commodities

Contango

a

Backwardation

Sources of return b. Commodity investment

Risk Effect on portfolio

c. Commodity index strategy

Active investment