Sheet by Quartic Global Investment Performance Standards CFA · VII(B): Reference to CFA Institute,...

Q Sheet – CFA® Level I 2019 1 © Quartic Training Limited

Sheet by Quartic CFA® Level I 2019

Ethical and Professional Standards

Ethics & Trust in the Investment Profession

• “Right” vs legal

• Codes of ethics: principle- vs rule-based

• Hierarchy: Profession / Vocation / Job

• Ethical decision-making framework: (1) fact-

finding, (2) biases, (3) decision, (4) reflect.

Code of Ethics, Standards of Prof Conduct

Standard I: Professionalism

I(A): Knowledge of the law

I(B): Independence and objectivity

I(C): Misrepresentation

I(D): Misconduct

Standard II: Integrity of capital markets

II(A): Material non-public information

II(B): Market manipulation

Standard III: Duties to clients

III(A): Loyalty, prudence, and care

III(B): Fair dealing

III(C): Suitability

III(D): Performance presentation

III(E): Preservation of confidentiality

Standard IV: Duties to employers

IV(A): Loyalty

IV(B): Additional compensation arrangements

IV(C): Responsibilities of supervisors

Standard V: Investment analysis,

recommendations, and actions

V(A): Diligence and reasonable basis

V(B): Communication with clients and prospective

clients

V(C): Record retention

Standard VI: Conflicts of interest

VI(A): Disclosure of conflicts

VI(B): Priority of transactions

VI(C): Referral fees

Standard VII: Responsibilities as a CFA Institute

member or CFA candidate

VII(A): Conduct as Participants in CFA Institute

Programs

VII(B): Reference to CFA Institute, the CFA

Designation, and the CFA Program

Global Investment Performance Standards

0. Fundamentals of Compliance

1. Input Data

2. Calculation Methodology

3. Composite Construction

4. Disclosures

5. Presentation and Reporting

6. Real Estate

7. Private Equity

8. Wrap Fee / SMA Portfolios

Quantitative Methods

The Time Value of Money

Risk-free rate: 1 + nominal = (1 + real) x (1 +

inflation)

Or: nominal real + inflation

Then add risk premiums

On calculator: N, I/Y, PV, PMT, FV

• PV FV

• Annuities and annuities due (BGN mode)

• Deferred annuities (e.g. calc PV then discount)

• Uneven cash flows (use CF worksheet)

• Nominal vs effective rates (I-CONV worksheet)

Continuous compounding

1-year HPR = eRc – 1 = Effective

Rc = ln(1 + HPR) = Nominal

Discounted Cash Flow Applications

( )0 1

Nt

tt

CFNPV

r=

=+

IRR = discount rate that creates NPV = 0

Rule (if normal CFs): NPV > 0, or IRR > WACC

If conflict, NPV wins

1 0 1

0

P P DHPR

P

− +=

MWR (IRR of external CFs) vs TWR (GM of HPRs)

360BD

Dr

F t=

EAY = (1 + HPY)365/t – 1


0 0

360 360MM BD

D Fr HPY r

t P t P= = =

Statistical Concepts and Market Returns

Arithmetic, geometric, harmonic, weighted means:

1

N

ii

X

or xN

==

1

1

(1 ) 1T T

G tt

R R=

= + −

1

1H

n

i i

nX

X=

=

1

n

w i ii

X w X=

=

Population/sample variance (= SD2):

2

2 1

( )N

ii

X

N

=

−

=

2

2 1

( )

1

n

ii

X X

sn

=

−

=−

1

n

ii

X X

MADn

=

−

=

Kurtosis: leptokurtic > 3, normal = 3, platykurtic < 3

Quantiles: location L = (n + 1) x (y/Q)

Chebyshev’s inequality: 1 – 1/k2

Coefficient of variation: SD ÷ mean

Sharpe ratio: (RP – RF) ÷ sp

Probability Concepts

Mutually exclusive and exhaustive: sum = 1

Total probability:

P(A) = P(AS1) + P(AS2) + … + P(ASn) = Σ[P(A|Si)P(Si)]

Bayes formula: P(E|I) = P(I|E) x P(E) ÷ P(I)

Conditional prob (A and B): P(AB) = P(A) x P(B|A)

If independent: P(B|A) = P(B) ➔ P(AB) = P(A) x P(B)

Addition rule: P(A or B) = P(A) + P(B) – P(AB)

If mutually exclusive: P(A or B) = P(A) + P(B)

Variance, covariance & correlation

( )2 2( ) ( ( ))p p p

R E R E R = −

, ,cov ( ) ( )

i j i j i j i i j jE R E R R E R = = − −

2 2 2 2

,2 cov

p a a b b a b a bw w w w = + +

Counting rules

Factorial n! (2nd “x”)

Permutation nPr (2nd “–”)

Combination nCr (2nd “+”)

Labeling n! ÷ (n1! x n2! x … x nk!)

Common Probability Distributions

Binomial distribution: p(r) = nCr x pr x (1–p)n–r

z-score probabilities:

0 to 1: 34% ±1.645: 90%

± 1.96: 95% ± 2.58: 99%

Population confidence interval: mean ± (z/2 x s)

Computing z-score: z = (x – ) ÷

Shortfall risk: P(RP < RL)

Safety first ratio = [E(RP) – RL] / σP

Roy’s Criterion: min risk, max SFRatio

Sampling and Estimation

Central limit theorem – sampling distribution:

(1) mean is μpop

(2) variance is σ2/n

(3) approx normal for large n

Standard error: ÷ √n or s ÷ √n

Which distr’n? Pop SD known ➔ z, unknown ➔ t

Confidence interval for pop mean:

x-bar ± (z/2 x /√n) or x-bar ± (t/2 x s/√n)

Hypothesis Testing

Test of population mean

H0: μ = μ0 vs Ha: μ ≠ μ0 (two-tailed)

H0: μ ≥ μ0 vs Ha: μ < μ0 (one-tailed)

H0: μ ≤ μ0 vs Ha: μ > μ0 (one-tailed)

Test statistic = (observed - ) ÷ SE

then use z- or t-distribution

Type I error: reject true H0

Type II error: do not reject false H0

Equality of means: H0: μ1 – μ2 = D0 (t distrib)

Paired comparisons: H0: μd = μd0 (t distrib)

Population variance: H0: σ2 = σ02 (2 distrib)

Equality of variances: H0: σ12 = σ2

2 (F distrib)

Technical Analysis

Reversal patterns: H&S, inverted H&S, double/triple

tops/bottoms

Continuation patterns: flags, pennants, triangles,

rectangles

ROC oscillator: M = (V – Vx) × 100 or (V ÷ Vx) × 100

RSI = 100 x Σu ÷ (Σu + Σd)

Stoch. oscillator %K = 100 x (C – L14) ÷ (H14 – L14)


MACD = MA(26) – MA(12), then Signal Line =

MA(MACD)

Arms index (TRIN) = (vol ÷ #) ÷ (vol ÷ #)

Economics

Topics in Demand and Supply Analysis

Demand function:

Item 0 1 Item 2 3 Subst 4 Comp

dQ b bP b I b P b P= − + + −

Own-price elasticity:

%

%

d dd x x Xp d

x x X

Q Q PE

P P Q

= =

Other elasticities: change Px for I or Py in equation

Substitution and income effects if price

• SE +ve, IE +ve: consumption

• SE +ve, IE –ve (= inferior) but < SE: consump

• SE +ve, IE –ve and > SE: consump ➔ Giffen

good. (NB: Veblen = conspicuous consump.)

Optimal production o/put: MR = MC, MC not falling

Continuing operations

1. AR > ATC: normal profits ➔ continue

2. AR = ATC: breakeven point (TR = TC)

3. ATC > AR > AVC: continue short-term

4. AR = AVC: shutdown point

5. AVC > AR: close down immediately

The Firm and Market Structures

Perfect competition: price taker, identical

products, large number of firms (none dominating),

no barriers to entry/exit, flat Dd curve, econ profit

in short-term only, costs minimized @ MC = MR

Monopolistic competition: large number of firms,

differentiated product, low barriers, econ profit s-t

only, ATC not minimized at MC = MR

Oligopoly: small number of interdependent firms,

similar or differentiated product, high barriers.

Four models: kinked demand curve; Stackelberg

dominant firm; Cournot duopoly; Nash equilibrium

Monopoly: single firm, unique product, extreme

barriers, l-t econ profit, price discrimination

Market concentration if Si = market shares:

N-firm = sum to N of Si. HHI = sum to N of Si2

Aggregate Output, Prices, & Econ Growth

GDP deflator: CPInow ÷ CPIbase

GDP = C + I + G + (X – M); alternatively = national

income + cap consumption + stat discrepancy

IS curve: real IR vs real income (downward slope)

LM curve: real IR vs real income (upward slope for

each M/P level)

Production function:

( ) ( )potGDP

L KA W L W K = + +

( )potGDP /capita

CA W C = +

US approx. weightings: WL = 0.7 and WC = 0.3

Understanding Business Cycles

Business cycle: Expansion ➔ Peak ➔ Contraction

➔ Trough

Economic schools of thought: Neoclassical,

Keynesian, Monetarist, Austrian, New Classical

Unemployment types

• Frictional: jobs ✓, skills ✓

• Structural: jobs ✓, skills

• Cyclical: jobs , skills ✓

Lab force participation rate = LF ÷ WAP × 100%

Unemployment rate = U ÷ LF × 100%

Price indexes: Laspeyres (constant basket) vs

Paasche (current) vs Fisher (geometric mean)

Monetary and Fiscal Policy

Monetary policy: expansionary (IR, MS) vs

restrictive (IR, MS)

Money multiplier = 1/reserve requirement

Quantity theory: MS V = GDP = P Y

Central banks:

• Policy tools: OMO, policy rate, reserve ratio

• Features: indep’t, credible, transparent

Fiscal policy: expansionary (T, G, deficit) vs

restrictive (T, G, surplus)

Fiscal multiplier: 1 / [1 – MPC(1 – t)]

Time lags: recognition, action, impact


International Trade and Capital Flows

Comparative advantage: lower opportunity cost

➔ specialize & export ➔ higher global output

Models of trade: Ricardian (factor = labor) vs

Heckscher-Ohlin (factors = labor, capital)

Trade restrictions: tariff, quota, export subsidy,

min domestic content, voluntary export restraint

Trading blocs hierarchy: free trade area, customs

union, common market, economic union, monetary

union

Balance of payments

• Current account: merchandise & services,

income receipts, unilateral transfers

• Capital account: capital transfers, non-financial

assets

• Financial account: govt-owned assets abroad

less foreign-owned assets in country

Supranational organizations: IMF, World Bank,

WTO

Currency Exchange Rates

Price/Base notation, convert with 1/x

%real value of price ccy = %B prices – %P prices

+ %nom XR

Cross rates:

Forward rates: interest rate parity

/ /

1 IR

1 IRP

P B P B

B

F S+

= +

Trade and capital flows: elasticity approach

(Marshall-Lerner) vs J-curve vs absorption approach

Financial Reporting and Analysis

Introduction, Financial Reporting Standards

Balance sheet: Assets = Liabilities + Equity

Income statement

• Revs – COGS – op exps – int – tax = NI

Cash flow statement

• Opening cash + CFO + CFI + CFF = closing cash

Comprehensive income

• Δ in equity other than owner contribs/distribs

Owners’ equity

• Equity (start) + NI – dividends new/repurch

shares OCI = Equity (end)

IFRS Conceptual Framework

• Qualitative characteristics: fundamental

(relevant, faithful representation) vs enhancing

(comparable/verifiable/timely/understandable)

• Constraint: cost vs benefit

• Assumptions: accruals, going concern

Understanding Income Statements

Four revenue methods:

Earnings per share

• Basic calc: (NI – Pref divs) WANOS

• Time-weighted average:

• Shares issued/repurchased: apportion

• Stock divs/splits: backdate

• Diluted EPS: always worst case

• Convertible prefs (numerator: add div;

denominator: add new shares)

• Convertible bonds (num: add int x (1 – t);

denominator: add new shares)

• Options/warrants (denom: add net new

shares per Treasury stock method)

Understanding Balance Sheets

Balance sheet accruals:

• Cash in early or out late ➔ current liability

• Cash out early or in late ➔ current asset

Common size statements

• Balance sheet: each figure as % of total assets

• Income statement: each figure as % of sales

• Cash flow statement: % of sales, % of total CF, or

% of total inflows/outflows


Understanding Cash Flow Statements

Both methods: now add B/S adjustments

Direct method: simpler if CF components provided

Δ cash = –Δ non-cash asset; Δ cash = Δ liabilities

Free cash flow

FCFE = CFO – FCInv + ΔDebt

FCFF = CFO + int(1–t) – FCInv

Financial Analysis Techniques

Activity ratios

Receivables turnover = Sales ÷ average A/R

DSO, days sales outstanding = Avg A/R x 365 ÷ sales

Inventory turnover = COGS ÷ average inventory

DOH, days’ inv on hand = Avg inv x 365 ÷ COGS

Payables turnover = Purchases ÷ average A/P

Days payable = Avg A/P x 365 ÷ purchases

Cash conversion cycle = DOH + DSO – days payable

Defensive interval ratio = (Cash + marketable

investments + A/R) ÷ daily cash expenses

Total asset turnover = Sales ÷ average total assets

Fixed asset turnover = Sales ÷ avg net fixed assets

Working capital turnover = Sales ÷ avg working cap

Liquidity ratios

Current ratio = Current assets ÷ current liabilities

Quick ratio = (Curr assets – inventory) ÷ curr liabs

Cash ratio = (Cash + mktble investmts) ÷ curr liabs

Solvency ratios

Debt-to-assets (total debt) ratio = Int-bearing D ÷ TA

Debt-to-capital = Debt ÷ (debt + s/h equity)

Debt-to-equity = Debt ÷ s/h equity

Financial leverage = Average TA ÷ average equity

Interest coverage = EBIT ÷ interest payments

Fixed charge coverage = (EBIT + LPs) ÷ (int + LPs)

Profitability ratios

Gross profit margin = GP ÷ sales

Operating profit margin = Operating profit ÷ sales

Pretax margin = EBT ÷ sales

Net profit margin = NI ÷ sales

Return on assets = NI ÷ average TA

Operating RoA = EBIT ÷ average TA

Return on total cap = EBIT ÷ (STD + LTD + equity)

Return on equity = NI ÷ average total equity

Return on common eq = (NI – pref divs) ÷ avg CE

DuPont analysis of RoE

2-step: RoA x fin leverage

3-step: NPM x ATo x fin lev

5-step: tax burden x int burden x Op PM x ATo x FL

Div payout ratio = C/S divs ÷ (NI – pref divs)

Retention rate = 1 – div payout ratio

Inventories

Basic relationship: BI + P = COGS + EI

Four flow-through methods (assume inflation)

• FIFO: EI = recent; COGS = older. Profit/tax ,

CFO , inventory/equity

• LIFO: COGS = recent; EI = oldest. Profit/tax ,

CFO , inventory/equity . N.b. US GAAP only!

• Specific ID & wtd avg: in between LIFO & FIFO.

LIFO to FIFO adjustments

Balance sheet:

• Inventories: add LIFO Reserve

• Cash: less LR x t

• Retained earnings: add LR x (1 – t)

Income statement:

• COGS and EBIT: less ΔLR

• Tax: add ΔLR x t

• NI: add ΔLR x (1 – t)

Long-lived Assets

Capitalization decision on expenditure:

• Capitalize: –ve CFI, PP&E , future earnings vs

• Expense: –ve CFO, PP&E

Depreciation methods

SL: Dep = (C – SV) ÷ DL ➔ assets/equity/EBIT higher

DDB: Dep = 2 x NBV ÷ UL ➔ assets/eq/EBIT lower

Units of prod, Service hours: similar to SL

Impairment rules

US GAAP: (1) compare NBV to ΣCFs to see if there is

impairment; (2) if impaired, reduce to fair value or

ΣPV CFs

IFRS: write down to recoverable value (if < NBV) =

higher of (i) fair value less selling costs, (2) value in

use (= PV CFs)

Revaluation: IFRS only, via OCI


Estimating asset ages

• Avg age = accum dep dep exp

• Avg remaining life = net PPE dep exp

• Est’d useful life = hist cost dep exp

Intangible assets

General rule: cap & amortize if purchased, expense

if internally created

Goodwill: annual review for impairment

Income Taxes

Source of deferred tax:

• Tax expense > taxes payable ➔ DT liability

• Tax expense < taxes payable ➔ DT asset

• DTL = (EBT – TI) x t

• DTA = (TI – EBT) x t

Change in tax rate

• Re-/devalue DTA/DTL in line with tax rate:

• Tax :

• DTA (➔ equity , tax exp ) or

• DTL (➔ equity , tax exp )

• Tax :

• DTA (➔ equity , tax exp ) or

• DTL (➔ equity , tax exp )

Non-current (Long-term) Liabilities

Accounting for bonds

Initial liability bond price

Interest expense = liability x yield

US GAAP capital lease definition:

Any of: (1) title transfer at end; (2) bargain purchase

option; (3) lease ≥ 75% of useful econ life; (4) PV

MLPs ≥ 90% fair mkt value

IFRS finance lease definition:

Lessors: similar to US except (3) “major part” of

UEL, and (4) “substantially all” FMV

Lessees: most leases are finance

Accounting by lessee

• Operating: I/S & CFO show regular pmt (no B/S)

• Finance: capitalize. Asset depreciates; liab

amortizes; dep’n + int expenses; CFO & CFF

Accounting by lessor

US GAAP

• Sales-type: immediate GP

• Direct financing: no GP but higher int income

IFRS: all leases treated similarly to sales-type

Pension plans

• Defined contribution: simple accounting,

expense and CFO as incurred

• Defined benefit: net funded status (net pension

asset/liab) on sponsor’s B/S

Financial Reporting Quality

Note financial reporting quality vs earnings quality

Quality spectrum

1. GAAP, decision-useful, sustainable, adequate

returns

2. GAAP, decision-useful, but sustainable?

3. Biased accounting choices

4. Within GAAP, but earnings management

5. Non-compliant accounting

6. Fictitious transactions

Corporate Finance

Corp Governance and ESG: An Introduction

Corporate Governance definition: procedures,

controls, and incentives to minimize a range of

conflicts

Stakeholders

• Shareholders

• Creditors/bondholders

• Managers/employees

• Directors

• Customers

• Suppliers

• Government and regulators


Stakeholder conflicts

• Principal-agent

• Controlling vs minority s/hs, inc dual class

• Managers vs board

• Shareholders vs creditors

• Customers vs shareholders

• Customers vs suppliers

• Shareholders vs government/regulator

Stakeholder management: mechanisms

• General meetings

• Board of directors (one- vs two-tier)

• Audit

• Reporting & transparency

• Related-party transactions

• Remuneration policies

• Say on pay

• Creditor contracts

• Employee law/contracts

• Customer & supplier contracts

• Laws & regulations

Capital Budgeting

NPV and IRR: see Quants for basics

Normal CFs: NPV & IRR decisions concur

Multiple/no IRR issues

Other methods

• Payback period: till ΣCF = 0

• Discounted payback: till ΣPV(CF) = 0

• Profitability index = ΣPV(future CFs) ÷ CF0 then

invest if PI > 1 (i.e. NPV > 0)

Cost of Capital

WACC = wd x rd x (1 – t) + wp x rp + we x re

• Cost of debt, rd(1 – t)

• Cost of preferred equity: rp = Dp / P

• Cost of common equity:

• CAPM: re = RF + β(E(Rm) – RF)

• Change leverage: βE = βA x (1 + (1 – t) x D/E)

• DDM: re = D1/P0 + g

• Bond yield: re = bond yield + risk premium

Optimal capital budget

Other concerns

WACC: use target (not current) weights

Country equity risk prem = sov yd spread$ x E/D,$

Break points: where MCC rises

Flotation costs: use either –ve CF0 or an increased re

Measures of Leverage

Business risk: sales vs operating

Financial risk: NI , RoE % EBIT Q(P V) S VC

DOL% Sales Q(P V) F S VC F

− −= = =

− − − − % EPS EBIT Q(P V) F

DFL% EBIT EBIT I Q(P V) F I

− −= = =

− − − − % EPS Q(P V) S VC

DTL DOL DFL% Sales Q(P V) F I S VC F I

− −= = = =

− − − − − − Breakeven quantity QBE = (F + I) ÷ (P – V)

Operating breakeven quantity QOBE = F ÷ (P – V)

Working Capital Management

• Drag vs pull on liquidity

• A/R: create aging schedule

• Inventories: EOQ vs JIT

• A/P: consider discounts, e.g.

1/10, net 30 or 1/10th Prox net 30th

• Cost of short-term financing:

{interest + fees} ÷ loan x 12/#months

Operating vs cash conversion cycle:

Yields on short-term funds

Yield measures (also see Quants):

0

360MM

Dr

P t=

360BD

Dr

F t=

0

365DBEY

P t=

Portfolio Management

Portfolio Management: An Overview

Number 1 rule: diversify ➔ risk reduction

• Steps in portfolio management:

1. Plan (IPS)

2. Execute (asset alloc, analysis, build pf)

3. Feedback (monitor, rebalance, report)


• Institutional investors: DB pensions,

endowments/foundations, banks, insurance

cos, investment cos

Portfolio Risk and Return: Part I

Single stock expected return and variance:

( )1

1 n

tt

E R R Rn =

= = ( )2

2

1

1 n

tt

R Rn

=

= −

Portfolio expected return and two-asset variance:

( ) ( )1

n

p i ii

E R w E R=

=

2 2 2 2 2

,2

p a a b b a b a b a bw w w w = + +

Utility (where A = level of risk aversion):

( ) 21

2U E R A= −

Portfolio Risk and Return: Part II

Adding the risk-free asset

Straight lines CML (M = market portfolio) vs CAL

( )( )

: M F

p F p

M

E R RCML E R R

−= +

( )

( ):

T

T F

p F p

R

E R RCAL E R R

− = +

Slope = Sharpe ratio

Systematic risk: beta

, ,

2

covi M i M i

MM

= =

CAPM: E(Ri) = RF + βi(E(RM) – RF)

Applications of CAPM

Jensen’s alpha: forecast – required return

Sharpe: Treynor: M-squared:

p F

p

R RS

−=

p F

p

R RT

−=

( ) ( )2 Mp F M F

p

M R R R R

= − − −

Basics of Portfolio Planning & Construction

Investment policy statement, IPS

• 2 objectives: risk, return

• 5 constraints: liquidity, time horizon, tax,

legal/regulatory, unique circumstances

Asset allocation: SAA (strategic, long-term) vs TAA

(tactical, short-term deviations)

Risk Management: An Introduction

Definitions

• Risk: exposure to uncertainty

• Risk exposure: extent of risk (e.g. $)

• Risk management: process of defining,

measuring, adjusting risk levels

• Risk tolerance: max loss a firm can tolerate

• Risk budgeting: allocating risk levels to

specified measures (e.g. SD, VaR, beta)

Risk management framework

• Process and infrastructure for RM

• Board: perform risk governance

• Management: define strategies, perform risky

activities, identify risk exposures

• RM infrastructure: identify risks; measure risks;

monitor risks; report; strategic analysis

Financial risks: market, credit, liquidity

Non-financial risks: settlement, legal, compliance,

model, operational, solvency

Modifying risks

• Risk prevention (avoidance)

• Risk acceptance (self-insurance)

• Risk transfer (insurance)

• Risk shifting (derivatives)


Fintech in Investment Management

Big Data

• Structured vs unstructured

• 3 Vs: volume, velocity, variety

Artificial intelligence & machine learning

• ML: training vs validation data

• Supervised vs unsupervised

• Overfitting vs underfitting

Applications

• Text analytics/NLP, robo-advisory services, risk

analysis, algo trading

Distributed ledger technology

Multiple copies, immutable records

Blockchain: hash codes link blocks

Equity Investments

Market Organization and Structure

Market types

1. Quote- (or price- or dealer-) driven: OTC,

dealers use own inventory

2. Order-driven: order book listed by price then

time

3. Brokered: illiquid assets

Trade instructions

• Execution: market, limit, AON, hidden, iceberg

• Validity: Day order, GTC, IOC, good-on-close,

stop loss

• Clearing: specifying broker

Leveraged transactions

• Purchasing asset on margin

• Pay initial margin, and call money rate on rest

• Leverage ratio = 1/IM

• Margin call @ maint mgn: P0 x (1–IM) ÷ (1–MM)

Security Market Indexes

Price return vs total return:

1 0

0

P

V VHPR

V

−= 1 0 1

0

T

V V IncHPR

V

− +=

Market Efficiency

Market efficiency: new info ➔ rapid Δ prices

Efficient market hypothesis: It is impossible to

outperform consistently using … information

Three forms:

1. Weak form: past market data

2. Semi-strong form: also public data

3. Strong form: also private data

EMH anomalies

Time series: calendar, momentum/overreaction

Cross-sectional: size/value effect

Other: closed-end fund discount, earnings surprise,

IPOs

Behavioral finance

Loss aversion, herding, overconfidence,

representativeness, mental accounting,

conservatism, narrow framing

Overview of Equity Securities

Common stock: ownership and votes

Possible features: proxy voting, cumulative voting,

multiple classes, callable/putable

Preferred stock: priority over common stock, fixed

(not guaranteed) dividend

Poss features: cumulative, participating, convertible

Private equity ownership: VC, LBO, PIPE (PFI)

Non-domestic investing: GDR, ADR, GRS, BLDR

Intro to Industry & Company Analysis

Industry classification systems

• Commercial: GICS, RGS, ICB


• Government: ISIC, NACE, ANZSIC, NAICS

Porter’s Five Forces: new entrants, rivalry among

competitors, substitute products, suppliers, buyers

Industry life cycle

Equity Valuation: Concepts and Basic Tools

Shareholder actions

• Cash vs stock dividend

• Stock split (+ reverse)

• Share repurchase

Chronology of div dates: declaration, ex-div, holder-

of-record, payment

Discounted dividend model

General form:

01 (1 )

t

tt

CFV

r

=

=+

Preferred share: V0 = D ÷ r

Holding period DDM:

( ) ( )0

1 1 1

nt n

t nt

D PV

r r=

= ++ +

E.g. for one or two years:

( ) ( )1 1 1 1

0 1 1 11 1

D P D PV

rr r

+= + =

++ +

( ) ( )

1 2 20 21 1

D D PV

r r

+= +

+ +

Gordon growth model (note g b x RoE):

0 10

(1 )D g DV

r g r g

+= =

− −

Temporary supernormal growth:

( ) ( ) ( ) ( )

( )1 2

0 1 2

1... ,

1 1 1 1

nn nnn n

D gD D D VV V

r gr r r r

+= + + + + =

−+ + + +

Market multiples

Methods: comparables vs forecasted fundamentals

0 1 1

1

P D E

E r g=

−

Other multiples: P/CF, P/B, P/S, EV/EBITDA, EV/OI

EV = enterprise value = MVe + MVd – cash

Asset-based valuation: Revalue PP&E, ignore

unstated intangibles

Fixed Income

Fixed-Income Securities: Defining Elements

Bond indenture

• Coupon (e.g. fixed vs floating, annual vs semi-

annual, step-up, credit-linked, PIK, deferred,

zero, index-linked)

• Principal repayment (bullet vs amortizing vs

balloon, sinking fund)

• Also specifies: collateral, credit enhancements

(internal vs external), covenants, options etc

Bond markets: national (domestic vs foreign),

eurobonds, global

Contingency provisions

• Callable: issuer option, usually higher coupon

• Putable: investor option, usually lower yield

• American vs European vs Bermudan style

Convertible bonds

• Conversion ratio: # shares per bond

• Conversion price: par value ÷ CR

• Conversion value: share price x CR

• Conversion premium: bond price – CV

Other contingency prov’ns: warrants, CoCo bonds

FI Markets: Issuance, Trading, and Funding

Bond issuers

• Government, supranational, quasi-gov’t

• Corporate: financial vs non-financial

• Structured finance, inc MBS/ABS

Primary markets

• Private placement: institutions, low liquidity


• Public offering: underwritten offering (see

diagram), best effort offering, shelf

registration, auction (single vs multiple pricing)

Other features

• OTC vs exchange trading

• Settlement T+3 (corp) vs T+1 (govt) vs same

day (MM)

• US Treasury: bills vs notes vs bonds

• Bank loans: bilateral vs syndicated

• CP: discount (U.S.) vs add-on (EuroCP)

• MTNs: used for structured securities

Repurchase agreements: overnight or term repo,

with implied repo rate

Introduction to Fixed-Income Valuation

Basic valuation

• Enter N, I/Y, PMT, FV, cpt PV

• Annual vs semi-annual coupon

• Note yield vs price relationship; pull to par

• Spot/zero rates: use for each CF separately

• Floating-rate notes: set I/Y = Libor + req’d

margin; PMT = Libor + quoted margin

Flat vs full pricing: 4 steps

• Value on previous coupon date

• Full price: compound YTM over fraction of year

• Accrued interest AI = straight line coupon

• Flat price = full price – AI

Yield measures

• Current and simple yields

• Yield to maturity

• Yield-to-first-call, yield-to-worst

• Option-adjusted yield

• True yield, gov’t equiv yield

Spreads: benchmark vs G vs I vs Z vs OAS

Money market instruments

• Discount (e.g. T-bill) vs add-on (e.g. Libor,

CDs), 360 vs 365 days

• BEY = 365-day add-on yield

Spot/Forward rates: Quartic banana method

to convert spots forward rates

Introduction to Asset-Backed Securities

Securitization: converting illiquid financial assets to

tradable securities

Residential mortgage loans

• Fixed rate vs ARM vs hybrid vs convertible

• Foreclosure: recourse vs non-recourse

• Repayments: amortization vs partial amort vs

interest only; prepayment option

Residential MBS issuers

• Agencies (Fannie Mae, Freddie Mac, Ginnie

Mae) vs non-agencies (banks)

• MPS (mortgage pass-through security):

• WAC (gross) vs pass-through rate (net)

• WAM (legal maturity) vs WAL (shorter)

Cash flows = princ repayments, prepmts, interest

Prepayment risk

• Contraction risk: low IR, more prepayments

• Extension risk: high IR, lower prepayments

Prepayment measures

• SMM = prepayment (beginning balance –

scheduled repayments for the month)

• CPR: annual prepayment rate


PSA prepayment benchmark:

Collateralized mortgage obligations (CMOs)

Sequential pay structure: principal to A (high

contraction risk) then B then C (high extension risk)

Planned amortization class: senior (PAC) tranche has

PSA band, e.g. 50 to 150 PSA, gets 2-sided

protection from support tranche

Other securities

• Non-agency RMBS: credit risk ➔ internal credit

enhancements

• Commercial MBS: non-recourse loans, use DSC

and LTV to analyze; often sequential pay

structure; balloon vs call risk

• Non-mortgage ABS: auto loan vs credit card

(non-amortizing) receivables

• CDO: CBO, CLO, structured finance CDO,

synthetic CDO

Understanding Fixed-Income Risk & Return

Total return rules

Assuming reinvestment rate = current YTM:

• If yield n/c, receive YTM, regardless of sale date

• If yield before 1st coupon:

• Receive < YTM0 if holding period < MD

• Receive > YTM0 if holding period > MD

MD: Macaulay duration, wtd avg time till cash paid.

E.g. 3 year annual-pay 4% bond @ 5% YTM:

Modified duration: in price per in yield

ModD = MD ÷ (1 + r) [r = coupon period HPR]

or = (P– – P+) ÷ (2 x P0 x ΔYTM)

Effective duration: (P– – P+) ÷ (2 x P0 x Δcurve)

Other duration factors

• Higher for Long maturity, Low coupon, Low

yield (3 Ls). Call or put reduces duration

• Portfolio: Dpf = Σ(wiDi)

• Money duration = ModD x price

• Then value = –money dur x Δy

• PVBP = value if Δy = 1bp

Convexity: = (P– + P+ – 2P0) ÷ (P0 x Δy2)

• +ve except for callable bond at low yields

• ΔP = [(–ModD x y) + (0.5 x C x y2)]

Fundamentals of Credit Analysis

Expected loss = default risk x loss severity

Seniority ranking

• First lien (secured), Second lien (secured),

Senior unsecured, Senior subordinated,

Subordinated, Junior subordinated – then

preferred and common stock

Credit ratings

Investment/junk cut-off grade: Baa3/Ba1 (Moody),

BBB–/BB+ (S&P, Fitch)

Four Cs of credit analysis

• Capacity, collateral, covenants, character

• Capacity: ratio analysis

• Profitability: EBIT, EBITDA, FFO, FCF

• Leverage: D/Cap, D/EBITDA, FFO/D

• Coverage: EBITDA/int, EBIT/int

Yields and spreads

• T-bond yield = real RF + E(infl’n) + maturity prm

• Yield spread = liquidity prm + credit spread

• Δspread return impact: [(–D x S) + (0.5C x S2)]

Special considerations

• High yield: consider holding company, debt

structure/covenants, fin projections, liquidity

sources

• Sovereign bonds: political/economic risks, local

vs foreign currency credit ratings

• Non-sovereign govt debt: GO vs revenue bonds

Derivatives

Derivative Markets and Instruments: overview

• Exchange traded (futures, some options):

standardized, higher regulations & liquidity, no

default risk


• OTC (forwards, swaps, some options):

customized, default risk

• Contingent claims (options & CDS) vs forward

commitment

Pricing vs valuation: driven by arbitrage

• Pricing = agreed trading price at settlement

• Valuation = amount a party would pay to take

over a contract

Forward contracts

• Long vs short

• Settlement: physical vs cash

• Long benefits if ST > F0(T)

Forward pricing and valuation:

( ) ( )( ) ( )0 0cos 1

T

FF T S ts bens R= + − +

( ) ( ) ( )( )0cos

t tV T S ts bens PV F T= + − −

Expiration: VT(T) = ST – F0(T)

Futures contracts

• Positions marked to market daily

• Most contracts closed out before exp

• Margin arrangements:

• Initial margin at start; maintenance

margin ➔ must top up to IM

• Value = 0 after marking to market

• Futures pricing forwards

• Correlation with IR: +ve ➔ futures > forward

Swaps

• Regular exchange of cash flows

• Plain vanilla: fixed for floating interest

• Payments = net interest x NP x D/360

• Price = fixed rate to make value = 0 at start

Credit default swaps

• “Insurance” on asset’s credit risk

• Pay regular premiums

• Receive payout if credit event happens

• No need to own insured asset

Options

Terminology:

• Long vs short, call vs put, American vs

European, exercise/strike price, ITM, ATM,

OTM, premium, payoff vs profit, breakeven

• Intrinsic value:

• IVC = max(0, St – X)

• IVP = max(0, X – St)

Where:

• Adj IVC = max[0, St – PV(X)]

• Adj IVP = max [0, PV(X) – St]

Put-call parity: fiduciary call = protective put

c0 + PV(X) = St + p0

Put-call forward parity:

( )0

0 0

( )

1T

F

X F Tc p

R

−+ =

+

Binomial tree for assets

“Up probability” Hedge ratio Call value

1F

R d

u d

+ −=

− c c

HS S

+ −

+ −

−=

− ( )1 1

0

1

1F

c cc

R

+ −+ −=

+


Alternative Investments

General characteristics

• Low liquidity, specialist managers, fewer

regulations, less transparency, high fees, low

diversification

• Risk: higher than other assets, but low

correlation. Risk measures: VaR, Sortino ratio,

shortfall risk, stress-testing

• Return: usually higher; must separate into

alpha vs beta

• Survivorship and backfill biases

Hedge funds

• Lighter regulations

• Absolute vs relative objective

• Legal: limited partnership

• LPs = investors; GPs = managers

• Restricted redemptions

• Trading vs reporting NAV

• Fund of funds: lower capital req’t, more

diversified, higher fees

• Strategies: event-driven, relative value, macro,

equity hedge

Fees: management/incentive fees in the form “2 +

20”, often with hurdle rate and high water mark

Private equity

• Legal: limited partnership

• Management fee: on committed cap

• Incentive fee on payout to LPs

• Valuation: comparables, DCF or asset-based

• Exit strategies: trade sale, IPO, recapitalization,

secondary sale, liquidation

Venture capital – stages of investing: formative

stage (angel, seed stage, early stage), later stage,

mezzanine stage

Leveraged buyout – significant debt, management

buyout or buy-in, MBO/MBI

Real estate

• General features: inflation hedge, low

correlation, unique, illiquid, indivisible, high

management costs, often highly geared

• Appraised prices often used

• Risks: economic (IRs, regulations) vs

management; higher risks for property

development

• Categories include commercial, REIT

• RE indexes: appraisal vs repeat sales vs REIT

Valuation methods

• Direct: (1) comparable sales, (2) income (either

NOI ÷ cap rate or DCF), (3) cost

• Indirect, REITs: (1) income-based (P/FFO or

P/AFFO where FFO = NI + dep’n – gains on sale;

AFFO = FFO – capex), (2) asset-based (using

NAV)

Commodities

• Low returns, high , but low correlation

• Most common investment method: derivatives

• Spot market pricing: demand vs supply, can be

volatile short-term

• Futures pricing: spot price x (1 + RF)T +

storage costs – convenience yield

Infrastructure

• Economic vs social

• Direct: buy assets

• Indirect: shares, ETF, funds

• Master LP REIT cash flow

• Brownfield vs greenfield

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