2012.CFA.L2.Summary.ppt

1

Ethical and Professional Standards

Study Session 1 – 2

Weighting 10%

2Overview of Level II Ethics

Code of Ethics

Standards of Professional

Conduct

CFA Institute Research Objectivity Standards

Study Session 1

Ethics Cases:- Glenarm

Company- Preston Partners- Super Selection

Other topics:- Fair dealing & disclosure- Changing investment objectives- Prudence in Perspective

Study Session 2

CFA Institute Soft Dollar Standards

3Overview of the Code and StandardsCode of Ethics

• Act in an ethical manner

� Integrity is paramount and clients always come first

• Use reasonable care and be independent

• Be a credit to the investment profession

• Uphold capital market rules and regulations

• Be competent

Standards of Professional Conduct

I: ProfessionalismA.Knowledge of the LawB.Independence and ObjectivityC.MisrepresentationD.Misconduct

II: Integrity of Capital MarketsA.Material Nonpublic InformationB.Market Manipulation

III: Duties to ClientsA.Loyalty, Prudence, and CareB.Fair DealingC.SuitabilityD.Performance PresentationE.Preservation of Confidentiality

IV: Duties to EmployersA.LoyaltyB.Additional Compensation ArrangementsC.Responsibilities of Supervisors

V: Investment Analysis, Recommendations, and Actions

A. Diligence and Reasonable BasisB. Communications with Clients and

Prospective ClientsC. Record Retention

VI: Conflicts of InterestA. Disclosure of ConflictsB. Priority of TransactionsC. Referral Fees

VII: Responsibilities as a CFA Institute Member or CFA Candidate

A. Conduct as Members and Candidates in the CFA Program

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

4Standards of Professional ConductStandard I: Professionalism

I(A): Knowledge of the Law• Understand and comply with all laws, rules,

regulations (including Code & Standards) governing professional activities

• Comply with more strict law, rule, regulation• Do not knowingly assist in violation, otherwise

dissociate from activity

Guidance• Most strict• First – notify supervisor or

compliance• May confront wrongdoer directly• Dissociate if necessary• Inaction may be construed as

participation• No requirement to report violations

to governmental authorities, but this may be appropriate in certain cases

I(B): Independence and Objectivity• Use reasonable care, judgment to

achieve, maintain independence in professional activities

• Do not offer, solicit, accept any compensation that could compromise independence, objectivity

Guidance• Modest gifts OK• Distinguish between gifts from clients and gifts

from entities trying to influence• May accept gift from clients – must disclose to

employer – must get permission if gift is for future performance

• Investment banking relationships – do not bow to pressure to issue favorable research

• For issuer-paid research, flat fee structure is preferred

5Standards of Professional ConductStandard I: Professionalism

I(C): Misrepresentation• Do not make misrepresentations

relating to investment analysis, recommendations, actions or other professional activities

Guidance• Standard covers oral, written, or

electronic communications• Do not misrepresent qualifications,

services of self or firm, or performance record, characteristics of an investment

• Do not guarantee a certain return• No plagiarism – written or oral

communications

I(D): Misconduct• Do not engage in any professional

conduct involving dishonesty, fraud, deceit, or commit any act that reflects adversely on professional reputation, integrity, or competence

GuidanceThis Standard covers conduct that may not be illegal, but could adversely affect a member’s ability to perform duties

6Standards of Professional ConductStandard II: Integrity of

Capital Markets

II(A): Material Nonpublic Information• Members in possession of nonpublic

information that could affect an investment’s value must not act or cause someone else to act on the information

II(B): Market Manipulation• Do not engage in practices that

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

Guidance• “Material” – if disclosure of information would

impact a security’s price or if reasonable investors would want the information before making an investment decision

• Information is “nonpublic” until it has been made available to the marketplace

• Information made available to “analysts” is considered nonpublic until it is made available to investors in general

• Mosaic Theory

Guidance• Do not engage in transaction-

based manipulation – give false impression of activity / price movement; gain dominant position in an asset to manipulate price of the asset or a related derivative

• Do not distribute false, misleading information

7Standards of Professional ConductStandard III: Duties to Clients

III(A): Loyalty, Prudence, and Care• Act with reasonable care and exercise

prudent judgment• Act for benefit of clients and place their

interests before employer’s or own interests• Determine and comply with any applicable

fiduciary duty

III(B): Fair DealingDeal fairly, objectively with all clients

when:• Providing investment analysis• Making investment recommendations• Taking investment action• Engaging in other professional activities

Guidance• Take investment actions in client’s best interests• Exercise prudence, care, skill, and diligence • Follow applicable fiduciary duty• Manage pools of client assets according to terms

of governing documents• Make investment decisions in context of total

portfolio• Vote proxies responsibly and disclose proxy

voting policies to clients• “Soft dollars” must benefit client

Guidance• Different levels of service okay as

long as disclosed, and does not disadvantage any clients

• Investment recommendations: all clients must have fair chance to act on every recommendation

• Investment actions: treat all clients fairly – consider investment objectives, circumstances


III(C): Suitability• Know client’s risk and return

objectives, and financial constraints• Update information regularly• Make investment recommendations or

take investment actions that are consistent with the stated objectives and constraints

• Look at suitability in a portfolio context

III(D): Performance Presentation• When communicating investment

performance information, ensure that information is fair, accurate, and complete

Guidance• When in advisory relationship, gather

client information at the outset and prepare IPS

• Update IPS at least annually• Consider whether leverage (derivatives)

is suitable for client• If managing a fund to an index or other

mandate, invest according to mandate

Guidance• Do not misstate performance or

mislead clients about investment performance

• Do not state or imply ability to achieve returns similar to those achieved in the past


III(E): Preservation of ConfidentialityKeep current and prospective client information confidential, unless:• Illegal activities are suspected• Disclosure is required by law• Client or prospect allows disclosure of the information

Guidance• In some cases it may be required by law to report activities

to relevant authorities• This Standard extends to former clients• Exception: May provide confidential information to CFA

Institute for an investigation under Professional Conduct Program

10Standards of Professional ConductStandard IV: Duties to

Employers

IV(A): Loyalty• Must act for the benefit of their employer

GuidanceLoyalty – Independent practice:• If planning to engage in independent practice, notify employer of services provided,

expected duration, and compensation• Do not proceed without consent from employerLoyalty – Leaving an employer:• If seeking new employment, act in best interest of employer until resignation is effective• Do not take records or files without permission• Simple knowledge of names of former clients is OK• No prohibition on use of experience or knowledge gained at former employer Loyalty – Whistleblowing:• Permitted only if it protects client or integrity of capital markets• Not permitted for personal gain

11Standards of Professional ConductStandard IV: Duties to

Employers

IV(C): Responsibilities of Supervisors

• Must make reasonable efforts to detect and prevent violations

IV(B): Additional Compensation Arrangements� Do not accept gifts, benefits, compensation,

consideration that competes with, or creates a conflict of interest with, employer’s interest unless written consent is obtain from all parties involved

Guidance• Compensation and benefits covers

direct compensation by the client and other benefits received from third parties

• For written consent from “all parties involved,” email is acceptable

Guidance• Supervisors must take steps to

prevent employees from violating laws, rules, regulations, or the Code and Standards

• Supervisors must make reasonable efforts to detect violations

12Standards of Professional ConductStandard V: Investment Analysis, Recommendations, and Actions

V(A): Diligence and Reasonable Basis• Exercise diligence, independence, and

thoroughness

• Have a reasonable and adequate basis, supported by appropriate research, for any investment analysis, recommendation, or action.

V(B): Communication with Clients and Prospective Clients

• Disclose the basic format and general principles of investment processes and promptly disclose any changes that might affect those processes materially

• Identify important factors and include them in communications with clients/prospective clients

• Distinguish between fact and opinion in the presentation of investment analysis and recommendations

Guidance• Make reasonable efforts to cover

all relevant issues when arriving at an investment recommendation

• Determine soundness when using secondary or third-party research

• Group research and decision making: As long as there is reasonable basis for opinion, member does not necessarily have to agree with the opinion

Guidance• Distinguish between facts and opinions• Include basic characteristics of the security• Inform clients of any change in investment

processes• Suitability of investment – portfolio context • All communication covered, not just reports

13Standards of Professional Conduct

Standard V: Investment Analysis, Recommendations, and Actions

V(C): Record Retention• Develop and maintain appropriate records to support

their investment analysis, recommendations, actions, and other investment-related communications

Guidance• Maintain records to support research, and the

rationale for conclusions and actions• Records are firm’s property and cannot be

taken when member leaves without firm’s consent

• If no regulatory requirement, CFA Institute recommends retention period of 7 years

14Standards of Professional Conduct

Standard VI: Conflicts of Interest

VI(A): Disclosure of Conflicts• Must make full and fair disclosure to clients, prospects or employer of all

matters that could reasonably be expected to impair their independence and objectivity or interfere with respective duties

GuidanceDisclose to clients:• All matters that could impair objectivity – allow clients to judge motives, biases• For example, between member or firm and issuer, investment banking relations,

broker/dealer market-making activities, significant stock ownership, board service

Disclose to employers:• Conflicts of interest – ownership of stock analyzed/recommended, board

participation, financial and other pressures that may influence decisions• Also covers conflicts that could be damaging to employer’s business

15Standards of Professional ConductStandard VI: Conflicts of Interest

VI(C): Referral Fees• Must disclose to

employer, clients, and prospective clients

VI(B): Priority of Transactions• Investment transactions for clients and

employers must have priority over investment transactions in which a Member or Candidate is the beneficial owner

Guidance• “Beneficial owner” – has direct /

indirect personal interest in the securities

• Client, employer transactions take priority over personal transactions (including beneficial ownership)

• Family member accounts that are client accounts must be treated as other client accounts

Guidance• Disclosure allows clients and

employers to evaluate full cost of service and any potential biases

• Disclosure is to be made prior to entering into any formal agreement for services

• Disclose the nature of the consideration

16Standards of Professional ConductStandard VII: Responsibilities as a CFA

Institute Member or CFA Candidate

VII(A): Conduct as Members and Candidates in the CFA Program• Must not engage in any conduct that compromises the reputation or

integrity of CFA Institute or the CFA designation or the integrity, validity, or security of the CFA examinations.

GuidanceConduct includes:• Cheating on the exam• Disregarding rules and policies or security measures related to

exam administration• Giving confidential information to candidates or public• Improper use of CFA designation to further personal and

professional objectives• Misrepresenting the CFA Institute Professional Development

Program or the Professional Conduct Statement

17Standards of Professional ConductStandard VII: Responsibilities as a CFA

Institute Member or CFA Candidate

VII(B): Reference to CFA Institute, the CFA Designation, and the CFA Program • Must not misrepresent or exaggerate the meaning or implications of membership in

CFA Institute, holding the CFA designation, or candidacy in the CFA program

GuidanceCFA Institute membership:• Complete PCS annually• Pay membership dues annuallyUsing the CFA designation:• Don’t misrepresent or exaggerate the meaning of holding the CFA designationReference to the CFA program:• May reference participation but no partial designation• OK to say “passed all levels on first attempt,” but do not imply superior abilityImproper use of the CFA marks:• The “Chartered Financial Analyst” and “CFA” marks must always be used either

after a charterholder’s name or as adjectives, not as nouns

Failure to comply with results in an inactive member status

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Definitions

I. General

III. Selection of brokers

Soft Dollar Standards

II.Relationship with clients

VI. DisclosureIV. Evaluation of

research


VII. Record keeping

Appendix: Permissible research guidance

V. Client-directed brokerage

General Principles

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Relationship with clients• Disclose involvement in soft dollar• OK to use brokerage from agency trades to obtain research – client should receive

some benefit• OK to use client brokerage obtained from principal trades to benefit other client

accounts, as long as disclosed

Selection of brokers• Consider trade execution capabilities


General• Soft dollar practices must benefit client, whose interests always come first• Allocation of client brokerage – must not be based on amount of client referrals

investment manager receives from broker

Two fundamental principles• Client property• Duty to minimize transaction costs, obtain best execution & use client brokerage to

benefit clients

Soft dollar practices• The use of client brokerage by investment manager to obtain products/services to aid

manager in investment decision making process

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Evaluation of research• Meet definition of Standard• Benefit client• Documentation of basis• Disclosure and consent obtained if benefit other clients• Investment manager pays for research if doesn’t meet criteria • Mixed-use research – allocate

Client-directed brokerage• Cannot use brokerage from another client to pay• Manager: Disclose duty of best execution• Disclose to client that client’s selection may adversely affect execution and adequacy

of research

CFA Institute Soft Dollar Standards34

Disclosure• Disclose types of third-party research received• To comply with Soft Dollar Standards, send client statement of practices annually• On client request, provide description of product / service obtained through client

brokerage generated by client’s account• Provide total amount of brokerage paid from all accounts (where manager has

discretion)

21

Record keepingManager must maintain records• Document arrangements obligating manager to generate specific dollar amount of

brokerage• Document client arrangements re: client brokerage• Document brokerage arrangements• Document basis for allocations – mixed use brokerage• Show how products / services obtained assist in investment process• Show compliance with CFAI Soft Dollar Standards, responsible party• Include copies of disclosures / authorizations from clients


Permissible research: 3 level analysis• Level I: define the product or service• Level II: determine usage• Level III: mixed-use analysis – investment manager makes proper allocation

22

Objectives

Research objectivity

policy

Reasonable and adequate

basis

Procedures for compliance

Public appearances

Relationships with subject companies

Investment banking

CFAI Research Objectivity Standards

Personal investments and trading

Timeliness of research reports and

recommendations

Compliance and

enforcement

Disclosure

Rating system

Research analyst

compensation

23

Objectives of the Standards

• Prepare research, recommendations, investment action – clients always first• Full, fair, meaningful disclosures of conflicts• Promote effective policies/procedures – minimize conflicts affecting

independence/objectivity• Support self-regulation – adhere to specific, measurable standards, promoting

independence, objectivity• Provide ethical work environment


Required Compliance Procedures

Research objectivity policy• Provide written policy on research independence and objectivity• Have supervisory procedures that ensure compliance• Have a senior officer who attests to the firm’s implementation and adherence

Public appearances• Require covered employees to disclose both personal and firm conflicts of interest to

the interviewer/host and, if possible, to the audience

24


Reasonable and adequate basis• Appoint a supervisory analyst or a review committee to evaluate and approve

research report recommendations

Investment banking• Separate research analysts from the investment banking division• Research analysts are not supervised by or report to the investment banking• Investment banking or corporate finance divisions are unable to modify, review,

approve or reject research recommendations and reports

Research analyst compensation• Compensation should reflect the quality and accuracy of the recommendations made• Compensation should be not be connected to the analyst’s involvement with

investment banking or corporate finance activities

Relationships with subject companiesResearch analysts are not allowed to:• Share research report with a subject company prior to the publication of the research

report• Promise a favorable report or a certain price target to a subject company or corporate

issuer


25


Personal investments and trading• Firm should have policies to ensure covered employees’ personal investment

dealings are properly managed

Timeliness of research reports and recommendations• Reports should be issued on a timely and regular basis

Compliance and enforcement• Effective compliance procedures should be in place• The compliance procedures should be supervised and audited & maintain internal

audit records

Disclosure• Firm to provide full disclose of conflicts of interest

Rating system• Rating system should be helpful to investors in their decision-making process


26

26

Recommended Procedures for Compliance

Research objectivity policy• Identify and describe covered employees• Covered employees to be trained regularly and indicate in writing their adherence to the

policy annually• Disclose conflict of interest that covered employees face • Identify factors on which research analysts’ compensation is based• Disclose the terms for the purchase of research reports by clients

Public appearances• Ensure that the audience of a presentation has enough information to make informed

judgments• Be prepared to disclose conflicts of interest• Firm should require research analysts that are participating in public appearances to

disclose investment banking relationship with the subject company and whether the analyst has participated in marketing activities for the subject company

• Research reports on the companies discussed should be provided to the audience for a reasonable fee


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27


Reasonable and adequate basis• Develop written guidance for judging what constitutes reasonable and adequate basis• Provide or offer to provide supporting information, and disclose current price of the

security

Investment banking• Prohibit research analysts from communicating with the investment banking or corporate

finance department prior to the publication of a research report• Investment banking or corporate finance personnel may review reports for factual

accuracies or to identify possible conflicts• Implement quiet periods for IPOs and secondary offerings• Analysts not be allowed to participate in marketing roadshows for IPOs and secondary

offerings

Research analyst compensation• Compensation should be based on measurable criteria• Direct link of analysts’ compensation with investment banking and corporate finance

activities is not allowed but firm should disclose to what extent analysts’ compensation depends on investment banking revenues


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Relationships with subject companies• Implement policies that govern analysts relationship with subject companies• Implement guidelines that only those sections of the report related to factual information

that could be verified by the subject company is shared before publication• Compliance and legal departments get a copy of the draft report before it is shared with

the subject company

Personal investments and trading• Approval required prior to trading in securities in the industries assigned to the analyst• Should have procedures to prevent employees from trading ahead of investing client

trades�Restricted period of at least 30 days prior and 5 days after a report is issued

• Analysts permitted to sell contrary to their recommendation when in extreme financial hardship

• Covered employees to provide a list of personal investments• Establish policies to prevent short-term trading of securities


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Timeliness of research reports and recommendations• Reports and recommendations should be issued at least quarterly• If the coverage of a firm is discontinued, a “final” research report should be issued

Compliance and enforcement• Distribute a list of activities that constitute violations and the disciplinary sanctions

Disclosure• Disclose investment banking or other corporate finance relationships & conflicts of

interests• Provide information on their recommendations and ratings• Disclose the valuation methods used to determine price targets, including risk factors

Rating system• Rating systems should include recommendation and rating categories, time horizon

categories, and risk categories• Absolute or relative recommendations are allowed• Employees should be prohibited from communicating a recommendation contrary to

the current published one


30

Study Session 2 topics

The Glenarm Company

Applicationsof Standards

Preston Partners

Super Selection

Case Studies

Trade Allocation: Fair Dealing and Disclosure

Changing Investment Objectives

Prudence in Perspective

Ethics and Professional Standards

31

Quantitative MethodsStudy Session 3

Weighting 5 – 10%

32

Study Session 3

Time-Series Analysis

Multiple Regression

Correlation and Linear Regression

Overview of Level II Quant

33Covariance & Correlation

Covariance

• may range from +ve to –ve infinity• units are squared hence less meaningful

� ��

� ��

�

n

t,1 1 t,2 2t 1

1,2

R R R Rcov

n 1

Correlation

• standardised measure of relationship• bounded by -1 and +1• the closer to absolute 1, the stronger the relationship

� �� 1,2

1,21 2

Covr

Significance of correlation coefficient

H0: = 0 Ha: 0

Two-tailed testDegrees of freedom are n – 2

Limitations to correlation analysis

•outliers affect the coefficient•spurious correlation: linear relationship but no economic explanation•a nonlinear relationship exists which cannot be captured by correlation2

r n 2t = 1 r

�

�

34Linear Regression

x

x

xx

xx

x

x

x

xx

x

x

x

x

x

x

xx

Y, dependentvariable

Xi

�i error termor residual

ii XbbY 10ˆˆˆ �

X, independentvariable

Yi

iY

Basic idea: a linear relationship between two variables, X and Y. Note that the standard error of estimate (SEE) is in the same units as ‘Y’ and hence should be viewed relative to ‘Y’.

Mean of �i values = 0Standard deviation of �i =standard error of the estimate (SEE)

Least squares regression finds the straight line that minimises the SEE by minimising:

SSE) errors, squared theof sum ( � 2i �

35Significance of coefficients

Hypothesis Tests on a Regression CoefficientTo test statistical significance:

H0: bi = 0 Ha: bi 0

Other tests are possible, for example:

H0: bi 1 Ha: bi < 1

Confidence interval for the population value of a regression coefficient

Predictions for the dependent variable

Given the estimated regression coefficients and an assumed value for the independent variable(s) we

can predict the value of the dependent value using:

Degrees of freedom = n – (k + 1)

i

iii s

bbt ,statistic Test ��

ii b of error standard s :Where �

� �ii svalue t criticalb ��

110i XbbY �

Confidence interval for the prediction of Y

n – 2 degrees of freedom

� �fsvalue-t criticalY ��

��

��

��

� 2

222

)1()ˆ(11x

f snXX

nSEEs

36

i10i XbbY � � � SSEY-Y2

ii �

� � SSRY-Y2

i �

� � SSTY-Y 2i �

iY

0b

Y

X

Y

Components of Variation

Total variation = sum of squared totals (SST) = actual - expected

Explained variation = sum of squared regressions (SSR) = predicted – expected

Unexplained variation = sum of squared errors (SSE) = actual – predicted

37

Analysis of Variance Table

Coefficient of determination

R2 = explained variation in ytotal variation in y

R2 is the proportion of the total variation in y that is explained by the variation in x’s

R2 = r2 for linear regression

InterpretationWhen correlation is strong (weak, i.e. near to zero)•R2 is high (low)•Standard error of the estimate is low (high)

Standard Error of Estimate

Source of Variation

Degrees of Freedom

Sum of Squares Mean Square

Regression (explained)

1 = k Regression sum of squares (RSS) Mean sum of squares (MSR) =

RSS/kError (unexplained)

n – (k + 1) = n - 2 Sum of squared errors (SSE)

Mean squared error (MSE) = SSE/(n – 2)

Total n - 1 Sum of squares total (SST)

SSTRSS

�

� � � � MSE1kn

SSE1kn

�SEE

n

1ii

� �

� �

�

�

ANOVA, SEE and R-squared

38

General form of model:

Predicting the dependent variable

ikk22110i Xb....XbXbbY � �

Independent variables

Dependent variable

Partial slope coefficientsY-intercept

Error term, residual

st variableindependen theof valuesassumed theareX.....,X,X

b....,b,b parameters regression for the estimates are b....,,b,b

:where

k21

k10k10

kk22110i Xb....XbXbbY �

Multiple Regression

39

Hypothesis tests on individual regression coefficients

To identify which independent variables are individually important in a multiple regression we perform a t-test on each slope coefficient with bi = 0. (seen earlier)

Degrees of freedom = n – (k + 1)

Determining the collective significance of the independent variables

Perform an F-test:

H0: None of the independent variables significantly explain the dependent variable.

b1 = b2 = b3 = …… = bk = 0Ha: At least one of the independent variables significantly explains the dependent variable. At least one bi 0Reject H0 if computed F > F-critical

Test statistic:

i

iii s

bbt ,statistic Test ��

ii b of error standard s :Where �

� �)1k-(nerrors squared of Sum

ksquares of sum Regression

F

�

table) ANOVA from (data MSEMSR

error squared Mean squares of sum regression Mean

�

�

Looking up the critical F-value

Use table corresponding to the significance level of test (�) i.e. (one-tailed!!!!)Numerator dof = k

Denominator dof = n – (k + 1)

Significance of coefficients

40Other Issues in Multiple Regression

Adjusted R2

• As you incorporate more variables R2 can only go up, even if some of the new variables are statistically insignificant

• Hence in multiple regression we use adjusted R2. This measure of fit does not automatically increase when another variable is added.

No calculations are required

Qualitative independent factors• These are variables that attain

discrete states, rather than taking values from a range.

• We use Dummy Variables for these factors.

• To distinguish between n categories, we need n-1 dummy variables.

� � � ��

��

��

��1-kn

1nR11R 22

Qualitative dependent variables with binary outcomes• Logit models - estimate the probability that the event will occur based on logistic

distribution• Probit models - as with logit, except based on normal distribution• Discriminant models - based on regression analysis, but producing a score which

can then be used to assess likelihood of event (e.g. credit scoring)

Interpreting p-values• A p-value is the smallest

significance level ( ) at which we can reject H0

41

Assumptions of a multiple regression model

1. The relationship between the dependent variable, Y, and the independent variable, X, is linear

2. Expected value of the error term is 0

3. The variance of the error term is the same for all observations (homoskedasticity)

4. The error term is normally distributed

5. The error term is uncorrelated across observations (i.e. no serial correlation)

6. No linear relationship exists between two or more independent variables (i.e. no multicollinearity)

Limitations of regression analysis1. Regression relations change over

time (non-stationarity)

2. If assumptions are not valid, the interpretation and tests of hypothesis are not valid

Violations of regression assumptions1. Heteroskedasticity – error term has

non-constant variance

2. Serial correlation – error terms are correlated with each other

3. Multicollinearity – linear relationship between independent variables

Assumptions, Limitations, Violations

42

Description• Variance of the error term is non-

constant.

• Unconditional: Not related to independent variables � causes no major problems.

• Conditional: related to independent variable � this is a problem.

Correction• Compute robust standard errors

(aka White-corrected standard errors) used to recalculate the t statistics

Effect on statistical inference• Estimated standard errors of the

regression coeffs. are likely to be wrong.

• With financial data they are likely to be too small, hence actual t-stats too high, so coefficients might appear significant when they are not (Type I error).

Detection•Scatter diagrams (plot residual against each independent variable and against time).•Breusch-Pagan test: regress the residuals2

against the independent variables, then test the significance of the resulting R2 using a one-tailed chi-square test. A significant value is evidence of heteroskedasticity.

Heteroskedasticity

43Serial Correlation

Description• Autocorrelation (serial correlation)

arises when the residuals are correlated with one another

• Usually arises with time series data

• Autocorrelation may be positive or negative

Correction• Adjust the coefficient

standard errors, e.g. using the Hansen method (which also corrects for conditional heteroskedasticity)

• Improve the specification of the model.

Effect on statistical inference• Positive autocorrelation can lead to too

low estimates of coefficient standard errors, hence too large t-stats, causing Type I errors.

• Negative autocorrelation can cause the standard errors to be overstated, causing Type II errors.

Detection (if not autoregressive model)•Scatter plot of residual errors •Calculate the Durbin-Watson Statistic, DW 2(1 - r).

Where r = sample correlation coefficient between consecutive residuals

0 2 4dL dU 4-dL4-dU

Evidence of positive

autocorrelation

Evidence of negative

autocorrelationNo evidence ofautocorrelationTe

st is

am

bigu

ous

Test

is

ambi

guou

s

44Multicollinearity

DescriptionTwo or more independent variables are mutually correlated, making the interpretation of the regression output problematic.

CorrectionRemove one or more of the

offending independent variables

Alternatively perform a more advanced technique such as stepwise regression

Detection• Conflicting t- and F-tests: significant F-statistic

combined with insignificant individual t-statistics• High correlation coefficient between two

independent variables (rule of thumb: > 0.7 but works only if no more than two independent variables are present)

• When dealing with more than two independent variables, low pair correlations could still lead to multicollinearity

• Signs on the coefficients that are opposite to what is expected

Effect on statistical inference• Inflates SEE and coefficient standard

errors leading to lower computed t-stats

• As a result, the null is rejected less frequently leading to Type II errors

45Model Specification Issues

biased and inconsistent regression coefficients

Leading to:

Unreliable hypothesis testing and inaccurate predictions

Examples of misspecification:• Omitting a variable

• Failing to transform a variable[e.g. using market cap as an independent variable instead of ln(market cap)]

• Incorrectly pooling data[e.g. using data spanning two distinct monetary policy regimes when building a model to predict inflation]

• Using the lagged value of the dependent variable as an independent variable

• Forecasting the past[using variables measured at the end of a period to predict a value in the period]

• Errors in the measurement of the independent variables

Model Misspecification

causes:

46

Trend ModelsVariable is a

function of time

Moving-Average (MA) models

Variable is a function of weighted average of previous error terms

Autoregressive (AR) models

Variable is a function of earlier value(s) of itself

Autoregressive Moving-Average (ARMA) models

A hybrid approach

Autoregressive Conditional Heteroskedasticity (ARCH) modelsUsed when variance of the error term

is dependent on the size of earlier errors

Types of Time-Series Models

47Trend Models

Linear trend modelValue of time series in period t,

yt = b0 + b1t + �t

Average change in y is constant in absolute terms = b1

Log-linear trend modelThe natural log of the value of time series in period t,

ln(yt) = b0 + b1t + �t

Exponential trend: average rate of change in y is constant = eb1 – 1

Might be a better model to use if a linear trend model produces serially correlated errors.

Limitations of trend model• The one independent variable may be

insufficient to explain changes in the dependent variable.

• Model errors are often serially correlated (use DW to detect) and hence assumption violated.

data series

straight line of best fit

y

t

t

y Observation

Trend

48

Exists if time series data is well-behaved,

so process can be represented with a

relatively simple model (e.g. AR)

Covariancestationarity

E.g. AR(p):

xt = b0 + b1xt-1 + b2xt-2 + … + bpxt-p + et

Series has:• constant mean• constant variance• constant covariance

with itself over time

If not covariance stationary then

regression results, both statistically & financially,

are meaningless

Mean reversionTime series has tendency to

converge to its mean:

Necessary condition for

parameters to be estimated by AR

regression methods

No finite mean-

reverting level � not

covariance stationary

First differencingmight help a time

series achieve covariance stationarity

� �1

0

b1b :AR(1) For�

Autoregressive Models

49

Chain rule of forecastingInputs used in multi-period forecasts are themselves

forecasts

xt = b0 + b1xt-1 + b2xt-2 + … + bpxt-p + t

Random walksValue in one period is equal to the value in previous period plus a random error:

xt = b0 + xt-1 + t

If b0 0 then random walk with drift

This is an AR(1) model with b1 = 1

Known as a unit root hence the mean reverting level is undefined

Serial correlation• Serial correlation within an AR model

causes estimates of the regression coefficients to be inconsistent � big problem.

• Cannot test for it using the DW statistic.

• Instead use a t-test to see whether any of the residual lag autocorrelations differ significantly from zero.

• If some are significant then the model is incorrectly specified.

• Increase the order of the model by incorporating the offending lags.

• In case of seasonality, add xt-4 for quarterly data, and xt-12 for monthly data

No finite mean-

reverting level � not

covariance stationary

Autoregressive Models cont.

50

Qth order moving average model, MA(q)

xt = �t + �1�t-1 + �2�t-2 + … + �q�t-q

• A time series will be well represented by a MA(q) model if the first q autocorrelations of that time series are significantly different from 0, while subsequent autocorrelations equal 0 (the autocorrelations drop suddenly to 0 after the first q)

• With most AR time series the autocorrelations start large and decline gradually as the lags increase.

ARMA modelsCombines both autoregressive lags of the dependent variable and moving-average errors.

Problems:

• Parameters can be very unstable - slight changes in data sample or initial guesses of parameters can give very different final estimates

• Choosing the right model is more art than science

• Model may not forecast well - in most cases a much simpler AR model will do as good a job

• Require large amounts of data (at least 80 observations)

Moving Average Models

51

Description of heteroskedasticity• Variance of the error term is non-

constant.

• Unconditional: Not related to independent variables � causes no major problems.

• Conditional: Is related to independent variable � this is a problem.

Correction• Compute robust/corrected standard

errors (aka White-corrected standard errors) or

• Use an ARCH model to forecast the variance of the error term

Autoregressive Conditional Heteroskedasticity

• Variance of error terms in one time period is dependent on the variance of the error terms in another period.

• SEs of the regression coefficients in models will be incorrect and hypothesis tests will be invalid.

• ARCH(1) detected by performing following regression:

(ut is an error term)

• If a1 is statistically different from zero then the series is ARCH(1).

• Can then use ARCH model to predict variance of errors with the following equation:

tuaa � 21-t10

2t ˆˆ ��

ARCH Models

2t10

21t ˆˆ �� aa �

52

In-sample vs Out-of-sample forecast errors• In-sample forecasts are for values within the estimation period. Can use the SEE to

compare the in-sample errors of competing models.

• Out-of-sample forecast errors represent the differences between actual and predicted values of the time series outside of the period used to construct the model.

• Can use the RMSE (Root Mean Squared Error, i.e. the square root of the average squared forecast error) to judge which model is most accurate.

The Dickey-Fuller (DF) Test for a Unit Root

• Test is based on a transformed version of the AR(1) model xt = b0 + b1xt-1 + �t

• Subtracting xt-1 from both sides produces:xt - xt-1 = b0 + (b1 – 1)xt-1 + �t or xt - xt-1 = b0 + g1xt-1 + �t where g1 = (b1 – 1)

• If there is a unit root in the AR(1) model, then g1 will be 0 in a regression where the dependent variable is the first difference of the time series and the independent variable is the first lag of the time series.

• DF test: H0: g1 = 0, time series has a unit root and is nonstationaryHa: g1 0, time series does not have a unit root

• Test is conducted by calculating a t-statistic for g1 and using a revised set of critical values computed by DF.

Other Issues in Time Series

53

Cointegration• Two time series are cointegrated if a long-term financial or economic relationship

exists between them such that they do not diverge from each other without bound in the long run (e.g. they share a common trend)

With a simple regression the following scenarios are possible:1. Neither time series

has a unit rootCan safely use linear regression

2. One or other time series has a unit root

Error term in the regression will not be covariance stationary � one or more regression assumptions violated �regression coefficients might appear significant when not

3. A) Both time series have a unit root but are not cointegrated

As with 2. above

3. B) Both time series have a unit root but are cointegrated

Error term in the linear regression will be covariance stationary but we should be very cautious in interpreting the regression results. The regression estimates the long-term relation between the two series but may not be the best model of the short-term relation.

Multiple Time Series

54

Start

Time Series - Summary

55

EconomicsStudy Session 4

Weighting 5 – 10%

56

Study Session 4

Economic Growth

Regulation and Antitrust PolicyIn a Globalized Economy

Trading with the World Currency Exchange Rates

Foreign Exchange Parity Relations

Measuring Economic Activity

Overview of Level II Economics

57Economic Growth

� Real GDP = measure of inflation-adjusted income and output� Standard of living = level of real GDP per labor hour = level of labor productivity� Economic growth = % change in real GDP per labor hour = growth in labor productivity =

improvement in standard of living

� Rule of 70: a country’s economic activity will double every (70/growth rate) years

58Economic GrowthPRECONDITIONS FOR ECONOMIC GROWTH

Theories of Economic Growth

• Markets• Property rights• Monetary exchange

New Growth Theory

Neoclassical Growth Theory

• Saving and investment in new capital

• Investment in human capital• Discovery of new technologies

For economic growth

to continue

Classical Growth Theory GDP growth will be driven back to the subsistence level

LT GDP growth requires technological change

Discovery of new products and techniques is down to luck

At a given level of technology, on average, a 1% increase in capital per labor hour results in a one third of 1% increase in real GDP per labor hour

PRODUCTIVITY

One Third Rule Methods for Increasing Economic Growth

• Encourage savings• Encourage basic R&D• Stimulate international trade• Improve the quality of education

59Regulation and Antitrust Policy

Governmentregulation

Social regulation

Economicregulation

Based upon� Product quality� Product safety� Employee safety

Natural Monopolies� Cost-of-service regulation� Rate-of-return regulation

Negative Side Effects� Creative response� Feedback effect

Regulator Behavior Theory

Capture Theory� Industry controls

regulator

Share-the-gains, Share the Pains Theory

� Legislators� Customers� Regulated firms

60Trading with the World

� Comparative advantage refers to the lowest opportunity cost to produce a product. � Law of comparative advantage: trading partners can be made better off if they specialize

in producing goods for which they are the low-opportunity-cost producer and trade for the goods for which they are the high-opportunity-cost producer

Restrictions on Trade� Tariff is a tax imposed on imported goods� Quota is a limitation on the quantity of goods imported� Voluntary export restraints (VERs) are agreements by exporting countries to limit the

quantity of goods they will export to an importing country� Two primary forces underlying trade restrictions:

� Governments like tariff revenue� Domestic producers affected by lower-cost imports use political means to gain

protection from foreign competition

61Currency Exchange Rates

Foreign Exchange Quotations

Direct Quotes• DC/FC• Usual method of

quoting currencies

Indirect Quotes• FC/DC

Triangular Arbitrage

Profit is calculated by “going around the triangle”.

Choose the way > 1

Always sell the base currency and by the quoted!

USD

CHF GBP1.5600

USD/GBP

2.3182 CHF/GBP

1.486

0

CHF/USD

USD GBP CHF USD or

USD CHF GBP USD

£/$ x CHF/£ x $/£ or

CHF/$ x £/CHF x $/£

£:$ £ base $ quoted

£/$ $ base £ quoted

62Triangular Arbitrage

Bid and Ask

$

€

“BID”meansturning€ into $

“ASK”meansturning$ into €

CHF GBP

1.3500 USD/GBP

Ask rate = ?.???? CHF/GBP

1.50

00 C

HF/U

SD1.

5010

CHF

/USD

Bid Rate = ?.???? CHF/GBP

1.3510 USD/GBP

63Currency Exchange RatesBid – Ask Spread

Factors affecting spread:• Volume• Volatility• Dealers long/short position• Term (forward contracts

only)

Triangular Arbitrage1. Choose a direction and formulate equations:

£/$ x CHF/£ x $/CHF2. Check examiner has given the quotes for the

right base and quoted combinations.If not you will need to take reciprocals noting that the bid and ask swap when you do

3. Using the bids move round the triangle selling the base and buying the quoted currency

4. Did you get > 1? If not take the reciprocal of the ask quotes to move the opposite direction.

USD

CHF GBP

£/$ 0.7113 – 0.7116

Bid (lower)

Bank sells £

Bank buys $

Ask (higher)

Bank sells $

Bank buys £

Forward Contracts

Premium – base currency buys more future quoted

Discount – base currency buys less future quoted

Fwd – Spot

Spotx

360

Contract Days

Fwd Pm or Disc =

64

Factors That Cause a Currency to Appreciate/Depreciate

� Differences in income growth: Country with rapid income growth has more demand for imports and foreign currency, domestic currency depreciates

� Differences in inflation rates: Higher inflation means exports more expensive, imports cheaper, domestic currency depreciates

� Differences in real interest rates: Country with higher real rates will attract foreign investment, increased demand for domestic currency so it appreciates

� A fixed rate system has a set rate of exchange to another currency� A currency board creates domestic currency only in exchange for the other currency, held in

bonds and other liquid assets. The currency board promises to redeem the domestic currency at the fixed exchange rate into dollars

� A pegged exchange rate system is based on a commitment to use monetary policy to keep exchange rates within a band

Other Exchange Rate Regimes


65

Fiscal Policy and Exchange Rates

Expansionary monetary policy leads to:� Rapid economic growth (increases imports)� Higher inflation (decreases exports)� Lower real interest rates (increase investment to abroad)All three cause the domestic currency to depreciate

Monetary Policy and Exchange Rates

� Unanticipated restrictive fiscal policy leads to:� Slower growth (decreases imports) appreciation� Lower inflation (increases exports) appreciation� Lower real interest rates (increases investment abroad)

depreciation� Financial capital is more mobile, so third effect dominates in

short run� Expansionary policy Short run appreciation


66

Purchasing Power Parity� Based on the “Law of One Price”� Absolute PPP: Same basket of goods will cost the same everywhere, after

adjusting for exchange rates� Relative PPP: Changes in exchange rates will just offset changes in price levels

(i.e., differences in inflation)

Uncovered Interest Rate Parity• Countries with high interest rates (and high inflation rates) should have currency values that

fall over time• Assumes PPP and Fisher hold• Assumes constant real exchange rate

International Fisher Relation• Inflation differentials between countries are the prime drivers of interest rate differentials• Key = real interest rates the same in every country!


Covered Interest Rate Parity• Forward rates are arbitrage free rates set using interest rate differentials.

67Foreign Exchange Parity Relations

International Fisher Effect

SpotForward

InterestRate Parity

PurchasingPower Parity

The forward rate is the best unbiased predictor of the future spot rate

Uncov

ered

Inter

est

Rate P

arity

B

QINT1

INT1

+

+

0t

SpotFuture Spot

)REAL1)(INF1(

)REAL1)(INF1(

B

Q

++

++

68

Purchasing Power Parity Interest Rate Parity (covered)

Parity Relationships

International Fisher EffectExact Methodology:1+r = (1+real r)(1+E(i))

Linear Approximation:r = real r + E(i)

Where:r = nominal interest ratereal r = real interest rateE(i) = expected inflation

Uncovered Interest Rate Parity


Foreign Exchange Expectation Relation

E(S) = F

E(% S) = F - SoSo

E(ST) = So x (1+Iquoted)T

(1+Ibase)TFwd = So x

(1+Rquoted)

(1+Rbase)E(ST) = So x

(1+Rquoted)

(1+Rbase)

69Measures of Economic Activity

Gross Domestic Product (GDP)

Total market value of all final goods

and services provided in a

country over a stated period of time

(1yr)

Gross National Income (GNI)

Total goods and services produced by the citizens of a

country

Net National Income (NNI)

GNI less depreciation.

Amount of resources utilized or worn out by the production process

Value of production- cost of inputsGDP

Output

Consumption+ InvestmentTotal domestic expenditure+ Exports of goods and servicesTotal final expenditure- Imports of goods and servicesGDP

Expenditure

Wages and salaries+ Self-employment income+ Company trading profits+ Government and enterprise

trading surpluses+ Rental incomeGDP

IncomeGDP+ net property income from abroadGNI- DepreciationNNI

Can be expressed in current or constant prices

GDP at market prices – indirect taxes + subsidies = GDP at factor prices

70

Financial Reporting & Analysis

Study Sessions 5, 6 & 7

Weighting 15 – 25%

71Overview of Level II FSA34

Inventories

Intercorporate Investments

Study Session 5

Multinational Operations

Study Session 6

Employee Compensation

Long-Lived Assets

Integration of Financial Statement Analysis Techniques

Study Session 7

The Lessons We Learn Financial Reporting Quality

72Inventories

With inflation and LIFO, COGS is higher and end. inv. is lower.

With deflation and LIFO, COGS is lower and end. inv. is higher.

Weighted average cost is in between FIFO and LIFO.

Inventory methodsPerpetual vs. Periodic

SystemsPerpetual: updates inv. after each purchase/sale.

Periodic: records purchase/sale in "Purchases" account , inv./COGS determined at period end.

LIFO reserve will increase with rising prices and stable/increasing inv.inv FIFO = inv LIFO + LIFO reserve .COGS FIFO = COGS LIFO –

LIFO reserve.NI = LIFO reserve

(1-t).

LIFO reserveUnder LIFO, inv. purchased last is treated as if it’s sold first.

LIFO liquidation occurs when a company appears to sell the inventory it purchased first.

LIFO liquidationUnder IFRS: Lower of cost or NRV, NRV = sales price - selling cost

Under US. GAAP: Lower of cost or market (replacement cost), NRV < Market < NRV – Normal profit margin

Inventory valuation

73Long-lived assets

IFRS: Annually, CV vs. recoverable amount (FV-selling cost), can be reversed

US. GAAP: Tested, two steps: recoverability test, then measuring the loss, loss recoveries are prohibited

Impairment Long-lived assets disclosure

Fixed asset useful life, Fixed asset SV, Depreciation method, Useful calculations regarding a firm’s FA: average age, average depreciable life, remaining useful life

In the year of impairment: NI lower, ROA & ROE will decrease

In subsequent year: lower depreciation, NI higher, ROA & ROE will increase

Impact of Impairment US GAAP: upward revaluation is prohibited, except for long lived assets held for sale

IFRS : permitted

Upward revaluation: A & E increase, D/E decrease, subsequent periods: Higher depreciation, Lower ROA and ROE

Revaluation to FV

74Leases

transfer title

bargain purchase option

75% of the asset’s economic life

90% of the fair value of the leased asset

Capital lease criteria

Capital lease:

Sales-type lease: Manufacturer, dealer, PV of the lease payments is greater than carrying value of the leased asset (COGS)

Direct financing lease

Lessor: capital vs. operating lease

Relative to operating leases, capital leases will make assets higher, liabilities higher, net income (early years) lower, CFO higher, CFF lower, total cash flow the same, EBIT higher

Lessee: capital vs. operating lease

75Intercorporate Investments

shares are a genuine small investment for dividend/capital gains purposes

<20% votesshares are to ensure a significant influence is exerted over the other company (but NOT outright control)

“Affiliate/Associate”

Equity Account

20 – 50% votesshares are to take over and control the company

“Subsidiary”

Consolidate (Purchase method)

Pooling (Merger method)

> 50% votes

Secondary market?

No

Held-to-maturity securities

Available-for-sale securities

Trading securities

Yes

Debt securities which the company intends to hold to maturitySecurities are carried at amortized cost

May be sold to satisfy company needsDebt or equityCurrent or non-currentCarried in the balance sheet at market valueIncome statement same as cost method

Acquired for the purpose of selling in the near termCarried in the balance sheet as current assets at market valueIncome statement includes dividends, realised & unrealised gains/losses

B/S Historic CostI/S Dividends/Int

76Equity AccountingEquity Accounting: Significant Influence“One line consolidation”Initially recorded at purchase price (cost)Subsequent periods:B/S: Cost + earnings pickup – dividends� B/S = %Share x � Retained earningsI/S: Earnings pickup (% share of NI)

Purchase Price > Book Value

Investment initially recorded at cost

However within cost:

% Net Assets Acquired

%FMV adjustments

Goodwill

Cost paid

$m

X

X

X

X

FMV adjustments impact future earnings

Adjust earnings for up/down stream inter group unearned profits

Impairments

Carrying value > Fair value

Decline considered permanent

No reversal (US GAAP)

Reversal allowed (IAS)

UpstreamProfits recognized in investee I/SUnconfirmed profits –eliminate pro-rata share

DownstreamProfits recognized in investor I/SUnconfirmed profits –eliminate pro-rata share

Fiscal years beginning post Nov 2007 IFRS 159Can elect to hold investment at fair value with changes in fair value taken to the I/SConvergence with IAS 28/39

77Joint VenturesJoint Ventures•Equity account: Required US GAAP Permitted IAS“one line consolidation”•Proportional consolidation recommended by IAS“line by line proportional consolidation

• Report pro-rata share of all accounts, net out intercompany transfers

• Make both sides of intercompany adjustments in joint venture accounts

• No minority interest (consolidated on the basis of ownership not control)

• The rest is as per a normal consolidation

• Interest cover - overstated

• Return on assets - overstated

• Debt ratios skewed

Stockholders equity, Net Assets and NI same under both methods

Total asset and total liabilities differ

Big impact on ratios

78Consolidation (Purchase Method)

Steps

1. Record any finance raised in parent company’s balance sheet

2. Record investment in subsidiary in parent’s balance sheet.

(Investment recorded at purchase price)

3. Adjust subsidiary identifiable net assets to fair market value (IAS 100% of FMV adjustments, US GAAP parents share of FMV adjustments)

4. Calculate goodwill on acquisition

Proceeds

% Identifiable Net Assets

Goodwill

5. Eliminate inter-company transactions

6. Add together assets and liabilities 100% regardless of ownership

7. Eliminate investment in parent company’s books

8. Include Common Stock and Additional Paid in capital of parent only

9. Include parents reserves and % share of any post acquisition retained earnings in the subsidiary (unlikely)

10. Calculate Minority Interest

Minorities % share of Net Worth of sub (at FMV IAS, at book value US GAAP)

11. Total Balance Sheet

X

(X)

X

•Control of subsidiaries decisions: Operating/Financing/Investing

•Share ownership > 50%

•Reflect control not ownership

79Goodwill

Business Combination – with Less 100% Interests

Allowed in both US GAAP and IFRS

= consideration / % of interests acquired – fair value of net assets

MI is stated (% of MI shareholders own) (consideration / % of interests acquired)

Full goodwill

Only allowed under IFRS

= consideration – fair value of net assets X % of interests acquired

MI is stated (% of MI shareholders own) X FV of net assets

Partial goodwill

80Business CombinationsPurchase Method Pooling of Interests Method

US: no longer permitted (since 2001)

IAS: no longer permitted (since 2003)

US: required under SFAS 141 – Business Combinations

IAS: required under IFRS 3 –Business Combinations

Treats transaction as acquisition of target by buyer

Treats transaction as merger of equals

Still studied, as move from pooling to purchase has been prospective, not retrospective

No goodwill

No minority interest

No fair value adjustment

Restate prior periods

Post and pre acquisition earnings pooled

Combine equity

Goodwill on consolidation

Purchase consideration 10

% FMV (assets – liabilities) (8)

Goodwill 2

Goodwill

Minority Interests

Fair value adjustments

Post acquisition earnings

81Impact on AccountsCost vs.. Equity

� If sub earnings > 0 and sub dividend payout < 100%, parent results are more favorable under equity method:

� Parent earnings larger

� Parent cash flows the same

� Interest coverage and return on investment ratios higher

� Capital ratios lower

� Cost method preferred if sub is not profitable

� Assets and liabilities are different, but equity is the same

� Revenues and expenses are different (operating income), but net income is the same

� Reported cash flows are different

� Equity method includes only capital flows between parent and sub

� Consolidation method includes all cash flows except between parent and sub

� Financial ratios different

Consolidation vs. Equity

Proportionate Consolidation vs. Equity Method� Equity, net income and ROE are the same under both methods

� Most other accounts and ratios change

� Equity method overstates ROA

� Equity method hides liabilities

� Equity method hides footnote info

82

Purchase vs.. Proportionate vs. Equity A/C

� Current RatioConsolidated > Proportionate > EquityAssuming investee ratio > parents

� LeverageConsolidated > Proportionate > Equity

� Net Profit MarginEquity > Proportionate > Consolidated

� Gross MarginConsolidated > Proportionate > EquityAssuming investee ratio > parents

� Return on Assets ROAEquity > Proportionate > Consolidated

Impact on Accounts

Purchase vs. Pooling� Assets

Purchase > Pooling� Equity

Purchase > PoolingAssuming purchase is funded by issuing equity Net IncomePurchase < Pooling

� Profit MarginsPurchase < Pooling

� ROA and ROEPurchase < Pooling

83

Impairment of goodwillIdentification:

Measurement:

Group Accounting

Carrying value of reporting unit +

goodwill

Fair value of reporting unit>

Carrying value of goodwill

Implied fair value of goodwill>

Fair value of reporting unit –fair value of identifiable net assets

Bargain Purchase (-ve goodwill)

Price < % FMV of identifiable net assets

Reassess FMV of identifiable net assets

US GAAP- reduce non current assets

- take remainder to I/S as an extraordinary gain

IAS - take as gain to I/S

US GAAP & IFRS Differences

In-process R&D

Contingent liabilities

Contingent consideration

Convergence ProjectFMV adjustments for 100% of net assets not just purchased elementMinority interest calculated using FMVIn-process R&D capitalizedContingent consideration recognized at acquisition dateMinority interests in equityRemaining Differences:US GAAP full goodwillIFRS full or partial goodwill

84Special Purpose EntitiesA separate legal entity established by asset transfer to carry out some specific purpose

Uses Access capital or manage risk

Characteri-stics

Issue

Securitized loans, synthetic leases, sale of accounts receivable, R&D costs

Thinly capitalized, lack of independent management, servicing agreements

Prior to Fin 46R consolidation was based on voting rights not risk and reward of ownership

Purpose

VIE Criteria Fin 46R1. Equity interest less than

10% of total assets2. Equity investor lacks:

• Decision making ability• Obligation to absorb

losses• Right to receive

residual returnsA VIE must be consolidated in a company’s accounts if the company is the primary beneficiary (Previously only if controlled via voting rights)

Variable Interests:Guarantees of debtSubordinated debt instrumentsLease residual interest guaranteesParticipation rightsAsset purchase options

Qualifying SPEs US GAAP only

Not consolidated if SPE:•Independent and legal separate from sponsor•Has total control over asset•May only hold financial assets•Sponsor must have limited financial risk

85Pension Plans

Employee directs investment policy

Employer will appoint an investment manager

Asset manageme

nt

Employee owns assets, employer acts as agent

Employer owns assetsAsset

ownership

Employee carries the risk

Employer carries the riskRisk

DefinedContributionDefined Benefit

Income Statement = Employer Contribution

Balance Sheet - Asset/Liability = excess or shortfall in payments relative to specified contribution level

No major analyst issues

Income Statement = Pension expense

Balance Sheet - Asset/Liability = Cumulative payments into plan less cumulative pension expense SFAS 87 & IAS19Post 2006 SFAS 158 Asset/Liability = Funded status

Major issue for analysts

PBO (Projected Benefit Obligation)Present value of all future pension payments earned to date based on expected salary increases over time. Assumes employee works until retirement. Estimate of liability on a going concern basisABO = Accumulated Benefit ObligationVBO = Vested Benefit Obligation

86Pensions

Service cost

Interest cost

Actuarial gains or losses

Prior service cost

Benefits paid

ENDING PBO

-/+

-/+

+

+

=

BEGINNING PBOX

-

Reconciliation disclosed in foot notes (SFAS 132)

Benefits paid to retirees

Fair value of plan assets at end of year

Fair value of plan assets at start of year

Actual return on plan assets

Employer contributions

Plan participant contributions

Expenses

X

+

+

+

-

=

-

Reconciliation disclosed in foot notes (SFAS 132)

87Pensions

Actual Events

Service Cost

Interest Cost

Smoothed Events (SFAS 87)Expected Return on Plan AssetsAmortisation of gains/lossesAmortisation of prior service costsAmortisation of transition asset or liability

+

+

-

+/-

+/-

+/-

Reported Pension Cost X

Other EventsCurtailment/Settlements/ Termination

+/-

Pension Expense FV of Plan Assets – PBO = Funded Status

FV > PBO = Overfunded

FV < PBO = Underfunded

Funded Status = Economic Position of Plan

Funded Status B/S Asset/Liability SFAS 158

Funded Status

Actuarial (Gain)/Loss

Prior Service Cost

Net Transition Asset

Balance Sheet (Liability)/Asset

+/-

+/-

+/-

+/-

+/-

88Actuarial Assumptions

LowerLowerLowerPension Expense

No changeNo changeLowerABO

No changeLowerLowerPBO

Higher Expected Return on Assets

Lower wage rate

increases

Higher discount rate

ActuarialAssumptions

3 main delayed events� Actuarial gains & losses� Prior service adjustments� Transition assets & liabilities

Net of:

Plan Assets

Actual vs.. Expected return

Plan Liabilities

� PBO due to � actuarial assumptionsAmortised if net gain or loss > 10% of opening PBO or Market related plan assets value

Delayed Events

89Post 2006 SFAS 158

SFAS 158 Impact on Financial Statements� Income Statement same as SFAS 87� Balance Sheet = Funded Status

Adjust balance sheet asset/liability to funded statusAdjust deferred tax assetAdjust comprehensive income (equity)

� Assuming net actuarial losses the new standard will increase the pension liability and reduce equity

90

Income Statement:Adjusted pension expense = service cost + interest cost – actual return on plan assetsAlternatively = � funded status + employer contributionImprovement in funded position reduced economic expenseWorsening of funded position increases economic expenseRequired for both SFAS 87 and 158

Analyzing Pension Disclosures

Balance Sheet:Replace accounting asset/liability with funded status take any change to equityNB only required for SFAS 87 not 158

Cash Flow Statement

Cash flow = employer contribution into fund ( CFO)

Contribution > Economic Expense = Principal repayment CFF CFO

Contribution < Economic Expense = Source of funding CFF CFO

Analyst should adjust CFO and CFF for after tax amounts

Analyst Adjustment

91Employee Compensation

Employee compensation:� Salary� Bonus� Share based compensation

Managerial compensation disclosure:� US GAAP - Proxy statement to SEC� IAS – Accounting disclosure

Share based compensation

Advantages:

Reduces agency problem

No cash outlay

Disadvantages:

Dilution of EPS

Employees limited influence over share price

ownership risk aversion

Stock options risk taking

Dilution of existing shareholders

Stock Based Appreciation Rights

Payments linked to share value performance

No shares held

Advantages:

Avoids dilution

Avoids risk aversion

Disadvantages:

Cash outflows

Expense spread over service life

92Stock Compensation PlansStock Options� Prior to June 2005

� Account APB 25� Footnote Disclosure SFAS 123

� Post June 2005� Account SFAS 123

APB 25 Intrinsic value at grant dateSFAS 123 Fair value at grant date

(similar to IFRS 2)

DisclosureNature and extent of arrangementMethod of determining fair valueImpact on periods income

Fair valueMarket premium of similar option orvaluation model:

BSMBinomialMonte Carlo

Stock Purchase PlansEnable employees to purchase stock at a discount to market valueRecognize expense over life of option if compensatory (5% rule)Service Based AwardsCompensation linked to length of serviceRecognize expense over vesting periodPerformance Based AwardsNon price related and price relatedRecognize over estimated time to meet criteriaCan lead to accounting manipulation

All models require 6 inputs:1. Exercise price2. Stock price at grant date3. Volatility4. Risk free rate5. Expected term (time to expiry)6. Dividends

93Foreign Currency TranslationFunctional currency Reporting currencyLocal currencyThe currency of the primary economic environment in which the firm generates and expends cash flows.

The currency in which the multi-national firm prepares its final, consolidated financial statements. For exam purposes, most likely to be the US$

The currency of the country in which the foreign subsidiary is located

Temporal method of translationaka “Remeasurement”

Current Rate method of translationaka “Translation”

SFAS 52 Hyperinflation = cumulative 3 year inflation rate > 100%Use temporal method – prevents book value of PP&E falling

Net asset position and depreciating local currency - reduces $ value of net assets � negative translation adjustment under

current rate method

Temporal method if amount of liabilities exposed to current rate exceeds exposed assets – (net liability position) a depreciating currency makes this liability smaller

94Temporal/RemeasurementLiabilities (current)

Common Stock (historic)

Retained earnings (ß)

Liabilities + Equity

X

X

X

X

Temporal

1. Produce top of Balance Sheet (Total Assets)

2. Produce Shareholders Funds and Liabilities (retained earnings = plug figure to ensure that the balance sheet balances)

3. Produce reconciliation of retained earnings

4. Net Income in the Income Statement will be different from NI in retained earnings. The difference is the exchange gain/(loss) which is taken to the income statement

Opening retained earnings

Net income (ß)

Dividends

Closing Retained earnings

X

X

(X)

X

SFAS 52 Hyperinflation = use TemporalIAS 21 Hyperinflation = use indexing

Monetary assets/liabilities = current rates (cash, AR, AP, STD,LTD)

Non monetary assets/liabilities = historic rates

95Current/Translation

All Current Approach

1. Produce Income Statement – translating at average rate

2. Derive closing retained earnings

3. Compute Balance Sheet

4. Top and bottom of the balance sheet will not balance. The difference is the translation gain/(loss)

5. Force the balance sheet to balance by including the adjustment on the balance sheet in the equity section

Opening retained earnings

NI (from income statement)

Dividends

Closing Retained earnings

X

X

(X)

X

All assets/liabilities = current rates

96Impact on RatiosTranslation/All Current (Compared to LC)� No change from translation using all-

current method for pure income statement and balance sheet ratios

� Mixed ratios are distorted� FX rate changes affect consolidated ratios,

even when no “real” change occurs

Comparing Temporal and All Current� Process:

� Step 1: LC appreciating or depreciating?� Step 2: Examine numerator

� Translated at which rate? (current, avg, historic, etc.)

� Will numerator be larger or smaller?� Step 3: Examine denominator

� Same as numerator� Step 4: Determine impact on ratio

Remeasurement/Temporal (Compared to LC)

� Even pure ratios may be distorted due to mix of current and historic in B/S or average and historic in I/S

� Mixed ratios now a blend of current, average and historic!

97IAS & Transaction RiskIAS 21 Similar to SFAS 52Exceptions

� Integral subsidiaries – temporal method� Foreign entities – all current� Revaluations – historic rate at time of revaluation� Hyperinflation – indexing� Goodwill – current or historic rate � Losses resulting from the acquisition of an asset invoiced in an overseas

currency can be expensed (SFAS 52) or added to capitalized cost

Transaction Gains/(Losses)

Transaction recorded at spot rate

Receipt or payment at a later date

Issue = movements in spot rate between entering and settling a contract

Gains and losses reported in income statement (no guidance to where)

• Within SGA

• Non-operating income/expense

reduces comparability

98The Lessons & DerivativesThe lessons we learn1. Read all info including MDA and Footnotes2. Be sceptical – persistently higher than average growth rates3. Understand what you are looking at: pro-forma information4. Follow the money (cash flow and earnings divergence)5. Understand the risks (business & financial)

Derivative Accounting

B/S fair value

Speculatively held – gains/losses I/S

Hedging purposes – location per SFAS 133

Fair Value Hedge

Hedging asset/liability value

Gains and losses I/S

Cash flow hedge

Hedging the future cash flows of a transaction

Unrealized gains/losses to comprehensive income

Accumulated gains/losses released to I/S when the transaction affects earnings

Hedging foreign currency exposure

All current – gains/losses to comprehensive income

Temporal - gains/losses to I/S

99Financial Reporting QualityAccrual vs.. Cash Accounting

Cash:

Transaction recorded on payment/receipt

Advantages: No subjectivity/Easy to verify

Accrual:

Revenue/Expense triggered by earnings process

Advantages: Timely and relevant information/Indication of value creating activities

Disadvantages: Subjective measurement/earnings management

1. Revenue Recognition:• % completion method• Earnings activities

complete• Assurance of receipt• Bill and hold• Unearned income

2. Depreciation Choices:• Method (S/L vs accel’)• UEL• Salvage value

3. Inventory Choices• FIFO/LIFO/AVCO• Normal cost• LOCOM rules

4. Goodwill• Fair value measurement• Impairments

5. Deferred Tax• Valuation allowance

6. Pension Accounting• Discount rate• Expected returns• Salary growth

7. Assets held at FMV8. Stock Options9. Provisions

100Financial Reporting QualityManipulation Incentives:

Analyst Expectations

Remuneration (Bonus/Stock Option)

Debt Covenants

Financing (raising further funds)

Disciplining Mechanisms:

External Auditors

Internal Audit/Committee

Management Certification

Class Action Law Suits

Regulators

Market ScrutinyEarnings:

Quality = persistence/sustainability

Mean reversion

Cash flow and accruals elements

Accruals element – not sustainable

Accruals – naturally self correct

Richardson, Tuna, Wu – companies restating earnings have highest accruals

Calculations:

Aggregate Accruals

Accrual based earnings NI

Cash based earnings

= -

Net Operating

Assets NOA

Total assets -cash

Total liabilities –total debt

= -

Aggregate Accruals

NOAt NOAt-1= -

Aggregate Accruals

NI – (CFOt + CFIt)= -

B/S based aggregate accruals

Cash flow based aggregate accruals

101Earnings ManagementRevenue Recognition Problems:Range of problems:Recognition of sale before completion of earnings processRecognition of sale without assurance of receiptEstimates:Credit salesDeferred/Unearned revenueWarranty provisionsSales returnsWarning Signs:Large ARLarge Unearned RevenueLower future cash-flows and accounting rates of return

Accelerating Revenue RecognitionRange of problems:Recognition of sale before completion of

earnings process (assessing the completion date)

Lowering credit standardsCut off issues (moving sales between periods)Warning signs:Bundled productsManagement vested options ITMPressure to meet earnings forecastsRaising additional financeLarge ARLarge Unearned RevenueDisproportionate revenue in last ¼

Recognizing revenue to early:Bill-and-hold salesLessor use of sales type vs.. direct financing leasesRecording sales prior to acceptance by customer (sales of equipment prior to installation)Incorrectly using % completion method for long term contracts

102Earnings ManagementClassification of non operating earnings as operating:Range of problems:1.Investment income2.Divestiture of non current assetsNB. No accrual or deferral reversal in later periodsWarning signs:Temporary inconsistency of items included within definition of operating income

Expense Recognition:Range of problems:Discretion over depreciation and amortizationImpairment recognitionApplication of lower of cost and fair value

rulesWarning signs:

of methods or lives – depreciation (disclosed in footnotes)

Conference calls – additional informationLIFO liquidationsInventory obsolescence

Deferring Expenses:Range of problems:Capitalization of operating expensesWarning signs:

Net non current assets (B/S broad measure accruals)Consider asset growth in the context of expected sales and margin growthSoftware development costs - discretion

Classification of operating expenses as non operatingRange of problems:Incorrect classification reduces COGS or SG&AWarning signs:Company’s with genuine special items that can be piggy backedChanges in operating profit margin or gross margin accompanied by spikes in special items

103Earnings ManagementBig Bath ProvisionsRange of problems:1. Impairments – future I/S

improvements via depreciation2. Restructuring or impairment charges

reversed in subsequent periods3. Use of high or low bad debt reserves

out of line with peers

Off Balance Sheet ItemsRange of problems:1.Assets and liabilities avoiding recognition:

Operating leases Sale of AR with recourseTake or pay/through put agreementsEquity accounted SPVs

Warning signs:SEC obligations to report future cash flow obligations of operating leases – analyst may discount to PV and restate

Goodwill:Range of problemsFMV adjustments on acquisitionFuture impairments

Warning signs:Goodwill reported and not impaired forcompanies where market cap < book value

IASB & FASB move to fair value accountingIssues:Some assets have readily identified fair values

e.g. listed equitySome assets don’t have readily identified fair values (assets with no actively traded secondary markets)

e.g. unlisted equitye.g. specialized equipment

Valuation models = discretionary inputs

104Modifying the Balance Sheet

� Unrecorded Items� Special Purpose Entities � Operating Leases� Guarantees� Contingent liabilities

� Recorded Items� Marketable securities� Accounts receivable� Inventory� Proportional vs.. equity a/c� Property Plant and Equipment� Capitalized interest� Goodwill� Intangibles (R&D)� Redeemable Pref/Convertible Debt� Long term debt� Pension Liabilities (SFAS 87!)� Stock Option plans (Pre SFAS 123R)� Deferred Income Taxes

Comprehensive IncomeNet IncomePension adjustmentsUnrealised gains and losses on available for sale securitiesCumulative foreign currency translation adjustmentsComprehensive Income

$XX

X

XX

US G

AAP

COGS LIFO – FIFOCapitalization of operating leasesReversal of deferred tax assets/liabilitiesMark to market LTD

Adjustments (not required by US GAAP)Capitalized interest reversalOff Balance sheet itemsFunded status of pension plan

105

� Adjust COGs to LIFO� Litigation or gov’t actions� Discontinued ops� LIFO liquidations� Capitalize Op leases� Capitalized interest� Economic cost of pension

plan� Temporal gains/(losses)

Normalized Earnings� Normalizing Operating Earnings

� Discretionary accounting changes� Regulated accounting changes� Realised capital gains/losses� Gains/losses on repurchase of debt� Catastrophes� Insurance settlements� Strikes� Impairment or restructuring

Inter-firm comparisons (adjustments)

Inventory methods

Depreciation assumptions/methods

Pension plan/Stock option assumptions

Capital/operating leases

Cyclical FirmsRemove the impact for

valuation:1. Averages over the

business cycle2. Average ratios applies

to current sales or equity

3. Regression model approach

Internationalcomparisons

LIFO prohibitions

Extraordinary items

Capitalized R&D

Accelerate Depn

Asset revaluation

Acquisition a/c

106

Corporate FinanceStudy Sessions 8 – 9

Weighting 5% – 15%

107Overview of Level II Corp Fin

Capital Budgeting

Study Session 8

Capital Structure and Leverage

Corporate Governance

Study Session 9

Mergers and Acquisitions

Dividends and Dividends Policy

108Capital Budgeting (1)

Expansion vs. replacement (see

next slide)� Expansion –

investment to increase the business

� Replacement –replacement of existing equipment with newer alternatives

Inflation and capital budgeting� Real (or nominal) CF

discounted using real discount rate (or nominal)

� Inflation increases company’s real taxes

� Higher than anticipated inflation decreases the worth of interest payments to bondholders

� Inflation does not affect sales and expenses equally

� Use cash not accounting profit� Incremental cash flows only

– Ignore sunk costs– Use opportunity costs–Include net working capital increases/decreases

� Cash flows based on opportunity costs� Cash flow timing is important (time value of money)� Analyze after-tax cash flows� Financing costs reflected in required return

Depreciation methods and cash flows

� Accelerated methods provide higher tax savings and hence better cash flows in the earlier years compared to straight line methods

� Example of accelerated method – MACRS

Comparing projects with unequal lives

� Least common multiple of lives approach – look at NPVs over a common life

� Equivalent Annual Annuity – find the annuity (PMT) that equates the NPVs at the cost of capital

109Expansion vs. replacement projects

Expansion Projects – investment to increase the business

1. Initial cash outflow = FCInv + NWCInv

2. Annual operating cash flow = (Sales – cash operating expenses – depreciation)(1 – tax rate) + Depn

3. Terminal year non-operating cash flow = Cash proceeds from sale of FCInv + NWCInv – tax rate x (Cash proceeds – BV of FCInv Termination)

Replacement projects – replacement of existing equipment with newer alternatives

1. Initial cash outflow = FCInv + NWCInv – Cash proceeds of old asset + tax rate x (Cash proceeds – book value of old asset)

2. Annual operating cash flow = (Sales – cash operating expenses – depreciation)(1 – tax rate) + Depn

3. Terminal year non-operating cash flow = (Cash proceeds from sale of FCInv + NWCInv– tax rate x (Cash proceeds – BV of FCInv Termination)

110

Stand-alone – the project’s individual risk

� Sensitivity to e.g. assumed sales

� Best/worst scenario analysis

� Monte Carlo simulation– random lots of scenarios– generate probability distribution for NPV and IRR

Capital rationing� Management constraint

on the size of the capital budget

� Optimal choice is to select investments that maximize the overall NPV within the capital budget

Using SML in Capital budgeting (Based on )Kproject required return = KRF + (Kmkt – KRF) project

� Kproject required return = discount rate to discount project cash flow

� Use of project beta to calculate required return when project risk is different from the company

Real Options� Real options are options that allow managers to make

decisions at a later date where these decisions are dependent upon future events or information

� Examples: Timing options; sizing options; flexibility options and fundamental options

� Real option analysis� Work out the NPV without including the real options.

If the NPV is positive, accept the project. There is no need to consider the real options if these options enhance the project value.

� Work out the NPV based on estimated future cash flows. Then add the value of the real options. This approach is useful when the NPV is negative.

Capital Budgeting (2)

111Capital Budgeting (3)Economic versus accounting incomeEconomic income = cash flow + change in market value NB: Change in MV = Ending MV – Beginning MVorEconomic income = cash flow – economic depreciation

Accounting income differs from economic income in the following ways:� Accounting depreciation is based on initial cost of the investment and reflects the decline

in the book value. Economic depreciation reflects the decline in the market value of the investment.

� Interest expense is included in accounting income but ignored in economic income.

Other valuation models� Economic profit (EP) = NOPAT - $WACC = EBIT(1 – t) – [WACC x Capital]

� NPV = MVA = sum of PV of all future EPs discounted at WACC� Residual income: RIt = NIt – reBt-1

� NPV = sum of PV of all future RIs discounted at cost of equity� Claims valuation – looks at the cash flows to debt holders and equity holders. The sum of

the PV of these cash flows equal project NPV

112Capital structure� Objective of capital structure decision is to maximise firm value and minimises the WACC

Taxes and its impact on value of the firm & re� Interest are tax deductible, debt capital provides a

tax shield that increases the value of a company.� Proposition I (with taxes): value is maximised at

100% debt�Value of a leveraged firm = value of an

ungeared firm + value of the tax shield� Proposition II (with taxes): WACC is minimised at

100% debt� With tax, WACC is

� Cost of equity is

� � eda rVEt1r

VDr �

��

��

��

��

� �t1EDrrrr daae ��

��

�� )(

MM Proposition without taxes� Proposition I: Capital structure

decision does not affect the company’s market value

� MM assumed no taxes and no cost of bankruptcy

� Value of ungeared firm = value of a leveraged firm

� Proposition II: The cost of equity is linearly related to the firm’s debt to equity ratio�Without taxes, WACC is

�Cost of equity is�As D/E increases, cost of equity

would increase

eda rVEr

VDr �

��

��

��

��

��

�� EDrrrr daae )(

D/E

Cos

t of c

apita

l

rd

WACC

re

MM no taxD/E

Cos

t of c

apita

l

rdWACC

re

MM with taxes

113Debt financing: other issues (1)In reality, the value of a leveraged firm is affected by factors other than the interest on the debt. These factors are:

Agency costs� Agency costs of equity – conflicts

between equity owners and managers who managed the company.

� The net agency costs of equity include:� Monitoring cost – incurred by

shareholders to supervise the managers.

� Bonding costs – incurred by management to assure shareholders that they are working for shareholders’ interests.

� Residual loss – incurred even though there is monitoring and bonding systems in place as these systems are not flawless

� Theory says that if a firm uses more debt, it would reduce the net agency costs of equity.

Financial distress costs

� Costs of financial distress and bankruptcy can be direct or indirect costs.

� Probability of bankruptcyHigher operating or financial leverage leads to higher probability of financial distress

Cost of asymmetric information

� Managers of the firm have better information compared to outsiders.

� Valuation implications:Stock offering �negative signal Debt offering � positivesignal

� Pecking order theory says that mangers choose financing methods that are the least observable signals to the most apparent signals. Manager prefers to use internally generated funds, then debt and finally equity.

114Static trade-off theory� Under the static trade-off theory, as

higher proportion of debt is being used, there exist a point where the benefit arising from the use of debt (i.e. tax shield) is offset by the costs of financial distress.

� An optimal capital structure exists where the value of the firm is maximized.

� The optimal capital structure is a function of many factors

Vungeared

VLeveraged

Max firm value

MV

of firm

Debt ratio

Optimal Debt ratio

PV tax shields

Cost of financial distress

Cost of capital

Optimal D/E ratio

D/E ratio

rd

WACC

re

Between 0% and 100%

Implications for managers’ decisions� MM I (No Taxes): Capital structure

irrelevant� MM I (With Taxes): 100% debt maximizes

value� Pecking order theory: Capital structure is

by-product of individual financing choices� Static trade-off theory: Trade off cheaper

debt financing with costs of financial distress; optimal capital structure between 0% and 100%

115Debt financing: other issues (2)Target Capital Structure� Used when making decisions on raising new finance� For managers maximizing firm value target = optimal

capital structure� Practice – fluctuation around target:

� Exploitation of opportunities in a specific financing source

� Fluctuating debt/equity markets affecting weightings

Capital Structure and ValuationAnalyst considerations:� Changes in capital structure over

time� Capital structure of competitors

with similar business risk� Factors effecting agency cost –

corporate governance

International Difference in Leverage� Japan/France more debt than US/UK� Debt maturity – longer in US than Japan� Developed markets have more total debt

and longer maturity than emerging markets

Institutional/Legal Factors• Strength of legal system• Information asymmetry• Taxes

Financial Markets/Banking System

• Liquidity• Reliance on banking system• Institutional Investor presence

MacroeconomicFactors

• Inflation• GDP growth

Debt Rating Agencies� Cost of capital tied to debt ratings� Goals for achieving certain ratings may

effect capital structure

116Dividends and dividend policy (1)Factors affecting dividend payout policy� Taxation of dividends� Flotation costs of a new issue� Restrictions on dividend payments� Signalling effects� Clientele effects

Taxation of dividends:Double taxation and split rate systems:� Effective tax rate

= corporate tax + (1 – corp tax) x individual tax� Split tax rate – use corporate tax rate for

distributed income� Imputation system – div taxed only at

shareholders’ rate

Signalling effect:• Dividend initiation – mixed view• Unanticipated dividend increase –

signal strong future prospects• Unanticipated dividend decrease –

negative signal

Residual dividend model� Dividend = actual earnings

minus the equity portion of firm’s capital budget

� Advantages: simple to use; investment opportunities considered independent of the dividend

� Disadvantages: unstable dividend payments; uncertainty as to dividend increases investors assessment of risk

117Dividends and dividend policy (2)

Pay a specific % of total earnings over long-term

Focus on steady $ payout –even though earnings may be volatileIn practice this increases with the long term rate of growth of the company

Longer term forecast of capital budget is determined –excess earnings over this period are then spread more evenly each year

Easy to useBUTInvestors may prefer stable dividends

Targetpayout ratio

Dividendstability

Longer-termresidualdividend

ResidualDividend

Dividend using the target payout approach:� ��

� � � ��

expected target previous adjustmentexpected dividend = + increase payout dividend factorin EPS ratio

118Dividends and dividend policy (3)

� Investors will prefer NOT to receive dividends due to their higher tax rates.

� Low dividend payout policy will be rewarded.

� Evidence shows Ks decreases as payout ratio increases –investors are rewarding the certainty of near term dividends with a lower level of risk.

� Higher dividend payout policy will be rewarded.

� Dividends can be manufactured – sell a little bit of stock to get the cash you want.

� Theory requires a number of assumptions.

� Policy has NO effect on value.

The tax aversion theoryThe bird-in-the-hand theoryDividend irrelevance theory

Rationales for stock repurchases� Signal that future outlook is good� Share dilution due to exercise of stock

options� Distribute cash � Company views its own stock as good

investment� Change the capital structure

Dividend initiationBased on dividend preference theory Dividend initiation � Lower risk� Lower cost of equity� Higher PE ratio

119Corporate governance (1)

Definition:The system of principles, policies, procedures and clearly defined responsibilities and accountabilities used by stakeholders to overcome conflicts inherent in the corporate form” (McEnally and Kim)

Objectives:� Eliminate or reduce conflicts of interest� Use the company’s assets properly

An effective system will:� Define the rights of shareholders (and other important stakeholders)� Define and communicate to stakeholders the oversight responsibilities of

managers and directors� Provide fair and equitable treatment in all dealings between managers,

directors and shareholders� Have complete transparency and accuracy in disclosures regarding

operations, performance, risk, and financial position


Corporate shareholders have no input in the day to day mgmt of the firm – this lack of control can create conflict between managers and shareholders

Similar to sole proprietors – conflicts between partners are dealt with by implementing a partnership agreement

Since owners and managers are one in the same no conflict exists here. Conflicts mainly involve creditors and suppliers

Distinct legal entities –managers act as agents of co.

Two or more owner managers

Owned and operated by a single individual

CorporationsPartnershipSole Proprietorship

Managers and shareholdersManagement may act in their best interests not those of the shareholders�Using funds to expand the size of the firm�Granting excessive compensation and perquisites�Investing in risky ventures�Not taking enough risk

Directors and shareholdersDirectors may align more closely with managers than shareholders� Lack of independence� Board members with personal relationships

with managers� Board members having consulting or other

business agreements with the firm� Interlinked boards� Directors are over compensated

Agency Relationships

Conflicts of Interest


Determining the effectiveness of the Board

� Composition of board: 75% of directors independent� Independent chairman on board (not CEO)� Qualifications of directors� How board elected (annual elections)� Board self-assessment practices� Frequency of separate sessions for independent directors (annually)� Audit committee and audit oversight (only independent directors)� Nominating committee (only independent directors)� Compensation committee and management compensation (mostly performance-based)� Use of independent and expert legal counsel� Statement of governance policies� Disclosure and transparency (more disclosure is better)� Insider or related-party transactions (board approval for related-party transactions)� Responsiveness to shareholder proxy votes

122Corporate governance (4)Board Of DirectorsThe board of directors have a responsibility to:� Institute corporate values� Ensure firm complies with all legal and regulatory requirements� Create long term strategic objectives� Determine management’s responsibilities� Evaluate the performance of the CEO� Require management to supply the board with complete and accurate information� Meet regularly� Ensure board members are adequately trained

Investors and analysts should assess the following policies of corporate governance:� Codes of ethics� Directors’ oversight, monitoring and review

responsibilities� Management’s responsibility to the board� Reports of directors’ oversight and review of

management� Board self-assessments� Management performance assessments� Directors’ training

Corporate Governance and Company Value

� Firms with strong/effective governance systems exhibit:

Higher measures of profitabilityHigher returns for shareholders

� Weak/ineffective governance system:Increased risk to investorsReduced valueExtreme cases: bankruptcy

123Mergers and acquisitions� Acquisition: One company buys only part of

another company� Merger: One company absorbs another

company entirely

Forms of integration� Statutory merger: target company ceases to

exist� Subsidiary merger: target company becomes a

subsidiary of the acquirer� Consolidation: acquirer and target form a

completely new company

Types of Merger

Acquirer

Forward integration

Horizontal

Conglomerate

Brewery Another Brewery

Pubs

Training

Hops Farms

Merger motivations� Synergies� Achieving more rapid growth� Increased market power� Gaining access to unique capabilities� Diversification� Bootstrapping� Personal benefits for managers� Tax benefits� Unlocking hidden values� Achieving international business goals

Bootstrapping EPS� A way of packaging earnings from

two companies after a merger� Increase in earnings per share� Real economic gains are not

necessarily achieved� Occurs when a firm with a high P/E

ratio acquires a firm with a low P/E ratio

Backward integration

124Industry life cycle and common mergers� Mature growth phase:

~ Industry characteristics: reduced profit margins due to new competition, but potential still exists for above average growth

~ Merger motivation: efficiency, economies of scale/synergies

~ Horizontal and vertical� Stabilization phase:

~ Industry characteristics: competition has reduced most of industry’s growth potential

~ Merger motivation: economies of scale, reduced costs, improve management

~ Horizontal� Decline phase:

~ Industry characteristics: declining profit margins, overcapacity, and lower demand due to shifts in consumer tastes

~ Merger motivation: survival, operating efficiencies, new growth opportunities

~ Horizontal, vertical, and conglomerate

� Pioneer/development phase: ~ Industry characteristics:

uncertain of product acceptance, low profit margins, and large capital requirements

~ Merger motivation: access to capital, management talent

~ conglomerate and horizontal

� Rapid growth phase:~ Industry characteristics: high

profit margins, accelerating sales, and earnings, but still low industry competition

~ Merger motivation: access to capital, expand growth capacity

~ conglomerate and horizontal

125Mergers transaction characteristicsComparing Forms of Acquisition

Friendly merger offersAcquirer approaches management

Negotiations and due diligence

Definitive merger agreement

Public announcement and shareholders vote

Attitude of target management

Usually avoids assuming

Acquirer assumes

Liabilities

NoneS/H pay CGS/H taxes

Target pays CGNoneCorporate taxesNone for “small”ShareholdersApproval

To targetTo shareholderPayment

Asset PurchaseStock Purchase

Hostile merger offersAcquirer submits proposal to board of directors

Successful Unsuccessful

Tender offer Proxy battle

Offer made to shareholders Proxy solicitation

126Takeover defense & HHIPre-offer defense mechanisms

� Poison pill: flip-in pill and flip-over pill� Poison put� States with restrictive takeover laws� Staggered board� Restricted voting rights� Supermajority voting provision for mergers� Fair price amendment� Golden parachutes

Post-offer defense mechanisms� “Just say no” defense� Litigation� Greenmail� Share repurchase� Leveraged recapitalization� Crown jewel defense� Pac-man defense� White knight defense� White squire defense

Virtually certain

50 or moreHigh> 1800

Possible100 or moreModerateBetween 1000

& 1800

No actionAny amountNot concentrated< 1000

Antitrust Action

Changein HHI

IndustryConcentration

Post merger HHIHerfindahl-

Hirschman IndexKey measure of market power for determining anti-trust violations

n2

ii=1

HHI = (MS ? 100)

127Valuing a target company (1)

Discounted cash flow method� Similar to FCFF approach in

SS 12� Determine free cash flows

available to investors after necessary expenditures

� Choose appropriate discount rate (target company WACC adjusted for merger effects)

� Discount cash flows back to the present

� Determine terminal value –constant growth or market multiple

Comparable transaction analysis� Also uses relative value metrics

for comparables� Comparables are recent takeover

transactions, not just comparable firms!

� No need to calculate separate takeover premium

3 methods to evaluate a target company

Comparable company analysis

� Uses relative value metrics from similar firms

� Adds a takeover premium to determine fair price to pay

128Valuing a target company (2)

Discounted cash flow method

Advantages� Easy to model changes in

cash flow from synergies� Using forecasts avoids

biases that may exist in current market data

� Model is easy to customizeDisadvantages� Model is difficult to apply

when free cash flows are negative (rapid growth firm)

� Estimation error – terminal value

� Changing discount rates can have large impact on estimate

Comparable transaction analysis

Advantages� No need to estimate a

takeover premium� Estimates of value are

derived directly from recent deal prices

Disadvantages� Assumes past M&A

transactions were accurately valued

� May not be enough comparable transactions available

� Difficult to incorporate synergies or changing capital structures into analysis

3 methods to evaluate a target company

Comparable company analysis

Advantages� Easy access to data� Estimates of value are

derived from the market (reduces estimation error)

Disadvantages� Assumes market is

valuing comparable firms correctly

� Must determine takeover premium separately

� Difficult to incorporate synergies or changing capital structures

� Historical data used to estimate a takeover premium may not be timely

129Evaluating a merger bid� Post-merger value of an acquirer: VAT = VA + VT + S – C� Gains accrued to the target: GainT = TP = PT – VT

� Gains accrued to the acquirer: GainA = S – TP = S – (PT – VT)� Adjustment for stock payment: PT = (N PAT)

where: N = number of new shares target receivesPAT = price per share after merger announced

Effect of PaymentCash offer � Acquirer assumes the risk and receives the potential reward� Gain for target shareholders is limited� If synergies more than expected, takeover premium for target is fixed, so acquirer wins� If synergies less than expected, acquirer losesStock offer� Some of the risks and potential rewards shift to the target firm� Target shareholders will own part of acquiring firm� Confident synergies will be realized

� Acquirer wants to pay cash; target wants stock to participate in upside� Lack of confidence in synergy estimates

� Acquirer wants to pay in stock to share risk; target wants cash to lock in any gains

130Mergers benefits & restructuringDistribution of merger benefits

Short-term effect on stock price� Targets gain approximately 30%� Acquirer’s lose between 1% and 3%

Long-term effect on stock price� Acquirers tend to underperform� Failure to capture promised synergies

Corporate restructuring� Divestitures: Selling, liquidating, or spinning off a division or subsidiary� Equity carve-outs: creates a new, independent company; sell shares to outside

stockholders through a public offering� Spin-offs: create a new, independent company; distribute shares to parent company

shareholders – no cash for parent� Split-offs: existing shareholders must exchange shares for shares of new division � Liquidations: break up the firm and sell its assets piece by piece

Reasons for divestitures� Division no longer fits into

management’s long-term strategy� Lack of profitability� Reverse synergy – individual parts are

worth more than the whole� Infusion of cash

131

Equity Investments Study Sessions 10,11 &12

Weighting 20 -30%

132Equity Investments - Overview

Valuation process

Residual Income Valuation

Market-Based Valuation: Price

Multiples

Free Cash Flow

Valuation

Valuation in Emerging Markets

Return concepts

Industry Analysis

Five competitive forces

Discounted Dividend Valuation

Private Company Valuation

A note on asset

valuation

133

Graham and Dodd 1934 – 1962Value should be independent of price

Financial statement analysis, earnings power, growth prospects

Relative valuation methods

“Blocking and tackling”

A Note on Asset ValuationJohn Burr Williams (1938)

Value is the present value of cash flows at an “opportunity cost of capital”

Discount rate was not clearly defined

DDM and FCF models

Forward-looking

Modern Portfolio Theory (1959)Harry Markowitz (Portfolio Selection):

Value includes growth and risk, efficient frontier dominates other portfolios, covariance is key, diversification is a free lunch

William Sharpe:

Cost of capital is function of systematic, non-diversifiable risk

Unsystematic risk can be diversified away

Developed CAPM

Modern Valuation TechniquesFixed income: PV of coupons and par

value discounted by YTM

Common stock: PV of future cash flows discounted by the required return

DDM: PV of expected dividends

FCFF: discounted at WACC

FCFE: required return on equity

Relative value: earnings multiplierResidual income: current book value +

PV of expected economic profit

134

Uses:• Stock selection• Reading the market• Projecting the value of

corporate actions• Fairness opinions• Planning and

consulting• Communications with

analysts and investors• Valuation of private

business• Portfolio construction

and management

Valuation = the estimation of an asset’s value

Absolute – based on variables perceived to be related to future investment returns

Relative – based on comparisons with similar assets

Inputs – should be qualitative as well as quantitative

Valuation Process -Overview

1. Understand the business2. Forecast business

performance3. Select the relevant

valuation model(s)4. Convert forecasts to a

valuation5. Make the

recommendation or investment decision

Critical step that involves financial statement analysis (including quality of earnings analysis) combined with an evaluation of industry prospects, competitive position and corporate strategies.

Valuation Process

135

Industry Competitive Analysis Five Elements of Industry structure: Threat of new entrants, Threat of substitutes, Bargaining power of Buyers, Bargaining power of Suppliers, Rivalry among Existing Competition

Three Generic Strategies: Cost Leadership, Product Differentiation, Focus

Valuation Process Importance of F/S Footnotes

Footnotes reveal management’s discretion in choices of accounting methods and estimates

Analyst’s ability to accurately forecast result derived from quality inputs

Greater transparency in earnings results in higher stock price—management’s ultimate goal

Accounting ShenanigansAccelerating or Premature Recognition of Income

Reclassifying gains and non-operating income

Expense recognition and losses

Amortization, depreciation, and discount rates

Off-balance sheet issues

Considerations in ValuationFits the Characteristics of the Company (Does it pay dividends? Is earnings growth estimable? Does it has significant intangible assets)

Is appropriate based on the quality and availability of input data

Is suitable given the purpose of the analysis

Considering only one model is not good

136

Perceived mispricing• = any difference between the analyst’s estimate of intrinsic value and the market price

• reflected in the abnormal return, alpha, the analyst expects to earn.

Ex ante alpha = expected holding-period return – required return

Ex post alpha is used to assess the success of the analyst’s strategy= actual holding-period return - contemporaneous required return

Model selected must be:• consistent with the characteristics of the company being valued;• appropriate given the availability and quality of data;• consistent with the purpose of valuation, including the analyst’s ownership

perspective (i.e. extent of the investor’s influence over the company).

Valuation Process

Ownership PerspectiveMarketable publicly traded minority interest—DDM approach is the benchmark value

Premiums for control—FCFE approach

Discounts for lack of marketability for non-publicly traded stocks

Discounts for lack of liquidity for publicly traded stocks

137

Different Returns/Rates• Holding Period Return, Realized Return, Expected Return, Required Return, Return from

Price Convergence, Discount Rate, Internal Rate of Return

Return Concepts

Ways of Measuring the Required Return

• Multifactor Models

Req’d Return=(factor sensitivity)i*(factor risk premium)i + …. + (factor sensitivity)n*(factor risk premium)n

CAPM:

� �� fmf rrE�rE(r) ��

“equity risk premium”

138Return Concepts

Ways of Measuring the Required Return

Fama – French Model

Req’d return on stock j = Rf + bmkt,*(Rmkt – Rf) + bSMB,j*(RSMALL-RBIG) + bHML,j*(RHBM-RLBM)

Rmkt – Rf = return on a value weighted market index minus risk free rateRSMALL-RBIG =small cap return premiumRHBM-RLBM =value return premium

Pastor-Stambaugh Model

Builds on the Fama French Model by adding a liquidity factor

Macroeconomic Multifactor Models e.g. Burmeister, Roll and Ross Model

Uses economic variables believed to affect cash flows as factors within the model.

139Return ConceptsWays of Measuring the Required Return

Build-Up Method

Req’d return =Rf + Equity risk premium + size premiuim + specific company premium

Bond Yield Plus Risk Premium

Req’d return =YTM on long term debt + risk premium

Country Spread Model and Country Risk Rating Model

Calculates the premium to be added to the req’d return when investing in emerging mkts

140Return ConceptsEstimating Beta

Public Companies

Use regression of company stock returns against the market

Adjust for beta drift by using adjusted beta

Adjusted beta=(2/3)*regression beta + (1/3)*1

Thinly traded/non public companies

Estimated beta for ABC=unlevered beta of similar quoted company *

(1+(debt of ABC/equity of ABC))

Unlevered beta of similar quoted company = Beta of similar co.*

1/[1+(debt of similar co/equity of similar co)]

141Return Concepts

Estimating Equity Risk Premium using…..

Historical estimatesStrengths:•Objective. Simple, unbiased if investors rationalWeaknesses:•Assumes mean and variance are stationary•Different ways of calculating mean return (geometric, arithmetic)•Different ways of estimating risk free rate (can use long or short term bonds)

142Return ConceptsEstimating Equity Risk Premium using…..

Forward looking / Ex Ante estimatesStrengths:•Doesn’t depend on assumption of stationarity3 Types…..

Gordons Growth ModelStrengthsAssumptions used are

reasonable and inputs to the model can easily be sourced

Weaknesses• This estimate will change

over time and needs updating, assumes stable growth

Supply Side EstimatesStrengths:• Uses proven models

and current informationWeaknesses:• Only appropriate for

developed countries

Survey EstimatesStrengths:• Uses expert opinions

and more likely to be reliable

Weaknesses• There maybe large

differences of opinion

143

Porter’s 5 forces

Top-down forecasting1. Macroeconomic

2. Industry

3. Company

Understanding the business• How attractive are the industries in which the

company operates, in terms of offering prospects for sustained profitability?

• What is the company’s relative competitive position within its industry?

• What is the company’s competitive strategy?

3.

2.

1.

FIRMRIVALRYSUPPLIERS BUYERS

SUBSTITUTES

Bargainingpower Threat of substitute

products or services

Threat ofnew entrants Bargaining

power

POTENTIAL ENTRANTS

Industry and Company Analysis

144

Risks of each generic strategyCost Leadership• New entrant enters market with lower cost base and/or technological breakthrough

reduces rivals production costDifferentiator• Consumers cease to value differentiating factor and/or rival company does it betterNiche• Interest in niche from big players and/or smaller players target sub-sectors of niche

CostLeadership

Differentiation

Narrow TargetBroad Target Focus

CompetitiveAdvantage

Low costs in all market segments• economies of scale• proprietary technology• pref. access to raw materials

Satisfy particular consumer needs

• product/delivery/marketing • premium pricing

A focuser will be an above average performer if it can achieve product differentiation in its chosen sub-sector

A focuser will be an above average performer if it can achieve cost leadership in its chosen sub-sector

Competitive Strategies

145

Industry life cycle

Industry life cycle phasesPioneer - Acceptance of the product or service uncertain, implementation of business strategy is unclear. Period of high risk with many failures.

Growth – Acceptance of the product or service established. Accelerating sales and earnings. Industry growth faster than the general economy. Profit margins above average.

Mature – Industry growth corresponds to the growth of the general economy. Participants compete for share in stable industry.

Decline – Demand for the industry’s product steadily decreases due to shifting tastes or technologies. Profit margins are diminished.

Classification by business cycle reaction• Growth Industry Stocks - experience

accelerating sales and high profit margins during all phases of the business cycle

• Defensive Industry Stocks - product demand independent of the business cycle, therefore less cyclical than the overall market

• Cyclical Industry Stocks - product demand tends to vary directly with the business cycle

Sal

es

Time

Growth Maturity DeclinePioneer

Business and Industry Life Cycles

146

Industry External Factors• Technology • Government• Social changes• Demographics• Foreign influences

Supply analysis• In the long term, demand will equate to supply

• In the short term, there could be shortfalls in supply due to long lead times etc

Demand analysisAn analyst is in a position to assess future demand for the industry’s output by developing• A macroeconomic forecast• An industry classification• An external factor review

Two additional sources of information• A study of the firm’s customers• A study of the industry’s inputs and

outputs

Factors influencing pricing practices and hence profitability• Product segmentation - Firm’s ability to differentiate its product over various market

segments.• Concentration – The greater the concentration, the greater the likelihood of collusion.• Ease of industry entry – Greater ease of entry � prices toward the marginal cost.• Supply input price – Changes in resource prices will have major implications of profitability.

Industry Analysis

147

Dealing with inflation in emerging market valuation

Country Risk Premium

•No satisfactory method for estimation

•Premium is often overstated

Real valuation approach

Nominal valuation approach

Incorporating EM risks

Adjust the required return by adding a

country risk premium

Adjust the cash flows in a scenario analysis (preferred)

Valuation in Emerging Markets

148

Generic DCF model

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CFVConsider using dividends for CF when:

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bears an understandable and consistent relationship to the company’s profitability;

• the investor takes a non-control perspective.

DCF

149

Generic DDM

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Dividend Discount Models

150

Gordon growth model Strengths:• Suitable for stable, mature,

dividend paying firms• Easily applied to indices• Easily communicated &

explained• Can be used to determine

growth rates, rates of return and PVGO

• Supplements other methodsLimitations:• Very sensitive to inputs• Not easily applied to non-

dividend paying stocks• Unpredictable growth patterns

makes using the model difficult

Problem with two-stage model with constant growth in both stages

Assumption that a firm’s high growth rate will suddenly drop to a lower level overnight is

highly unrealistic.

Improvement built into H-modelOver a set time the high initial growth will

decline in a linear fashion to the sustainable long-term growth rate

Rationale for three-stage model• With a good product, some companies may

sustain a high growth rate in the short-term

• The business is most likely to go through a growth phase, transitional phase, then mature phase

Spreadsheet approachUsed when even the three-stage DVM is too simple for a real-life application

DCF Commentary

151

Multi-stage modelsStrengths:• Flexibility• Can calculate implied growth rates

or required returns• Can incorporate the impact of

different assumptions into the model• Relatively easy to construct using

spreadsheet softwareLimitations:• Estimates are only as good as the

inputs used• Model must be fully understood to

arrive at accurate estimates• Estimates are very sensitive to

assumptions regarding growth and the required return

• Formula and data input can lead to errors that are difficult to identify

Sustainable growth rate Rate at which earnings (and dividends) can continue to grow indefinitely, assuming that the firm’s leverage is unchanged and no new equity finance is raised.

Estimating return on equity (ROE)

EquityAssetsx

AssetsSalesx

SalesEBIT

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g = b x ROE Where: b = retention rate

ROE = expected return on equity

152

• FCFs are not published but need to be computed from published financial statements

• Free means after fulfilling all obligations and without impacting on the future growth plans of the company

Free Cash Flows to Equity (FCFE)= net income

non-cash items in income statement

- investment in working capital - investment in fixed assets+ net increase in debt

or= CFO*

- investment in fixed assets+ net increase in debt

* Assuming interest received and paid and dividends received have been classified as an operating cash flow as required under US GAAP

Free Cash Flows to the Firm (FCFF)= net income

non-cash items in income statement+ interest expense x (1 – tax rate)- investment in working capital- investment in fixed assets

or= CFO

+ interest expense x (1 – tax rate) - investment in fixed assets

or= FCFE

+ interest expense x (1 - tax rate) – net increase in debt

NB: May be given EBIT or EBITDA as starting point for FCFE or FCFF calculations

FCF Models

153

Calculation of WACC is covered in Corporate Finance

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Forecasting FCF - Apply a growth rate to most recent reported free cash flow or forecast each component separately.Sensitivity Analysis – Often utilized to assess the impact of uncertain assumptions.

FCF Models

154

Preferred to DDM when:• Firm pays no dividends.• Firm is paying dividends but

dividends differ significantly from the firm’s capacity to pay dividends – i.e. dividends imperfectly signal the firm’s long-run profitability.

• Free cash flows appear to be better aligned with profitability over the analyst’s forecast period.

• Investor takes a control perspective since the firm is being analyzed as a takeover target

FCFE v FCFF models For firms with relatively stable leverage, FCFE is more direct and easier to use.Situations where the FCFF approach is more useful include:• proposed purchase of entire firm (i.e. equity

and debt capital) with a subsequent reorganization of the capital structure.

• firms where FCFE is negative.• firms with history of leverage changes –

FCFF may be more meaningful than an ever-changing growth pattern in FCFE.

Free cash flow proxiesBoth net income and EBITDA are regarded as fairly poor proxies since:• both ignore the important distinction between profit and cash flow• both ignore the reinvestment of earnings needed for growth • EBITDA ignores the tax that the firm needs to pay before any distribution to investors

FCF Further Aspects

155

Overview• Price multiples are ratios of a stock’s market price to some measure of value per share.• Method of comparables involves comparing a stock’s price multiple to a benchmark

multiple to determine whether or not the stock is appropriately valued.• Method based on forecasted fundamentals relates multiples to company fundamentals

using a discounted cash flow model.• A justified price multiple is a multiple justified by an analyst based on either of the

above methods.

P/E multiple

• Earnings may not exist or be negative • Need to adjust “book” earnings to

sustainable or recurring earnings• Management discretion with

accounting practices distort earnings and affect comparability of P/Es across companies

• Earnings power is the primary driver of investment value

• P/E ratio is a popular measure with investors

• Empirical research shows that P/Es may be related to differences in long-run average stock returns

Drawbacks of using P/E:Rationales for using P/E:

Price Multiples

156

P/E ratio based on fundamentals

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Methods used to find normalized earnings for cyclical businesses:

• Method of historical average EPS – use the average EPS over the most recent full cycle

• Method of average return on equity – use the average ROE (based on the most recent full cycle) multiplied by the current book value per share

Value = earnings x P/E ratio

P/E multiple increases if:• growth rate increases• firm’s risk level decreases causing the

required return to decrease • interest rates decrease causing the

required return to decrease • payout ratio increases (although g will

also be negatively affected)

Determining earnings Analyst may adjust for:• company specific transitory,

nonrecurring components*• transitory components due to

business or industry cyclicality• accounting method differences*• potential dilution (e.g. due to

options and convertibles)

Valuation using P/E

157

Steps for valuation using comparables

1. Select and calculate the price multiple that will be used in the comparison.2. Select the comparison asset or assets.3. Calculate the benchmark value of the multiple, i.e. the mean or median value of the

multiple for the comparison assets.4. Compare the stock’s actual multiple with the benchmark value.5. If possible, assess whether differences in the fundamental determinants of the price

multiple explain any of the difference in 4 and modify conclusions accordingly.

P/E to growth ratio• Step 5 above could involve calculating the P/E-to-g (PEG) ratio.

• A high P/E should be justified by high growth – so this ratio should be roughly constant for all firms in a sector.

• A high ratio may indicate an overpriced share, a low ratio an under priced share.

PEG Ratio

158

Value = book value x P/B ratio

• relies on consistent application of accounting standards

• not good for firms with off Balance Sheet human capital

• depreciated historical cost of assets may be different across similar firms due to the age of the assets

• book value more stable than EPS• works with zero or negative earnings• for some firms, book values of assets

may approximate market values• empirical evidence suggests differences

in P/Bs may be related to differences in long-run average returns

Drawbacks of using P/B:Rationales for using P/B:

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required return to decrease • ROE increases

Book value of equity is:• net assets; or• shareholders’ funds

P/B Ratios

159

Value = sales x P/S ratio

• fails to highlight cost control issues within a firm

• does not reflect differences in cost structures among different companies

• meaningful even if EPS is negative• sales figures less subject to manipulation • less volatile than P/E• viewed as appropriate for valuing the stock of mature,

cyclical and zero-income companies • research suggests that differences in P/Ss may be

related to differences in long-run average returns

Drawbacks of using P/S:Rationales for using P/S:

Fundamental P/S

E/S = profit margin

P/S multiple increases if:• growth rate increases• payout rate increases, but ….• profit margin increases• firm’s risk level decreases causing the


required return to decrease

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P/S Ratios

160

Value = cash flow x P/CF ratio

• certain cash flows are ignored if proxies are used such as EPS plus non-cash charges

• FCFE is superior for valuation but introduces volatility problems and may also be negative at certain times

• addresses the issue of differences in accounting conservatism between companies (quality of earnings)

• cash flows less subject to manipulation than earnings• less volatile than P/E since CF tends to be more

stable than earnings• research suggests that differences in P/CFs may be

related to differences in long-run average returns

Drawbacks of using P/CF:Rationales for using P/CF:

Fundamental P/CF Measures of cash flows that may be used:CFO = cash flow from operationsFCFE = free cash flow to equityCF = earnings plus non cash

charges or incomeEBITDA = earnings before interest, tax,

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P/CF Ratios

161

• focus on D/P is incomplete as it ignores capital appreciation

• dividends now would displace future earnings, which implies a trade-off between current and future cash flows

Drawbacks of D/P approach:

• dividend yield is a component of total return• dividends are not as risky as the capital

appreciation component of total return

Rationales for using dividend yield:

Dividend yield modelValue = annualized dividend / dividend yield

Enterprise Value/EBITDA• EV = MV of all equity and debt less cash

& liquid investments = NPV of firm’s earning activities

• EV should be a predictable multiple of EBITDA

Rationales for using EV/EBITDA:• Useful in comparing firms with different

financial leverage• Eliminates accounting manipulation in

depreciation & amortization• EBITDA more stable than other earnings

measures, and normally positiveDrawback of using EV/EBITDA:

• EBITDA ignores required capital and working capital investments

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162

Overview• Residual Income = accounting profit - charge for equity capital employed

• Residual income represents returns in excess of shareholder expectations, or “economic income”

Forecasting residual income• This might use internal management

forecasts for the next few years. Problem = bias.

• Could use fundamental forecasts of earnings growth and dividend policy.

The general model

where:V0 = value of share todayB0 = current per-share BV of equityBt = expected per-share BV at time tr = required rate of return on equityEt = expected EPS for period tRIt = expected per-share RI

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recognition of value is different in the RI model.

• The total PV produced by all models should be consistent, in theory, so long as each uses fully consistent assumptions.

Residual Income Models

163

Drivers of RI and link to P/BAssuming a constant growth rate in earnings, g, and a constant ROE and dividend payout, the residual income valuation model simplifies to:

This formula is linked to:

Multi-stage RI model – Continuing RI • Continuing residual income is residual income

after the forecast horizon.

• It is likely that residual income will decline in the long run until the firm is making a “normal” return (i.e. ROE = r � RI = 0).

• Possible continuing RI assumptions are:• RI continues indefinitely at a positive level• RI is 0 from the terminal year forward• RI declines to 0 as ROE reverts to r over time• RI reflects reversion of ROE to some mean

Applicable RI model when RI fades over time from time T

w (fade rate) takes values between 0 and 1:

w = 0 � no expectation of any future RI

w = 1 � same level of RI continuing forever

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Residual Income Models

164

Implied Growth RateCan be calculated given the P/B ratio and the required rate of return on equity by rearranging the single-stage RI formula:

Justifying Continuing RI PersistenceFactors suggesting high :

• Low dividend payout ratios

• High historical industry persistence

Factors suggesting low :

• Very high rates of return (ROE)

• Large special items e.g. non-recurring items

• Large accounting accruals

Problems Applying RI Models• violations of clean surplus: currency translation adjustments, minimum liability adjustment,

unrealised gains/losses on available-for-sale securities

• off-balance sheet items: operating leases, LIFO inventory, goodwill, assets/liabilities not at FMV

• non-recurring items: extraordinary items, discontinued operations, accounting changes

• Differing international standards

RI Models – Further Aspects

165

• Easily manipulated by changing accounting assumptions

• Ignore changes in reserves other than income and dividends

• Many adjustments may need to be made to accounting data to get comparable figures

• Terminal value doesn’t dominate estimate

• Uses available accounting data• Useful even if firm doesn’t pay dividend,

and not distorted by irregular dividends• Can be used with unpredictable cash

flows• Models focus on economic profitability,

not just accounting profitability

Weaknesses of RI models:Strengths of RI models:

When to use a RI model:RI model is most appropriate when:

• company does not pay dividends, or its dividend are not predictable• company’s expected FCFs are negative within the analyst’s forecast horizon• great uncertainty exists in forecasting TVs using an alternative PV approach

RI model is least appropriate when:

• there are significant departures from “clean surplus accounting”• determinants of RI are not predictable

RI Models Commentary

166

Alternative measuresRI (see earlier slide)

EVA® = NOPAT – (WACC x IC)

MVA = Market value of firm – IC

Accounting vs Economic ProfitabilityEconomic profitability reflects the dollar cost of debt and equity capital used to generate cash flow.

Accounting profitability (ROE) only includes an accounting accrual related to interest expense.

One way of assessing relative economic profitability is to compute an EVA spread:

EVA spread = ROC – WACC

where ROC = NOPAT/Invested Capital

Methods of Increasing EVA®• Increase Revenues• Reduce operating expenses• Use less Invested Capital• Take advantage of positive NPV

projects• Reduce WACC

Value-Based Metrics

167Private Company Valuation

Private Company Specific Factors• Stage of lifecycle, size, Taxes• Quality and Depth of Management• Management/Shareholder overlap• Quality of financial and information• Liquidity, Marketability, Control

Private Company Valuation Approaches• Income Approach �PV of expected future income � High Growth Phase Companies• Market Approach � Recent Transaction Price Multiples � Mature Phase Companies• Asset-based Approach � Firm’s assets’ value minus liabilities � Early Stage Companies

Liquidity and Marketability• Minority referred to Liquidity• Difficult to be sold referred to Marketability� DLOC = 1-[1/(1+control Premium)]� Total discount = 1-[(1-DLOC)(1-DLOM)]

Scenario Comparable Data Subject Valuation Adj. to Comp. data for control

1 Controlling Interests Controlling Interests None

2 Controlling Interests Noncontrolling Interests DLOC

3 Noncontrolling Interests Controlling Interests Control Premium

4 Noncontrolling Interests Noncontrolling Interests None

168

Alternative InvestmentsStudy Sessions 13

Weighting 5 – 15%

169SS13 Overview

Alternative AssetValuation

Private EquityInvestment Analysis Income Property Hedge Funds

170Real Estate Investments

Type Main Value Determinants

InvestmentCharacteristics

Principal Risks Likely Investor

Raw Land Supply/demandLocation

Passive, illiquid, limited leverage, no tax depreciation, CGT, low current income

Alligator! Uncertain appreciation

Speculators, developers, long-term investors

Apartments No of households, incomes, location, population growth

Active management, both current income and capital gains, high liquidity and leverage, inflation hedge

Startup risks due to uncertain demand, need of professional management

Well capitalised in need of tax shelter

Office buildings

Business conditions, location, tenant mix

Active management, income and capital gain, moderate liquidity and leverage

Startup risk, obsolescence, quality of management , competing properties

High net worth companies and individuals in need of tax shelter

171Real Estate Investments cont.Type Main Value

DeterminantsInvestmentCharacteristics

Principal Risks Likely Investor

Warehouses Commercial and industrial activity, flexibility of design, easy access and convenience

Passive, moderate liquidity and leverage, mostly income

Oversupply (cheap) and obsolescence

Investors seeking high cash flow, minimal management and tax shelter

Shopping centres

Population, income level, location, tenant mix, lease terms

Active management, low liquidity, moderate leverage, both income and capital gain, tax advantages

The right tenant mix, obsolescence, competition, maintaining quality management, high vacancy rates

Well capitalised seeking tax shelter

Hotels and Motels

Level of business and tourist activity, location

Active management, limited liquidity, and leverage, tax depreciation

Economies of scale, quality management, competing facilities

Wealthy investors or REITS

172

Valuing Real EstateGenerally use NPV or IRR analysis

CFAT = cash flow after taxesERAT = equity revision after taxEI = initial equity investment

Steps in Calculating CFATStep 1: Compute taxes payable

Taxes payable = (NOI – depreciation –interest) tax rate

Step 2: Compute cash flows after tax (CFAT)CFAT = NOI – debt service – taxes payable

Step 3: Compute equity reversion after taxesERAT = selling price – selling costs –mortgage balance – taxes on sale

IRR Problems• Multiple or no IRR are the result of cash flow changing

signs more than once - common with property renovations

• Misleading IRR decisions due to size and timing of cash flows

• Conflicting IRR and NPV decisions for mutually exclusive projects

• Solution - use the NPV methodology and select projects with positive NPV

Evaluating Real Estate• If NPV > 0, or NPV = 0, then

purchase the property. A positive NPV means that the present worth of the property is greater than the equity cost of the investment. A zero NPV means the investors equity cost is unaffected

• If NPV < 0, don’t invest in the property as it destroys value

Valuing Real Estate

EIIRR

ERATIRR

CFATIRR

CFATNPV nnn �

�

)1()1(...

)1( 11

173

Cap Rate and Discount Rate•Discount rate (r) - the required rate of return on a real estate investment given the risk and uncertainty of cash flows

•Cap rate (r – g) - the required return less the expected growth of net operating income (NOI)

Methods to Estimate Cap RateMarket Extraction Method – considered the most accurate but depends on appraisal data and comparable properties

Band-of-Investment Method – useful for properties that utilise both debt and equity financing; uses a sinking fund factor to calculate the cap rate as a WACC figure; depends on comparable property data

Built-up Method - Useful when comparables not available

Property Analysis and Appraisal

1 10

0

0

NOI NOIMV

r g RWhere R = market capitalization rate

� ��

0NOIR (ME) = MV

�

�0R (BOI) = (mtg weight mtg cost)

+ (equity weight equity cost)

0R (BU) = pure rate + liquidity premium + recapture premium + risk premium

Limitations of Direct Income Capitalisation•Selecting the correct cap rate may be difficult due to lack of available market data, or low-quality data•Approach is limited to income-generating properties, not owner-occupied properties with non-monetary benefits•Properties that provide little or no income or benefits cannot use this method

174

Value CreationReengineer firm

Obtain lower cost financing

Goal alignment

Exit RoutesIPO

Secondary Market

MBO

Liquidation

VC v Buyout Characteristics�Cash flow�Product �Asset base�Management team entrepreneurial record�Leverage�Risk assessment �Exit strategy�Operations�Capital required in growth phase�Returns�Activity in public capital markets�Future funding �Carried interest

Private EquityRisks

LiquidityCompetitionAgencyCapitalRegulatoryTaxValuationDiversificationMarket

Structure and TermsStructure – LPTermsManagement fees

Carried interest

Ratchet

Hurdle Rate

Target fund size

Vintage

ValuationDue Diligence

CostsTransaction Placement feeFund set up Performance feeAdministrative Management feeAudit

175Private EquityControl Mechanisms in PE

TransactionsCompensation & Tag-along, drag-along clauses

Board representation & Non-compete clauses

Priority in claims, Required approvals, & Earn-outs

Corporate Governance terms Key man clause & performance disclosure and confidentiality

Claw-back & distribution waterfall

Tag-along, drag-along clause & Remove for cause

No-fault divorce & Investment restrictions

Co-investment

Valuation Methodologies DCF

Relative value or Market approach

Real option analysis

Replacement cost

VC method & leverage buyout method

Calculating Payoff Multiples and IRRsCalculating the exit value

Calculating the claimant’s payoffs: Debt, Preference shares, PE firms, Management

Calculating the total investment and total payoff, using these two can get the Payoff Multiples for PE firms

Calculating the IRRs for PE investors and management equity

176Private EquityPerformance Measurement

�Multiples: Popular, simple, easy to use and differentiates between realized and unrealized returns, specified by GIPS�Paid in Capital (PIC) – % of capital used by GP

�Distributed to PIC (DPI) – measures GP realized return, cash on cash return

�Residual Value to PIC (RVPI) –measures LP’s unrealized return

�Total value to PIC – measures LP’s realized and unrealized return, sum of DPI, and RVPI

ValuationIssue

Buyout VentureCapital

Use of DCF

Frequently used

Uncertain cash flow

RelativeValue

Validates DCF

No comps

Use of Debt

High Low, more equity

Keyreturndrivers

EPS growth, P/E expansion, debt reduction

Pre-money valuation, future dilution

Other ValuationVC – Single / Multiple financing rounds

LBO - Target IRR

- Cash flow

177Private EquityFor a Single Financing Round

Step 1: Post-Money Valuation

POST = FV /(1+r)N

Step 2: Pre-Money Valuation

PRE = POST-INV

Step 3: Ownership Fraction

f = INV/POST

Step 4: No. of the shares to be held by the PE firm

Spe = Se [f/(1-f)]

Step 5: Price per share

P = INV/ Spe

For Multiple Financing RoundsStep 1: the compound discount rateStep 2: Post-Money Valuation (round 2)POST2 = FV/ (1+ r2)Step 3: Pre-Money Valuation (round 2)PRE2 = POST2 – INV2Step 4: Post-Money Valuation (round 1)POST1 = PRE2 / (1+ r1)Step 5: Pre-Money Valuation (round 1)PRE1 = POST1 – INV1Step 6: Ownership Fraction (round 2)f2 = INV2 / POST2Step 7: Ownership Fraction (round 1)f1 = INV1 / POST1Step 8: No. of the shares to be held by the PE firm Spe1 = Se [f1 /(1- f1)]Step 9: Price per share after financing (round 1)

P1 = INV1 / Spe1Step 10&11: Price per share after financing (round 2)

Spe2 = (Se + Spe1) [f2 /(1- f2)]P2 = INV2 / Spe2

178Private EquityIRR Method

Ownership Fraction

Step 1: Investor’s expected future wealth W = INV (1+r)N

Step 2: Ownership Fraction f = W/FV

Price per share

Step 3: No. of the shares to be held by the PE firm Spe = Se [f/(1-f)]Step 4: Price per share P = INV/ SpePost-Money & Pre-Money Valuation

Step 5: Post-Money valuationPOST = INV/f or POST = P

(Spe+ Se)Step 6: Pre-Money valuation

PRE = POST - INV or PRE = P Se

Adjusting the Discount Rater* = [(1+r)/(1-q)] – 1r* = discount rate adjusted for probability of failurer = discount rate unadjusted for probability of failureq = probability of failure in a year

Target IRR MethodTarget IRR must meet or exceed:The cost of the LBO debt financingThe cost of equity capital for a similar unlevered firmThe return that the fund managers market to client investors

Equity Cash Flow MethodDiscount the future value of equity back to the present using an expected return on equity for each period that reflects the then capital structureThe beta for equity that accounts for the financial leverage:

N

terminalequity valuePV of equity investment =(1+target IRR)

AssetEquity E

D E

��

Equity Equity Market( ) [ ( ) ]f fE R R E R R��

179

179

Fee Structures•Paid on quarterly or annual basis•High-water mark provision

Hedge Fund Returns•Factor models•Alpha: manager skill•Beta: market exposure•Hedge fund returns are often not normally distributed Sharpe ratio or other classical ratios may be useless

Hedge FundsPerformance biases

•Voluntary report to databases•Selection bias•Backfill bias•Survivor bias

Funds of funds (FOF)•Retailing (exposure to a large number of hedge funds)•Access to funds closed to individuals•Diversification•Expertise•Due Diligence Process

Hedge Fund Strategies•Arbitrage-based funds•Convertible bond arbitrage strategies•Equity market neutral funds•Event driven funds•Risk arbitrage (merger arbitrage)•Fixed-income arbitrage•Medium volatility arbitrage•Global macro funds•Long-short equity funds•Managed futures funds•Multi-strategy funds•Directional hedge fund strategies•Dedicated short bias funds•Emerging market hedge funds

180

180

Market risks •Can be limited by understanding the beta exposures of individual hedge funds and increase the allocation to funds with lower market risks•Alternatively, allocate to managers with the highest alpha and hedge away the common factors at the FOF level

Hedge Fund Risk

Event risks•Event driven funds, such as those following mergers and distressed or special situation investments•Event driven funds have a lower correlation with market indices, but their returns can change dramatically with event risk•Events may affect broader market risks

Operational risks•Include inadequate resources, unauthorized trading and style drift, the theft of investor assets, and misrepresentation of investments and performance•Can be minimized by a strict delineation of duties

Counterparty risk•Arises when owed money on a swaps or options contract and the seller of the contract fails to deliver the gains

Leverage•Can magnify market risk and counterparty risk•Can be gained through derivatives

181

Fixed Income InvestmentsStudy Sessions 14 & 15

Weighting 5 – 15%

182Overview of Level II Fixed Income

General Principles of Credit Analysis

Term Structure and Volatility of

Interest Rates

Valuing Bonds with Embedded Options

Study Session 14: Valuation Issues

Mortgage-backed Sector of the Bond Market

Asset-backed Sector of the Bond Market

Valuing MBS/ABS

Study Session 15: Structured Securities

183Credit Analysis

Key ratios• Profitability• Short-term solvency• Capitalization/Leverage• Coverage

Credit Risk� Default Risk� Credit Spread Risk� Downgrade Risk

� High yield issuer – Debt structure (bank loans), corporate structure, covenants

� Asset Backed Securities - Quality of underlying collateral

� Municipal Securities – Tax/revenue-generating ability of the issuer

� Sovereign Debt - Economic and political risk – 2 ratings (local & foreign currency debt)

Key Considerations

The 4 Cs• Character• Capacity• Collateral• Covenants

184Credit Analysis S&P Framework

Net income+ Depreciation+/ Other noncash items

Funds from operationsIncrease in NWC

Operating cash flowCapital expendituresFree operating cash flow

– Cash dividendsDiscretionary cash flow

–Acquisitions+Asset disposals+Other sources (uses)

Prefinancing cash flow

Cash flow ratios

Coverage ratios

Funds from operationsTotal debt

Funds from operationsCapex

Free operating CF + interestInterest

Debt service coverage

Free operating CF + interestAnnual interest + principal

Debt payback period

Total debtDiscretionary CF

185Term Structure

Parallel shifts

Yield Curve Shifts

Twists

Butterfly shifts

Yield curve construction: 4 bond universes

• on-the-run Treasuries• on-the-run + some off-the-run Treasuries• all Treasuries• Treasury stripsAlternative: swap rate (LIBOR) curve

Shape of yield curve� Defined by “term structure” of interest

rates� Three theories:

- pure expectations (shape shows expected implied forward rates)- liquidity theory (long-term bonds give higher yield to compensate for higher IR risk)- preferred habitat (investors must be compensated for investing in less-preferred habitat)

Yield

Maturity

Yield

Maturity

New steepened curve

Original curve

Yield

Maturity

Positive butterfly shift

Original curve

Yield

Maturity

Original curve

Megative butterfly shift

186Volatility of Interest Rates

Impact of non-parallel shifts on price measured by Key

Rate Duration

Approximate percentage change in value in response to a 100 basis point change in a

key rate, holding all other rates constant

Historical yield volatility

Implied volatility

Yield volatility and

measurement

Forecasting yield volatility

Volatility derived from option pricing

models

� �

� � !tdayonyieldthey

yyln100XWhere

1TXX

Variance

t

1ttt

T

1t

2t

�

�

��

�

�

�

� �

�T

1t

2t

1TXiancevar

Best estimate of average X is zero. Hence:

Maturity

Spot rate

key rate

Effective Portfolio Duration = Sum of Key Rate Duration

187Bonds with Embedded OptionsBinomial Model

� �� 2L,1U,1 eii

Callable: call price is effective cap at each node

Putable: put price is effective floor at each node

Backward induction1. Populate interest rate

tree with rates2. Discount from end3. At each node take

average price, consider call/put and add cash flow

Spread measures� Nominal spread

= YTMcorp – YTMTreas(ignores shape of yield curve)

� Zero-volatility/Z/Static spread- spread added to spot rates to get theoretical bond price = actual bond price

� Option-Adjusted Spread- spread added to the interest rate tree to get theoretical bond price = actual bond price

Treasury term structure

z-spread: credit, liquidity and option risks

OAS: credit and liquidity risks only

“option cost”

� �

y y

0

y y 02

0

BV BVED

2 BV y

BV BV 2 BVEC

2 BV y

��

��

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� � �

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188Relative Value Analysis

OvervaluedOvervaluedOvervaluedActual

OAS < 0

Fairly pricedOvervaluedOvervaluedActual

OAS = 0

UndervaluedUndervalued if actual OAS > required OAS*

Undervalued if actual OAS > required OAS*

ActualOAS > 0

IssuerBenchmarkSector BenchmarkTreasury

Benchmark

*Relative to same benchmark

189Convertible Bonds

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interest.6

Premium 5.

.4

.3

.2.1

��

��

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valuestraightbondofpriceMarketvaluestraightover

ratioconversionshareperdividendsratioconversioncoupon

shareperaldifferentiincomeFavourableshareperdifferenceincomefavourableshareperpremiumconversionmarketperiodpayback

stockcommonofpricemarketshareperpremiumconversionmarketratiopremiumconversionMarket

pricemarketpriceconversionpremiumconversionMarketratioconversionCBofpricemarketpriceconversionMarket

ratioconversionstocktheofpricemarketvalueConversion

Convertible bond value = Straight value + equity call option – bond call option + bond put option

“Common stock equivalent” (conversion value > straight value) vs..“Fixed income equivalent” (conversion value < straight value)

190Mortgage-Backed Securities

US Mortgage market – key features

Home loans in the form of fixed-rate level-payment fully amortized mortgages

Mortgage Passthrough SecuritiesOnly one class of bond investorCash flows: net interest, principal payments, curtailmentsMostly issued by agencies: Ginnie Mae, Fannie Mae, Freddie Mac

principal outstanding

t

Non-agency MBS� Collateral can be individual loans (vs.. passthrough securities for

agency MBS)� No government guarantee� Normally have max LTV, payment-to-income and size criteria

Pool

Mortgage 1

Mortgage 2

Mortgage N

…

Investor 1

Investor 2

Investor N

…

Pass-through securities backed by the pool are issued to investors


Prepayment RatesPSA Benchmark

Assumes the monthly prepayment rate increases as it seasonsCPR

Conditional prepayment rate (CPR) is the expected annual prepayment rate.

Can be converted to SMM (single-monthly mortality rate):

� � 12/1CPR11SMM ��

Contraction Risk: IR # hence prepayments $ hence expected life #

Extension Risk: IR $ hence prepayments # hence expected life $

Factors affecting prepayment behaviour1.Prevailing mortgage rates2.Housing turnover3.Characteristics of the underlying mortgage loans

Annual CPR

Age in months

30

100 PSA

50 PSA

125 PSA6%

3%

7.5%


Mortgage Paythrough SecuritiesSeveral classes of investors

Collateralized Mortgage ObligationsSecurities issued against passthrough securities for which the cash flows have been reallocated to different bond classes known as tranches

Planned Amortization Class

TranchesAmortized based on a sinking fund schedule established within a range of prepayment speedsSupport tranche absorbs any excess

Stripped MBSPrincipal and interest payments are paid to different security holders:

Interest Only (IO) StripsPositively related to mortgage rates: as IR #there is more prepayment of principal leading to less cash flow for the IO strip

Principal Only (PO) Strips

Very sensitive to prepayment ratesPrices rise as IR #

Sequential Pay Tranches

Each class of bond retired sequentiallyTranche A – Most Contraction RiskTranche Z – Most Extension Risk

193Commercial MBS

• CMBS are backed by a pool of commercial mortgage loans on income producing property

• CMBS differ from residential MBS in that they are non-recourse loans. Hence each property must be assessed in isolation rather than as a pool

• Call Protection at the Loan Level– Prepayment lockout– Defeasance– Prepayment penalty points– Yield maintenance charge

• Call Protection from the actual CMBS structure: as the CMBS is sequential paying (by credit rating), the AA rated tranche cannot be repaid before the AAA rated tranche• Debt-to-service coverage (DSC) ratio

= ratio of net operating income to debt service.

• Need DSC need > 1, but also check average & dispersion.

• Loan to Value (LTV) ratio• The lower the LTV, the greater the

protection afforded to the lender• Note value estimates may vary

considerably

Balloon RiskRisk of default at end of loan, when most of repayment is due

194Asset-Backed SecuritiesABS: Key Features

Credit Enhancements

Types� credit card receivables� auto loans� home equity loans� manufactured housing loans� Small Business Admin loans� corporate loans� bonds� other credit-sensitive receivables

Amortizing (e.g. auto loans) vs..

Non-amortizing (e.g. credit card loans)

vs.

Prepayment (sequential pay ABS, tranches having differing prepayment/extension risks)

vs.Senior-subordinate structure

(senior tranche protected against default by subordinate) a.k.a.

credit tranching

Internal credit enhancements:1. Reserve funds2. Overcollateralization3. Senior/subordinated structure

External credit enhancements:1. Corporate guarantee by seller2. Bank letter of credit3. Bond insurance

195Types of Asset-Backed Security

Credit Card Receivables• Non-amortizing, with cash

flows = interest, fees, principal

• 3 amortization structures: passthrough, controlled amortization, bullet payment

• Prepayment measured by “monthly payment rate”

Home equity loans• Often closed-ended HELs,

fixed or floating rate

• Cash flows similar to MBS

• Can be split into tranches: NAS vs. PAC

• Prepayments are modelled on issuer-specific prospectus prepayment curve (PPC)

Manufactured housing loans

• Amortizing over 15-20 yrs

• Lower prepayments than MBS because (1) small loans, (2) depreciating collateral, (3) low credit quality of borrowers

• Prepayment model: CPR with PPC

Student loans• Floating rate, with

deferment, grace & repayment periods

• Prepayments from defaults or loan consolidations

SBA loans• Variable rate, 5-25

years

• Prepayments measured via CPR

Auto Loans• Prepaid if sold, traded in, repossessed,

destroyed (insurance proceeds), early repayment or refinanced – but…

• Refinancing uncommon since collateral value depreciates rapidly and new car loans often below market rates

• Prepayments: CPR & SMM

196ABSs: Other issues

Collateralized Debt Obligations

CDO = ABS backed by pool of bonds, loans, MBSs or ABSs

Arbitragetransaction

(motivation: earn the spread)

vs.Balance sheet

transaction (motivation:

remove debt from B/S)

Cash CDO (underlying =

cash debt instruments)

vs.Synthetic CDO

(credit derivatives

create economic equivalence to

cash instruments)

197Valuing MBS/ABSTechniques for valuing MBSs and ABSs

Cash flow yield analysisDiscount rate that makes the present value of the future cash flows equal to the current price. Prepayment assumption required.

Can calculate bond equiv yield:

]1)i1[(x2BEY 6M � �

Spread measures� Nominal spread: hides

prepayment risk� Z-spread: same

problem, but considers y.c. shape

� OAS: best measure

Monte Carlo and spreadsThe rates in the Monte Carlo model can be “tweaked”so that model’s resultant price of MBS/ABS = market price.

Level of “tweak” is the OAS, since the model incorporates the prepayment option.

Hence for investing: biggest OAS = cheapest investment

Best spread measure for valuations

� no option (or option exercise unlikely): use Z-spread

� embedded option, not IR path dependent: OAS with binomial

� embedded option, IR path dependent: OAS with Monte Carlo

Monte Carlo vs. binomialMonte Carlo incorporates IR path, so can use prepayment model to produce value.

Binomial model does not have ability to value securities that are IR path dependent, since backward induction starts at end of timescale.

198Duration Measures MBS/ABS

MBS Duration Measures

Effective DurationFrom Monte Carlo model. Shock yield by +/-�y, reapply the model then plug results into duration formula.

Cash Flow DurationEstimate CF and hence CF yield, shock yield by +/-�y, re-estimate CFs and hence new prices, then plug results into duration formula.

Coupon Curve Duration

Calculate duration by changing couponinstead of yield.

Empirical DurationUse linear regression to identify how price changes with yields.

02P PDuration

P y� �

��

199

Derivative InvestmentsStudy Sessions 16 & 17

Weighting 5 -15%

200Overview of Level II Derivatives

Forward Market and Contracts

Future Market and Contracts

Study Session 16: Derivatives Investments: Forwards and Futures

Options Market and Contracts Interest Rate

Derivatives Instruments

Credit Derivatives

Study Session 17: Derivatives Investments: Options, Swap and Interest Rate

Swap Market and Contracts

201Forward Contracts

Obligation to:� buy (long)� sell (short) an asset at an agreed price on an agreed forward date

Value & Price– Value = PV of net advantage to long from

having contract at forward price (FP)– Price = FP set when contract initiated, for

no-arbitrage must = cash asset price + net cost of carry

Credit riskParty with the positive value faces credit risk in that amount

202Forward Contract Prices & Values

PV of difference between interest at FRA rate and at the current forward rate for the FRA period

Calculate the forward interest rate. E.g. 4 7 FRA, use fwd rate from time 4 to 7

FRA

Currency Forwards

Equity Index Forwards

(So - PVD) x (1+Rf )TEquityForwards

VALUE (to the long at time t)= (spot price – PV benefits)– PV of forward price

FORWARD PRICE= spot price + net costs of carry

TYPE

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203Futures Contracts

Like forwards, but standardised, exchange traded and subject to margining

Basis = spot price – futures priceContango = negative basis. Most likely scenario.Backwardation = positive basis. It will occur if benefits holding assets large enoughConvergence As maturity approaches, basis converges to zero (due to arbitrage)

��

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market to mark last oftime at futures of price

price futures current

contract futuresof Value

Futures price v. Forward price

– In principle same no-arbitrage price applies to both

– But investors preference for mark-to-market feature (cash flow effect) could make futures more (/less) valuable than forwards

– Effect of mark-to-market ignored on following slides

204Futures pricingFutures arbitrage– Futures price (like forward) determined by arbitrageIf futures trades above theoretical FP then: Cash and carry arbitrage– Buy cash asset with borrowed money and sell futureIf futures trades below theoretical FP then:Reverse cash and carry arbitrage– Short sell cash asset, invest proceeds, and buy future

Generic futures pricing formula:

FP = S0 (1 + Rf)T +FV(NC)-FVD

NC=Storage Cost-Convenience Yield

FVD=Future Value of Cash Flow

Convenience Yield: Non-monetary benefits from holding asset, e.g., holding asset in short supply with seasonal/highly risky production process

Eurodollar deposits vs T-bills•Eurodollar deposits are US$ denominated deposits outside the US priced off the LIBOR curve using 360 day convention•While T-bills are discount instruments, Eurodollar deposits are add-on instruments

Difficulty in pricing Eurodollar futures•Eurodollar futures cannot be priced easily as LIBOR is an add-on interest and arbitrage transaction cannot be constructed perfectly as is the case with T-bill futures

205Pricing Financial Futures

FP = [(So x (1+Rf )T) – FV(Coupons)]/CFS0,CF = Price, Conversion Factor of CTD bond (Cheapest To Deliver bond gives highest implied repo rate)

T-Bond

Exactly the same as for forwardsEquity & Currency

PriceType of Future

Normal Backwardation• Hedgers (shorts) are rejecting

price risk• Speculators (longs) will require

compensation to accept risk•Result: Futures price < expected spot price

Normal Contango• Hedgers (longs) are rejecting

price risk• Speculators (shorts) will require

compensation to accept risk•Result: Futures price >expected spot price

206Options basics (refresher)

call payoff = max(0, ST – X)call profit = max(0, ST – X) – C0

put payoff = max(0, X – ST)put profit = max(0, X – ST) – P0

Long LongShort Short

Call Put

B/E = strike + prem

B/E = strike -prem

Max loss = premium

Max profit = premium

Max profit = unlimited

Max loss = unlimited

Max loss = B/E

Max profit = B/E

207Options Jargon (refresher)

Call PutIn the money S – X = +ve; S – X = –veOut of the money S – X = –ve; S – X = +veAt the money S – X = 0; S – X = 0

– Moneyness– Strike/exercise price (X)– Underlying price (S)– expiration– European/American– Intrinsic value– Time value

Intrinsic value– Call: Max (S-X,0)– Put: Max (X-S,0)

Time value– Premium minus Intrinsic value

208Caps, floors, collars

Collar– (long) collar = long cap + short floor– zero cost if cap premium = floor premium

Cap– series of interest rate caplets,

calls with identical strikes & equally-spaced expiries

– bought by borrower

Floor– series of interest rate floorlets, puts

with identical strikes & equally-spaced expiries

– bought by lender

209Put-call parity

Synthetics– c0 = p0 + S0 - X/(1+r)T (synthetic call = long put + long underlying + short bond)– p0 = c0 - S0 + X/(1+r)T (synthetic put = long call + short underlying + long bond)– S0 = c0 - p0 + X/(1+r)T (synthetic underlying = long call + short put + long bond)– X/(1+r)T = p0 - c0 + S0 (synthetic bond = long put + short call + long underlying)

Arbitrage – If Put-call parity doesn’t hold then any of the equations below tells you how to get a profite.g. if c0 > p0 + S0 - X/(1+r)T then sell call and buy synthetic call (buy put & U/L & sell bond [=borrow])

for options on futures:c0 + [X - f0(T)]/(1+r)T = p0

Cost of fiduciary call (long call + Zero Coupon Bond): c0 + X/(1+r)T

must equal cost of protective put (long put + stock): p0 + S0

210Option pricing models

Discrete time – underlying asset is assumed to move only at discrete points in time

Continuous time – underlying asset can move at any point in time

e.g. Binomiale.g. Black-Scholes-Merton

limit of discrete time model as period length 0

211Binomial option pricing

SymbolsS = stock price at start of periodS+ = upper potential end-of-period stock price = S uS- = lower potential end-of-period stock price = S d

(if d is not given, then assume d = 1/u)c+ = call value at expiry if stock rises = Max(0,S+ - X)c- = call value at expiry if stock falls = Max(0,S- - X)r = risk-free rate per period

Hedge ratio (delta) – a risk-free portfolio requires n units of stock per call, where n (hedge ratio) =

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SScc

Option value – for no arbitrage, call price at start of a period:

where:r1�)c(1�cc

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Valuing American optionsAt each point, substitute intrinsic value if larger than ‘roll-back’ value

Given call value can estimate put from put-call parity

2122-period Binomial example (1)

� Stock price = $100� Each period stock either rises 25% or falls 20% (so u = 1.25, d = 0.8)� European call option expires at end of two periods, strike = $97.5� Risk free rate = 7% per period

Stock = $100Call = ?

Stock = $125

Stock = $80

either

or

Stock = $156.25Call = $58.75

Stock = $100Call = $2.50

either

or

Stock = $64Call = $0

either

or

AB

C

2132-period Binomial example (2)

� At all three points (because r, u, and d are the same each period): 6.0

8.025.18.007.01

dudr1� �

��

��

�

� Point B (i.e. at end of first period, assuming stock price rose):

! ! $33.881.07

$2.5)6.0(175.58$0.6r1

�)c(1�cc B ��

�

� �

�

� Point C (i.e. at end of first period, assuming stock price fell):

! ! $1.401.07

$0)6.0(15.2$0.6r1

�)c(1�ccC ��

�

� �

�

� Point A (now, using cB as c+ and cC as c-):

! ! $19.52��

�

� �

1.07$1.40)6.0(188.33$60.

r1�)c(1�cc CB

A

214Valuing interest rate options

Valuing an option on a bond- work backwards to value the

bond at each point in the tree- value option on bond using

conventional binomial approach

Valuing a cap or a floor- use rates in tree to evaluate

payoff for each caplet/floorlet- use rates in tree to discount p-

weighted payoffs back to a PV

interest rates in tree will be provided, and assume p = 0.5

Binomial Model

� �� 2L,1U,1 eii

215Black-Scholes-Merton model

Assumptions of BSM– Underlying asset price follows a geometric lognormal diffusion process– Risk-free rate and volatility of asset known and constant over option life– No cash flows (e.g. dividends) on the underlying– No transaction costs or taxes– European style options

)N(dXe)N(dSc 2Tr

10

c��

� � � �� T�

T/2�rlnd2c

XS

1

0 �

T�dd 12 ��As per binomial, given call value can estimate put from put-call parity

216Extensions of BSM

)N(dXe)N(deSc 2Tr

1�T

0c��

BSM Model with dividends

� �� T�

T/2�rlnd2c

XeS

1

T -�0

�

!)XN(d)(T)N(dfec 210Tr c

��

Black’s model (options on futures)

� � � �T�

T/2�lnd2

X(T)f

1

0 �

Application to interest rate options –replace f0(T) with forward interest rate from the date of expiration of option to end of period of underlying interest rate in the option

T�dd 12 ��

217The Greeks

PositivePositiveVegaVolatility

Interest rate

Passage of time

Underlying price

Factor

NegativePositiveRho

NegativeNegativeTheta

NegativePositiveDelta

Relationship between change in factor and change in premium

PutCall

Factor sensitivity

priceasset ueoption val

��

expiry to timeueoption val

��

rateinterest �ueoption val �

y volatilitprice ueoption val

��

priceasset Delta

��

�GammaEstimating volatility:� Historical (std. devn. of past log returns)� Implied (by pricing model & current premium)

218Delta hedging

0

2

4

6

8

10

12

14

16

12 14 16 18 20 22 24 26 28 30 32 34 36

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1Intrins ic value Total value delta (right ax is)

Delta is the slope of the premium versus asset price line. Call deltas vary between 0 and +1 (since the line moves from being flat to a 450 slope)

Gamma is the slope of this line, it measures how fast delta changes as the underlying price moves. It is positive, and greatest for ATM options

� A long position in a stock with a short position in call options so value of portfolio does not change with the value of the stock.

� Number of calls required =(but beware of gamma)delta call

shares ofnumber

219Swaps and swaptions Plain Vanilla Interest Rate Swap• An agreement to exchange fixed rate

payments for floating rate payments• Based on a notional principal. • Payments are netted off• Equivalent to issuing a fixed-coupon bond

and using proceeds to buy a floating-rate bond

• Equivalent to a series of off-market FRAs• Equivalent to a series of interest rate calls

and puts

Currency Swap• An agreement to exchange payments

denominated in one currency with payments in another currency.

• Principal amounts are exchanged at the start and end of the swap.

• Interest payments not netted off as they are in different currencies

• Equivalent to issuing a fixed- or floating-rate bond in currency A, converting proceeds to currency B and buying a fixed-or floating-rate bond in the latter currency

Equity Swap• An agreement to swap fixed

payments for a return on a stock or stock index

• If the equity returns are negative, the fixed rate payer must also pay the percentage decline

• Equivalent to buying/selling equity A and selling/buying the bond/equity B

SwaptionsPayer Swaption� An option to enter into a pay fixed swap� As interest rates increase, the option

becomes more valuableReceiver Swaption� An option to enter into a receive fixed swap. � As interest rates decrease, the option

becomes more valuable

220Pricing and valuing swaps

Pricing (setting the fixed rate)

Interest rate swap pricing� Use the premise that an interest

rate swap is equivalent to issuing a fixed rate bond and investing in a floating rate bond.

� The fixed rate must be set so that the values of the 2 bonds are the same at initiation.

� At issue, the floating rate bond has a value equal to its face value.

� Therefore, the value of the fixed rate must be: � �

� ��

flow ifor DFflowlast for DF-1F th

Valuation- Difference between PVs of the two

flows- Discount fixed cash flows at the new

LIBOR rates- use fact that PV of FRN at coupon

date = par to simplify floating rate PV- NB LIBOR at the start of each

coupon period determines the coupon paid at the end of the period

221Swaption

Value of Payoff for a Payer Swaption)� PV of the difference between

payments based on higher existing (market) swap rate and payments based on strike rate

� Discount CFs based on “spread”between contract and market

Payer swaption� Right to enter swap as fixed-

rate payer (wins if rates increase)

Receiver swaption� Right to enter swap as fixed-

rate receiver (wins if rates fall)

Uses� Hedge anticipated floating rate

exposure in the future

� Speculate on IR changes

� Terminate an existing swap (i.e., buy the right to enter into an offsetting position)

222Interest rate options

� Interest rate call payoff:Notional principal

Max(0,underlying rate at expiry – exercise rate) (days in underlying rate/360)� Interest rate put payoff:

Notional principal Max(0,exercise rate - underlying rate at expiry) (days in underlying rate/360)

� For both types:• payoff is at end of underlying notional loan period, rather than at expiry (for other

options payoff is at expiry)• compare with FRAs• Cap = series of interest rate calls• Floor = series of interest rate puts

223Credit Default Swap

Strategies� Basis trade� Credit curve flattener� Credit curve steepener� Index trade� Options trade� Capital structure trade� Correlation trade

Characteristics� Insurance contract on

“reference obligation” (a specific bond or loan)

� Buyer pays seller default swap premium (default swap spread)

� Protects buyer from losses due to default

� Swap seller is long the credit risk only

224

Portfolio ManagementStudy Session 18

Weighting 5 – 15%

225

PORTFOLIO MANAGEMENT

Portfolio Concepts

A Note on “Market

Efficiency”

Portfolio Management Process & the Investment

Policy Statement

The Theory of Active Management

International Asset Pricing

Overview of Portfolio Management

226Mean and standard deviation

2,12122

22

21

21 2

:assets2for e.g.

Covwwwwport � �� Covi,j =

E[(Ri-E(Ri)) (Rj-E(Rj))]

Variance(for standard deviation take square root)

Expectedreturn

For a portfolioFor an individual investment

jifor

1 1 1

222

%

� � � �n

i

n

i

n

jijjiiiport Covwww ��

��

��

� ��

return potentialy probabilit

)(RE )()(1

i

n

iiport REwRE

�

�

��

�

�

��

�

��

��

��

22 )(RE

returnpotential

prob�

ji

ijCovr

��ij n,Correlatio

If estimating an investment’s E(R) & s from time series data

then use these formulae, but use

actual return for each period in place of

potential, and set all probs equal

Most important factor when adding an investment to a portfolio that

contains a number of other investments is average covariance

with all the other investments

227Mean Variance Analysis

..

.

A

B

C.

D

�

E(R)

..

.

A

B

C.

D

�

E(R)BCD is the

efficient frontier

opportunity set of available portfolios

ABCD is the minimum variance frontier

Assumptions:• Investors are risk-averse• Investors know expected returns,

variances, and covariances for all assets

• Investors use Markowitz framework

• Frictionless markets: no taxes or transactions costs

Minimum Variance Frontier--Smallest variance among all portfolios with the same expected returnConstruction:1. Estimation: Forecast expected return, E(R), and variance, 2, for each individual asset2. Optimization: Solve for weights that minimize the portfolio 2 given target return and portfolio

weights that sum to one3. Calculation: Calculate E(R) and 2 for all the minimum variance portfolios from Step 2

228Correlation and DiversificationLower correlation � higher bow �greater diversification

This is for a two-asset portfolio

E(r)

30%

20%

10%

0%0% 10% 20%

Total Risk

= –1= –0.3

= +0.3

= +1

Variance for an equal-weightedportfolio:

2 2P i

1 n 1� = � + Covn n

�

229Adding in a risk-free assetCombinations of a risk portfolio and a risk-free asset will lie on a

straight line:

Standard deviation

Expe

cted

Ret

urn

..P

RF

Lending at RF

Borrowingat RF .

.PRF

.MCM

LE(R)

�

Hence, given assumptions on next slide: CML (Capital Market Line)

M is the market portfolio (optimal risky portfolio)

All investors want to be on

CML

230CML vs. CAL

Security Market Line CMLRisk measure Systematic Total

Application Required return for securities

Asset allocation for Rf and M

Definition Graph of CAPM Graph of efficient frontier

Slope Market risk premium Sharpe ratio

• The Capital Market Line assumes homogeneous expectations

• CML Equation

• The Capital Allocation Line assumesheterogeneous expectations

• CAL Equation

C��

��

M

FMFC

R-)E(RR)E(R C��

��

T

FTFC

R-)E(RR)E(R

231

Total Risk

MarketRisk

Total Risk = Unsystematic Risk + Systematic Risk

Unsystematic Risk

Systematic Risk

Number of Stocks in the Portfolio

Systematic vs. Unsystematic Risk

232Using the SML

.RF

.MRM

�i

E(Ri)

�M=1

SML

.RF

.MRM

�i

E(Ri)

�M=1

SML

SML shows expected return

(per CAPM)

Compare this to anticipated

(forecast) return

• A stock that is overpriced will plot below the SML

• A stock that is underpriced will plot above the SML

• A stock that is correctly priced will plot on the SML

E(Ri) = RF + �i(E(RM)- RF)

= Expected Return – Required Return

233CAPM in The Real World

Two key assumptions…1. Investors can borrow/lend at risk-free rate2. Unlimited short-selling and access to short proceeds

…yields two implications…1. Market portfolio lies on the efficient frontier (market portfolio is efficient)2. Linear relationship between expected return and beta

If the 2 key assumptions are violated…1. Market portfolio might lie below the efficient frontier (might be inefficient)2. Relationship between expected return and its beta might not be linear

234The Market Model

LOS 71.a: discuss how the Index Model simplifies CAPM

• Regression of an asset’s returns against an observable index’s returns:

• Expected return:

• Variance:

• Covariance:

E(Ri) =�i +�iE(RM)

Ri = �i + � iRM +�i

�i2 � � i 2�M2 ��

2

Cov ij = � i� j� M2

Beta Instability Problem� Historical beta not necessarily a good predictor of future relationships….

Adjusted beta� Mean-reverting level of beta = 1� Adjust beta to reflect this mean-reverting level

i,t = 0 + 1 i,t–1, where 0 + 1 = 1Most popular values: 0 = 1/3 and 1 = 2/3

� Adjustment moves beta towards 1� Adjusted beta moves toward 1 more quickly for larger values of 0

235Active Risk and Return

• Active return is the difference between the portfolio return (P) and its benchmark (B): RP – RB

• Active risk (“tracking risk”) is the standard deviation of the active return

• Source of active risk can be active factor risk and active specific risk

• Factor portfolio vs. tracking portfolio

Information RatioActive return per unit of active risk

Measures manager’s consistency in generating active returns

P B

P B

(r r )IR=s(r r )

��

236Multifactor models/APT

& & & &

APT (Arbitrage Pricing Theory)

= sensitivity of the actual return from security i to changes in an index representing risk factor k

& = the difference between the expected return for a one- unit exposure to factor k and the risk-free return

APT assumptions:

• Security returns can be described by a factor model

• Sufficient securities to diversify away the unsystematic risk

• No arbitrage opportunity

CAPM assumptions:• Competitive capital market• Markowitz investors• Unlimited risk-free

lending/borrowing• Homogenous expectations• One-period investment

horizons• Frictionless markets

Multifactor models

• analyst chooses number and the identity of the factors -enough so model adequately predicts security returns (but not too many)

• Macroeconomic models use underlying economic influences (e.g. real GDP growth, unexpected inflation)

• Fundamental factor models use specific aspects of the securities (e.g. P/E ratio, firm size)

237International Asset Pricing

Real Exchange Rate RiskThe possibility of exchange rate changes that are not explained by inflation differentials

Real exchange rate = spot rate x foreign price leveldomestic price level(dc/fc)

%� real spot = %� nominal spot rate – (inflationQ – inflationB) (dc/fc)

238ICAPMForm of ICAPM:

E(R) = Rf + bGMRPG + '1FCRP1…… + 'kFCRPk

whereE( R) = expected return required on investment xRf = risk free rate in investor’s home country (domestic)bG = the world beta of stock x (sensitivity to changes in global portfolio value)MRPG = the world risk premium'k = sensitivity of stock* x to changes in real exchange levelsFCRPk = foreign currency risk premium

Foreign Currency Risk Premium

OR

Domestic Currency Sensitivity

Exporter 'LC < 0Importer 'LC > 0' = domestic currency sensitivity'LC = local currency sensitivity

' = 'LC + 1

*in domestic currency returns

� �basequoted r-rS

S-)E(S=FCRP0

01��

��

FCRP = E(S 1) - FS0

239Equity & Bond ExposuresCurrency Exposures of National Economies

Equity Markets Bond Markets

Increased long-runeconomic activity

Currencydepreciation

Higher equityprices

causes

causes Negativecurrencyexposure

Traditional Model

Increased long-runeconomic

activity

Currencyappreciation

Higher equityprices

causes

causes

Positivecurrencyexposure

Money Demand Model

Increase in realinterest rates


Lower bondprices

causes

causes Negativecurrencyexposure

Free Markets Theory

Government to decrease real

rates


Higher bondprices

causes

causes Positivecurrencyexposure

Government Intervention Theory

240Active Management

Treynor-Black Model:• Only a limited number of securities are analyzed. The rest are assumed to be fairly priced.• The market index portfolio (M) is the baseline portfolio. The expected return and the

variance of M are known.• To create the active portfolio:

• Estimate the beta of each security to find mispricings. Those with non-zero alphas will be put into the active portfolio with the following weights: (+ alpha � + weight, - alpha � -weight)

• The cost of less-than-full diversification comes from the non-systematic risks of the mispriced stocks, 2(e), which offsets the benefit of the alphas.

• Estimates of , and 2(e) are used to determine security’s weights (+ or -) in the active portfolio n

A i ii=1

� = w�n

2 2 2A i i

i=1� (� )= w� (�)

Active management and market equilibrium:• empirical evidence:

• abnormal returns produced by some managers• some anomalies in realized returns have persisted over prolonged periods

• if no one can beat the passive strategy, money will flow away from active managers and their expensive analysis - prices will no longer reflect sophisticated forecasts - subsequent profit opportunity lures back active managers who once again become successful

n jii 2 2

j=1i j

��w =� (�) � (� )

n

A i ii=1

� = w�

241Active ManagementTreynor-Black Model (cont’d):• The expected return and the standard deviation of the Active portfolio (A):

E(RA) = A + A{E(RM) – RF}

• Combine the active portfolio and M to create the optimal portfolio which will maximize the Sharpe’s ratio

• When short positions are prohibited, simply discard stocks with negative alphas.• We should adjust the alpha estimated by an analyst by his past accuracy. Therefore if a

manager has consistently overestimated alpha on a stock in the past, we have to “discount” his analysis . That will give a smaller weight to the stock

2 2 2A A M A� = � � +� (� )

242The portfolio management processSteps:1. Planning

• Specify investor’s objectives and constraints• Create the investment policy statement (IPS) –

formal document governing all investment decision making, with a central role in the whole portfolio management process

• Formalize capital market expectations• Create the strategic asset allocation

2. Execution step• Construct a portfolio with the appropriate asset

allocation3. The feedback step

• Monitor objectives and constraints and capital market conditions, rebalance portfolio as needed

Objectives:• Return• Risk tolerance

(ability & willingness)

Constraints:• Time horizon(s)• Liquidity needs• Taxes• Legal & Regulatory needs• Unique circumstances

Typical IPS elements:• Client description• Purpose of the IPS• Identification of duties and

responsibilities• Formal statement of objectives

and constraints• Calendar schedule for portfolio

performance and IPS review• Performance measures and

benchmarks• Considerations for developing

the strategic asset allocation• Investment strategies and

investment styles• Guidelines for portfolio

adjustments and rebalancing

Time horizon directly affects ability to take risk

Importance of ethicalconduct (managers are in

a position of trust)

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