2012 CFA L2 Summary

1
Ethical and Professional

Standards
Study Session 1 2
Weighting 10%
2
Overview 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
3
Overview of the Code and Standards
Code 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: Professionalism
A.Knowledge of the Law
B.Independence and Objectivity
C.Misrepresentation
D.Misconduct
II: Integrity of Capital Markets
A.Material Nonpublic Information
B.Market Manipulation
III: Duties to Clients
A.Loyalty, Prudence, and Care
B.Fair Dealing
C.Suitability
D.Performance Presentation
E.Preservation of Confidentiality
IV: Duties to Employers
A.Loyalty
B.Additional Compensation
Arrangements
C.Responsibilities of Supervisors
V: Investment Analysis,
Recommendations, and
Actions
A. Diligence and Reasonable Basis
B. Communications with Clients and
Prospective Clients
C. Record Retention
VI: Conflicts of Interest
A. Disclosure of Conflicts
B. Priority of Transactions
C. 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
4
Standard 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
5
Standard 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
Guidance
This Standard covers conduct
that may not be illegal, but
could adversely affect a
members ability to perform
duties
6
Standard II: Integrity of
Capital Markets
II(A): Material Nonpublic Information
Members in possession of nonpublic
information that could affect an
investments 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 securitys 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
7
Standard 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 employers or own interests
Determine and comply with any applicable
fiduciary duty
III(B): Fair Dealing
Deal 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 clients 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
8
III(C): Suitability
Know clients 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
9
III(E): Preservation of Confidentiality
Keep 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
10
Standard IV: Duties to
Employers
IV(A): Loyalty
Must act for the benefit of their employer
Guidance
Loyalty Independent practice:
If planning to engage in independent practice, notify employer of services provided,
expected duration, and compensation
Do not proceed without consent from employer
Loyalty 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
11
Standard 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, employers 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
12
Standard 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
13
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 firms property and cannot be
taken when member leaves without firms
consent
If no regulatory requirement, CFA Institute
recommends retention period of 7 years
14
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
Guidance
Disclose 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 employers business
15
Standard 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
16
Standard 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.
Guidance
Conduct 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
17
Standard 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
Guidance
CFA Institute membership:
Complete PCS annually
Pay membership dues annually
Using the CFA designation:
Dont misrepresent or exaggerate the meaning of holding the CFA designation
Reference 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 ability
Improper use of the CFA marks:
The Chartered Financial Analyst and CFA marks must always be used either
after a charterholders name or as adjectives, not as nouns
Failure to comply with results in an inactive
member status
18
Definitions
I. General
III. Selection of
brokers
Soft Dollar Standards
II.Relationship
with clients
VI. Disclosure
IV. Evaluation of
research
CFA Institute Soft Dollar Standards
VII. Record keeping
Appendix: Permissible
research guidance
V. Client-directed
brokerage
General
Principles
19
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
20
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 doesnt 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 clients 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 clients account
Provide total amount of brokerage paid from all accounts (where manager has
discretion)
21
Record keeping
Manager 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 firms 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 analysts involvement with
investment banking or corporate finance activities
Relationships with subject companies
Research 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
27
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
28
28
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
29
29
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
Applications
of 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 Methods
Study Session 3
Weighting 5 10%
32
Study Session 3
Time-Series
Analysis
Multiple
Regression
Correlation and
Linear Regression
Overview of Level II Quant
33
Covariance & Correlation
Covariance
may range from +ve to ve infinity
units are squared hence less meaningful
( )( )
=

=
n
t,1 1 t,2 2
t 1
1,2
R R R R
cov
n 1
Correlation
standardised measure of relationship
bounded by -1 and +1
the closer to absolute 1, the stronger the
relationship
o o
=
1,2
1,2
1 2
Cov
r
Significance of correlation coefficient
H
0
: = 0 H
a
: 0
Two-tailed test
Degrees 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 correlation
2
r n 2
t =
1 r
34
Linear Regression
x
x
x
x
x
x
x
x
x
x x
x
x
x
x
x
x
x
x
Y, dependent
variable
X
i
c
i
error term
or residual
i i
X b b Y
1 0

+ =
X, independent
variable
Y
i
i
Y
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 c
i
values = 0
Standard deviation of c
i
=
standard error of the
estimate (SEE)
Least squares regression finds the straight
line that minimises the SEE by minimising:
SSE) errors, squared the of sum (
2
i
=
35
Significance of coefficients
Hypothesis Tests on a Regression Coefficient
To test statistical significance:
H
0
: b
i
= 0 H
a
: b
i
0
Other tests are possible, for example:
H
0
: b
i
1 H
a
: b
i
< 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
i i
i
s
b b
t , statistic Test
=
i i
b
of error standard s : Where =

( )
i i
s value t critical b

1 1 0 i
X
+ =
Confidence interval for the
prediction of Y
n 2 degrees of freedom
( )
f
s value - t critical Y
+ + =
2
2
2 2
) 1 (
)
( 1
1
x
f
s n
X X
n
SEE s
36
i 1 0 i
X b
+ =
( ) SSE Y
- Y
2
i i
( ) SSR Y - Y
2
i
( ) SST Y - Y
2
i
i
Y
0
b
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
R
2
= explained variation in y
total variation in y
R
2
is the proportion of the total
variation in y that is explained
by the variation in xs
R
2
= r
2
for linear regression
Interpretation
When correlation is strong (weak, i.e. near to zero)
R
2
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/k
Error
(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)
SST
RSS
=
( ) ( )
MSE
1 k n
SSE
1 k n
SEE
n
1 i
i
=
+
=
+
=
=
ANOVA, SEE and R-squared
38
General form of model:
Predicting the dependent variable
i k k 2 2 1 1 0 i
X b .... X b X b b Y c + + + + + =
Independent
variables
Dependent
variable
Partial slope coefficients Y-intercept
Error term,
residual
s t variable independen the of values assumed the are X
..... , X
, X
b .... , b , b parameters regression for the estimates are b
...., , b
, b
: where
k 2 1
k 1 0 k 1 0
k k 2 2 1 1 0 i
X
.... X
+ + + + =
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 b
i
= 0. (seen earlier)
Degrees of freedom = n (k + 1)
Determining the collective significance
of the independent variables
Perform an F-test:
H
0
: None of the independent variables
significantly explain the dependent variable.
b
1
= b
2
= b
3
= = b
k
= 0
H
a
: At least one of the independent
variables significantly explains the
dependent variable. At least one b
i
0
Reject H
0
if computed F > F-critical
Test statistic:
i
i i
i
s
b b
t , statistic Test
=
i i
b
of error standard s : Where =

( )) 1 k - (n
errors squared of Sum
k
squares of sum Regression
F
+
=
table) ANOVA from (data
MSE
MSR
error squared Mean
squares of sum regression Mean
=
=
Looking up the critical F-
value
Use table corresponding to the
significance level of test (o) i.e.
(one-tailed!!!!)
Numerator dof = k
Denominator dof = n (k + 1)
Significance of coefficients
40
Other Issues in Multiple Regression
Adjusted R
2
As you incorporate more variables R
2
can
only go up, even if some of the new
variables are statistically insignificant
Hence in multiple regression we use
adjusted R
2
. 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 - k n
1 n
R 1 1 R
2 2
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 H
0
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 analysis
1. 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 assumptions
1. 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 residuals
2
against the independent variables, then test the
significance of the resulting R
2
using a one-
tailed chi-square test. A significant value is
evidence of heteroskedasticity.
Heteroskedasticity
43
Serial 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.
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
4 d
L
d
U
4-d
L
4-d
U
Evidence of
positive
autocorrelation
Evidence of
negative
autocorrelation
No evidence of
autocorrelation T
e
s
t

i
s

a
m
b
i
g
u
o
u
s
T
e
s
t

i
s

a
m
b
i
g
u
o
u
s
44
Multicollinearity
Description
Two or more independent variables are
mutually correlated, making the
interpretation of the regression output
problematic.
Correction
Remove 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
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
45
Model 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 Models
Variable 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) models
Used when variance of the error term
is dependent on the size of earlier
errors
Types of Time-Series Models
47
Trend Models
Linear trend model
Value of time series in period t,
y
t
= b
0
+ b
1
t + c
t
Average change in y is
constant in absolute terms = b
1
Log-linear trend model
The natural log of the value of time series in
period t,
ln(y
t
) = b
0
+ b
1
t + c
t
Exponential trend: average rate of change in y
is constant = e
b
1
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)
Covariance
stationarity
E.g. AR(p):
x
t
= b
0
+ b
1
x
t-1
+ b
2
x
t-2
+
+ b
p
x
t-p
+ e
t
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 reversion
Time 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 differencing
might help a time
series achieve
covariance
stationarity
( )
1
0
b 1
b
: AR(1) For
Autoregressive Models
49
Chain rule of forecasting
Inputs used in multi-period
forecasts are themselves
forecasts
x
t
= b
0
+ b
1
x
t-1
+ b
2
x
t-2
+
+ b
p
x
t-p
+
t
Random walks
Value in one period is equal to the
value in previous period plus a random
error:
x
t
= b
0
+ x
t-1
+
t
If b
0
0 then random walk with drift
This is an AR(1) model
with b
1
= 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 x
t-4
for quarterly
data, and x
t-12
for monthly data
No finite
mean-
reverting level
not
covariance
stationary
Autoregressive Models cont.
50
Q
th
order moving average model, MA(q)
x
t
= c
t
+ u
1
c
t-1
+ u
2
c
t-2
+
+ u
q
c
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 models
Combines 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:
(u
t
is an error term)
If a
1
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:
t
u a a + + =
2
1 - t 1 0
2
t
c c
ARCH Models
2
t 1 0
2
1 t
c o a a + =
+
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 x
t
= b
0
+ b
1
x
t-1
+ c
t
Subtracting x
t-1
from both sides produces:
x
t
- x
t-1
= b
0
+ (b
1
1)x
t-1
+ c
t
or x
t
- x
t-1
= b
0
+ g
1
x
t-1
+ c
t
where g
1
= (b
1
1)
If there is a unit root in the AR(1) model, then g
1
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: H
0
: g
1
= 0, time series has a unit root and is nonstationary
H
a
: g
1
0, time series does not have a unit root
Test is conducted by calculating a t-statistic for g
1
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 root
Can 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
S
t
a
r
t
Time Series - Summary
55
Economics
Study Session 4
Weighting 5 10%
56
Study Session 4
Economic Growth
Regulation and Antitrust Policy
In a Globalized Economy
Trading with the World Currency Exchange Rates
Foreign Exchange Parity Relations
Measuring Economic
Activity
Overview of Level II Economics
57
Economic 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 countrys economic activity will double every (70/growth rate) years
58
Economic Growth
PRECONDITIONS 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
59
Regulation and Antitrust Policy
Government
regulation
Social regulation
Economic
regulation
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
60
Trading 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
61
Currency 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 GBP
1
.
5
6
0
0

U
S
D
/
G
B
P
2.3182 CHF/GBP
1
.
4
8
6
0

C
H
F
/
U
S
D
USD GBP CHF USD or
USD CHF GBP USD
/$ x CHF/ x $/ or
CHF/$ x /CHF x $/
:$ base $ quoted
/$ $ base quoted
62
Bid and Ask
$
BID
means
turning
into $
ASK
means
turning
$ into
CHF GBP
1
.
3
5
0
0

U
S
D
/
G
B
P
Ask rate = ?.???? CHF/GBP
1
.
5
0
0
0

C
H
F
/
U
S
D
1
.
5
0
1
0

C
H
F
/
U
S
D
Bid Rate = ?.???? CHF/GBP
1
.
3
5
1
0

U
S
D
/
G
B
P
63
Currency Exchange Rates
Bid Ask Spread
Factors affecting spread:
Volume
Volatility
Dealers long/short position
Term (forward contracts
only)
1. Choose a direction and formulate equations:
/$ x CHF/ x $/CHF
2. Check examiner has given the quotes for the
right base and quoted combinations.
If not you will need to take reciprocals noting
that the bid and ask swap when you do
3. Using the bids move round the triangle selling
the base and buying the quoted currency
4. Did you get > 1? If not take the reciprocal of
the ask quotes to move the opposite direction.
USD
CHF GBP
/$ 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
Spot
x
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.
67
International Fisher Effect
Spot
Forward
Interest
Rate
Parity
Purchasing
Power
Parity
The forward rate is the best unbiased predictor of the future spot rate
U
n
c
o
v
e
r
e
d

I
n
t
e
r
e
s
t
R
a
t
e

P
a
r
i
t
y
B
Q
INT 1
INT 1
+
+
0
t
Spot
Future Spot
) REAL 1 )( INF 1 (
) REAL 1 )( INF 1 (
B
Q
+ +
+ +
68
Purchasing Power Parity Interest Rate Parity (covered)
Parity Relationships
International Fisher Effect
Exact Methodology:
1+r = (1+real r)(1+E(i))
Linear Approximation:
r = real r + E(i)
Where:
r = nominal interest rate
real r = real interest rate
E(i) = expected inflation
Uncovered Interest Rate
Parity
Foreign Exchange
Expectation Relation
E(S) = F
E(%S) = F - S
o
S
o
E(S
T
) = So x
(1+I
quoted
)
T
(1+I
base
)
T
Fwd = So x
(1+R
quoted
)
(1+R
base
)
E(S
T
) = So x
(1+R
quoted
)
(1+R
base
)
69
Measures 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 inputs
GDP
Output
Consumption
+ Investment
Total domestic expenditure
+ Exports of goods and services
Total final expenditure
- Imports of goods and services
GDP
Expenditure
Wages and salaries
+ Self-employment income
+ Company trading profits
+ Government and
enterprise
trading surpluses
+ Rental income
GDP
Income
GDP
+ net property
income from
abroad
GNI
- Depreciation
NNI
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%
71
Overview 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
72
Inventories
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 methods
Perpetual vs. Periodic
Systems
Perpetual: 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 h
(1-t).
LIFO reserve
Under LIFO, inv. purchased
last is treated as if its sold
first.
LIFO liquidation occurs
when a company appears
to sell the inventory it
purchased first.
LIFO liquidation
Under 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
73
Long-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 firms 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
74
Leases
transfer title
bargain purchase option
75% of the assets 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
75
Intercorporate Investments
shares are a genuine small
investment for
dividend/capital gains
purposes
<20% votes
shares are to ensure a
significant influence is
exerted over the other
company (but NOT
outright control)
Affiliate/Associate
Equity Account
20 50% votes
shares 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 maturity
Securities are
carried at
amortized cost
May be sold to satisfy company
needs
Debt or equity
Current or non-current
Carried in the balance sheet at
market value
Income statement same as cost
method
Acquired for the purpose of
selling in the near term
Carried in the balance sheet
as current assets at market
value
Income statement includes
dividends, realised &
unrealised gains/losses
B/S Historic Cost
I/S Dividends/Int
76
Equity Accounting
Equity Accounting: Significant Influence
One line consolidation
Initially recorded at purchase price (cost)
Subsequent periods:
B/S: Cost + earnings pickup dividends
A B/S = %Share x A Retained earnings
I/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)
Upstream
Profits recognized in
investee I/S
Unconfirmed profits
eliminate pro-rata share
Downstream
Profits recognized in
investor I/S
Unconfirmed profits
eliminate pro-rata share
Fiscal years beginning post Nov 2007 IFRS 159
Can elect to hold investment at fair value with
changes in fair value taken to the I/S
Convergence with IAS 28/39
77
Joint Ventures
Joint 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
78
Consolidation (Purchase Method)
Steps
1. Record any finance raised in parent
companys balance sheet
2. Record investment in subsidiary in
parents 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
companys 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
79
Goodwill
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) h(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
80
Business Combinations
Purchase Method Pooling of Interests Method
US: no longer permitted (since 2001)
IAS: no longer permitted (since 2003)
US: required under SFAS 141
IAS: required under IFRS 3
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
81
Impact on Accounts
Cost 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 Ratio
Consolidated > Proportionate > Equity
Assuming investee ratio > parents
Leverage
Net Profit Margin
Equity > Proportionate > Consolidated
Gross Margin
Assuming investee ratio > parents
Return on Assets ROA
Equity > Proportionate > Consolidated
Impact on Accounts
Purchase vs. Pooling
Assets
Purchase > Pooling
Equity
Purchase > Pooling
Assuming purchase is funded by
issuing equity
Net Income
Purchase < Pooling
Profit Margins
Purchase < Pooling
ROA and ROE
Purchase < Pooling
83
Impairment of goodwill
Identification:
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 Project
FMV adjustments for 100% of net assets not
just purchased element
Minority interest calculated using FMV
In-process R&D capitalized
Contingent consideration recognized at
acquisition date
Minority interests in equity
Remaining Differences:
US GAAP full goodwill
IFRS full or partial goodwill
84
Special Purpose Entities
A 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 46R
1. Equity interest less than
10% of total assets
2. Equity investor lacks:
Decision making ability
Obligation to absorb
losses
Right to receive
residual returns
A VIE must be consolidated in a
companys accounts if the
company is the primary beneficiary
(Previously only if controlled via
voting rights)
Variable Interests:
Guarantees of debt
Subordinated debt instruments
Lease residual interest guarantees
Participation rights
Asset 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
85
Pension Plans
Employee directs
investment policy
Employer will appoint
an investment manager
Asset
manageme
nt
Employee owns
assets, employer
acts as agent
Employer owns assets
Asset
ownership
Employee carries
the risk
Employer carries the
risk
Risk
Defined
Contribution
Defined 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 & IAS19
Post 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 basis
ABO = Accumulated Benefit
Obligation
VBO = Vested Benefit
Obligation
86
Pensions
Service cost
Interest cost
Actuarial gains or losses
Prior service cost
Benefits paid
ENDING PBO
-/+
-/+
+
+
=
BEGINNING PBO
X
-
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)
87
Pensions
Actual Events
Service Cost
Interest Cost
Smoothed Events (SFAS 87)
Expected Return on Plan Assets
Amortisation of gains/losses
Amortisation of prior service costs
Amortisation of transition asset or
liability
+
+
-
+/-
+/-
+/-
Reported Pension Cost
X
Other Events
Curtailment/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
+/-
+/-
+/-
+/-
+/-
88
Actuarial Assumptions
Lower Lower Lower
Pension
Expense
No change No change Lower ABO
No change Lower Lower PBO
Higher Expected Return
on Assets
Lower wage
rate
increases
Higher discount
rate
Actuarial
Assumptions
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 assumptions
Amortised if net gain or loss > 10% of
opening PBO or Market related plan
assets value
Delayed Events
89
Post 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 status
Adjust deferred tax asset
Adjust 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 assets
Alternatively = funded status + employer contribution
Improvement in funded position reduced economic expense
Worsening of funded position increases economic expense
Required for both SFAS 87 and 158
Analyzing Pension Disclosures
Balance Sheet:
Replace accounting asset/liability with funded status take any change to equity
NB 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
91
Employee 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
92
Stock Compensation Plans
Stock Options
Prior to June 2005
Account APB 25
Footnote Disclosure SFAS 123
Post June 2005
Account SFAS 123
APB 25 Intrinsic value at grant date
SFAS 123 Fair value at grant date
(similar to IFRS 2)
Disclosure
Nature and extent of arrangement
Method of determining fair value
Impact on periods income
Fair value
Market premium of similar option or
valuation model:
BSM
Binomial
Monte Carlo
Stock Purchase Plans
Enable employees to purchase stock at a
discount to market value
Recognize expense over life of option if
compensatory (5% rule)
Service Based Awards
Compensation linked to length of service
Recognize expense over vesting period
Performance Based Awards
Non price related and price related
Recognize over estimated time to meet criteria
Can lead to accounting manipulation
All models require 6 inputs:
1. Exercise price
2. Stock price at grant date
3. Volatility
4. Risk free rate
5. Expected term (time to expiry)
6. Dividends
93
Foreign Currency Translation
Functional currency Reporting currency Local currency
The 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 translation
aka Remeasurement
Current Rate method of translation
aka 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
94
Temporal/Remeasurement
Liabilities (current)
Common Stock (historic)
Retained earnings ()
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 ()
Dividends
Closing Retained earnings
X
X
(X)
X
SFAS 52 Hyperinflation = use Temporal
IAS 21 Hyperinflation = use indexing
Monetary assets/liabilities = current rates
(cash, AR, AP, STD,LTD)
Non monetary assets/liabilities = historic
rates
95
Current/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
96
Impact on Ratios
Translation/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!
97
IAS & Transaction Risk
IAS 21 Similar to SFAS 52
Exceptions
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
98
The Lessons & Derivatives
The lessons we learn
1. Read all info including MDA and Footnotes
2. Be sceptical persistently higher than average growth rates
3. Understand what you are looking at: pro-forma information
4. 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
99
Financial Reporting Quality
Accrual 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 FMV
8. Stock Options
9. Provisions
100
Financial Reporting Quality
Manipulation 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 Scrutiny
Earnings:
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
NOA
t
NOA
t-1
= -
Aggregate
Accruals
NI (CFO
t
+ CFI
t
) = -
B/S based aggregate accruals
Cash flow based aggregate accruals
101
Earnings Management
Revenue Recognition Problems:
Range of problems:
Recognition of sale before completion of
earnings process
Recognition of sale without assurance of
receipt
Estimates:
Credit sales
Deferred/Unearned revenue
Warranty provisions
Sales returns
Warning Signs:
Large AR
Large Unearned Revenue
Lower future cash-flows and accounting
rates of return
Accelerating Revenue Recognition
Range of problems:
Recognition of sale before completion of
earnings process (assessing the
completion date)
Lowering credit standards
Cut off issues (moving sales between periods)
Warning signs:
Bundled products
Management vested options ITM
Pressure to meet earnings forecasts
Raising additional finance
Large AR
Large Unearned Revenue
Disproportionate revenue in last
Recognizing revenue to early:
Bill-and-hold sales
Lessor use of sales type vs.. direct financing leases
Recording sales prior to acceptance by customer (sales of equipment prior to installation)
Incorrectly using % completion method for long term contracts
102
Earnings Management
Classification of non operating
earnings as operating:
Range of problems:
1.Investment income
2.Divestiture of non current assets
NB. No accrual or deferral reversal in
later periods
Warning signs:
Temporary inconsistency of items
included within definition of operating
income
Expense Recognition:
Range of problems:
Discretion over depreciation and amortization
Impairment recognition
Application of lower of cost and fair value
rules
Warning signs:
of methods or lives depreciation
(disclosed in footnotes)
Conference calls additional information
LIFO liquidations
Inventory obsolescence
Deferring Expenses:
Range of problems:
Capitalization of operating expenses
Warning signs:
Net non current assets (B/S broad
measure accruals)
Consider asset growth in the context of
expected sales and margin growth
Software development costs - discretion
Classification of operating expenses
as non operating
Range of problems:
Incorrect classification reduces COGS
or SG&A
Warning signs:
Companys with genuine special items
that can be piggy backed
Changes in operating profit margin or
gross margin accompanied by spikes in
special items
103
Earnings Management
Big Bath Provisions
Range of problems:
1. Impairments future I/S
improvements via depreciation
2. Restructuring or impairment charges
reversed in subsequent periods
3. Use of high or low bad debt reserves
out of line with peers
Off Balance Sheet Items
Range of problems:
1.Assets and liabilities avoiding
recognition:
Operating leases
Sale of AR with recourse
Take or pay/through put
agreements
Equity 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 problems
FMV adjustments on acquisition
Future impairments
Warning signs:
Goodwill reported and not impaired for
companies where market cap < book value
IASB & FASB move to fair value accounting
Issues:
Some assets have readily identified fair values
e.g. listed equity
Some assets dont have readily identified fair
values (assets with no actively traded
secondary markets)
e.g. unlisted equity
e.g. specialized equipment
Valuation models = discretionary inputs
104
Modifying 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 Income
Net Income
Pension adjustments
Unrealised gains and losses on
available for sale securities
Cumulative foreign currency
translation adjustments
Comprehensive Income
$
X
X
X
X
X
U
S

G
A
A
P
COGS LIFO FIFO
Capitalization of operating leases
Reversal of deferred tax assets/liabilities
Mark to market LTD
Adjustments (not required by US GAAP)
Capitalized interest reversal
Off Balance sheet items
Funded status of pension plan
105
Adjust COGs to LIFO
Litigation or govt 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 Firms
Remove the impact for
valuation:
1. Averages over the
business cycle
2. Average ratios applies
to current sales or
equity
3. Regression model
approach
International
comparisons
LIFO prohibitions
Extraordinary items
Capitalized R&D
Accelerate Dep
n
Asset revaluation
Acquisition a/c
106
Corporate Finance
Study Sessions 8 9
Weighting 5% 15%
107
Overview 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
108
Capital 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 companys
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
109
Expansion 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 projects
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 )
K
project required return
= K
RF
+ (K
mkt
K
RF
)
project
K
project 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.
111
Economic versus accounting income
Economic income = cash flow + change in market value
NB: Change in MV = Ending MV Beginning MV
or
Economic 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: RI
t
= NI
t
r
e
B
t-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
112
Capital 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
( )
e d a
r
V
E
t 1 r
V
D
r
|
.
|
\
|
+
|
.
|
\
|
=
( ) t 1
E
D
r r r r
d a a e
|
.
|
\
|
+ = ) (
MM Proposition without taxes
Proposition I: Capital structure
decision does not affect the
companys 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 firms debt to
equity ratio
Without taxes, WACC is
Cost of equity is
As D/E increases, cost of equity
would increase
e d a
r
V
E
r
V
D
r
|
.
|
\
|
+
|
.
|
\
|
=
|
.
|
\
|
+ =
E
D
r r r r
d a a e
) (
D/E
C
o
s
t

o
f

c
a
p
i
t
a
l
r
d
WACC
r
e
MM no tax
D/E
C
o
s
t

o
f

c
a
p
i
t
a
l
r
d
WACC
r
e
MM with taxes
113
Debt 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
bankruptcy
Higher 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 positive
signal
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.
114
Static 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
V
ungeared
V
Leveraged
Max firm value
M
V

o
f

f
i
r
m
Debt ratio
Optimal Debt ratio
PV tax
shields
Cost of financial
distress
C
o
s
t

o
f

c
a
p
i
t
a
l
Optimal D/E ratio
D/E ratio
r
d
WACC
r
e
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%
115
Debt 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 Valuation
Analyst 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
Macroeconomic
Factors
Inflation
GDP growth
Debt Rating Agencies
Cost of capital tied to debt ratings
Goals for achieving certain ratings may
effect capital structure
116
Dividends 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
firms 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
117
Pay a
specific % of
total
earnings
over long-
term
Focus on
steady $
payout
even though
earnings
may be
volatile
In 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 use
BUT
Investors
may prefer
stable
dividends
Target
payout ratio
Dividend
stability
Longer-term
residual
dividend
Residual
Dividend
Dividend using the target payout approach:
| | | |
| | | |
| |

| |
| |
\ . \ .
\ . \ .
expected target
previous adjustment
expected dividend = + increase payout
dividend factor
in EPS ratio
118
Investors will prefer
NOT to receive
dividends due to their
higher tax rates.
Low dividend payout
policy will be rewarded.
Evidence shows K
s
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 theory The bird-in-the-hand theory Dividend 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 initiation
Based on dividend preference theory
Dividend initiation
Lower risk
Lower cost of equity
Higher PE ratio
119
Corporate 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 companys 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
120
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
Corporations Partnership Sole Proprietorship
Managers and shareholders
Management 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 shareholders
Directors 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
121
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
122
Board Of Directors
The 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 managements 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
Managements 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 profitability
Higher returns for shareholders
Weak/ineffective governance system:
Increased risk to investors
Reduced value
Extreme cases: bankruptcy
123
Mergers 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
124
Industry 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 industrys 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
125
Mergers transaction characteristics
Comparing Forms of Acquisition
Friendly merger offers
Acquirer approaches management
Negotiations and due diligence
Definitive merger agreement
Public announcement and
shareholders vote
Attitude of target management
Usually avoids
assuming
Acquirer
assumes
Liabilities
None S/H pay CG S/H taxes
Target pays CG None Corporate taxes
None for small Shareholders Approval
To target To shareholder Payment
Asset
Purchase
Stock Purchase
Hostile merger offers
Acquirer submits proposal to board of directors
Successful Unsuccessful
Tender offer Proxy battle
Offer made to shareholders Proxy solicitation
126
Takeover defense & HHI
Pre-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
more
High > 1800
Possible
100 or
more
Moderate
Between 1000
& 1800
No action
Any
amount
Not concentrated < 1000
Antitrust
Action
Change
in HHI
Industry
Concentration
Post merger
HHI
Herfindahl-
Hirschman Index
Key measure of
market power for
determining anti-trust
violations
n
2
i
i=1
HHI = (MS ? 100)
127
Valuing 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
128
Valuing 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 customize
Disadvantages
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
129
Evaluating a merger bid
Post-merger value of an acquirer: V
AT
= V
A
+ V
T
+ S C
Gains accrued to the target: Gain
T
= TP = P
T
V
T
Gains accrued to the acquirer: Gain
A
= S TP = S (P
T
V
T
)
Adjustment for stock payment: P
T
= (N hP
AT
)
where: N = number of new shares target receives
P
AT
= price per share after merger announced
Effect of Payment
Cash 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 loses
Stock 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
130
Mergers benefits & restructuring
Distribution of merger benefits
Short-term effect on stock price
Targets gain approximately 30%
Acquirers 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
managements 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%
132
Equity 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 1962
Value should be independent of price
Financial statement analysis, earnings
power, growth prospects
Relative valuation methods
Blocking and tackling
A Note on Asset Valuation
John 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 Techniques
Fixed 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 multiplier
Residual 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 assets
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 business
2. Forecast business
performance
3. Select the relevant
valuation model(s)
4. Convert forecasts to a
valuation
5. 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 managements discretion in
choices of accounting methods and estimates
Analysts ability to accurately forecast result
derived from quality inputs
Greater transparency in earnings results in
higher stock pricemanagements ultimate goal
Accounting Shenanigans
Accelerating 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 Valuation
Fits 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 analysts 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 analysts 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 analysts ownership
perspective (i.e. extent of the investors influence over the company).
Valuation Process
Ownership Perspective
Marketable publicly traded minority interestDDM approach is the benchmark value
Premiums for controlFCFE 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
Reqd Return=(factor sensitivity)
i
*(factor risk premium)
i
+ . + (factor sensitivity)
n
*(factor
risk premium)
n
CAPM:
( ) ( )
f m f
r r E r E(r) + =
equity risk premium
138
Return Concepts
Fama French Model
Reqd return on stock j = R
f
+ b
mkt
,*(R
mkt
R
f
) + b
SMB,j
*(R
SMALL
-R
BIG
) + b
HML,j
*(R
HBM
-R
LBM
)
R
mkt
R
f
= return on a value weighted market index minus risk free rate
R
SMALL
-R
BIG
=small cap return premium
R
HBM
-R
LBM
=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.
139
Return Concepts
Build-Up Method
Reqd return =R
f
+ Equity risk premium + size premiuim + specific company premium
Bond Yield Plus Risk Premium
Reqd return =YTM on long term debt + risk premium
Country Spread Model and Country Risk Rating Model
Calculates the premium to be added to the reqd return when investing in emerging mkts
140
Return Concepts
Estimating 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)]
141
Return Concepts
Estimating Equity Risk Premium using..
Historical estimates
Strengths:
Objective. Simple, unbiased if investors rational
Weaknesses:
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)
142
Return Concepts
Estimating Equity Risk Premium using..
Forward looking / Ex Ante estimates
Strengths:
Doesnt depend on assumption of stationarity
3 Types..
Gordons Growth Model
Strengths
Assumptions 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 Estimates
Strengths:
Uses proven models
and current information
Weaknesses:
Only appropriate for
developed countries
Survey Estimates
Strengths:
Uses expert opinions
and more likely to be
reliable
Weaknesses
There maybe large
differences of opinion
143
Porters 5 forces
Top-down forecasting
1. 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 companys relative competitive
position within its industry?
What is the companys competitive strategy?
3.
2.
1.
FIRM
RIVALRY
SUPPLIERS BUYERS
SUBSTITUTES
Bargaining
power
Threat of substitute
products or services
Threat of
new entrants Bargaining
power
POTENTIAL ENTRANTS
Industry and Company Analysis
144
Risks of each generic strategy
Cost Leadership
New entrant enters market with lower cost base and/or technological breakthrough
reduces rivals production cost
Differentiator
Consumers cease to value differentiating factor and/or rival company does it better
Niche
Interest in niche from big players and/or smaller players target sub-sectors of niche
Cost
Leadership
Differentiation
Narrow Target
Broad Target
Focus
Competitive
Advantage
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 phases
Pioneer - 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 industrys 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
S
a
l
e
s
Time
Growth Maturity Decline Pioneer
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 analysis
An analyst is in a position to assess
future demand for the industrys output
by developing
A macroeconomic forecast
An industry classification
An external factor review
Two additional sources of information
A study of the firms customers
A study of the industrys inputs and
outputs
Factors influencing pricing practices and hence profitability
Product segmentation - Firms 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
return of rate required r
t time at flow cash expected CF
0) (t today asset the of value V
where
t
0
=
=
= =
( )
=
+
=
1 t
t
t
0
r 1
CF
V
Consider using dividends for CF when:
there is a dividend record to analyze;
the dividend policy established by the board
bears an understandable and consistent
relationship to the companys profitability;
the investor takes a non-control perspective.
DCF
149
Generic DDM
equity on return required r
t time at dividend expected D
0) (t today share the of value V
where
t
0
=
=
= =
( )
=
+
=
1 t
t
t
0
r 1
D
V
No growth model
r
E) (or D
V
0
=
Holding period of n years
Single Holding Period
( )
1
1 1
0
r 1
P D
V
+
+
=
t time at price share P
where
t
=
Expected HPR
0
1 0 1
P
D P P
r
+
=
( ) ( ) ( )
n
n n
2
2
1
1
0
r 1
P D
...
r 1
D
r 1
D
V
+
+
+ +
+
+
+
=
Present value of growth opportunities = market value of share - no growth value per
share
Gordon growth model
( )
g r
D
g r
g 1 D
V
1 0
0
+
=
Two-stage DDM
( ) ( )
n
n
n
1 t
t
t
0
r 1
V
r 1
D
V
+
+
+
=
=
H-model
H = half the number of years for
anticipated decline in growth
( ) ( )
L
L S 0
L
L 0
g r
g g H D
g r
g 1 D
+
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 methods
Limitations:
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 firms high growth rate will
suddenly drop to a lower level overnight is
highly unrealistic.
Improvement built into H-model
Over 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 approach
Used when even the three-stage DVM is too simple for a real-life application
DCF Commentary
151
Multi-stage models
Strengths:
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 software
Limitations:
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
firms leverage is unchanged and no new equity
finance is raised.
Estimating return on equity (ROE)
Equity
Assets
x
Assets
Sales
x
Sales
EBIT
EBIT
EBT
EBT
Income Net
Equity
Income Net
ROE
=
=
Further Aspects
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
f non-cash items in income
statement
- investment in working capital
- investment in fixed assets
+ net increase in debt
or
= CFO*
+ 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
f non-cash items in income statement
+ interest expense x (1 tax rate)
- investment in working capital
or
= CFO
+ interest expense x (1 tax rate)
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
( )
=
+
=
1 t
t
t
r 1
FCFE
value Equity
( )
=
+
=
1 t
t
t
WACC 1
FCFF
value Firm
Equity
Debt
capital. the
providing is whom of regardless
operations s firm' the of value
total the represents This value".
enterprise " as to referred Often
Constant growth
models:
( ) ( )
g WACC
g 1 FCFF
value Firm
g r
g 1 FCFE
value Equity
0 0
+
=
+
=
Generic 2-stage
model:
( ) ( )
n
1 n
n
1 t
t
t
0
r 1
1
g r
FCF
r 1
FCF
V
+
+
+
=
+
=
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
firms capacity to pay dividends i.e.
dividends imperfectly signal the
firms long-run profitability.
Free cash flows appear to be better
aligned with profitability over the
analysts 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 proxies
Both 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 stocks market price to some measure of value per share.
Method of comparables involves comparing a stocks 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
g r
b 1
g r
E
D
E
P
P/E Leading
1
1
1
0
= =
( )( )
g r
g 1 b 1
g r
E
g) (1 D
E
P
P/E Trailing
1
1
0
0
+
=
+
= =
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
firms risk level decreases causing the
required return to decrease
interest rates decrease causing the
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 stocks 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:
Fundamental P/B
g r
g ROE
B
P
0
0
=
P/B multiple increases if:
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:
payout rate increases, but .
profit margin increases
( )( )
g r
g 1 b 1
S
E
S
P
0
0
0
0
+
|
.
|
\
|
=
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 operations
FCFE = free cash flow to equity
CF = earnings plus non fcash
charges or income
EBITDA = earnings before interest, tax,
depreciation and amortization
measure flow cash Chosen
model FCFE from equity of Value
CF
P
0
0
=
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 model
Value = annualized dividend / dividend yield
Enterprise Value/EBITDA
EV = MV of all equity and debt less cash
& liquid investments = NPV of firms
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 positive
Drawback of using EV/EBITDA:
EBITDA ignores required capital and
working capital investments
price Market
quarters four next over dividends Forecasted
D/P Leading
price Market
4 dividend quaterly recent Most
D/P Trailing
=
=
Other Models
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:
V
0
= value of share today
B
0
= current per-share BV of equity
B
t
= expected per-share BV at time t
r = required rate of return on equity
E
t
= expected EPS for period t
RI
t
= expected per-share RI
( )
( )
=
+
+ =
+
+ =
1 t
t
1 t t
0
1 t
t
t
0 0
r 1
rB E
B
r 1
RI
B V
Relationship with other models
RI, DDM and FCF models = DCF models but
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/B
Assuming 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
0 0 0
B
g r
r ROE
B V
+ =
g r
r ROE
1
g r
g ROE
B
P
0
0
+ =
=
( )
( ) ( )( )
1 T
1 T T
1 T
1 t
t
1 t t
0 0
r 1 r 1
rB E
r 1
rB E
B V
+ +
+
+
+ =
e
Terminal value of RI
Residual Income Models
164
Implied Growth Rate
Can 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 Persistence
Factors 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 doesnt dominate
estimate
Uses available accounting data
Useful even if firm doesnt 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
companys expected FCFs are negative within the analysts 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 measures
RI (see earlier slide)
EVA = NOPAT (WACC x IC)
MVA = Market value of firm IC
Accounting vs Economic Profitability
Economic 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
167
Private 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 Firms 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 Investments
Study Sessions 13
Weighting 5 15%
169
SS13 Overview
Alternative Asset
Valuation
Private Equity
Investment
Analysis
Income Property Hedge Funds
170
Real Estate Investments
Type Main Value
Determinants
Investment
Characteristics
Principal Risks Likely Investor
Raw Land Supply/demand
Location
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
171
Real Estate Investments cont.
Type Main Value
Determinants
Investment
Characteristics
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 Estate
Generally use NPV or IRR analysis
CFAT = cash flow after taxes
ERAT = equity revision after tax
EI = initial equity investment
Steps in Calculating CFAT
Step 1: Compute taxes payable
Taxes payable = (NOI depreciation
interest) htax rate
Step 2: Compute cash flows after tax (CFAT)
CFAT = NOI debt service taxes
payable
Step 3: Compute equity reversion after taxes
ERAT = 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, dont invest in the
property as it destroys value
Valuing Real Estate
EI
IRR
ERAT
IRR
CFAT
IRR
CFAT
NPV
n n
n
+
+
+
+ +
+
=
) 1 ( ) 1 (
...
) 1 (
1
1
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 Rate
Market 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 1
0
0
0
NOI NOI
MV
r g R
Where R = market capitalization rate
= =
0
NOI
R (ME) =
MV
0
R (BOI) = (mtg weight mtg cost)
+ (equity weight equity cost)
0
R (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 Creation
Reengineer firm
Obtain lower cost
financing
Goal alignment
Exit Routes
IPO
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 Equity
Risks
Liquidity
Competition
Agency
Capital
Regulatory
Tax
Valuation
Diversification
Market
Structure and Terms
Structure LP
Terms
Management fees
Carried interest
Ratchet
Hurdle Rate
Target fund size
Vintage
Valuation
Due Diligence
Costs
Transaction Placement fee
Fund set up Performance fee
Administrative Management fee
Audit
175
Private Equity
Control Mechanisms in PE
Transactions
Compensation & 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 IRRs
Calculating the exit value
Calculating the claimants 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
176
Private Equity
Performance 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 LPs unrealized return
Total value to PIC measures LPs
realized and unrealized return, sum of
DPI, and RVPI
Valuation
Issue
Buyout Venture
Capital
Use of
DCF
Frequently
used
Uncertain
cash flow
Relative
Value
Validates
DCF
No comps
Use of
Debt
High Low, more
equity
Key
return
drivers
EPS
growth,
P/E
expansion,
debt
reduction
Pre-money
valuation,
future
dilution
Other Valuation
VC Single / Multiple financing rounds
LBO - Target IRR
- Cash flow
177
Private Equity
For 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
S
pe
= S
e
[f/(1-f)]
Step 5: Price per share
P = INV/ S
pe
For Multiple Financing Rounds
Step 1: the compound discount rate
Step 2: Post-Money Valuation (round 2)
POST
2
= FV/ (1+ r
2
)
Step 3: Pre-Money Valuation (round 2)
PRE
2
= POST
2
INV
2
Step 4: Post-Money Valuation (round 1)
POST
1
= PRE
2
/ (1+ r
1
)
Step 5: Pre-Money Valuation (round 1)
PRE
1
= POST
1
INV
1
Step 6: Ownership Fraction (round 2)
f
2
= INV
2
/ POST
2
Step 7: Ownership Fraction (round 1)
f
1
= INV
1
/ POST
1
Step 8: No. of the shares to be held by the PE
firm
Spe1 = S
e
[f
1
/(1- f
1
)]
Step 9: Price per share after financing (round 1)
P
1
= INV
1
/ S
pe1
Step 10&11: Price per share after financing
(round 2)
S
pe2
= (S
e
+ S
pe1
) [f
2
/(1- f
2
)]
P
2
= INV
2
/ S
pe2
178
Private Equity
IRR Method
Ownership Fraction
Step 1: Investors expected future wealth W =
INV h(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 S
pe
= S
e
[f/(1-f)]
Step 4: Price per share P = INV/ S
pe
Post-Money & Pre-Money Valuation
Step 5: Post-Money valuation
POST = INV/f or POST = P
h(S
pe
+ S
e
)
Step 6: Pre-Money valuation
PRE = POST - INV or PRE = P
hS
e
Adjusting the Discount Rate
r* = [(1+r)/(1-q)] 1
r* = discount rate adjusted for probability
of failure
r = discount rate unadjusted for
probability of failure
q = probability of failure in a year
Target IRR Method
Target IRR must meet or exceed:
The cost of the LBO debt financing
The cost of equity capital for a similar unlevered
firm
The return that the fund managers market to
client investors
Equity Cash Flow Method
Discount the future value of equity back to the
present using an expected return on equity for
each period that reflects the then capital
structure
The beta for equity that accounts for the financial
leverage:
N
terminal equity value
PVof equityinvestment =
(1+target IRR)
Asset
Equity
E
D E
=
+
Equity Equity Market
( ) [ ( ) ]
f f
E 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
distributedSharpe ratio or other classical
ratios may be useless
Hedge Funds
Performance 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 Investments
Study Sessions 14 & 15
Weighting 5 15%
182
Overview 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
183
Credit 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
184
Credit Analysis S&P Framework
Net income
+ Depreciation
+/ Other noncash items
Funds from operations
Increase in NWC
Operating cash flow
Capital expenditures
Free operating cash flow
Cash dividends
Discretionary cash flow
Acquisitions
+Asset disposals
+Other sources (uses)
Prefinancing cash flow
Cash flow ratios
Coverage ratios
Total debt
Capex
Free operating CF + interest
Interest
Debt service coverage
Free operating CF + interest
Annual interest + principal
Debt payback period
Total debt
Discretionary CF
185
Term 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 strips
Alternative: 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
186
Volatility 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
( )
( ) | |
t day on yield the y
y y ln 100 X
Where
1 T
X X
Variance
t
1 t t t
T
1 t
2
t
=
=
=
T
1 t
2
t
1 T
X
iance var
Best estimate
of average X
is zero.
Hence:
Maturity
Spot
rate
key rate
Effective Portfolio Duration =
Sum of Key Rate Duration
187
Bonds with Embedded Options
Binomial Model
( )
o
=
2
L , 1 U , 1
e i i
Callable: call price is
effective cap at each node
Putable: put price is
effective floor at each node
Backward induction
1. Populate interest rate
tree with rates
2. Discount from end
3. At each node take
average price,
consider call/put and
add cash flow
Spread measures
Nominal spread
= YTM
corp
YTM
Treas
(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 0
2
0
BV BV
ED
2 BV y
BV BV 2 BV
EC
2 BV y
A +A
A +A
=
A
+
=
A
188
Relative Value Analysis
Overvalued Overvalued Overvalued
Actual
OAS < 0
Fairly priced Overvalued Overvalued
Actual
OAS = 0
Undervalued
Undervalued if
actual OAS >
required OAS*
Undervalued if actual
OAS > required OAS*
Actual
OAS > 0
Issuer
Benchmark
Sector Benchmark
Treasury
Benchmark
*Relative to same benchmark
189
Convertible Bonds
( )( )
1 Premium . 7
interest
. 6
Premium 5.
. 4
. 3
. 2
. 1
=
=
=
=
=
=
=
value straight
bond of price Market
value straight over
ratio conversion
share per dividends ratio conversion coupon
share per al differenti income Favourable
share per difference income favourable
share per premium conversion market
period payback
stock common of price market
share per premium conversion market
ratio premium conversion Market
price market price conversion premium conversion Market
ratio conversion CB of price market price conversion Market
ratio conversion stock the of price market value Conversion
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)
190
Mortgage-Backed Securities
US Mortgage market key
features
Home loans in the form of
fixed-rate level-payment fully
amortized mortgages
Mortgage Passthrough Securities
Only one class of bond investor
Cash flows: net interest, principal
payments, curtailments
Mostly 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
191
Prepayment Rates
PSA Benchmark
Assumes the monthly
prepayment rate
increases as it seasons
CPR
Conditional
prepayment rate
(CPR) is the expected
annual prepayment
rate.
Can be converted to
SMM (single-monthly
mortality rate):
( )
12 / 1
CPR 1 1 SMM =
Contraction Risk: IR | hence prepayments | hence expected life |
Extension Risk: IR | hence prepayments | hence expected life |
Factors affecting
prepayment behaviour
1.Prevailing mortgage rates
2.Housing turnover
3.Characteristics of the
underlying mortgage loans
Annual
CPR
Age in
months
30
100 PSA
50 PSA
125 PSA
6%
3%
7.5%
192
Mortgage Paythrough Securities
Several classes of investors
Collateralized Mortgage Obligations
Securities issued against passthrough securities
for which the cash flows have been reallocated
to different bond classes known as tranches
Planned
Amortization Class
Tranches
Amortized based on
a sinking fund
schedule established
within a range of
prepayment speeds
Support tranche
absorbs any excess
Stripped MBS
Principal and interest
payments are paid to different
security holders:
Interest Only (IO) Strips
Positively 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
rates
Prices rise as
IR |
Sequential Pay
Tranches
Each class of
bond retired
sequentially
Tranche A Most
Contraction Risk
Tranche Z Most
Extension Risk
193
Commercial 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 Risk
Risk of default at end of loan,
when most of repayment is due
194
Asset-Backed Securities
ABS: 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 funds
2. Overcollateralization
3. Senior/subordinated structure
External credit enhancements:
1. Corporate guarantee by seller
2. Bank letter of credit
3. Bond insurance
195
Types 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
196
ABSs: Other issues
Collateralized Debt
Obligations
CDO = ABS
backed by
pool of bonds,
loans, MBSs
or ABSs
Arbitrage
transaction
(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)
197
Valuing MBS/ABS
Techniques for valuing MBSs and ABSs
Cash flow yield analysis
Discount 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 ) i 1 [( x 2 BEY
6
M
+ =
Spread measures
Nominal spread: hides
prepayment risk
Z-spread: same
problem, but considers
y.c. shape
OAS: best measure
Monte Carlo and spreads
The rates in the Monte Carlo model can be tweaked
so that models 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. binomial
Monte 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.
198
Duration Measures MBS/ABS
MBS Duration Measures
Effective Duration
From Monte Carlo
model. Shock yield by
+/-Ay, reapply the model
then plug results into
duration formula.
Cash Flow Duration
Estimate CF and hence CF
yield, shock yield by +/-Ay,
re-estimate CFs and hence
new prices, then plug results
into duration formula.
Coupon Curve
Duration
Calculate duration by
changing coupon
instead of yield.
Empirical Duration
Use linear regression
to identify how price
changes with yields.
0
2
P P
Duration
P y
+
=
A
199
Derivative Investments
Study Sessions 16 & 17
Weighting 5 -15%
200
Overview 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
201
Forward 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 risk
Party with the
positive value
faces credit risk
in that amount
202
Forward 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. 47
FRA, use fwd rate from
time 4 to 7
FRA
Currency
Forwards
Equity Index
Forwards
(S
o
- PVD) x (1+R
f
)
T
Equity
Forwards
VALUE (to the long at time t)
= (spot price PV benefits)
PV of forward price
FORWARD PRICE
= spot price
+ net costs of carry
TYPE
( )
( )
|
|
.
|
\
|
+

t T
f
t
R 1
FP
PVD S
( )T R
0
e S
( ) ( )
|
.
|
\
|
|
.
|
\
|
t T R t T
t
e
FP
e
S
T
base f,
T
quoted f,
0
) R (1
) R (1
S
+
+
( ) ( )
|
|
.
|
\
|
+
|
|
.
|
\
|
+
t - T
quoted
t - T
base
t
) R (1
F
) R (1
S
203
Futures Contracts
Like forwards, but standardised, exchange
traded and subject to margining
Basis = spot price futures price
Contango = negative basis. Most likely
scenario.
Backwardation = positive basis. It will
occur if benefits holding assets large
enough
Convergence As maturity approaches,
basis converges to zero (due to arbitrage)
|
|
.
|
\
|
|
|
.
|
\
|
=
market to mark last of
time at futures of price
price futures
current
contract futures
of 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
204
Futures pricing
Futures arbitrage
Futures price (like forward) determined by arbitrage
If futures trades above theoretical FP then:
Cash and carry arbitrage
Buy cash asset with borrowed money and sell future
If 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 = S
0
(1 + R
f
)
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
205
Pricing Financial Futures
FP = [(S
o
x (1+R
f
)
T
) FV(Coupons)]/CF
S
0
,CF = Price, Conversion Factor of CTD bond
(Cheapest To Deliver bond gives highest implied
repo rate)
T-Bond
Exactly the same as for forwards Equity & Currency
Price Type 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
206
Options basics (refresher)
call payoff = max(0, S
T
X)
call profit = max(0, S
T
X) C
0
put payoff = max(0, X S
T
)
put profit = max(0, X S
T
) P
0
Long Long Short 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
207
Options Jargon (refresher)
Call Put
In the money S X = +ve; S X = ve
Out of the money S X = ve; S X = +ve
At 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
208
Caps, 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
209
Put-call parity
Synthetics
c
0
= p
0
+ S
0
- X/(1+r)
T
(synthetic call = long put + long underlying + short bond)
p
0
= c
0
- S
0
+ X/(1+r)
T
(synthetic put = long call + short underlying + long bond)
S
0
= c
0
- p
0
+ X/(1+r)
T
(synthetic underlying = long call + short put + long bond)
X/(1+r)
T
= p
0
- c
0
+ S
0
(synthetic bond = long put + short call + long underlying)
Arbitrage If Put-call parity doesnt hold then any of
the equations below tells you how to get a profit
e.g. if c
0
> p
0
+ S
0
- X/(1+r)
T
then sell call and buy
synthetic call (buy put & U/L & sell bond [=borrow])
for options on futures:
c
0
+ [X - f
0
(T)]/(1+r)
T
= p
0
Cost of fiduciary call (long call + Zero Coupon Bond): c
0
+ X/(1+r)
T
must equal cost of protective put (long put + stock): p
0
+ S
0
210
Option 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. Binomial
e.g. Black-Scholes-Merton
limit of discrete time model as
period length 0
211
Binomial option pricing
Symbols
S = stock price at start of period
S+ = upper potential end-of-period stock price = S u
S- = 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) =
+
+
S S
c c
Option value for no arbitrage, call price at start of a
period:
where:
r 1
)c (1 c
c
+
+
=
+
d u
d r 1
+
=
Valuing American
options
At each point, substitute
intrinsic value if larger than
roll-back value
Given call value can
estimate put from put-call
parity
212
2-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 =
$100
Call = ?
Stock = $125
Stock = $80
e
it
h
e
r
o
r
Stock = $156.25
Call = $58.75
Stock = $100
Call = $2.50
e
it
h
e
r
o
r
Stock = $64
Call = $0
e
it
h
e
r
o
r
A
B
C
213
2-period Binomial example (2)
At all three points (because r, u, and d are the
same each period): 6 . 0
8 . 0 25 . 1
8 . 0 07 . 0 1
d u
d r 1
=
+
=
+
=
Point B (i.e. at end of first period, assuming stock price rose):
| | | |
$33.88
1.07
$2.5 ) 6 . 0 (1 75 . 58 $ 0.6
r 1
)c (1 c
c
B
=
+
=
+
+
=
+
Point C (i.e. at end of first period, assuming stock price fell):
| | | |
$1.40
1.07
$0 ) 6 . 0 (1 5 . 2 $ 0.6
r 1
)c (1 c
c
C
=
+
=
+
+
=
+
Point A (now, using c
B
as c
+
and c
C
as c
-
):
| | | |
$19.52 =
+
=
+
+
=
1.07
$1.40 ) 6 . 0 (1 88 . 33 $ 6 0.
r 1
)c (1 c
c
C B
A
214
Valuing 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
( )
o
=
2
L , 1 U , 1
e i i
215
Black-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(d Xe ) N(d S c
2
T r
1 0
c
=
( ) ( ) ( )
T
T /2 r ln
d
2 c
X
S
1
0
+ +
=
T d d
1 2
=
As per binomial, given call value can
estimate put from put-call parity
216
Extensions of BSM
) N(d Xe ) N(d e S c
2
T r
1
T
0
c

=
BSM Model with dividends
( )
( ) ( ) ( )
T
T /2 r ln
d
2 c
X
e S
1
T -
0
+ +
=
| | ) XN(d ) (T)N(d f e c
2 1 0
T r
c
=
Blacks model (options on futures)

( ) ( )
T
T /2 ln
d
2
X
(T) f
1
0
+
=
Application to interest rate options
replace f
0
(T) with forward interest rate
from the date of expiration of option to
end of period of underlying interest rate
in the option
T d d
1 2
=
217
The Greeks
Positive Positive Vega Volatility
Interest rate
Passage of time
Underlying price
Factor
Negative Positive Rho
Negative Negative Theta
Negative Positive Delta
Relationship between change in
factor and change in premium
Put Call
Factor sensitivity
price asset
ue option val
A
A
expiry to time
ue option val
A
A
rate interest
ue option val
y volatilit price
ue option val
A
A
price asset
Delta
A
A
= Gamma
Estimating volatility:
Historical (std. devn. of past log returns)
Implied (by pricing model & current premium)
218
Delta hedging
0
2
4
6
8
10
12
14
16
1
2
1
4
1
6
1
8
2
0
2
2
2
4
2
6
2
8
3
0
3
2
3
4
3
6
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
Intrinsic value Total value delta (right axis)
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
45
0
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 of number
219
Swaps 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
Swaptions
Payer Swaption
An option to enter into a pay fixed swap
As interest rates increase, the option
becomes more valuable
Receiver Swaption
An option to enter into a receive fixed swap.
As interest rates decrease, the option
becomes more valuable
220
Pricing 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 i for DF
flow last for DF - 1
F
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
221
Swaption
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)
222
Interest 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
223
Credit 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 Management
Study 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
226
Mean and standard deviation
2 , 1 2 1
2
2
2
2
2
1
2
1
2
: assets 2 for e.g.
Cov w w w w
port
+ + = o o o
Cov
i,j
=
E[(R
i
-E(R
i
))(R
j
-E(R
j
))]
Variance
(for standard
deviation take
square root)
Expected
return
For a portfolio For an individual investment
j i for
1 1 1
2 2 2
=
= = =

+ =
n
i
n
i
n
j
ij j i i i
port Cov w w w o o
|
|
.
|
\
|
=
return potential
y probabilit
) (R E ) ( ) (
1
i
n
i
i port
R E w R E
=
=
|
|
.
|
\
|
|
|
.
|
\
|
=
2
2
) (R E
return
potential
prob o
j i
ij
Cov
r
o o
=
ij
n, Correlatio
If estimating an
investments 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
227
Mean Variance Analysis
.
.
.
A
B
C
.
D
o
E(R)
.
.
.
A
B
C
.
D
o
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 return
Construction:
1. Estimation: Forecast expected return, E(R), and variance,
2
, for each individual asset
2. Optimization: Solve for weights that minimize the portfolio
2
given target return and portfolio
weights that sum to one
3. Calculation: Calculate E(R) and
2
for all the minimum variance portfolios from Step 2
228
Correlation and Diversification
Lower 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-weighted
portfolio:
2 2
P i
1 n 1
= + Cov
n n
229
Adding in a risk-free asset
Combinations of a risk portfolio
and a risk-free asset will lie on a
straight line:
Standard deviation
E
x
p
e
c
t
e
d

R
e
t
u
r
n
.
.
P
R
F
Lending at R
F
Borrowing
at R
F
.
.
P
R
F
.
M
C
M
L
E(R)
o
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
230
CML vs. CAL
Security Market Line CML
Risk measure Systematic Total
Application Required return for
securities
Asset allocation for R
f
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 assumes
heterogeneous expectations
CAL Equation
C o
o
+ =
M
F M
F C
R - ) E(R
R ) E(R C o
o
+ =
T
F T
F C
R - ) E(R
R ) E(R
231
Total Risk
Market
Risk
Total Risk = Unsystematic Risk + Systematic Risk
Unsystematic Risk
Systematic Risk
Number of Stocks in the Portfolio
Systematic vs. Unsystematic Risk
232
Using the SML
.
R
F
.
M
R
M
i
E(R
i
)
M
=1
S
M
L
.
R
F
.
M
R
M
i
E(R
i
)
M
=1
S
M
L
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(R
i
) = RF +
i
(E(R
M
)- R
F
)
= Expected Return Required Return
233
CAPM in The Real World
Two key assumptions
1. Investors can borrow/lend at risk-free rate
2. 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
234
The Market Model
LOS 71.a: discuss how the Index Model simplifies CAPM
Regression of an assets returns against an observable indexs returns:
Expected return:
Variance:
Covariance:
E(Ri) =oi +iE(RM)
Ri = oi +iRM +ci
oi
2
= i
2
oM
2
+ oc
2
Cov ij = ijoM
2
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,t1
, where
0
+
1
= 1
Most 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
235
Active Risk and Return
Active return is the difference
between the portfolio return (P) and its
benchmark (B): R
P
R
B
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 Ratio
Active return per unit of active risk
Measures managers consistency in
generating active returns
P B
P B
(r r )
IR=
s(r r )
236
Multifactor models/APT
E(R
i
) = R
f
+ b
1
1
+ b
2
2
+ b
3
3
+ .+ b
k
k
APT (Arbitrage Pricing Theory)
b
k
= sensitivity of the actual return from security i to
changes in an index representing risk factor k
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)
237
International Asset Pricing
Real Exchange Rate Risk
The possibility of exchange rate changes that are not explained
by inflation differentials
Real exchange rate = spot rate x
foreign price level
domestic price level
(dc/fc)
%A real spot = %A nominal spot rate (inflation
Q
inflation
B
)
(dc/fc)
238
ICAPM
Form of ICAPM:
E(R) = R
f
+ b
G
MRP
G
+
1
FCRP
1
+
k
FCRP
k
where
E( R) = expected return required on investment x
R
f
= risk free rate in investors home country (domestic)
b
G
= the world beta of stock x (sensitivity to changes in global portfolio value)
MRP
G
= the world risk premium
k
= sensitivity of stock* x to changes in real exchange levels
FCRP
k
= foreign currency risk premium
Foreign Currency Risk Premium
OR
Domestic Currency Sensitivity
Exporter
LC
< 0
Importer
LC
> 0
= domestic currency sensitivity
LC
= local currency sensitivity
=
LC
+ 1
*in domestic currency returns
( ) base quoted r - r
S
S - ) E(S
= FCRP
0
0 1
FCRP =
E(S1) - F
S0
239
Equity & Bond Exposures
Currency Exposures of National Economies
Equity Markets Bond Markets
Increased long-run
economic activity
Currency
depreciation
Higher equity
prices
causes
causes Negative
currency
exposure
Traditional Model
Increased long-run
economic
activity
Currency
appreciation
Higher equity
prices
causes
causes
Positive
currency
exposure
Money Demand Model
Increase in real
interest rates
Currency
appreciation
Lower bond
prices
causes
causes
Negative
currency
exposure
Free Markets Theory
Government to
decrease real
rates
Currency
appreciation
Higher bond
prices
causes
causes
Positive
currency
exposure
Government Intervention Theory
240
Active 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 securitys weights (+ or -) in the
active portfolio
n
A i i
i=1
= w
n
2 2 2
A 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
j
i
i
2 2
j=1
i j
w =
() ( )
n
A i i
i=1
= w
241
Active Management
Treynor-Black Model (contd):
The expected return and the standard deviation of the Active portfolio (A):
E(R
A
) =
A
+
A
{E(R
M
) R
F
}
Combine the active portfolio and M to create the optimal portfolio which will maximize
the Sharpes 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 2
A A M A
= + ( )
242
The portfolio management process
Steps:
1. Planning
Specify investors 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
allocation
3. 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 ethical
conduct (managers are in
a position of trust)

2012 CFA L2 Summary

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

2012 CFA L2 Summary

Uploaded by

Copyright:

Available Formats

1

Ethical and Professional

of error standard s : Where =

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

of error standard s : Where =

Blacks model (options on futures)

Active management and market equilibrium:

You might also like